Contagion fears grow as Cyprus bailout proposal breaks taboos

The controversial proposal to impose losses on insured bank depositors in Cyprus – in a €10 billion bailout largely without historic precedent – has raised the spectre of a new phase in the eurozone crisis, without urgent redress, according to some hawkish analysts, bucking the hitherto relatively sanguine market reaction. The proposed raid - which could soon be ultimately defeated - on Cypriot deposits highlights the absense of an EU common liability plan, exposing the chronic nature of political fragmentation in the single-currency bloc, analysts say.

The prospect of depositor flight, especially among corporates, and the negative banking sentiment in Greece, Spain and Italy should trigger new crisis-stabilization efforts among eurozone policymakers, analysts say, departing from the sell-side consensus that the bailout plan is exceptional in nature and any contagion would be limited.

On Monday, Cyprus was reportedly preparing new proposals that would see depositors with up to €100,000 taxed at a lower rate of 3%, while savers with €100,000 to €500,000 would be taxed at 10%, and balances above this threshold at 15%. The original and much-maligned tax proposal, in return for bank equity, saw every depositor under €100,000 taxed at 6.75%, and those over this benchmark at 9.9%. By Tuesday lunchtime, the plan was hanging in the balance amid a wave of dissent in the Cypriot parliament. Irrespective of the final terms of the bailout, the damage has already been done, say analysts. On March 6, Euromoney broke the news that policymakers were planning the controversial depositor bail-in policy in a bid to ensure foreign depositors share the pain while only a small proportion of banks’ liabilities comprise bonds, meaning the burden of adjustment was always going to fall on regular Cypriot taxpayers in a German election year that has reduced the prospect of direct fiscal transfers.

The deposit equity-swap has been interpreted as a de facto haircut for those that are covered by the deposit guarantee (on balances up to €100,000) but it has been billed by Nicosia as a tax to side-step legal challenges. Burden-sharing has also been imposed on subordinated bond holders. European policymakers claim the structure of the Cypriot bailout is exceptional, citing the fact the banking sector is seven-times larger than the country’s GDP, with the latter representing just 0.2% of the EU’s GDP.

Irrespective of the structure of the levy, the tax, and the decision not to force senior unsecured banks’ bondholders to take a hit, violates the fundamental principle that insured deposits sit at the top of the creditor hierarchy in any restructuring, and undermines confidence in the EU deposit protection scheme, more generally, analysts say.

Contagion risk

Analysts at UBS say: “In the event of the peripheral economies requiring additional capital, the risk is that a precedent has been set. The EU has signalled that it will consider depositor bail-in rather than letting a country’s debt/GDP level rise to an unsustainable level. Clearly this provides a catalyst to start a bank-run at a point when the impact of such is most likely to be catastrophic for the economy involved which, in turn, is likely to make a resolution more challenging.”

The tremors from the Cypriot crisis could reverberate for years to come, knocking confidence in the integrity of a critical instrument to stabilize the eurozone banking system: depositor insurance. “The US created its deposit insurance scheme in the 1930s to restore confidence at a time that deposits looked seriously at risk,” Nomura analysts say. "The euro area might have lost the opportunity to create such a guarantee scheme at the regional level for a long time."

On the upside in the short-term at least, Nomura analysts say systemic eurozone risk will be mitigated by the provision of central banks’ liquidity facilities. “The combination of ELA and ECB liquidity can match every euro of deposit flight for as long as there is enough collateral available," they say. "In extremis, the issuance of debt guaranteed could be considered.” 

Jennifer McKeown, analyst at Capital Economics, adds: “Aside from Greece, deposit flight from eurozone banks has been limited during the crisis so far. But now that the cat is out of the bag that deposits can be hit, there is surely a huge risk of deposits flowing from other countries’ banking sectors, putting an increasing burden on the ECB to fill the gap.” Malcolm Barr, a well-respected eurozone economist at JPMorgan, recommends a raft of eurozone policy measures in a bid to reduce any contagion, including a “heightened” commitment by the ECB to boost term liquidity and ease collateral rules as well as fiscal forbearance, such as a one-year moratorium across the region on new wealth taxes, until harmonized arrangements for deposit insurance are in place.

Nomura analysts, led by Jacques Cailloux, note that eurozone deposits, including in the periphery, have been far stickier than generally perceived, with Greek household and corporate deposits down some 30% from their 2008 peak, which is still relatively modest given the scale of wealth destruction as well as financial and political disorder in Athens during the past six years.

Nevertheless, analysts note that the most mobile of the deposit base, principally corporates, could seek to “arbitrage” deposit-levy risk in countries most vulnerable to similar depositor bail-in policies, such as Greece. “In the case of Greece, there is a widely held view that the next step to bring the country back to sustainability will be via OSI," say Nomura analysts. "The Cyprus deal suggests that a levy on Greek deposit cannot be ruled out when and if OSI will be considered.”

Banking fallout

The Cypriot bailout is a boost to senior bondholders, according to RBS, as “the Eurogroup has imposed burden-sharing on sub debt but spared senior, consistent with the restructuring of Irish, Spanish and Dutch banks. This reinforces the eurozone's who-fails-pays philosophy to hurt stakeholders of failing institutions, rather than socializing losses across the system.”

Maintaining their underperform call on Italian and Spanish subordinated debt, RBS credit analysts note: “In the near term, peripheral bank spreads and especially sub debt will likely widen," they say. "We would expect Spain and Italy to be hurt the most, given bank asset risk remains elevated in both countries.”

Perversely, the uncertainty over creditor hierarchy norms, as the Cyprus bailout lays bare – with depositors, rather than senior bondholders, penalized – will provide little reassurance for those creditors that have been spared the impact of burden-sharing, according to Nomura. “Quite the contrary, the conclusion from this, in our opinion, should be that the uncertainty around future resolutions remains very high and thus the risk premium on debt instruments in cases where indebtedness remains a concern should rise," they say.

In the event of a bank run in Spain and Italy, the implied cost of equity would hit levels seen in the summer of 2011, indicating a fall of 37% from current valuations, according to UBS. If a bank run is avoided, the implied cost of equity is likely to normalize to 11% to 12% but earnings and profit forecasts are to be slashed amongst “the 'lower quality' banks, which are closer to a bail-in due to shortage of capital (Spanish banks) or weak profitability and asset quality concerns (Italian banks),” UBS analysts say.

The research note adds: “On the other hand, quality banks with strong capital positions and hence now higher attractiveness for depositors and debt investors should see their competitive position improve and outperform the sector. This favours the quality banks we are recommending, in particular, BNP, DNB and Credit Suisse, our current preferred names.”

Eurozone's soul

While the broader financial impact of the tentative deal remains unclear, analysts are more united by the political impact. With a consensus largely forged last year on the need for greater fiscal and banking coordination – touted as a crisis circuit-breaker, combined with ECB support – the Cyprus bailout should serve as a wake-up call to remind investors that EU governance and bailout mechanisms are not in place, highlighting the fragility of the recent eurozone market confidence.

Nomura analysts draw a sobering conclusion: “The Cyprus deal suggests that little can be expected in the form of outright solidarity in the upcoming decisions on the future of the architecture of EMU. The banking union is likely to keep the risk largely in local hands before mutualizing any of it. While this makes economic and political sense for the north, it is probably not compatible with the view of the south.

"Likewise, in the field of fiscal union, the message is pretty clear with no sovereign debt mutualization in sight. Those who have pinned their expectations around the political announcements to further economic integration during the course of 2013 should reassess their expectations and scale them down."

Analysts at Credit Suisse agree: “These events are likely to weaken the pro-EU political centre in yet another country. As elections in Greece and Italy have shown, the risk the economic and financial crisis is exposing is a steady rise in support for new and radical political parties in the periphery, for whom membership of the euro is not a necessity. Such a trend now looks inevitable in Cyprus.

“More broadly, these actions will further erode popular support for the euro and EU in the periphery: preserving membership of the euro will increasingly be about preserving the value of wealth, rather than a political goal. And in the long term that does not look particularly sustainable.”

The counterpoint comes from analysts at Société Générale: “The tough stance on conditionality, backed up by letting a comparatively small eurozone state take the full force of this stance, could work as a wake-up call to force both Italy and Spain further forward towards structural reform, which would ultimately benefit the banks.” Irrespective of the final terms of the bailout, the damage to confidence in the security of bank deposits and EU policymaking has already been done.