Tuesday, March 26, 2013

Musings on the Cyprus bail-out

I fear that just when I should have been doing my writing tonight, I ended up watching Oman play Australia in the soccer. It was an exciting match, beginning with some disastrous Australia v Oman Cahill scoresplay and then ending with great excitement when Australia seemed to be returning from the dead. In the end it was a 2-2 draw, a fair result.     

On matters economic, I have watched events unfold in Cyprus with interest and a degree of befuddlement. There were several things I didn't understand. 

The first was the delay in action. I have the strong impression, it may be an unfair impression, that authorities in Cyprus and elsewhere were to some degree sitting on their hands hoping that things would get better. If you have to take nasty medicine, and this is nasty medicine, then it is often better sooner rather than later.

The second was the initial decision to attempt to inflict cuts on those with smaller deposits below the level covered, as I understand it, by the guarantee on bank deposits. That sent a shudder through Europe since it said that the guarantee was worthless. I thought that was a bit silly.

The third was the failure of the Russian Government to provide any form of support. This was actually one case where Russia could have exercised real sway for the outlay of a relatively small sum of money.

But perhaps the most the most important thing of all was what the whole episode said about bank regulation at national level. This is the third recent case after Iceland and Ireland where failures in the banking system effectively brought a country to its knees.

Cyprus benefited in immediate economic terms through the growth of its banking system. Yet the risks in that growth should have been obvious from a risk management perspective and especially after the lessons from other countries.

To go back to a recent discussion between Winton Bates and myself, this was not a case of market failure as such. Rather, it is a case where particular failures have profound local impacts. The Government of Cyprus could have avoided the failure through the application of rigid rules, but then it would not have got the immediate gains. So we have a different type of regulatory problem.

What approach might the Government have followed to optimise the gains while reducing the risks? Unlike general regulatory approaches with their universal rules, Cyprus' small size and limited number of financial institutions probably required a far more hands on, targeted interventionist approach. Therein lies the failure. 


Listening to the news reports overnight, my very brief comment on regulatory failure is a tad simplistic. Part of the difficulty lies in the different roles that have banks have in local and international contexts. Just noting at this point.


Winton Bates said...

I think the only sensible form of regulation that could have prevented the crisis would have been a more stringent equity capital requirement. Prior to the GFC, regulators would have had to have super-human foresight to see the risks involved in banks accepting deposits from Russians and using the funds to invest in Greek government bonds.

Jim Belshaw said...

Winton, that's certainly the approach that's been taken to global regulatory reform since the GFC with the emphasis on capital requirements and stress testing. My initial thinking was a little different since it focused primarily on Cypriot responses.

As I understand it, Cyprus chose to become or allow itself to become an international banking centre offering tax concessions to encourage funds. It did so because of the perceived economic benefits to the nation. Now, and thinking just of Cyprus, we arguably have a public policy rather than regulatory problem as such, the failure to focus on downsides.