A Better Cyprus Deal

The discipline of failure and loss makes a comeback

by WSJ

Practice still makes imperfect, but Sunday's overnight deal to save Cyprus is a big improvement over the last attempt. Brussels and Nicosia have finally agreed to try an orderly, market-based solution to the country's financial mess—even if it did first have to exhaust every bad idea.

Under Sunday's deal, Laiki Bank, the country's second largest, will go bust immediately. All of its creditors will be wiped out, though insured deposits of less than €100,000 will be protected. Larger depositors will be given equity shares in a "bad bank" that will hold Laiki's more dubious assets. The bank's viable assets will be transferred to Bank of Cyprus, the less troubled of the country's terrible two.

Meanwhile, Bank of Cyprus's uninsured depositors and other creditors will take haircuts sufficient to ensure a 9% capital ratio, likely in the neighborhood of 35%. Not a cent of the EU and IMF's €10 billion rescue will go toward recapitalizing a Cypriot bank. The Cyprus government will be left with debt of 140% of GDP—worrisomely high, but lower than originally envisioned.

All of this doesn't go as far as our suggestion last week that both Bank of Cyprus and Laiki be put into resolution and that uninsured deposits be swapped for bank shares. But Sunday's deal gets most of the way there, while eliminating the worst features of the earlier deal.

By protecting insured depositors, the deal honors a government promise that is an implicit contract. The forced transfer of large deposits into equity is unfortunate, but then it is also a reminder that banks fail and that uninsured deposits are, well, uninsured. This is a useful lesson in the limits of government guarantees and a welcome blow against moral hazard.

The survival of Bank of Cyprus is a political sop to protect Cypriot jobs, though it also means the bank might eventually need another restructuring down the road. Bank of Cyprus will assume Laiki's €9 billion in emergency debt to the European Central Bank, and more borrowers are likely to default as property prices continue to fall. Don't be surprised if Bank of Cyprus needs to take another bite from creditors.

The other risks associated with Sunday's deal were less avoidable. Cypriot banks will face withdrawals when they reopen, most likely on Tuesday. The country has operated mostly on cash since March 15, so bank accounts will bleed out even if small depositors know their savings won't be confiscated and the ECB acts as a backstop. But confidence in Cyprus's banking system has been shaken, and much of the business that had used the Mediterranean island as a tax haven will flee.

Nicosia will now face the usual conditions of a euro-zone rescue: labor-market reforms, fiscal discipline, privatizations, pension and health-care reform. All of this is overdue in Cyprus and will be necessary if the country is to have a future beyond Russian offshore business.

Speaking of Russia, Nicosia dithered on supporting a deal last week in the hope that Moscow's largess might obviate a German-led rescue. Cypriot Finance Minister Michalis Sarris had offered the Kremlin everything including the kitchen sink, but Vladimir Putin was unmoved. Now that Cypriots know that Mr. Putin values good relations with the EU more than he values kinship with Cyprus, Nicosia might think twice about signing away the country's natural-gas future to any partner.

Dmitry Medvedev also offered no love for Sunday's deal, saying that, "In my view, the stealing of what has already been stolen continues." The Russian Prime Minister's new concern for property rights is touching, even if he knows that uninsured deposits wouldn't have been spared under any plausible agreement with Brussels.

The larger issue is how much of a precedent this is for future EU bailouts. The necessary bank failure was only imposed in round two, and then only because the Cyprus Parliament rejected round one. Brussels may also have resisted its taxpayer bailout impulses only because Angela Merkel faces an election this year and didn't want to tell Germans they had to rescue the deposits of Russian oligarchs.

The question is what the EU will do when there's no German election and the next failing financial system is bigger than Cyprus's. It's probably inevitable given the many political actors that these rescues will turn out to be a Night at the Improv. But they will happen less frequently, and will be less chaotic, if the EU begins to apply the discipline of failure and loss contained in Cyprus round two.