Mind the sovereign, too | FT Alphaville

Mind the sovereign, too

There are a couple of points worth restating about how peripheral euro zone depositors might come to think about Cyprus’s deposit tax.

First, even if they come to view their deposits as more vulnerable in light of the Cypriot precedent, they’ll also know that the justification for a similar wealth tax is much weaker in countries whose banks aren’t suspect Russian stashes have more typical rosters of depositors. Although the language in Monday night’s Eurogroup statement was ambiguous, its mention of the importance of protecting insured depositors reinforces the point.

Second, for all that’s happened in the last couple of years, the European Central Bank of the Draghi era hasn’t allowed any banks to fail for a lack of liquidity (versus a solvency problem) despite multiple episodes of severe capital outflows.

David Watts of CreditSights has an excellent note that makes the two points above, and then goes on to add that “whether Cyprus triggers a renewed a bout of sovereign meltdown probably depends more on how the Eurozone supports the Cypriot government from here than on what’s been done to depositors.”

He further notes:

The government has a €1.415 bn bond falling due this June. That bond is an international bond and so cannot be easily restructured in the same way as Greece’s. If the Cypriot government cannot gain access to sufficient funds then there is a risk of a disorderly default on that bond. But having imposed pain on deposits, we tend to think the Eurozone governments will now be more willing to support the government.

If there is a clear message that should be taken from this latest bailout it is possibly that investors should be wary of relying on a more constructive stance from Germany in the run up to elections in that country. Although it is interesting to note that the Eurogroup of finance ministers released a statement on Portugal and Ireland at the same time as they announced the Cyprus bailout stating their determination: “to support Ireland’s and Portugal’s efforts to regain full market access and successfully exit their well-performing programmes, in the context of continued strong programme implementation and compliance”.

So a PSI restructuring or disorderly default on Cyprus sovereign debt is less likely now. Probably the deposit-tax advocates view their idea as (and maybe have tried to sell it as) a kind of quid pro quo for avoiding later pain of a different kind.

Much more in the note, which is among the clearest pieces of research we’ve come across in the last couple of days, and also takes a good stab at explaining why deposits in some form were an inevitable target and other solutions were discarded. It all starts with this chart, of course:

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The longer-term risks are a different matter, and JP Morgan’s Alex White has a short note echoing some of Joseph’s earlier points, but they too are worth highlighting again (bold ours, and we broke up the pars for readability):

In the longer-term, we expect significant ongoing ripple effects from the revealed preferences and attitudes that have emerged in the Cypriot case.

Firstly, the affair reflects a change of behaviour amongst the policy making community, which looks more willing to accept risk in an OMT world.

Secondly, it hints at a far more hawkish German attitude than we expected, which could have implications for the implied willingness to intervene in extremis elsewhere in the periphery (we will write more on this shortly). Essentially, we are seeing the rise of ‘the Germany that can say no’.

Thirdly, these events are likely to lead to gradual change in the behaviour of depositors around the region.

We do not expect short-term bank runs or direct contagion, Near-term impacts on bank equity have been relatively limited so far (mostly in the 4% range). However depositors will now be aware that they are effectively taking a significant credit risk when they leave funds in weak banks backed by weak sovereigns – and there is a good chance that rates may need to rise in the periphery to reflect this increased perceived risk (indeed, we believe this action hints at broad risks for anyone with capital in a fiscally stressed country).

The long-term implication for bank funding in the periphery is not a positive one, in our opinion, and by implication, there could be impacts on the supply of credit. Effectively, this would appear to work directly against the objectives of Banking Union, which is designed to ensure that a Euro in a Cypriot bank can ultimately be treated in the same way as a Euro in a German bank.

In our opinion, there is a good case to say that the Cyprus crisis may blow over in the near-term, but the long-term breach of faith between Euro area policymakers and regional depositors will remain (even if the insureds are ultimately made whole). Despite the muted reaction so far, Europe has reminded investors that there are significant problems behind the curtain.

Both notes, again, in the usual place.