Why Small Countries Have Large Banking Sectors (and why it makes sense)

On a size-to-GDP ratio, the Cypriot banking sector is the 4th largest in Europe, following Luxemburg, Malta and Ireland. Total assets in the economy are about €134 billion euros with GDP amounting to just €18 billion. Many have been accusing the state for allowing its banking sector to reach such levels. Yet, they do not seem to understand a principle from Economics 101: Comparative advantage.

Economics teaches us that just like people, countries tend to specialize in different things. For example, Germany specializes in heavy industrial products and Cyprus in the banking sector. The only difference is that the latter is more costly to save that the former. Unfortunately, banks are not like other companies. They carry with them not just the their savings, loans or deposits but the ones of the whole economy. Which are guaranteed up to 100,000 (be it Euros or Dollars).

Experience shows us that no "small" country can have a substantial heavy industry. The infrastructure, human capital and physical space that is required for that make it impossible to create such in countries where the land is not vast. We tend to specialize at what we are good at, what we can offer at a low cost and high quality. In those countries, a knowledgeable army of accountants, lawyes and bankers is available at any time to accommodate the needs of any investor. With corporate tax currently at 10%, taxation treaties with Russia and many other countries around the world, no taxes on dividends small wonder that depositors rush to island. In addition, high interest rates made the country more attractive to foreign capital. This however, does not make any of that money neither illegal nor laundered. It merely justifies why countries like Ireland, Cyprus, Luxemburg, Malta, Singapore, Hong Kong, Guernsey and others are primarily based on services and not industry.

Compared to GDP, every small country with a developed banking sector has a large asset-to-GDP ratio. In absolute numbers though, these amounts are not that significant:

Ireland: 1.105 trillion

Cyprus: 134 billion

Malta: 53.4 billion

Luxembourg: 959 billion

Total deposits in the countries above is approximately 2.2 trillion euros or approximately 1/4 of deposits in Germany. The idea of reducing the size of the banking sector is just as insane as reducing the amount of good manufactured in Germany because they would be a problem in the economy if production is halted. By forcing a reduction in the banking sector in any of the aforementioned "small" countries, a reduction in output and growth in essentially imposed.

The idea is absurdly capitalistic: the big can have more because they can afford to while the small should be smaller because they endanger the small ones. If small nations agree to reduce their banking sector they are essentially signing their death penalty.