Watching the Cyprus situation unfold, I have to admit to being amazed / captivated / distraught / panicked (not necessarily in that order). Many times over the past few days I have started to write something only to stop because I didn’t know what to say that hasn’t already been said. But here are a few thoughts about the proposal (vetoed Tuesday in Cyprus’ parliament) that depositors share some of the burden:
(1) It was such a surprise that we’re not even sure what to call it.
This is a bit of an overstatement, I know, because there certainly was a precedent for foreign deposits being at risk of loss after the European Free Trade Association ruling in January regarding Iceland’s limited responsibility to its foreign depositors . But the Cyprus proposal did generate a wide variety of phrases to describe the mandatory participation of depositors, e.g., tax, levy, seizure. The term expropriation also comes to mind – a “deposit grab” for short.
But here’s another way to think about it – an unprecedentedly-negative nominal interest rate. When I first started covering the inflation-linked bond market, I remember highlighting a key distinction between real and nominal yields – the former could be negative whereas the latter could not, in part because no one would tolerate paying a bank to hold their funds when they had a mattress as an alternative. Over time, however, our tolerance for negative nominal yields has increased, albeit mainly under the veil of transactions fees. And while the discussion over quantitative easing often centers on what happens when a central bank reaches the zero lower-bound, in practice there have been some brief examples where the bound has been breached . Perhaps the deposit-grab has taken quantitative easing to a whole new level.
(2) Banks more generally face a deposit catch-22
What this situation in Cyprus has highlighted is just how important deposits are to the health of the financial system. At some level, this was already known – on one hand, deposits are a source of liquidity for a bank. It’s one of the reasons why when a bank fails, its deposits are usually quickly taken over by another institution (related to the reputation point above, this also means that deposit guarantees are rarely required to pay out). But just as quickly as they appear, deposits can also evaporate. More deposits means more liabilities, requiring a bank to hold more capital to protect itself from a potential erosion. As a result, deposits are linked to capital ratios.
One way to reduce the liability side of a bank’s balance sheet and hence improve its capital position is by shrinking its deposits. The direct threat the proposal posed to deposits, even though rejected, suggests that the objective may be fast achieved. Hence the proposal that depositors share some of the burden may have been a misguided attempt to provide much-needed liquidity while at the same time improving the capital position of the banking sector.
(3) Reputation has taken a huge hit
Whenever I talk about the recent financial crisis, one of the things I highlight is the importance of reputation when confronted with challenges. Like regulatory capital, reputation serves as a buffer providing a firm, or a sovereign, with the ability to overcome difficulties. Without it, things can quickly spiral out of control.
The proposal that emerged over the weekend on Cyprus has irreparably damaged reputation at a time when it is most needed. Gone is the credibility of political leaders – just one week before the proposal was announced, Cyprus’ president said losses on depositors were “out of the question”. This is reminiscent of assurances various banking chief executives made in the early stages of the financial crisis – our confidence has been thoroughly undermined. Gone also is the credibility of the European deposit guarantee. Now that a deposit-grab has been put on the table, it is hard to envision a clear path to reopening the banks in Cyprus while avoiding a massive deposit outflow (as I write this, the “bank holiday” has been extended through the weekend).
 Duxbury, Charles, and Charles Forelle, “Iceland Wins Case on Deposit Guarantees,” Wall Street Journal, January 28, 2013, available at http://online.wsj.com/article/SB10001424127887323375204578269550368102278.html.
 Keister, “Why Is There a “Zero Lower Bound” on Interest Rates?” Liberty Street Economics blog, Federal Reserve Bank of New York, November 16, 2011, available at http://libertystreeteconomics.newyorkfed.org/2011/11/why-is-there-a-zero-lower-bound-on-interest-rates.html.