And … then they came for the deposits

It had to happen. Given the moral hazard (profits accrue to a handful of cronies while risks and bailouts are socialised) that has already been created since 2007, a group of desperate policy makers beholden to big business interests had to come after th little guy. That it happened in so brazen a fashion as with the tax on all depositors in Cypriot banks has caught everyone by surprise. The standard operating procedure of crony capitalists is to work behind the scenes and lean on each other to make sure the rich and powerful escape without any problems. On this occasion though the grab was public and has terrible consequences beyond Cyprus.

If you get past the headlines, this was a direct tax on Russian oligarchs laundering money via Cyprus. It is a well-known fact that Cypriot banks are bloated with Russian depositors. It is assumed (although difficult to prove through available data) that foreigners (mainly Russian) hold over half of Cyprus’ 70 billion in deposits. Cyprus has a long history of being a destination for deposits fleeing geopolitical risk. First, it was money from the Levant amidst the Lebanese civil war. Second, there was money fleeing the Balkan civil wars. Finally, there came money fleeing from political risk during the early-mid 1990s in Russia. The last trend continued into the 2000s.

The EU has long wanted to curb Cyprus' label as an offshore centre for Russian money, especially since the island nation joined the union in 2004. The bailout has given the EU an opportunity to do just that. Aside from explicitly demanding that Cyprus targets depositors, terms of the bailout also include increasing tax revenues from corporate and interest income to reduce the island nation’s appeal as an offshore centre.

Banking is a confidence game. At its core, they accept short term deposits and lend out (in much larger multiples, thus building leverage) to longer term risky projects. The difference in timing and risk is how banks make money. Problems come when investors lose confidence and demand all their money back on the same day. No commercial bank can ever honour such a request. Out of the ‘great depression’ in the US came a solution to this problem: deposit insurance. The logic goes that if the government can guarantee the public the value of their deposits, individual bank problems won’t spill out of control to systematic problems, given the guarantee by the sovereign of returning your money back (with a cap to the maximum amount). The trust in banks is an explicit trust in the ability, willingness and credit worthiness of the state.

It’s the extension of trust from banks to the creditworthiness of sovereigns that makes what happened in Cyprus have potential nasty consequences elsewhere, including at home. What is to prevent any government from raiding private deposits in order to meet tough conditions being put on them by foreign lenders? As Sri Lanka goes through a phase of a significant fall in tradeable goods exports and competitive loss of BPO work to the Philippines, soaring government debt dominated in foreign currencies need to be serviced and honoured. While passing through unsustainable (and eventually self-fulfilling) price increases on utilities will be the first phase of this move, a potential rise in global yields (and change in risk appetites) will force the government to look elsewhere for money. That’s the hour between dog and wolf that depositors and investors need to watch.

Although we can take comfort in knowing that most of the banks in the country are reasonably safe, zombie loans and depths of capital shortfall are only known during a crisis. For now though, people need not panic. We have not yet become a laundering hub along the lines of Cyprus, Dubai and Singapore. Recent changes to various regulations encouraging institutions to move in that direction will only have consequences in about a decade.

Events in Cyprus should however awaken depositors who have a false sense of security that parking money in term deposits carries no “capital” risk. As Martin Wolf wrote in the Financial Times of London, “Banks are not vaults. They are thinly capitalised asset managers that make a promise – to return depositors’ money on demand and at par – that cannot always be kept without the assistance of a solvent state. Anybody who lends to banks has to understand that.” The risk to your capital may come from both irresponsibly run banks and badly managed public finances. Unfortunately, the alternative to banking is burying your money in your garden. That’s an unattractive proposition no matter which way you look at it.