Cyprus And Banking
What has happened in Cyprus in the past few weeks is unprecedented. The European policy before that had been to fight debt by creating more debt.
Banks with toxic debt were saved by governments guaranteeing the debts, buying the debts from the banks, or nationalizing the banks.
Then, in turn, when the individual governments got into trouble they were to be bailed out by the EU. The costs of bank failures are this way passed on to the next generation, some of it in the form of tax increases, but most of it by way of future inflation.
The way this works was extensively set out in our December article on “inflation the hidden tax”. The beauty of that system is that nobody understands who or what caused the slow deterioration in the standards of living. No fingers to point, nobody is losing deposits, nobody is out of a job due to a readily identifiable cause.
And how many of us would have talked about the banking problem in Cyprus if the EU would have simply given Cyprus the 16 billion euros instead of only 10 billion and making Cyprus cough up the remainder itself? What is a mere 6 billion divided over each European taxpayer?
What is unprecedented about the restructuring deal is that the difficult path was taken: in the end it was agreed on for the Cypriot banks that it assigns, to some degree, the costs to those who were responsible for assessing the risks; i.e. the depositors at the illiquid banks. People will lose their deposits and bank employees their jobs.
This goes against the accepted wisdom that it is of the utmost importance to any economy that people retain confidence in the banking system, and all else should yield to that goal. According to that logic banks should always be bailed out, no matter what their financial position is.
How did it get this far?
In a classic old style bank operating under a system of full-reserve banking you would deposit your valuables, typically your gold, get a warehouse receipt in return, and when you present the warehouse receipt you get the gold back. A run on this type of bank is of no consequence whatsoever. You wouldn’t get interest but pay a charge to the bank for storing your gold.
In modern fractional reserve banking however, when you put your money in a savings account, the bank clerk doesn’t put it in a locker until you come and collect it, instead the money is lent out to other people. A promise is made to the depositors that the funds held with the bank are redeemable on demand while in fact the funds are lent to other people who might not have to repay their loans in another 25 years.
Now, things work out when only a small fraction of depositors make use of their right to be paid on demand, but if more than a small percentage does this the bank cannot meet its obligations. It is fraudulent because the bank cannot guarantee that its deposits are payable on demand (unless it has taken out insurance against a bank run).
In order to look at the ability of a bank to cope with a bank run, i.e. a request of many depositors at the same time to be paid on demand, several measures are used. One important measure is the capital adequacy ratio (CAR).
CAR is defined as Equity divided by Risk Weighed Assets. Under the Basel accords most government issued securities can be assigned a 0% risk, while secured loans are assigned a higher risk, and unsecured private loans the highest risk. Laiki bank got into financial trouble without doing much out of the ordinary. Applying this risk model, Laiki Bank could invest its deposits supposedly risk free in the well-paying Greek government bonds.
Turned out they were not risk free after all when Greek government bonds got their 53.5% haircut last year. Greek banks took a hit, but were bailed out. Cypriot banks took a hit too, but where not bailed out.
So, although understandable and one of the many banks, the mistake of Laiki was to blindly apply the accepted risk management models and not to sufficiently diversify their assets. Their misfortune was that the mood in Europe has changed.
As of October last year Laiki was not able to meet its obligations any longer and since then it has received the staggering amount of 9 billion euros in European Liquidity Assistance from the ECB. Just to put this into context: this amounts to 50% of the Cypriot GDP.
The initial bank restructuring deal was luckily voted down by the parliament. It entailed that all deposit holders of Cypriot banks would lose a percentage of their deposit.
This would have been unfair, not because the small deposit holders would also have been affected, because as German Finance Minister Schäuble quite rightly noted, deposit insurance is only as good as the solvency of the government insuring the deposits. It would have been very unfair towards the Cypriot banks that have followed a conservative financial policy. They and their depositors would be equally punished for financial risks taken on by other banks and their depositors.
The current solution in which the insured accounts of Laiki will be transferred to Bank of Cyprus which will be forced to restructure itself and Laiki itself will be wound up is the best solution (of the available options) because it holds those responsible where the blame is.
It would be unfair to say that the problems are the fault of those who stop giving the money, unless what is meant is that the money should not have been lent in the first place. And indeed that would have been better in hindsight, because now Bank of Cyprus is saddled with an additional 9 billion euros in debt, which is the European Liquidity Assistance, that had been provided to Laiki in the past 6 months.
Shift in thinking
Although painful for Cyprus in the short run, this is the first concrete step where costs have not been all passed on to unidentified future tax payers. Instead, it lays a small part of the responsibility where it should be: with every individual who chose to hold their funds in a bank, but didn’t consider it necessary to spend the time and effort to assess the credit worthiness of the bank.
In a statement to the Financial Times of London Dutch Finance Minister and President of the Eurogroup of euro zone finance ministers Jeroen Dijsselbloem on March 25th said that the Cyprus deal will serve as a template for future bank restructurings in the euro zone:
“If there is a risk in a bank, our first question should be ‘Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?’. If the bank can’t do it, then we’ll talk to the shareholders and the bondholders, we’ll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders,” he said.
Finland’s Prime Minister, Jyrki Katainan, chipped in with: “In a normal market economy, an investor always has a risk of losing money. That’s why I think it’s fair and right, and also part of a normal market economy, that owners of a bank, investors, and biggest depositors—who can be seen as investors—take their own responsibility, in one way or another.”
“If I finance a bank and I know if the bank will get in trouble, I will be hit and I will lose money, I will put a price on that,” Mr Dijsselbloem said. “I think it is a sound economic principle. And having cheap money because the risk will be covered by the government, and I will always get my money back, is not leading to the right decisions in the financial sector.”
The comments of Mr Dijsselbloem caused turmoil in the markets and he promptly instructed his secretary to retract his words shortly after. It is surprising to hear these words from Finance Minister from a country which just 2 months ago applied the exact opposite principle in rescuing and nationalizing the Dutch bank SNS Reaal. This is the last bank in a row in the Netherlands that has been nationalized now. The only major private banks in the Netherlands left are Rabobank and ING Bank, and the latter was bailed out by the Dutch government in 2008.
Hypocrisy in politics is nothing new of course, but if it truly is to serve as a template for future bank restructurings it does signal a seismic shift in thinking.
Until now virtually every bank that failed in Europe has been bailed out, under the mantra that it is fundamental that people retain confidence in the banking system, and that this confidence has to be blind confidence. Now it has been shown that confidence based on the promises of politicians is misplaced, confidence in a bank should be based on its balance sheet and its financial policies; just as with any other business.
A great new, but ages old, lesson has been learned: do your own research, don’t count on the government, and blame yourself only if you put your money where you thought it would be safe but turned out not to be.
How to assess banks
How to assess where your money is safe then? Mr Dijsselbloem signaled that one measure to look at is the total ratio of bank deposits to GDP. He thinks that a maximum of 4 is a good number. Cyprus had a ratio of 8, in Iceland it was 10. This doesn’t bode well for some other countries then, because Malta has a ratio of 10, Luxembourg of 23 and Cayman Islands of 200+.
There is nothing wrong in itself though with a high ratio of bank deposits as a multiple of GDP. Looking at this measure is really a short-cut. What matters is how solid the banks are: would they go bankrupt the moment a small percentage of the depositors lose all important “confidence” and withdraw their money.
One measure to look at is the above mentioned Capital Adequacy Ratio (CAR). The Basel I accord defined CAR as the ratio of a bank’s capital to its risk weighted assets. There are two types of capital, tier one and tier two. The first is primarily share capital, the second also includes other types such as preference shares and subordinated debt.
The main problem here is that short term government bonds are classified as zero-risk. The key requirement under Basel I and II is that tier one CAR is at least 4% and total CAR 8%. Under Basel II risks should be weighed as per external credit ratings. Under Basel III tier one CAR has to increase to 6% among a host of other measures.
The short-coming though is that these various Basel standards are heavily biased in favour of holding government issued debt (although less so than under Basel I). Holding these assets under these models will mostly be considered virtually risk free. So in order to get the real picture you’ll need to look deeper into the various asset classes. Just to show how inadequate these measures can be if taken at face value without looking into the underlying assets: Bank of Cyprus had a tier 1 CAR of 11.9% in 2010, well above even Basel III requirements.
Another measure is the Liquidity Ratio. Liquidity Ratio, expresses a company’s ability to repay short-term creditors out of its total cash and own bank deposits. The Liquidity Ratio is the result of dividing total cash and bank deposits by short-term borrowings. It shows the number of times short-term liabilities are covered by cash.
The Liquidity Ratio measures the extent to which a corporation or other entity can quickly liquidate assets and cover short-term liabilities, and therefore is of interest to short-term creditors, which in case of banks are the depositors.
In the context of banking, a narrower measure is often employed which is the Cash Reserve Ratio. While different countries use different definitions, it usually is defined as the fraction of the deposits held with the bank in deposit accounts divided by its reserves.
The reserves are the money that the bank has not lent out but that it holds as deposits with the central bank or in vault cash. Many countries have a reserve requirement, in addition to a minimum CAR, which is the minimum reserve ratio that has to be maintained. In the US it is 10% for the larger banks, in the Eurozone 1%. In Belize it is 8.5%, and in Lebanon 30%.
The Deposits to GDP ratio however is not totally irrelevant; it is a relevant measure of the capacity of the state in which the deposits are held to bail out the banks in question should there be a run on the banks, assuming the government is willing to bail out banks.
Then take Panama, it has no central bank, no deposit insurance, no lender of the last resort, and no reserve ratio. However its banks maintain one of the highest liquidity ratios in the world: 60%. So there you have the best guarantee at all without meticulous regulation: banks will have to act responsibly because it is clear and has always been clear that nobody will be bailed out.
Cyprus, what’s next?
Back to Cyprus. There have been demonstrations and outrage, but nothing compared to the street riots that would have occurred in Spain or France if they would have had to swallow this bitter pill. The Cypriots are pragmatic, resilient, and entrepreneurial people; they too realise that wealth has to be earned, and they too don’t want an economy based on handouts.
This bank restructuring was necessary and while it is always a preferable solution if someone else foots the bill, it is much preferable over a solution where there would have been no pain on the current deposit holders with Laiki and Bank of Cyprus, and the buck would have passed on entirely to future tax payers.
What remains to be seen now is which tax increases and spending cuts will be taken by the Cypriot government. An increase in the corporation tax rate to 12% is on the table but this wouldn’t affect the basic attractiveness of Cyprus as a holding, financing and licensing location.
Research the bank you put your money into. You wouldn’t believe it but Cyprus has banks which maintain liquidity ratios as high as 70%; and of course you can always have a Cypriot company hold its funds at a bank account outside Cyprus.
Adiraan Struijk, chairman Freemont Group
Deutsche Bundesbank: The Germans are poorer than the Italians and Spaniards
Net assets of German households are on average much lower than Italian or Spanish ones and the country is faced with serious impacts of the economic crisis. This startling conclusion is reached by the German central bank. Germany, the driver of the European economy.
The main reason for this conclusion is the fact that the Germans own significantly less real estate than Southern Europeans.
According to the Bundesbank, the median household net private property in Germany is € 51,400, while in neighboring France it is € 113,500, in Italy € 163,900 and in Spain , plagued by high unemployment rates, even 178,300 Euros.
While the average Spanish household has a net worth of 285,800 Euros and the average Austrian household 265,000 Euros, German households come in at 195,200 Euros.
“Most households in Germany – nationwide 73 percent – have net assets level ‘below average’,” says the Central Bank’s study. While in Germany 44 per cent of households own a house or an apartment, in Italy it is over 68 percent and in Spain nearly 83 percent. Those in Germany who do not possess their properties are significantly poorer than owners of real estate.
To defend the German welfare a bit, questions must be posed at the methodology of the research. First of all, the system of property rentals in Germany is well developed so many people simply decide to rent rather than to buy. Secondly, the social network is strong as well – the urge to save for retirement, study or unemployment is very limited.
Risk Free Investing is a Joke. What Does This Mean For Your Entitlements?
For decades The Western world has been blessed with stability and growth. Those under 30 had never experienced a real crisis in their life. This has given us a false sense of security.
The current situation shows that not all is what we thought it to be. This article will explain why a lot of people pay a heavy price for the current developments…
The stability we have had translated itself into the way we plan our financial future. Especially in northern Europe, as soon as you start your first job, you will get into a pension plan. Calculations will be made, explaining what your financial future will look like. 40, 50, 60 years into the future.
To guarantee this future, pension funds are obliged to invest according to strict rules and regulations. To keep an optimum, risk free and well diversified portfolio.
Looking at the portfolio of an average pension fund, you can indeed verify this claim. But what are they investing your money in and why?
In the 50’s investors used to invest according to the Modern Portfolio Theory. This theory basically explains how diversifying in different asset classes, protects your portfolio from the risk created by one individual asset class.
The problem is that this theory does not protect the portfolio against big market corrections that affect different asset classes at the same time, like the one we saw in 2008.
In the 60’s, portfolio theorists have found the answer in the so called risk free investment (readers of the first article will see a pattern emerging here).
Risk Free Investment? That sounds great!
So what is a risk free investment? There are no risk free investments.
Most people in the financial world have a memory span of maximum 30 / 40 years, since that is the time they are working. The last 40 years government bonds of Western nations were risk free. And still, they are perceived as a safe haven today.
Countries like the United States, Germany, and the Netherlands can borrow money for next to nothing. Institutional investors are heavily invested in these countries.
The Germans were even able to issue bonds at a negative yield, meaning: you have to give them money in other to by able to lend them money. It is genius.
And how risk free are government bonds?
History has shown that government bonds are everything but risk free. Holders of the mentioned German bonds, in the 20th century alone lost their entire investment three times!
But this cannot happen anymore, times are different! Right?
The southern European countries show us that also in current times countries can go bankrupt. Or does anyone still think that Greece is paying back all its debt, plus interest?
So these “Risk Free Assets” that are not risk free at all? What else?
Another great negative is that world wide all central banks are debasing their currencies. This inflation of the currency supply will inevitably lower the exchange rate of every single unit compared to goods and services in the market place.
The Euro or Dollar you will one day receive, will never buy the same as the one you put in now!
The previously mentioned risk free bonds are also denominated in fixed units. Every round of bailouts and quantitative easing slices a piece of their purchasing power.
So far, inflation is not on the radar of the markets. But it will. Especially, when bank start lending again and all that newly printed money will start circulating.
The way things are going now, an entitlement plan that provides a good standard of living now, will look completely different 10 years from now. Let alone 40.
Where to go from here?
The world needs a new paradigm. A new way of assessing the real worth of assets and investment portfolios. One that is not tainted by the disastrous policies of our central planners.
Asset, portfolio and pension fund managers need to understand that their methods are becoming obsolete, and the rules applied to them are not in favor of their customers. Hopefully they come to their senses soon. The population has entrusted the capital of many years of hard labor into their hands and many place their entire future well-being in their hands!
What do you have to do? If you have made it this far into the newsletter, you must now understand that you simply cannot count on the promises of the politicians, the central bankers or your pension fund.
History is filled with examples of people who were wiped out, because they relied on those exact same promises. In the future many people will be wiped out because they rely on them today.
You will not be one of them.