Wednesday, 20 March 2013

How Pulling the Plug on ELA makes Cyprus Systemic

A bank run in 1933
We cannot possibly know whether Germany (or the ECB for that matter) had threatened to pull the plug on Cyprus`s Laiki Bank Emergency Liquidity Assistance (ELA) if the island did not accept the deal. Yesterday, joyful Cypriots who gathered outside the Parliament house, saw 36 MP`s voting against the referendum which imposed a one-off tax on deposits in Cyprus. Today, German Finance Minister Wolfgang Schauble warned that the ECB will pull the plug on the both Cypriot banks.
Two words for that: Non-credible threat
Here`s why:
Schauble comments that "(..)we are much more stable in the eurozone - we took measures to protect ourselves from the risks of contagion ... but I don't want to have any of this.". It appears that he has not taken a good look at the situation in Greece nowadays. Bank of Cyprus has €7bn of deposits in Greece (01/09/2012), while Laiki bank has another €7bn (31/12/2011) and Hellenic bank approximately €600m (31/12/2012)*. In total, the Cypriot banks control about €15bn in deposits in Greece, or approximately 11,8% of domestic deposits in the country (approximately €127bn).

If the ECB pulls the plug on Laiki Bank, the whole Cypriot banking system will collapse in a matter of days, taking the Greek subsidiaries with it. This will mean that the Greek government will have to compensate deposits up to €100,000, which even in a an extremely optimistic scenario will be approximately  €7,5bn, money it does not have. Thus, the collapse of Cyprus will trigger a severe deterioration of the Greek banking system, which in turn will trigger the ever greater deterioration of the Greek economy. If the Greek state does not afford to pay insured depositors it will mean that it will have to either allow them to default or do the unthinkable: a deposits haircut for those who have more than  €100,000 in deposits. Yet, this will trigger a bank run, and people will return to the keeping their money under the proverbial matress.

In addition, if Greece is systemic as stated (and if it wasn`t it now is due to the inane decisions to influx taxpayers` money instead of allowing the ECB to print money) its collapse cannot be afforded. If we reach the bank run stage, then Italian and Spanish depositors will run to banks in order to save what they an, allowing for the first large-scale bank run in the West since the 1930`s. The amount of money needed by the ECB to avoid Greek collapse will be far greater than the amount currently required for the Cypriot banks to continue their operations.

Skeptics might argue that if the Greek state has announced that it can absorbe the Cypriot banks` subsidiaries in Greece, it can do it even if they collapse. I beg to differ: there is a difference between a controlled passing of operations to the Greek banks (a procedure which may take a significant amount of time) and the sudden collapse of a bank. In the controlled situation it is highly unlikely that depositors will panic, and an even less chance of a bank run. In the uncontrolled one, panic, dispair and bank run will be the major ingredients in an explosive situation. We have all seen scenes of enraged Greek employees violently protesting for salary cuts. One can only imagine how the scene will change if they are to face a personal bankruptcy.

Wolfgang Schauble should be extremely careful about his comments. He is risking a credibility which cannot be regained easily once lost. Statements of this kind do not put markets at ease. They create more uncertainty and fear as people realize what the truth is really like.

*Data taken from Bank of Cyprus, Laiki Bank and Hellenic Bank annual quarterly reports

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