It then approved early this morning (Monday, March 25) in Brussels, a plan acceptable to Cypriot leaders but not subject to approval by the Cypriot Parliament. (Ironically, the German, Finnish and Dutch legislatures may have to vote to authorize the European Stability Mechanism (ESM) to approve loans to Cyprus in April.)

Today’s bailout means tiny Cyprus (its € 25 billion GDP is 0.19% of the Euro zone’s € 13 trillion GDP – and Cypriot share  will be significantly smaller after its banking sector is down-sized), will remain in the Euro zone, which it joined in May 2004.  The bailout also means that the Cyprus’  over-extended banking system will be dramatically restructured and  that Cyprus will have to endure an austerity program.  Another consequence is that  Cyprus will no longer be one of the Euro zone’s principal tax havens.

Key elements of the bailout include: A one-time tax of up to 40% on uninsured bank deposits (those over EUR 100,000) and capital controls.  Doubtful bank assets from Cypriot banks will be segregated into a “bad bank.”  The largest bank, the Bank of Cyprus, will take over the viable assets of the second largest, the Cyprus Popular Bank, which is 84% government-owned and will be closed.  Senior bondholders will also contribute to recapitalization of the Bank of Cyprus. The banking system will be closed “until further notice.” The ECB is expected to insure euro liquidity to the Cypriot banks once they are restructured.  IMF loans will be accompanied by an economic austerity program.

The bailout relieved markets at their opening on Monday,  with Asian and European equity markets rising modestly, after sinking last week.  Euro bond yields are easing and the EUR is  edging up against the USD.

The € 10 billion bailout of Cyprus, the fifth Euro country to be bailed out by the Troika, will prevent the island’s banking system from collapsing and perhaps forcing Cyprus out of the euro. Disturbingly, a “CyprExit” from the Euro zone had been hinted at, irresponsibly, by Euro zone finance officials during the bailout negotiations, presumably because they thought Cyprus’ tiny size meant it was not vital to the integrity of the Euro zone.  It is worth noting that from the Cypriot view the bungled negotiations were not due to the lack of time: Cyprus requested the EC to bail out its banking system last July.

No matter how tiny, however, the Cyprus affair is an acutely embarrassing reminder that the euro currency remains vulnerable to banking and sovereign debt problems, even though important progress has been made in Euro zone governance and regulation since the Euro crisis began in late 2009.

Far larger problem countries include Italy, still without a government since its general elections on Feb. 24-25; Spain, still plunged in recession with a 26% unemployment rate; and even France, which is the core of the Euro system with Germany, but whose fiscal situation if worsening with its increasingly uncompetitive economy  stuck in recession .
Moreover, key parts of the Cyprus bailout raise basic questions about the Euro system. These include the possibility that insured deposits might be taxed to bail out failing banks, an eventuality not lost on depositors in weak banks in other Euro countries. The imposition of capital controls by a Euro zone state in crisis violates one of the principles underpinning the European Union. The ECB’s inability to intervene directly to save “bad” banks is a reminder that the planned banking union and Single Supervisory Mechanism managed by the ECB must be accelerated.  It is equally clear that Euro zone banks’ core capital remains far too reliant on sovereign debt issued by deficit-prone and debt-ridden Euro governments. And Cyprus illustrates, once again, how the Euro zone’s survival depends on “virtuous”, but increasingly grumpy, north Euro zone taxpayers paying to bail out errant “Club Med” members.

Ironically, all of these problems were highlighted by IMF’s first-ever Financial System Stability Assessment (FSSA) of the European Union on the eve of the Cypriot crisis. The 60-page FSSA was approved by the IMF Executive Board and published, with considerable fanfare, on Friday, March 15, the day before the Troika’s representatives agreed, early Sunday morning, on their politically ill-considered conditions for resolving Cyprus’ pesky banking crisis.

Taxing Insured Deposits
The most egregious Troika demand was a one-time tax of 6.5% on savings deposits in Cypriot banks insured by the government up to EUR 100,000; and a 9.9% levy on uninsured savings over that amount. It should be noted that Cyprus’ President Nico Anastasiades, elected on Feb. 25 as head of a new Center-Right government,  approved the proposal to tax the government-insured deposits.  But it was the Troika’s flagrant repudiation of the EU-wide principle of insuring small savers’ deposits that infuriated Cypriot parliamentarians , who unanimously rejected the Troika’s conditions early last week.

Within 48 hours, the red-faced Troika made it clear they were ready to revise their bailout conditions. Today’s final agreement avoids taxing insured deposits, although it will severely penalize the more speculative, uninsured deposits. These are said by Moody’s to include € 20 billion in deposits by Russian, plus those of other tax-evasive non-resident individuals and corporate entities. (The Russian government refused to help a second time, having lent Cyprus € 2.5 billion in 2011. It is thought that Moscow finds Cyprus useful as an off-shore tax haven; a potential source of off-shore natural gas and oil (a sensitive issue for Istanbul which insists that any gas and oil also belongs to Turkish Cyprus); a window on to the bitter Greek-Turkish rivalry in Cyprus, and as a base near Moscow’s Syrian ally.)
The Troika’s initial demands made it appear as if the EC had forgotten its years of travail with deposit guarantee schemes (DGS) designed to avoid the catastrophic bank failures of just a few years ago, notably in Ireland and Iceland.   In discussing the initial proposal to tax insured deposits, Jeroen Dijsselbloem, the 46-year-old Dutch finance minister (since late last year) and new President  of the Eurogroup (the Euro zone’s  17 finance ministers), told the European Parliament on March 21: “Whether we are incompetent or not, I’ll leave up to you to judge.”

Competence is an important consideration in the on-going Euro crisis. The Irish and Icelandic bank failures, plus the Euro sovereign debt crisis, had forced the European Commission in July 2010 to revise its Directive on Deposit Guarantee Schemes (DGS) to harmonize and simplify protection of saving deposits, provide for a faster payout, and improve financing of such plans.  Today, national DGS in virtually all EU countries will reimburse up to EUR 100,000 (or the equivalent in non-EUR currencies) in savings deposits in a failing bank.

A new flare-up of the debt crisis in summer 2012 then forced Euro political leaders to agree on a Euro zone banking union, which was to have included a single deposit guarantee scheme for all Euro zone banks.  Although all EU member states agreed that a Euro-wide DGS was essential to such a fundamental banking reform, the surrender of sovereign control of national banking systems, and taxpayers’ liability implicit in a Euro-wide DGS, were too much for German political leaders, facing a tough Federal election due in September, as well as  other northern countries responsible for guaranteeing deposits in peripheral Euro states.  As a result, the Euro-wide DGS was shelved as an immediate component of the new Euro banking union. (The City of London financial center has a perpetual allergy to regulatory constraints and the  British government  refuses to agree to an EU-wide DGS.)

As the IMF’s FSSA emphasized, deposit guarantee schemes are essential to the Euro system because they prevent depositor runs that can quickly cause banks to fail.   Thus, the Troika’s initial proposal of a tax on Cyprus’ insured deposits looked suspiciously, and mystifyingly, like reneging on the fundamental sanctity of insured deposits.  The move also raises questions about what the Troika might do in the next chapter of the Euro crisis.

Capital Controls
Similarly, Cyprus’ new bailout agreement calls for capital controls with strict limits on individual and corporate movements of assets and changes of accounts, as well as strict rationing of cash withdrawals from ATMs. Investors elsewhere in shaky Euro zone countries may well be asking themselves if capital controls could be imposed if and when their government runs into trouble.

If the question were limited only to marginal economies such as Cyprus and Greece, it might not be of great concern to markets. But the Troika’s actions suggest that basic protections in the Euro system, such as deposit insurance and free capital movement, might be at risk.  Since tax authorities in Paris and Rome are targeting high net worth individuals and foreign companies, French and Italian residents and corporate entities must be concerned.  A French survey, published this past weekend, found that 40% of respondents thought the Socialist government of President Francois Hollande might tax savings.

One potentially useful aspect of the bailout involves Greece’s Piraeus Bank’s absorption of the Greek units of the Bank of Cyprus and the Cyprus Popular Bank (also called the Laiki Bank), once they are restructured and recapitalized.  This will make the Piraeus Bank one of Greece’s largest banks and contributes to the consolidation of the Greek banking system, as well as reducing Cypriot exposure to Greek sovereign debt issues.

But the Troika’s erratic moves to resolve the Cypriot crisis leaves the markets basically unhappy.  Moody’s Investors Service commented in a note reported by Bloomberg today: “Policy makers’ recent decisions raise the risk of deposit outflows, capital flight, increased bank and sovereign funding costs and broader financial-market dislocation throughout the euro area in the future.”

The IMFs Assessment
Despite the Troika’s embarrassing lapsus last week, the IMF’s first assessment of overall financial stability in the European Union was relatively positive, considering the magnitude of the Euro debt crisis since late 2009 and the dire predictions of the euro’s demise.

Much has been achieved to address the recent financial crisis in Europe, the IMF wrote in the FSSA, noting new Euro institutions, such as the ESM (which will be allowed, in principle, to recapitalize banks directly); the new European System of Financial Supervision (EFSF), and the planned Single Supervisory Mechanism (the SSM, to be managed by the ECB) for the new banking union,  which we have described in other reports.

The FSSA also lists the ECB’s numerous “unconventional measures” since 2007 to protect financial stability in the Euro zone. It also pointed out that “virtually all EU governments have started fiscal adjustment programs with varying degrees of success.

The IMF praises EU banks which have raised “considerable new capital” under the guidance of the new European Banking Authority (EBA) although “pockets of weak banks remain” – Cyprus being the latest example. Banking restructuring is, however, too slow with the number of credit institutions dropping a paltry 5% since 2007. Only 60 banks have been deeply restructured. Moreover, many EU banks are still excessively dependent on wholesale funding and/or are too exposed to illiquid or impaired assets.

National government support has been excessive, the IMF warned, and, as we have seen, can trigger an adverse loop between banks and governments. Burden sharing with creditors, i.e. “haircuts” for bondholders, has been rare, although Greece forced creditors to take losses, as will uninsured depositors in Cyprus.

But Cyprus was a perfectly timed example of what the IMF’s FSSA warned are serious vulnerabilities that remain in the EU, and require intensified efforts across a wide front. These include:

1. Bank balance sheet repair. Progress toward strong capital buffers needs to be secured and disclosures enhanced. To reinforce the process, selective asset quality reviews should be conducted by national authorities, coordinated at the EU level.
2. Fast and sustained progress toward an effective Single Supervisory Mechanism (SSM) by the ECB and the planned banking union is imperative. The IMF warns that the ECB must build “supervisory expertise of the highest quality” and have “resources commensurate with its supervisory tasks.” These are essential to anchor financial stability in the Euro zone and for ongoing crisis management. The European Stability Mechanism (ESM) must start to directly recapitalize Euro banks as soon as the SSM becomes effective.
3. There must be a stronger EU-wide financial oversight framework. Enhanced coordination across various supranational agencies is essential to achieve policy consistency, especially at the national level.

The IMF  warns: “Financial stability has not been assured.”
Recent assessments of individual EU member states show vulnerability to stresses and dislocations in wholesale funding markets; a loss of market confidence in sovereign debt; further downward movements in asset price,  and downward shocks to growth. These vulnerabilities are exacerbated by the high degree of concentration in the banking sector, regulatory and policy uncertainty and the major gaps in the policy framework that still need to be filled.

From our point of view, the Cyprus affair illustrates how careless, early-in-the-morning crisis management can escalate an otherwise manageable mini-crisis into one that shakes markets and, worst of all, reduces confidence in the Troika’s ability to resolve such problems while continuously improving governance of the Euro zone.

J. Paul Horne is an Independent International  Market Economist and a frequent contributor to European Affairs