Cyprus: Yesterday's News

by Dechert LLP

photo of Rick JonesAs we predicted a few weeks ago (discussed here), Cyprus has rapidly fallen off the screen. Back to business as usual, based upon an iron-willed refusal to see the spreading cracks in the edifice of the common market financial system and willful blindness to the implication of such events.

Sir Mervyn King, the late Governor of the Bank of England, recently said that to start a bank run is stupid, but to fail to join one underway is irrational (or something like that). This trenchant bit of advice should be considered by pretty well everyone long the euro. What one wonders is whether the absence of a full scale bank run so far is evidence that all is well, or a symptom of a commonly shared psychosis that perhaps if no one notices the broken system, no deluge will follow.

I have been taken aback by the number of pronouncements by the political and economic chattering classes that Cyprus was, well perhaps not good, but not bad. It was a special case; or no one cares about Russian oligarchs; or that it was too small to matter; or it was about time someone other than the taxpayers cleaned up a banking problem.

I have sympathy with some of those notions, but, on the other hand, didn’t Cyprus just establish that all of these zombie and aspirationally zombie banks are on their own? When the policy community of the EC is trying their darndest to preserve business as usual and keep the lid on while hoping that the passage of time is the balm that cures all ills, was this, in any sense, a good idea?

Didn’t they just establish that deposits aren’t safe? Didn’t they just establish that senior bondholders and equity investors can no longer rely on the sovereigns to cushion the risk of their bets? Didn’t they just establish that these banks are on their own, and if they have not the resources to continue to support the capital needs of the marketplace, it’s just too bad?

Didn’t Cyprus raise the really nifty question of what’s the value of a euro in a bank in Cyprus? Would you buy one of those euros for a euro? I certainly wouldn’t.

Mr. Dijsselbloem, the now famous erstwhile Dutch agro-economist who is serving as the Chair of the Eurogroup Finance Ministers probably spoke truth, albeit perhaps unintentionally, when he confirmed that Cyprus was the model for the resolution of banks going forward. Look, as we’ve said before in this Blog, any chance of fixing Europe depended upon the balm of cheap credit and the passage of really serious periods of time for the system to self-repair. The plan, assuming there is a plan, seems to have been to shoot the Indian closest to the stagecoach by fixing each failing problem bank with bailing twine and duct tape, and so give the continent time to grudgingly embrace what needs to be done. If the EC could get a common bank supervisory scheme it could, in turn, lead to EC wide deposit insurance, which could lead indirectly to mutualization of debt and all that could, could become part of the solution to fix what’s wrong.

It’s gone. Cyprus killed it. Mr. Dijsselbloem added an exclamation mark. Mr. Draghi’s assurances, which had kept the lid on since last summer, now seem rather empty. Capital controls in Cyprus are now expected to last a very long time. If a euro in a Cyprus bank is not worth a euro, if a small business in Italy, Spain, Portugal, Greece (and perhaps soon, France), cannot borrow except at a spread hundreds of basis points higher than borrowing costs in Germany and the northern tier, do we really have one currency anymore? Do we? If the currency stops functioning like a currency, is it still a currency? Why hold on to the dreary thing if fixing your national economy requires significant devaluation of the currency to succeed, when the benefits of a common currency are rapidly disappearing?

I know I’ve been harping on the irrationality of the European monetary system for some time and waiting for it to unwind, and trying to help people think of what happens when it does. I also know an awful lot of folks (many with PhDs) think that I just don’t get it. With apologies to Jeff Foxworthy, here’s a test for you:

  • If those capital controls in Cyprus stay in place and don’t go away soon, then you ought to think maybe I’m right.
  • If the borrowing spreads in the middle market in southern Europe continue to be wide to Germany, then you ought to think I may be right.
  • If another bank fails, and it’s not bailed out by the EC and IMF, then you ought to think I might be right.
  • If the borrowing costs in the southern fringe sovereigns start to creep out again, you ought to think I might be right.
  • And if capital flows begin to move from the weaker banks in the southern fringe to the northern banks or out of the EU entirely, you might want to think I’m right.

So there’s a set of benchmarks on my doom and gloom analysis, let’s run the movie forward a couple of reels and see what happens.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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