Surprised by Cyprus? You shouldn’t be25th March 2013

If we are ever to understand opportunity and risk, we need to think for ourselves, and think well outside of the box. Or perhaps in Cyprus’ case the holiday suitcase. The mainstream does none of this, stuck in silo thinking all of its own making, so no wonder they get surprised by events.

If one can ever take satisfaction from a disaster, I was quietly pleased to have blogged on 20th February “the next default … Cyprus … a bail-in of bank depositors … queues forming outside the doors … and panic.” So, a month before the reality broke, a month before the mainstream, you read all about it here at FYI Business Economics. (Click here for the original article “The Europe of Broken Dreams, Part 5: Default”)

The problem with the mainstream …

With a few honourable exceptions, following mainstream media and Economists for real analysis, interpretation and understanding is a forlorn hope. They tend to FOLLOW the event, quoting established thinking, whereas as individuals and businesses we need to sharpen up and learn to LEAD, planning ahead, exploring a wide range of opinions and options, testing their validity and acting accordingly.

This blog is neither a news source nor psychic service, and never will be. But the mainstream, seemingly comprised primarily of neo- and new-Keynsians, commits to justifying, defending and prolonging our current monetary systems, however damaging the costs to society may be.

Outside of the box is a much better place to be, and makes you far more alive to the new paradigms that are busy toppling the traditional order of things.

A quick reminder of how we got to Cyprus …

Remember Not the Nine O’Clock News? There was a great sketch, where Rowan Atkinson visits the bank to withdraw his deposit, only to be told that the shoebox where the bank kept his money had been stolen. But banks don’t work this way.

Put simply, banks retain sufficient cash, and access to cash and transferrable funds, to meet the likely needs of their depositors. The rest they lend out to generate a profit. As they lend more, they create new deposits, and so can start to expand exponentially. Their constraints are capital (their shareholders’ “skin in the game”, measured in relation to their total lending), and liquidity (their ability to continue to fund their lending in the short-term and to repay depositors in the event of a “run”), and those pesky regulators.

In previous blogs we have seen how central banks, regulators and international agreements apply risk-weighting to lending, so that some lending (for instance to governments) is deemed “risk free”, requiring very little capital to be held against it, whereas mortgages with a high loan to house value ratio are treated as riskier, and require far more capital to be held to protect against default.

The historic links between Greece and Cyprus, and the regulatory encouragement that all European Government lending was a similar risk, combined with a failure of business risk management, created an incentive to invest in Greek Government debt, and this is precisely what the Cyprus banks did. (This merry-go-round is covered in more depth here). But then along came the Greek bail-out, where Greek debt was defaulted on, and suddenly these Cyprus banks had a huge bad debt forced upon them, creating a gaping hole in their balance sheets. Their losses on lending to individuals and businesses have fared even worse. So even if all their lending was recouped the following day, there would not be enough to repay all their depositors. They had become insolvent.

An insolvent bank either needs to close, or raise new capital, or seek liquidity support from a central bank. The idea is that the central bank can pump in enough money for long enough to ensure that depositors get their money back when they ask for it, which buys time for the bank to restructure and rebuild its capital from future profits.

The problem with bank capital …

As we have found in the UK, you can’t just bail-out a bank and assume that the work is done. It isn’t. The measure of thumb we have referred to before is that the Eurozone banks are geared 26:1, so for every €1 of their own capital they have lent out €26.

Lets assume that they lose €1 of the €26 as a bad debt. They now need another €1 to replace their capital, so maybe the shareholders step in. Lose another €1 of the remaining €25, and that’s another €1 of capital they need, so maybe the Government steps in. Then they lose another €1, and maybe the Central bank helps to prop things up for a time. Then they lose another €1, and another €1 and so on, and so on. Looking across the southern Eurozone, where property values have crashed, unemployment is high and economies are contracting, it is only too easy to see a whole series of bad debts requiring a whole series of impossible new bank bail-outs.

The problem with liquidity …

In the UK we have our own currency, and although it isn’t a practice to be encouraged, if we have to print more money we can do so. So our authorities can continue to support our own banks for as long as they choose to do so.

In Cyprus they can’t print more Euros. Their Eurozone partners won’t let them. And these Cyprus banks will need an awful lot on liquidity to meet withdrawals the moment they reopen their doors, hence the suggestions that capital controls will be introduced – keep your remaining money in the bank, or else. So they are between a rock and a hard place.

… Aren’t bank deposits guaranteed?

Yes and no. The idea that your money remains your money is false. As we have seen it isn’t put in a shoebox. You are merely an unsecured creditor of the bank, so if the whole thing goes pop you face losing all or part of your money. People used to be careful where they put their money, and were aware that if interest rates offered by one institution were higher than elsewhere, that was a warning sign that it was more desperate for deposits. This is exactly what happened a few years ago with Iceland – but depositors had forgotten the pricing of risk.

Then a politician somewhere decided to guarantee bank deposits. This seemingly did away with one side of the risk, as the depositor was free to chase the highest interest rate, happy in the knowledge that the state would make good on any loss, at least up to a limit.

If you were really unlucky you lived in Ireland, where some barmy politicians decided to guarantee all bank deposits. The Irish are still paying for the consequences of that rash commitment.

In the UK a bank deposit guarantee works, in so far as we can always print more to repay the depositor if the bank can’t. In countries which don’t have their own sovereign currency, they can’t, and a Euro guarantee is worthless if the rest of the Eurozone and the ECB won’t play ball.

… Where does this leave bank depositors?

As unsecured creditors, and facing a loss. Even if it is avoided for now, it will come around again. In fact the proposal is not a loss, but that the levy is turned into shares owned by the depositors. But at what price those shares are issued, and whether they are saleable thereafter is an open question.

Lets look at a specific example, Cyprus’ second largest, the Laiki Bank Group, otherwise heroically named as the Cyprus Popular Bank. I have gone to the trouble of studying their 9 month results to September 2012, and this gets interesting:

The bank has total assets of €30bn, and Capital of €1bn. Never mind leverage of 26:1, this bank is leveraged 30:1.
Over 9 months they have lost €1.1bn. That’s about €1,000 for every man, woman and child in Cyprus.
40% of their loans are in Greece, and 42% in Cyprus. In Greece, 40% of these loans are non-performing (typically meaning that either interest or repayments have not been met for 90 days or more). In Cyprus 17% are non-performing. Overall that’s €7bn of non-performing loans, or over €6,000 for every man, woman and child in Cyprus.
As regulators have pressed them to improve their capital, they have shrunk lending by 13%. But their deposits have fallen faster, down 17%.
Earlier, in 2011, the bank lost €2.3 bn as a result of the Greek “rescue”. Thats another €2,000 for every man, woman and child in Cyprus.
The bank spent money buying-back bonds it had previously issued at 55c in the Euro. That was €115m sucked out of investors, but that’s a mere €100 for every man, woman and child in Cyprus.
The bank raised new capital of €1.8bn during the year, not from real investors, but from the Cyprus Government. And guess what the Cyprus Government used to pay for these shares? Yes, Cyprus Government bonds! I wonder for how much longer they will be of any value. That’ll trigger the need for another bail-out.
Now this most unfortunate bank is being investigated by the US Treasury for alleged “inadequacy in compliance with US sanctions against Iran”.
Mid 2012 the bank’s capital stood at just half the level of risk-weighted assets needed to meet international regulations ( Tier 1 capital). Just filling this hole would require E1.1bn, and that’s just to cover historic problems. That’s around €1,000 for every man, woman and child in Cyprus.

Are you getting the idea? This is just one bank, and the sums the regulators say it needs to bail it out are just sticking plasters compared to the scale of current and future losses that require more funding. This represents enormous sums to most people on the street.

Bail-outs beget further bail-outs, which beget further bailouts and on it goes. So why weren’t we told this at the time of the first bail-out? Perhaps the politicians, regulators and central bankers didn’t realise, or just chose not to share this chilling news.

… Thank goodness we are British!

Not so fast. We may not face state-sanctioned withdrawals from our bank accounts, but we face all other manner of financial repression.

Inflation: In February 2013 RPI stood at 3.2% inflation a year. Over 3 years this is the same as 9.9% (6.75% to 9.9% was the haircut originally proposed for Cyprus depositors), it is just that it goes unseen. It is financial repression.

Negative real interest rates: Receiving a lower rate of interest than inflation? If you are earning 0.5% on your savings, and inflation is 3.2% pa, you are losing 2.7% pa. Over 3½ years that is the same as 9.9%. Another form of financial repression.

Collapsing pound: Buy anything from overseas? Of course you do, from fruit, to clothing, to cars. Even if everything you buy is made in the UK, the raw materials to provide those goods or services are most likely from overseas, like much of our power generation, fuel and delivery costs. Well the £ has taken just 2 years to plunge 9.9% against the dollar, pushing up the cost of imports and the final prices we pay. More financial repression.

Taxes: As Bastiat stated over 150 years ago, “The state is the great fiction by which everyone seeks to live at the expense of everybody else. Everyone wants to live at the expense of the state. They forget that the state lives at the expense of everyone.” (For more on Bastiat, see here). Curious then that the same uproar over the levy/expropriation/theft/tax on Cyprus deposits doesn’t occur when income, spending or transactions are taxed. This Cyprus levy is just another form of “wealth tax” that has so excited politicians here. Whatever form of tax, it is repression.

Suddenly a 9.9% bank levy starts to sound quite modest. But maybe it’ll stand at 40% by the time you read this article.

… Where will it end?

Go back to my European series of 5 articles, and see if you agree that, for them, default is ultimately inevitable. If you agree – or disagree – I’d love to hear from you to continue the debate. But as the mainstream seeks to sustain the unsustainable we will see continuing financial repression, allegedly “for the public good”. Strike this out, and read “to sustain the muppets who got us into this mess”, and you are nearer the truth.

Muppets abound within the Eurozone (sadly we also have more than our fair share over here), where there will be even more restrictions on withdrawing cash, and limits on using cash and cards before this has run its course. Savings won’t be available when deposits mature, they will be forcibly tied up for longer, or converted into bank capital. For now we have extended bank holidays, but when Cyprus’ depositors do get hold of their money – whether it be Euros or old Euro notes stamped to denote a brand new currency – they won’t be allowed to take much of it overseas.

Is this a recipe for social breakdown? Yes. Is it good for any economy? No. Are there geo-political ramifications? You bet there are. Where will it kick off next? My guess is across the Eurozone southern states and perhaps ultimately France, with Northern states equally full of protestors vociferously stating why they shouldn’t help. Default is coming.

And outside the Eurozone? Well in the UK we also have the same unsustainable levels of government debt, insolvent banks, and high levels of private debt. Whilst governments here and abroad will enforce repression and blame the banks, and whoever else they can lay their hands on, they know jolly well that their unsustainable social experiments and unfunded promises have got us to this point. They just won’t admit it. If they read the history books, they would know that no fiat (unbacked) currency lasts forever, and that any monetary system must revolve around trust, which seems to be in short supply.

Is all this trauma necessary? Well Cyprus has to lance the boil somehow, with or without the support of the Eurozone. Either the banks need to default (with shareholders, bondholders and depositors taking the pain now) with a great deflation in asset prices as the credit bubble pops once and for all, or the state strives to sustain banking with all the financial repression and dramatically lowered living standards that entails over many years. Then similar arguments apply to Government debt and also private debt. It’ll be a long road.

None of the options are pretty, but outright default is certainly more honest, and means everyone can start rebuilding sooner, rather than later. And they will need, through the pain, to create a totally new economy. [UPDATE: They have now announced a new and huge levy just on the larger, uninsured depositors. Lets see how this plays out …

… When will outright default happen?

25 years ago I told an aspiring politician that a European common currency would be a recipe for social chaos. Some predictions clearly take time to pass.

2½ years ago I warned a Director of a highly successful quoted international property Plc that capital controls were coming. He laughed. I wonder if he now sees what I mean.

I have a sneaky suspicion that events in the Eurozone, beyond Cyprus, will now be unfolding a little faster.