The Cyprus debacle seems to have taken a course towards a resolution of some sort, with the announcement last week of a bailout plan that includes, among other measures, a one-time tax levy on wealthy (supposedly Russian) depositors in Cyprus banks, even when reports are now surfacing that the Cyprus banking system has been experiencing steady capital flight for several months now, with savvy Russian depositors being tipped-off by money managers way in advance of things reaching their dramatic climax over last week. The bailout deal sets a significant precedent, and fires a warning shot towards European jurisdictions who have allowed their banking systems to become offshore parking lots for hot money, to the tune of multiples of national GDPs.

I distill 4 fundamental lessons from this episode:

1) Capital controls are back, clearly embedded in the bailout terms: Capital controls are an extraordinary breach of basic EU rules, which allow freedom of labor and capital movement. Indeed, article 63 of Europe’s internal market rules explicitly states that “all restrictions on the movement of capital between member states and between member states and third countries shall be prohibited” unless there is an issue of “public security”. But there are few signs of the EU enforcing article 63 when it comes to Cyprus, even when the capital controls proposed are currently treated as temporary measures.

2) All deposit accounts are at risk, and some euros are more equal than others: the latest plan, which will see accounts with less than €100,000 protected, has established a new template for future bank bailouts: that depositors’ cash above the “insured” amount can and will be raided.

3) “Too big to fail” still holds: Some will argue that as big savers in the Bank of Cyprus and Laiki, the island’s two biggest banks, are taking such a haircut, the “too big to fail” mantra no longer works. But in truth the banks were minnows within the euro zone. Their near-collapse tells you that the ECB will do all it can to protect banks it regards as “systemic”, but will let the others go hang.

4) EU stress tests are worthless: The European Banking Authority’s annual health check on euro zone banks at the height of the euro crisis in July 2011 revealed significant concerns about just eight banks – five Spanish, one Greek and two Austrian. The Cypriot banks – Bank of Cyprus, Laiki, and Hellenic – passed what was supposedly a grueling assessment. Bank of Cyprus chief executive officer Andreas Eliades said at the time: “The stress test results justify the group’s strategic choices and actions, and illustrate its very strong capital base even under the most extreme, difficult and adverse scenarios.” Make of that what you will.

So who’s next to follow Cyprus’ path in the euro zone? Speculations have been swirling as of late, identifying Slovenia, Malta, Slovakia, or even Luxembourg as potential next domino piece to fall. In essence, Cyprus fell into its mess due to four fundamental factors that converged at a particular point in time, namely: weak fiscal situation, large debt overhang, banking sector size too big (and too weak), and too much reliant on foreign funding. I figured if I plot those 4 dimensions based on latest data observations (2012) for a host of euro zone countries, maybe one can discern possible next targets? Below is my attempt at a visualization in Tableau software. The x and y axis are self explanatory, depicting the debt and fiscal situation respectively, the relative size of the bubbles represents the size of the banking sector relative to national GDP, and finally he bubble color represents the extent of which that banking sector is reliant on foreign deposits (the more red, the “hotter” the funding). The data was sourced from the latest IMF World Economic Outlook edition, and the ECB’s Eurostat. Voila!

Basically, we’re looking for big, red bubbles that are closer to the upper right quadrant of the chart. Cyprus is right there, along with Portugal, France, Spain, Malta, Ireland, Belgium, Slovenia, Slovakia, Austria and Hungary, to name a few culprits. Malta looks particularly worrying, but consider this: Despite the size of Malta’s banking sector, assets held by the more important banks are slightly more than twice the country’s GDP. This is half the EU average. More importantly though is that the vast majority of deposits and loans administered by these banks are domestically derived: Maltese banks have very little exposure to foreign government bonds, have more than enough cash reserves to cover their loan portfolio and adopted over the years a very conservative low-risk approach to investment.

Slovenia has had its share of rumors lately, and the chart above shows it to be on the edge of the danger zone. These fears could be well founded: Slovenian GDP is set for a deeper-than-expected 1.9pc contraction this year, compared with an earlier estimate of 1.4pc, according to official forecasts released on Friday. The revised forecast brings government predictions in line with the IMF’s gloomier verdict that that the economy will shrink 2pc this year, the most in the European Union after Greece and Cyprus. As such, Slovenia’s cost of borrowing soared to a record high on Wednesday, with yields on two-year debt tripling over the past week, jumping from 1.2pc to 4.26pc before falling back slightly on Thursday. Ten-year yields have reached a post-EMU high of 6.25pc. Add to it the Russian connection, and you’ve got yourself a self-fulfilling prophecy.

Personally, I would be nervous about Belgium, particularly after the IMF’s latest assessment, which states: “The economy has entered a second year of near zero growth amid persistent vulnerabilities. While an improvement in external conditions, even if gradual, should support the recovery, the economy’s capacity to rebound and create jobs is constrained by structural rigidities and a loss of competitiveness. The financial sector has been transformed and downsized in the aftermath of the financial crisis, but vulnerabilities remain. Combined with the fragile situation of public finances, these vulnerabilities could, in an adverse environment, undermine macroeconomic stability.” Hum, zero growth, large and weak banks, lousy fiscal, large debt overhang, and an IMF warning to boot? That’s hard numbers. Does the market agree? Belgium bond yields went lower, so maybe the market knows something I don’t, or maybe it’s just a prelude.

By the way, the Tableau visualization above is interactive and dynamic (and Hungary is hiding behind Austria, conveniently), so feel free to click on data points and bubbles and explore around, then write to me or in the comments section below and tell me which euro zone country would be next to fall to the all-new, all-improved punishing bailout treatment.


A colleague of mine, who goes by “19th & H”, had the following reactions to yesterday’s Euro banking deal. I thought they were worth posting as a guest blog post ( ;


Last night, the euro area agreed on yet another deal, and this is one seems significant for Spanish and perhaps Irish banks, although questions remain. It seems that Germany, after losing the semi-final against Italy yesterday, has realized that it winning streak may be over……

The first reaction of global markets (equities, oil, bonds) was positive, but we will have to see how long it will last (the half-life of euphoria after European deals had fallen to about 3 hours)….

This has reduced the risk in the short term of a euro area break-up although bond markets are now realizing that Italy will officially become a recipient of (limited) European funds.

Direct injection

The deal allows the EFSF and ESM financing vehicles to directly inject capital into banks. This is good news for Spain and its banks. You may remember that the original announcement two weeks ago of a ■100 billion bank loan to Spain’s bank bail-out fund FROB had about a 3-hour positive effect, until investors started to realize that this would increase sovereign debt, and that Spain would carry the risk of losses.

Under the new deal, the capital injection bypasses the FROB and the Spanish sovereign, so it will not add to public debt. Given Spain relatively low sovereign debt, the main concern has always been the contingent liability of bank recapitalizations, so it is hoped that the vicious circle of weakening banks and sovereign in Spain has broken. Spain is still suffering from a deep recession and unemployment, so there will still be a lot of tension on its public finances though.


The second concern was that the uncertainty whether the original loan to the FROB of two weeks ago would have seniority status over all other Spanish bond holders. For EFSF loan this apparently decided case by case, while for the ESM this was automatic. This means that any intervention in any bond market would automatically move all other creditors down the ladder and increase risk of default for everyone else. Once market realized this, Spain’s bond yields went even higher than before the deal of two weeks ago.

The new deal removes this seniority status, so EFSF and ESM loans will not receive any preferential treatment. This is good news for the remaining private-sector bond holders.

These are major concessions from Germany, as it had always insisted on loans through the sovereign to retain influence to push through reforms.

Single banks supervisor

The ECB will host a single banks supervisor for the entire euro area. This seems to include not just cross-border banks but also regional banks. As it was the regional cajas savings banks that were making the largest losses in Spain, this seems to make sense. It is a major concession from Germany, as it wanted to exclude its own Landesbanken from European supervision (those banks made major bets on the US subprime market, and some had to be bailed out). Apparently, the euro-area supervisor will also be able to force recapitalizations and wind down failing banks, which would reduce political influence to keep national champions artificially alive.

Although this seems to be a concession of Germany, it will also have more influence on other euro area banks, and the seat will be in Frankfurt at the ECB. Meanwhile, the UK will be happy that its own banks are not included by this supervisor.

Direct bond buying but less direct monitoring

The new deal will also allow the two funds to directly buy bonds on the primary and secondary market. I thought that this had already been agreed earlier, but maybe there were some obstacles. This will make the ECB and Draghi happy, as they have stopped buying bonds since end-2011.

It was also agreed that new bail-out would not necessarily have the same IMF-EU-ECB monitoring as was the case in Greece, Ireland and Portugal, which carried a big stigma (comparable to the stigma attached to the IMF’s own programs). As the IMF introduced Flexible and Precautionary Credit Lines for good performers, the euro area will do something similar. Given that bond market have largely forced austerity and structural reforms in Italy and Spain, they can now ask for ESFS/ESM help without being subject to humiliating missions.

Italy pushed hard for this deal, so Italy will probably be the next recipient of funds, which completes the PIIGS acronym that had been buzzing around since 2010 (we would almost forget that Cyprus has also requested bail-out this week due mostly to banking sector exposure to Greece).

It is hinted that the Ireland deal may be revised to have fewer conditions and monitoring, as it was a case similar to Spain (the banking sector collapse dragged down the sovereign), which could be good news for Ireland.

Questions remain

Although this could take pressure off Spain’s banks and sovereign and Ireland, while also benefiting Italy through bond buying, many questions remain.

The big question remains how much firepower the EFSF and ESM have. The ■500 billion EFSF has already been partly used for the Greek, Portugal and Ireland bail-outs, and will inject up to ■100 billion into Spanish banks, so how much influence can it have on Italy’s trillion euro bond market? Similar question for the ESM, which will become active soon, but has a similar size.

The implicit assumption must be that both funds will soon obtain European banking licenses, and would be able to borrow on the market. In order to make an impact on Italian yields, it will need to borrow a lot on the market. Would investors lend to an EFSF/ESM which will on-lend to Italy at a lower rate than lending to Italy directly? If that is the case, investors must assume that either EFSF/ESM’s economists are much smarter than those working in Italy, or they must believe that the funds will still be entirely underwritten by the strong European sovereigns.

Creating a new banking supervisor from scratch will take a while, and many details need to be fleshed out. There is no agreement on a common deposit insurance, which could still expose some sovereigns to the risk of a bank run that exceeds their own national deposit insurance funds.

All in all, this deal has the potential to divert bond market attention away from Spain, but now they will have to deal with Italy.