Cyprus Deal Is Good for the Euro Zone for Now

The government of Cyprus has cut a deal with the International Monetary Fund, the European Commission, and the European Central Bank to “rescue” it from a potential banking collapse that could have had ripple effects throughout the Euro zone.

Replacing a very bad deal that the supranational “troika” tried to ram down Cyprus’s throat last week—in which even small depositors saw their meager savings confiscated to save reckless banks—the new plan includes the following:

  • Cyprus’s second largest bank, Laiki, will be broken up into a “good” bank and a “bad” bank. The “good” bank will be merged with the larger Bank of Cyprus and the bad bank will be gradually liquidated.
  • Laiki’s shareholders and bondholders will take a haircut based on the bank’s ultimate value. Holders of uninsured deposits (more than €100,000) will also take a hit, but people who have €100,000 or less in insured deposits will be spared.
  • Bank of Cyprus will be recapitalized with the help of uninsured depositors, shareholders and bondholders, and it will boost its key capital ratio to 9%. Those depositors, including many foreign nationals, may lose up to 40% of their holdings.
  • The IMF, EC and ECB will lend €10 billion to Cyprus itself (but not the banks) to protect the country from the ripple effects of the banking crisis.

Banks remain closed and Cyprus is looking to impose some forms of capital controls to keep money from fleeing the country in a massive bank run.

Demonstrators in Cyprus protest Europe's "rescue" package, Photo: Flickr/theglobalmovement.

Demonstrators in Cyprus protest Europe’s “rescue” package, Photo: Flickr/theglobalmovement.

This won’t be the end of Cyprus’s problems—the economy may contract by 5% this year, perhaps further eroding the big banks’ balance sheets. But I think this particular deal accomplished two things:

  1. It protected the concept of deposit insurance, which will be vital in preventing future bank runs in much more important countries like Spain and Italy.
  2. It reintroduced, at least in a limited way, the idea of moral hazard. By refusing to extend more than €10 billion in loans to Cyprus, and forcing the Cypriot banks and government to find the additional money they’ll need to recapitalize, the IMF, EC, and ECB said these banks at least weren’t too big to fail.

And, of course, it removed the risk of contagion—for now.

European officials flip-flopped on whether Cyprus would be considered a model for future rescues. (I suspect it will be a laboratory rather than a template.) But the deal got good marks from the Financial Times’ brilliant but euroskeptical columnist Martin Wolf:

The current plan is closer to what one would wish to see in an orderly bank resolution… Given unwillingness to make outright grants to Cyprus, the present plan is almost certainly the least bad one. It protects the small deposits and imposes a rational resolution process.

Nonetheless, Wolf pointed out, this deal doesn’t solve the euro’s deep problems:

The crisis has also demonstrated that, even when the price of staying inside the union seems high, as it has been for many Cypriots, debtors are willing to pay it…At the same time, the will to sustain the eurozone intact is formidable. This then is a clash between an irresistible force and an immovable object.

The Cyprus deal doesn’t address Europe’s biggest issue—stagnant growth; for Cyprus, that may even get worse.

But at least for now, it’s removed the risk of market contagion and allowed Europe to muddle through another mini-debt crisis. Of such small victories is progress made.


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