Cyprus Mail

Banking psychology, arithmetic and bail-ins as a policy

By Costas Apostolides

LAST MONDAY my daughter sent me an SMS asking whether something was up because she saw people queuing up in front of ATM machines of the co-operative credit societies, and asked whether there are again rumours of a haircut of deposits kept in cooperative banks or cooperative societies. We investigated a little and found that the scare was down to the report of the Independent Experts Commission on the Cyprus Banking Sector and the recommendation that all co-op institutions receiving deposits be merged.

This was perhaps the third rumour about the co-operatives since the crisis began, and yet again appears unfounded. It does, however, demonstrate the power of rumour and psychology with respect to banking.

Banking is based on psychology, not accounting and economics. If people feel that their deposits are threatened, no bank can survive. This is simply because bank deposits are converted to loans by banks so that they may generate income and pay interest to depositors, and when funds are withdrawn time is needed to be able to get funds back from borrowers to pay depositors.

Therefore the key to success is confidence in the banks. If there is uncertainty any bank will collapse if not supported, and the contagion can threaten the whole economy.

The adoption by the European Union of a bail-in policy for banks facing problems, whereby money is taken from depositors to save banks, was initially unique to Cyprus. It is now a general policy for the European Union. The move attacks this basic principle of banking and destroys confidence in the whole system. If confidence is destroyed then people will withdraw their funds, and the arithmetic of how much should be taken from deposits becomes a moving target and can spread to other banks.

For example Laiki Bank lost the confidence of depositors owing to a combination of recession in Greece, losses in its Greek branches, and extraordinarily bad management and possible corruption. To keep Laiki afloat over €10 billion was provided in support from the European Central Bank. Since then more than €3.5 billion left the banking system in the 15 days of March 2013, and funds are still leaving the system mainly from Laiki but also from Bank of Cyprus (now forcibly merged).

In an economy where bank deposits are four times the level of Gross Domestic Product the risks are extraordinary, and great care is required in order to achieve a soft landing, that is maintain the essence of the banking system and limit the negative effect on economic activity. Therefore controls on banking have been put in place and are being relaxed every few days. The emphasis of everyone is on getting the new merged Bank of Cyprus back to normal operations and releasing depositors’ funds, when in fact the government and the Europeans should be stressing the need for gradual controlled change. This implies foreign exchange controls over a long period, something which is contrary to EU law and policy.

The EU and the government do not appear to understand the psychological effect on depositors and think that the whole exercise is an accounting matter with reducing the need for government, Central Bank and European Central Bank support its main objective.

Mistakes have been made, particularly the way the Cyprus bank branches in Greece were forcibly sold off for a song, and the fact that controls were not in place when those crucial Eurogroup meetings were taking place. Mistakes are still being made, notably the fact that at this time a temporary board of directors is making the decisions with a CEO on a four month contract.

Merging the two biggest banks and making a smooth transition in difficult circumstances, takes time and should not be undertaken by a temporary board that will go away and leave the hard part of administration and restoration of confidence to a new set of owners and managers after the major decisions are taken by the “temps”.

Clearly the board should have been established with a longer mandate with the new owners being represented when the issue of the” bail-in come haircut” is resolved and the shareholders are clearly identified. In other words the Central Bank, government and the new owners should have had a two year period to work together towards re-establishing consumer and depositor confidence in the Bank of Cyprus, and the CEO should have had a two year contract.

It is unique that in the case of the Bank of Cyprus the CEO has a shorter contract than many temps brought in to cover staff pregnancies!

The situation is extremely difficult for the Central Bank, and mistakes are inevitable. In order to re-establish order in the banking system the government, the Central Bank, the shareholders and the Europeans have to work together to get the banking system in order and provide a basis for growth.

Without growth Cyprus cannot get out of this mess. But the Europeans want the model to be changed, and that requires a decade or two to accomplish, though what the new model should be is undefined and only generalities have been expressed to date.

It is not easy to transform an economic model, especially in a worldwide recession when major markets are hit (notably the UK in Cyprus’ case but also for Spain and Portugal). Yet the rise of unemployment means that the need for recovery is urgent. The young people registered unemployed today will be in middle age by the time the innovation economy talked about today transforms the economic structure of the country. That is politically unsustainable and socially very dangerous as Greece demonstrates every day with the rise of fascism.

The way out is for the government, Parliament and the Central Bank to cooperate, for the politicians to work together and come up with an agreed agenda as to how to bring the Bank of Cyprus back into the fold, and to develop a strategy for stimulating the economy, while also transforming it.

If the politicians continue to confuse good governance with public relations, and keep bickering, there is no hope for a soft landing. The lead should come from the government, and if President Nicos Anastasiades can implement his campaign slogan that the “crisis needs leadership”, by getting everyone to work with him to achieve common goals, there is still hope for the future.

Costas Apostolides is chairman of EMS Economic Management Ltd [email protected]

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