The Central Banks' Failure to Eliminate Risk

Now, it's Cyprus--tiny Cyprus, with 0.2% of the EU's GDP--that's shaking up the financial world.  The Asian stock markets are falling on Monday, March 18, 2013, and stock futures indicate that the European and U.S. stock markets are also headed downward.  Runs have already started at Cyprus' banks, and a bank holiday was declared for Monday, in order to stop the outflow of rats from the ship. 

The proximate cause of the panic is a proposed EU bailout for Cyprus that includes taking from depositors at its banks 6.7% of deposits under 100,000 Euros, and 9.9% of deposits exceeding 100,000 Euros.  Surprisingly, this tax (which is to help pay for the bailout) would hit small depositors that were supposed to be fully insured up to 100,000 Euros.  The bailout violates a sacrosanct principle of bank regulation--that deposit insurance cannot be impaired.  Deposit insurance is the key to depositor confidence, and the foundation of commercial banking.  America's banking system recovered from the Great Depression (which saw thousands--yes, thousands--of bank failures) only when deposit insurance was instituted.  If you scare depositors, an entire banking system can go belly up in less time than it takes to scramble a couple of eggs.

The powers that be which fashioned the Cyprus bailout--the EU, the European Central Bank and the IMF--imposed the depositor tax because of the somewhat shady doings of Cypriot banks.  They extended the scope of their businesses way beyond their home island, accumulating assets amounting to twice the size of Cyprus' GDP.  Reportedly, around half of their deposits are from Russians, and suspicions of money laundering, tax evasion, and other alleged shenanigans lurk.  The stolid burghers of northern Europe have been wrinkling their noses over the unsavory aromas rising from Cyprus' banks, and they evidently view a tax on depositors as fair compensation for the trouble the EU is now being put to.

Whether or not the deposit tax is fair is, from a commercial standpoint, pretty much irrelevant.  The financial markets thrive on confidence.  The EU's financial crisis eased last summer when the head of the European Central Bank said, in substance if not words, that he would authorize the printing of money to prop up failing EU member nations.  The bond vigilantes backed down.  But the Cyprus bailout's tax on deposits is the opposite of money printing, and implies that losses are possible for holders of deposits in banks at other weak EU nations.  There's nothing that shakes confidence like the prospect of losses, especially if one was supposed to be insured against them. 

The financial markets have been coasting on a mellow buzz from toking up on central bank monetary accommodation.  Ultra low interest rates and quantitative easing have taken the edge off volatility, and the markets seem to know no fear.  But there is no way to eliminate financial risk.  You can only transfer it somewhere.  The Cypriots apparently wanted to transfer the risks and costs of their bankruptcy as far north as they could.  But the folks up north didn't seem to cotton to that notion.  So the risks and costs blew back, and as we now see, blowback can be nasty. 

Who knows how this will all end.  No doubt high ranking officials on both sides of the Atlantic are engaged, even as we write, in frantic discussions to figure out how to prevent the spread of financial contagion.  The baseline problem is that the EU as a whole hasn't decided how to allocate the costs of resolving its financial crisis.  This is probably a harder problem than the resolution of the U.S. government's current dysfunction, since, in Europe, people from disparate countries and cultures must somehow find common ground.  Since these are the same people who fought two horrendous World Wars against each other in the 20th Century, it remains unclear if they will succeed.

In the meantime, remember that central bank monetary policy can provide a methadone high, at best.  It won't last forever, and the aftermath may be a real downer.  It's fine to feel good about the financial markets right now.  But keep in mind that the central banks cannot eliminate financial risk, and if you relax your vigilance, risk could bite your left ankle in a flash.