Depositors in the firing line

Ordinary citizens forced to accept losses.

The financial rescue for Cyprus agreed by eurozone finance ministers in the early hours of Monday morning (25 March) represents the first time in eurozone bail-out history that ordinary depositors have been punished.

Crucially, however, and in a change to the original deal agreed on 18 March and overwhelmingly rejected by Cyprus’s parliament, those with deposits up to €100,000 will not lose money.

The initial plan would have imposed a one-off levy of 6.75% on deposits below €100,000 and 9.9% on deposits greater than that. Under the revised agreement, the size of levies on deposits above €100,000 remains to be worked out. However, they are likely to be far greater than under the original scheme, possibly even as high as 40%, Cypriot Finance Minister Michael Sarris said yesterday (26 March).

This is the first time since the euro crisis began that ordinary deposit-holders have been forced to accept losses as a condition of a sovereign bail-out. However, it is evidently not the first time that private deposit-holders have lost money in the course of the crisis, since in several countries the collapse of individual banks has resulted in customers losing money.

In the rescues of the Irish and Spanish banking sectors in 2011 and 2012, only junior bondholders – those whose investments have the lowest level of protection – were affected by the terms of the rescue. In those bail-outs, the eurozone’s leadership was reluctant to hit senior bondholders and other private creditors for fear of scaring investors away from the eurozone.

With the Cyprus rescue, the philosophy has changed. In this case, it is partly because Cyprus’s financial sector is small, albeit huge relative to its own economy. Mainly, however, it is because of a determination to reduce the build-up of government debt and burden on the taxpayer resulting from bailing out banks.

It follows that Cyprus’s banking sector will undergo a complete overhaul and will be reduced in size significantly. Laiki, also known as the Popular Bank of Cyprus, will be shut down immediately. Its ‘good’ assets, including insured deposits below €100,000, will be folded into the Bank of Cyprus.

Deposits above €100,000 in Laiki, estimated to total about €4.2 billion, will be frozen and placed in a ‘bad bank’. Part of this sum will be taken by the government, which will also impose losses on bondholders. Deposits above €100,000 in the Bank of Cyprus will also be frozen. A proportion of these will be used to recapitalise the banking sector.

The European Central Bank on Monday agreed to continue to give emergency support to Cypriot banks but said that it would “continue to monitor the situation closely”. It had last week threatened to withdraw funding if a suitable rescue plan had not been agreed.

The agreement with Cyprus means that eurozone countries, through the European Stability Mechanism (ESM), and the International Monetary Fund (IMF), will contribute €10bn to the country’s financial rescue.

Since the deal no longer includes levies on deposits of less that €100,000, it will not have to be endorsed by the Cypriot parliament. It will have to be formally approved by the national parliaments of the Netherlands, Germany and Finland but is unlikely to run into significant opposition.

With a banking sector eight times the size of its gross domestic product, Cyprus has been under suspicion for several years of over-reaching itself. Cypriot banks’ exposure to Greek debt and Greek sovereign bonds, whose value has plummeted since the start of the eurozone crisis, only exacerbated the fragile situation. As a deep recession hit, the Cypriot government struggled to provide financial support to the financial industry. Cyprus received a €2.5bn loan from Russia in 2012 that helped it inject €1.8bn into Laiki, but this proved insufficient.