Michaelides orphanides (eds ) the cyprus bail in; policy lessons from the cyprus economic crisis (2016)

The conference took place around two months after the Cyprus Bail-in, the agreement reached on March 25 between the Cyprus government and the Troika the European Commission, ECB the and

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World Scientific Publishing Co Pte Ltd.

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Library of Congress Cataloging-in-Publication Data

Names: Michaelides, Alexander G (Alexander George), 1969– editor |

Orphanides, Athanasios, editor.

Title: The Cyprus bail-in : policy lessons from the Cyprus economic crisis /

Alexander Michaelides & Athanasios Orphanides, [editors].

Description: New Jersey : Imperial College Press, [2015]

Identifiers: LCCN 2015035740 | ISBN 9781783268757 (alk paper)

Subjects: LCSH: Financial crises Cyprus History 21st century | Debts,

Public Cyprus History 21st century | Cyprus Economic conditions 21st

century | Cyprus Economic policy.

Classification: LCC HB3808.3 C97 2015 | DDC 330.95693/04 dc23

LC record available at http://lccn.loc.gov/2015035740

British Library Cataloguing-in-Publication Data

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Copyright © 2016 by Imperial College Press

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2 Self-Fulfilling Prophecies in the Cyprus Crisis:

5 What Happened in Cyprus? The Economic

Consequences of the Last Communist

Athanasios Orphanides

v

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vi Contents

Sofronis Clerides

Gikas A Hardouvelis

8 Making the Best of It: Lessons from Ireland’s

Alan Ahearne

Section 3: The Future of the Euro Area 281

9 Large versus Small States in The Eurozone,

Yannis M Ioannides

10 The European North–South Divide: Dealing with

Michael Haliassos

Lorenzo Bini Smaghi

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Preface

This volume is based on the proceedings of the 2nd Scientific

Confer-ence organised by the Tassos Papadopoulos Centre for Studies, under

the title “Cyprus: Five years in the Eurozone”, that took place at

Nicosia, Cyprus, on May 17 and 18, 2013

The conference took place around two months after the Cyprus

Bail-in, the agreement reached on March 25 between the Cyprus

government and the Troika (the European Commission, ECB the

and the International Monetary Fund)

At the time of the conference there was substantial confusion

and uncertainty about the future of the Cypriot economy Should

Cyprus abandon the euro as some local politicians and international

commentators were arguing? What caused the total sum of money

to fund the public sector needs and recapitalize the banking system

rise to 17 billion euros, around 100% of GDP? What did the future of

Cyprus look like within the euro-area? What lessons could be drawn

about the architecture of euro-area institutions in light of such crises?

These were questions that the conference addressed and the collection

of papers that follows is indicative of a wide variation of arguments

that were aired at the conference

We would like to thank the participants at the conference who

came to Cyprus to present their views and also for their

contribu-tion in this volume The list of contributors includes authors from

Cyprus, Greece, Ireland, Germany, Italy, and the USA and we hope

that the contributions that follow will achieve the stated aim of the

conference, which is to understand better what happened in Cyprus

vii

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viii Preface

and what lessons this crisis can offer academics and policy makers

around the world

We would like to thank the Tassos Papadopoulos Centre for

Stud-ies for continuing to support the objective understanding and

scien-tific analysis of recent economic events in Cyprus We would also

like to thank Chrisis Pantelides, the executive director of the Centre,

for organizing the conference at short notice We would also like to

thank KPMG Cyprus for generously sponsoring the conference

Alexander Michaelides

Athanasios Orphanides

London and Cambridge

June 15, 2015

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Introduction

Alexander Michaelides and Athanasios Orphanides

This volume is motivated by the Cyprus economic crisis that

culmi-nated in the decision to bail-in uninsured deposits in March 2013 as a

way to prevent sovereign debt bankruptcy The events in Cyprus were

one of the acts in the euro area crisis that started in early 2010 with

no signs of abating at the time of writing in June 2015 In addition

to the events in Cyprus, the volume discusses the experience in two

other crisis-stricken countries (Greece and Ireland) in the broader

context of the growing pains of the Economic and Monetary Union

(EMU) project The objective is to draw lessons from the crisis that

could help improve the design of the institutional architecture of the

euro area and provide guidance to policy makers, practitioners and

academics to improve decision-making both in preventing crises but

also in managing crises once they develop

The volume has three parts The first part aims to document

the chronology of events and offer a narrative about the crisis The

second part presents ways to overcome a crisis based on the Cypriot

and Irish experiences, while the third part puts the Cypriot crisis

in a broader perspective and discusses the future of the euro area

based on the experience from the evolution and final resolution of

the Cypriot crisis

The first part of the volume consists of five contributions that

discuss in detail various aspects of the evolution and final resolution

of the Cyprus crisis The issues discussed include Cyprus’ long term

competitiveness problems, the deterioration of public finances, the

ix

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x Introduction

development of structural imbalances, the inter relationship between

the sovereign’s credit worthiness and the soundness of the

bank-ing system, and political economics Particular attention is paid to

handling the liquidity and solvency issues in the banking sector, for

example the difficulties associated with handling emergency liquidity

assistance (ELA) during the crisis, and the uncertainties involved in

assessing the banks’ capital needs, which eventually determined the

bail-in

In the first chapter Michalis Sarris emphasizes the importance

of structural reform and sound public finances as a prerequisite for

international competitiveness and as a guarantee of high living

stan-dards in the long term

In the second chapter Stavros Zenios details the rapid downgrades

of the Cypriot sovereign debt in the 2010–2012 period and the delay

in signing a memorandum of understanding with Cyprus’ Euro Area

partners The paper discusses the methodology used by investment

firm PIMCO to estimate the capital needs of the Cypriot banking

system in the summer of 2012 and the potential implications from

the uncertainty around the given estimates Self-fulfilling prophecies

can arise when starting from large negative estimates that are made

public in the otherwise benign goal of “full transparency.” The way

emergency liquidity assistance (ELA) was offered to Cyprus Popular

Bank (CPB) is also discussed, and the delay in reaching an agreement

is explained by political expediency

In the third chapter Costas Xiouros focuses on the handling of

the ELA given to Cyprus Popular Bank (CPB) Xiouros makes the

case that the ELA was mishandled, and discusses the steps taken to

resolve the two largest Cypriot banks in March 2013 The ELA rules

and regulations are demystified with an application to the granting

of ELA to the two largest Cypriot banks by the European Central

Bank (ECB) through the national central bank of Cyprus (CBC)

Xiouros also quantifies, based on publically available information,

the impact of the series of decisions in March 2013 on the different

stakeholders

In the fourth chapter Alexander Michaelides discusses how

Cyprus went from a boom to a bail-in Michaelides discusses the

January 27, 2016 11:57 The Cyprus Bail-In 9in x 6in b2256-fm page xi

macroeconomic imbalances (fiscal, banking, credit and external) that

built up over a number of years but became more pronounced after

2008 He argues that the delay in reaching an agreement was

catas-trophic and that this delay arose from political calculations

Igno-rance of the dangers from delay perhaps arose from the false sense

of security from the boom of the previous thirty years, despite the

stark warning signals offered by the explosion that destroyed the

main electricity-producing plant in the country in July 2011

Polit-ical mistakes at the European level (the banker-holders of Greek

government debt in Cyprus were treated differently from their Greek

counterparts) compounded the Cypriot political mistakes to push the

country in an unsustainable position in March 2013

In the final chapter of the first part, Athanasios Orphanides

describes what happened in Cyprus as a microcosm of the

deci-sions taken at the European level and emphasizes the importance

of political decisions in affecting economic outcomes Orphanides

reviews developments in Cyprus from the introduction of the euro

in 2008 to 2013 Among others, he discusses implications of the

private sector involvement (PSI) that imposed losses on holders of

sovereign debt that European governments consider “risk-free” in

European Union Directives This European political decision

mag-nified the losses for Cyprus when local Cypriot politicians did not

ask for a recapitalization of Cypriot banks through European funds

when the Greek sovereign debt was written off in October 2011

This differential treatment relative to banks in Greece exacerbated

the banking sector’s problems in Cyprus Orphanides also

high-lights the delay in reaching an agreement with the Troika and

also rationalizes it based on political expediency The chapter ends

by repeating Rudi Dornhusch’s lesson: “Populism always ends in

tears.”

The second part of the volume merges lessons from the crisis

with ways to overcome a crisis of such magnitude The

contribu-tions distil commonalities from the experiences of Cyprus, Greece

and Ireland to draw lessons for successful exit from the crisis, while

at the same time highlighting the complexities associated with the

decision-making process in the European Union

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xii Introduction

In the first chapter of the second part, Sofronis Clerides

empha-sizes the dysfunctional decision-making process at the European

level, economic imbalances and failure to deal with them, and the

problems arising from excess liquidity channelled from bankers to

developers Following the “crisis is an opportunity” dictum, Clerides

recommends that Cyprus refocus its comparative advantage away

from “low taxes” to expert legal, accounting, shipping and

finan-cial services with full implementation of finanfinan-cial transparency laws

Industries that can be important for Cyprus in the future can be

the continued growth of the tourist sector, but also the provision of

higher value-added activities like health, energy and education

In the second chapter in this part of the volume, Gikas

Hardouvelis emphasizes that post-March 2013 Cyprus should aim to

re-establish trust in the financial system and aim to lift capital

con-trols as soon as possible Structural reforms and fiscal policy

credi-bility are also important milestones Hardouvelis emphasizes that

Cyprus should not waver from being a member of the euro area as a

matter of geopolitical priority, should follow the agreed path with the

Troika and should not delay the implementation of the required

struc-tural reforms Social consensus on the required policies is also

empha-sized as an important prerequisite for successful exit from the crisis

In the third chapter in this part of the volume, Alan Ahearne

discusses the experience of Ireland, a case that can be compared to

Cyprus, both in terms of causes and in terms of lessons for the future

Ahearne emphasizes the importance of adhering as close as possible

to the program and illustrates the “benefits of virtuous behavior.”

In the case of Ireland these benefits came in the form of roughly

30 billion euros of promissory notes for bank recapitalizations, with

longer maturities and held by the Central Bank of Ireland

The last section of the volume deals with the future of the Euro

Area in light of the Cypriot experience as a member of the euro area

since 2008 The experiences of Cyprus, Greece and Ireland, discussed

at different levels of detail in the volume, provide useful lessons about

the problems that need to be tackled at the euro area level Primary

among these is the design of the monetary architecture of the euro,

a project that has already started with the banking union

January 27, 2016 11:57 The Cyprus Bail-In 9in x 6in b2256-fm page xiii

In the first chapter of the third part, Yannis Ioannides discusses

the democratic deficit that emerges in the euro area due to the

incom-pleteness of monetary union if collective decisions do not account for

the heterogeneity of member states, such as differences in the size of

their population He shows how the monetary union introduces

pro-found interdependence that influences national decisions on fiscal

pol-icy which remains a national competence As a result, supranational

considerations influence national fiscal policy and complicate

ques-tions of democratic accountability The weight smaller states have in

collective decisions may need to be disproportionally large, relative

to that of larger states, rather than proportional to their respective

populations Ioannides discusses voting structures in the European

Union and euro area in this context and offers a comparison with the

United States

In the second contribution in this part of the volume Michael

Haliassos interprets the Cyprus bail-in as “part of a consistent

strat-egy of the North to avoid moral hazard.” Haliassos emphasizes the

importance of growth-enhancing strategies in countries like Cyprus

that face potentially unsustainable sovereign debt levels

In the final chapter Lorenzo Bini-Smaghi discusses the future of

monetary architecture in the Eurozone Bini-Smaghi addresses the

question whether the single primary mandate given to the European

Central Bank (ECB) is a sufficient objective function for the ECB

to pursue, whether there is a conflict between monetary policy and

financial stability objectives and the various attempts by the ECB

to manage the euro area sovereign debt crisis In times of crises, the

monetary authority cannot act in a vacuum and not engage with the

fiscal authority and other stakeholders on account of being perceived

not to be independent

We hope the analysis offered in this volume can provide insights

on how future crises of such magnitude can be prevented, how risk

management at the national and international level should operate

once such a crisis erupts, and how the institutional design of the euro

area would need to be adapted to improve the odds of its survival

and future success

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Section 1

Cyprus in Crisis: What Happened

in Cyprus?

1

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Chapter 1

Cyprus in the Eurozone

Michalis Sarris∗

Membership of the Eurozone creates opportunities and can offer

substantial benefits to its member nations Trade expansion in the

context of a much larger market for goods and services, substantial

capital movements and the pursuit of investment opportunities

facil-itated by a stable currency, an environment of low interest rates, and

overall moderate inflation have helped stimulate the labor market

and increased the overall standard of living throughout the Eurozone,

including Cyprus However, membership also calls for responsible

economic policy choices, including adherence to the provisions of

zone-wide agreements

In countries which, while benefiting from the advantages of the

Eurozone, have not taken their membership responsibilities seriously,

the severe and protracted worldwide recession resulting from the

financial crisis of 2007–2008 brought to the surface preexisting and

home-grown underlying economic weaknesses These weaknesses in

most cases had their roots in one or more of the following causes:

(i) a serious erosion of relative competitiveness, resulting from

per-sistent differences in the evolution of unit labor costs and the

associ-ated higher rates of inflation; (ii) a rapid expansion in public sector

expenditure, with the scope for increases in government revenues

unable to keep pace, leading to growing fiscal deficits and a sharp

∗Former Finance minister of the Republic of Cyprus.

3

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4 The Cyprus Bail-In: Policy Lessons from the Cyprus Economic Crisis

rise in government debt, pushing borrowing costs to exceptionally

high levels; and, (iii) inadequate macro-prudential regulation leading

to unsustainably high growth rates in bank credit Cyprus belongs

to this category of Eurozone countries — it experienced, perhaps

uniquely, all three imbalances

The near total neglect of macro-economic imbalances (both

inter-nal and exterinter-nal) was exposed by the world economic crisis and

was punished swiftly and harshly by financial markets in the

con-text of the ensuing persistent sovereign debt crisis in the Eurozone

Nations in the southern part of the Eurozone, including Cyprus in

May 2011, began one by one to lose access to international capital

markets to cover their governmental borrowing needs As a result, a

long-lasting recession, characterized by growing unemployment

par-ticularly amongst the young, has been causing misery in about half

a dozen Eurozone countries

The expectation that European institutions and key Eurozone

countries would work together to deal with the crisis did not

mate-rialize Instead of providing immediate and direct support to resolve

the Greek sovereign debt crisis, for example, key Eurozone

policy-makers focused on improving the “architecture” of the Eurozone,

following political rather than economic criteria, reacting to, instead

of anticipating, market sentiment Characteristic of this poor crisis

management was the decision by the leaders of Germany and France

on October 18, 2010 at Deauville to introduce credit risk in

mar-kets which had hitherto been considered as safe government debt:

the now infamous Greek PSI This was followed by another error on

March 16, 2013 in Brussels when the Euro group decided to

intro-duce credit risk in bank deposits, thereby undermining confidence in

the banking system

Member countries of the Eurozone, including Cyprus, had no

choice but to adopt and implement a strict set of policy programs

to correct fiscal imbalances and improve competitiveness, while in

a number of cases they had to deal with a banking crisis This

challenge in the case of Cyprus was fostered by a negative

feed-back loop between weak public finances unable to support banks

in need of capital, and banks systematically underestimating risk,

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch01 page 5

becoming embattled and, thereby, undermining the sustainability of

public finances Rather than recalling the series of missed

opportuni-ties to timely deal with the crisis in Cyprus, or analyzing the severe

blow dealt to the country’s banking system in March 2013, this

sec-tion will instead focus on a small number of observasec-tions which could

help Cyprus to gradually return to a satisfactory pace of economic

growth and employment creation

First of all, a strong consensus should be reached that Cyprus’

political and economic future is firmly within the Eurozone This is

an extremely urgent and important message to reassure both local

and international potential investors in the Cyprus economy

Sec-ond, the futile debate amongst economists and politicians over the

dilemma between fiscal austerity and economic growth should be set

aside This debate should have little relevance to the policy choices

of a small, open economy like Cyprus, where fiscal multipliers, which

estimate the negative impact of reduced government spending and

increased taxes on economic activity, are relatively small This is

because the effect of governement spending cuts is spread over

sev-eral trading partner countries through a reduction in imports rather

than impacting domestic production Indeed, it should be part of

the consensus that the major impediment to sustainable growth is

not insufficient spending, but structural weaknesses which must be

urgently addressed

The most advisable course of action, therefore, should be to

con-centrate on the implementation of fiscal consolidation add and,

there-after, budgetary discipline as agreed in the Memorandum of

Under-standing with the Troika in Cyprus (the European Commission,

European Central Bank, and the International Monetary Fund) This

is based on the well-established principle that sound public finances

are a prerequisite for economic development, that an economy with

large budget deficits and growing government debt cannot grow and

create employment opportunities, and that fiscal discipline is the

cornerstone of a broader program of structural reforms leading to

improved competitiveness, faster growth, and employment creation

The recent experience of the UK and Ireland is instructive in this

respect Confronting in 2010 record peace-time budget deficits and

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6 The Cyprus Bail-In: Policy Lessons from the Cyprus Economic Crisis

total indebtedness, both countries have persevered with austerity

with ultimately beneficial results for their economies

Based on the Greek experience, where it appeared that a very

large fiscal adjustment was being implemented over too short a

period, the Troika in Cyprus has agreed to extend the period of fiscal

correction to balance the budget by 2018 While this makes possible

a more gradual fiscal adjustment, to regain early access to financial

markets, it will be necessary to convince these markets that Cyprus

has a credible plan of sustainable fiscal consolidation, including fiscal

rules, and well-managed institutions that inspire confidence Surprise

announcements on both public spending and government revenue

policies must be avoided at all costs

In the context of re-establishing confidence in the

sustainabil-ity of public finances, a serious effort is needed towards reforming

and rationalizing the welfare state The key elements of this urgent

reform should be a much better targeting of social expenditure on

protecting the most vulnerable population groups, while at the same

time strengthening the incentives to participate in the workforce The

clear outcome should be a permanent reduction in the size of the

pub-lic sector A very good contemporary example is that of Denmark,

where in a low-key manner and without social unrest, the oversized

welfare state is being reduced in accordance with changing economic

realities

In the same spirit, as it is likely that further adjustments may be

necessary during the course of the period of implementation of the

Memorandum of Understanding with the Troika, and because it is

often politically easier to make fiscal corrections through raising taxes

rather than reducing expenditure, special attention should be paid

to the stability of the tax system, with the raising of taxes avoided

as much as possible One of the stylized facts from the experience

of many countries is that fiscal consolidation is much more

sustain-able when it is achieved through expenditure reductions rather than

tax increases, and a stable and predictable tax system is a strong

incentive for private sector investment and job creation

As the experience of even those countries which are showing

signs of economic recovery suggests, the most lasting and probably

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch01 page 7

the cruelest consequence of the world economic crisis is

unemploy-ment Unemployment in Cyprus, as in many other places, is most

pronounced amongst the younger generation, many of whom have

already been seeking work for a long time The strategy for

address-ing the key challenge of reducaddress-ing chronic unemployment has two

dimensions: first, the foundations for job creation have to be put in

place through a stable and enabling macroeconomic and private

sec-tor development environment; second, workers need to be helped to

acquire the skills and be provided with the incentives to be able and

have the desire to access new job opportunities

Political courage will be needed for structural reforms that

increase competition and reduce the role of the state in key

sec-tors, including telecommunications and energy These reforms tend

to be politically more demanding than fiscal consolidation because

of well-established interest groups and because structural reform

often means that initially jobs are both created and lost But the

experiences of other countries show that, although results may take

time to materialize, such reforms eventually lead to higher levels of

employment and a more productive job market Cyprus has shown

in the past that it is characterized by a high level of entrepreneurship

and, given the correct and supportive business environment, this can

translate into the creation of businesses in new sectors and give a

boost to job creation

But to take advantage of these new job opportunities, the labor

force must be better prepared and trained The experience of

Ger-many shows that unemployment has less to do with labor costs and

more with the preparation of young people with the skills that are

needed in a modern labor market It is therefore imperative that

systems of education, training, and lifelong learning in Cyprus be

adapted to the needs of the evolving labor market, as skills gaps are

a serious impediment to employment growth The fundamentals of

the Cypriot approach to education need to be carefully reassessed and

the phenomenon of “overqualified but under-skilled”, whereby young

people gain qualifications which are not appropriate for the available

jobs or not given the opportunity to obtain alternative skills, must

be decisively reversed This is especially true as the energy sector is

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8 The Cyprus Bail-In: Policy Lessons from the Cyprus Economic Crisis

likely to gain relative importance in Cyprus Systems of

apprentice-ship and the combination of academic studies with work experience

have been successful not only in Germany but also demonstrably in

the Netherlands, Sweden, Finland, and Norway

Looking to the future, a determined effort to live up to the

respon-sibilities of Eurozone membership is vitally important This can be

achieved by addressing a structural fiscal deficit through a multi-year

program of expenditure control, a reversal of the rapid growth of the

state, structural reforms to improve the productivity and

competi-tiveness of the economy, important improvements in the functioning

of the banking system and an overhaul of education and training

systems

At the same time, important systemic shortcomings in the

func-tioning of the Eurozone must also be urgently addressed and

cor-rected These include concrete steps towards a European Banking

Union, strengthening the code of conduct for national governments,

supported by better surveillance and improved governance and the

establishment of a credible mutual support framework to deal with

the challenges of excessive sovereign debt And above all, a greater

contribution to the Europe-wide adjustment process through higher

domestic consumption in surplus countries such as Germany, Austria

and the Netherlands so that the burden of adjustment will be lighter

on those countries which have to reduce their current account deficits

While the challenges may appear daunting, the correct solutions exist

and must be identified and implemented as soon as possible in order

to ensure a prosperous future for the entire Eurozone

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 9

Five years after joining the Eurozone, Cyprus goes (virtually)

bankrupt, leading to questions over how a country that in 2008 had

satisfied the strict Maastricht criteria could be cutoff from the

finan-cial markets by mid 2011 and face default by the end of 2012 There

is no simple answer Complex systems fail in complex ways and

sys-temic crises usually result from a combination of bad management

and bad luck, from multiple and substantial failures of institutions

and people in positions of authority However, it is not possible to

place the responsibility on just one or two key players; if any of the

components of such a complex system had behaved differently, the

crisis may have been averted Attempting to place all responsibility

on a single factor, as has been the case in Cyprus, obscures

signifi-cant facts

∗University of Cyprus and The Wharton Financial Institutions Center, USA The

paper was written while the author was a non-executive director of the Central Bank of

Cyprus The opinions expressed herein have not been shared with or endorsed by the

Central Bank.

9

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A debt crisis was fermenting in Cyprus long before the country

was cutoff from the markets Zenios (2013b) describes the state of

different aspects of the economy that combined to create a “perfect

crisis” The diverse factors that contributed to the crises of other

countries were present in Cyprus as well (see, e.g., the comprehensive

analysis of the Irish Investigation Commission (Commission 2011)):

a Prerequisites for crisis,

h Shallow government guarantees

To understand the Cyprus crisis we follow a narrative in three distinct

stages:

1 The period up to the onset of the international crisis in 2008

During this period, households, corporations, and the

govern-ment accumulate excessive debt The country’s

competitive-ness erodes but significant imbalances are obscured by an

over-developed banking sector The conditions were set for the

Cypriot economy to suffer a heavy blow when the international

crisis erupted Mr Michalis Sarris, Minister of Finance under

President Papadopoulos, stated during the hearings of the

Inves-tigation Commission on May 15, 2013 that he had warned the

have to ask the EU for assistance” The state of the economy up

to the time of the crisis is discussed in Zenios (2013b)

2 The period 2008–2011 when the government of Cyprus loses access

the Greek government bond haircut

During this period public debt grows from 52.9% GDP in the first

quarter of 2008 to 71.1% GDP by the end of 2011 Together with

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 11

(23.03% of the country’s GDP), the vicious circle of

interdepen-dence between banking and public finances was set in motion

This interdependence, and its adverse effects under stress

condi-tions, is well documented in the literature; see especially Mody

and Sandri (2011) for the Eurozone case Without an

appropri-ate policy response, Cyprus was headed for the exit of

interna-tional markets and only the timing was unknown It is worth

noting that market access was lost on May 30, before the

explo-sion of July 11 destroyed the country’s main power plant This

is a period of “faulty judgment” that led to the accumulation of

major problems

3 The period 2012–2013 when Cyprus negotiates an assistance

pro-gram with its international lenders under strict conditionality

This is a period of negligence and procrastination Politics stand

in the way of appropriate policy responses and the initial

and steps such as bailing-in bank depositors appear unavoidable

This is a period of “mismanagement” that leads to the final

col-lapse The Cyprus crisis culminates with the Eurogroup meeting

of March 25, 2013, when the country is put under the supervision

of international lenders

An analysis of several aspects of the crisis is provided in thereport prepared by the author as an expert advisor for the Special

Investigation Commission Unfortunately, important information

relating to the period 2012–2013 is classified as confidential and

In this chapter we provide the data from the author’s report to

the Special Investigation Commission (Zenios 2013a), without the

confidential information In Zenios (2014) the same data are used

to analyze the fairness of the Cyprus bail-in and to show that it

1The Special Investigation Commission decided by majority 2–1 not to investigate

the collapsed Laiki bank The majority also decided not to incorporate the analysis

procured from the expert advisor A dissenting opinion was issued by ex-Obudsman

Eliana Nicolaou, who also adopted the report of the advisor Links to all three documents

(in Greek) are available at: http://wp.me/p2GuKg-dD.

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 12

produced effects consistent with George Soro’s reflexivity

princi-ples First, there will be a discussion on the significant

procras-tinations during the crisis; a point also commented on by others

(see Michaelides (2014) and the chapter by Orphanides in this

volume) It was possible to delay making any decisions by

keep-ing the Cyprus Popular Bank (CPB), the country’s second largest

systemic banks, “on life support until the Presidential elections”

using emergency liquidity assistance (ELA), to quote Panicos

will show how handling the ELA was misguided and exacerbated

the problems Another blow came from a due diligence study by

PIMCO that seems, from other evidence, to have exaggerated the

estimates of bank recapitalization needs and pushed the country’s

debt into unsustainable territory The PIMCO study was used to

guide data-driven policy on an issue where a billion here and a

bil-lion there would have significant adverse effects; this is the topic

of Section 4 The PIMCO events and the subsequent self-fulfilling

prophecies are discussed in Section 5, while Section 6 draws

con-clusions

2 Delay Tactics

Following the Greek PSI, the two major systemic banks of Cyprus

needed recapitalization On May 18, 2012, the Parliament approved

government funding for recapitalization of CPB in case sufficient

funds were not raised from private sources, for a total amount up

bil-lion This bill would not come due until June 2017, but the country

(i) could not afford it and (ii) was paying to save a bank that evidence

showed was insolvent

Parliament was presented with the recapitalization bill by the

Ministry of Finance, with an ultimatum that without its immediate

2Quote from an interview with the Cypriot edition of KATHIMERINI of March 26,

2013.

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 13

approval the country’s second largest systemic bank would collapse

Indeed, the parliament had no time to study the issue or room

to maneuver If CPB did not secure sufficient capital by June 30,

its license would be withdrawn, leaving the government with a bill

was just enough time to approve the government underwriting, give

the tightest deadline to raise private capital and, eventually, as

amounting to about 10% of GDP

However, the situation could well have been avoided CPB needs

had been determined by EBA stress tests since December 2011 At

the time the Board of Supervisors had asked national authorities

to place an obligation on troubled banks to strengthen their

cap-ital positions by building up a buffer with a Core Tier 1 capcap-ital

ratio of 9% by the end of June 2012 The capital shortfall of CPB,

bil-lion and a much better profit profile than CPB, registered a shortfall

lower exposure to Greek government bonds, had a capital

short-fall estimated by a Central Bank of Cyprus (CBC) exercise of only

second quarter of 2012, could not possibly raise the required capital

on its own On this basis the procrastination from December 2011

until May 2012 is hard to justify

Alarms were sounding about the approaching storm Repeated

downgrading of the Cyprus sovereign from the end of 2010 was a

clear signal of accumulating problems (see Figure 1) At the

begin-ning of 2012, ratings finally hit non-investment grade (i.e., junk);

by the time a recapitalization decision was ready to be made, two

of the rating agencies had rated government bonds as junk and the

3Summary of EBA stress tests at www.centralbank.gov.cy/nqcontent.cfm?a id= 12394

&tt= article&lang= en Data for Hellenic are from private communications The EBA

stress test focused on sovereign exposures, while the CBC analysis considered also

domes-tic deteriorating conditions Hellenic Bank, with estimated needs 212.8 mil had booked

losses of only 77 mil from the Greek PSI.

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 14

Parliament enacts law for state-aid

Figure 1 Progression of credit ratings of the Cyprus government.

third had a negative outlook On June 25, the third rating agency

also downgraded to junk and thereafter government bonds became

ineligible for regular ECB operations (Recent work shows that if

a comprehensive early warning system was in place, it would have

issued warnings starting in 2009–2010 for increased risk of banking

crisis, and from 2010 for sovereign crisis (Panayi and Zenios 2015).)

The Government was forced to act to avert the bank collapse

but it had no means to do so Two days after the recapitalization

of CPB, the Government applied to international lenders for

the Credit Default Swaps spreads of Eurozone countries that applied

for assistance Spain, Greece, Ireland, and Portugal applied for

assis-tance when their spreads were around 600 bp Cyprus delayed until

its spreads had exceeded 1,500 bp After it applied for assistance,

there was no agreement for eight months while other crisis countries

had reached an agreement within two months of applying Agreement

4Reuters report http://www.reuters.com/article/cyprus-bailout-idUSL6E8HRFSR201

20627.

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 15

Figure 2 Spreads of 5-year CDS of government bonds for European countries

under assistance programs (Marked with a triangle are the dates of applying for

assistance and with a bullet the dates of reaching agreement Graph as presented

by A Orphanides at the Tassos Papadopoulos Center Conference on “Five Years

Euro”, May 17, 2013).

was only reached after a change of Government following the

Presi-dential elections of February 2013

During this period of procrastination and indecision, the

prob-lems were aggravated The deterioration of financial indicators will

be demonstrated here, but it is also worth noting that several

exter-nal adverse factors came to play during 2012–2013:

1 Cyprus missed the opportunity to negotiate an agreement

together with Spain The two countries applied together for

assis-tance and Eurogroup president Jean-Claude Juncker publicly

urged Cyprus authorities on September 15, 2012 to “sign the

ear-liest a Memo of Understanding to be in the rescue package with

other countries that applied for aid on March 1, 2012” If Cyprus

had negotiated together with Spain it would have been systemic

and possible to achieve a better deal

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 16

2 In January 2012, Jean-Claude Juncker (Luxemburg) was

suc-ceeded as president of the Eurogroup by Jeroen Dijsselbloem

(Holland) As prime minister of Luxemburg, Juncker did not share

the opinion (advocated by the German Minister of Finance and

shared by his Dutch counterpart) that Cyprus’ large banking

sec-tor was the problem per se His statement to Der Standard after

the Eurogroup decision is characteristic of the support Cyprus

could have expected if a decision was made before the changing

of the guard: “It was the first time I wasn’t in the Eurogroup

I would have wished for a more gentle approach to small

savers.”

3 On November 5, 2012, German magazine Spiegel made its first

public reference to a Secret Services report on money laundering

of Russian funds in Cyprus This led to a tougher German stance

on a rescue package for Cyprus

Let us examine now some hard data relating to the deterioration

of the banking sector during the period of procrastination

3 ELA to Cyprus Popular Bank

Starting from September 27, 2011, CPB resorted to ELA The initial

bank was led into resolution on March 28, 2013; see Figure 3, noting

in particular the rapid increase in the summer of 2012

by July 6, 2012 During this period of inaction the following events

prompted a flight of deposits from CPB and increased reliance on

emergency assistance: (i) Greek elections with the risk of Greek exit

branches of CPB, (ii) the downgrading of a 1.3 billion covered bond,

and (iii) the downgrade of Cyprus by Fitch on June 25 that made

2.6 billion of government bonds in the bank’s portfolio ineligible for

normal ECB operations

Published financial indicators for the period 2005–2012 (see

Figure 4) raise concerns over whether the bank was solvent during

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 17

0 50 100 150 200 250 300 350 400 450 500

ELA ELA servicing at 2.5% Profitability 2010

Parliament enacts law for state-aid

Figure 3 ELA to CPB Bank, 2011–2013 The continuous line is the cost of

financing of ELA as per ECB rules The dotted line is the bank profitability

before taxes as of 2010 ELA is measured on the left axis and the cost of ELA

and bank profitability on the right; all in millions of euro.

Before tax profits Cash and cash equivalent

Figure 4 Cyprus Popular Bank financial indicators and ELA, 2005–2012.

(Source: CPB accounts).

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 18

this period Until the end of 2011, when the bank started drawing

ELA, both reserves and profits were negative Comparing the cost of

ELA with bank profitability (Figure 3), it can be seen that even if

2010 profitability was maintained — an overly optimistic scenario —

the Bank was not in a position to service ELA past June 2012

Two issues are now raised:

(a) Was the bank satisfying regulatory requirements for capital

ade-quacy during the period of high ELA financing? The answer

was negative after the Greek PSI, as revealed by the stress test

But what happened after recapitalization with the Government

bond?

(b) Was ELA granted according to ECB rules, i.e., was the bank

solvent and did it post adequate collateral?

To answer these questions one needs access to Central Bank data

Those were collected and analyzed by the author for the Investigation

Commission on the Cyprus economy This analysis remains

confiden-tial so these questions are answered here based on public data

3.1. Was granting of ELA to Cyprus Popular Bank

an act of prudence?

The fact that CPB went into resolution tells us that at some point

it had become insolvent Figure 3 shows that the lines indicating the

cost of ELA and bank profitability intersect in June 2012 Therefore,

after June 2012 the bank’s ELA debt would become unsustainable

even if its balance sheet and business activities did not deteriorate

further The bank became insolvent

Further evidence is obtained from the transfer of ELA and the

associated collateral from CPB to BOC as part of the resolution

pro-cedure Based on publicly available data, Xiouros and Zenios (2013)

by BOC; this would indicate violation of ECB rules that require

ade-quate collateral BOC managers Evdokimos Xenofontos and Yiannis

Kypri in their deposition to the Investigation Commission (see Pikis

et al., 2013, p 91) expressed doubts that BOC received adequate

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 19

assets to cover the ELA obligation Xenofontos provided an

estimate

Hence, publicly available data provide evidence that (1) ELA was

granted to an insolvent bank and (2) the posted collateral was

insuf-ficient

It is recognized that the distinction between liquidity and solvency

problems is blurred during a crisis, and the evidence is not definitive

without access to Central Bank data With different handling what

may appear as insolvency could turn around and be merely a

tem-porary liquidity problem As we see next, however, the Governor of

the Central Bank was aware of the bank’s solvency problems, but

justified the decision to provide ELA in any case

3.2. Were the authorities aware of the problems?

There is evidence that the authorities were aware of the problems

First, there is the July 2, 2012 ECB opinion on the recapitalization

of CPB (ECB 2012, author’s underlining):

(a) Recapitalization versus resolution

In view of the fact that the support measures aim to address vency problems at a financial institution, the ECB considers that the objectives pursued may be better achieved through bank resolu- tion tools A fully fledged resolution regime, comprising tools such

sol-as bridge banks, sol-asset separation, and transfer of business would offer legally sound means of resolving institutions on the brink of insolvency, safeguarding financial stability, whilst addressing stake- holder rights.

(b) Financial stability considerations

recapitalization of banks with funded or, a fortiori, unfunded

government bonds has a number of drawbacks from a financial bility perspective More specifically, market participants may not regard the injection of unfunded recapitalization bonds as a credible recapitalization technique, as it does not result in the provision of fresh cash to the bank, and thus may not help restore market access.

sta-Despite the fact that it can serve as a means of meeting the ital adequacy ratio, recapitalization through the injection of such

cap-January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 20

unfunded recapitalization bonds can only change the risk tion capacity of the bank gradually over time, as cash flows asso- ciated with these bonds are accumulated Also, recapitalizations through government bonds forming part of the bank’s assets can reinforce the feedback loop between the state and the bank This is

absorp-to be avoided.

The ECB is concise in the first paragraph and prescient in the

sec-ond However, this opinion was requested by the Ministry of Finance

on May 30, 12 days after the recapitalization measures were enacted

into law by the Parliament, and was issued on July 2, two days after

the recapitalization deadline of June 30 had expired It then remained

confidential for six months It is noteworthy that the ECB has a

man-date to provide opinions on measures that affect financial stability

and systemic banks Its opinion should have been solicited on time

and made available to the parliament From the EBA warnings of

December 2011, until June 2012 when action was needed, there was

ample time to seek ECB opinion

Cyprus Central Bank took a diametrically different approach than

the ECB They adopted an argument that CPB would become

sol-vent via the assistance program, once an agreement with the Troika

was reached This argument was made by then Deputy Governor

Spiros Stavrinakis to the Investigation Commission and was

reiter-ated by Governor Demetriades

even if capital adequacy indicators were below the minimum

require-ment [ .] there was the prospect of an assistance program and therefore

it was the position of the Central Bank that Laiki Bank, if it was not

solvent could become solvent because of the prospects of the program

and the signing of agreement (Spyros Stavrinakis, in Pikis et al., 2013,

p 132–133 Author’s translation).

The Central Bank continued to provide emergency liquidity assistance

to Laiki Bank, kept the license of Laiki Bank on the basis of the

appli-cation of the Government of the Republic for assistance (Panicos

Deme-triades, in Pikis et al., 2013, p 141 Author’s translation).

The Central Bank officials admit that the Bank was insolvent but

solvency would be restored via the assistance program These

expla-nations are not acceptable without a fully functioning European

Stability Mechanism (ESM) in place to directly recapitalize banks

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 21

The ELA system could not work as the Governor and his deputy

argued

4 The PIMCO Study for Recapitalization

of Cyprus’ Banks

Once it became unavoidable that international assistance was needed,

international investment firm PIMCO was retained by the Central

Bank to conduct a bottom-up, loan level due diligence of the Cyprus

banking system The objective was to quantify the capital needs of

Cyprus’ financial institutions, thereby determining the needs of a

res-cue package as far as the banking sector was concerned The study

was conducted under the direction of a Steering Committee

com-prised of representatives from CBC and other Cypriot authorities,

European Commission, ECB, European Financial Stability

Facil-ity/European Stability Mechanism, European Banking Authority,

and the IMF (as observer) Capital estimates were generated under

“base” and “adverse” macroeconomic scenarios established by the

Steering Committee for a forecast period extending to June 30, 2015,

PIMCO (2013)

The adverse scenario estimates were deemed by the international

lenders as the appropriate reference capital needs for the country to

deal with the banking aspects of the crisis This number was added to

the country’s fiscal deficit and the needs to refinance public debt and

an overall number was reached Based on these estimates, decisions

were made for resolution of CPB, the amount of the rescue

pack-age and the decision to bail in depositors The amount of haircut

to depositors of BOC was also driven partly by the PIMCO

esti-mates although for the final decision a new study was carried out

by KPMG

Under the adverse scenario, the aggregate capital shortfall for

of June 30, 2015; see data from Figure 7 of the PIMCO (2013) study

The overall loss rate for loans across all participating institutions

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 22

over the three-year forecast period was estimated at 23.0% of

exist-ing gross loans and new loans originated durexist-ing the forecast period

For domestic banks (BOC, CPB, and Hellenic) the aggregate capital

period of 24.8% The aggregate capital shortfall for co-operatives was

589 million with an overall loss rate of 17%

a total which represented 130% of GDP This level of debt is

unsus-tainable and is the reason that the solution of bail-in was devised

rollover, privatizations and gold sales, and to limit the program to

10 billion

The EC debt sustainability report contained the following

state-ment:

Recapitalization needs arise from expected losses estimated by PIMCO

in an adverse scenario and to ensure that the banks remain

suffi-ciently capitalized at 9% core tier one In response to the results of

the due diligence exercise, Bank of Cyprus and Cyprus Popular Bank

have been intervened and restructured and thus programme money will

not be used to recapitalise Laiki and BoC Against this background,

the recapitalisation of the remainder of the restructured banking

sec-tor amount to around EUR [2.5] bn over the programme period, taking

into account that further recapitalisation needs may arise in the case

of higher-than-projected loan loss provisions The recapitalisation bond

injected in Laiki in June 2012 is not replaced by ESM financing

(Euro-pean Commission Directorate General Economic and Financial Affairs,

Assessment of the public debt sustainability of Cyprus, Provisional draft,

April 9, 2013).

Hence, the accuracy of the PIMCO estimates was crucial for the

Eurogroup decision of March 2013 Excessive loss estimates would

increase the haircut imposed on uninsured depositors of CPB and

BOC Insufficient loss estimates would make the program fail, as

future losses would exceed the program provisions Creditors have

an incentive to overestimate losses to avoid future difficulties and

recover their loan Borrowers have an incentive to underestimate

losses in order to minimize immediate difficult adjustments In the

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 23

case of Cyprus, with losses estimated at around 100% of GDP,

nei-ther side can push the problem to the onei-ther, as adjustments of this

order of magnitude have an adverse impact on growth Of course,

underestimating losses will make the program fail with inadequate

provisions, but overestimating losses and making excessive provisions

will adversely impact economic growth beyond what is expected by

the country’s current indebtedness and inadvertently make the

situ-ation worse

The PIMCO study, while methodologically sound, made

assump-tions that led to significant overestimation of the banking sector

needs Three follow-up studies can be used to assess the accuracy

of the PIMCO estimates:

i BlackRock: Commissioned by CBC to assess the reasonableness

of PIMCO

ii KPMG: Commissioned by CBC in its capacity as Resolution

Authority for BOC in view of the bank restructuring plans

iii Clayton/Eurorisk: Commissioned by the Board of Directors of

Hellenic to determine the bank’s recapitalization needs

The BlackRock study was carried out to assess the PIMCO

methodology It should be possible to learn from it any

assump-tions or methodological approaches that would lead to

overestima-tion of losses The KPMG and Clayton/Eurorisk studies used their

own alternatives to PIMCO modes for estimating losses and hence

can be used to double-check the PIMCO estimates

All of the studies were carried out by competent professionals,

and it is common for forecasting exercises to generate

disagree-ments among those who carried them Some differences could be

resolved if the teams involved had time to engage in discussions

Quite often methodological disagreements are resolved following an

exchange of reasoned arguments In other cases the differences are

a result of underlying assumptions and then it is much more

diffi-cult to establish what the valid assumptions are The end-user should

demand transparency so that he or she is aware how the assumptions

impact the forecast In the case of PIMCO, there is limited

trans-parency on the dataset used and the statistical analyses performed

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 24

Combining the lack of transparency with the impact of the overlay

assumptions made by the Steering Committee make it challenging

to verify the results Limited transparency would not have been a

problem if subsequent studies converged to similar estimates with

PIMCO However, when there are significant differences, the lack of

transparency raises doubts over the results

Unfortunately, the studies that followed PIMCO are confidential

and so is the report to the Investigation Commission (Zenios 2013a)

that used these studies to assess the accuracy of the PIMCO

esti-mates Therefore, again the assessment here will be made on the

basis of the publically available data From press reports we learn

that under the Clayton/Eurorisk study, Hellenic would have a

estimates should be downward adjusted by 21%; see Table 1

Athanasios Orphanides, Governor of CBC until May 2, 2012, in

his deposition to the Investigation Committee on August 23, 2013

of Orphanides to the Investigation Commission, however this part

of his deposition is not included in the Commission’s report, Pikis

Table 1 Needs of the Cyprus banking system after adjusting the PIMCO

estimates based on a subsequent study by Clayton/Eurorisk (mil Euros).

BOCY CPB Hellenic TOTAL

PIMCO expected loss

estimates

Banking system needs —

January 27, 2016 11:56 The Cyprus Bail-In 9in x 6in b2256-ch02 page 25

et al (2013) The recapitalization needs obtained by adjusting the

PIMCO estimates based on the Clayton/Eurorisk study is very close

to Orphanides’ estimate Finally, a report in the New York Times

refers to the Blackrock study (that was reviewed by the editor of the

article) and mentions at least 1 billion lower estimates by BlackRock

than by PIMCO (Landon Jr., 2014)

Hence, there are three publicly available estimates that point in

the same direction: significant downward adjustment of the PIMCO

estimates

Of course the ex-governor of CBC has reasons to downplay the

expected losses created under his watch and he has been a vocal critic

of his successor and the PIMCO study Similarly, Clayton/Eurorisk

has reasons to be biased in favor of their clients Further insights can

be gained from the first IMF review of the Cyprus program (IMF,

2013) The IMF report states:

both exercises estimated probabilities of default and loss given

default While the two exercises are not directly comparable [ .]

prelim-inary estimates suggest that overall losses on the end-March portfolios

were similar, even as KPMG projected somewhat lower peak NPLs (IMF,

2013).

Although the IMF review finds that the subsequent KPMG

study produced similar estimates to PIMCO, the differences of

non-performing loans under the two studies can be viewed in Table 2

The KPMG estimates are on average (non-weighted) 17% lower than

PIMCO, which is of the same order of magnitude as the downward

adjustment obtained from the Clayton/Eurorisk study

This is further evidence to support the analysis of Table 1 and,

therefore, it can be stated with reasonable confidence that the needs

Table 2 Non-performing loans under the KPMG and PIMCO studies.