What Cyprus Tells Us About Banking Regulations

In all the haranguing over Cyprus, one sentiment has repeatedly emerged: the idea that it's somehow just for bank depositors—particularly the biggest ones—to take a hit in any bailout. According to this school of thought, Cyprus's suddenly back-from-the-dead plan to tax bank deposits is only fair.

Finland's Prime Minister, Jyrki Katainan, sums it up: "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 savers are to be considered investors, it seems the risk-return tradeoff is way out of whack in Cyprus. After all, these folks seem poised to take a haircut akin to a big equity bear market, yet the potential upside of a savings account is pretty far from equity-like. Simply, I believe Mr. Katainan’s view is misguided, particularly since savers don't intend to put their principal at risk. They want to park their funds in the most liquid, stable vehicle there is, and they accept the possibility the value of their money won't even outpace inflation. That's true regardless of deposit size. I simply don’t see how one can call folks who want risk-free savings “investors” in a bank.

But here's where things get thorny. Cyprus's banks are teetering on insolvency because they're over-exposed to Greek debt, and like all of Greece's private creditors, they weathered two haircuts in 2012. If savers should be spared these losses, does that mean banks should be ring-fenced? Limited from making proprietary trades with retail deposits? Does Cyprus validate the Volcker and Vickers rules?

Well ... not really.

A typical bank’s business model is simple: It takes deposits and lends them to people and businesses. Cypriot banks had plenty of funds to lend, but loan demand wasn't commensurate with supply—understandable considering deposits far outstripped GDP. So banks had to do something with the excess capital—simply parking it at the ECB didn't make sense, as idle cash tends not to fetch a return unless the central bank pays on excess reserves (the ECB doesn’t). Thus, the banks turned to proprietary trading, as banks tend to do when lending isn't profitable. Otherwise, they can't provide a palatable interest rate to savers, and they'll lose customers to more competitive institutions.

Propriety trading isn’t inherently bad, and on its own, it didn't bring down Cyprus’s banks. Bad decision-making did. Had these banks not over-concentrated in Greek bonds—if they'd diversified, like any smart investor and institution—they wouldn't be in this predicament. Perhaps, rather than ban proprietary trading, regulators should give banks a framework for more prudent trading. Maybe make them follow that cardinal rule of investing: Don't put more than 5% of your assets in any one security. Or something similar to foster prudent decision-making.

Cyprus also exposes some key shortcomings of Basel III, which aims to prevent bank failures from upending a financial system. It raises capital requirements and toughens banking standards around the globe—an effort to eliminate the likelihood of future bailouts. But Basel III wouldn’t have prevented a Cypriot bailout. Consider: With a Capital Adequacy Ratio of 11.9% Tier 1 capital of 11.0% in 2010, Cyprus’s largest bank, Bank of Cyprus, was well-insulated by Basel III standards. And it didn’t rely on wholesale funding, which Basel III assumes would be especially vulnerable to a panic or credit freeze—it was funded by Basel III’s preferred means, deposits. Yet here we are, with Bank of Cyprus practically insolvent and capital controls necessary to prevent fund flight after EU officials tried to expropriate depositors’ money.

Thanks to Cyprus, we also now have tangible evidence Basel III’s “solution” to the purported “too big to fail” conundrum misses the mark. Driven by regulators’ apparent belief the biggest, most globally interconnected banks are somehow the riskiest, Basel III applies extra-tough standards to those banks deemed “globally systemically important financial institutions” (G-SIFI) for their sheer size and global presence. Tighter standards for the most systemically important banks might sound rational, but Basel III doesn’t account for a bank’s size relative to its home economy—its systemic importance to its own financial system. A bank’s size relative to domestic GDP has more bearing on its government’s ability to throw it a lifeline if necessary, and many G-SIFIs are actually small enough to be bailed out. However, not only would Cyprus’s financial system get crushed if its big banks failed, but they’re too big for the tiny nation to bail out. Basel III does naught to address this—in Cyprus nor similarly small countries with huge banking sectors.

Think about it. Deposits in the entire US banking system totaled about $10.8 trillion as of September 30, 2012 (latest FDIC data)—about 68% of GDP. That includes seven banks deemed G-SIFI by the Financial Stability Board—but the largest has deposits of only about 7.6% of US GDP. In Cyprus, by contrast, bank deposits total about €68 billion—about four times GDP. Bank of Cyprus and the second-largest bank, Laiki, held deposits of €27.9 billion and €17.8 billion. Yes, in Cyprus, one bank has more deposits than the entire country’s output—a systemically important bank if ever there was one. But not according to Basel III.

Now, you might think this all just confirms German Finance Minister Wolfgang Schäuble’s assessment: That Cyprus’s status as an offshore financial haven is unsustainable—the country’s banking system can’t afford to have excess foreign deposits. But that’s a hasty verdict—it ignores countries like Switzerland, where total deposits more than double GDP, and the Cayman Islands, where deposits are more than three times GDP. The offshore haven model isn’t inherently flawed. Banks just need to act prudently. That’s true regardless of size.

And therein lies the real issue. Those who zero in on bank size and proprietary trading fail to see what really matters: whether a bank has a strong business model and prudent operations. Large size and proprietary trading aren’t inherently unsustainable. Bad business is. But unless regulators realize this, they’ll keep missing the target.

If you ask me, Cyprus has proven in spades that the past few years of regulatory overreach haven’t “fixed” anything. Sweeping, one-size-fits-all regulations with arbitrary standards rarely do. Will regulators see this and devise a system that accounts for the industry’s needs, supports good practices, lowers the likelihood of imprudent activity and enables banks to function freely, and stay healthy and profit?

Sadly, for now, I wouldn’t hold my breath.