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Home > Blogs > Gervais Williams > The thin end of a very worrying wedge?

The thin end of a very worrying wedge?

Cyprus: the thin end of a very worrying wedge? Gervais Williams

Cyprus is a small country.  And globally there are very few depositors outside of Cyprus who have significant cash balances in their banks.  To most, the recent decision to fund the bailout of the Cypriot banking system through a sizable tax on larger depositors is little more than a news story.  However my view is that it risks changing the behavior of large depositors.  And unchecked the consequences could be serious.

At this stage it is easy to argue that Cyprus is a special case.  Although Cyprus is a part of the EU, its banking system is oversized relative to its economy in part because it has been a convenient staging post for overseas investor’s capital.  But following the announcements over the weekend, large depositors will be following events very closely.  For many it is an unwelcome shock that banks within the EU can impose sizable haircuts on deposits which were previously regarded as safe.

At the very least, large depositors are going to be a lot more wary going forward.  Cyprus may be regarded as a one-off case.  But even so, some large depositors will change their behavior from now on to ensure that there are no surplus funds left in various other southern European banks overnight.  At the margin this will make it a bit harder for these banks to access sufficient wholesale funding for their routine activities.

Big problems would follow if another financial territory got into similar difficulties.  One event can be dismissed as one-off, whereas two could be regarded as a new trend.  If another country were to run in to similar problems events could turn ugly fairly quickly.  Large depositors would take fright and quickly spiral into a bank run on wholesale funding at weakest points of the financial system.

Clearly central banks around the world are alert to this problem. My worry is that the problems with Cyprus have occurred when financial markets have been relatively buoyant. Quantitative Easing has been driving up asset prices around the world.  And yet despite this positive background Cyprus has been obliged to announce this deposit tax.

The financial sector needs confidence to operate successfully.  The problem with Cypriot proposals is that it risks planting the seed of doubt.  This may resemble some of the problems we saw with banking crisis in 2008; a liquidity crisis in a small part of the financial sector that progressively widens to put more banks at risk.

My worry is that the Cyprus announcement will change the behavior of large depositors.  And that is the thin end of a very worrying wedge.
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Tags: bailout , banks , Cyprus , EU , EU economy , European Monetary Union , eurozone , Financial Markets , quantitative easing
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