CYPRUS EXPOSES EUROZONE´S LACK OF FINANCIAL STABILITY / THE FINANCIAL TIMES COMMENT & ANALYSIS

Cyprus exposes eurozone’s lack of financial stability

Howard Davies

March 22, 2013

Over the past three years the EU has shown a remarkable facility for turning problems into crises and crises into catastrophes. Last summer it seemed that a new leaf had been turned. Mario Draghi, the European Central Bank president, pledged to do “whatever it takes” to stabilise the euro, and the fairly rapid agreement to establish a banking union seemed to be another positive step forward.

 

 

But it now seems this dawn was false. The Cyprus crisis has caused the rock to roll back down the hill. Like Sisyphus, the eurozone’s policymakers must now begin pushing it back up.

 

 

The Germans are absolutely right in logic – as they often are – that Cyprus has for years been pursuing a very dangerous strategy. Its banking system is too large – not quite Icelandic in scale, but close enough. Banking assets are about eight times gross domestic product, too big to be credibly supported by the Central Bank of Cyprus. The close links developed with Russia are another high risk factor. Limassol now looks like a Black Sea resort. By no means all of the Russian money is “hot” in the legal sense, but a situation in which Cyprus appears to be the largest overseas investor in Russia, intermediating funds from Russian companies domiciled in Caribbean offshore centres, does not look logical or sustainable. And it has certainly generated hostility in the rest of the EU, causing politicians and officials elsewhere to ask just who is benefiting from an expensive rescue package.

 

 

But all this is sherry – or perhaps vodka? – under the bridge. The question is what to do now.


Plan A, in which all bank depositors would contribute towards bridging the gap between the funds offered by the EU and International Monetary Fund, and what is needed to stabilise the debt position, was decisively rejected by the Cypriot parliament. And there is little sign that Moscow is prepared to throw good roubles after bad.


Europe should in any event be nervous about the conditions that may be attached to any support from that quarter. How good an idea is it to increase Russia’s hold on gas reserves?
 

 

 

Plan C, or gamma in Cyprus I suppose, involves creating a “bad bank”. That may make sense in the medium term, but in itself does not create new money. And it is time-consuming to separate good assets from bad. There is also a risk of knock-on impacts on Greece. Many of the Cypriot banks’ bad assets are in Greece.


So we may soon find ourselves looking for delta or epsilon. (I knew ancient Greek O-level would be useful one day.) These letters of the alphabet will require more support from the EU, and probably the IMF too. That is unwelcome, and will be hard to swallow in Berlin, but the alternative is financial autarchy for the island and withdrawal from the eurozone, which will expropriate bank depositors in a different way.


Up to now the ECB’s role in the negotiations has – oddly – been in the hands of Jörg Asmussen, the former German finance ministry official who now sits on the central bank’s executive board. Over the weekend Mr Draghi will need to take firm charge. He will need to make good, once again, on the pledge to do “whatever it takes”.

Beyond the weekend, the Cypriots have shown that banking union, as currently defined, is no such thing. We may have a single supervisor, or are about to have. But without a mutually guaranteed, eurozone-wide deposit protection scheme, and a centrally funded resolution authority, Europe is still a long way from financial stability.

 

 

 

The writer is a former chairman of the UK Financial Services Authority, former deputy governor of the Bank of England and former director of London School of Economics. He is now a professor of practice at Sciences Po in Paris