We looked at this a little in class today. With the proviso that we couldn't find conclusive figures on the reserve situation, it seems that the situation is essentially that the Cypriot Banks are either insolvent or very very close to it, as a result of losses that they took on Greek Bonds in the haircut imposed for the Greek Bailout. The losses the banks have announced would easily have blown through their loss provisions and their capital buffers. So its fundamentally a liability problem rather than an asset issue, which is also supported by the proposal to give shares to the depositors for the "tax". The interesting complication on all this, is that although there looks to have been a lot of money transferred into Cyprus it appears to have been flowing out again just as quickly courtesy of a significantly negative trade imbalance, and there's also been significant monetary outflows for the last 6 months. So the reserve situation is probably not that great either.

But all said and done, this is 1 million population country - it's the equivalent of perhaps a medium sized US Bank going under, and in principle the ECB might well be best off just letting the Cypriot banks fail and honouring the deposit insurance, and let all concerned learn once again the perils of off-shore banking. I rather suspect the problem there is that the ECB's mechanisms for doing that are simply far less well developed than the US/FDIC's.

I am reassured that a dweller of Iceland has a similar view to mine that it is a containable situation. The media are making this out to be a disaster in the making. I realize that this question is a bit real-time for many, but it is the one I live in. Many thanks.

I' ll write about the politics behind the 'lines' of last Eurogroup decision for 'deposit-haircut'.

I think Germany has to decide what really wants for other countries of Europe. Do Germans want to destroy everything other European people have created? I remind you that Cyprus is a financial centre in southeastern Europe and more than 50% of Cypriots live from the service sector. So it's like telling them, "go and financial 'suicide' now and probably you' ll live better later, after closing all your current shops".

I really don' t know what Germans want and act like this way, but they seem to open Pandora's box.

Probably they want a smaller eurozone and decided to start from one of the smallest parts of it.

What do you think about?

I agree that, for size reasons, it´s tempting to let the Cypriot banks fail but if the market interprets this is what will happen tomorrow, for instance, with Spanish banks , Cyprus may become a sort of European Lehman Brothers. One thing is to talk about moral hazard in the class room and quite another one to put the idea into practice.

I am not suggesting for one moment that Cypriot banks should be allowed to fail. The decision to allow Lehman to go under was a disasterous one because it lead to a complete freezing of credit channels. However, this seems to be a game of chicken now between the Troika, who want some contribution, and the Cypriots, who may get next to nothing if the banks are allowed to go under. In principle, the deposit insurance coverage is provided by the Cypriot government, which is a joke given the size of bank deposits relative to GDP. European markets are extremely sanguine today. Portugal 10-year yields are down 23bps, Italy down 9bps, Spain down 5bps, Ireland down 2bps. Is this because they assume that there will be a deal or have markets decided that the systemic consequences are limited? Perhaps the assumption is that Russia will provide aid to protect Russian depositors in exchange for future oil and gas rights? Hard to know. However, when the US Congress voted down TARP on the first vote, the US stock market plunged. No such effect here with Euro Stoxx up 1.2% today.

These are very different problems. Letting Lehman Brothers go was a big mistake because it blew a hole in the asset side of the banking balance sheet - where reserve money and interbank clearing occur. At least from the work I've done so far modelling this system, it seems there much, much less fault tolerance in terms of its ability to handle those defaults on the asset/inter-bank side.

The Cypriot case on the other hand is a known problem in banking - their banks are or are very close to insolvent. They have losses on their loans that exceed, even if they were placed into runoff, the amount they have on deposit. No bank can recover from that situation - it's an inherent problem in the banking system itself.

Now I personally disagree with the statements going around that Cyprus's financial sector is some multiple of their GDP and that's the problem. If Cyprus wants to be a banking centre, that's it free choice. But if any bank in any banking system takes losses on their lending above the threshold for their interest income receipt to cover, then it will fail - and that's a 'feature' of the banking system. I completely agree btw. that the ECB needs to get its head around deposit insurance being a currency problem not a national problem if it wants to have free movement of funds within the Euro zone.

Obviously from public data, it's not possible to make any assessment on how good or bad their bank's lending behaviour was. Looking at a couple of their balance sheets, they didn't look that bad. It didn't look like they were securitizing, superficially at least, they just looked like fairly normal banks.

So then we have what appears to be the cause of the bank's problems is that they took a hair cut on their greek lending - which was mandated by the EU as part of solving the Greek problems last year - and they weren't able to absorb it with their existing loss provisions and profits. Not surprisingly given the size of the losses. So essentially this is a cascade failure - and one that could have been (and judging by the currency outflows from Cyprus these last few months was ) predicted as soon as the Greek write-offs occurred. Does anybody here really think that the European politicians, or indeed any politicians understood these kinds of issues inherent in the mechanical operation of the banking system when they set up the Euro, or indeed as they're making their decisions now?

The lunatics have taken over this asylum.

I am really scared by the position of EU in this matter, if they can demand Cyprus today to nationalize 10% of deposits, thus throwing off a basic principle, who is to say they will not demand other small countries to do the same? Seizing private property as "national emergency" without any compensation is a good way out for many governments.

We are defined by what we do and, just as well by what we would never do.

Bradut I am not sure that it is fair to say that the deposits are being 'nationalized.' I am 100% behind property rights (shame on Argentina for seizing Spain's stake in Repsol last year, which was nationalization). If there is no rescue, how much value would be left in the deposits at Cypriot banks? That said, there is a fine balance between moral hazard (if you never risked anything putting money in a bank then that would have bad consequences) and the externalities of bank runs. In the case of the U.S. financial crisis, Bear's shareholders were made to pay but all debt holders were made good. With Fannie and Freddie, the debt holders were fine but equity and preferred holders were severly clipped. AIG it was the equity holders. Lehman it was everyone. The problem with Cyprus is that there are just about only deposit holders to clip because the banks have very little market debt and very little equity as well. The more I think about it, I believe the deposit insurance limits should be respected and the haircut should fall on uninsured deposits. However, I am interested in people's views on creative solutions.

If the reason for this levy was "a desire to make Russian depositors bear some of the costs of the bailout", why impose it also on €20.000 deposits? (I doubt many of those belong to Russian oligarchs.)

In fact, "over €30bn of the banking sector's €68bn in deposits are accounts of under €100,000" (at least according to this article: http://www.guardian.co.uk/commentisfree/2013/mar/20/cyprus-sense-anger-betrayal-everywhere ). But it was clearly absurd to expect Cypriots (or their parliament) to agree to insured deposits - money that ordinary citizens have probably saved for their children to study abroad, or for retirement - taking a cut, especially when theoretically they'd be entitled to the whole sum if the banks were left to fail. Although I heard it was actually Anastasiades who decided to distribute the levy, not to go up to 10% of uninsured deposits, the widespread conjecture that Europe is using Cyprus as a guinea pig here doesn't seem to me so far-fetched. If they really wanted to avoid trouble, couldn't they muster another€ 5bn or whatever it is? (For comparison, the Bank of England's QE over the last few years has amounted to £375bn.)

BTW, I agree with Jacky that nothing has necessarily been done "wrong" here, the risk of this happening is simply inherent to the banking system. Of course, deposit insurance was invented to reduce this instability, but now we have eurozone countries with, effectively, no central bank, so unless the ECB takes on this duty there might as well be no insurance. And I also agree with the most depressing bit, that the lunatics are running the asylum.

Just one point of clarification. The Bank of England's QE is liquidity not capital. The ECB has injected 10 billion euro into one of the banks in Cyprus via the ELA funding program. The current rescue is a capital injection not a liquidity injection. The Fed, BoE, ECB, BoJ etc. cannot do that. The Fed has injected over $2 trillion of liquidity via QE, QE2, and the current QE3 program but not one cent of equity (except to the extent that QE has boosted asset values).

Dear John, bank deposits have a risk, known and accepted by depositors, and there should be a fund built to insure the risk for deposits below 100.000 EUR in case of bankruptcy. Those who have deposited sums below 100.000 EUR should not care if the bank fails. Those who have larger deposits should expect to be called as creditors in bank insolvency procedure if is the case. If Cyprus banks fail, their assets will be liquidated and creditors will receive as much as can be obtained from those assets. This risk also is legal, normal, and should have little impact on whole EU, as Cyprus banks are relatively small size compared to most EU banks.

The risk of deposits taxation without warning as a EU accepted solution has wider implications, concerning all EU members especially lower power countries.

However, the Genie was out of the bottle as soon as the solution was formulated. It's a bank-run management situation right now.

Agreed and I believe the proposal to hit insured depositors was a Cypriot one to keep the tax rate below 10% on the larger deposits. However, I also believe the deposit insurance is a liability of the Cypriot government at this point and not of the EU. It is a mess. There is talk of a plan that the EU could seize the two banks and create a good bank with deposits below the insurance ceiling and a bad bank with the rest. One estimate is that losses to uninsured depositors under this plan could be around 40%. Maybe all of this will persuade Russia to kick in the 5.8 billion EUR in exchange for oil and gas rights. We shall see. U.S. markets not overly concerned about it at this point.

Yes, I suppose Anastasiades wanted to limit the rich Russians' losses as much as possible in a half-hearted, misguided attempt to keep the Cypriot banking sector working as before. In my opinion, it would be fairer, legal and better for Cyprus in the long-run to forgo that kind of business in favour of something more sustainable, and protect its citizens now as much as possible (as Bradut says). It's true that converting the insurance into sovereign debt could be a disaster; but if instead they ended up leaving the euro, at least a depreciated Cypriot pound would make them a very successful tourist destination - and they have the human capital to diversify.

You're right, John - I just mentioned the BoE's QE for comparison, because basically 5.8bn isn't much considering the stakes involved here for everyone. But it's true that the Cypriot banks' problem is not one of liquidity but that they are insolvent. The EU will have to stop this cascade of failures somewhere, it's a question of how far certain politicians are willing to let it go on for short-term political gain.

Well, we had in Brazil, in 1990, a President (Fernando Collor de Mello) who has brought to indisponibility deposits over certain value (in order to contain inflation), to be returned to the owners more than one year later. It was considered a great violence against private property by all Federal Courts in our country, except the superior ones. Supreme Court has not spoken of such an unconstitutionality, for when the first complaint has come there, the money had been all returned to their owners.

I remember the Brazil episode. I was at the Federal Reserve at the time. I think there are huge differences however. First, Brazil's inflation was 600%, so a one year freeze (depending on the interest rate) would have taken most of the real value of the deposits. Second, it was a bizarre form of monetary tightening (and, in my mind, quite immoral).

I think Samuel is right. Going forward Cyprus will have to become a tourist destination again more than an offshore financial center.

As for systemic risks, Italian 10-years today are 4.51%, which is the lowest since late February. Spain is at 4.81%, which has reversed the rise of the last week and a half. Markets 'feel' different and I know that is not a quantifiable term but it does not appear to be September 1998 or August 2011. I may be wrong but my feeling is that whether Cyprus is bailed out or not, it is not a systemic issue for the markets.

Isn't this the problem that dare not speak its name though?

When there's 600% inflation a year, either the banking system's regulation has failed completely, or the government is printing money. Either way, trying to control this process by freezing deposit withdrawals is the wrong answer at a very fundamental level of monetary system understanding.

Brazil´s episode was quite different. The economy was indexed, and therefore the 600% inflation was almost totally nominal and not real. I agree that freezing deposits are the worst way to deal with the crisis, and it is arguable that it can be a temporary measure to avoid a total break in the system. As an analogy, if a patient has a condition, deacreasing the temperature and slowing the overall system can help in order to bring the system back to its regular functions.

And finally, countries that base their economies on fiscal paradise or tax free systems should revise their policies in order to be compliant with a new worldwide system, based more on efficiencies than in defficiencies.

Modern Cyprus crisis is not associated with an imbalance of the budget. First, under the pressure of the three EU countries, Cypriot banks suffered losses (not received in full insurance) from the Greek government obligations. But they promised to support. Seeing that the Cypriot banks loss is very serious and they promised to give 10 billion. Cyprus had to find the missing 5.8 billion. Cypriots tried to get money from a tax deposits. Cypriots decided to shift money problems for depositors.

Summary. Despite the downgrade Cyprus Popular Bank and Bank of Cyprus, help allocate Cyprus. But many companies will leave the island because there are many other good offshore.

I also agree with your view, that large depositors should participate on the bail in of Cypriot banks. There is no formal state insurance for deposits over 100.000 Euro. Moreover, I do not think it is fair that tax payers (cypriots or others) should pay for banks errors.

Cypriot banks are too big for the economic dimension of Cyprus. The situation is similar to Iceland and Ireland. Malta and Switzerland face similar chalanges. The financial systems of these countries receive a lot of deposits. They have to find investment opportunities to offer the promised interests to depositors and at some point they start to take more and more risks.

Cypriot crisis has emanated of course through the banking sector. However, all attempts to see that as only banking mismanagement is quite a mistake , as in my view , it has been linked through two important reasons: (1) the fortune of the Greece economy (2) the free capital mobility of the Euro zone area - to the whole gamut of the single currency agenda and the political ambitions of the European union. Once, the Cyprus is under crisis, many stake holders have to share the burden willingly or not .. The largest depositors may also share the burden ; but because of the present restrictions imposed on capital movement out of Cyprus , in any case, one Cyprus Euro, now, can not have the same value as a Euro in Germany ! In future Cypriot banking sector will definitely shrink and they will not continue to receive lot of deposits . But it will pull down the real income of countries like Cyprus .Unlike the US Federal reserve system, the European central bank is not acting as the lender of the last resort to pump the necessary liquidity into the systems , due to the pressures from both Germany and the IMF .

One supplementary explanation is needed by me on the issue with some commentators that Cyprus is not facing a liquidity problem by the banks but a solvency crisis and, therefore ,no need for the European Central bank to inject additional liquidity to countries like Cyprus : In this context ,One may recollect the quantitative easing measures so successfully adopted by both the Federal Reserve System in the USA, and the bank of Japan ; and the core of such quantitative easing is through purchasing of both financial and real assets by the Central banks , not only to inject the additional liquidity but also to shore up the sagging asset values in the economies.

The U.S. Fed bought only Treasuries, Agency debt, and Agency MBS. There was no shoring up of asset values from the purchases except to the extent that it worked through the Tobin Portfolio Balance Effect. The Fed bought no equities, but equity prices have doubled. The Fed bought no sub-prime MBS or derivatives, but these have surged too. Yes solvency and liquidity are close tied together in a marked-to-market world and the liquidity in the U.S. was important. However, it would not have worked alone without the injections of capital from TARP.

Yes , I do agree that the effect on asset prices work not necessarily through direct purchase of any particular asset by the Central Bank of any country but also through the substitution effect of the portfolio effect..Not only James Tobin, but Milton Friedman much focused on this effect . According to Milton Friedman, why the great depression of the 1930 played havoc in depressing all prices including the asset values , was because the monetary authorities refused to buy assets ( It does not matter , which asset ) and shore up the prices . It is an elementary theory of portfolio effect, that once the public have excess real balances through open market operations or any other asset buying by the central bank that , in order to restore the portfolio balance the public will try to buy other assets as well including equities , as you refereed in the present US case.Therefore, here there is no serious differences in focus and implications . The Only matter of some difference in approach is following the present chair of the US Federal reserve system Bernbenanke and his research team, , some direct purchases of mortgage assets etc were only brought into the tools of monetary policy.Yes, I do admit the relevance of the capital injection to the banks under these circumstances. But , to turn a blind eye to the declining income and consumer expenditure, and the increasing unemployment rate in southern European countries , and arguing that further cutting of the budgets and also denying any role for the European central bank to act as the lender of the last resort to these countries like Cyprus, Greece and Spain , is something from which , I seriously differ from.Then, we would be repeating the experiences of the great depression , where many counties were stuck up with the rigidity of then prevalent Gold standard and refused to increase the money supply as argued by Milton Friedman , and in this case the rigidity of the European Euro standard.

china may be there to rescue the Cyprus by buying its debt. however sale of gold or libralised banking policy could be an answer to this problem.

Cyprus though that Russia will help in bail out ! But they did not help much. China can easily help, though China is very recently in slowing down mode . Will they help ? Let us watch and see . India is itself in a BoP crisis in a small way and so not expected to help.The liberalized banking policy is ,said to be or alleged to be ,the culprit for the crisis in Cyprus in the first insance. So finally Cyprus will have to depress its expenditure , which is not good for Cyprus as well as other European countries.But ,that is what the IMF and Germany want Cyprus to do.

MTP I am simply not convinced that the portfolio balance effect is that large. In the financial crisis, people wanted ultra safe assets (cash, T-bills, which at times carried negative rates). So if the Fed buys Treasuries, it replaces one quasi-cash asset with cash. It does remove duration from the bond market and (in mortgages) some prepayment risk (removing negative convexity). But I don't see why this would result in purchases of equities on a large scale. Once the system was stabilized (again TARP, FDIC insurance, FDIC guarantees of bank debt) and a recovery could be seen in the offing, then equities began to rise. The increase in equity prices has matched the recovery in profits and multiples (around 15) are still fairly low (at least compared to corporate bond yields).

Having said that, I have underestimated the degree to which Treasury yields would fall. However, this is a global phenomenon. For 10-years: U.S. 1.72%, Canada 1.74%, Germany 1.23% UK 1.72%, Japan 0.57%, France 1.75% and the G7 outlier Italy 4.07%. We see Mexico 10-year yields at 2.46% and Brazil at 2.69%. The PB-effect seems to be pushing out across the risk spectrum of sovereign debt.

I am an old fashioned economist: So I put my esteemed colleague's narration in the perspective of the old theoretical frame : When people are said trying to put all the additional liquidity in to cash and liquid T bills etc , in effect , this is to argue that the economy is in a liquidity trap , and what ever money is supplied will be absorbed as demand for money or near money assets,the elasticity of demand is infinite and therefore the monetary policy is ineffective .One can reasonably debate about the liquidity trap in the US context , and even in Japanese context, though majority of the mainstream economists do not subscribe to that view of the empirical reality even in those countries. In southern European countries the reality is certainly the opposite : There is no appetite to put more money by the public into money holdings or the safe government T Bills.. In fact, because of all the premiums to be paid by the issuers of the government debt , the interest rates including that for safe government T Bills are soaring high. In fact, Germany and IMF are precisely arguing that point that the government debt level is already very high and therefore it should be reduced in those countries . Yes, in the US context , there is a reasonable debate , especially by the well known economist Paul Krugman that , because investors are ready to absorb the US T Bills as a safe heaven investment, one need not excessively worry about the the government debt especially when the US economy is still not in good recovery mode, and therefore fiscal policy of government spending is OK even now in US context , and may be that one need not over emphasis the real balance effect or the portfolio effect etc there and fiscal policy can do the job. But , in the context of southern European countries, there is not much scope or the governments have the capacity to increase their expenditure by depending on the " safe heaven " T Bills issues. And therefore, let me reiterate that the European Central bank has to play the lender of the last resort function , and try to use its monetary policy and make the one currency Euro system flexible enough to support the Southern European countries.I am really pained by the news yesterday I read that the Spain's unemployment rate has increased to 30 % and many young people are struggling to earn a living

In response to the Krugman- DeLong argument that yields say don't worry about debt I would point out that months before Greece was a problem, spreads were very tight on Greek debt to German bunds. As to the liquidity trap, the theory as advanced by Keynes was that yields couldn't fall further because rates were expected to rise and so the speculative demand dominated. New money couldn't lower yields further because cash was just held. In the context of the U.S. I have argued that QE is hurting grow the because the repression of long-term yields is causing savers to save more for retirement. This includes state and local pension funds and defined benefit plans as well as retirees. But this strays from the point about Cyprus.

I observe that our differences of views have been much narrowed especially with reference to the economies of Cyprus and Europe, from where we started our discussion . . However, I notice that I have serious differences of views with my esteemed colleague on the effectiveness of the Quantitative Easing ( QE for the US economy . I have seen people opposing the QE from diametrically opposite angles : some politicians and economists argue that QE has not been successful because it increases inflation and therefore inflationary expectation , and hence as per the Fisher effect the long term yields can not be brought down and investments can not be stimulated and so the Quantitative easing ( QE) can not succeed .. Now my esteemed friend argues just the opposite that the long term yields are brought down successfully by the QE and it encourages or forces more saving by the retirees and pensioners etc, and therefore aggregate demand could not be stimulated. In my view, the reality is that the Quantitative Easing ( QE) has definitely helped the US economy and otherwise, the financial crisis of 2008 and the US recession would have slipped into a depression mode. In fact, that is the difference between Europe and the US and that the Europe has not been able to revive as much as the US because of the rigidity of a single currency and the lack of a flexible monetary policy to cope with conflicting interests and demands of the member countries . Well, having said that , it does not mean that all the long standing growth issues of a long run nature can be answered by the monetary policy in the US . In spite of all beautiful theories of endogenous growth through perpetuating the quality improvements in capital, there is a limit where the capital can push growth and that is what the classical economists were genuinely concerned with.

I thank my esteemed colleague, for having stimulated my thoughts and hope to see you personally and discuss one day in US where my son is working ! Best Regards!

My greater concern is the current talk about bailing Detroit out--it will create a terrible example and lead to potentially extreme moral hazard problems.

From examining how the U.S. bailouts have gone, I would strongly caution Cyprus to ensure accountability for banking officials if executing any bailouts. Here in the U.S., a Democratic Congress pressured by Obama passed the bailouts in 2008 with a lack of foresight, since the bailouts were then used by numerous CEOs to give themselves huge bonuses and golden parachutes.

http://www.ips-dc.org/reports/executive_excess_2010

In other words, Cyprus should require that the top executives (CEO and 4-5 other top execs) at bailed out companies be released by the company as a requirement for the bailout with minimal compensation afterward. Cyprus should further require that their replacements be voted on by the bank's shareholder's, along with their subsequent compensation. A lack of accountability for banking management played a role in misuse of bailout funds, and I'd urge Cyprus not to make the same mistake.

The UMTS auction in Germany in Juj/Aug 2000 resulted in approx. 50 billion Euro, which was fine for government but awkward for the people since the telecom companies had to consider how to reimburse their customers. Some T-companies failed. This money could not be spend inti improvements.The resume was rather mixed.

Now we wil have the next 2nd generation auction. (GMS et al.)

WP: Durch die Versteigerung der UMTS-Lizenzen im Juli/August 2000 nahm die Bundesrepublik Deutschland 98,8 Milliarden DM (entspricht etwa 50 Milliarden Euro) ein. Das veranlasste den damaligen Finanzminister Hans Eichel zu dem Ausspruch, UMTS stehe für „Unerwartete Mehreinnahmen zur Tilgung von Staatsschulden“.[8][9] Die Ausgaben der Unternehmen für die ersteigerten Lizenzen waren in Deutschland absolut betrachtet (nicht pro Einwohner) international am höchsten.

Some strategic considerations pertaining to such issues, e.g. when to default, are attempted modeled in these papers:

These papers may be useful:

Welburn, J.W. and Hausken, K. (2015), “A Game Theoretic Model of Economic Crises,” Applied Mathematics and Computation 266, 738-762.

Welburn, J.W. and Hausken, K. (2016), “Game Theoretic Modeling of Economic Systems and the European Debt Crisis,” Computational Economics, Forthcoming 10.1007/s10614-015-9542-3.

Hausken, K. and Pluemper, T. (2002), “Containing Contagious Financial Crises: The Political Economy of Joint Intervention into the Asian Crisis,” Public Choice 111, 3-4, 209-236.

Article A game theoretic model of economic crises

Article Game Theoretic Modeling of Economic Systems and the European...