Cyprus: what happened to the sanctity of insured deposits?

In the turmoil created by the decision of the Cyprus Government to impose a 6.75% levy on deposits up to 100,000 euros and 9% above, it might be useful to look at the legal aspects of this decision. The issue of a guarantee scheme for deposits is not new, and even Cyprus established such a scheme in 2000. This posts walks through the relevant European and Cypriot regulation.  I argue that there is no precedent for Cyprus’ levy and that it creates a serious risk of contagion.

European regulation

On July 12, 2010, the European Commission adopted a legislative proposal for a thorough revision of the Directive on Deposit Guarantee Schemes. It mainly deals with a harmonization and simplification of protected deposits, a faster payout, and an improved financing of schemes. These proposed amendments follow urgent legislative changes that the Commission proposed in 2008 and that entered into force in early 2009. The proposal is accompanied by a report.[1]

The press release of July 12, 2010 is unambiguous about its scope and objectives

As part of its work creating a safer and sounder financial system, preventing a future crisis and restoring consumer confidence, the European Commission has today proposed changes to existing European rules to further improve protection for bank account holders and retail investors. Furthermore, the Commission has launched a public consultation on options to improve protection for insurance policy holders, including the possibility of setting up Insurance Guarantee Schemes in all Member States. For bank account holders, the measures adopted today mean that in case their bank failed, they would receive their money back faster (within 7 days), increased coverage (up to € 100 000) and better information on how and when they are protected.[2]

The most important elements of the proposal include, in pertinent part, the following:

  • Better Coverage: the upgrade to € 100,000 by the end of this year is now confirmed. This means that 95% of all bank account holders in the EU will get all their savings back if their bank fails. Coverage now includes small, medium and large companies as well as all currencies. Excluded are all deposits of financial institutions and public authorities, structured investment products and debt certificates.
  • Faster payouts: bank account holders will be reimbursed within seven days.
  • Long-term and responsible financing: concerns have been expressed that existing Deposit Guarantee Schemes are not well funded. Today’s proposals will ensure that they are now more sound.

Cyprus regulation

The Central Bank of Cyprus is also explicit about its own Deposit Protection Scheme established in September 2000, and operating since then, in accordance with Article 34 of the Banking Law of 1997 as subsequently amended, and the Establishment and Operation of the Deposit Protection Scheme Regulations of 2000 to 2009.  In accordance with these Regulations, a Deposit Protection Fund has also been established which operates as a separate legal entity administered by a Management Committee

The Deposit Protection Scheme is activated in the event a decision is reached that a member bank is unable to repay its deposits, or as a result of a Court’s order for the winding-up of a member bank.  Where a bank is unable to pay its deposits, the relevant decision is adopted by the Central Bank of Cyprus or, where a member bank is incorporated in a country outside the Republic of Cyprus, by the competent supervisory authority of the country of incorporation.

The maximum level of compensation, per depositor, per bank, is €100,000.  This limit applies to the aggregate deposits held with a particular bank.  When calculating the amount of compensation payable to a depositor, any loans or other credit facilities granted by the depositor’s bank are set-off against the deposits.  Any counterclaims that the bank concerned may have against the depositor, in respect of which a right of set-off exists, can also be set-off.[3]

The new levy on deposits.

As I wrote in Huffington Post this weekend, the decision by the European Union violates the sanctity of insured deposits[4]. It is difficult to understand how such a situation could have erupted without the European political leaders realizing the implications of their decision. One has to understand that this did not come about by surprise. The meeting of Consilium comprised of the heads of State and Governments was preceded by a meeting of the relevant Ministers of Finance.

After the storm started, the President of the Eurozone, made the following statement on March 18, 2013:

I reiterate that the stability levy on deposits is a one-off measure. This measure will – together with the international financial support – be used to restore the viability of the Cypriot banking system and hence, safeguard financial stability in Cyprus. In the absence of this measure, Cyprus would have faced scenarios that would have left deposit holders significantly worse off.[5]

There is no precedent for such a violation of the basic principles of deposit protection. As to the statement of the one-off measure, it was already used to justify the loss of value imposed by the Greek Government that eventually cost 75% of the amount held by private Greek sovereign bondholders.

The biggest risk is one of contagion: once a country starts getting in trouble, it is very likely that its deposits will flee the country and make the situation of its banking system worse, if not hopeless.  It seems that the European leadership has not been aware that they were apprentice sorcerers. As Euromoney put it on March 18, [6] it is the kiss of death of pooled deposit insurance in Europe. It means that the ailing European Banking Union is unlikely to contain any form of mutual deposit insurance.   The decision by the European Central Bank to stop providing liquidity to Cyprus banks is a questionable way to force Cyprus to accept the terms of the bailout.

How will Europe recover from such terrible mistake?