But the banks are made of marble, with a guard at every door; and the vaults are stuffed with silver, that the farmer sweated for, goes the chorus to the Pete Seeger classic written by an upstate New York farmer named Les Rice in 1948.
After the last few years of bank bailouts, first in the United States and just this week in the island nation of Cyprus, one has to wonder if maybe Seeger and the Wobblies were right in their distrust and hatred of the banking system.
Yesterday, the government of Cyprus and the European Union announced that that nation’s bankrupt financial system would be restructured and recapitalized. As part of the restructuring, for the first time – though not likely the last – the European Union finally stood up to the banks’ investors and refused to simply print money to bail out Cyprus. Under the deal, it appears that contracts and agreements may actually be honored, and depositors and investors (including the Cypriot government) would finally pay the lion’s share of the cost for restructuring.
According to Jeroen Dijsselbloem, head of the Eurogroup of finance ministers, the deal would put an end to the uncertainty that affected Cyprus, but even the best-protected senior bondholders investing in Laiki Bank (the nation’s second largest) would see their holdings “wiped out,” while contributions to recapitalize the Bank of Cyprus (essentially the country’s central bank) would come from senior bondholders, junior bondholders, shareholders and we now know substantially from uninsured depositors who may likely see 40 percent of their uninsured savings wiped out.
Cyprus must do this in order to stay in the Eurozone, something that is important to that troubled country that is still divided following what was essentially a civil war in the early 1970s. While this will be difficult – particularly for the uninsured depositors – consider how different this is to a similar situation that occurred in Iceland just a few years ago.
Banks in Iceland, just like those in Cyprus, marketed themselves as a protected “offshore” haven for savings for depositors from larger countries. In the case of Iceland, much of the money came from Britain, while in the Cypriot case, the monetary flows were from Russia. In both cases, the deposits in what were essentially poorly capitalized banks grew to levels far in excess of the national GDP, and predictably, in both cases the banks failed.
Following the bank collapse in Iceland, the government of the United Kingdom stepped in to protect depositors and initiated claims against Iceland, which eventually prevailed in court leading to large losses for the British treasury. In other words, even though depositors in Iceland knew that their principle was not fully protected, they were bailed out at the cost to the taxpayers. This occurred at about the same time that the United States was also bailing out the bondholders, depositors and shareholders in its largest banks. These two actions have led both investors and savors to believe that governments would continuously burden taxpayers to protect them from bad investment decisions. Economists call this a moral hazard and have warned that the banking system would have a tendency to take undue risks because the costs that could incur will simply be pushed onto taxpayers.
This has ended on the rocky shores of Cyprus. For once governments have stood up to both investors and large depositors and have required that those responsible (and who have benefitted from undue investment risk) pay for the cost of their errors.
The big question now will be how this impacts the banking sector in other weak European economies, specifically Greece, Italy, Spain and even France. If this action leads to a run on banks in these economies it would throw the Eurozone into chaos, a problem that would soon spread around the world (what the finance types have called contagion). On the other hand, this could finally be the first move toward repairing a financial system that is built on a mountain of debt rather than on productive activities. As bad financial investments are unwound and the resources moved toward more productive activities, the Eurozone could see a boom in production and economic growth.
Let’s all hope that the banks are really made of marble and that they can withstand this shock. It would be good for Europe, and ultimately would force the American government to come to terms with its debt fueled phantom economy.