Tough love for Aphrodite’s Island

Centuries old Greek Cypriot links personified in legend by Aphrodite the Greek Goddess of love and mythological Lady of Cyprus are again intertwined in the Cyprus banking crisis.

The early days of Cyprus’ financial services growth received a significant boost from EU status, Russian nationals anxious to protect their new found wealth spotted the Cypriot safety net and parked significant funds in this summer playground, safe from the birth pangs of a state emerging from its communist past.

As Russia joined the ranks of the BRICs, the Cypriot banking system ran out of places to invest the burgeoning cash pile in its domestic economy. The indigenous banks moved on to near neighbours Greece.

A look at the 2012 interim statements for Bank Laiki (Cyprus Popular Bank) and Bank of Cyprus reveals a ‘GGB’ lending line running to billions of euros. It was not hot money from Russia that took the Cypriot banking system down, but the EU imposed haircut on Greek Government Bonds.

The Cypriot Government already deep in hock could not recapitalise its banks and went cap in hand to the EU. For all the fine words about the crisis developing into a new phase, the need for senior bondholders and uninsured depositors to share the pain, the reality is protection for savers - previously a key plank of the much vaunted banking union fell away in the face of German opposition to bailing out ‘Russian oligarchs’.

Neither Merkel nor Steinbruck could face the German electorate in July with the prospect of yet another Southern European bail out, this time, benefitting Russian clients.

Russia protested and the EU has likely done considerable damage to this relationship. With the big name cash already withdrawn, Russia showed no inclination to tip more into the kitty.

The Cyprus bailout at €10bn became the straw that broke the camel’s back, in reality, an insignificant sum in light of Greece at €240bn, Spain €100bn and Iceland €85bn.

What does all this mean for the Eurozone?

The assumption that a Euro is worth the same and is just as safe wherever it is invested in the EU is well and truly shattered. The soon to be introduced Cypriot capital controls and state appropriation of as much as 50% of foreign depositors’ funds, is likely to see a depositor pull out in Spain, Italy and Portugal as overseas and domestic investors worry about contagion and seek safe havens outside the Eurozone.

Political expediency and the North-South European divide have dealt a serious body blow to the euro project.

Cyprus is likely finished as an international banking centre with a predicted 25% fall in GDP, crippling unemployment, and a painful economic adjustment beginning. Speculation is already mounting as to which EU finance centres might be next.

Depositors will assess much more carefully where they place their funds as the implicit state guarantees in the Eurozone are found wanting.

Values such as political and fiscal stability, the rule of law, respect for property, (including cash), an absence of debt, both private and public, balanced national budgets, well capitalised banks with diversified funding sources and safe asset books, all undervalued in the go go years, are back in fashion, big style.

It isn’t the fact that a banking system is a significant multiple of its underlying economy that is the problem. Where the majority of any banking system gets into difficulty, there is no balance sheet in any country large enough to rescue it.

‘We’ll do anything it takes’ may have reassured the markets and worked for the ECB but in reality it is a fig leaf.

Cyprus has a banking system 7 x the size of its own GDP, but many other countries including those in the EU are larger. Luxembourg has operated pretty consistently at 20 x GDP for many years, and individual banks in a number of EU countries including Britain exceed the size of domestic GDP.

The issue isn’t size, but the stability of the operating model.

Why a Cyprus could not happen in Jersey

Firstly, concentration risk was a big problem for the Cypriot banks with deposits sourced substantially from Russia and lent mostly to Greece.

In Jersey, deposits are sourced from around 200 countries including from the new high growth markets. In terms of lending, Jersey does not have any indigenous banks nor does it invest significant funds into the Jersey economy.

Jersey’s banking industry comprises leading international banks of global standing selected only from the Top 500. Deposit value is up-streamed to large systemically important parent banks in London, Paris, Frankfurt and New York. Here, the deposits are blended into the treasury operations of major banking groups supporting the real economies of the major nations.

The Jersey banking model is diversified, does not rely on wholesale funding and is inherently stable.

The second major difference relates to public finances. Too little attention is paid to this crucial area as Cypriot depositors have found to their cost. Cypriot debt is now already at 83% of GDP and forecast to go beyond 100% by 2020. In 2012, the Troika assessors were reported to have said:

“The island's wage bill, which lawmakers heard was proportionately the highest in the eurozone, needed to be reduced, public benefits revamped, wage indexation modified and changes made to the public pensions system.”

A huge public debt pile meant that Cyprus had no internal ability to shore up its banks having exposed itself to that risk. It has now decided to dip into depositors’ money instead.

In Jersey, there is no assumption of this implicit risk due to the more stable banking model already described and the small saver is protected by a depositor compensation scheme. There is also never likely to be any temptation for the Jersey Government to raid depositors because unlike most European nations, Jersey has no debt, no deficit, stable reserves and a policy of balanced budgets.

Speculation has already begun on where Cypriot deposits might flow and apart from assessing banking models and brand stability, arguably the biggest factor in savers minds should be the state of public finances.

The following graph uses data taken from the Economist Intelligence Unit and shows, for a number of international finance centres, the level of public debt expressed as a percentage of GDP.

The final two measures that depositors should consider, are commitment to international regulatory standards and financial strength.

Why are these measures important?

One of the issues that got in the way of support for a resolution by the EU was the concentration of deposits by Russian clients and concerns as to whether anti money laundering procedures have been strong enough.

That said, IMF/Moneyval reports on Cyprus have generally been reasonable although a special inspection has been announced at the request of the Troika focusing specifically on bank due diligence on customers.

Jersey has an exemplary track record in this area having been cited by the IMF as a top tier centre and achieved the highest compliance ratings ever recorded at its last full review.

Moving to financial strength, the trigger that caused the Cypriot crisis to come to a head was a breach of the Basel capital rules intended to provide a buffer against losses. The heavy write downs on the Greek Government bonds threated to take this down to below 5%, whereas the Basel requirement is 9%. This breach of regulatory capital standards caused the ECB to threaten to cut off funding lines unless urgent action was taken.

Whilst Jersey subscribes to the Basel standards, the average core capital ratio across the banking sector is 14.8%, some 50% higher than the required international standard, indicating exceptional financial strength in our banking industry.

The bailout terms in Cyprus will punish savers and the capital controls being introduced will have a long lasting effect on confidence (http://jsy.fi/Xf0DXc)

Trust in the EU has also taken a hit as a result of the initial (now withdrawn) decision to tax insured deposits.

Many depositors will now be looking for a safe harbour in a troubled and uncertain world.

With an 800 year old constitution, a track record of political and fiscal stability, sound public finances, functioning courts and a respect for the rule of law - including for property rights, and with a rock solid banking system, there can be few better or safer choices than Jersey.

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