Cyprus & Systemic Risk, It's Worse Than You Think

In an optimistic scenario, the risk that the Cyprus affair symbolised reached its zenith as leaders raced to meet the ECB’s deadline last weekend, and will continue to fade from here on. This is an optimistic scenario though, as a glance at the headlines shows.

Despite the many powerful waves of financial crisis that we’ve lived through, few issues have elicited as much apocalyptic language as Cyprus, and deservedly so. Even if Cyprus does fade out of the market’s focus now, there is an elevated risk that we’ll come back to it in the future as the event that first underscored how successfully the ECB backstop was suppressing risk within the system. I’ve talked many times about entering a new era, where interventionist policies determine economics and markets. Cyprus goes down in history as the first clear global macro event that demonstrated such policies in action.

The island’s crisis may also come to be remembered as the time that European leaders finally exposed the world to their collective lack of understanding and inability to achieve politically and economically balanced share of responsibility.

In my best judgement, the sequence of events must have gone something like this:

- Europe agrees to help Cyprus, and puts a weighty sum of capital on the table, but refuses to carry the full burden when so much foreign money is parked in Cypriot banks (this money clearly found shelter in Cyprus on the assumption that depositors won’t ever be hurt, be they insured or not).

- Cyprus bulked at the socioeconomic cost of destroying its largest sector by inflicting losses on an investor group that Europe had thus far protected. Responding to Europe’s demand for a domestic contribution, it took the path of writing down all deposits, an understandable move to signal to foreign account holders that this wasn’t something targeted at them. Such a move of course also threatened to unravel the European banking sector. At this stage, Europe should have blinked but didn’t.

- Instead, the Troika then let Cyprus announce an extremely dangerous plan, and the chaos of negotiations in Russia, deadlines from the ECB and readjustment to a more reasonable plan followed.

Cyprus is an exceptional case, and deserves to be treated as such. But, the genie is out of the bottle now, and genii are like toothpaste, very hard to get back in. Uninsured depositors are now at risk. Even insured depositors have had a shot across their bow. When the data is available, expect to learn that deposits reduced across much of Europe over the last weeks, as investors reacted sympathetically.

Europe’s banks were already struggling with capital requirements, even whilst being perpetually bashed by the media. Now they face a new pressure in the danger of depositor retreat. Euro-dollar exchange rates will be a good indicator of how market confidence is holding up going forward. And wholesale funding will become ever more important once more.

Equally importantly, in calling Cyprus’ bluff, the EU once again gave a nod to misapplication of capital structure, allowing bondholders to remain whole. Some of that was officially reversed as Laiki bondholders are finally taking the hit. But in the case of BoC it is not yet clear whether they have skirted the axe. They should not be allowed to of course. There should be a clear legal case against the hit on deposits ahead of senior bonds.

This capital structure point notwithstanding, the messy bailout of Cyprus has reached a reasonable conclusion. The Cypriots knew they were pushing the limits allowing in so much foreign capital, the foreign investors knew they were relying on moral hazard to protect their deposits, and Europe turned a blind eye. All have taken a hit, and a full bailout was neither reasonable nor frankly feasible, given the debt dynamic it would have unleashed.

The problem, more than Cyprus, more than capital controls in the Eurozone, is where things go from here. The ECB’s promise to do whatever it takes to keep the Eurozone whole was noble and impressively designed. But we have seen its dark side in recent weeks. We have now seen how spectacularly far we can drift from economic reason, without markets reacting. Market pricing is an important aspect of risk recognition, we now know it is totally dysfunctional. The open free market era is officially over.