Can Cyprus Avoid a Bank Run And Remain In The Euro Zone?

There’s no sure way to tell what the fallout from the closure of Cyprus’s second-largest bank will be, but word on the street is that it will be bad. Cypriot leaders and the Troika — a coalition of European Union finance minsters, the European Central Bank, and the International Monetary Fund responsible for ensuring euro-zone economic stability — reached an eleventh-hour deal to close the bank over the weekend.

The dissolution of the bank is unique for a few reasons. Perhaps most significantly, it is the first time that senior bondholders and depositors will be charged for the cost of a bailout since the crisis began in 2008. Until this development, the Troika had set a precedent of leaving depositors and senior bondholders relatively unscathed. This meant that banks in bailout nations, or banks that had received bailouts directly, remained at least reasonably attractive to debt investors and would-be depositors. At the very least, they had no explicit reason to move their money out of the financial system.

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Deposits under 100,000 euros will be left alone, but deposits over that much will be charged as much as 40 percent in order to finance the 10 billion euro bailout package. As the bank dissolves, Cyprus’s largest bank — which will also be forced to charge depositors — will inherit viable assets. With emergency liquidity more or less secured, policymakers are left to face an infuriated public and dubious market participants…

One of the fundamental grievances is that depositors and senior bondholders no longer feel like their money is safe. Banks in Cyprus have been closed for at least 10 days, ever since the whole ordeal began, and will remain closed until at least Thursday. The government is concerned — and rightly so — that once the banks reopen people will make a run for their money. In this scenario, individuals have a rational fear that their money is not safe in Cypriot banks. Taken one at a time, it makes sense for them to move their money somewhere safer.

However, taken in aggregate, individual actors behaving in this ostensibly rational way produces a bank run, which is a net negative. With expectations high that everybody will try to move their money as soon as humanly possible, Cypriot policymakers are instituting tight controls on cash and capital flows that will remain in effect for at least a few weeks. The fact that these controls will be in place is by itself evidence of the extraordinary nature of the situation.

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Speaking to Bloomberg, Cypriot finance minister Michael Sarris commented on the delicate nature of the controls: “We are having deliberations together with bankers and our partners to see what is the right balance between controls that will not cripple the economy, that will allow the economy to function.”

Understandably, the situation has spooked observers. If the Troika decides to enact similar bailout terms on nations such as Greece, Italy, or Spain, depositors would make a run on the banks and bondholders would try to sell everything they could. There’s no need to reiterate how needlessly destructive this would be for the EU economy.

Perhaps the only thing more concerning than navigating the fallout of the bailout and near financial collapse is the idea that Cyprus could exit the euro zone. A few economists have called for Cyprus to entertain the idea, but Sarris is a vocal objector.

“It would be catastrophic to even talk or entertain the idea and much less exit the euro zone,” he said in an interview with Bloomberg. “Our place is in Europe, our place is in the euro zone and we will do whatever it takes to stay there.”

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The crisis in Cyprus is highlighted by the fact that the nation’s banking system holds assets equal to 750 percent of the country’s 2012 GDP of about $24 billion. Cyprus Popular Bank is 84 percent owned by the nation’s government, and will be wound down with major losses going to uninsured depositors and bondholders. Bank of Cyprus, the nation’s largest bank, will take over viable assets and receive 9 billion euros ($11.69 billion) in emergency liquidity provided by the central bank.

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