The sight of queues appearing outside banks in Cyprus over the weekend has raised the spectre of contagious bank runs across Europe – the eurocrisis is back

This wasn’t supposed to happen. Just a few months back, we were reassured from all respectable quarters that the eurozone crisis was – in the words European Commissioner Olli Rehn – past its “high point”. Of course, Greece was still a basket case, Spain, Portugal and Ireland scarcely better, but judicious intervention by the European Central Bank (ECB) had exorcised the spectre of immediate default and bank failure.

And then, in short order, ungrateful Italians refused to the opportunity of parliamentary elections to bestow the requisite gratitude on the banker appointed in 2011 to oversee them. Almost a third preferred to chance it with a ranting bearded comedian, while many of the rest threw their lot back in with a priapic former property developer, current TV mogul, and ongoing star of his very own courtroom drama serial, one Silvio Berlusconi. Cue official consternation. Italy is the eurozone’s fourth largest economy: adrift for well over a decade – posting a perversely impressive average growth rate of 0% over the last 15 years – with public debts of over 100% but a primary surplus on government spending, its politics a permanent rebuke to the happy dreams of quiet and sensible management that central bankers long for. No stable parliamentary majority can be formed, Beppe Grillo’s Five Star Movement refusing participation in any government, and new elections due shortly.

If Italy has caused some urgent grinding of bureaucratic teeth it is Cyprus, in deep crisis since at least mid-2012, solutions parked pending elections – that is now be provoking outright panic. The eurozone’s third-smallest economy, with a GDP equivalent to 0.2% of the total, perhaps disappeared under the official radar somewhere. Disentangling complacency from outright stupidity from plain corruption in the monstrous SNAFU now engulfing the island is a challenge. In any case, the decision of the Cypriot government to attempt to confiscate funds from bank accounts is genuinely close to unfathomable – politically catastrophic, economically ruinous.

The deal currently on the table, but now subject to renegotiation, is that those holding less than €100,000 will pay a one-off sort-of tax of 6.75%. Those holding over that amount pay 9.9%. Rather awkwardly, Nicos Anastasiades was elected President barely a month ago with a repeated promise not to impose confiscations on ordinary Cypriots and so the deal is being sweetened (and a campaign pledge swerved) by offering depositors shares in Cyprus banks of purportedly equal value to their losses – an inducement roughly equivalent to getting magic beans (magic not included). As an additional bonus, the government was currently promising all those who hold their money in Cyprus bank accounts for the next two years preferential rights in a yet-to-be-drilled gasfield off the coast of the island – rights that are themselves contested by Turkey, Israel, and Lebanon. With these stellar incentives, the reader will be astonished to learn that the queues appearing outside banks in Cyprus over the weekend were not of would-be depositors rushing to open accounts.

Over-fed, under-regulated

This was, needless to say, not quite the original plan when Cyprus finally joined the euro in 2008. The island took the opportunity offered by euro membership to become the low-tax, low-regulation, no-questions-asked haven of choice for capital heading westwards into the eurozone. There are good European precedents for small islands having big plans for their financial institutions: Iceland, Ireland, and (why not?) the UK – and who, surveying that list, would not want to follow suit?

Cyprus’ banks built on longstanding ties to the Russian mob to provide a Mediterranean conduit for dirty cash looking for a clean euro-denominated home. A pleasingly lackadaisical approach to transparency helped seal the deal. The German secret services, the BND, estimated last year that some €17bn in Cypriot banks originated in Russia – more than Cyprus’ entire GDP, and much of it of questionable provenance. As the money flowed in from 2008, Cypriot bank balance sheets took on the wholesome, glossy sheen of a seriously overfed dog, shortly prior to it vomiting all over the carpet, and noisily expiring.

Still, before that unhappy event, the owners could pretend the mutt was in rude health. Governments deluded themselves, briefly, that they were managing a sleek financial hub for the Levant: a great post-modern centre for trade and commerce, smoothing out the eddies and roughs in the global flows of finance, etcetera, with the kind of wearily familiar arrogance that could almost cover up for the manginess of the cur on parade.

Cypriot banks, meanwhile, continued to ask few questions. Occasional requests for restraint, or even perhaps to examine more closely the provenance of the grub on offer were greeted as akin to biting the hand that was feeding. As recently as January this year, Cypriot banks were still being censured by the EU for their lack of transparency.

Unintended consequences

The rush of deposits helped fuel the expansion of Cypriot bank lending to an extraordinary degree. By 2011, the total assets of Cyprus’ banks – the amounts they loaned elsewhere – amounted to 835% of the country’s GDP. Much of this was loaned to Greece, to both public and private sectors. Sharing a common language, and apparently in the belief (held right up to the end of 2009) that eurozone sovereign debt could never default, Cypriot banks snapped up Greek debt by the bucketload. By the end of 2011, just two Cypriot banks had loaned the Greek government an amount equivalent to 160% of Cyprus’ GDP. This left them exceptionally exposed to risks from Greece. Already in practice wobbly from 2009 onwards, the second Greek bailout, arriving in early 2012, with its debt write-downs, pushed Cyprus’ banking system towards outright collapse.

They have been placed by the ECB on an Emergency Liquidity Assistance (ELA) drip over the last year, keeping the system afloat, but additional funding for stricken banks has now become well and truly unavoidable. With the full cost of the bailout needed – up to €17bn – equivalent to 100% of Cyprus’ GDP, and with Cyprus unable to use the European Stability Mechanism without further inflating its spiraling public debts, some additional source of financing had to be found. Without it, as described by Anastasiades in a speech on Sunday evening, Cyprus potentially faced a banking collapse, followed by default on its national debt, and exit from the euro.

The ECB, realizing this, used the threat of removing ELA funding to beat the Cypriot government into line: alongside the usual demands for austerity and privatization, the ECB, and EU governments led by Germany, wished (it seems) to see Cyprus close its dirty money sluices into the EU, while minimizing the costs to themselves. They offered a €10bn bailout, but insisted that the remaining expense, some €5.8bn, was met by depositors themselves. The IMF, for its part, wanted only those with more than €100,000 held in Cypriot accounts to take the hit – reasoning, probably correctly, that richer depositors were largely crooked, and that arbitrary confiscations would destroy Cyprus’ tax haven status. Hot money does not go where it does not feel safe.

But whatever the case, this was blackmail by the ECB, plain and simple. Rather than resist it, however, the Cypriot government turned the demand into a generalised deposit grab – big or small. The “tax” on smaller holdings makes essentially no sense at all – politically or economically. It only begins to acquire a rationale if the primary aim of the government was to use revenues from smaller depositors to reduce the hit to the larger: that, in other words, ordinary Cypriots are getting soaked to ease burden carried by the mobsters. That, in theory, should help Cyprus preserve its precious tax haven status. It hasn’t worked. Vladimir Putin has already complained of a dangerous “precedent” being established on the island. Cyprus tax havens days appear to be over.

Politically, robbing grannies to pay oligarchs was always going to be a tough sell. Perhaps newly-elected President Nicos Anastasiades fancied a challenge: economic collapse and a disintegrating banking system not quite hitting the spot. Perhaps he hoped his address to the nation could persuade hard-pressed Cypriots that those luxury dachas won’t, after all, pay for themselves. But with the mood outside Parliament curiously indifferent to the fate of large depositors, and the minority government requiring cross-party support for its measures, the vote needed to ratify the package has now been delayed until Thursday. The government will attempt to lean the deal more heavily on the larger depositors in an effort to secure parliamentary assent.

Bank runs

Monday was the Orthodox festival of Clean Monday, a day of fasting and atonement; its bank holiday has now been extended to Thursday: this should give plenty of time for the contemplation of humanity’s frailties, although more prosaically it may also serve to concentrate Cypriot minds on the frailties of their banks when they eventually reopen. Short of cast-iron and credible guarantees being given that deposits will be protected – but, of course, these guarantees were already supposed to be in place – there is little reason for anyone with any cash remaining in a Cypriot bank account to keep it there. The banking system is demonstrably unsafe and, what’s worse, your own savings will be raided to try and support it – a lose:lose situation. With just a few depositors beginning to follow that line of thought, withdrawing their savings, it would rapidly become entirely rational for Cypriot savers to want to remove their cash from the banks as soon as they can get to it – precipitating a full-blown bank run, and the collapse of the banking system.

That’s Cyprus. It’s possible that, somewhere inside the devious brains of the ECB, the thought made its appearance that Cyprus is both an exceptional case – immense bank deposits relative to equity; colossal overseas deposits relative to domestic – and sufficiently small to be contained. But if depositors in other eurozone countries also begin to think along similar lines, runs on the banks can spread. Particularly where banking systems are chronically fragile, as in Spain and Portugal, the risk of financial contagion – crisis leaping from country to country – is now substantial. A fundamental support of the banking system, that of protecting the depositor, has been undermined by the Cyprus decision. Without it, no eurozone bank – least of all those in southern Europe – can be considered truly safe. Greeks have €13bn in branches of Cypriot banks, now under threat; the collapse of the Cypriot banking system would almost certainly spill over to the Greek.

Bank runs and bank failures, it is now widely agreed, helped prolong the Great Depression. (In a further historical irony, it was Ben Bernanke, current chair of the Federal Reserve, who perhaps most popularised this argument.) Southern Europe is already sinking into stagnation. A major banking crisis will drown it. The political consequences, meanwhile, with Italy likely to face another election shortly, could be immense.

As for Cyprus, the solution is now in the hands of its people. Official political circles have fumbled the ball. The government could still call the ECB’s bluff: default on its external debt, pushing costs elsewhere and removing a great chunk of the debt burden. It could nationalise the failed banks, wiping out the few bondholders they have but with the aim of protecting smaller depositors while confiscating from the larger. A euro exit is possible. The threat of any of this should, at least, act to concentrate minds elsewhere.

None of that would happen without significant pressure. Already demonstrations have been called against the deposit raid and the terms of the bailout. The need for an alternative is stark. This year has already seen the collapse of one EU government after mass protests. Cyprus makes a good case for another.