Economics 101 illustrates the dubious relationship between depositors and banks, and every market participant understands that a bank run is a catastrophic scenario. To prevent such a thing, depositors must feel like their money is safe. In order to create this feeling, governments around the world have developed one form of deposit insurance or another, essentially promising the average Joe that no matter what — if banks behave badly, become insolvent, and begin to collapse — their hard-earned cash won’t be lost.
Consensus among observers seems to be that the the single most ill-conceived aspect of the initial bailout package for Cyprus was the attempt to charge a 6.75 percent levy against small deposits. The reason is that the charge undermines the feeling of safety that is necessary to prevent a bank run. The initial proposal, sprung over the weekend when banks were closed and followed by an extended bank holiday where cash withdrawals were severely limited, violated this principle to such a degree that economists around the world have expressed concern over the possibility of bank runs across the euro zone…
Unsurprisingly, Cypriot policymakers rejected the initial bailout conditions in a landslide vote. Not only were they unwilling to blast their constituents with an unprecedented fine, but they recognized the consequences of violating the trust of depositors. Namely, if depositors in other bailout nations do not believe their money is safe — because the Troika set precedent in Cyprus — they may, in mass, move their money elsewhere.
Additionally, if any banks were to fail in the future, depositors would be left with the very real fear that their deposits could be charged to finance a bailout. The 10-second takeaway is that market participants do not feel like EU regulators know what they are doing, and the uncertainty is as damaging as anything else.
In the meantime, Cyprus is gearing up to re-open its banks for the first time in over a week by instituting tight controls on money transfers and by hiring extra security. The nation’s central bank fired the CEO of the Bank of Cyprus, while the chairman of the bank submitted his resignation on Tuesday. A special administrator has been appointed to run the bank in the interim.
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