End of an Era Cypriot Financial Sector Faces Collapse
The disastrous financial situation in Cyprus is largely a result of the country's crumbling banks. For years, the island nation profited from its bloated financial sector, but now it will likely have to liquidate its two largest banks. In Nicosia, government leaders fear that could decimate the economy.
If Cyprus doesn't receive billions in foreign aid within a few weeks, the country will default by June at the very latest. But insolvency could come even sooner for the country's two largest banks. The Bank of Cyprus and Laiki Bank are only able to survive at the moment through emergency aid from the European Central Bank, which on Thursday threatened to cut off all liquidity on Monday if terms of a European Union bailout deal aren't finalized with the government in Nicosia.
The banks are actually the very core of Cyprus' problems at the moment. They are bloated, pumped full of Greek sovereign bonds and more or less already bankrupt. Without these banks, Cyprus wouldn't need to seek aid from the permanent euro bailout fund, the European Stability Mechanism (ESM). The banks' difficulties have destroyed Cyprus' reputation on the international financial markets and investors are no longer willing to lend to the country.
Already last year, the government had to prop up Laiki, the country's second largest bank, with 1.8 billion, an amount that accounts for about 10 percent of Cyprus' annual gross domestic product. Now the ailing financial sector requires an additional 10.8 billion in aid -- an unimaginably large figure for a small nation that has just under a million residents. The EU aid would represent the lion's share of the 17.5 billion bailout Cyprus currently requires.
As such, it makes sense that euro-zone member states and the International Monetary Fund have made it a precondition that these banks also participate financially in the rescue. The only question is whether there's any viable alternative than to tap the accounts of banking customers directly in order to raise the 5.8 billion missing in the bailout.
- The bank's investors have already lost massive shares of their investments. In the fall of 2011, the three biggest financial institutions still had a market capitalization of 2.4 billion, but it has since fallen to 500 million. Since mid-2012, the Cypriot government has owned 84 percent of Laiki Bank. By then, private investors were only still in possession of shares that held a total value of several million euros. Major shareholders at other banks also have relatively little to contribute to any rescue package. Just take billionaire Russian investor Dmitry Rybolovlev, who owns 5 percent of the Bank of Cyprus. In recent months, he has had to sit back and watch as the value of his holding shrank to around 20 million.
- Holders of bank bonds were to be next in line to be held liable for the bailout. They lent money to the financial institutions and had to assume that, in the worst case, they wouldn't get it back. In a passage that attracted little attention over the weekend, the Euro Group also announced that second-tier bonds would also be seized as part of the restructuring program. Those possessing Tier-1 guaranteed bonds would not be hit. Still, it is doubtful that this channel would suffice to raise the 5.8 billion needed. Cypriot banks have long relied on the gigantic deposits held in their accounts and have not needed to issue large quantities of bonds to raise cash. As such, there is a paucity of bonds that could now be seized as part of a restructuring program.
- This leaves the depositors. This is by far the largest single source of potential money. Statistics collected by Greece's central bank suggest that some 68 billion is deposited in Cypriot banks. Around 25 billion of that sum originated from foreign depositors, a large share of them from Russia and Ukraine. This is where the so-called "one-off stability levy" rejected on Tuesday by the Cypriot parliament was supposed to be applied.
Calls for Banks to Be Wound Down
Many experts believe that the cleanest solution would be to provide for an orderly insolvency for the banks and for them to be liquidated. "That would make more sense than ripping off the small depositors," said Hans-Peter Burghof, a banking professor at Germany's University of Hohenheim.
Still, if the banks were made to go bankrupt, depositors would still feel the pain -- but only the big ones. Deposits of up to 100,000 would be protected by state deposit guarantees. Under this scenario, it would be the shareholders and bondholders who would lose a good deal of their investments.
Under this scenario, the chances of the feared contagion infecting banks in other countries would also remain rather small, Burghof believes. Data from the Bank for International Settlements in Basel, Switzerland, shows that, at the end of September 2012, the Cypriot banks had a total of $441 million in debt with foreign banks -- a dimension that could be coped with easily. Spain, by comparison, has a whopping 132 billion in liabilities to foreign banks.
Another proposal being considered is to wind down the two banks, park their most toxic assets in a "bad bank" and then sell the rest to Russia's VTB Bank, which is active on the island.
Cyprus Fears Future of Its Business Model
The only country that faces any significant risks is Greece, where subsidiaries of Cypriot banks active there would have to be split off from their parent companies and operated as separate entities, possibly under the tutelage of Greek financial institutions. But that is already envisioned in the Euro Group's rescued plan.
According to reports, a solution for winding down the two banks had also been part of the negotiations among euro-zone member states, Cyprus and the IMF. Together with the agreed to 10 billion from the ESM, it would generate enough money to prevent the entire country from going bust. But the Cypriot government has so far vehemently opposed the plan, because a liquidation of the country's two biggest banks would bring instant death to the very business model that has made Cyprus a small banking center. Hardly any investors would continue parking their money there, no matter how low the tax rate was.
Ultimately, Cyprus will have to reinvent itself. Until the crisis hit, the financial and real estate sectors comprised a quarter of the country's gross value add. Another quarter comes from tourism. Industry only comprises about 12 percent. Cyprus, it appears, tied its entire fate to its banks. And as long as the government remains unprepared to change this, the country could well be headed for bankruptcy.