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Markets Watch Europe Warily as Cyprus Formulates Depositor Tax

Markets were rattled over the Cypriot banking crisis, which has focused attention on the lack of a deposit guarantee scheme for the euro zone.

As Cypriot government officials scrambled to rework a planned bank tax to ease the pain on small depositors, concern grew Monday that the proposed European bailout of Cyprus — which for the first time imposes a haircut on bank deposits — could spread nervousness and possible capital flight to other peripheral European countries such as Portugal, Spain and Italy.

“The Cyprus decision is going to make institutional investors think very carefully about putting funds in European banks that might have to ask for a bailout at some point in the future,” says Michael Hewson, senior market analyst at CMC Markets in London.

“The bail-in of bank depositors has the potential to create new turmoil and possible bank runs in other peripheral countries if people start to fear similar treatment in the future,” wrote Carsten Brzeski, a senior economist at ING Belgium, in a note to clients. “Although the haircut on deposits is presented as a tax, this operation creates the impression that secured deposits below €100,000 ($130,000) are, in fact, not secure within EMU. Will depositors believe that Cyprus is a special case, or will they also run to their banks?”

Markets were generally calm after a weekend of speculation and surprise. Bank stocks in the euro zone offered an indication of possible contagion. Large Italian banks plunged, with Unicredit down 3.61 percent, Banca Intesa Sanpaolo dropping 2.52 percent and Banca Popolare down 2.5 percent. In Spain, Banco Santander, the nation’s largest bank, slid 3.7 percent and BBVA was down 2.58 percent.

The unease also hit the euro, which dropped two cents from Friday, closing at 1.2952. That was the lowest level since December.

The controversy caused a move toward the core in the euro zone, with 10-year German bunds dropping five basis points and Italian and Spanish government bonds rising four basis points. The Portuguese 10-year at one point rose 30 basis points, but closed nine basis points higher. Analysts said the move in government bonds was much less than the swings witnessed at the height of the euro zone crisis last year.

Meanwhile, Cypriots thronged ATM machines in their island nation over the weekend to try to make withdrawals after the initial terms of the bailout package were announced. Monday was a bank holiday in Cyprus, and the banks will remain closed on Tuesday until parliament acts on the bailout plan. The Cypriot government has put a freeze on electronic transfers.

The initial deal, reached between Cypriot and European Union officials in Brussels on Saturday, called for a 6.75 percent tax on deposits under €100,000 and 9.9 percent above that amount. When hundreds of Cypriots gathered outside the parliament building in Nicosia on Monday with the word "No" painted on their palms, members of parliament offered alternatives, with the tax on small deposits possibly falling to 3 percent and larger deposits being hit with a levy of as much as 12 percent.

Jörg Asmussen, an executive board member of the European Central Bank who played a key role in negotiating the terms of the bailout, suggested some EU flexibility Monday in implementing the new deposit levy. EU governments, which are contributing €10 billion to the bailout, would be satisfied as long as the one-time tax netted €5.8 billion, he indicated. “It is up to the government alone to decide if it wants to change the structure of the contribution from the banking sector,” Asmussen said.

Jane Foley, a currency strategist at Rabobank International in London, said that markets have been calmed by the promise last year by ECB president Mario Draghi to do “whatever it takes” to preserve the euro. The huge provision of liquidity by central banks has “made investors far more resilient to bad news” such as the Cyprus announcement, she said. While the market is certainly more jittery than a couple of months ago, thanks largely to Italy’s uncertain election result last month, there have been no big swings in sovereign bond values, as there were a year ago.

The big issue at the heart of the Cyprus bailout is sanctity of the various European nations’ deposit insurance schemes, which are supposed to protect small depositors. An effort to create a single guarantee scheme for European banks was shelved last fall in the face of German opposition.

“If you create a precedent of haircutting depositors, then other countries’ depositors could move their money from smaller banks to larger banks that are safer,” Alberto Gallo, head of European macro credit research at RBS in London, tells Institutional Investor.

Gallo says that in Spain and Italy there are small banks with very little equity or senior and subordinate debt. They tend to have only deposits and covered bonds. Depositors in those banks could perceive a tail risk of haircuts and move their funds out, he added.

As a result, RBS is shorting the debt of smaller banks in Spain and Italy, he said.

In addition, the Cyprus bailout package could make other governments, such as Spain, more reluctant to seek an EU bailout in the future. Spain received €40 billion from its EU partners to recapitalize its banks last year, but many analysts believe the government itself may need assistance eventually. “Cyprus makes it much more difficult for Spain to ask for a bailout,” Hewson says, because such a bailout may now come with the same penalty for Spanish depositors. Even if Cyprus now revises the bank tax, the genie of violating deposit insurance is out of the bottle and can not be put back in, he added.

European officials maintained that Cyprus was a special situation because of the relative size of the banking system, which is seven times larger than the island’s economy of €17 billion. About one third of bank deposits in Cyprus are non-EU, mainly from Russia. There was a feeling in Germany that Russian depositors were probably concealing illegal gains and should be made to absorb some of the brunt of the bailout costs before the German parliament would vote in favor if the plan.

The Russian government, which had agreed to restructure €1 billion of debt to Cyprus as part as the plan, was clearly angered by the tax on deposits. President Vladimir Putin said the tax was “unfair, unprofessional and dangerous,” Kremlin spokesman Dmitry Peskov said.

Gallo said that protecting senior debt holders was now the established practice in Europe because it avoided cross-border flight. In addition, the size of the banks in Cyprus was so large compared to the senior debt that it would not have raised sufficient funds to penalize the bondholders.

“The bail-in risk is unlikely to rattle periphery depositors at this point,” Goldman Sachs said in a note to clients. “After all, Cyprus is late in addressing its bank issues. Elsewhere on the periphery, especially in Spain and Ireland, depositor risk perception has improved.”

Huw van Steenis, banks analyst at Morgan Stanley, said in a note that while contagion among peripheral countries is possible, “more likely, it may direct deposits from perceived weaker to stronger banks.” He foresees downward pressure on European bank stocks in the near term.

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