Is Cyprus the Warning Bell
That Bank Deposits Are No Longer Safe?
After the crisis in Cyprus, the world community was put on notice that bank deposits may no longer be safe. Contrary to expectations, even smaller depositors, not just the big depositors, lost money in Cyprus banks. This raises a troubling question: will bank bail-ins—by depositors, creditors and bondholders—become the norm in other countries as well?
Since 1800, there have been more than 250 defaults on government debt. The most recent defaults were Argentina in 2002 and Greece in 2012. Since 1970, there have been 147 banking crises around the world. Currently, the European Union Eurozone(EU) is facing a sovereign debt crisis, without a fiscal union, this which raises concerns about the survival of the euro. A sovereign debt crisis means that a country is no longer able to repay or refinance its public debt. Normally, a country can print more of its currency to pay its debts, but the common Euro prevents this. Monetary policy in the Eurozone is in the hands of the European Central Bank, so a sovereign debt nation in the Eurozone cannot print its own money to pay off its debts. Therefore, these Eurozone nations face the prospect of paying extremely high interest rates when they are no longer able to borrow.
Although Cyprus appears to be like other financial crises, on closer examination, there is a striking difference. The Cyprus crisis marked the beginning of a new approach to bank insolvency. Instead of bailouts funded by the taxpayers, a new bail-in regime was implemented. This means that bank losses in the failing Cyprus banks were borne, not by the taxpayers in a bailout, but by the financial institution’s depositors, shareholders, and bondholders in a bail-in.
This article describes the events that led up to the Cyprus crisis and how the EU handled that crisis. In addition, this article explores whether similar bail-in regimes are spreading to other countries, including the United States?
Cyprus is a small Mediterranean country with fewer than one million inhabitants. It joined the EU in 2004, and four years later was accepted into the euro currency union (euro-zone). Cyprus’ GDP was approximately $23 billion, less than 0.2 percent of the euro-zone’s GDP. Because of its lax regulations and lower tax rates (e.g. its 10 percent corporate tax rate was the lowest in Europe), foreign money flooded into its banks. Almost half of its €70 billion in bank deposits were held by foreign investors. In particular, it became a popular destination for Russian oligarchs and businesses—and rumor says the Russian mafia—to park their money. Moody’s estimated that $19 billion of the deposits were owned by Russian corporations. By mid-2011, its banking sector had grown to be eight times its GDP and three Cypriot commercial banks grew to five times their original size.
Cyprus’ economy grew steadily until the 2007 global financial crisis, when the Cyprus economy was hit—and hit hard. Cypriot banks, deeply invested in the Greek economy, took huge losses—amounting to 25 percent of the country’s GDP—when private holders of Greek bonds were required to take “voluntary” haircuts in 2012. The value of Greek bonds fell by 70 percent and Cyprus banks suffered losses of more than €4 billion. This caused the failure of two large Cypriot banks—the Bank of Cyprus and Cyprus Popular Bank.
In addition, Cyprus faced a huge current account deficit. This means that its imports were much greater than its exports, which largely consisted of revenue from tourism and services. Households and business firms quickly found themselves deeply mired in debt. Not only was the private sector indebted, the Cypriot government’s debt had also grown substantially because of generous civil service pay and benefits, linked to an index and adjusted twice a year. By 2011, Cyprus faced a budget deficit of 6.3 percent of its GDP and its public debt had reached 72 percent of GDP. This increased the size of Cyprus’ government debt-to-GDP-ratio to approximately 140 percent.
In July 2012, Cyprus became the fifth euro-zone country to seek a bailout from the EU in the amount of €17.8 billion. A bailout is where the money to keep the financial institution operating comes from the taxpayers through their government. A bail-in is where the money needed to keep the financial institution solvent comes from the financial institution’s bondholders, creditors, and depositors.
The European Union Reacts
The amount of money involved in the Cyprus bailout was small compared to that of previous bailouts in Greece, Spain, Portugal and Ireland. The Greek bailout has amounted to approximately €240 billion (so far); Spain has required approximately €100 billion, Portugal approximately €78 billion, and Ireland approximately €85 billion. Even so, the Cyprus bailout was the hardest case that the euro-zone finance ministers, the International Monetary Fund (IMF), and the European Central Bank (ECB) had faced up until that time. Part of the difficulty was that the bailout was almost as large as Cyprus’s GDP. The other difficult part of the situation in Cyprus involved murky geopolitics, such as the suspicion that Cyprus was a tax haven for illegal Russian money—which Cyprus has denied. In addition, there were rumors that certain large depositors received advanced warning that allowed them to pull their money out before other depositors.
To complicate matters more, Germany appeared to be in no mood to rescue the Russian mafia. Germany’s parliament, tired of bailing out its southern cousins, insisted that the creditors of the Cyprus banks share the pain. As a result, the EU bailout was limited to €10 billion, with the proviso that the rest (over €7 billion) must be borne by the banks. However, the sale of bank assets provided less than €1.5 billion and Cyprus banks had few private bondholders. The only liquid assets available to them were its bank deposits. As a result, Cyprus bank depositors were left holding the bag.
On March 16, 2013, the bail-in took effect. A 9.9 percent levy was imposed on the country’s bank deposits over the government insured limit of €100,000 ($130,000) and a one-time levy of 6.75 percent was imposed on deposits below the insured limit. Deposits below €20,000 were exempted from the tax.
In order to restructure its banking system, Cyprus and its international lenders agreed to convert 47.5 percent of the deposits over €100,000 in the Bank of Cyprus to equity. The nation’s second largest bank, Cyprus Popular Bank (also known as Laiki Bank), was closed and put into receivership. Its shareholders and bondholders lost their investment.
To avoid bank runs, the Cyprus government imposed temporary capital controls. Not only did this limit the free flow of currency in and out of a member EU country, it violated a founding principle of the euro zone currency that all euros are equal. However, after this Cyprus banking crisis, it appeared that not all euros are equal; a Cyprus euro was deemed to be more risky. During the early days of the financial crisis, the EU raised bank deposit insurance to €100,000, but its actions in Cyprus appeared to revoke that EU guarantee of the safety of bank deposits, up to that limit.
After Cyprus, depositors in ailing banks, especially those in weak countries, must now be concerned about the possibility of having their savings raided. Jeroen Dijsselbloem, head of the Euro-group of finance ministers, declared that the Cypriot deal represented a new template for failed banks. Under this newly-established Cyprus bail-in regime, creditors, bondholders, and depositors, not taxpayers, would bear the financial losses of a “too big to fail” failed bank.
The European Union Bail-In Framework
In July 2012, the European Stability Mechanism (ESM) replaced the European Financial Stability Facility (EFSF) as the euro-zone‘s permanent rescue fund. Any new EU bailout would be financed through the ESM. The fund could lend up to €500 billion in total. The ESM also included significant changes. Unlike the EFSF, under which borrowing was backed by guarantees from the euro-zone members, the ESM was backed by paid-in capital contributed by euro-zone members. The ESM could help troubled sovereigns by extending loans, buying bonds in the primary market, and providing credit lines to governments. In addition, the ESM could inject funds directly into banks instead of indirectly through loans to governments. However, this required that countries met strict economic and fiscal conditions.
In November 2014, European Central Bank became the single supervisor of the euro-zone banks. A Single Resolution Mechanism (SRM) was established. If the ECB’s new supervisory board found an institution to be insolvent, it had the authority to close and restructure the institutions based on the rules of the Bank Recovery and Resolution Directive (BRRD) proposal. The EU Regulation on the Single Resolution Mechanism went into force on August 19, 2014. Under this regulation, a Single Resolution Board (SRB) was given centralized power over the orderly resolution of failed banks to minimize costs to taxpayers and the real economy. The SRB was expected to work in close cooperation with the national resolution authorities (NRA) of participating Member States.
Also included in the banking union was a Euro-zone deposit guarantee scheme. While the EU deposit guarantee of €100,000 will remain the same, the rules will co-ordinate better the way governments arrange for that insurance to be paid. EU member states and the European parliament agreed on reforms to make available funds of up to 0.8 per cent of the banking sector’s insured deposits for payouts.
Credit derivatives in the first quarter of 2015 for insured U.S. commercial banks and savings associations were 203.1 trillion. Many of the counterparties to these derivatives could be European banks, posing significant risk of losses to U.S. banks. In addition, Europe is the second largest importer of U.S. good and services, and an economic slowdown in Europe will have a strong effect on the U.S. economy.
Bail-In Possibilities in Other G-20 Countries?
Despite denials, a bail-in mentality appears to have already spread to some other G-20 member nations. Besides the European Union, G20 member countries include Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Republic of Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, the United Kingdom, and the United States.
The Financial Stability Board (FSB)—which includes the G-20 finance ministers and central bankers and certain global financial institutions—agreed to the Key Attributes of Effective Resolution Regimes for Financial Institutions in October 2011. The Key Attributes includes the transfer of bank losses from the taxpayer to the shareholders, then bondholders, and finally depositors of failed institutions; that is, a bail-in.
This FSB requirement was codified in the Banking Act of 2009 in the United Kingdom, included in Canada’s Economic Action Plan of 2013, and also included in Australia’s Government Budget of 2013-2014. Of course, the citizens in these countries will only become aware of the existence of such bail-in measures when they are actually implemented in failing “to big to fail” financial institutions in their own countries.
As reported in the European Parliament News on Dec. 12, 2013, a draft EU bank recovery and resolution directive was negotiated, with a view to the directive entering into force on Jan. 1, 2015, and the bail-in system to take effect on Jan. 2016. A final directive was adopted in 2014.
A Bail-In Framework Already Exists in the United States?
In the United States, with little fanfare, the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010, set priorities for the liquidation of a “too big to fail” failing financial institution. Most importantly under this new law, financial firms that have been put into receivership will no longer be allowed to receive an infusion of taxpayer funded equity into the failing institution as had been allowed in the past. These new Dodd-Frank provisions have changed the landscape of how, or to what extent, depositors will be reimbursed in the event of a financial institution failure.
Because taxpayer dollars can no longer be used to inject equity and allow insolvent institutions to continue operating, there are now only two sources of funds to cover the failed financial institution’s bank depositors. Figure 1 illustrates and summarizes what these two sources of funds are: (1) the FDIC Deposit Insurance Fund (DIF), and (2) the saleable or transferrable assets of the failed financial institution. Starting with the DIF, deposits over $250,000 are not insured. However, in the event of systemic problems in the financial sector, the DIF could be quickly depleted, leaving even insured FDIC depositors (with less than $250,000 in deposits), reliant on the financial institution’s assets for full recovery. Furthermore, if the FDIC insurance fund runs dry, the DIF fund would have to borrow from the Treasury. If this amount is substantial, that would result in a further burden on taxpayers, which a bail-in regime specifically seeks to avoid.
Figure 1: Sources of Funds for Depositors if the Financial Institution Gets Shut Down
Although the word bail-in is not used, here is how certain Dodd Frank provisions impact what might happen to depositors’ funds. Title II of that Act provides for the orderly liquidation of insolvent financial institutions in a specific order, as illustrated in Figure 1. After various claims by administrators, the government, and employee compensation and pension plans, and other senior secured claims, the junior unsecured claims come next, followed by the salaries of executives and directors, and lastly, shareholders or other equity holders in the financial institution. The financial institution’s depositors are not distinguished as a class; they fall under the general category of junior unsecured creditors.
To understand the impact of these provisions requires understanding what happened when derivatives holders were given exemptions from the prioritization of claims in the bankruptcy code. In particular, while the Bankruptcy Act of 2005 does not technically give derivatives super-priority status in bankruptcy proceedings, in essence, that is the effect of the exemptions. For example, if collateral is removed from the financial institution by derivatives holders before the institution is insolvent, that collateral does not have to be returned to the financial institution, unlike other creditors in bankruptcy. These exemptions regarding derivatives pose a potentially grave threat to a failed financial institution’s depositors.
Normally in bankruptcy, there is an automatic stay against creditors trying to collect on debts. However, with the latest changes in the Bankruptcy Act of 2005, derivatives holders are not subject to such an automatic stay. This means that derivatives and repurchase agreement (Repo) holders can take actions that place them at the front of the collection line, to the detriment of the financial institution’s depositors. Those owed under derivatives or Repo contracts can demand collateral before the institution is declared insolvent, without having the collateral deemed to be a voidable preference and returned to the financial institution.
They can even seize and liquidate collateral after the institution has been declared insolvent, giving them preference even over secured creditors (let alone depositors of financial institutions, which are only unsecured creditors). Furthermore, counterparties in swaps can cancel their contracts with the financial institution, also potentially removing valuable assets. Derivatives holders have other advantages as well. The net result is that derivatives holders have been put squarely at the front of the line for payment, to the detriment of the financial institution’s depositors.
Some Dodd-Frank provisions attempted to improve the position of depositors, but these provisions are inadequate. Because of the so-called “Volker Rule,” some of the riskiest derivatives, including some credit default swaps, are required to be put in a separate entity from depositors. In other words, because of this “push out” rule, these derivatives holders would not be able to seize the assets funded by depositors.
Even so, there are still many derivatives that remain in the front of the line for repayment, ahead of depositors. And while some of these derivatives (e.g. interest rate swaps) may have lower risk, they can still pose significant risk to the financial institution and its depositors. Compounding the concerns about derivatives and their detrimental impact on depositors, the Consolidated and Further Continuing Appropriations Act of 2015, relaxed the Dodd Frank requirements about which derivatives contracts have to be pushed out away from the depositors’ funds. This change in the law now potentially allows a riskier class of derivatives to get in line for payment in front of the financial institution’s depositors.
Under Dodd-Frank, the FDIC can prevent derivatives claimants still in front of depositors from seizing assets, but only for one day. During this day, the FDIC must scramble to find a private entity to take over all of the banks derivatives contracts. Some of these derivatives may represent an asset, because they are a claim by the bank on another. However, others are a liability because they represent a claim by another against the bank. Since the bank is already in trouble, in all likelihood these derivatives in total are more likely to represent potential liabilities than assets.
Thus, the derivatives, when viewed in total, are likely to be viewed as undesirable to a potential acquirer, especially considering the short time frame and the complexity of derivatives contracts. In addition, the FDIC is charged with reducing systemic risk. The 24 hour stay on the insolvent financial institution could panic the derivatives market, if other derivative holders become concerned that they cannot collect collateral on their own derivatives. Thus, the FDIC may be reluctant to impose this 24 hour stay, even though it is empowered to do so. For all of these reasons, the 24 hour stay seems very unlikely to be helpful to the insolvent financial institution’s depositors.
Furthermore, under Dodd-Frank, the FDIC may move the depository institution’s assets (that is, what’s left over after derivatives claims) to a new bridge institution, separate from the claims of creditors (See Figure 2). Almost certainly, some claimants will be left behind. Those claimants must wait in an inactive, failed institution until the bridge institution is sold off. Only after money is collected from the sale of the bridge institution, will the claimants that were left behind be paid. Since the sale proceeds of the bridge institution are unlikely to equal the claims of these creditors, claimants left behind are likely to suffer large losses.
Figure 2: The Bridge Institution and Creditors Left in the Insolvent Institution under Dodd-Frank
Claims of the creditors that become part of the new bridge institution will be paid because the bridge institution will continue to operate as a going concern. To be able to sell the new bridge institution, the assets in the bridge institution are likely to be greater than the claims moved into the bridge institution from the original depositor institution. The claimants most likely to be moved over to the new bridge institution are FDIC insured depositors (below $250,000), while uninsured FDIC depositors may not. Eventually, when the bridge institution is sold, the claimants moved over to the bridge institution become part of the acquiring institution; that is, any depositors in the bridge institution would become depositors of the acquiring bank.
In summary, it is not clear to what extent depositors or other creditors will be moved with the assets into the bridge institution. Since claims against the depository financial institution are almost certainly much greater than the assets of the bank, many creditors may get left behind. Bank deposits that do not get moved over to the new bridge institution will remain unsecured debt, which will have to wait to be paid until the sale of the bridge institution. The depositors and other creditors that got left behind, as shown in Figure 2, will likely take significant losses, and will get paid in order of priority as illustrated in Figure 1. It is important to bear in mind that the derivatives claimants have already removed their collateral before this process begins.
Given the enormous holdings of derivatives by some of the largest “too big to fail” financial institutions most likely to trigger the Dodd-Frank 2010 provisions, the possibility exists for the financial institution’s depositors to still be left holding the bail-in bag. Because of the preferential treatment of derivatives, there is likely to be a large reduction in assets that would otherwise be available to depositors. The Dodd-Frank 2010 reform law prevents depositors from being bailed out by FDIC taxpayer funded equity, while at the same time continues to expose depositors to potentially massive losses due to the explosively growing class of derivatives holders that can lay claim to assets. When the meager size of the DIF is taken into consideration, it appears that a bail-in regime in the United States is now possible.
Prior to the financial crisis in 2008, only deposits up to $100,000 were insured by the FDIC. In an attempt to restore trust in the United States banking system after depositors lined up in front of IndyMac Bank in California in 2008 to withdraw their funds, the federal government temporarily raised the insured bank deposit limit to $250,000, and eventually made that $250,000 limit permanent. Although it may appear that U.S. bank depositors could potentially recover more than that $250,000 limit by holding certain types of multiple bank accounts, in reality this might not be possible. The federal debt of the United States government is now more than $18 trillion, up from “just” under $6 trillion in 2000. As noted on the Federal Deposit Insurance Corporation (FDIC) website: “The FDIC receives no Congressional appropriations – it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities. The FDIC insures approximately $9 trillion of deposits in U.S. banks and thrifts – deposits in virtually every bank and thrift in the country.” If there truly was a “run on the banks”, is it realistic to assume that American banks and thrifts could actually fund the FDIC to guarantee bank deposits up to $250,000?
The bail-in in Cyprus appears to have changed the landscape—perhaps forever. The cost of bank failures—particularly the failure of those deemed to be systemically important or “too big to fail”—appears to be shifting from the taxpayers to shareholders, bondholders, creditors, and depositors of the failed financial institutions.
Although the EU was the first to have implemented this shift in Cyprus, an argument can now be made that some other G-so countries are poised to adopt and implement bail-in regimes as well. Many countries are still reeling from the effects of the Financial Crisis of 2008 and facing worrying large levels of government debt, as well as continuing economic, financial, and global instability. Will the investors, creditors, and depositors of failed financial institutions in other G-20 countries soon experience the bail-in “solution” imposed on Cyprus banks? Only time will tell.
 “Just When You Thought It was Safe,” The Economist, March 23, 2013, p. 16.
 “Make A Model of It, Not a Mess,” The Economist, March 16, 2013, p. 14.
 Coy, Peter, “The Cyprus Sinkhole by Peter Coy,” Bloomberg Businessweek, March 25, 2013, pp. 6-7.
 “A Fifth Bitter Lemon,” The Economist, June 30, 2012, p. 74.
 “Aphrodite’s Indebted Island,” The Economist, January 26, 2013, p. 48.
 “A Bungled Bank Raid,” The Economist, March 23, 2013, pp. 75-77.
 “Just When You Thought It Was Safe,” The Economist, March 23, 2013, p. 16.
 “Cyprus, Lenders Set Bank of Cyprus Bail-in at 47.5 Percent,” Reuters News, July 30, 2013.
 Press Release, “Public Consultation on the Contributions of Credit Institutions to Resolution Financing Arrangements Launched, European Commission, June 20, 2014. http://europa.eu/rapid/press-release_IP-14-706_en.htm?locale=en (last visited on May 18, 2015).
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 For a more detailed discussion, see, Mark J. Roe, “The Derivatives Market’s Payment Priorities as Financial Crisis Accelerator,” 63 Stanford Law Review, March 6, 2011, pp. 539-587.
 In a repo agreement, an institution agrees to “sell” treasury securities in order to receive money. The institution buys back the treasuries at a markup later. In effect, the institution is borrowing, where it’s treasury securities are the collateral.
 Kathy M. Kristof and Andrea Chang, “Federal Regulators Seize Crippled IndyMac Bank,” Los Angles Times (Online), July 12, 2008. http://articles.latimes.com/2008/jul/12/business/fi-indymac12 (last visited August 3, 2015).
About the Author(s)
Joetta Forsyth, PhD, is an assistant professor of finance at the Graziadio School. Dr. Forsyth received her bachelor's and master's in economics at the University of Chicago; in 1995, she graduated from the Harvard Business School with a PhD in business economics and a concentration in finance and industrial organization. Prior to joining the Graziadio School, Dr. Forsyth taught finance at the University of Michigan's Business School and the University of Southern California's Marshall School of Business.
Linnea B. McCord, JD, MBA,, Associate Professor of Business Law at the Graziadio School of Business and Management, Pepperdine University. Dr. McCord started teaching business law and ethics more than 30 years ago, first as an in-house corporate counsel and later as the General Counsel of a division that was part of a high-tech Fortune 500 multinational corporation, headquartered in New York and Paris. Her area of expertise is the critical role Rule of Law plays in the long-term success of economies and countries and why American Rule of Law is unique in the world.
Terry Young, PhD, has over 15 years of business experience in Asia and the United States. Thoroughly versed in international economics, Dr. Young has extensive knowledge of the global marketplace, with primary emphasis on Asia. Her consulting expertise includes global sourcing, business start-ups and management in such industries as food distribution, the textile and garment industries, agriculture, electronics, and real estate development. Dr. Young's 20-year university teaching experience includes assignments at the University of Southern California, at two California State University campuses, and a full-time professorship at Pepperdine University's Graziadio School of Business and Management where she received the Luckman Distinguished Teaching Award in 1994.