Cyprus and Capital Controls

Having failed to agree a bank resolution regime more than four years into the Eurozone banking crisis, the EZ authorities have, at the second attempt, come up with a resolution of the Cypriot banks. The haircuts of uninsured bank creditors appear to be 60% and more.

After a bank resolution, the surviving banks are solvent. Naturally, depositors may feel sore, and there could be deposit flight as soon as they re-open, even where the haircuts have been severe enough to make them adequately capitalised again. But not to worry, the central bank is there to deal with irrational deposit flight. It is after all the lender of last resort.

But lo and behold, the Cypriot government has imposed capital controls – even insured deposits not facing a haircut are restricted. But since the written-down assets of the surviving banks are now in excess of their liabilities (they have been resolved) these assets will be money-good at the central bank.

Not so apparently. If the ECB believes that the surviving Cypriot banks are now solvent, why is there any need for restrictions on depositor withdrawals? Is the ECB prohibiting liquidity provision through ELA after a bank resolution to which it has been a party? 

Of course the haircuts may, in the eyes of the ECB, be inadequate to ensure solvency. In which case why is the deal not modified further? Capital controls effectively create an inconvertible currency trapped in Cypriot banks, a precedent likely to be remembered when trouble strikes elsewhere. Do re-opening US banks decline to release deposits after the Feds have done their work, for the want of a lender of last resort?

Simon Wren-Lewis on Buti and Carnot

Simon Wren-Lewis has a typically thoughtful post on the European Commission’s approach to fiscal adjustment as set out by Buti and Carnot in a post linked to by Philip a couple of weeks back.   In the context of the zero lower bound constraint on monetary policy, it is hard to disagree with him on the inappropriate aggregate stance of eurozone fiscal policy.  

But I think his discussion neglects an important second dimension of the challenge faced by the Commission (and indeed the ECB).   In addition to being in recession, the fiscal lender of resort (LOLR) function is still a work in progress.   This function has come a considerable way since early 2011, when a hard line on official creditor seniority, and the threat of a low trigger for PSI in future bail out programmes, pushed Ireland  and Portugal – followed not far behind by Italy and Spain – deep into “bad equilibrium” territory.   (Some thoughts from the time here.)   In strengthening the lender of last function, the Commission is constrained by the concerns of stronger countries about the fiscal risks they are taking on, which they see as further aggravated by moral hazard.  

(Sometimes I do wonder if the reluctance on LOLR can be fully explained by conflicting interests.   Although it relates more to banking side, the recent comments – even if partially retracted – by the new Eurogroup head does give cause for concern about the appreciation for the importance of the LOLR for avoiding a serious escalation of the eurozone crisis.)   

The Fiscal Treaty, for example, must be seen as part of the quid pro quo for developing the LOLR.   The ESM – absent some of the more damaging elements of the original proposal – and the ECB’s OMT programme would be unlikely without the strengthening of the rules-based framework.    This must be balanced by the Commission against unwelcome implications of the rules for the aggregate fiscal stance.  

Given their advocacy for a strengthened LOLR, I do think the Commission sometimes gets a bum rap.

Free Exchange: Orphanides Interview

This is an interesting interview with Orphanides, covering the dynamics of the Cypriot situation over the period of the crisis – here.

Banks: Bail Outs or Bail Ins?

Nicolas Veron has a good account of the time-varying attitudes of European policymakers to troubled banks in this FT article  here.

DoF: Revised MOU

28-3-2013 Draft Memorandum of Understanding March 2013.
28-3-2013 Draft Memorandum of Understanding March 2013 Searchable
28-3-2013 Draft Memorandum of Economic and Financial Policies March 2013