The banking crisis in Cyprus came as a sharp reminder to savers around the world that banks are not necessarily the safe havens they like to imagine. The plan to impose a 6.75 percent tax on savings up to €100,000 (NZ$153,000) and a 9.9 percent tax on savings above that was proposed by the Cyprus government as a way of raising the €5.8 billion they needed to find to qualify for a €10 billion International Monetary Fund bailout.
However, politicians swiftly backed away from their plan to tax savings once they saw the depth of public fury.
Under the deal finally agreed with the IMF, Cyprus’s second largest bank, the Laiki, will be closed. The Laiki Bank is 84 percent owned by the Cypriot government following a €1.8 billion bailout last year, with the balance held by private and institutional investors, including bank staff. All deposits of up to €100,000 will be transferred to the country’s biggest bank, the Bank of Cyprus, while €4.2 billion worth of deposits over €100,000 will be placed in a “bad bank” along with shareholder and bondholder funds, and will probably all be wiped out.1
The Bank of Cyprus will also undergo a massive restructuring to return it to a healthy state. Thousands of staff will lose their jobs. Shareholders and bondholders are likely to lose their investments and all depositors with funds of over €100,000 are expected to face losses of around 30 percent.
Overseas divisions of these banks are said to have some protection – those that are incorporated in other countries are effectively separate entities and as subsidiaries operate under a different set of rules. Even those that are run as “branches” appear to have some measure of autonomy.
The biggest losers from the Cyprus banking crisis are undoubtedly Russian nationals. They are estimated to own over €20 billion of the €68 billion deposited in Cypriot banks, with many holding deposits of over €100,000. But with Cyprus having been widely recognised as an offshore finance centre and tax haven, the cost of having to rebuild their economy from the ruins of their banking system, will fall heavily on all citizens. The economy has effectively been crushed with debt levels already standing at 143 percent of GDP. Once capital controls are lifted, more money will flee the system and the economy will continue to spiral down.
The Cyprus crisis has served to focus world attention on banking systems and governments. Most people still regard banks as large safe deposit boxes, with little concern for the security of their funds. However, the reality is that bank deposits are risk investments – investors lend their saving to banks, who lend them on to those with inadequate savings.
But what the Cyprus government has also revealed is that when pressured by the terms of a bailout, cash strapped governments are not above dipping into the savings accounts of citizens for the purpose of gathering taxes. This incident is a sharp reminder – and a warning – of the extraordinary power of governments.
In Cyprus – and all European Union countries – bank deposits of up to €100,000 are safeguarded by a retail deposit scheme, which protects small depositors in the event of a banking collapse. That’s why savings of up to €100,000 have been exempted from the bank restructuring changes that were announced in Cyprus. Such schemes however, cannot protect depositors from government taxation; as Cypriots demonstrated, only strong public opposition can do that!
So what are the lessons for New Zealand from the banking crisis in Cyprus?
First and foremost the events in Cyprus have highlighted the importance of having a strong economy and a strong banking sector. While we could always wish for more rapid economic growth, on a global scale New Zealand is not doing too badly, and our banking sector is amongst the most highly rated in the world.
Secondly, it demonstrates the importance of having provisions in place to enable a country to cope with a banking crisis as swiftly as possible and in a way that minimises collateral damage.
Fortunately the Reserve Bank has been working on just such a scheme – Open Bank Resolution – which is almost ready for implementation. I asked Dr Don Brash, the former Governor of the Reserve Bank and this week’s NZCPR Guest Commentator, if he could provide some background information for readers. In his article Open Bank Resolution – better than bank closure or government bailout, Dr Brash explains:
“The reality is that while no bank is too big to fail, some banks are too big to close. Why? It’s not just that very large banks hold a huge portfolio of loans which keep the economy ticking over, and a huge volume of deposits, but mainly that all banks are closely linked through the electronic payments system. Pull one of the major components of that payments system out and the whole system stops. The damage which would be done to the whole economy would be absolutely massive.”
Dr Brash continues, “For more for than a decade the Reserve Bank has been working on how a distressed bank could be failed without being closed. As I understand current thinking, if a systemically important bank were to get into serious trouble, its shareholders would lose all their money, its board and senior management would get fired, and bank creditors (including depositors) would have a small proportion of the money owed to them by the bank frozen – but with the bank continuing to operate under statutory management.” You can read Dr Brash’s full explanation HERE; more details can be found on the Reserve Bank website HERE.
While any freeze on savings would be undesirable, it is important to look at the options. If a failing bank was allowed to close, depositors would almost certainly lose most of their savings – not to mention the huge damage a bank failure would inflict on the economy. Freezing savings – with a view to eventually repaying the deposits in full – is therefore seen as the lesser of two evils.
Other options, of course, involve government bailouts – but the cost can be crippling. Ireland’s government debt was only 25 percent of GDP before the Global Financial Crisis. It is now over 100 percent, largely as a result of bank bailouts. Deposit Insurance Schemes, of the sort that protected Cypriot depositors with savings of up to €100,000, are another variation, but New Zealanders have already had first hand experience of the problems associated with such schemes.
The Labour Government introduced a Retail Deposit Guarantee Scheme as a temporary measure on October 12th2008 during the dying days of their administration. Since Australia had just introduced deposit guarantees, it was seen as a necessary step to maintain depositor confidence in New Zealand’s financial institutions during the worst of the Global Financial Crisis. A Wholesale Guarantee Facility was introduced a few weeks later on November 1st to ensure banks had access to international funding markets. While the wholesale guarantee facility was closed down in April 2010, having issued 24 guarantee certificates covering $10.3 billion – and netting the government $290 million in fees – the retail deposit guarantee scheme was extended until December 2011.
According to the Auditor General, a total of ninety-six institutions were accepted into the Scheme – 60 non-bank deposit takers such as finance companies and credit unions, 12 banks, and 24 collective investment schemes. No banks accepted into the Scheme failed, and there was no run on the money in banks. No building societies or credit unions accepted into the Scheme failed.2
However, of the 30 finance companies accepted into the Scheme, nine failed, triggering taxpayer bail-outs. Some $2 billion was paid out to more than 42,000 depositors – the lion’s share being to investors in South Canterbury Finance, which had 35,000 investors and debts of $1.6 billion.
When issuing its Regulatory Impact Statement in September 2009 on extending the retail deposit guarantee scheme, Treasury noted that the scheme was having a perverse effect on institutional behaviour, creating distortions in financial and capital markets. These included “encouraging guaranteed depositors and deposit taking institutions to make riskier investment decisions since the gains from these riskier decisions will be accrued by the depositors and deposit taking institutions, while potential losses to depositors (of up to $1 million per depositor per institution) will be borne by the taxpayer”.3
Treasury goes on to define this as a “moral hazard” problem, and explains that as a result of the guarantee, “finance companies (which tend to be involved in higher-risk and higher-return lending) have grown their deposit books by approximately $880 million (19%) since the guarantee was introduced in October 2008. Before the guarantee, the deposit books of many finance companies were shrinking. In some cases, finance companies have used retail funding to replace their bank funding lines.”
The major failure was undoubtedly South Canterbury Finance (SCF), a finance company that grew far too quickly, and invested far too much of its funds in the risky property development sector. With the company reputed to have been in trouble as early as mid 2008, there are legitimate questions as to not only how it was able to gain approval for acceptance into the scheme in the first place, but also why it was able to enter the extended scheme on 1st January 2010.
In an article in the Herald in September 2010, investment analyst Brian Gaynor outlined how, instead of using the Deposit Insurance Scheme in a prudent way to consolidate and reduce its exposure to risk, SCF took advantage of the scheme and the government guarantees to expand its speculative activities. It increased borrowings between 2008 and 2009 by $418 million to a record $2.1 billion, and increased its loans by $308 million to a record $1.7 billion. Meanwhile cash reserves, which stood at $322 million in December 2008, had plunged to $22 million by December 2009. Most investors wanted to pull out their investments before the end of the government guarantee period, with a massive 99.2 percent of the total borrowings worth $1.877 billion due to be repaid over the following 12 month period.4
In effect, New Zealand’s experience of retail deposit guarantee schemes gave new meaning to the expression ‘privatising profits and socialising losses’. Courtesy of taxpayers, investors in failing finance companies not only got their money back if the institution defaulted, but they also received the full interest due to them – even though they were being paid higher interest rates than normal to cover the higher risk they took when investing in finance companies rather than banks. Taxpayers were forced to bear the full costs of bad management practices by these companies.
In light of this experience, when deciding how to best prepare for a bank failure, the Reserve Bank explained that “The New Zealand Government has looked hard at deposit insurance schemes and concluded that they blunt the incentives for investors and banks to properly manage risks, and may even increase the chance of bank failure.”5 The open bank resolution plan has been designed to avoid such pitfalls.
- Economist, A better deal but still painful ↩
- Auditor General, Treasury: Implementing & managing Crown Retail Deposit Guarantee Scheme ↩
- Treasury, Regulatory Impact Statement – extending the retail deposit guarantee scheme ↩
- Brian Gaynor, South Canterbury and inevitable train wreck ↩
- Reserve Bank, Open Bank Resolution ↩