Sigrún Davíðsdóttir's Icelog

Both in Cyprus and Iceland foreign funds flowed into the islands, in the end forcing the government to make use of extreme measures when the tide turned. These measures are normally called ‘capital controls’ which in these two cases hides the fact that the measures used are fundamentally different in all but name. In Iceland, the controls contain the effect of lacking foreign currency, effectively a balance of payment problem – in Cyprus, the controls were a way of defending banks against bank run, i.e. preventing depositors to move funds freely.

It is a sobering thought that two European countries now have capital controls: Iceland and Cyprus; sobering for those who think that in modern times capital controls are only ever used by emerging markets and other immature economies. Cyprus has been a member of the European Union, EU, since 2004 and part of the Eurozone since 2008; since 1994 Iceland has been member of the European Economic Area, EEA, i.e. the inner market of the EU. – The two EEA countries were forced to use measures not much considered in Europe since the Bretton Woods agreement.

Although the concept “capital controls” is generally used for the restrictions in both countries the International Monetary Fund, IMF, is rightly more specific. It talks about “capital controls” in Iceland and “payment restrictions,” i.e. both domestic and external, in Cyprus.

Both countries enjoyed EEA’s four freedoms, i.e. freedom of goods, persons, services and capital. –Article 63 of the Treaty on the Functioning of the European Union prohibits “all restrictions” on the movement of capital between Member States and between Member States and third countries.

Both countries attracted foreign funds but different kind of flows. While the going was good the two islands seemed to be thriving on inflows of foreign funds; in Iceland as a straight shot into the economy, in Cyprus by building a financial industry around the inflows. Yet, in the end the islands’ financial collapse showed that neither country had the infrastructure to oversee and regulate a rapidly expanding financial sector.

It can be argued that in spite of the geography both countries were immature emerging markets suffering from the illusion that they were mature economies just because they were part of the EEA. As a consequence, both countries now have capital controls and clipped wings, i.e. with only three of the EEA’s four fundamental freedoms.

The “international finance centre”-tag and foreign funds

Large inflows of foreign funds are a classic threat to financial stability. At the slightest sign of troubles the tide turns and these funds flow out, as experienced by many Asian countries in the 1980s and the 1990s. Capital controls are the classic tool to resume control over the situation. None of this was supposed to happen in Europe – and yet it did.

Although not on the OECD list of tax havens Cyprus has attracted international funds seeking secrecy by inviting companies with no Cypriot operations to register. After the collapse of the Soviet Union money from Russia and Eastern Europe flowed to the island as well as from the Arab world. Even Icelandic tycoons some of whom grew rich in Russia made use of the offshore universe in Cyprus.

The attraction of Cyprus was political stability, infrastructure, a legal system inherited from its time as a British colony and the fact that English is widely spoken in Cyprus. By the time of the collapse in March 2013 the Cypriot banking sector had expanded to be the equivalent of seven times the island’s GDP. This status did also clearly limit the crisis measures: president Nicos Anastasiades was apparently adamant to shelter the reputation of Cyprus as an international finance centre arguably resulting in a worse deal and greater suffering for the islanders themselves (see my article on the Cyprus collapse and bailout here).

Iceland also tested the offshore regime. Under the influence of a growing and partly privatised financial sector the Icelandic Parliament passed legislation in 1999 allowing for foreign companies with no Icelandic operations to be registered in Iceland. Although it could be argued that Iceland enjoyed much the same conditions as Cyprus, i.e. political stability etc. (minus an English legal system), few companies made use of the new legislation and it was abolished some years later.

But Iceland did attract other foreign funds. Around 2000 a few Icelandic companies started their shopping spree abroad. The owners were also large, in some cases the largest, shareholders of the three main banks – Kaupthing, Landsbanki and Glitnir. The banks’ executives saw great opportunities for the banks to grow in conjunction with the expanding empires of their main shareholders and largest clients. By 2003 the financial sector was entirely privatised, another important step towards the expansion of the financial sector.

In addition, the Icelandic banks had offered high interest accounts abroad from autumn 2006, first in the UK, later in the Netherlands and other European countries, even as late as May 2008. Clearly, Icelandic deposits were not enough to feed the growing banks. They found funding on international markets brimming with money. In 2005 the three banks sought foreign financing to the amount of €14bn, slightly above the Icelandic GDP at the time. In seven years up to the collapse the banks grew 20-fold. In the boom times from 2004 the assets of the three banks expanded from 100% of GDP to 923% at the end of 2007.

The Icelandic crunch: lack of foreign reserve

At the collapse of the Icelandic banks in October 2008 Icelandic króna, ISK, owned by foreigners, mostly through so-called “glacier bonds” and other ISK high interest-rates products amounted to 44% of GDP. These products, popular with investors seeking to make money on high Icelandic interest rates, had been flowing into the country, very much like “hot money” flowing to Asian countries during 1980s and 1990s.

Already in early 2005 foreign analysts spotted funding as the weakness of the Icelandic banks. In. February 2006 Fitch pointed out how dependent on foreign funding the Icelandic banks were. In order to diversify its funding one bank, Landsbanki, turned to British depositors in October 2006 with its later so infamous Icesave accounts. The two other banks followed suit. In addition, the banks were supporting carry trade for international investors making use of high interest rates in Iceland.

Steady stream of bad news from Iceland during much of 2008 caused the króna to depreciate drastically. After the collapse foreigners with funds in Iceland sought to withdraw them. On November 28 2008 the Central Bank of Iceland, CBI, with the blessing of the IMF, put capital controls in place (an overview of events here). IMF’s favourable stance to capital controls was a novelty at the time; not until autumn 2010 did the Fund officially admit that controls could at times solve acute problems as indeed in Iceland.

It was clear that the CBI’s foreign reserves were not large enough to meet the demand for converting ISK into foreign currency. What no one had wanted to face before the collapse was that the CBI could not possibly be a lender of last resort in foreign currency.

The controls were from the beginning on capital, i.e. capital could neither move freely out of the country nor into the country. The controls were not on goods and services, hence companies could buy what they needed and people travel but investment flows were interrupted (further re the controls see here).

The migrating króna problem

The core problem calling for controls was and still is ISK owned by foreigners, i.e. offshore ISK, but the nature of the problem has changed over the years: the original carry trade overhang has dwindled down to 16% of GDP, through CBI auctions where funds seeking to leave were matched with funds seeking to enter. Now, the major problem is foreign-owned ISK assets in the estates of the three banks, i.e. owned by foreign creditors who, without controls, would seek to convert their ISK into foreign currency.*

As outlined in CBI’s latest Financial Stability report, published last September there is a difference between the onshore and the offshore ISK rate: 17% in autumn 2014, about half of what it was a year earlier. These and other factors indicate that the non-resident ISK owners, i.e. those who owned funds in the original overhangs, are most likely patient investors; after all, interest rates in Iceland are higher than in the Eurozone. Although these investors cannot move their funds abroad the interests can be taken out of the country.

The classic problem with capital controls as in Iceland is that the controls – put in place to gain time to solve the problems, which made them necessary – can also with time shelter inaction. With the controls in place the urgency to lift them disappears. Over time, controls invariably create problems as the CBI pointed out in its latest Financial Stability report: The most obvious (cost) is the direct expense involved in enforcing and complying with them. But more onerous are the indirect costs, which can be difficult to measure. The controls affect the decisions made by firms and individuals, including investment decisions. Over time, the controls distort economic activities that adapt to them, ultimately reducing GDP growth. 

The main ISK problem is now nesting in the estates of the three collapsed banks where the problem, as spelled out in the CBI’s last Financial Stability report , is that “…settling the estates will have a negative impact on Iceland’s international investment position in the amount of just under 800 b.kr., or about 41% of GDP. This is equivalent to the difference in the value of domestic assets that will revert to foreign creditors, on the one hand, and foreign assets that will revert to domestic creditors, on the other. The impact on the balance of payments is somewhat less, at 510 b.kr., or 26% of GDP.

The balance of payment, BoP, problem could be solved in various ways, i.a. through swaps between Icelandic creditors who are set to get foreign currency assets from the estates, sales of ISK assets for foreign currency and write-down on some of the ISK assets. In addition there are tried and tested remedies such as time-structured exit tax where those who are most keen to leave pay an exit tax, which is then scaled back as the problem shrinks.

The political stalemate

In March 2011, under the Left government in office from early 2009 until spring 2013, the CBI published Capital account liberalisation strategy, still the official strategy. The strategy is first to tackle the offshore króna problem outside the estates, which has been done successfully (judging by the diminishing difference between the on- and offshore ISK rate) through the CBI auctions. That part of the strategy has now come to an end with the last auction held on 10 February.

The next important step towards lifting the controls is finding a solution to the foreign-owned ISK in the bank estates. Their creditors are mostly foreign financial institutions, either the original bondholders or investors who have bought claims on the secondary market.

As indicated above there are solutions – after all, Iceland is not the first country to make use of capital controls while struggling with BoP impasse. However, as long as the political unwillingness, or fear, to engage with creditors prevails nothing much will happen.

When the present Icelandic coalition government of Progressive party (centre; old agrarian party) and the Independence party (C) came to power in spring 2013 it promised rapid abolition of the capital controls. So far, the process has been a protracted one with changing advisers, unclear goals and general procrastination. There has at times been an echo of the belligerent Argentinian tone, blaming foreign creditors for the inertia in solving the underlying problems; importantly, the Progressive party has promised huge public gains from the resolution of the estates, which it seems to struggle to fulfil.

In its concluding statement in December 2014 following the Article IV Consultation IMF points out that the path chosen in lifting the controls “will shape Iceland for years to come. The strategy for lifting the controls should: (i) emphasize stability; (ii) remain comprehensive and conditions-based; (iii) be based on credible analysis; and (iv) give emphasis to a cooperative approach, combined with incentives to participate, to help mitigate risks.” The “cooperative approach” refers to some sort of negotiations with creditors, which the government has so far completely ruled out.

It is important to keep in mind that the estates of the banks, by now the major obstacle in lifting the controls, are estates of failed private companies. The banks were not nationalised and the state has no formal control over the estates. However, as long as the ISK problems of the estates are unsolved the winding-up procedure cannot be finished and consequently there can be no payouts to creditors.

The winding-up procedure will either end with bankruptcy proceedings, which majority of creditors are against, or with composition agreement, which the majority seems to favour. Crucially, the minister of finance has to agree to exemptions needed for composition, which means that the government is indirectly if not directly responsible for the fate of the estates.

The political tension regarding the controls is between those who claim that solving problems necessary to lift the controls is the main objective and those who claim that no, this is not enough: the state needs and should get a cut of the estates.

Finance minister Bjarni Benediktsson has strongly indicated that his objective is to lift the controls whereas prime minister Sigmundur Davíð Gunnlaugsson has allegedly been of the latter view. He has recently been supporting his views by stressing the great harm the banks caused Iceland reasoning that pay-back from the banks would be only fair. This simplified saga of the banking collapse is in conflict with the 2010 report of the Special Investigative Committee, SIC, which spelled out the cause of the collapse as regulatory failure, failure of the CBI and political failure in addition to how the banks were funded and managed.

The government has Icelandic and foreign advisers working on these issues. But as long as the government does not make up its mind on what direction to take nothing moves. Meanwhile Iceland is effectively cut from markets, which makes the financing cost high, in addition to other detrimental effects of the capital controls.

The Cypriot crunch: bank run

The run up to the Cypriot banking collapse in March 2013 was a sorry saga of mismanaged banks, mismanaged country and the stubborn denial of the situation ever since Cyprus lost market access in May 2011. But contrary to Iceland, there has been no investigative report into the collapse, which means that in Cyprus hardly any lessons can be drawn yet from the calamities.

Data from the European Central Bank, ECB, shows that deposits were seeping out: in June 2012 they stood at €81.2bn. In January 2013 they were €72.1bn, down by 2%, in February at €70bn, 2.1% month on month and in March €64.3bn. According to the Anastasiades report (written at the behest of president Anastasiades, leaked to NYTimes and published in November 2014) €3.3bn were taken out of Cypriot banks March 8–15, the week up to the bail-in.

This was an altogether different situation from circumstances in Iceland ensuing from the collapsing banks. Cyprus, part of the Eurozone, was not struggling to convert euros to other currency but it was struggling to convince those holding funds in the Cypriot banks not to withdraw them and move them abroad.

As Iceland, Cyprus was trying to maintain a banking system far larger than the domestic economy could possibly support under adverse circumstances. By the end of 2011 there were 41 banks in Cyprus: only six were Cypriot; 16 were from EU countries and tellingly 19 were non-EU banks. It was clear to regulators that the size was a risk but they maintained that both regulation and supervision was conservative enough to counteract the risk, as bravely stated in a report by the Ministry of Finance on the financial sector in Cyprus. – Ironically, Cyprus had to seek help from the troika just a few months after these assertive words were written.

The controls were put in place with the full acceptance of the troika, i.e. the IMF, the EU Commission and the ECB. “The Enforcement of Restrictive Measures on Transactions in case of Emergency Law of 2013” as the capital controls measures were called by the Cyprus Central Bank, CBC, restricted i.a. daily cash withdrawal to €300 daily, no matter if directly or with a card, or its equivalent in foreign currency, per person in each credit institution. Cheques could not be cashed.

Trade transactions were restricted to €5,000 per day; payments above this sum, up to €200,000 were subject to the approval of a Committee established within the CBC to deal with issues related to the controls. For payments above €200,000 the Committee would take into account the liquidity buffer situation of the credit institution. Salaries could be paid out based on supporting documents. Those travelling abroad could only take the equivalent of €1,000 with them.

The roadmap for abolishing them came in August 2013, again with the full blessing of the troika. There was no time frame, only that the measures would be “in place for as long as it is strictly necessary.” They would be removed gradually and with prudence, always with a view on financial stability. First the restrictive measures on transaction within Cyprus would be abolished and only subsequently could the restrictions on cross-border transactions be lifted.

The controls have since gradually been eased and by May 2014 all domestic restrictions were indeed fully eliminated. On 5 December 2014 i.a. the limit for travel abroad was sat at €6,000, from previous €3,000 and business activity not subject to approval was sat at €2m. With the last change, on 13 February, those travelling abroad can now take €10,000 with them. Transfers of funds abroad were increased from the December limit of €10,000 to €50,000. The island’s pension funds are still subject to capital controls.

As in Iceland, abolishing, for unspecified time, one of the EEA’s freedoms was to be in place only for a short time. Until late 2014 it seemed as if the Cypriot capital controls might be entirely abolished by the end of that year. That did not happen. The last bit remaining is the politically tough one.

The task for Cyprus: overcoming the political hurdles

With the domestic restrictions abolished the IMF Staff report in October 2014 for the Article IV Consultation pointed out that the “external-payment restrictions” in Cyprus have to be relaxed in a gradual and transparent way. “…owing to the short deposit-maturity structure, significant foreign deposits (close to 40 percent of the total), large reliance of BoC (Bank of Cyprus) on ELA (Emergency Liquidity Assistance), and the lack of other market funding, external restrictions remain in place. While restrictions do not apply to fresh foreign inflows into Cyprus, they limit outflows, hampering trade credit and affecting overall confidence.” If the external restrictions remain in place they can damage investors’ confidence and consequently foreign direct investment, FDI.

As in Iceland, the main Cypriot problems stem from political tensions, which “could have adverse implications for confidence and the recovery,” according to the IMF. The key obstacle in Cyprus is lack of progress in addressing non-performing loans, NPL, staggeringly high in Cyprus at 37.9% of total gross loans in 2014. Debt-restructuring framework, including i.a. a foreclosure legislation and insolvency regime is still a lingering political problem. Further, banks need to restructure and build capital buffers, critical to lift the remaining restrictions.

Visiting Cyprus in early December I was told that the work on the NPLs was about to be finished and a new insolvency framework would be in place by the end of the year. It is still not in place, a sign that the politial tensions have not eased. In spite of all that has been done Cypriots have lost trust in their banking system: almost two years after the collapse it is estimated that the islanders keep up to 6% of GDP at home, under their proverbial mattresses or wherever people stash cash.

The political test for Cyprus and Iceland

Both islands face a political challenge lifting capital controls.

In 2012 the CBI published a report on Prudential Rules Following Capital Controls, thus outlining what is needed once the capital controls have been lifted. This is greatly facilitated by the fact outstanding work of the SIC. Consequently, life and prudence after the controls are lifted has been staked out.

Iceland is however struggling to throw off shackles of nepotism, even more so under the present government than for quite a while: personal connections seem to matter more not less than before. Lifting the controls will test the times, if they are new times with accountability, transparency and fairness or the old times of nepotism, opacity and special favours.

Cyprus stands harrowingly high on the Eurobarometer corruption index and it suffers from lack of stringent analysis of what happened, making it difficult to draw any lessons, i.e. on how regulation needs to be improved, failures at the CBC etc. Cyprus authorities have some way to go in order to win trust with the islanders. The fact that no public inquiry has been held into the collapse, no investigation, no report written adds fuel to the already low trust. I have earlier written that Cyprus with high unemployment and contracting economy bitterly needs hope.

Both Cyprus and Iceland will have to show that they understand what happened and how it can be prevented from happening again. The exit from capital controls for both these islands will depend on political decisions, which will shape their next decades.

*I have blogged extensively on Icelog on the capital controls in Iceland. Here is the latest one, on the politics. Here is one from end of last year, on i.a. the various possible solutions. I have at times blogged on Icelog on Cyprus or compared Iceland and Cyprus. Here is a collection of blogs on Cyprus, i.a. two on the topic of Cyprus, Iceland and capital controls. – This post is being cross posted on A Fistful of Euros.

 

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Why do the inhabitants of an EU country prefer to keep cash amounting to ca. 6% of GDP hidden at home? Badly burnt after the banking collapse in March 2013 Cypriots neither trust their government nor banks to keep their money safe. After following from afar the events in Cyprus I recently visited the island. Many Cypriots feel that the banking collapse is now only history and no point thinking about it. But that is far from the truth: as long as neither Cypriots nor the other EU countries know the whole Cypriot saga it can neither provide lessons nor a warning; and the mistrust lingers on. In addition to a public investigation of what really happened and why, write-downs of household debt and a functioning insolvency framework Cypriots desperately need one thing: hope for the future.

Crisis-stories are a plenty in Cyprus and the islanders are more than willing to tell them. During the traumatic days in March 2013 when the banks were closed for ten long days people called the Central Bank of Cyprus, CBC, crying. “The bail-in wasn’t fair because it hit depending on with which bank you were banking,” one Cypriot said. “And look at what it’s done to us, all the empty space in the centre,” said the owner of a small business. “One of my clients,” said a man working in finance, “had a loan of €5m and €7m in deposits. Next day, he still had a loan of €5m but only €100,000 in deposits.” The client, of course, banked with Laiki Bank, also known as Cyprus Popular Bank and Marfin Popular Bank. Then there was the man on the beach in Paphos, selling boat trips. He now owns 500,000 shares in Bank of Cyprus worth quite a bit less than the €500,000 on his account until his funds, together with all other deposits above €100,000, were converted into shares.

In March 2013 Cyprus stared into the abyss of financial collapse. In order to qualify for a €10bn Troika loan, the absolute maximum the Troika – i.e. the European Union, EU, the European Central Bank, ECB and the International Monetary Fund, IMF – was willing to lend, Cyprus had to raise €5.8bn. After the Eurogroup threw out its first rescue plan, which included a levy on guaranteed deposits, i.e. less than €100.000, the Cypriot government grabbed deposits above €100,000 in Laiki to merge it with Bank of Cyprus where non-guaranteed deposits were turned into shares. This bail-in came as a surprise but had indeed been worked on since summer of 2012 by a small group of Cypriot officials.

From the Cypriot point of view it seems unfair that whereas Cyprus had to find own funds other hard-hit European countries – Ireland, Greece, Portugal and Spain – got Troika loans to bail out banks. The overwhelming feeling in Cyprus is that the island’s 1.1m inhabitants and an economy contributing 0.2% of the euro zone economic output was too small and insignificant to matter to the Troika. Abroad lingers the suspicion that Russian money in Cyprus were unpalatable to the Troika.

However, the reason for the misery seems more complicated and closer to home: the government of Demetris Christofias was adamant not to enter a Troika programme; a noble aim in itself but the government’s manoeuvres to avoid it seem less noble. CBC officials fed incomplete if not misleading information to the ECB. Fragments of this story have emerged only recently, not from the two attempted public enquiries but from a secret report done at the behest of president Nicos Anastasiades, later leaked to the New York Times.

“People want answers,” one Cypriot said but so far, there are few answers but plenty of questions, the most pressing being why there is no wish for  a proper investigation on the events leading to the drama in March 2013. The Special Investigative Committee, SIC, set up in Iceland after the Icelandic collapse in 2008 would be an ideal inspiration.

The story of the Cypriot collapse has many intriguing aspects. One of them is the sale of Greek branches of Cypriot banks, i.a. Bank of Cyprus’ Greek operations; another is the purchase of Greek sovereign bonds (mainly from German banks, which had a high exposure on Greece) by Cypriot banks, possibly seeking high-risk high yield investment to cover earlier disastrous lending.

Below, two further aspects are scrutinised: why the bail-in happened and why the Troika accepted, though only for some hours, a crisis levy on guaranteed deposits.

The rumours before the collapse and the hope that this time, it would be different

As in Iceland, the Cypriot banking sector was far too large – seven times the island’s GDP – for Cyprus to support it on its own. Its destabilising core was Laiki Bank,. The bank had for a long time offered higher interest rates than other banks; only ever attractive to risk-takers and naïve investors who do not recognise it as a warning sign. In the summer of 2012 the Cypriot government attempted to solve the Laiki problem by nationalising the bank.

With Ireland, Portugal, Greece and Spain struggling there had been little focus on tiny Cyprus but its problems were evident to anyone who bothered to look. After the nationalisation of Laiki there were talks with the Troika in late summer and autumn 2012 as to what should be done. No one, least of all the Cypriots, expected any drama. My Cypriot contacts kept telling me that the talks would no doubt end quietly in a negotiated bail-out of some sort. After all, Cyprus was a small economy, the Troika had by now some practice in dealing with failing banks threatening an entire economy; and there was also a growing awareness that private debt should not be shifted on to the state. Compared to the on-going Greek drama his would go well, I heard.

There were however rumours that this time it would indeed be different. In January 2013 Landon Thomas wrote in the New York Times of “Questions of Whether Depositors Should Shoulder the Bill:” officials in Brussels and Berlin were said to be working on “a controversial plan that could require depositors in Cypriot banks to accept losses on their savings. Russians, holding about one-fifth of bank deposits in Cyprus, would take a big hit.” Truly a radical departure from bailouts in Portugal and Ireland and a haircut, albeit only after an earlier bailout, in Greece – so far, bank deposits had been held sacrosanct.

Considering the delicate situation CBC governor Panicos Demetriades gave a rather remarkable interview to Wall Street Journal on March 5 2013 where he rejected the idea of haircut on depositors. Instead, he aired the idea of a “special solidarity levy” on interest income, which could give the state an annual income of as much as €150m – a risible sum compared to what was needed – but hoped that privatisation would gather €4.5bn. Alex Apostalides lecturer at the European University Cyprus has recently written about an encounter with Demetriades on the fateful 15 March 2013: when asked, Demetriades said that any haircut on deposits would be a catastrophe for the banking sector.

At the beginning of 2013 all the Cypriot political energy was in the presidential election campaign. But some were more aware than others that something might happen; there are still rumours of people who emptied their bank accounts just before the bail-in. ECB data shows that deposits were seeping out. In June 2012 they stood at €81.2bn. In January 2013 they were €72.1bn, down by 2%, in February at €70bn, 2.1% month on month and in March €64.3bn. According to the Anastasiades report €3.3bn were taken out of Cypriot banks March 8–15, the week up to the bail-in.

Capital controls, i.e. limits on amounts taken out from deposits or moved between deposits, were part of the package in March 2013. Yet, money did allegedly seep or even flow from certain deposits in spite of the controls. In Cyprus stories are told of private jets clouding the skies over Nicosia on and after 18 March, carrying neck-less black-clad men accompanying their angry-looking masters to the banks; all returned smiling with bursting hold-alls. List with names of people said to have taken out money in spite of the controls circulated in the media. – All of this is part of the still unwritten report of what really happened.

What seemed like good idea at the time: ‘un-guaranteeing’ the €100,000 deposit guarantee

On Friday March 15 2013 the Eurogroup met in Brussels at 5pm after markets closed. In the wee hours of March 16 the Group published a statement and its representatives held a press conference. The statement itself was short but not sweet, at least not for the Cypriots who had hoped and believed that their island would be assisted like other troubled euro-countries.

The press release stated (emphasis mine in all quotes):

The Eurogroup further welcomes the Cypriot authorities’ commitment to take further measures mobilising internal resources, in order to limit the size of the financial assistance linked to the adjustment programme. These measures include the introduction of an upfront one-off stability levy applicable to resident and non-resident depositors. Further measures concern the increase of the withholding tax on capital income, a restructuring and recapitalisation of banks, an increase of the statutory corporate income tax rate and a bail-in of junior bondholders. The Eurogroup looks forward to an agreement between Cyprus and the Russian Federation on a financial contribution.

The Russian loan never materialised any more than a Russian loan promised to the governor of the Central Bank of Iceland, CBI as the Icelandic banks collapsed in October 2008. (Cyprus’ relationship with Russia was long-standing Iceland was not known to have any particular relationship with Russia, which meant that this promise seemed very much out of the blue.) However, just as the Christofias government was against a Troika programme the governor of the CBI and a few others were equally against seeking assistance, in Iceland’s case from the IMF.

Interestingly, neither the March 16 press release nor the statement specified what ‘an upfront one-off stability levy’ implied. Those who gave the 4AM press meeting seemed  ill at ease and unwilling to spell out the action. Christine Lagarde director of the IMF only talked of “burden sharing.”

According to Reuters, citing an unnamed source, Cyprus “agreed a one-off levy of 9.9 percent to apply to deposits in Cypriot banks above 100,000 euros and of 6.7 percent for deposits below 100,000 euros…”

With this fundamental diversion from earlier policies the Eurogroup agreed that an EU country could touch deposits below the guaranteed €100,000. In other words: depositors in EU now knew that in a financial crisis their guaranteed deposits were no longer untouchable.

Whether a momentary mental black-out or a wish to try something unorthodox this solution evaporated over the weekend. The statement released following a Eurogroup phone conference on Monday March 18 carried a very different message:

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.

Given the fact that the Eurogroup had less than 48 hours earlier agreed to a levy on guaranteed funds the words “continues” and “reaffirms” do not quite rhyme with the earlier statement.

The banks remained closed on the following Monday, March 18 2013 as the Cypriot government under president Nicos Anastasiades, only in power since March 1, struggled to get a grip on failing banks – and to find another solution when the original idea lost its sparkle.

In a rare display of tense irritation the ECB issued a statement on March 21 saying that the ECB governing council had “decided to maintain the current level of Emergency Liquidity Assistance (ELA) until Monday, 25 March 2013. Thereafter, Emergency Liquidity Assistance (ELA) could only be considered if an EU/IMF programme is in place that would ensure the solvency of the concerned banks. – As far as is known, this is the only time the ECB has ever issued a statement acknowledging the end of ELA.

The Cypriot banks remained closed for whole ten days, until March 28. When they opened again there were capital controls in place to prevent a run on the banks – and depositors in Laiki and Bank of Cyprus had been singled out to carry the cost.

In hindsight, it is profoundly interesting that the Eurogroup, ECB and the IMF did indeed agree to a levy on guaranteed deposit. Allegedly, the Germans were not happy but agree they did. In the end, things did change in the coming days. Further, a general levy was voted down in the Cypriot parliament. The Cyprus collapse did not happen over a few days in March but over almost two years, from May 2011 when the island lost access to markets. The course of events cannot just be explained by panic.

Indeed the bail-in was no panic solution but had been in the making for more than half a year; only the Cypriots did not know it.

A pact with the offshore devil

Since slamming a levy on guaranteed deposits truly was a novel idea the short struggle to ram this measure through merits attention, also because it can be argued that it was indeed a much fairer financing of the crisis solution than the one used.

According to much of the media coverage the idea of a levy on guaranteed deposits came from the Cypriot government. However, sources close to these events have indicated to me that the EU commission, attempting to merge various and to some degree conflicting points of view, originally suggested a levy on guaranteed as well as non-guaranteed deposits. The preposition was that Cyprus had to fund a big part of the rescue package, banks have heaps of money on deposits – and a small percentage levy is a relatively painless way for a state to spread the burden in a crisis.

The various parties to the talks were advocating various solutions. IMF advocated the full resolution of the two banks, Laiki and Bank of Cyprus and did not seem to be opposed to a bail-out. The Anastasiades government was looking for a traditional bail-out programme apparently unaware that the Christofias government had worked on a bail-in (more on that below). The Commission was looking for a middle way where wealth tax could perhaps fill a gap if needed but sensed that a bailout was out of the question.

The country needed to raise €5.8bn in order for the Troika to lend the €10bn needed. It was a matter of arithmetic how to juggle the percentage so as to land on the right sums; it proved a struggle as Reuters recounted on 18 March. President Anastasiades and his team refused to go above 10% on the uninsured deposits and settled for 9.9%. These deposits amounted to €38bn, insured deposits were €30bn which meant that €2bn had to be taken off the latter if the government held onto 10% being the pain threshold; ergo, the percentage had to be respectively 6.75% and 9.9%.

Non-Cypriot officials wanted the percentage on the guaranteed deposits to be lower, even considerable lower. Already at the meeting the feeling was the Anastasiades was sheltering the island’s offshore status, ignoring the interest of ordinary Cypriots.

The political reaction in Cyprus drew the attention from the fact that after sleeping on it the Eurogroup woke up realising that the levy would ‘un-guarantee’ the guaranteed €100,000. The original plan must have come with some convincing reasoning (from the EU Commission, right?); otherwise, it would not have gone through. For sure, it worked like magic – but struck by daylight the carriage was again a pumpkin.

“The guaranteed deposits turned out to be EU’s sacred cow,” one source said. In a certain sense, for every country crisis is utterly unique, not in the general mechanism, but in the outward detail. If Cyprus had indeed accepted a levy on guaranteed deposits the EU would have been in a difficult position: it would have had to argue that Cyprus was an utterly unique case.

In order to reach the necessary sum of €5.8bn 15% levy on the uninsured deposits would have done the trick. But on an island, which lives – and has lived well – from its off-shore status and the foreign funds it attracts the government baulked at taxing the non-guaranteed deposits too heavily so as not to drive these funds elsewhere. That was the cost of the Cypriot pact with the offshore devil.

Laiki: the core of the Cyprus problem

In the euro-crisis context the bail-in was a remarkable solution but as can be seen from the Anastasiades report it was, quite remarkably, not a new idea. It had been in the making for some time, at least from autumn 2012, and was closely connected to the core problem: Laiki. The report traces the drafting of a new bank resolution framework, which rested on using deposits in an insolvent bank in a bail-in.

The desperate state of the Cypriot economy was exposed when Cyprus lost market access in May 2011, much due to Laiki Bank owned and managed by Andreas Vgenopoulos. Laiki was diligently issuing bullet loans to Vgenopoulos’ companies. Bullet loans are familiar to those who have studied the operations of the Icelandic banks where they were issued to large shareholders and other favoured clients. The Icelandic bullet loans to these clients were either constantly rolled over or refinanced, rarely paid back. The bullet loan magic on a balance sheet is i.a. that in spite of not being paid back they are not non-performing.

One insistent question for Cypriots is why the CBC and other Cypriot authorities allowed Laiki to operate as it did and for so long. By summer 2012 the Cypriot authorities had run out of excuses and justifications for continued assistance to Laiki, to the ECB and others. Instead of investigating Laiki’s operations, the bank was nationalised, hook line and sinker and no questions asked.

It is a pertinent question when the CBC realised that Laiki was a dead bank. There were leaks in Cypriot and Greek media in autumn and winter 2012 on the severe state of Laiki, allegedly known to the CBC. Even sending staff to be questioned by a prosecutor CBC focused on investigating the leaks, not the issues they raised.

Nationalising Laiki increased the state’s liabilities; the EU and the IMF were uneasy, as expressed at a Eurogroup meeting 12 September 2012 in Cyprus. Laiki was in a sorry state and it was dragging down another weak bank, Bank of Cyprus. The government continued its delay-tactic, thereby taking the entire banking sector hostage.

The Troika held a meeting 9 November 2012 in Cyprus but could not reach an agreement with Cyprus. By now, Cyprus was, quite literally, living on borrowed money, straight from the ECB: on 15 November 2012 ECB’s Emergency Liquidity Assistance, ELA, to Cypriot banks, i.e. Laiki, amounted to €11.9bn, around 65% of GDP.

The Troika’s patience was evaporating fast: when president Demetris Christofias visited Brussels 22 November he was informed the ECB would stop the ELA immediately. The following day finance minister Vassos Shiarly said the government had now agreed to the terms of the “Memorandum of Understanding on Specific Economic Policy Conditionality.”

The birth of a brutal and unfair solution

The November 2012 MoU was full of good intentions. But the direction taken was not new. During the Troika meeting in Cyprus in June 2012 those present had agreed that the core of the Cypriot problem was an over-extended financial sector, which the feeble island economy could not support. Consequently, an alternative way to recapitalisation had to be found but the question was how.

In a 2 July 2012 letter ECB stated, referring to its opinion on legal support for Laiki, that the best way was to use a fully-fledged bank resolution tool, as outlined in Directive proposal, COM (2012) 280 final adopted in June 2012, for bank resolution where the cost was not being borne by tax payers, adopted in June 2012 and later developed into a Bank Recovery and Resolution Directive.

Hence, amongst those working on the coming Cyprus banking rescue operation it was already clear by the summer of 2012 that Cyprus could not expect anything like the other troubled euro countries. The assessment circulating, i.a. from Fitch, was that Cyprus needed €10bn in financial aid, 60% of GDP.

The three key objectives of the MoU were “to restore the soundness of the Cypriot banking sector by thoroughly restructuring, resolving and downsizing financial institutions, strengthening of supervision, addressing expected capital shortfall and improving liquidity management; to continue the on-going process of fiscal consolidation in order to correct the excessive general government deficit” by reducing current primary expenditure, maintaining fiscal consolidation i.a. by increasing the efficiency of public spending, enhancing tax collection and improve the functioning of the public sector; structural reforms to support competitiveness.

As the MoU shows Cyprus was not stingy with its promises, i.a. : “With the goal of minimising the cost to tax payers, bank shareholders and junior debt holders will take losses before state-aid measures are granted. Before any state recapitalisation is granted, the Central Bank of Cyprus will require a conversion of any outstanding junior debt instruments into equity for the purpose of protecting the public interest in financial stability, including by implementing voluntary or, if necessary, mandatory subordinated liability exercises (SLE)… the necessary legislation will be introduced no later than [January 2013]. The Central Bank of Cyprus together with the EC, the ECB and the IMF will monitor any operation converting junior debt instruments into equity.”

The innocent-looking clause in the November 2012 MoU, which the Cypriot government was arm-twisted into accepting, was a further foreboding of the bail-in to come: The authorities will introduce legislation establishing a comprehensive framework for the recovery and resolution of credit institutions, drawing inter alia on the relevant proposal of the European Union.

The Anastasiades secret report concludes that it was clear from summer 2012 that the legal tools being forged would prevent a bail-out, forcing Cyprus to rescue its financial system with own resources, i.e. a bail-in:

“However, the perception which prevailed was that neither the government nor the CBC adequately understood this context. Moreover, no one admitted to know or have heard about the bail-in before the Eurogroup of 15 March 2013. The fact that the government, the state and its institutions acted as if they could not comprehend what was going on in order to disguise their inadequacy… ultimately proved to be a very effective policy to avoid taking responsibility. The reality is that as early as 6 November 2012, the CBC Governor, Panicos Demetriades, informed the ECB President, Mario Draghi that the resolution law was almost done, three whole weeks before the MoU of 25 November. …

From the moment the two major banks would pass into the hands of the Resolution Authority, the CBC should have to act within the given legislative framework and to provide solutions which would not bear any burden to the taxpayer. The law in itself was prohibiting the bail out and was legalizing the bail-in.“

The law, legalising a bail-in, was supposed to be passed in January 2013 but the Cypriot government and the CBC continued the delay game. After being reassured that short-term financing need was covered, the Eurogroup finally accepted to wait; it seemed clear that the final agreement on a programme would have to wait until after the election in February.

When the Anastasiades government came into power March 1 2013 neither the out-going government nor the CBC presented it with the draft for the resolution law. Accordingly, the new government seems to have intended to negotiate a bail-out as in previous Eurozone crisis countries. The old powers and the CBC kept quiet, making it look as if the bail-in was all the work/fault of the new government – or that is at least how the story is told in the Anastasiades report. The Resolution of Credit and Other Institutions Law of 2013 was published 22 March 2013 as part of the crisis measures.

The Anastasiades report shows that though panicky the decisions taken over the fateful days in mid March were no last-minute solutions. The Christofias government had been planning a bail-in, i.e. a self-financed salvation or refinancing of the banking system – and it was vehemently against entering a Troika programme.

The “punishment for the Russian connection” theory and other speculations

In hindsight – always a great vantage point – a one-off levy on deposits, even a tiny sliver on guaranteed deposits, would have been a lot less painful to Cypriots in this time of great crisis. But the political reaction in Cyprus was such that the government stepped back and abandoned any general levy. “The measures chosen did not punish risk-takers but made some people poorer completely by chance,” one source said.

“The solution was to treat deposit holders as investors,” as one Cypriot put it. Indeed, but only deposit holders in two banks took the hit for everyone else; a much more brutal and arguably a less fair measure than a levy.

In the weeks following the Cypriot bail-in there were speculation that the anomalous outcome had been dictated by a lack of trust in Cyprus for allowing Russian funds to flow so freely through the country’s banking system. It is alleged that 20% of Cypriot deposits are Russian; considering the long-standing connections between Russia and Cyprus this does not seem shockingly much.

In addition there are rumours, strenuously denied by Cypriot authorities, that the island’s financial system had been facilitating money laundering. According to persistent rumour the German authorities had commissioned a secret report that showed as much. However, nothing concrete did ever materialise and certainly no German report.

Cypriot officials were very much aware of these rumours and visited some European capitals in January 2013, i.a. Den Haag, to rebut the rumours and explain measures taken in Cyprus against money laundering.

The IMF viewed Cyprus as a unique case because of the size of its banking sector. Germany was in no mood for a bail-out. “Cyprus had irritated the Troika so much,” one source said. The ECB press release on ELA 21 March 2013 proves the point. Christofias had publicly spoken badly of the IMF; his attempts to get loans from China and Russia were not successful.

Essentially, a bail-in had been in the making for a while and seems to be what Christofias and his government had in mind. “It was clear that Cyprus would indeed be different,” on source said. “The obstacles were mostly political.”

Why the Christofias government did aim at a bail-in can only be clarified in a Cypriot SIC report. Perhaps the government saw that as a good way to keep the Laiki story buried, a continuation of the fact that Laiki had been nationalised but neither restructured nor scrutinised. And/or Christofias the communist was content to nationalise it to prove a political point. Fundamental question on the March 2013 events can only be answered in a thorough report. Sadly, it seems that very few Cypriots believe that such a tell-all report is possible on their little island.

No appetite for investigations

The Anastasiades report bears the telling title: Laiki Popular Bank – How a bank’s mismanagement toppled an economy. Laiki was not the only problem in the Cypriot economy but it was the crystallisation of many problems. Some advisers had recommended action on Laiki already when Cyprus lost market access in May 2011 but to no avail. As one source said: “It was a grave mistake not to take Laiki over earlier.”

The Anastasiades report was not intended for publications. It was not the first investigation into the Cypriot banking mess. There was an earlier planned investigation, which as the Anastasiades report stated, “didn’t happen.”

In August 2012 the CBC assigned Alvarez & Marsal, a management and restructuring consultancy, to examine why Laiki and Bank of Cyprus had requested state support, which they got, in total €1.8 bn. The following four points were to be investigated:

1. Bank of Cyprus’ losses from investing in Greek bonds
2. The purchase of shares of the Romanian bank Banca Transilvania
3. The acquisition by the Bank of Cyprus of the Russian bank Uniastrum
4. The merger of Marfin Laiki with Egnatia and in specific the conversion of Egnatia from a subsidiary of Marfin Laiki to a Cypriot bank

In October 2013 this assignment was in the news, not for the firm’s findings but for its fees: on top of €4.5m it turned out that CBC governor Panicos Demetriades had, without the CBC knowledge, agreed to a further fee of €11m. Nothing has been heard of the report and regrettably the four items above remain unexplained.

As the Anastasiades report states: Now we know why: An investigation into the reasons why the Cyprus Popular Bank requested state support of €1.8 bln, would reveal the disastrous decision taken by the Christofias government to nationalize the Cyprus Popular Bank and this was achieved in collaboration with both CBC Governors, initially Orphanides and later on Demetriades.

The Anastasiades report comes to its own conclusions:

The Cyprus Popular Bank, was insolvent before the haircut of the Greek bonds. After the haircut, the Bank had little chance to survive. The only realistic option for a successful recapitalization was through the EFSF. However, it was impossible to receive funding from the EFSF without entering a programme. Christofias’ government followed a policy of avoiding the programme at all costs. By refusing the programme, Christofias’ government led the entire banking sector into captivity.

What the Anastasiades report spells out quite clearly is how Cypriot authorities, from autumn 2011, led by the various ministers of finance and governors of the CBC kept convincing the ECB that all was well and fine with Laiki. When it was no longer possible to dress the bank up as a solvent company the bank was nationalised. In March 2013 it was no longer possible to plaster over the cracks, the bank was restructured and merged with Bank of Cyprus – at the cost of €5.8bn from deposits in the two banks.

According to the New York Times, Benoît Coeuré executive board member of the ECB was also instrumental in coming up with a collateral plan when there were seemingly no collateral left to support further ELA for Laiki. Cypriot authorities, led by the CBC, conspired to thwart suspicious ECB. This whole exercise left the Cypriot state with €10bn of ELA debt, apparently the cost of trying to save a failed bank.

After the events in March 2013 president Anastasiades set up an investigative committee to examine possible civil, criminal and political liabilities regarding the development in the Cypriot economy and financial sector. The six members were all elderly judges with long careers.

Their report was handed over to the cabinet end of September 2013. It has not been made public. The documents leaked by the New York Times indicate that there is plenty of material that the commission did not make use of. Since this report has not been published it is impossible to say how thorough it is but the general feeling is that the 280 pages did not reveal anything much. The attempts to investigate the events leading up to March 2013 and the aftermath have so far been futile exercises.

Based on available material it seems logical to conclude that the bail-in was part of the Christofias government plan to avoid a Troika programme and possibly the scrutiny that might follow. If the latter was the case all fears have been groundless: regrettably, the Troika has never pushed for an investigation to clarify events.

The fact that Cypriot authorities did everything to hide and deny the dire situation from May 2011 had hardly mellowed the Troika in March 2013 when action could no longer be postponed. But it does not explain the attempt to put a levy on insured deposits.

Being a gateway to offshore structures may not have helped Cyprus. That said, EU and IMF officials are hardly squeamish in these matters: Luxembourg and Malta offer similar environment not to mention the tax structures provided by Ireland and the Netherlands.

What Cyprus needs

The ECB is trying to strengthen trust in the European banking sector. In general, an important step towards creating confidence “is to recognize loans that are bad and write them off, ” according to William White, former economic adviser to the Bank for International Settlements. Non-performing loans have been a major problem in the Cypriot financial sector. I heard in December that with a new insolvency or foreclosure framework this would be resolved.

I therefore find it both surprising and worrying that according to Eurogroup remarks 16 February 2015 the foreclosure framework has still not been finalised but is much needed in order to enable banks to clean their balance sheet and start lending again. This is now the main hurdle in the recovery program for Cyprus.

Household debt is a problem – Cyprus could do with some general measures similar to the Icelandic “110% way” where mortgages were written down to 110% of the estimated value of the property to pull households out of the doldrums of negative equity.

“Confidence in the Cypriot banking sector has not been restored,” one source pointed out. That can i.a. be seen from the fact that many prefer to keep cash at home; as much as 6% of GDP could be under pillows and mattresses.

As so often in countries plagued by corruption everyone is aware of it but it is rarely mentioned except when it surfaces in news. But is indeed a huge problem as can be seen from EU Anti-Corruption Report 2013: 78 % of Cypriot Eurobarometer respondents claim corruption is widespread, EU average is 76 %; 92 % say that bribery and good connections is the easiest way to access certain public services, EU average is 73 %. Among Cypriot business people 64% say corruption is a problem compared EU average of 43 %. And most seriously, 85 % of entrepreneurs think that favouritism and corruption hamper business competition in Cyprus when EU average is 73 %.

Cypriots need to know exactly what happened and when – and so does Europe, if any lessons are to be drawn from the crisis. But most of all, Cyprus needs hope. Parents need to believe there is future for their children on the island. Young people have to see a reason for staying after their education or returning there after studying abroad. A country marred by untold stories, unexplained action and corruption is simply not a good country for growth and optimism – the necessary prerequisite for hope.

*My oral sources are all from Cyprus. In agreement with them they are not identified by position since Cyprus is a small country. – This blog is cross-posted on A Fistful of Euros.

 

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Cyprus is struggling with its capital controls, with no fixed abolition date in sight. Iceland has also discovered that the best way forward is to have a plan with benchmarks but no time limit. Here are some facts on the Icelandic controls, what is at stake and for whom. As Cyprus might find out – and Iceland is already experiencing – the longer the controls are in place, the stronger the forces against abolishing them.

Capital controls come in many shapes and sizes and capital controls in Iceland and Cyprus are of different nature, set to solve different problems. In Iceland, the controls were put in place end of November 2008. At the time, more capital was flowing out of Iceland than could ultimately be converted into foreign currency. The problem stemmed from ISK600bn, €3.76bn, owned by foreigners (or entities abroad), hence the name “offshore krona/ISK” – there was no way the Central Bank of Iceland could find enough foreign currency to convert these ISK investments into foreign currency. Like in Asia in the 1980s these investments, in Iceland called “glacier bonds,” were made to profit from high interest rates in Iceland.

With time, new sources of ISK that need to be paid out in foreign currency have piled up, in total creating a problem amounting to about ISK1200bn, €7.52bn, ca. 70% of the GDP of Iceland. The core of the problem is ISK assets, needing to be converted into foreign currency at some point and kept firmly in place for now by the capital controls. With the controls in place there are various restrictions on movement of assets in out and of the country. I.a., every Icelandic citizen in Iceland has to hand over to the CBI whatever they earn in foreign currency.

The situation in Cyprus, part of the Eurozone, is different. The Cypriot capital controls were needed to prevent a run on the banks, i.e. hindering that deposit holders would empty the banks. Consequently, the controls were more invasive and much more felt, with maximum withdrawal etc. The controls have gradually been eased but there is now, as far as I can see, no certainty as to when or exactly what conditions need to be in place to abolish them.

The laws on capital controls in Iceland expired last year but there is now no time limit. The CBI has certain benchmark needed to be reached.

In Icelandic, one way of describing a short-lived blessing is “peeing in one’s shoes” – it is a quick warmer but the effect does not last and ends up as a messy problem. That is exactly what capital controls are: a quick blessing, which in time turns out to be costly and eventually costlier than the benefits. It is well established that the longer capital controls are in place the greater the damage: they tend to create an asset bubble as too many currency units chase too few investment opportunities, they distort the business environment and eventually they are inductive to criminal behaviour and corruption and – as anecdotal evidence now shows in Iceland: capital controls create unjustified privileges.

The ISK1200bn problem held in place by capital controls

In Iceland, the capital controls now hold three more or less equally large batches of ISK seeking to be paid out in foreign currency. The glacier bonds now amount to ca. ISK400bn, €2.51bn. Those who own them may to a certain degree be patient investors, happy to enjoy Icelandic interest rates, still quite a bit higher than in the Eurozone.

The second ISK400bn batch consists of ISK exposures with direct or indirect state guarantees. The largest part, ISK270bn or €1.69bn, are bonds exchanged between the new and the old Landsbanki when the new one was set up. Other exposures here are loans of state owned companies like Landsvirkjun, the energy company.

The third ISK400bn batch consists of ISK assets in the estates of Glitnir and Kaupthing, which need to be paid out in foreign currency. Ca. 90% of these assets are owned by foreigners but Icelandic creditors like the CBI and Icelandic pension funds own ca. 10% of these assets, meaning that 10% would float back into Iceland when/if these assets (and the estates’ foreign assets) are paid out. It also means that whatever happens to these creditors (i.e. whatever measures used to dissolve the estates and pay out creditors), does not only apply to foreigners but also to Icelandic creditors. And 10% is not a trivial figure in proportion to the Icelandic economy.

In order to lift the capital controls it is necessary to solve the problems that keep the controls in place. This means that in Iceland the size of the problem is roughly 70% of GDP. That in itself would be no mean feat – but in addition, the government (or at least the Progressive Party) has declared that this process has to create a windfall of ca. ISK300bn, €1.88bn, which it wants to use for further debt relief for those who are too well off to have benefitted from earlier debt relief (which so far is the most extensive debt-relief in any debt-hit European country).

Basically every one who does not have debt at stake thinks this policy, first launched as an election promise by the Progressive Party before the election in April, is a bad idea (i.a. potentially inflation-fuelling; funds would be better used to pay down sovereign debt, i.e. benefitting the whole population), amongst them the CBI, OECD, and the IMF. As reported earlier on Icelog, Prime Minister Sigmundur Davíð Gunnlaugsson does not take seriously criticism from foreign “acronyms,” meaning the OECD and IMF – but that is another story.

The glacier bonds and the state-guaranteed assets – 2 x ISK400bn

Though the two estates pose the trickiest problem, the two other batches also need to be dealt with. The glacier bondholders may well get some offer inducing them to stay, such as unfavourable exchange rate/levy. Also, as mentioned above, some of these investors may be in no hurry to leave.

The CBI and others have indicated that the real problem of state-guaranteed ISK assets, though ISK400bn in total, is thought to be ISK250bn because there are ca. ISK150bn worth of foreign assets/revenues to offset it.

Part of the solution would be to extend the maturity of the Landsbanki bonds, now the topic of intense negotiations between the Landsbanki estate and the new Landsbanki. Due to Icesave, the Dutch and the UK guarantee deposit schemes are the estate’s largest shareholders. Dutch and British officials have a thing or two to say on this matter and they are not necessarily dripping with milk of human kindness after the EFTA Surveillance Authority and the EU unexpectedly lost the Icesave case at the EFTA Court.

The trickiest ISK400bn batch

It is clear that the funds for the debt relief should not come from just any of the three problem batches but from the one that mainly regards foreign creditors, i.e. the Glitnir and Kaupthing batch. Politicians, mainly from the Progressive Party, hoping for a windfall here, seem to hope that although the ISK400bn assets are not trivial, the foreign creditors might be willing to negotiate a write-down – or some other measure that would result in funds for the government (though these are assets of private companies) – in order for the creditors to get their hands on the foreign assets in these two estates, the equivalent of ISK1500bn, €9,40bn, close to 90% of Icelandic GDP.

These foreign assets are sitting there, ready to be handed over – ca. ISK1000bn, €6.26bn, in cash, the rest in assets. It is clear though that the CBI, which by law needs to agree to the estates’ composition (or whatever happens to them) will not grant any asset payout until the destiny of the ISK assets is decided. No piecemeal service here.

The possible measures and solutions re Kaupthing and Glitnir are now being furiously pondered on and discussed among those who have a skin in this game – meaning the administrators of the two estates, the creditors (or their ad hoc creditor committees and their representatives), the CBI and the government, probably mostly within the ministry of finance.

Bjarni Benediktsson minister of finance and leader of the Independence Party is well positioned to make an enlightened choice since he has all relevant experts at his fingertips. Also, IP is traditionally well connected to the ministerial administration. Gunnlaugsson, who no doubt will want to follow this closely – given the election promises at stake for him and his party, ultimately his credibility – might find himself in a more difficult position in terms of access to the same kind of expertise, if he wants to make his own independent assessment. The PP, out of government from 2007 to 2013, might not have the same access as the IP.

Why postponing a solution may be a costly option

Foreigners, who have had dealings with Icelanders, often mention that it is notoriously difficult to get Icelanders to make up their mind and commit to a final decision. The estates might be one such problem where the government will find it very difficult to make up its mind, not least because the PP, after their rhetoric and promises, have to present a solution that looks like a victory over the foreign creditors, with the funds to show.

These problems have been clear to everyone concerned for a long time and clearly all those involved with the two estates have been problem-crunching for months now. One of my sources pointed out to me that if this problem is not solved relatively quickly, i.a. a solution presented in the coming month (though the fine and final details make take some mulling-over) this might drag out for quite a while because it would suggest a fear to bite the bullet rather than a lack of informed options.

But can’t the government just wait around until it has found the perfect solution for the two estates? Not necessarily because without a solution the capital controls stay in place. And the longer it takes to solve the issues of the two estates the harder it is to solve. Delays of half or whole years might burden Iceland with added costs of the capital controls.

A delay can have two-fold effect on the estates: the assets will change – and claims will most likely be sold to a different category of investors compared to present creditors.

As to the assets, unsold assets give scope for negotiation of value. The more assets sold and turned into cash, the less scope to negotiate on value. The thinking among some in Iceland is that the creditors of Kaupthing and Glitnir could just solve the problem by giving the ISK assets to the state (for example, handing the over the CBI), in order to get at least the ISK1500bn foreign assets. Negotiating a write-down is more or less the rule in this situation but a pure gift sounds more than wishful since all creditors have to maximise their recovery. Amongst them are the CBI and Icelandic pension funds, which might find it difficult to justify this kind of magnanimous action.

That said, the creditors may in due time well show some creativity and present a solution that indicates they understand the problems Iceland faces. Remains to be seen.

As time passes, it will be more difficult for creditors to show any kind of creativity because more assets will be sold and converted to cash, leaving only the currency rate to be negotiated.

Thus, it can be argued that time is not on the side of the state. The creditors will not be happy to wait but they can get out of the situation if they want to and they, being professional investors and institutions, have seen all of this before.

Here is what delays might do to the creditor group. For now, the original bondholders in Kaupthing and Glitnir own more or less half the claims, with the other half having been sold off to those who specialise in distressed debt. The division is not quite clear-cut because banks and big creditors often invest with the buyer when they sell off their claims in order to get a cut of the up-side if there is any.

If creditors start to think that the assets will be dealt with “sub specie aeternitatis” they will sell their claims – and the more hopeless it seems the more the write-off and the more virulent the buyers. The vulture kind, prepared to sue everyone to hell in order to get as much out of the claims as possible. – This potential change of creditors will of course not happen over night but yes, over time if creditors start to lose hope and just want to get however little out of what they have.

Consequently, the longer it takes to find a final settlement re Kaupthing and Glitnir the greater the difficulties in finding a solution, bringing on losses for domestic creditors as well. And, worst of all, the capital controls stay in place.

The destructive effect of capital controls and the rise of a new Icelandic nomenklatura

In several reports, i.a. on financial stability, the CBI has in no unclear terms spelled out the cost of capital controls for the Icelandic economy brought on by a potential asset bubble and distorted business behaviour. The CBI deems that these are potential risks, which have not yet happened.

It is notoriously difficult to tell when there is bubble, i.e. when assets are mispriced and asset prices have been rising fast in Iceland, i.a. property prices and shares of listed companies. Both the CBI and financial analysts say that so far, these price increases are in tune with the economy, not a bubble.

The no less worrying effect is, I think, that capital controls are potentially fertile ground for corruption. With time, they create a booming industry seeking to avoid the controls. And with time this industry will do what it can to keep the controls in place.

This is a general course of events in countries with some kind of capital controls. In addition, the capital controls in Iceland are slowly creating its own special kind of a privileged nomenklatura that can buy assets at a cheaper price than other Icelandic mortals.

In order to relieve the pressure of the offshore ISK, the CBI came up the with the idea of offering offshore ISK owners a way of investing this money, given certain terms and conditions, if they bring in foreign currency in addition to the offshore ISK. This seemed like a reasonable way to attract foreign investment to Iceland. The problem is that this has, apparently, not attracted foreign investors but gives Icelandic investors, with foreign assets (which have to be since before the capital controls) and offshore ISK, the possibility of buying assets in Iceland, be it property or financial assets, at a ca. 20% discount to Icelanders who have nothing but their hard-earned not-worth-much ISK.

This new nomenklatura is now pretty clear and known to everyone though it is hardly ever mentioned in the Icelandic debate. I can certainly not remember ever having heard a politician mention this (but here I might be wrong since I don’t follow the Icelandic debate in detail).

Another sneakier way is less well known but indeed existing, I’m told.

It is always presumed that the glacial bondholders are foreigners. That is probably how it was in the beginning of time, i.e. when these investment objects were created and up to the collapse. What I now hear from various sources is that there are Icelanders in this group. No, not necessarily the notorious billionaire “Viking raiders” but wealthy Icelanders, in Iceland, who have bought the bonds after the collapse and now hold them through foreign companies or “nostro” accounts of foreign banks. Out of the total ISK400bn these may not be high sums but, again in Icelandic context, quite a bit of money.

Here is the trick: the law on capital controls allow glacial bondholders to convert the interest rate of glacier bonds into foreign currency and move them abroad. Icelandic glacial bondholders can then take this foreign currency and bring it back to Iceland through the CBI investment offer, to buy Icelandic assets, meaning they get the Icelandic assets at ca. 20% discount, as mentioned above.

It would be very interesting to know who these alleged Icelandic glacial bondholders are. It would throw light on how privileges are meted out in the regime of capital controls and clarify the stance that certain individuals may take in the public debate.

Waiting is not an option – if the cost of capital controls matters

As argued above, there are various reasons why waiting is costly, why waiting compounds the problem of the capital controls and makes the ensuing problems more engrained over time. Needless to say it is extraordinarily difficult to say exactly at what point the cost is greater than the benefits of the controls. Also, assessing the cost of the corruption the capital controls create is particularly hard to evaluate.

The capital controls in Iceland have been in place for the best part of five years – in Cyprus only for five months. Although the controls in the two countries are of different nature, put in place to solve different problems, Iceland can be an interesting example for Cyprus – and possibly, with time, an example of what to avoid.

*Here are some earlier Icelogs on capital controls.

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As Cypriots get used to the idea of capital controls, the first indictments in a big alleged capital control fraud case surface in Iceland. But why did Iceland need capital controls?

Capital controls have been in place in Iceland since November 28 2008, almost two months after the emergency legislation was passed, on October 6 2008, marking the beginning of the collapse of the Icelandic financial sector. With its own currency, the krona/ISK, access to liquidity was not a problem but dwindling foreign currency reserve posed an acute problem.

“Glacier bonds” and other foreign-owned assets in Iceland

With high inflation and high interest rates in a world with low inflation and low interest rates in the years 2005 to 2008 Iceland was a popular destination for money looking for a place to collect interest rates. Foreign banks, notably Toronto Dominion, offered so called “glacier bonds” issued in ISK. At the time of the collapse, ca. foreign-owned ISK680bn, now €427m, were nesting on bank accounts in Iceland – the Icelandic GDP is now around 1600bn. This number is now believed to be about ISK400bn, 25% of GDP (CBI, see p. 12 here).

Although a part of these inflows were “patient money,” i.e. money being placed in Iceland to gather high interest rates for longer term, the sense was that ca. ISK 300bn was short-term investment. Foreseeing rapid outflow, causing major instability and draining the foreign reserves of the Central Bank of Iceland, the capital controls were put in place – and money could no longer flow freely in and out of the country.

Much of this money is in short and long term Icelandic sovereign bonds and other sovereign papers and on accounts with the CBI or the retail banks. Following recent change in the laws on capital controls the offshore krona investments are now greatly restricted.

In addition to the “glacier bond” overhang foreign creditors of the holding companies of Kaupthing and Glitnir (which own the new banks, Arion and Islandsbanki) own additional Icelandic assets, ca. ISK600bn. The plan now is to solve the underlying causes for the capital controls together with negotiations on composition of the two banks – but so far, it is unclear what happens. The CBI would like to see at least one of the two banks sold to foreigners so as to make the sale “currency neutral” but as I’ve written about earlier strong forces in Iceland favour a sale of both banks at knock-down prices to Icelanders.

Icelandic capital controls – no bother in daily life except for companies and investors

To begin with, Icelanders planning to go abroad had to visit a bank, with their flight ticket to buy foreign currency. People could no longer transfer money abroad from their bank accounts, as they had been able to earlier. Otherwise, ordinary people did not much sense the capital controls. Icelanders traveling abroad can use debit/credit cards.

Unlike Cyprus, there were no caps on how much money people could take out from their bank deposits in Iceland. The Icelandic capital controls were not put in place to hinder outflows from deposits in Iceland but strictly to hinder pressure on CBI’s forex reserves and to hinder that the offshore krona – krona owned by foreigners – could flow into the Icelandic economy.

As it is now, the capital controls permit only internal trading in offshore ISK among non‐residents, i.a. they restrict capital transactions between residents and non‐residents. Companies with regular foreign interaction can seek dispensation and many companies now operate under a dispensation scheme.

But with capital controls companies in Iceland are restricted in their investments abroad, all forex earnings by Icelandic companies abroad have to be repatriated, i.e. brought back to Iceland and placed with the CBI. Of course, companies have learnt the hard way to live with it but as someone said to me recently, it is the capital controls’ mentality that is so deadening – this restriction of activities that the controls bring.

Efforts to lift the capital controls – so far, little progress

The CBI has outlined the long-term risk of capital controls. Too many krona chasing too few investment opportunities can lead to an asset price bubble and this might already be happening. Corruption may very well grow around dispensations and other forms of exemption, as well are around attempts to circumvent the laws.

The CBI policy to lift the capital controls was introduced in August 2009 but without any time limits:

This first phase of the strategy was implemented in late October 2009, but at the same time a strengthening of the regulatory framework was aimed at prohibiting inflows of offshore krónur, which were the main channel for circumvention until that time and had greatly undermined the foreign currency repatriation requirement. Subsequently, controls on long‐ term holdings – which were already held to a large extent by long‐term investors or would soon find their way into the hands of such investors (such as domestic pension funds) – were to be lifted gradually. Finally, controls on short‐term assets would be lifted, in part through auctions where market prices would determine which investors could convert ISK assets to foreign currency first. The strategy assumed that this problem would not be addressed until late in the liberalisation process, as a vast amount of highly liquid assets were owned by non‐residents likely to want to or be forced to sell them at the first opportunity. It was also assumed that the offshore krónur problem would eventually diminish to some extent through internal trading by non‐residents, where investors with a longer horizon and more tolerance for distress would acquire ISK assets from distressed investors willing to sell at lower prices.

On the introduction of this plan in August 2009 it was pointed out that it would take longer than anticipated to create the conditions necessary to lift the controls. Now, it has clearly taken much longer – because of Icesave, finalising the balance sheet of the new banks, restructuring, adverse conditions in international forex markets, Iceland’s low credit ratings etc – and there is no end in sight.

The capital controls gave rise to a manifest difference between the rate of ISK in Iceland and ISK offshore rate. As a step towards lifting the controls the CBI has held auctions where the rate is ISK/€ ~240 compared to bank rate of ISK/€ ~165. This indicates the still substantial spread between the offshore and onshore krona.

Capital controls and fraud

Shortly after the capital controls were in place it was rumoured that former bankers strategically placed both abroad and in Iceland were offering offshore krona deals too good to be legal. As the custodian of the controls CBI was to investigate alleged breaches.

It has, to say the least, taken time but last week the Office of Special Prosecutor in Iceland indicted four men who in 2009 are alleged to having facilitated trades amounting to ISK14.3bn in 748 transactions. The investigation opened in early 2010 and was announced, quite exceptionally, with fanfare and a press conference by the police. Those indicted – Karl Löve Johannsson, Gisli Reynisson, Olafur Sigmundsson, all former employees of Straumur Investment Bank and Markus Mani Maute – are all former bankers, aged between 39 and 50. Maute and Sigmundsson are living abroad, the former in the US, the latter in the UK.

According to the Icelandic media, this is the largest fraud case connected to the capital controls, but other 10-15 cases are being investigated. In the writ no mention is made of names of individuals or entities, 84 in total, that did business with the four. As I understand it, Icelanders in Iceland who made use of the service of the four would have violated the law as well but so far, it is unclear if any clients of the four will be indicted.

It seems that each of the four earned ISK164, just over €1m, on the transactions. It is assumed that the payments never came to Iceland – the charges indicate that the fees earned have not been found – but ended up in offshore companies owned by the four. It is known that a company or companies were set up on their behalf – most appropriately in Cyprus.

Cyprus and capital controls

Although Iceland is not a member of the EU it is a member of the single market through the EEA, which forbids capital controls. Iceland holds an exemption from the EEA and the IMF. With capital controls in Cyprus it is clear that many will try to find loopholes in the new law or directly violate them. If the authorities want to a) make them work b) avoid corruption the controls have been clear and easily enforceable. And it takes a specialised enforcement team to make sure the controls are not breeched. And in case of breeches, indictments have to follow.

As can be seen from the Icelandic experience, lifting capital controls is not easy. If things go as Cypriot authorities claim, there will be no reason for a deposit flight once the Bank of Cyprus has been restructured – and that is planned to take no more than a month, after which the controls can be abolished.

This sounds easy and straightforward but it remains to be seen if the plan works out. It has been indicated that the controls in Cyprus will be lifted in stages – as has been the plan in Iceland. The Cypriot authorities better make sure they know from the beginning what the aim is and how to get there. And they better take into account that fraud is an unavoidable part of capital controls.

*The two announcements from the Ministry of finance, Cyprus, regarding capital controls can be found here.

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At the time, the collapse of the three largest Icelandic banks in October 2008 was blamed on the Brits and Gordon Brown became a hate figure in Iceland. A nine volume report finally told Icelanders what had happened and why the banks collapsed. Only then, did it become clear how politicians had ignored warning signals, regulators were too lax and bank managers were, at best, economical with the truth. Rumours of foul play in the banks led to setting up an Office of the Special Prosecutor, which has already indicted leading bankers and shareholders. – Finding out the truth does not resolve economic woes but it answers the questions necessary to learn the right lessons. This is what Cyprus can learn from Iceland.

The first Icelandic reaction: it’s Gordon Brown’s fault

There is an old Icelandic belief that speaking ill of someone will give this person a hick-up. If that were true, Prime Minister Gordon Brown would have had the mother of all hick-ups during the second week of October 2008. The PM turned into a hate-figure in Iceland where he was blamed for having, single-handedly, driven the two largest banks – Kaupthing and Landsbanki – into bankruptcy. The state had already taken over 75% of the third bank, Glitnir, only to retract on it as it became obvious that even this part of the smallest bank was too much for the sovereign to shoulder.

An emergency legislation was passed late on October 6 2008, i.a. for steering the three biggest banks into resolution if needed. The next day the Icelandic Financial Services Authority, FME, took control of Landsbanki. Although those who understood that abroad the three banks were seen as closely linked and the collapse of one would spell the end of them all, there were desperate attempts to save Kaupthing. This is puzzling since Bank of England had already on October 3 stopped all new deposits going into the bank.

After months of wrangling with the banks’ managers in the UK and with Icelandic authorities and politicians, UK authorities lost patience on October 8 and closed down Kaupthing’s UK subsidiary, Kaupthing Singer & Friedlander. A day later, the FME took over control of Kaupthing.

The irritation and distrust of the British authorities surfaced when the UK Treasury used a freezing order, also used against alleged terrorist organisations, on all Icelandic companies in the UK. The measure was aimed at Landsbanki but the action was only narrowed down later and did cause many Icelandic companies and individuals great difficulty until it was finally revoked in June 2009.

These two actions – closing down of KSF and using the freezing order so broadly –caused angry and bewildered Icelanders to vent their anger towards PM Gordon Brown and British authorities. International media – on its first European banking collapse outing – had a field day, interviewing angry Icelanders.

Substitute the name “Angela Merkel” for “Gordon Brown” – and Cypriots will know how Icelanders felt these days in October 2008. Also Icelanders felt at the time they were under siege from a foreign power.

SIC – OSP

In December 2008, the Icelandic Parliament voted for two novelties: to set up a special investigative committee, SIC, to investigate what led to the banking collapse – and secondly, reacting to rumours about foul play within the banks, to set up an Office of Special Prosecutors to investigate alleged crimes related to the collapse.

Just after the collapse, before the SIC was set up, Kaarlo Jännäri – a Finnish expert – was asked to write a report on the causes of the collapse. In only 30 pages he outlined what was later confirmed and covered extensively by the SIC and concluded that the causes were a combination of bad banking, bad policies and bad luck. Interestingly, the media focused mostly on the bad luck when the report was published in March 2009. Yet, one of his conclusions was that even without an international crisis, the Icelandic banking model was not sustainable and the banks would eventually have failed.

The SIC was chaired by High Court judge, together with the Parliament’s Ombudsman and an economist. The SIC was supposed to take a year but it took longer. Eventually, on April 12 the great day dawned when the committee presented their findings and the report was published, in nine volumes in addition to on-line appendixes. The country came to a standstill on the morning the SIC press conference was broadcasted live. The first 2000 printed copies sold out the same day but the report is available on-line.

The SIC report: much worse news than anticipated

Most Icelanders, suffering from mistrust brought on by the collapse, did not expect much from the SIC and many felt that most things were known anyway. Both these expectations were wrong. The report unearthed events that were much worse than anyone had anticipated – and the report was both extremely thorough and extensive. It laid bare the complete failure of regulators to supervise, ia because as soon as FME staff gained insight into the banks the banks poached them. The economic policy of governments from 2000 and onward had been expansive, even during boom times.

Already in 2006, when things started to go downhill, most politicians only listened to the bankers, not critical voices, especially not if they came from abroad. Icelanders did not realise that funding dried up in 2006 but the banks narrowly saved themselves. Needless to say, the day of reckoning would have been less dramatic and less costly if it had happened in October 2006 and not two years later.

In trying to secure a currency swap in 2008 with foreign central banks the Central Bank of Iceland got no swaps but only stark words of warning in every bank they turned. Warnings the CBI chose to ignore.

Foul play in the banks

The report showed very clearly how the largest shareholders, together with their business partners, had also been the largest borrowers. Collaterals were frequently insufficient when lending to these favoured clients. The banks lent copiously to entities that bought shares in these same banks.

The OSP has recently indicted managers and staff from two of the banks for alleged market manipulation, partly carried out through lending companies to buy shares in the banks. Other cases brought by the OSP i.a. relate to breach of fiduciary duty. So far, around 15 bank managers and employees from the three banks have been indicted, in addition to two large shareholders, Olafur Olafsson and Jon Asgeir Johannesson.

The report was thorough not only because of the great expertise of its authors but also because the SIC had extensive powers to source information. It was i.a. allowed to waive bank secrecy and analyse loan documents.

Unfortunately, the report was not translated into English but here is a link to those parts, which have been translated, i.a. an executive summary, chapter 21, 160 pages, which summarises the whole report and an overview especially on the operations of the banks, by Mark Flannery.

No other crisis-struck country has as thoroughly investigated what happened – and specifically investigated alleged crime connected to its financial calamities. Both of these things have, to my mind, greatly benefitted Icelanders. It is easier to live in a country where a catastrophe that touches each and every person is understood and where events are analysed in order to learn from them. And most of all – that those who possibly are responsible for crimes hidden in the catastrophe have to answer for their deeds.

Surely, many Icelanders think that things have not changed enough and the justice is milling too slowly – but there is at least a point of reference as to what happened and why.

And now to Cyprus: the Greek haircut does not explain it all

Already now there are plenty of indications that there are things to unearth and investigate in Cyprus. In an interview with the Economist, former Central Bank governor Athanasios Orphanides says that the former government deflected all attempts from abroad to alert it to the increasingly serious situation and get it to react. Interestingly, Orphanides concludes that the €2.5bn loan from Russia at the end of 2011 was a mixed blessing: nothing was resolved and the loan badly used. It would have been better if no loan had been forthcoming, forcing the government to face reality. – Surely some untold stories here that Cypriots have a right to know of in detail.

As to the banks, why did they offer such high interest rates? How was that possible unless there were some high-risk investments at the other end? Or an unsustainable competition for deposits – the only means of funding for a banking sector, largely isolated from European markets.

The Greek haircut is blamed for the troubles of the two banks – Bank of Cyprus and Laiki Bank – but why did these two banks choose to gamble with €50bn – 250% of GDP – by buying Greek sovereign bonds? It is neither an excuse nor an explanation that sovereign bonds were seen as a safe bet at the time. The banks would surely have bought insurance (?). This high-stake bet on Greek bonds needs to be clarified, as this is the single most fateful action contributing to the recent demise – though it is only the last drop but not the real cause for the demise. The real reasons were actions or non-actions taken over a number of years, both by politicians and bankers.

Iceland and Cyprus: ignored warnings and hubris

And it is not true that no one ever said anything. Some experts have been worried for some years. In 2011, Constantinos Stephanou from the World Bank wrote an article in Cyprus Economic Policy Review, with the telling title: The Banking System in Cyprus: Time to Rethink the Business Model? The article spells out quite clearly the weaknesses of the Cypriot banking system, which in contrast to the oft-cited Luxembourg system relies not on foreign banks like Luxembourg but on few big domestic banks. Stephanou concludes with concrete policy advise on what needed to be done in order to secure safe banking operations. The question is if this advice was heeded – and if not, why not.

In November 2011 an IMF report contained stark warning on significant weaknesses (emphasis mine):

The large banking sector, with assets totaling (sic) over 8 times GDP by the broadest measure, and with significant exposure to Greece, is a significant vulnerability. Banks face significant capital needs to reflect mark to market valuations on their sovereign bond holdings and to achieve a 9 percent core tier one capital ratio, as mandated by the European Banking Authority. Non-performing loans are increasing, and further loan deterioration could add to recapitalization needs. Meanwhile, the system is also vulnerable to an outflow of deposits in the event of adverse circumstances. Cypriot banks receive significant liquidity support from the European Central Bank.

Yes, this was all clear whole eighteen months ago…

The Cypriot story is similar to the Icelandic one: there were warnings but hubris and wishful thinking made politicians immune to them. IMF reports are not the daily reading of the man on the street and if the media ignores them no one outside expert circles hears of them.

A list of Cypriot people and companies that had loans written off in Cypriot banks in previous years has now surfaced. The matter will now be investigated by three former Supreme Court judges. That is a very myopic approach – there is a lot more to investigate in the banks, the government, the regulators. What went wrong because of ignorance – and what happened because of corrupt practices? Do the Cypriots dare to unearth all of this?

The easy option of blaming the foreigners – and “we are all to blame”

As long as nothing is done to clarify what happened and investigate eventual criminal deeds, Cypriots have good reasons to be upset and angry – but less with Merkel & Eurozone Co than with Cypriot politicians in power for the last decade or so and the bankers who over the years made the wrong decisions and quite possibly worse. Blaming the Eurzone leaders – as the UK media has reported so diligently – and saying that “we are all to blame” are two ways of masking what really happened. And that some bear more blame than others.

A financial crash is not a catastrophe governed by laws of nature – it cannot be compared to an earthquake or a volcanic eruption. It is an event that comes about at the end of a long string of wrong or bad decisions. Analysing what happened, over the last few years leading up to the catastrophe, is necessary in order to learn from it. The shock in Cyprus is not just about money lost – it is about betrayal of politicians, civil servants, bankers and others in power. Those who suffer it need to know what happened and why – and they need to be sure that possible criminal acts are investigated.

What Iceland can teach others in terms of economics can be debated – but the SIC and the OSP are two things that can truly be an example for other crisis-struck countries.

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The idea of an doing” an Icesave,” of an “Icesave solution,” for Cyprus pops up again and again. But can Cyprus do an Icesave? The short answer is “no.” If doing an Icesave means Cyprus avoiding to reimburse foreign/Russian depositors Icesave provides no example to follow.

Icesave was a foreign operation. When the Icelandic banks failed, it was decided to keep alive the banks’ Icelandic operations, letting those abroad fail. It also meant that all deposits in Iceland were moved into new banks, the rest was wound up. The governments in the UK and the Netherlands reimbursed the Icesave depositors.

An “Icesave solution” indicates a division between domestic and foreign accounts. That is of no great use to Cyprus because the major part of the deposits in Cyprus are in Cyprus and that is also where the largest part of their operations are.

Contrary to the Cypriot situation, the largest part of the operations of the three Icelandic banks were abroad, not in Iceland. Kaupthing, the largest bank, had ca 80% of its operations abroad. The two others, Landsbanki and Glitnir, were heading in the same direction.

In Cyprus, the main operations of the banks are in Cyprus. Ergo, a division like the Icesave – or more exactly, in domestic and foreign operations – does not provide a Cypriot solution. EU Directives do not allow for differentiating between foreign and domestic depositors within the same country. Consequently, Cyprus can not decide to insure deposits owned by Cypriots and Cypriot entities and not others. Completely forbidden.

The only way to differentiate between deposits in Cyprus – for levy or any other action – is to differentiate between insured and non-insured deposits, i.e. between deposits under €100.000 and over €100.000. An Icesave “trick” does not help in Cyprus.

*Here is an earlier blog on the EFTA Court ruling re Icesave.

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** No lack of outpour blogs and comments re the Cypriot bailout. Bank shares are falling in London and elsewhere. The sense is that it’s not so much the principle of grabbing part of deposits but the fact that there is no minimum. I would definitely see it as positive to lower the loan and consequently the debt burden to the sovereign.

(This is getting a bit complicated but opinions flood the web – I’ve added to the Monday morning update, marked with *)

What will happen tomorrow? Extended bank holiday? Not (yet?) so, according to Kathimerini.

Guardian running live blog on events.

Cyprus president Anastasiades tells his version of the story via Euractive.

*Needless to say, Goldman Sachs thinks this is a good deal, via Business Insider.

*A digest and opinion from Tim Duy’s Fed Watch, the headline puts it clearly: “War on common sense continues.”

Russia, supposed to make a small contribution to loan and extending earlier loan of €2.5bn, have not made up their mind, according to Kathimerini.

Here is the Prodigal Greek, alias Yiannis Mouzakis, summing up things re the vote in the Cypriot Parliament and other relevant topics.

*Fistful of euros votes down Olli Rehn.

*The banks go free, not the depositors, a Guardian blog by Michael Burke.

Anonymous Pavelmorski writes another blog – after his first one found below – along these lines, what were they thinking.

Paul Krugman dives into the debate with a short blog, confessing he did not see this coming. Wonders how much the Russian element matters.

FT Alphaville looks at the fall-out of the Cyprus debacle as markets open: not pretty but not horrendous.

And FTA also looks at the lessons one can draw from the Cyprus package.

Frances Coppola writes a thorough and critical piece on the Cyprus shock, directed at the ECB.

My favourite blog of the day, so far, comes from Izabella Kaminska. She points out that no, this isn’t a great move but then, these Cypriot banks aren’t great either, which means they have difficult times finding equity. Kaminska writes:

Think of it this way. If I can persuade people to keep giving me money (to look after), I can make as many crappy loans as I want with that money — and I won’t be found out until the funding is either taken away from me completely (in which case I won’t have enough to give back), the bad loans are so bad I can’t even afford to pay the interest I owe (less of a problem in the zero yield environment), or last and not least the loans mature and I suffer principal loss.

The last situation can be easily masked if I can persuade new depositors to fund that loss unwittingly.

And that’s really what has been happening post crisis. All deposits retained in zombie banks (rather than nationalised ones where the equity gap has been funded by government instead ) were already in reality funding these losses unwittingly.

In other words, the moment you gave deposits to a bank whose loans were failing or were set to fail you were effectively providing loss absorbing equity anyway.

The Cyprus move makes overt what was already the case.

This is why there is a good chance that depositor funds and creditors of this type will now become a lot more information sensitive.

Depositors should now realise that governments which can’t afford to take the hit on their behalf or support positive deposit returns indefinitely (like the US can by giving away free national equity by means of paying IOER ) mean they are funding the gap instead.

This is the ultimate negative interest rate because it shows that the privilege of having deposits (delaying spending) is associated with principal loss, from the offset.

Which makes me think of a blog I wrote recently, on the crisis and the curse of cheap money.

– – – – – –

More from yesterday:

*It seems there is an ongoing discussion tonight about changing the levy so it won’t fall so harshly on those with low deposits – that the olive farmer will pay less and the oligarch more. OpenEurope blog recounts what went on earlier and how the finger-pointing is going. Weirdly enough, the Cypriot Government does not seem to have been defending the interest of the small deposit holders. BuisnessInsider indicates it fears pricing itself out of the money laundering business (which would be scary).

FT Editorial doesn’t mince its words: “Europe botches another rescue.”

FT Alphaville writes about the novelty of the deposit levy, not a positive surprise though.

WSJ has gathered fascinating details as to how the deal came about – a who, where and when story. A bit of credit to the unpopular Olli Rehn: “Mr. Rehn was the first to take the floor with a specific proposal. To raise funds, Nicosia should impose a special levy on deposits, taxing accounts of less than €100,000 at 3%, those up to €500,000 at 5% and those above at 7%.” – At 1 a.m., after numbers being thrown around and the Cypriot president firmly saying no, the bold and brutally clear Jörg Asmussen spelled out the problem: the two main banks were about to go bust, there was no time to mull over this much longer. Asmussen even pulled up his phone and called Mario Draghi, telling him the ECB might now have to deal with two collapsed banks (was Draghi really on the line or was this just Asmussen’s clever trick?) President Anastasiades gave in but insisted on the levy not going over 10% – and the 6.75%/9.9% deal was clinched.

And now, according to Reuters, it seems there is a real possibility that some of the original ideas, of a much lower or no levy on low deposits, may do a come-back. Here is a news summary of how things stand in Cyprus right now.

Below is what I posted earlier:

– – – – – –

Not much said in favour of the bailout but an outpour of dismay, shock and anger in every direction. Here is an overview of some of it, not in any particular order – but first some varia related to Cyprus:

The statement from the European Council.

Cyprus data from ECB’s statistical warehouse, on Cyprus.

An NYTimes article from April last year, just to add some flavour to the topic “du jour.”

Slides from a January presentation by the Ministry of Finance in Cyprus on the state of the Cypriot economy.

How much Russian money is there in Cyprus? Ekathimerini makes a guess: ca €35bn – in a €17bn economy.

On the bailout package:

The view from Cyprus, via Cyprus-Mail: Cyprus left reeling from the haircut on depositors.

FT’s Peter Spiegel tells the story how the deal came into being – in Berlin.

Hugo Dixon talks about “legalized bank robbery.”

Mohamed El-Arian finds the deal “muddled and risky.”

Karl Whelan wonders if the depositor tax spells the end of the EU.

Joseph Cotterill pulls a phrase from Whelan for his headline: “A stupid idea whose time has come” – rich in material and documents.

Edmund Conway writes on the “Tragedy of Cyprus,” drawing interesting US parallels.

Economist’s Schumpeter calls the deal “unfair, short-sighted and self-defeating.”

Business Insider on reaction from some financial analyst, wondering if the bailout will trigger havoc in Europe.

Felix Salmon writes a substantial piece on earlier developments, concludes that the bailout shows that Germany rules the Med countries.

The anonymous fund manager Pawelmorski talks about “a brutal lesson in RealPolitik.”

WSJ Stephen Fidler adds some points to earlier observations.

The Danish economist Lars Christensen adds some musing to Conway (see above), re NGDP targeting.

FAZ analysis (in German) speaks of loss of trust among European deposit holders.

Economist on the sanctity of bond holders in European bailouts.

My own blog re Cyprus – the unfairness and the loss of faith in the European Union.

I’m not sure what Rehn, Lagarde, Asmussen, Dijsselbloem e.al. expected when they announced the deal late Friday night (or early Saturday morning, depending how you divide the hours of the day and night) – but if good friends are those who tell you loud and clear what they think they can at least rejoice that they have many such friends.

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Five European sovereign bailouts, five ways of doing it – but one thing is common to them all: reckless lenders are spared (except in the last Greek round) and hedge funds rewarded. This time, even the smallest deposit holders are hit. One clear consequence: the European Union is rapidly losing support in its member states.

Now, with the experience of five European bailouts it is safe to say they come in different sizes – from the Greek one now totalling €240 to the latest, €10bn for Cyprus. Apart from the Greek haircut (finally after two attempts to stabilise Greece) bondholders have not been touched. In Cyprus where 48% of public sector debt is held by domestic banks, a haircut à la grecque would have felled the banks and not been of much help.

One particularity of the Cypriot banks is that although their assets are roughly eight times the island’s GDP they are mostly funded by deposits, not by whole-sale loans like i.a. the Icelandic banks were. After being badly hit by the Greek haircut last year – more like the last drop rather than the real reason for their troubles – equity in Cypriot banks has evaporated.

Laiki Bank is a case in point: its assets and liabilities is €30.4bn, its equity paltry €1bn. By turning 10% of deposits into equity, as the stability (or more sweetly, solidarity) levy roughly does – bingo, the equity is miraculously a much more sustainable 8% and the troika doesn’t need to provide lending to save the banks. Assuming there will be any deposits left in the Cypriot banks when banking resumes after an, apparently, prolongued bank holiday later this coming week (the banks were due to open on Tuesday, after a long weekend, but there is now rumour they will not open until Wednesday or even later).

By looting bank accounts the total sum needed is brought down: instead of a bailout sum of one Cypriot GDP, ca €17bn, “only” €10bn will be needed.

This is a drastic measure. If this could solve the problem it might have some merit – it would be a quick stab instead of the lingering pain in Greece – but that is more than uncertain. I find it very difficult to stomach that there was not a minimum sum left untouched. Let us say a pensioner with €30.000 would have kept his savings unscathed. Or even holding a sum equivalent to the minimum deposit guarantee of €100.000 untouched but putting a levy of 15% on everything above that. Perhaps none of this would have sufficed to bring the total loan down but yes, I still find this measure extremely brutal and this measure needs to be strongly underpinned and justified. The FT (paywall) has an account on how the deal was reached – it will not make the Germans more popular and it is still incomprehensible how this part of the bailout packet could end where it did.

It follows from the way Cypriot banks were funded that they have been stuffed with money, not from Cypriot pensioners and small savers but with Russian money and other foreign money hiding from attention. It has been known for a long time and what did the European Union or the ECB do about it? Not very much or at least nothing that drove this money away. Now, both Russian oligarchs and a Cypriot olive farmer are hit by the same measure. How fair is that?

One frequently mentioned thing over the last months is if Cyprus should chose the Icelandic way in terms of deposit holders. This advice normally comes without any explanation as to what was done in Iceland and seems to imply that deposit holders should or could be treated differently according to nationality. However, what was done in Iceland can’t possibly apply to Cyprus.

The deposits the Icelandic Government refrained from saving were deposits in Icelandic branches abroad, in reality so-called Icesave internet accounts in Landsbanki branches in the UK and the Netherlands. When deposits were moved into the new banks, where deposit holders could then access the funds previously held with the old banks, only deposits in Iceland were moved. – The Cypriot Government could not, on the basis of the Icelandic way, differentiate between, let us say foreign and Cypriot depositors in Cyprus. For the Cypriot Government, the problems relate to deposits in Cyprus, not abroad. Suggesting that the Cypriots follow the Icelandic course of action seems based on some ignorance about or misunderstanding of what was done in Iceland as the three banks collapsed in October 2008.

Interestingly, I am told that Greek and the Cypriot officials did ask the European Commission informally if the Icesave judgement – where the Icelandic state was not deemed to be obliged to guarantee the Deposit Guarantee Fund nor was it seen to have discriminated against deposit holders abroad (because deposits in Iceland were moved to the new banks, without the use of the Icelandic DGF) – could be of any consequence, i.e. use for them. The answer was a succinct “no.” The EU and the ECB firmly believe that the sovereign is the last guarantor of the financial system in each country – and now, in one case, a state has been allowed to confiscate money from depositors, olive farmers and oligarchs alike.

Cypriots are understandably furious – but the Cypriots, just like Icelanders some years ago, should be furious with their own politicians. There is little point in talking about neo-colonial powers. The EU, the ECB and the IMF have a say over the Cypriot economy because the way things were run in Cyprus. Being mired in debt – no matter if it is a person or a sovereign – leads to a loss of independence. That is the harsh and painful reality.

That said, it is interesting to reflect on the role of the European Union in the five bailout countries. All these countries, as well as some other Eurozone countries, made a huge effort during the 1990s to meet the EMU criteria and join the euro. But once these countries had cut off a heel there and a toe here, to fit the euro shoe the EU stopped being strict. As late as 2011, Mario Monti wrote a brilliant article in the FT, blaming the euro troubles on the EU being too deferential and too polite to its member states. The powerful states, i.a. Germany, have time and again intervened to prevent monitoring etc. (Icelog on Monti’s article here.)

Five countries have suffered from this laxness in the EU, apart of course from mistaken domestic policies. As Mervyn King wrote to his Icelandic opposite number in April 2008, explaining that the Bank of England refused to do a swap: “among friends it is sometimes necessary to be clear about what we think.” – Brutal clarity is sometimes needed but the EU failed to behave like a true friend.

And yet, there was all the time abundant evidence of things heading in the wrong direction. Olivier Blanchard, the chief economist of the IMF, lately berated by EU commissioner Olli Rehn for unhelpful additions (read “clarity”) to the debate, ended an article on Portugal in 2007 thus:

I began by arguing that Portugal faced an unusually tough economic challenge: low growth, low productivity growth, high unemployment, large fiscal and current account deficits.

I then examined various policy choices, from reforms increasing productiv- ity growth, to coordinated decreases in nominal wages, and the use of fiscal policy in this context. I want to end on a more positive note. There is a large scope for productivity increases in Portugal, and a set of reforms which could achieve them. A decrease in nominal wages sounds exotic, but is the same in essence as a successful devaluation. If it can be achieved, it can substantially reduce the unemployment cost of the adjustment. Fiscal policy can also help. While deficits must be reduced, temporary fiscal expansion could be part of an overall package, facilitating the adjustment of wages. The challenge is there. But so are the tools needed to meet it.

The first decade of the new millennium – and incidentally the first decade of the euro – is turning into a lost decade for Europe. The European Union, with its new currency, allowed the periphery – earlier with understandably high interest rates – suddenly to bask in low euro rates with the unrestrained banking systems in i.a. Germany and France only too happy to lend. When worst came to the worst, the lenders have (mostly) been spared and the inhabitants punished. No wonder the European Union is losing popularity in all of Europe as fast as the money flows out of Cypriot banks. It is painful to see that in spite of its rich intellectual heritage, Europe is now governed by extremely by narrow-minded policies and no understanding for their social consequences.

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Someone will have to take losses as Cypriot banks deleverage and the sovereign debt is brought down. The next big date for Cyprus is the beginning of June when a redemption on a €1.4bn euro bond is due – not a trivial sum in an €18bn economy. It might all be undramatic ­– but so far the EZ has shown amazing aptitude for tension and brinkmanship

After Pimco was hired to find out how much would be needed to recapitalise the Cypriot banks the first number the Pimcoans aired was €10bn, not a trivial sum in an €18bn economy. Following this shock, Blackrock was asked to review the Pimco methodology, after which Pimco continued its work. Instead of publishing the report as first intended it will be kept confidential until a bailout has been negotiated (or until it is leaked).

The number optimistic Cypriots are hoping for from Pimco is €8bn but that might be somewhat optimistic – €8.8bn might be more realistic. That the report isn’t made public might indicate that Pimco landed on the scary €10bn.

Now, why would 10bn be scary? Because, in this €18bn economy the €10bn adds to the 2.5bn loan already received from the Russians and to the ca €5bn the state will need to fulfil its obligations until it can return to the market. At the end of the third quarter of last year the public debt stood at 82% of GDP. The worst case bailout need of roughly a GDP would pull the debt up to a crippling 140% or so.

The feeling in Cyprus is that €10bn for the banks means that there will a great pressure on the island’s government to privatise in full. There are still plenty of semi state-owned entities, i.e. companies where the state owns 51%. This counts for telecoms, utilities companies and many others. – This makes me think of Iceland after the war and up to the 80s when political power was concentrated around state-owned companies, creating some very cosy relationships but not the most effective use of resources.

In spite of a left-leaning population in Cyprus the unwillingness to privatise doesn’t necessarily stem from ideological aversion but from the envisaged pain from sacking people, adding to the growing number of unemployed people. In a country of only 800.000 this is understandable. Unavoidably, privatisation spells loss of jobs and those in charge know it will hit family and friends. Privatisation in Cyprus will no doubt happen – but it will be painful if it needs to be done in a short span of time at exactly the time austerity is arriving on the shores of Cyprus.

Cyprus clearly has unrealised state-owned assets, which it wants to make money on according to its own plan. The same counts for revenue in sight from gas resources, now in sight off the shores of the island. Cyprus doesn’t want to pledge this revenue against the coming loans. The worse the situation is shown to be the less flexibility there is for the new Cypriot government following presidential election on February 17 and a second round a week later, in case no candidate gets a majority. The strongest candidate is Nicos Anastasiades, a conservative from Angela Merkel’s sister party in Germany. Merkel has already showed up on the island to support Anastasiades.

This time, the Troika won’t be the only lender. Russia has a stake in keeping the island afloat and has alread indicated it wants to add to the bailout packet, through the IMF.

The bailout hinder right now is the persistent rumour of money laundering in the island. Cypriot authorities have answered by pointing at the island’s track record in fulfilling the requirement of the OECD and other international instituations. That hasn’t helped and now, having realise that more is needed, the Cypriot Parliament and ministers have promised that whatever needs to be investigated can be so, however the Troika will want to go about it.

In summer when Cyprus requested a bailout my first impression of the Cypriot situation was that Cyprus will be another Greece with bad news surfacing over months and possibly years. My Cypriot sources strongly reject this theory and are adamant that in spite of being geographical neighbours, Cypriots and Greeks couldn’t be more different.

For a bailout to do the trick two things seem to be essential – to force the banks to shed debt and to find some way of writing down or extending maturity on Cypriot debt. This will have to be done, in order to find a sustainable solution but the question is how fast and how, which ultimately means that someone is going to lose. With no write-down, the bailout won’t be sustainable anymore than it was first and second time around in Greece.

Only recently Germany’s finance minister Wolfgang Schäuble last aired his argument that Cyprus isn’t important enough to save but he seems to be isolated here. The reputational argument is: if the EU can’t bail out one of its smallest brothers how convincing is it that they are able to see a big brother like Spain through its difficulties? The troika will fix a programme and loan for Cyprus. From EU sources it seems likely that Olli Rehn’s view will prevail – no write-down.

The financial argument is that there are no proper private sector investors to drag to the barber’s chair, forcing them to take a haircut. The bank debt hasn’t yet migrated to the state except for the €2.5bn Russian loan. As to the two biggest banks one is 85% owned by the Cypriot state and in the other the shareholders are the general Cypriot public, with the largest shareholder owning 1%. A hair-cut will hit domestic investors and the state.

How might things proceed? The wishful scenario is that after the signing of the MoU, possibly in March, Cyprus will – as it has already started – implent the necessary measures, demanded by the lenders. Well on track, let’s say six months later, it will ask for longer maturities. Russia has already indicated it is willing to extend the maturity of the five year loan 2.5bn loan from end of 2011. This needs to have happened by beginning of March when a €1.4bn is due on a Cyprus euro bond.

This is the undramatic version. Something dramatic might of course upset this smooth forecast. There has been a flurry of guesses today, following an FT article last night, which spelled out options, ia some form of a bail-in – looks like capital controls – that would hinder depositors in moving their money, to be discussed at an EZ meeting of finance ministers in Brussels today. Cypriot ministers ruled this firmly out. The EZ group chairman Jeroen Dijsselbloem refused to answer such a hypothetical question when asked if he would like to keep his money in a Cyprus bank. After the EZ meeting we seem to be back to wishful scenario. Until the unforeseen strikes.

*An earlier Icelog on Cyprus, a link to a recent update on Cyprus on the Prodigal Greek – and another earlier blog on Iceland and Cyprus.

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A small island, with a banking sector eight times its GDP, weak supervision, foreign money flowing in and some Russian connections. Iceland or Cyprus? Both.

With Cyprus now struggling to finalise bailout terms it is interesting to reflect on how similar the two islands are. In early October 2008, as the Icelandic banks were crashing, the Governor of the Icelandic Central Bank David Oddsson (leader of the conservatives 1991-2005, prime minister 1991-2004, CBI Governor 2005-2009, now editor or Morgunbladid) stunned the nation and the international community by announcing that Iceland did not need to turn to the IMF – Russia was willing to lend Iceland, apparently enough to pull the country out of financial quagmire.

Interestingly, this loan never materialised nor was it clear how or why the offer was made. Apparently the Russian ambassador did mediate the offer but then did not have the backing in Kremlin he either had understood or misunderstood he had. There is no lack of rumours as to why Kremlin might have been interested in bailing out the Icelandic government and who stood behind this. It is only safe to assume that the offer is unlikely to have been a fabrication of the staunchly conservative Oddsson but does indeed indicate some Russian interests in the Icelandic banks.

With Cyprus, Russian money flow and it is clear that there are huge Russian interests at stake. The Russian interests materialised in December 2011 when Russia lent Cyprus €2.5bn, maturing in 2016. Until last autumn, Cyprus seemed to hope for further €5bn from Russia but it now seems clear – at least for the time being – that more is not forthcoming from that part of the world.

The island has, through close contacts for many decades, been the chosen port into Europe for Russian money – also the money rising from dodgy privatisation deals and the oligarchs. Among those who made use of Cypriot money route are Bjorgolfur Thor Bjorgolfsson and his father Bjorgolfur Gudmundsson, who used money made in Russia in the ‘90s to buy Landsbanki; father and son have had companies registered in Cyprus.

It is clear that Cypriot supervision of the financial sector was more than lacking when it comes to supervising the flow of money from Russia and elsewhere. It seems fair to assume that there is money in Cypriot companies whose beneficial owners are unknown and money in Cypriot banks untested by the “know your customer” rule.

The key programme objective number 1, according to the Memorandum of Understanding is:

to restore the soundness of the Cypriot banking sector by thoroughly restructuring, resolving and downsizing financial institutions, strengthening of supervision, addressing expected capital shortfall and improving liquidity management;

But there is nothing specific on how this should be done, what is the target and how this will be verified. And there is nothing about the corruption thought to hover over the Cypriot banks, enabling the flow of dirty money into the tiny island economy. After all, why do funds float to countries like Cyprus – and for that matter Luxembourg – if not to do something that cannot be achieved in the more mature economies of Europe (though it is an uncomfortable thought why rich Russians are now so prominent in London)?

I have earlier stressed the correlation between the Eurozone crisis and corruption. Cyprus fits the case. It is an uncomfortable thought that the European Union might – yet again – close its eyes to corruption and deal with the Cypriot banks as if they were all about cricket and fair play.

Fortunately, most articles on the Cyprus bailout mention the Russian money, lastly articles in NYTimes, by Thomas Landon and James Kanter, who quotes Olli Rehn saying that a precondition for aid is that Cyprus needs to adopt “new laws against money laundering.”

If the EU insists on something more than just constructing some Potemkin villages, a bailout will hardly happen any time soon. Even after the next presidential election in February – a term now often mentioned – seems too soon. The euro was put in precarious conditions when EU postponed for two years to deal properly with Greece. Cyprus, with a GDP of around €20bn, is a much smaller problem and postponing a bailout there will hardly have Greek-portioned consequences.

Corrupt money is not just about ethics and morale but about the lethal effect of corrupt money management. If nothing is done now regarding the Cypriot banks, it is yet another victory for evil forces, which ultimately distort competition and crowd out healthy companies.

*An earlier Icelog on Cyprus is here, with links to documents such as the Memorandum of Understanding and IMF data on Cyprus – and here is an earlier blog, linked to an article of mine on Le Monde Diplomatique English website, on the correlation between crisis and corruption.

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