Europe’s New Bailout Template Should Scare Investors

europe bailoutThe most recent terms of the Cyprus bailout were announced in the wee hours of Monday morning while most Europeans were sleeping.  According to the terms, the two largest Cypriot banks are being “restructured.”  I put restructured in quotes because the Popular Bank of Cyprus, known as Laiki, is going away.  Shareholders, bondholders, and uninsured depositors will likely be completely wiped out, and insured deposits will be placed into a good bank that will be folded into the Bank of Cyprus.  The Bank of Cyprus will then be restructured with a contribution from shareholders, bondholders, and uninsured depositors.  The final haircuts for Bank of Cyprus investors and uninsured depositors has yet to be announced.

Even though financial markets initially showed relief when the Cyprus bailout announcement was made, that all changed later in the day after the Dutch Finance Minister, Jeroen Dijsselbloem, who also happens to be the current President of the Eurogroup, indicated that the manner in which Cyprus was bailed out should become a template for the rest of Europe.  Specifically, Dijsselbloem had this to say: “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 recapitalize 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 recapitalizing the bank, and if necessary the uninsured deposit holders.”  He further stated that the idea of governments and taxpayers bearing the costs of European bailouts had to stop.  That will certainly be news to a lot of investors and explains the sharp turn for the worse in equity markets after his comments hit the wires.

Dijsselbloem notes that what was done in the Cyprus bailout involved “pushing back the risks” to the banks.  That may be, but what it also did was dramatically increase the risks to the Eurozone.  As investors and uninsured depositors realize they are on the hook for woes in the banking system, what do you think those people are going to do?  If I had uninsured deposits at any bank in Europe that I even remotely considered to be a risk, I would withdrawal that money immediately.  If I owned the senior bonds of any banks that I considered to even remotely have a chance of failing, I would immediately sell those bonds.  That wouldn’t necessarily have been the case prior to the recent Cyprus bailout announcement and prior to Dijsselbloem’s statements about what future bailouts might look like.  By taking a stab at eliminating the moral hazard associated with government and taxpayer bailouts, Europe is changing the rules of the game.

Whether most professional money managers want to admit it or not, it is widely known that the solution to the world’s financial system woes in recent years was mostly to paper over the problem at the expense of governments and taxpayers.  If Cyprus becomes the template for future bailouts (and bail-ins), then the great battle between money printing/government borrowing and underlying deflationary trends, a battle that has been with us since the start of the financial crisis in 2007, has just changed.  When central banks print money and governments borrow to deal with bailouts, it has a counter-deflationary effect on economies.  When investors and depositors are forced to bail-in banks, it has a deflationary effect on economies.

Of course, it shouldn’t surprise anyone that Dijsselbloem has already issued a statement “clarifying” his comments.  Policy makers tend to do so when financial markets throw temper tantrums in reaction to something someone in a position of power says.  Regardless of the revised comments on bail-ins and templates, investors and depositors should not take comfort.  Dijsselbloem said very clearly in his original remarks, “Now we’re going down the bail-in track and I’m pretty confident that the markets will see this as a sensible, very concentrated and direct approach instead of a more general approach.”  If you have money invested anywhere in Europe, you should spend some serious time thinking about what might happen if just a small run on a bank occurs.  Think about how little of an outflow of deposits it would take to cause a liquidity crisis and the chances of that happening at any point over the next few years.  Waking up on a Monday morning to find out your deposits have been frozen and your bonds might be going to zero is certainly not a pleasant experience.  And that’s the route Europe has now decided to go when bailing out countries by bailing-in banks.

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