Bank bail-in plans: is France becoming nervous about being left alone with Germany?

As we have pointed out repeatedly, those who think that the eurozone is one German election away from a full banking and fiscal union (which includes a surprising number of British eurosceptics) should have another look around Europe.

As we noted last week, the latest draft of the bank recovery and resolution directive left plenty of questions unanswered.

[Background - this is the proposal which looks to establish a clear and standardised pecking order for losses in the instance of a bank failure. It is not the full 'banking union' proposal, which involves some form of combined backstop. Despite being first suggested as far back as 2010 and with a proposal put forward last summer which was largely ignored, this has become an important piece of legislation since the Cypriot crisis.]

That EU finance ministers failed to reach an agreement after 18 hours of talks on Friday is therefore not entirely surprising. What is perhaps slightly more surprising is the dividing lines and in particular which countries found themselves arguing the same side.

We highlighted before where each country broadly stands on this issue. This does not seem to have changed much, although the focus of the discussions has. Previously, much of the emphasis was on ‘depositor preference’ – i.e. when and to what extent uninsured depositors would face losses during a bank bail-in. Not exactly surprising given the Cyprus debacle.

A broad consensus seems to be emerging around a structure which protects insured depositors completely and gives added seniority to those uninsured deposits held by individuals and small and medium size enterprises. With the pecking order broadly settled, focus has shifted to the level of flexibility allowed within the structure, in particular whether bail-ins should be automatic or whether there should be sizeable national discretion to decide on which format to use.

This debate has seen the EU split into two broad groups: 

• One led by France, the UK and other non-eurozone countries, arguing for greater flexibility and national discretion – although presumably for different reasons, the UK because it fears its financial sector is larger and more varied than many in the eurozone and France because it is keen to keep open the option of a bank bailout due to fears automatic bail-ins could increase funding costs (souveraineté). 
• The second group is led by Germany and the Netherlands, both of whom are keen to limit flexibility to allow for a standard framework across the eurozone and also partly because they fear governments will put domestic political needs above those of the single currency as a whole. This is a trust issue as these countries' taxpayers may one day have to stand behind the continent's banks.

Ignoring the technical details for a bit, the wider political dynamic at work here is fascinating. France is actually on the side of the non-eurozone countries. This is bending assumptions as it's usually France that is the keenest on doing stuff at the level of 17 rather than 27, as Paris is proportionally stronger in that smaller constellation. Germany, on the other hand, prefers 27 to 17, for the opposite reason.

There seems to be good reason to expect some greater flexibility for non-eurozone countries, with the idea reportedly gaining support towards the end of negotiations.

Now, we don't want to read too much into this but first, this dynamic suggests that France could actually find itself isolated within the eurozone (we're looking forward to that FT headline). Secondly, as we have mentioned in the past, perhaps this is another indication of how Paris - who used to see the euro as a way to lock in Germany - is actually getting quite nervous about losing the UK as a balancing force in the EU.

As ever in Europe, there's always that political sub-story worth keeping an eye on.

Eurozone compromise on using ESM to directly recapitalise banks - a stopgap at best?

Eurozone finance ministers finally reached a compromise yesterday which will allow the ESM, the eurozone

bailout fund, to directly recapitalise ailing banks.

This is likely to be an important element of any ‘solution’ to the eurozone crisis, especially since it will probably be incorporated into the plans for a eurozone banking union and single bank resolution fund.

Below we summarise and analyse (in bold italics) the key points of the agreement:

€60bn limit: ESM funds available for direct bank recaps will be limited to €60bn out of the total €500bn, since this method of funding eats up the capital of the ESM more quickly. Given the size of the eurozone banking sector – around €34 trillion or 360% of eurozone GDP – this seems far from sufficient.

Burden sharing: National governments will have to contribute 20% of the funds for the first two years and 10% thereafter. Furthermore, ESM funds can only be injected once the bank has reached a core tier one capital buffer of 4.5% - any recapitalisation to achieve this minimum level will also fall on national governments. This is a logical compromise, but it means that the link between sovereigns and banks is not completely broken. It is only "diluted" (as EU Economic and Monetary Affairs Commissioner Olli Rehn put it). Combined with the above funding limit, this places some tight constraints on the level of capital injection possible.

Strict conditions: The funds can only be used for banks which are deemed 'saveable' and have no other alternative. These banks must also be systemically important (in the relevant member state at least). It must also be impossible for the member state to bailout the bank on its own without harming its fiscal sustainability. There must also be independent stress tests performed ahead of any ESM contribution. Any contribution will come with strict conditions both on the bank and possibly on the member state.

Bail-ins: The agreement states that “sufficient contributions from existing shareholders and creditors of the beneficiary institution”will need to be explored. This suggests that the final agreement on the Bank Recovery and Resolution Directive will play an important role in determining how and when this fund is tapped. The emphasis on bail-ins is of course positive but until related plans are settled uncertainty will remain.

Final liability: A subsidiary of the ESM will be set up to directly purchase equity in ailing banks. This allows final liability for the rescue programme to rest with the ESM rather than states.

Retroactive use (legacy assets): The funds can be used to retroactively takeover the burden of previous bank bailouts, although this will be decided on a case-by-case basis. German Finance Minister Wolfgang Schäuble described this as "a concession to our Irish friends". This gives hope to Ireland that the cost of its bank bailout can be shifted. However, given the above limits and the conditions, this still seems a distant prospect.

At first look then, it is positive that an agreement has been reached but this looks to be a stopgap at best. It is clearly tightly constrained by the limits on lending but also by the conditions – in particular the need for a strict independent stress test which could eat up precious time in a crisis. The hurdles to retroactive use are also significant – there is far from sufficient funds to cover for the Irish, Spanish and Greek bank bail-outs (up to €125bn in total), while opening a country's economy to further oversight is far from desirable.

To be fair, given how tied in this is with the single bank resolution mechanism, banking union and the Bank Recovery and Resolution Directive, it may be too early to fully assess how effective it might be. It's also worth noting that the plan will likely need approval from some national parliaments, notably the Bundestag (H/T Bruegel).

The most conerning point is probably that if this is a precursor to the eurozone's single resolution mechanism, it is likely to fall short of fully breaking the dangerous sovereign banking loop in the eurozone.

EU edges towards compromise on bank recovery and resolution plans

Tomorrow and Friday will see the next round of meetings between eurozone and EU finance ministers respectively.

The meetings will focus on a number of issues, but the key ones will arguably be the Bank Recovery and Resolution Directive (BRRD) and the plans for a single eurozone resolution mechanism.

The full agenda is spelled out in detail in this background briefing.

As we have noted before, the proposals for new rules for bank resolution are quite controversial and have caused significant splits both within the eurozone and the EU more generally. See our previous blog here which laid out each EU country's position.

Ahead of the meetings, we have managed to get a look at the latest draft of the Recovery and Resolution Directive. Despite being 300+ pages, it makes for some interesting reading.

From what we can see there are two key changes:

1. A compromise on depositor preference:
The previous draft looked to establish a clear hierarchy for bank bail-ins and put uninsured depositors on level pecking with other senior creditors. This draft moves away from that towards a bit more depositor preference. It says:

“In order to provide a certain level of protection for natural persons and micro, small and medium enterprises holding eligible deposits above the level of covered deposits, such deposits shall have a higher priority ranking over the claims of ordinary unsecured, non-preferred creditors under the national law governing normal insolvency proceedings.”

So under the current plans, insured depositors are the most senior, as previously. Uninsured (i.e. over €100,000) deposits from individual private citizens and SMEs will also be given preference over other senior creditors. Essentially, large firms' uninsured deposits will rank level with senior creditors (bondholders etc.)

As we noted before, this is similar to an idea put forward by Italy, but is also likely to appease France, Spain and Portugal.

2. A reduction in ex-ante funds
This is another controversial measure, with many (including the UK) disputing the usefulness of ex-ante funds (funds which are collected on an on-going basis and are therefore in place before any crisis). In the latest draft, the level of ex-ante funds has gone from 1% of all deposits to 0.5% of covered deposits – a fairly sizeable cut given that covered deposits are only a proportion of total deposits.

This looks like a concession to the other side of the spectrum, including the UK, Netherlands and Denmark.

Some concessions on key points to both sides then, as may have been expected. That said, there are likely to be plenty who are unsatisfied by the current draft and hopes of a final agreement this week may be premature.

We’ll keep trawling through the mammoth doc, and bring you any important developments.

Where do EU member states stand on bank bail-in plans?

It’s been pretty tough to follow where countries stand on the latest proposals for the EU’s Recovery and Resolution Directive, not least because the debate has lasted three years with people mostly talking past each other.

But the Cypriot crisis has now focused minds and a deal is top of the agenda. The proposal will lay out rules for bank bail-ins and dealing with cross-border banks, while it also links closely with plans for a eurozone banking union. To clear up the differences, we have put together a table.

(The table is broadly ordered by how strongly the country is in favour of uninsured depositor preference and how strongly against flexibility it is. Hence Spain which is strongly for depositor preference and little flexibility is near the top, while Sweden which barely favours a bail-in plan and wants significant flexibility is near the bottom – click to enlarge):

As you can see, there are some big splits remaining. The ECB, Spain, Portugal and France (amongst others) want a clear depositor preference regime – where uninsured depositors are the last to be written down. On the other hand, Germany, the Netherlands and the UK want more equality between senior bondholders and uninsured depositors. Going even further, there are Sweden, Poland and Denmark - which have already clearly defined national schemes which do not fit well with the EU plans for a bail-in hierarchy.

Another area of disagreement is the amount of national flexibility. Sweden, the UK and the Netherlands are pushing hard for flexibility, particularly for non-euro members. This has some backing from Germany. Further disagreements over the timeline for implementation and the level of resolution funds needed remain a bit of a free for all.

The few points they do agree on include: complete protection for insured depositors, a broad bail-in scheme and (somewhat ironically) the fact that this legislation is urgent.

We will keep updating the table as the negotiations develop. There is a lot of talk of compromise but as of yet there is a long way to get there.

The Cypriot bailout: A catalogue of farce

Having followed the twists and turns of the Cypriot bailout for the last couple of weeks we’ve been struck by how – even by the standards of eurozone crisis management – it has been spectacularly mishandled often with farcical results (FAZ's Klaus-Dieter Frankenberger described it as "hara-kiri crisis management"). Here's our highlights:

Sunday 17th – The blame game begins 
The tentative agreement between Cyprus and its creditors was only a day old when the different parties tried to shift the blame for the politically toxic levy on small insured bank deposits. German Finance Minister Wolfgang Schäuble kicked it all off by seeking to distance the German government from the decision by blaming the Cypriot government, the ECB and Commission, which in turn prompted a series of denials from everyone else. The suggestion was that it was actually the Cypriot government who opted to include small savers in order to avoid hitting wealthier depositors (mainly Russians) even harder. The blame game continued throughout the week.

Monday 18th – Gazprom steps in with an alternative bailout? 
Following the acrimony over the agreement, it was reported that Russian energy giant Gazprom approached the Cypriot government the same weekend with an offer to fund the €10bn necessary to restructure the Cypriot banking sector in exchange for rights to Cypriot gas reserves. Although the story fitted in nicely with the geo-political tension narrative, it was quickly denied. Despite that, the rumours of a Russian bailout continued to be batted around for the entire week - none of which proved to be true.

Tuesday 19th (Afternoon) – Cypriot Finance Minster’s non-resignation 
On Tuesday Cypriot Finance Minister Michalis Sarris flew out to Moscow to see if he could secure more favourable terms than those offered by the eurozone. While he was there, rumours began to fly around on twitter, seemingly substantiated by respectable news outlets like Kathimerini Cyprus, that he had resigned as he no longer enjoyed the confidence of President Nicos Anastasiades. Confusingly, further rumours began to circulate that Anastasiades had rejected his resignation. However Sarris later told Reuters that there was “no truth” to the original rumours.

Tuesday 19th (Evening) - Cypriot Parliament rejects bailout deal after days of negotiation
Originally scheduled for Monday, the Cypriot parliament’s vote on the deal negotiated by the eurozone finally took place on Tuesday evening after attempts at further postponement failed. The parliament voted overwhelmingly to reject the deal, with not a single MP voting in favour. Of course, the democratic vote is itself not the issue but it was farcical that the deal was pursued for four days before being put to a vote when it was clear it would need to be altered again. Not exactly effective crisis management, especially since the 'No' vote raised questions over Cyprus' place in the euro.

Thursday 21st - Cypriot ‘Plan B’ shot down immediately
Following the vote above, Cypriot officials sought to cobble together a ‘Plan B’ to keep their chances of a eurozone bailout alive. Options on the table included the creation of a solidarity fund securitised with social security fund reserves, state assets, Church property and expected natural gas revenues. However this was shot down immediately by the troika as it was feared that it would not lower Cypriot debt to sustainable levels. Adding to the farce, the WSJ reports that Sarris (still in Moscow at this point) wasn't returning calls from his eurozone peers. By Friday, the deposit levy was back on the table bringing negotiations full circle.

Saturday 23rd – Russia to retaliate by freezing European assets? 
With it looking inevitable that Russian interests would be badly burned however the Cypriot bailout was finally structured, the Guardian reported that former Kremlin advisor Alexander Nekrassov warned that “Moscow will be looking for ways to punish the EU. There are a number of large German companies operating in Russia. You could possibly look at freezing assets or taxing assets”. As usual, this was later denied.

Sunday 24th – Infighting within the troika
The negotiations also saw severe strains developing between different members of the EU-ECB-IMF troika with the latter (with German support) allegedly resisting attempts by the Commission to water down Cyprus’ own €5.8bn contribution to the bailout. The FT cites an IMF official as saying that “The commission keeps trying to work with [Cypriot leaders], to help them put something on the table, even if that something doesn’t add up”, although another source adds that the two sides have “kissed and made up”.

Sunday 24th – Cypriot President's resignation bluff backfires 
Unlike the non-resignation of the Cypriot Finance Minister, this really happened. Reuters cites a senior official as saying that this took place during a particularly heated exchange concerning the plans to restructure the country’s banking sector and the WSJ reports that at that point Anastasiades was calmly told by other leaders "to pack up and leave" if he wasn't ready to cooperate (he didn't).

Monday 25th (Afternoon) - Dijsselbloem's accidental honesty makes markets plunge 
You’d have been forgiven for thinking that with a deal finally having been hammered out, the situation would have settled down a bit. However, Eurogroup chief Joroen Dijsselbloem had other ideas, suggesting in an interview with Reuters and the FT that the Cypriot deal could become a template for any subsequent bailouts and bank restructuring in the eurozone. This saw markets around the world tumble for fear of further write-downs, particularly in Spain and Italy. Dijsselbloem then looked to row back from his comments reiterating that Cyprus was “specific” and that he was not even aware of the English word ‘template’ which had been widely attributed to him - although given this specific word was used by the interviewers we're not sure we entirely believe him. His comments got a mixed reaction - he was backed by the Commission and Finnish PM Jyrki Katainen - who said 'bail-ins' should be part of the eurozone's crisis management strategy - but ECB Executive Board member Benoit Coeure said that he had been "wrong" to suggest this.

Monday 25th (Evening) - Banks to stay closed even longer
It was originally announced that Cypriot banks would re-open on Tuesday with the exception of the two biggest - Bank of Cyprus and Laiki -which would re-open on Thursday. However, later that day, Cypriot authorities changed their minds and announced that all banks would remain closed until Thursday (this was just the latest of the many extensions to the bank holiday and the numerous other delays throughout the week).

Given that the final outcome of all of this was a plan which will likely slam the Cypriot economy and significantly reduce the standard of living (albeit while reducing moral hazard somewhat), it is hard to see the whole week other than an array of botched diplomacy and naive negotiations.

Cyprus crisis shows Europe cannot perpetually move in one direction only

In an op-ed yesterday's Times, Mats Persson argued that:

No matter how the nail-biting drama in Cyprus ends, the eurozone has never been this close to waving goodbye to a member. Yesterday afternoon the deputy leader of the ruling party claimed that his country was hours away from agreeing an emergency package of tax rises and spending cuts to secure the EU’s €10 billion rescue loan.

If no deal is struck by Monday, the European Central Bank, on whose cash Cypriot banks depend, will pull the plug. With a banking sector seven times the size of GDP, Cyprus would default and probably crash out of the euro. The big question is whether a country can exit the euro without taking all Europe down. In the case of Cyprus the answer is straightforward: it could leave without causing a crisis, but it wouldn’t be pretty.

For Cyprus it would be extremely messy. To avoid massive capital flight there would have to be strict controls on financial movements, with border guards ready to stop people taking cash out of the country. After that would come a decree establishing a new Cypriot currency and a series of defaults on foreign debt. This would probably all have to be done in a weekend to avoid panic and contagion. A new central bank in Nicosia would fire up the printing press, which could trigger inflation. Cyprus could limp on with the help of external cash, possibly from the EU and the IMF or Russia — but it would be painful.

 For the rest of Europe there is a fear that a Cypriot exit could bring down Greece, Portugal, Spain or Italy. There are three ways in which contagion can spread: direct losses for banks or governments elsewhere in the EU start a chain reaction; depositors in other countries panic and cause a bank run; or nervous international investors fearful of losing out to the “next Cyprus” push the cost of borrowing up for other indebted governments.

But this is unlikely. Cyprus accounts for only 0.2 per cent of eurozone GDP, and vulnerable countries have little exposure to its economy. Greece would take a hit, but is already ring-fenced via EU bailout funds. Depositors in other countries have so far been unfazed by Cyprus’s troubles and even markets have been relatively calm. This suggests that Cyprus is a special, and financially marginal, case. In addition, the ECB’s promise to “do what’s necessary” to save the wider eurozone will provide extra reassurance to markets.

Instead the risks of a Cyprus exit are mainly geopolitical. The fear is that Nicosia turns to Russia for aid in return for, say, a Russian naval base on the island. Given its location, this would be a strategic nightmare for Europe.

To avoid such a scenario, it would be vital for Cyprus to stay in the EU, even if it left the euro. While life outside the EU may sound appealing to many Brits, it is different for a small open economy such as Cyprus. To complicate matters, EU treaties currently provide only a way to leave the EU (Article 50 of the Lisbon treaty), not the eurozone.

However, the EU specialises in legal acrobatics and there are articles in EU treaties that can be used for all kinds of purposes. One such clause provides a general legal base to achieve the “objectives of the treaties”, which include protecting the EU itself. It will be wrapped in a cobweb of legal jargon, but will effectively come down to a political decision by EU leaders.

And this is where it gets interesting for Britain. A Cypriot euro exit would have wide political ramifications: one of the founding principles of the EU — “ever closer union” — would be history. A swift, “Band-Aid” solution would almost most certainly have to be followed by a reworking of the EU treaties to recognise that the direction of travel is no longer only towards greater integration. The EU will have become a two-way street in which powers can be passed back to member states and its laws and institutions will have to reflect that.

Even if Cyprus does not leave the euro — and a revised bailout deal remains the most likely outcome — this episode signals that Germany and the other northern European countries are no longer willing indefinitely to foot the bill alone. At the same time the eurozone continues to lack the tools to deal with an acute crisis. This makes change almost inevitable for the way the eurozone is governed. Some governments have already called for a formal mechanism to allow a country to exit the euro. Europe cannot, perpetually, move in only one direction. And, in one way or another, Cyprus may be about to prove that.

Cyprus update – halfway to a deal, but the biggest obstacle remains

It’s looking as if there will be a deal in Cyprus, although there are some big obstacles to be crossed to get there and it is likely to go down to the wire.

Last night the Cypriot parliament voted to approve a few bills which will make a significant bank restructuring possible and allow the government to install capital controls if it sees necessary, here are the key points of what was approved (and what was not):

• Plan to wind down Laiki bank – good assets and insured deposits below €100,000 will be shifted into a good bank which will be merged with the Bank of Cyprus. Bad assets along with uninsured depositors above €100,000 will be put into a bad bank – these depositors could lose as much as 40% of their money.
• Ability to enforce capital controls – these are wide ranging from limiting non cash transfers to turning standard current account deposits into time fixed ones, and pretty much anything else the government deems as necessary for ‘public order and safety’.
• The creation of a solidarity fund – this will not play a large role in the bailout deal, since it was already rejected by the EU/IMF/ECB Troika as an alternative to the deposit levy.
• No deal on the bank deposit levy – Eurozone finance ministers will meet on Sunday in Brussels with the Cypriot parliament only likely to vote on a deal after it has been cleared at this meeting.
• Bank of Cyprus has survived being ‘resolved’ for now.
• The Greek bank Piraeus will take control of the Greek parts of Laiki and Bank of Cyprus.

These measures are expected to raise just over €2bn (maybe more, we’re waiting on firmed details on the solidarity fund). That still leaves €3.5bn+ to be raised to meet the €5.8bn target set by the Troika – although reports yesterday suggested this may have been raised by €0.9bn due to worsening forecasts for Cyprus. Below we outline our key takeaways from the deal.

The largest obstacle to a deal remains: Clearly, this will once again come down to the deposit levy. With a smaller amount needing to be raised, it is likely to fall only on €100,000+ deposits. As we noted yesterday a levy of between 12% - 15% looks likely, although given the bank bailout plan it could hit some big Laiki depositors especially hard. Kathimerini reports that the levy could be pushed higher and focused on a smaller group of depositors. Ultimately, though, with few alternatives left now a levy on largest depositors seems the least destructive option (but still far from ideal).

This will go down to the wire: The ECB has set a Monday deadline for a bailout deal or it will cut of liquidity to Cypriot banks. The banks are due to open on Tuesday but this could be extended if no deal is found. As long as the banks stay shut (and with use of the capital controls, see below) they may be able to buy a few days to reach a deal, allowing the ECB to reverse its decision. Still, it will be a messy few days with the Cypriot parliament unlikely to vote on the deal until the it is approved by the Eurozone and assured of passing. If the deposit levy is only on large deposits, it should gain support from DIKO (the junior coalition partner), while reports suggest some opposition members could abstain or be absent from the vote to allow it to pass.

Still, this has been left very late and the decision to approve the above measures first seems to be putting the cart before the horse. This is not too surprising though (since clearly these were easier options to push through) and reminds us of other parts of the crisis – such as the decision to approve the ESM before the EFSF was revised to be fit for purpose.

The capital controls are severe: The government has significant leeway to limit the flows of capital. People have rightly been asking questions of whether this, de facto, moves Cyprus out of the single currency. Ultimately, money is no longer fungible between Cyprus and the rest of the Eurozone and, at this point in time, it’s hard to argue that a euro in Cyprus is worth the same as a euro elsewhere. The real problem though may not be imposing the controls but removing them, as WSJ Heard on the Street points out. It is hard to see how the Cypriot economy will be able to function properly with these strict controls on and at some point questions will surely begin to be asked if it would not be better off with a devalued currency outside the euro.

Why is Bank of Cyprus not being ‘resolved’? Reports suggest the Cypriot government has fought hard to stop the bank having the same fate as Laiki. This may be because it is the largest bank and a large employer in Cyprus, but it is could also be because it remains very close to the government and is the home for some of the largest Russian depositors. In any case, avoiding the tough decision to fully restructure the banking sector is likely to make things more difficult in the future.

Greek banks are getting a very good deal: The branches of Cypriot banks in Greece have around €22bn in assets and account for 8% of all deposits in Greece and 10% of loans. Clearly they are sizeable and hiving them off helps reduce the size of the Cypriot banking sector relative to GDP and reduces the cost of the bailout. It also protects the rest of Greece from contagion. That said, Piraeus is picking up a very good deal, not least because Cypriot exposure to the Greek crisis was a key driver of the current problems Cyprus faces. The purchase was done at a symbolic €1 but the cost of recap is €1.5bn. Funding will come from the Hellenic Financial Stability Fund (the Greek bank recap fund) and the Cypriot bailout programme – €950m from the former and €550m from the latter. So these banks, investors and depositors avoid any losses despite many being entangled in the Greek crisis. The fact that Piraeus bank shares were rocketing yesterday is a clear enough sign of who did better out of this deal.

The deal has come full circle and has been very poorly managed: as we noted yesterday, we are basically back to a mix of the deal proposed by the IMF (bank restructuring) and the Eurozone (deposit levy) last Friday. The impact the events of this week will have on Cyprus should not be underestimated – there will be a huge outflow of capital (or will be whenever the controls are removed) and significant political upheaval. This has been poorly handled by both sides – the Eurozone failed to listen to the Cypriot government and was complacent about the impact of Cyprus on the wider Eurozone economy. The Cypriot government has fought to hang onto an impossible business model, focused on big finance funded by foreign deposits, and has looked to play a risky geopolitical game. Unfortunately, the ones that lose from all this are the 800,000 people who live in Cyprus.

What if the Cypriot parliament votes against the deposit levy?

This is the question which is now holding global financial markets on the edge - could it really happen and what would it mean, we assess the possible scenarios below.

Could the Cypriot parliament vote against the levy?

According to Reuters, Cypriot government spokesman Christos Stylianides told state radio that the vote “looks like it won’t pass”. Meanwhile, via Zerohedge:

• CYPRUS PRESIDENT: PARLIAMENT BELIEVES BAILOUT PLAN UNJUST, GOVERNMENT MAKING OTHER PLANS.
• CYPRUS PRESIDENT: PARLIAMENT WILL REJECT BAILOUT PLAN

As we were tweeting yesterday, the DIKO party (junior coalition member with 8 MPs) had said it would not vote for the deal without some improvements, although we suspect reducing the burden on small depositors could help convince them. The European Party (2 MPs) had previously said it would not support he levy, however, according to CYBC, it has now said it would support the levy if depositors are compensated with interest bearing government bonds (we assume linked to gas revenues, something which the government has already offered).

That said, according to the Cypriot press, the latest proposal sees deposits below €20,000 exempt, deposits between €20,000 and €100,000 taxed at 6.75% and deposits over €100,000 taxed at 9.9% - this is unlikely to satisfy demands to exempt smaller depositors. It also seems unlikely to raise the required €5.8bn, not least because it applies the same rate as the original to a smaller pool of deposits.

Separately, there are conflicting reports this morning on whether the vote will be delayed again. The government is unlikely to put this to a vote until it is almost near certain of getting it through.

What would the fallout be?

The fallout of voting down the package could be explosive and we can only speculate about what could happen next, but its eurozone membership would likely be brought into doubt. As we noted in our flash analysis, there are few other alternatives for Cyprus to raise the necessary cash, while the eurozone has made it clear it cannot foot the entire bill (such an option would make Cypriot debt unsustainable anyway).

The eurozone would likely give Cyprus a few days either to change its mind or come up with an alternative way of financing the €5.8bn. Another parliamentary vote could be held (the EU of course has form when it comes to demanding the 'correct' vote).

The ECB has already reportedly warned that rejecting a levy would have dire consequences. Specifically, the two largest Cypriot banks would go without recapitalisation and could see their liquidity from the ELA (sanctioned by the ECB via the Bank of Cyprus) cut off, leading to them becoming insolvent and collapsing – putting their €30bn of deposits at risk, since the government obviously cannot guarantee them. This would likely bring down most if not the entire Cypriot financial system.

With the financial sector close to or in the process of collapsing and no support forthcoming from the eurozone or ECB, since Cyprus rejected their terms, Cyprus could even be forced to leave the eurozone and begin printing its own new currency, one that would have little international trust and could lead to a spiral of hyperinflation, etc, etc (i.e. a very nasty scenario).

There is, of course, a chance that if faced with the prospect of Cyprus leaving the euro, the rest of the eurozone could blink and find an alternative way to bailout Cyprus but the politics of such a scenario would get very ugly indeed. The ECB may not follow through on its threat to withdraw liquidity for Cypriot banks but this would only be a temporary reprieve. The Cypriot government will run out of cash at the start of June when it needs to pay off a €1.4bn bond, while the banks' position could be worsened by the likely deposit outflows once banks open, even if the tax is not applied.

What are these “other plans”?

It’s not clear exactly what Cypriot President Nicos Anastasiades meant when he suggested the government is making 'other plans'. We have long noted that deeper connections to Russia remain a viable option for Cyprus. With Russia angry at the eurozone for trying to burn some of its depositors, some more financial support could be forthcoming (but maybe only for Cyprus outside the eurozone) – with significant geopolitical implications as we noted here.

Other options which have been bandied around include: a financial transaction tax and the recent proposal from Lee C. Buchheit and Mitu Gulati (the men partly behind the Greek restructuring) to convert deposits into deposit certificates with fixed long term maturities. However, the former has been widely rejected by Cyprus and may not yield sufficient funding. The latter is an interesting proposal but may only offer liquidity support rather than solvency, while the banks would still remain under-capitalised. Such a proposal would still require significant backing from the eurozone and Russia – both of which are likely to come with onerous terms – and present similar obstacles to a deal.

So, all in all a 'No' vote, however tempting to Cypriot MPs, only leaves more drastic alternatives, hence it remains a possible but not probable outcome.

Eurogroup distances itself from decision to tax small depositors in Cyprus

At some point yesterday, it became clear that Cypriot President Nicos Anastastasiades would not have sufficient support to push the deal on the deposit tax through parliament – at least not in its current form.

That led to an extension of the bank holiday to at least Thursday, the parliamentary vote being moved to 4pm GMT today (from yesterday) and the Eurogroup holding a teleconference yesterday evening.

The result of the conference was this statement, the key part being:

The Eurogroup continues to be of the view that small depositors should be treated differently from large depositors and reaffirms the importance of fully guaranteeing deposits below EUR 100.000. The Cypriot authorities will introduce more progressivity in the one-off levy compared to what was agreed on 16 March, provided that it continues yielding the targeted reduction of the financing envelope and, hence, not impact the overall amount of financial assistance up to EUR 10bn.

The statement seems to be more of a hand washing exercise than a definitive end to the issues plaguing the Cypriot bailout – i.e. do whatever you need to in order to raise the €5.8bn but don’t blame us for your political troubles.

Ultimately, it is not clear that deposits below €100,000 will not be taxed. The two options on the table remain:

-          Depositors with up to €100,000, taxed at 3%; those with €100,000 to €500,000 taxed at 10%; and those with over €500,000 taxed at 15%. (This could also include an exemption of deposits below €20,000).

-          Tax deposits over €100,000 at 15.2% and exempt deposits below €100,000.

How much difference will this move make?

Well, removing the burden on smaller depositors would be a positive one, as we have suggested. That said, with the cat out of the bag as it were, this is unlikely to dial down frustrations or concerns significantly. This option is now on the table and the political divisions it has exposed are unlikely to be easily papered over.

Despite the fact that it seems the Cypriot government played a large role in the decision to structure the tax to hit smaller depositors in the first place, the anti-German feeling seems to be rising. Meanwhile, we still believe that the position of the government – which was elected on the basis of ruling out losses for any (large or small, foreign or domestic) depositors – remains precarious.

While everyone is speculating about contagion to other eurozone countries: What are the Italian and Spanish press actually saying about the Cypriot bailout?

Analysts - led by Anglo-Saxon ones - have lined up to say that, following the deposit levy as part of the Cypriot bailout, a bank run on the rest of the Mediterranean is now a near certainty.

New York Times columnist Paul Krugman went the furthest, arguing that

It’s as if the Europeans are holding up a neon sign, written in Greek and Italian, saying “time to stage a run on your banks!”

But for all these speculations, very few analysts have actually bothered to properly assess the mood and immediate reaction in Italy and Spain - whose depositors are meant to be lining up outside banks and cash machines to withdraw all their savings. Surely, the response and tone in the media of these countries on the day following the deal will give a pretty strong indicator as to whether Italian and Spanish depositors will perceive themselves as being 'next in line', or whether, in fact, they consider the Cypriot situation unique.

As Mats Persson argued on his Telegraph blog yesterday,

Fears of deposit-led contagion to other parts of the eurozone should definitely not be be overstated...viewed with a depositor's eyes from Barcelona or Bilbao, Spain may have very little in common with Cyprus.

Of course, this is all very hard to predict and if talks about a bailout kicks of in Spain and Italy, will depositors trust what politicians are telling them? But what do governments and pundits actually say in these two countries? Put differently, what did Spanish and Italians depositors actually hear when they woke up to the news that their Cypriot counterparts will now see their savings taxed?

Here's a summary.

Italy  

Italy has some relatively fresh memories of a deposit levy: the 0.6% prelievo forzoso from all Italian bank accounts enacted by the government led by Giuliano Amato in 1992, when Italian public finances were facing an "extraordinary emergency". So one would expect the Italian media - and Italians themselves - to make a pretty big deal of the Cypriot bailout.

Not quite.  Although Italy's borrowing costs have inevitably been driven up a bit by the news coming from Cyprus, the media is surprisingly relaxed (and certainly no queues outside ATMs). Of the largest Italian papers, only La Repubblica and La Stampa made some room for Cyprus on the front page of today's print edition. Pope Francis and Italy's own political troubles continue to dominate. However, some Italian commentators did flag up the risks involved in the Cypriot bailout for the rest of the eurozone.

Vittorio Da Rold of Il Sole 24 Ore calls the Cypriot bailout "a dangerous precedent which undermines confidence" in the eurozone.

Italian economist Giulio Sapelli put it more bluntly,

Stuff like this can generate bank panic throughout the EU. [European leaders] are crazy.

Ferruccio de Bortoli, editor of Il Corriere della Sera, has tweeted that Cyprus's deposit levy "risks creating uncertainty and fears".

Unsurprisingly, the authorities' reaction was targeted at being a lot more reassuring. Giuseppe Vegas, head of Italy's financial markets watchdog Consob, said,

There are no similarities between Cyprus and Italy...The markets are obviously nervous [over Cyprus], but I wouldn't dramatise.

Spain

Several Spanish dailies ran with Cyprus as front page story today (see here). The most common reference in the Spanish press is to Argentina's corralito - when Argentinians' accounts were frozen to prevent a bank run in the country at the end of 2001.

As in Italy, there are no signs of Spanish depositors taking to the cash points - but the interest rate on Spain's ten-year bonds has reached above 5% this morning. As in Italy, authorities have moved quickly to reassure the citizens that there is no risk of contagion spreading to Spain.

There has been some concern over contagion in the press, though, with Carlos Segovia, Economics Editor of El Mundo, writing,

Analysts from around the world start to doubt that Cyprus’s precedent may one day end up being applicable to other Southern European countries, even partially.

Under the headline, "We are a German colony", the paper's Washington correspondent Pablo Pardo goes all out,

The 'bailout' imposed by the EU [on Cyprus] is the closest thing to an armed robbery against that country's savers.

Spanish economist José Carlos Díez is not happy either. He writes in El País,

The Cypriot bailout deal confirms that there are no signs of intelligent life in Europe.

Spanish business daily El Economista is a bit more relaxed, saying in an editorial that a Cypriot-style corralito is "unthinkable" in bigger eurozone countries like Spain, Portugal or Italy. But the paper also notes,

A haircut should have been applied to bondholders before applying [the deposit levy], which now comes out as an inconsistent measure.

So critical and concerned about precedent set, but no "panic spreads amongst savers" type headlines that we have seen in certain other countries. We certainly do not play down the precedent, or defend the deal, but one should not exaggerate either.

There's no way this [the deposit levy] will be repeated in Spain or Italy, so it's not clear when the great bank run is supposed to take place - not that bank runs are impossible by any stretch of the imagination in these economies, but a deposit tax or even the precedent set here is not likely to be the cause. That said, a real question remains over whether this will hamper future bailouts, future funding from the eurozone or even the fledgling moves towards greater eurozone integration. But that is a slightly different discussion.

The Great Cypriot Game - How important is gas to Cyprus' economic and geopolitical future?

Update 12:00 18/03/13:

Russian Finance Minister Anton Siluanov has had some interesting things to say on the deposit levy (via Reuters):

"We had an agreement with colleagues from the euro zone that we'll coordinate our actions."

"It turns out that the euro zone actions on the introduction of the deposit levy took place without discussions with Russia, so we will consider the issue of restructurisation of the (Cyprus) loan taking into account our participation in the joint actions with the European Union to help Cyprus."

It seems Russia is none too happy with the eurozone approach, unsurprisingly. If it does refuse to ease the terms of the €2.5bn bailout loan it previously gave Cyprus, it could hit Cypriot funding requirements, although probably not by a substantial amount. Still it could result in eurozone bailout funds being used to pay off a Russian loan in the near future - something which may not sit well with German taxpayers. Again, the interesting fall out will be to see how this impacts Russia's approach to Cyprus and the EU more broadly.

***************** Original post ********************************

In the middle ages, Cyprus was a key battle ground between great powers seeking dominance in the region. Well, the country - which, remember, only accounts for 0.2% of eurozone GDP - could become a hotspot once more (though we shouldn't be over-excited about this).

According Greek Reporter, Gazprom made an offer over the weekend to the Cypriot government to fund the bank restructuring planned under the Cypriot bailout (which is set to cost up to €10bn) in exchange for exclusive exploration rights for Cypriot territorial waters. How reliable this story is remains to be seen, but it does hint at the geopolitical tension which we have been warning about.

Gazprom is known to be very close to the Russian government and despite Russian President Vladimir Putin overtly slamming the deposit tax - calling it "unfair, unprofessional and dangerous" -  it is unlikely that they would let this opportunity pass untouched. Fortunately, the Cypriot government is said to have rejected the deal off the bat, but if displeasure towards the eurozone and the EU grows, the Russian option may become increasingly appealing.

So how important is the gas element for Cyprus' economic and geopolitical future? Well, there is no denying that Cyprus could potentially be sitting on top of gas reserves worth many times its GDP. However, as a revenue stream it is far from a sure thing. Here is how we put it in our flash analysis released on Friday:

Recent exploration has suggested Cyprus may have between €18.5bn and €29.5bn (103% - 163% of GDP) in untapped gas reserves lying in its territorial waters (according to Deutsche Bank). There have been rumours that this future revenue stream could be incorporated or used to backstop the bailout somehow. Although an appealing idea, there is still a huge amount of uncertainty around the real value of these reserves and how soon they can begin producing revenue

So far, one field has been explored (known as Block 12) and estimates of its potential value go as high as €100bn. See below for a useful diagram (via Baker Tilley):

However, there are a few key points to remember when considering the impact of this on the Cypriot bailout:

• Exports from the gas fields are not expected to begin until 2019 at the earliest. Cyprus runs out of cash in June this year, a short and medium term solution is needed now. Tapping the further reserves (beyond Block 12) will take even longer.
• There needs to be significant investment, potentially up to $4bn to begin extracting the gas – the Cypriot government certainly cannot afford this. Although there is sizeable interest in the exploration rights, the FT’s Nick Butler notes that Noble Energy (which explored Block 12) is not bidding for further rights, which raises some concerns.
• Furthermore, Turkey is still contesting Cyprus’ ownership of these reserves. Although Cyprus currently has the backing of the international community, this dispute could further hold up progress in tapping these reserves. Many of the energy companies looking into Cyprus also have interests in Turkey and may not want to put those at risk.

To us then, the offer by the Cypriot government to provide Cypriot depositors with bonds linked to gas revenues sounds like a nice idea, but will not compensate these depositors for some years, at best.

But, remember with a view to Moscow, this is definitely one to watch.