Is the Cyprus Bank Fiasco the Template for the Future?

 

Takeaway

  • Unable to sell bonds, governments force their debt onto the balance sheets of private banks and other financial institutions
  • This tactic exposes those institutions to government debt risk, which in turn puts bank depositors at risk

We are living in profound times. The epic levels of deficit spending following The Great Recession are now having short-term remedial effects on the U.S. economy. But before we declare victory, we need to be clear that the real battle lies ahead. Over the next four decades, our government will be under unrelenting pressure to finance the commitments of other world governments and pay interest on its debt.

Even if the political miracle of balanced budgets were adopted, that wouldn’t eliminate the interest expense on the debt that has already been accumulated. Governments will need to marshal the political will to address that problem very soon, if it’s not already too late.

If they don’t, what lies ahead are more situations like the banking crisis in Cyprus — where, under pressure to sell debt, the government is effectively taxing private wealth.

Here’s how this occurs: Governments delude themselves and their constituencies into thinking there is no sovereign debt finance problem and thus no need to stop spending. A favorite tactic in this self-delusion has been to force-feed government debt onto the balance sheets of private banks and non-bank financial institutions.

Within the EU, the fallout spread across the continent. This means Greek debt (remember that?) is sprinkled onto the balance sheets of institutions across Europe — especially the Cyprus banks, as it turned out. Financial regulations allow this sprinkling of debt by declaring government debt to be safe and sound, pushing private institutions to expose themselves to government debt risk.

This is typically done before governments turn to their central banks to support their bonds, an outcome that has only occurred recently.

This is not a solution — it is merely an enabling device that allows the government to avoid short-term pain and financial embarrassment from not being able to sell its bonds to investors at low yields. But it builds on itself and blossoms into later and greater pain.

It’s an attempt to cure cancer with aspirin, covering up the underlying financing discomfort of the government debt overload. But with the advance of time, the aspirin has worn off and the cancer has spread.

This is a tectonic shift. It raises questions about the future costs and changes that could stem from the loss of confidence in government protection of wealth, especially among bank depositors.

The Cyprus fiasco was well more than a reorganization of the Bank of Cyrus. It is a revelation that developed-world banking is not anchored on terra firma for those holding the piggy banks, whether they are bank deposits, annuities or private pension funds. They are all at risk now, and they are no longer government-supportable.

The bottom line is that investors now need to examine carefully their chosen private financial institution’s balance sheets and their wealth holdings with a new understanding of risk in this new millennium.

Dr. Lew Spellman writes about global financial issues on his blog, The Spellman Report, where the full version of this article originally appeared. Spellman will speak about the implications of the Cyprus banking crisis at the next Texas Enterprise Speaker Series lunch on May 9.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.
 

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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