Simple and wrong solution of the Cyprus problem by Сергей Гуриев and Олег Цывинский…

The only rational explanation for the original plan of the Cyprus – is that German politicians do not like depositors Cypriot banks..

The financial system of Cyprus is so many problems within one column, they do not fit that column. Moreover, the situation is changing so rapidly that discussion is not in the current events in the newspapers but in the comments page. We have decided to devote this article to where it all began – with the first sentence of the EU “Tax Deposits” (At a rate of 6.75 and 9.9% for deposits up to and over 100 000 euros respectively).

To this proposal, the reaction not only Putin and Medvedev, but almost all economists – both Russian and foreign. Why? The point is not that we are talking about losses of investors. Cypriot banks in any case not be able to completely pay off its liabilities. Therefore, investors in Cyprus assets somehow lose some of their money. Can not avoid bankruptcy. But bankruptcy can be structured to effectively and fairly – and not set a dangerous precedent for other countries and banks. From this point of view “Tax on deposits” – a very bad decision.

First, the tax on deposits actually destroys the deposit insurance guarantee (Which in Europe apply to deposits of up to 100,000 euros). Deposit insurance – a key element of any modern banking system. Without deposit insurance banking system is much more susceptible to panic. Bank panic or lack thereof – a classic example of a situation that economists call the non-uniqueness of equilibrium. One such harmony – when all investors believe that everything is in order. In this equilibrium, there is no sense to run and take deposits, the bank quietly earns and pays interest on deposits. However, there is a second, poor balance – when investors are afraid that things are bad in the bank. They know that the bank invests in long-term assets. This is normal – this is the business of the bank. But if you must pay for all investors here and now, to liquidate the assets can only be big losses. In fact, to timely pay all depositors money is not enough. Depositors understand this and try to withdraw their money as soon as possible – not to remain last in the queue. Both internal consistency and balance are based on self-fulfilling expectations. If everyone thinks that things are bad, there is a bank panic and the bank does break, no matter how healthy it is. If everyone thinks that all is well, the panic and the bank will not be able to continue working.

It is in order to avoid the risk of panic retail investors, and invented a system of deposit insurance. “Tax on deposits” de facto cancel deposit insurance – and gives the signal that the EU considers such cancellation normal. It makes depositors of other banks, such as Spanish, to think that they too can lose money. The very thought may lead to the banking panic in Spain. They will take the money under the mattress or, for example, German banks are not so important – in any case it is about the Spanish banking system will cease to exist jiffy.

Of course, deposit insurance, and creates problems. Being protected from losses, investors are willing to trust money is more risky banks with higher rates. World Bank economist Asli Demirguc-Kunt and her co-authors collected data on deposit insurance around the world and showed that deposit insurance does increase the probability of bank failures. Therefore, deposit insurance, typically covers only a relatively small contribution (Holders who are less able to monitor banks’ risk and often take a decision to withdraw deposits on hearsay). In addition, it is necessary and banking regulation – the state limits the risks of placing banks.

The regulation does not always work – in all countries there are cases where banks do go bankrupt. In these situations it is very important the order in which investors lose their money. First, shareholders should be punished – and then the lenders and investors. This simple principle gives shareholders greater incentives to monitor the management of banks.

Lenders and large depositors also understand that in the event of bankruptcy and they are losing money (Or get them at once.) Therefore, they also have an incentive to choose less risky banks. It is this incentive to deprive the second disadvantage of the EU, namely, that the depositors of all banks are affected equally. This is a very dangerous precedent. It means that we should not take responsibility for the choice of the bank – still losing (“Tax on deposits”) are the same everywhere.

Third, the plan does not mean long-term solution, but just pretend that today “One-time” tax on deposits will be enough. As it is now, few believe. The main victim of the tax will be the reputation of European policy in the field of economy. Today it is a tax on deposits, tomorrow cancellation of international trade rules, the day after selective nationalization of enterprises? One of the main results of the macroeconomic research – the importance of reputation. After all, once lost it, reputation is very difficult to recover. And then no one will believe any low inflation, no attractiveness for investment, or in the future in the eurozone.

What to do? We have already mentioned, which is to deal with such problems, you can use the approach “Good bank – bad bank”, which has worked well during the banking crisis in Sweden in the 1990s. To avoid repetition, we describe only the main ideas of this approach. It is necessary to divide each ailing bank into good and bad. Good bank should get the remaining good assets. There also need to be translated insured deposits and liabilities to senior creditors. The remaining assets should be passed to the bad bank, whose shares will be shareholders and junior creditors original bank. Bad bank should not engage in lending – it’s just a management company of distressed assets. Her goal – eventually return to its investors if not all, but some means.

Main mystery – why the EU has formulated such a dangerous plan. If this plan was implemented, it would have wiped out all previous efforts to restore confidence in the European banking system. Moreover, the economy of Cyprus and its problems are minor compared with the effects of loss of reputation the European Union. The only rational (Albeit very strange) explanation – is that German politicians do not like to Cypriot banks and investors want to solve the Cyprus problem at their expense. Even if it will hit Europe itself. That says a lot about Russia’s image and its relation to Russia in Europe.

Authors Sergei Guriev and Oleg Tsyvinski – In order: Rector of the New Economic School and Professor at Yale University and New Economic School…

Post by Kyle Keeton
Windows to Russia…

kKEETON @ Windows to Russia…

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