The collapse of Lehman Brothers brought the global economy very close to the brink. The decision that was taken to allow the bank to go under has reshaped the landscape of the post Lehman financial system.
Focus now turns to a tiny island situated in the Mediterranean which accounts for only 0.2% of Eurozone GDP as the next pivot in the global financial saga. Cyprus’s story is by now a familiar tale of a rapid credit growth, decease a property bubble and a subsequent fall from grace when the global financial system collapsed in 2008.
Cyprus needs a loan of around 17billion from the EU and IMF in order to preserve its banks. However, the country is tasked with raising 5.8billion on its own in order to ‘unlock’ the rest of the bailout package. The reason for this is simply that Cyprus would be unable to take on the level of debt necessary if a full bailout was provided and its needs and resources differ to those of Ireland, Greece, Portugal, and Spain. For this reason, the Cypriot government was forced to look for alternative options…
Then came the Lehman moment. In an unprecedented move, it was proposed that the government should raise the necessary funds from the bank accounts of Cypriot depositors by imposing a depositor levy across all deposits regardless of Cypriot deposit insurance or not; 6.75% on loans of under 100,000 Euro and 9.9% on loans above. The proposal was resoundingly rejected in parliament after a public outpouring. Even the ruling Democratic Rally Party who proposed the levy abstained from voting. The rejection came despite an alteration to protect savers with less than 20,000 in savings.
However, the fallout from this rejected vote could be hugely significant to the Eurozone as a whole. Deposit insurance is a vitally important feature of modern banking. It serves investors by giving them the confidence that their money is safe and in a round-about way also protects governments by preventing bank runs from occurring. By undermining this principle, the Cypriots and Eurozone financiers have potentially opened a Pandora’s Box and shattered investor confidence in the entire Eurozone system. If it was proposed for Cyprus, it is now plausible that it could also be proposed and passed for a much larger economy; Italy, for example.
Cyprus, on the sixteenth of March set a very dangerous precedent that could potentially undermine one of the key pillars of banking; that confidence is very much dependent on the belief that depositor money is safe.
One can of course sympathise to a degree with Cyprus given that the biggest problem for the islands government at present is that they don’t really have any other options. Russia seems unwilling to provide the necessary assistance and is very unlikely to provide the full 5.8billion.
At time of writing, it is unclear whether Cyprus will be the first member state to be forced to leave the Monetary Union, which will carry enormous ramifications of its own, given that the European Monetary Union was designed as an entry only system. Nationalisation of pension funds, capital restrictions, a pooling of state assets and a restructuring of the levy are the main methods of securing the 5.8billion that is needed currently.
Regardless of the outcome of efforts by Cyprus to raise the necessary funding, the scale of the fallout from this rejected vote remains unseen. It could have a very significant impact on the future of the European and global financial system if investors sit up and take notice of it, even if Cyprus does manage to pull itself back from the brink over the coming days.