Are Runs on Cypriot Banks a Black Swan?

Is Cyrus a black swan? No one would have predicted that the threat of a wealth tax on Cypriot bank depositors would provoke a financial crisis, but, as of this morning, it looks like a distinct possibility.

It is unclear what the Cypriot parliament will do about the proposal to confiscate a percentage of bank deposits, but the idea itself has already triggered something of a run on banks in Cyprus. Most savvy commentators are predicting that the contagion could easily spread to Spain and Italy.

Apparently, the financial crisis that was roiling the Eurozone has not been resolved. Who knew?

Most people know that when they put their money in the bank most of it does not stay in the bank. The bank is required to keep a small percentage of your money in its vaults on reserve, but it puts the rest to work by loaning it out. It receives interest on its loans and gives you a portion as interest on your savings.

If everyone drops by the bank one sunny afternoon and asks for his money back, the bank will not be able to oblige. Most of the money is not there.

Obviously, the bank cannot just call in its loans. Think of what would happen to business if it no longer had credit lines. And then there is the more inconvenient possibility that some of the loans were offered as mortgages for properties that are worth less than the face value of the loan.

Those who are first in line will get their money; the rest will get little or nothing. Thus, people run to the bank. They do not saunter over at a leisurely pace.

In the past governments have tried to forestall this possibility by insuring deposits. Even if you are not first in line your money is guaranteed. The guarantee is limited, of course, but it covers the deposits of most people.

But, what happens when the government itself decides to tax all deposits, thus to confiscate wealth at all levels.

Countries like France already have a wealth tax. The government adds up the value of your assets and sends you a bill. But, it only applies above a certain lofty number.

When a country like Argentina cannot finance itself by taxation and borrowing—it defaulted on bonds a while back—it raids the retirement funds of citizens and invests the money in government bonds, thus, forcing citizens to lend the money to the government. Presumably, most of those who are affected are rich.

In most cases this government-sanctioned theft does not much bother anyone. Who cares about the rich? They can afford it, can’t they?

In fact, the Cypriots and their European cousins had first thought that they could use the bank deposits of wealthy Russian oligarchs to fund their government liabilities. Apparently, there is a great deal of Russian money in banks in Cyrus.

But then, the Cypriot authorities discovered that there was not enough Russian money to fund the bailout of their financial system. So they felt that they had no choice but to confiscate the wealth of small savers, the ones who had less than 100,000 euros, the ones whose deposits were, in principle, guaranteed by the government.

So, all the unrich Cypriots who believed that their government would only tax the wealthy woke up yesterday to a big surprise.

From the Financial Times:

Unless there is a last-minute reprieve for small savers, most Cypriot savers would act rationally if they withdrew the rest of their money simply to protect them from further haircuts or taxes. It would be equally rational for savers elsewhere in southern Europe to join them. The experience of Cyprus tells them that the solvency of a deposit insurance scheme is only as good as that of the state. In view of Italy’s public sector debt ratio, or the combined public and private sector indebtedness of Spain and Portugal, there is no way that these governments can insure all banks’ deposits on their own.

The Cyprus rescue has shown that the creditor nations will insist from now that any bank rescue must be co-funded by depositors.

The really puzzling thing is why did people not withdraw their money before? Did they not read the newspapers? Maybe they trusted the new president of Cyprus, who had promised them that he would never accept this? And why has there been so little deposit flight elsewhere in southern Europe? Did they, too, trust their governments? More importantly, will they continue to do so now?

If you think this is bad, guess what: the Wall Street Journal suggests that if the government of Cyprus does not implement the plan, things will be worse.

Bankruptcy, an exit from the euro and a major economic contraction..

But then again, having floated the idea of widespread wealth confiscation they have taken a giant step toward undermining confidence in the Southern European banks. Will this provoke a run on Spanish and Italian banks. After all, a Germany banking official has already suggested that 15% would be a good tax on Italian wealth. Link here.

By now, of course, wealthy citizens in Italy and Spain have transferred much of their money to German banks. The money that remains belongs to the unrich. As always, they will take the most important hit.

[Addendum: one of the best articles on the crisis comes to us from blogger Frances Coppola. It explains the situation in Cyprus and the possible consequences with exemplary clarity. I am grateful to the friend who passed it on to me... and now to you.]

[Another addendum: now The Economist has offered its own perspective, worth some attention.]