How safe are the EU banks?

Cyprus is divided. The northern part is Turkish while the larger southern part is Greek. U.N. efforts to find a way to unify the island have failed.

The economy of Greek Cyprus has been dependent on tourism, agriculture and, in recent years, on a financial industry that has come to rely heavily on money deposited by Russians and Ukrainians. The suspicion has been that much of these deposits come from laundered and shady money.

Cyprus, which represents less than 1 percent of the gross domestic product of the eurozone, was allowed to join the zone despite its divided status and question marks over its banks.

Cypriot banks lent large sums to Greece that cannot be recovered at least in the short term.

Two Cypriot banks including the main bank, the Bank of Cyprus, were in danger of defaulting on their debts. This would have bankrupted the Cypriot government.

Because of the many Russians who visited Cyprus and deposited funds there and the growing close relationship between Cyprus and Russia, the Cypriot government looked for a rescue from Moscow.

As this was not forthcoming, they had to appeal for a eurozone and International Monetary Fund rescue following those for Ireland, Portugal and Greece. The terms offered were tough.

The maximum loan was €10 billion and an amount of almost half as much had to be found by the Cypriots.

The Cypriot government decided that the only way to deal with the problem was to impose a sliding scale tax on deposits including small deposits of under €100,000, which were supposed to be guaranteed. This roused howls of protest and was rejected by the Cypriot Parliament.

The Cypriot finance minister was again sent to Moscow but had to return empty handed. After difficult further negotiations in Brussels, the terms of the loan were adjusted and the Cypriot government accepted that small depositors should be exempted from the proposed tax, which would consequently fall more heavily on large depositors many of whom are Russian. This aroused the ire of Russian President Vladimir Putin against the European Union, but it did not lead to Russian financial assistance.

Another condition of the bailout was the reorganization of Cyprus’ banks. Laika bank, which was in the worst shape, will be dissolved and the Bank of Cyprus restructured.

During the bailout negotiations the banks were shut down and limits were imposed on the amount depositors could draw daily. When the banks eventually reopened limits on withdrawals were maintained and capital controls imposed “temporarily.”

Such controls are contrary to basic EU rules and only permitted in exceptional circumstances for a limited period. In this case “temporary” may have to mean a long time.

The initial decision to impose a tax on deposits that were supposed to be guaranteed was a serious mistake by the Cypriot government. It should have been spotted and corrected by eurozone finance ministers.

The €10 billion limit was the maximum that Chancellor Angela Merkel, who faces an election later this year, thought that German voters would accept.

The Germans and other northern European countries, particularly Finland and the Netherlands, remain disillusioned with their southern neighbors, whom they accuse of profligacy.

The fear is that the Cyprus bailout will set a precedent in any possible future bailouts for Spain and Italy. The counter argument is that Cyprus with its overblown and inadequately supervised banking sector is an exceptional case and that Spanish and Italian banks are different.

Perhaps, but Italy has still not been able to form a new government after the recent elections and seems unwilling to undertake the economic reforms needed.

If an Italian or Spanish bailout were to be necessary, a run on the banks cannot be ruled out. Mario Draghi, the president of the European Central Bank, said last year that he would do whatever was necessary to ensure the stability of the euro, but the strains on the currency and the European economy could become critical.

The governor of the Bank of England has recently called on British city banks to strengthen their capital base. In his view, they have not made adequate provisions to cover all their possible losses on loans that had gone sour.

This demand, however, complicates the government’s wish to see more lending to small and medium enterprises. Austerity to cut the deficit is necessary, but growth requires the expansion of credit and demand.

Many British and European banks are too big to be allowed to fail. This inevitably increases the moral hazard posed by the irresponsible behavior of some bankers and financiers. The banks and fund managers are still paying themselves huge bonuses and complain bitterly about the decision of the EU to impose a limit on bonuses of not more than annual salary. They argue that this will simply lead to higher salaries.

The Swiss have agreed in a referendum that in Swiss companies shareholders should be able to decide on salaries and bonuses and have banned “golden hellos” and golden “goodbyes.”

There is much popular support here for curbs on bankers’ pay and bonuses, but the financial sector is such an important part of the British economy that bankers still have too much power.

The economic crisis that developed after Lehman Brothers were allowed to go bankrupt, forced the British government to take major stakes in Royal Bank of Scotland where the government control over 80 percent of equity and in Lloyds where the government’s stake is over 40 percent.

It will be some time yet before these stakes can be privatized. The crisis might have been prevented if the Financial Services Authority had been tougher and more competent.

The new arrangements for financial control in Britain should be better, but the City of London still calls for light-touch regulation to allow them to compete effectively in international markets.

The top priority for the EU should be the development of an effective banking union with tough rules and proper enforcement.

Hugh Cortazzi served as Britain’s ambassador to Japan from 1980-1984.

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