From Deauville to Cyprus: the seeds of another eurozone crisis have been planted.

Author:Engelen, Klaus C.

When the history of the euro area sovereign and bank debt crisis is written, the way the troika of Eurogroup finance ministers, the European Central Bank, and the International Monetary Fund managed the rescue of the outsized Cyprus offshore banking center will be useful as a case study to document the extremely fragile state of European monetary union at that point in time. The handling of the crisis puts big question marks around the June 2012 EU summit council resolution to transfer banking supervision to the European Central Bank--to a European institution acting as the euro area's financier of first resort for banks that lack access to market funding. This huge conflict of interest between supervising and funding large and small eurozone zombie banks and pursuing monetary policies oriented toward price stability is ignored by Europe's democratically elected leaders. When they talk about "Chinese walls," it is sheer nonsense--look at Cyprus.

On April 18, 2013, Germany's parliament passed the aid package for troubled Cyprus with a large majority--486 in favor and 104 against. Under a decision by the German Constitutional Court, the German legislature retains the right to vote on any new support program by the 700 billion[euro] European Stability Mechanism. Behind the impressive support of German legislators for the 10 billion [pounds sterling] ($13.05 billion) rescue loan provision was the fact that Eurogroup finance ministers in the case of Cyprus not only insisted on far-reaching reforms, but also put the reigning bank bail-out doctrine aside and required bank bail-ins by creditors and large depositors. Leaving a guarantee in the Cyprus bank resolution exercise to insure deposits of up to 100,000[euro] made it easier for Germany's left and green opposition parties to back the terms of the revised rescue agreement under which Cyprus also must raise 5.8 billion[euro] of its own money.

For the German government, the Cyprus rescue turned politically explosive in an election year after an intelligence report was leaked alleging that the island is a haven for Russian organized crime. And Sigmar Gabriel, the SPD floor leader, attacked Cyprus in a speech in the Bundestag as having "a business model based on Russian oligarchs, Serbian mafias, and tax evaders." Along with other German politicians, Gabriel dismissed claims that the Cypriot banking system could set off broader contagion if allowed to fail since it is "systemically undesirable."

Before discussing the complex new burden-sharing and rescue approach and its wide implications in detail, two developments in the run-up to the Cyprus banking disaster have to be explored.


The fallout from the bitter struggle between the new conservative president of Cyprus, Nicos Anastasiades, and ECB President Mario Draghi over removing Central Bank of Cyprus Governor Panicos Demetriades from office is bringing into the open the "smoking gun" of how Cyprus has been misusing the Eurosystem.

When the new conservative government's move to get rid of the Central Bank of Cyprus head reached the European Central Bank, Draghi was quick to come to the defense of Demetriades, who also has a seat on the ECB Governing Council, the main decision-making body of the Eurosystem.

In a letter to the Cypriot president, Draghi warned that the governor could only be dismissed on grounds specified by EU law and even then the action would have to reviewed by the European Union's Court of Justice.

The problem, however, is that the role of both the Central Bank of Cyprus and the ECB Governing Council--which can block the use of emergency liquidity assistance funds to a financial institution with a two-thirds majority--reveals a breakdown of governance and the rule of law in the Eurosystem. Emergency liquidity assistance liabilities were issued by the Central Bank of Cyprus to keep an insolvent Laiki Bank, the country's second-largest bank, afloat after the former Cypriot government presented its application to the euro area rescue funds in June of 2012.

Under the Eurosystem rules, emergency liquidity assistance loans should only be provided to solvent financial institutions. But in the case of Cyprus, emergency liquidity assistance funds were used--under pressure from the government and in collusion with its central bank governor--to delay the bankruptcy of Laiki Bank for almost a year.

In a six-page letter, Anastasiades responded to Draghi by denying any action aimed at sacking the central bank governor, but listing dubious policies and decisions that Demetriades was responsible for since taking office in May 2012 under the previous leftwing government of Demetris Christofias. "A systemically important financial institution of Cyprus, Laiki Bank, which according to the European Central Bank and the troika partners was already bankrupt, received 9.5 billion[euro] in Emergency Liquidity Assistance, an amount that accounts for 60 percent of GDP," wrote the Cypriot president. Together with 1.8 billion[euro] in bailout funds from the State of Cyprus, Laiki received 11.3 billion[euro], or 70 percent of GDE

In his letter, Anastasiades cites the March 28, 2013, confession of Demetriades in a press conference: "I was constantly informing the government about the risk for the banking system to collapse and that is why I proposed that the former government reach an agreement for a bail-out deal in June 2012, as the situation was evident since then. Emergency Liquidity Assistance for Laiki reached 60 percent of the GDP of Cyprus. This was not pleasant, but we had to sustain Laiki in order for the elections to take place, a new government to come to power and take its decision, and to reach agreement with our European partners so as to avoid not only the bankruptcy of Laiki, but also the bankruptcy of the country."

The Cypriot president continued: "I believe that the decision of Governor Demetriades not to annul the ongoing liquidity assistance provided to Laiki Bank by ELA with the aim of holding elections in February 2013, despite the fact that the 'situation was evident' since June 2012, demonstrates his failure of effective prudential regulation and supervision of the banking system." At the same time, "It raises questions related to the independency that the Governor enjoyed with the former Government."

The questions all this raises for the European Central Bank, its Governing Council, and for the troika must be answered if the...

To continue reading