Remember that island in the Mediterranean that was in turmoil about a year ago and turned to the European Union (EU) for a bailout? The situation in Cyprus was a bit confounding because the country was growing relatively robustly and had a small budget deficit. The issue was the country’s banks which were bigger than its domestic economy. Cyprus had about 8 trillion euros in deposits and only 4.5 trillion euros of annual government revenues, according to BCA Research cited in The Economist. Since bank deposit guarantees are only as good as the country providing them, Cyprus needed some help.
Eurozone leaders responded to the Cypriot bailout request with demands for austerity and reforms – pretty much the same thing they’d been requesting from other bailout recipients – but a ‘bail-in’ also was part of the package. What is a bail-in? The EU required debt holders and uninsured depositors help absorb bank losses and fork up new capital. Although the idea was initially rejected by the Cypriot parliament, the government capitulated relatively quickly. The Economist described it like this:
“At first, a raid on insured [bank] deposits was envisaged, though ultimately they were spared and the main victims were uninsured depositors – a decision made easier by the fact that many of them were Russians. But getting creditors both to absorb losses and to recapitalize the country’s biggest bank (which also had to absorb the second-biggest and even more comprehensively bust bank) is not proving to be a great success.”
How unsuccessful has it been? The Cypriot economy contracted by about 5 percent in 2013 and is expected to continue to wither this year. Unemployment in the country is at 17 percent.
There are several lessons that can be learned from events in Cyprus, according to The Economist: 1) It’s important to have a state-backed ‘bad’ bank where bad loans can be held and dealt with over the long term; 2) Forcing uninsured depositors to take a hit helped protect taxpayers, but it also damaged public confidence in banks; and 3) Fiscal policy makers need pragmatic and flexible solutions because every banking crisis is different.