March 20, 2013
Gulati & Bucheit on Cyprus
Posted by David Zaring

I do international financial regulation, but you really have to turn to others for sovereign debt.  Here's Buchheit and Gulati's three page long solution to the Cypriot debt crisis.  Here's Felix Salmon on it:

Their plan is simple:

First, leave all deposits under €100,000 untouched. Hitting those deposits was by far the biggest mistake of the Cyprus plan as originally envisaged, and everybody would be extremely happy if guaranteed depositors could be kept whole.

Second, term out everybody else by five years, or ten if they prefer.

That’s it! That’s the whole plan, and it’s kinda genius. If you have bank deposits of more than €100,000, they will be converted into bank CDs, with a maturity of either five years or 10 years — your choice. If you pick the longer maturity, then your CD will be secured by future Cypriot gas revenues, which could amount to hundreds of billions of dollars.

And if you have sovereign bonds, they too will be termed out by five years, giving Cyprus a bit of breathing room to get its act together.

Do that, say Buchheit and Gulati, and you manage to reduce the size of the needed bailout bymore than the €5.8 billion that Cyprus is currently planning to raise with its tax on bank deposits — and you don’t touch anybody’s principal at all. To be sure, the new CDs, which would be tradable, would surely trade at less than par: there would be a present-value haircut on deposits over €100,000. But that’s going to happen anyway. And at least in this case patient depositors will have a chance of getting all their money back in full — with interest. And, most importantly, guaranteed depositors will remain unscathed.

And here's Matt Levine on how the crisis is so strange.

The various reasons to object to this boil down to its violations of absolute priority; the way things are supposed to work is more or less:

  • When a bank goes bad its equity holders lose,
  • If zeroing the equity holders doesn’t cover the losses, then the bondholders lose,
  • If zeroing the bondholders doesn’t cover the losses, then the depositors lose,
  • But even there deposits under €100,000 shouldn’t lose, since they’re government guaranteed under the EU deposit insurance scheme.

In Cyprus sort of the opposite happened: equity holders are being diluted but not confiscated,1bondholders weren’t touched (there are essentially no bonds),2 and depositors under €100,000 were haircut in order to limit the damage to depositors over €100,000. The reasoning for this is unclear; a leading theory is that softening the blow on over-€100,000 deposits was viewed as necessary to retain Cyprus’s status as a haven for offshore deposits by tax-dodging Russian oligarchs. This is an odd theory; losing 9.9% of their money is no doubt a more pleasant proposition than losing 15% though it’s not what you’d call absolutely pleasant and they don’t seem particularly pleased with it

It is strange, but I agree with Andrew Sorkin that haircuts, in this case, aren't supremely terrible to contemplate.

By the way, if you’re wondering why investors left so much money in troubled Cypriot banks, here’s a trivia question: Would you have been better off leaving your money in a bank in the United States or in Cyprus over the last five years?

The answer: You would have been better off in Cyprus, even after the bailout, when your money was “confiscated.” If you had 100,000 euros in a Cypriot bank account over the last five years, where the interest rate has averaged about 5 percent, you would have about 127,600 euros today. Even after the bailout, which would require you to give up 10 percent of your deposit — 12,760 euros — you would be left with 114,840 euros. The American bank? The $100,000 you deposited at Bank of America five years ago is about $105,100, at the going rate of about 1 percent interest a year.

Finance, Financial Crisis, Financial Institutions, Globalization/Trade | Bookmark

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