Is anyone advising the Central Bank? (flickr: torbakhopper)

Readers of this columns will know that I was rather positive about the Cyprus solution at first. But the central bank, bestowed with new powers since the parliament’s emergency laws passed late March, is blundering its mandate, and plundering ordinary businesses to protect a long list of unacceptable exceptions.

The original deal several desirable features, and I list — verbatim from my earlier post — only the ones nullified by the central bank within days:

• The damage falls on those who took credit risk vis-a-vis banks that are now insolvent
• No laws or promises have been broken
• The creditors of still more or less healthy banks contribute nothing or next to nothing
• The decision of the amount of haircut is set not by politicians, but based on the money that’s actually in the bank after the EU bailout is in place also.

This “second” deal was already going to be remembered for not having to be voted on by the Cypriot parliament, thereby giving every Cypriot MP the perpetual right to criticize the deal at will. But now it is more likely to be remembered for how the home-brewed “Central Bank Measures“, fully authorised by the parliament’s emergency laws passed on March 23, manage to destroy the above benefits of the deal, one by one:

(1) The damage falls on those who took credit risk vis-a-vis banks that are now insolvent: Well, it turns out not all creditors are created equal. I quote:

the entire amount of deposits belonging to financial institutions, the government, municipalities, municipal councils and other public entities, insurance companies, charities, schools, educational institutions, and deposits belonging to JCC Payment Systems Ltd have been transferred to the Bank of Cyprus.
All other deposits exceeding €100,000 remain in the ‘bad’ Laiki Bank

Interesting: Why could no-one work out the damage to these other parts of the system earlier? At least two years passed since the Greek bonds got re-structured, which put Laiki and Bank of Cyprus into danger of imminent insolvency, delayed only by the ECB’s emergency liquidity assistance. There was plenty of time to work out how to protect this long list of favored sectors. Instead, Cypriots businesses (along with plenty of foreigners, to be sure) get this last-minute discrimination amongst depositors by political fiat of the central bank! I have written a special article about the terrorism of small exceptions in our government system. For years, the Cypriot government wasn’t willing to deal with the situation, and ended up hoping the Central Bank would do the dirty work. This strategy failed.

(2) No laws or promises have been broken. This is still true about the desposit guarantee up to EUR 100,000 (they have credit risk against Bank of Cyprus, and presumably they still have the state guarantee). But it is no longer true about a fundamental tenet of securities law, that all creditors of pari passu rank are to be treated equally. The discrimination amongst Laiki depositors is now open to legal challenge, which risks a real mess. For the avoidance of doubt: Here I am not talking about discrimination between banks (see point (3)), but between pari-passu creditors of the same bank!

(3) The creditors of still healthy banks contribute nothing or next to nothing: I should have formulated this more carefully. It was good that the depositors aren’t affected directly, but what is happening now is that the other banks get protected from bad investments they have made into Laiki or BoC (while Laiki and BoC clearly do not get any such protection). There is thus also arbitrary discrimination amongst banks in Cyprus: The banks which made large risky investments into Greek bonds get hit, while the banks which made large and risky deposits at now defunct Cypriot banks walk away protected.

(4) The decision of the amount of haircut is set not by politicians, but based on the money that’s actually in the bank after the EU bailout is in place also. This one they have really ridden roughshod over. The truth is The few remaining effected depositors (including Cypriot businesses) will lose disproportionally more, as the price of protecting banks, insurance companies, the government, and plenty of others who were in a much better position to know and understand the credit risk they were taking.

As much as I empathize with the intent to save education, avoid contagion into other banks, avoid negative feedback into government finances, etc., you can’t just draw an extremely long list of exceptions, when it’s been clear for more than two years that these banks are insolvent, and the net result is that you completely over-burden those depositors who were least in a position to know what was going on. How will the BoC justify protecting banks and insurance companies over other depositors?

Maybe we should blame the ECB for giving Cypriot banks a lifeline for too long. Or maybe we should be happy the ECB didn’t do “whatever it takes” for even longer. The fact remains, there was time, the ECB had bought it (and is paying for it), and it was wasted.

If, at the local political and legal level this will not end well, remember that the reasons will have little to do with the insolvency itself, and all to do with bad how after the last minute, foreigners and Cypriot businesses had to step in not just for the failed banks as had been agreed in Brussels, but also for the government, the other banks, insurance companies, and a long list of others.

But then again, maybe that’s to be expected from a central bank that does not control its own currency. My short-term prediction is still that the Cypriot issue will be contained. But it is nonetheless a reminder that, in its current form, with the current institutional apparatus, the currency union will fail eventually. This is the issue that Europe must face up to, outside of the day-to-day firefighting.