Economix Blog: From Lehman to Cyprus

FLOYD NORRIS

Notions on high and low finance.

The European decision not to honor deposit insurance in Cyprus, by making all depositors contribute to the cost of a bailout, reminds me of the decision to let Lehman Brothers go under. Moral hazard is being avoided. The question is what that will cost.

In the case of Lehman, the cost turned out to be far greater than anyone expected. Suddenly the crisis was affecting money market funds. We learned to our discomfort just how interrelated the world’s markets were. I doubt anyone involved in making the decision thought about money market funds until they learned one had just blown up, thanks to the Lehman failure.

In the wake of all the bailouts that followed Lehman, something of a consensus has evolved — at least among non-central bankers — that those who fund bad banks should suffer. Bank bondholders are clearly at risk.

But Cyprus banks apparently don’t have many bonds. If someone is going to suffer, it will be the depositors. So the clever idea of a one-time tax on bank deposits was adopted. It did not help the cause of the depositors that a lot deposits seem to come from Russian moguls, not exactly a sympathetic group.

But Europe should have learned from Britain’s fiasco at Northern Rock that deposit insurance matters, particularly for relatively small accounts. If they can wipe out such insurance in Cyprus, why not Spain? Or Italy? Or even France?

There is a risk that a lot of money will flow out of troubled countries’ banks. Those flows had started to reverse last year, after the European Central Bank stepped up to print money and reassure investors in government bonds. Now, there is every reason for depositors to seek out banks in the safest countries — and that means Germany.

Europe stands to save $7 billion out of the $17 billion a Cyprus bailout would cost. How does that compare with the cost of a run on Italian banks? There is no evidence the Europeans weighed that. Just as there is no evidence that the United States Treasury had any idea at all just how disastrous it would be if Lehman were allowed to fail.

The time to avoid moral hazard is when there is none. How is it that Cyprus banks were allowed to have capital structures that meant depositors had to suffer? How was it that Lehman had no liquidity when it needed it? Bad regulation is the answer.

Markets are down on Monday, but not disastrously. Perhaps it will turn out my fears are overstated, and that depositors will not panic in other countries. Let’s hope so.

Article source: http://economix.blogs.nytimes.com/2013/03/18/from-lehman-to-cyprus/?partner=rss&emc=rss