Cyprus: illiquidity vs insolvency

by Michael J. Howell30. March 2013 11:34
Banks are often insolvent: they are less often illiquid. Insolvent banks can survive: illiquid ones cannot. The key Cyprus banks and probably many Spanish banks are insolvent, but only the Cyprus banks are currently illiquid. The gift of more liquidity from the IMF/ ECB has been made conditional on depositors suffering a 'haircut' on their deposits. Many think this unfair, but is it? Cyprus banks allegedly lost most by investing in Greek debt. Unlike most other Western banks they were predominantly funded by retail deposits rather than wholesale funds. In other words, Cyprus is more an old-fashioned case of poor lending/ investment decisions than a question about lack of wholesale funding. Moreover, it is not systemic, or too big to fail. It is Europe's equivalent of the Barings failure.Therefore, the IMF/ ECB can afford to take a tough line. On the other hand, it is a fine-line being drawn here, and one that sees to rest on the source of bank funding. Spanish banks have also made poor lending decisions, but they are bigger, lately more dependent on wholesale funding and, more importantly, more likely a systemic threat. The ECB is funding these and other banks either directly through its balance sheet or indirectly through the Target2 balances. Therefore, strictly in pure banking terms the ECB are probably correct to force a haircut on Cyprus although the size is up for debate. What is less clear is why they are not doing the same for other Eurozone banks and, moreover, why the funding playing field is so uneven and ill-thought out. It tells us that (surprise, surprise) all decisions are political, and they are reactive. The air of crisis management hangs like a pall over the Eurozone. We remain skeptics, not about the integrity of the Euro, but about it's level. Future funding crises seem inevitable, and hence the Euro must drop more.

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