BOC is stuck between a rock (capital controls) and a hard place (limited ELA)
By Fiona Mullen, Director, Sapienta Economics
The European Central Bank (ECB) faces the growing risk of losing EUR 11 bln over Bank of Cyprus (BOC), and thereby suffering the eurozone’s first ever “official-sector” loss.
To explain why this is a risk, we have to go into some detail about what happened on March 25.
As most readers will know, the initial idea of March 15 (which the European Commission admitted was its proposal, according to a Financial Times insider) was to levy all depositors and thereby save both Cyprus Popular Bank (CPB/Laiki) and BOC.
When howls of outrage were heard across the eurozone and the Cypriot parliament rejected this solution on March 19, deposits under EUR 100,000 suddenly became untouchable.
The price of the parliament rejection was the closure of Laiki, the sale of the Greek branches for a song and mass haircuts all round.
Shareholders at Laiki lost everything, and non-exempt depositors over EUR 100,000 will have lost almost everything by the time the Laiki resolution is over.
BOC shareholders also woke up to find that their shares had been relegated to second-class status, in favour of haircutted depositors.
Litigation to establish whether this was all legal will doubtless go on for years and will prevent BOC from being sold to a strategic investor.
ELA “dump” on Laiki has created a liquidity problem
But the most important move, in terms of BOC’s long-term stability, was the decision to shift to BOC the EUR 9 bln in Emergency Liquidity Assistance (ELA) that Laiki had built up since October 2011. In addition to its own EUR 2 bln ELA, BOC now has a total ELA debt of EUR 11 bln on its books.
I am not going to get into the blame-game here, but the justification at the time was that the decision-makers did not want to cause contagion in the eurozone by burdening the Greek banks with Laiki’s ELA.
The problem with the overall March 25 deal was that, while the deposit conversion shored up BOC’s capital, the ELA transfer has hit BOC liquidity hard.
This is because BOC assumed EUR 9 bln in debt but did not acquire all of the assets that were used as collateral against that debt.
There are no official figures for how much ELA was created by the funding gap in the Greek branches. But inferring from financial statements, one can assume that it was around EUR 4.5 bln. BOC has had to make up the collateral on that EUR 4.5 bln from its own resources.
Depending on the discount applied to assets, one can assume that it now has perhaps EUR 15 bln of assets tied up as collateral to back EUR 11 bln of ELA.
BOC’s assets as of 17 May were reported by the Central Bank of Cyprus at EUR 38 bln. Thus, BOC could already have pledged around 40% of its assets. I do not know how much of a bank’s assets can be pledged in exchange for ELA, but one can assume that there is a limit.
After the sale of Greek operations, most of those pledged assets will be in Cyprus, and most of them will be property (bank branches).
Perhaps an existing bank will want to expand and buy the property that is currently occupied by ex-Laiki branches. But there is also the question of how much the branch property will fetch in a falling market and whether it will be enough to pay off the ELA debt.
In theory, Cypriot banks can now access liquidity directly from the ECB. But inferring from Central Bank data, they have yet to do so.
BOC may be unable to tap more ELA
What does all this tell us about BOC? My assumption is it means that, as a result of absorbing the Laiki EUR 9 bln but not absorbing all of the assets that backed it, BOC is collateralised up to the hilt.
It may well be the case that BOC has no more assets, or very few, to put up as collateral, perhaps only enough to cope with a few more months of seeping deposits.
This is also why we have not seen the liberation of the 30% locked, not-for-haircut deposits at BOC, why you still cannot open a new account at another bank and why capital controls generally remain in place.
Everyone knows that by keeping capital controls in place, it is preventing people from putting money in the bank and only serves to undermine confidence in the banking system.
So, BOC will continue to lose deposits even with capital controls. And without headroom to borrow more ELA, it will simply die a slow death, rather than a fast one, if capital controls are lifted without additional liquidity support.
If BOC goes under, then the EUR 11 bln in ELA held by BOC becomes a liability of the sovereign, namely the Republic of Cyprus. Since the troika decided that the extra EUR 5.8 bln to EUR 7 bln it was not prepared to give Cyprus on March 15 would make Cyprus’ debt unsustainable, you can be sure that the EUR 11 bln will be considered unsustainable now, when things have deteriorated considerably.
The only option the ECB would then face is to “haircut” its own EUR 11 bln credit, namely take the first ever loss in the eurozone crisis.
ECB faces two options
To avoid the slow death of BOC and its own subsequent losses, the ECB faces two options.
First, it could push for the full lifting of capital controls as soon as the asset review at BOC has been conducted and the final haircut is known. This may come as soon as July.
A lifting of capital controls will restore confidence in the banking system but only if there is full liquidity support from the ECB or the CBC (which can only lend with ECB permission).
This will probably require a bending of rules on ELA, so may not be popular with an institution that already faces the German constitutional court over its Outright Monetary Transactions (OMT).
A second option is to do something about the Laiki ELA, namely shift it back to where it belongs and have it dealt with as part of the resolution of Laiki. This may be the better, and to be frank, the fairer option.
There are those who will argue that by doing this, the ECB risks losing Laiki’s EUR 9 bln of ELA, if the resolution of Laiki fails to raise enough from asset sales.
But if the ECB does not take this step, it risks losing even more, namely the EUR 11 bln ELA currently on BOC’s balance sheet.
BOC is also an issue for EU political leaders
Sorting out BOC’s ELA problem is also of interest to EU politicians because of the link to the Cyprus problem and with it, the survival of the eurozone. Let me explain how these are linked.
On the basis of various pronouncements and ideas being bandied about in March, I have been worried for some time that a German politician, a European Parliamentarian or another EU leader will demand the imposition of the Annan Plan as a condition for the next bailout.
A second bailout is certainly coming if BOC’s problems are not resolved quickly and may well be coming in any case when we face some debt payments in 2015-16.
Those who are normally accused of meddling in Cyprus (the UK, the US and the UN) understand far better than EU politicians ever will that if Greek Cypriots were faced with an imposed plan, they would vote no in higher numbers than 2004, and proudly walk right out of the eurozone and EU.
Not to mention the fact that the Annan Plan is a big government model whose property provisions are predicated on rising property prices. I supported it in 2004 but today it would push the Cyprus economy deeper into trouble.
But EU parliamentarians do not know enough about Cyprus to understand this (not least because they do not subscribe to my reports—shameless plug!). There is a risk that will just try to impose the Annan Plan anyway, thus pushing Cyprus out of the EU.
Greek Cypriots would be left alone and friendless, with Turkish troops in the north and Lord knows what consequences given what is currently going on in Turkey.
While Britain and the US will be left to pick up the Eastern Mediterranean pieces, the EU will also suffer a serious blow. Cyprus will never be able to return the EUR 9 bln borrowed from EU taxpayers via the European Support Mechamism (ESM), the EUR 1 bln borrowed from the IMF and the EUR 11 bln ELA that will now be sovereign debt.
So, the EU will suffer its first eurozone exit, its first EU exit and a financial loss of EUR 21 bln.
Worse still, this could happen simply because no one is willing to admit that some of the decisions made during those crazy March nights were, in retrospect, taken in haste.
Last week the IMF admitted that it had made mistakes in Greece. It brought a welcome air of accountability into what has so far been an unseemly scrabble to avoid blame.
It is now the turn of eurozone leaders to step up to the plate. You never know, they might just save the EU in the process.
. Read on.