The imbroglio in Cyprus


Like Ireland, Iceland and the UK, Cyprus epitomises an economic model that favours the expansion of the financial sector at the expense of others. As we’ve just seen, once crisis hits the fragility of the model is clear for all to see. For Cyprus a downsizing of the sector makes sense (despite the opposition of vested interests), with other opportunities presented by off-shore gas reserves. But the situation in Cypriot has also provided us with some important lessons about how the EU and its members should deal with their financial sectors in this time of crisis.

Cyprus has fuelled the discussion about whether tax havens (and off-shore banking) should be accepted in the eurozone (or in the EU), even beyond considerations about money laundering and tax evasion. Arguably, they should not be. The argument that money in general would move elsewhere in the world is not convincing.

Cyprus has also exposed the pitfalls of bailing-in depositors in a rescue scheme. It is indisputable that burden-sharing arrangements need to involve all stake-holders. But the attempt to bail-in insured depositors was an unfortunate idea that broke a governmental promise that savings, as insured deposits, have a safe place in our banks. This could destabilise banks by causing citizens (especially of more vulnerable countries) to shun them. Eurogroup officials need to be more careful when discussing bail-ins so they do not undermine trust, and it is also clear that bailing-in would be easier within the framework of a functioning banking union that allowed contagion effects to be contained.

The eurozone crisis has provided plenty of evidence to suggest that its design and policy arrangements are inadequate, and that a one-size-fits-all monetary policy should have been accompanied by a fiscal union from the start. The eurozone is more a single currency area than a monetary union and the way it operates is more rigid than the gold standard regime of the interwar period, in spite of automatic stabilisers. (When we know where that international policy regime led into we should be quite worried.) Banking union may provide an exit out of the current troubles, to the extent that fiscal arrangements are mended and a fiscal capacity (as Herman van Rompuy put it) will come into being.

The functioning of a banking union needs the overhaul of the regulation and supervision of financial markets without ambiguity. Light touch regulation has brought havoc in the financial industry and economy at large. Business models have proved inadequate with their emphasis on trading and speculation, the use of fancy derivatives, and the neglect of risks and of complexity. Not only has “too big to fail” (and “too big to save”) become a formidable challenge to governments and central banks, but complexity and size itself are a challenge to management. Forcing organisations to become smaller and more simple (by using anti-trust legislation, splitting larger ones, and by ringfencing retail from trading operations) would be a step in the right direction. Systems could become more robust by relying on more capital rather than on debt, less leverage, and prohibiting the use of depositors’ money for banks’ own trading. Aligning incentives and limiting pay, linking it with performance and the interests of shareholders are also part of these reforms.

Although some have been alarmed by the substantial reduction in cross border financial flows, this could be seen as a healthy phenomenon, as such flows had expanded dangerously. It could also signal a more robust approach that shortens external supplies of goods and reduces the risks entailed by proliferating tail events and chain link disruptions.

If the situation in Cyprus can be seen to push European countries to consider the vulnerability of their own financial sectors, then instead of merely being a crisis it can also be seen as a useful warning that leads to corrections rather than further crises.

PS with the imposition of capital controls Cyprus has - for a while - de facto stepped out of the eurozone. This too has created another precedent as to whether free capital movement is a sacrosanct rule in the eurozone.

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