June 9, 2013
I was struck with disbelief when I first heard about what was going on in Cyprus in March. At first, all I knew was that the banks had closed and it was being said that they were going to levy a tax on all of the bank deposits at the two largest Cypriot banks in order to avoid bankruptcy. And this was at the suggestion of the IMF (International Monetary Fund), an organization outside of Cyprus. At the time, it sounded like all the deposits in the banks were going to take a 10% haircut. What I mean by this is that all the depositors were going to lose 10% of their money. This gradually morphed into the deal that I’ll describe in a bit.
When I consider what the alternatives were, I think I actually have to agree with the resulting solution. I still think what happened is horrible, but the fact is that the banks were insolvent and somebody was going to lose some money.
During the banking crisis in the U.S. in 2009, the government (and therefore, the taxpayers) bailed them out. In the case of Cyprus, the government is also bankrupt and cannot just print money like we can in the U.S. The option of the government bailing out the banks simply did not exist in this case. Even if it did, why would you want to put the Cypriot taxpayers on the hook to bail out these banks? Maybe 95% of the taxpayers banked at other banks that did not take huge risks and, therefore, were not insolvent. Why should all of the taxpayers be punished for the risks taken by a few banks?
How Cypriot Banks became Insolvent
Here is a brief overview of what took place: The Cypriot banks owned some of the sovereign debt of other European nations, including Greece. They were earning a nice interest rate, which is what allowed them to offer a nice interest rate to their depositors. The interest rates they were paying is what attracted a lot of foreign capital. They became a major financial center in Europe with many wealthy Russians moving their money there.
In 2011, Greece carried out what I’ll call a partial default on its sovereign debt. About 80% of what Greece owed to its creditors was wiped off the books of its creditors. It’s as if I borrowed $100 from you and I will only pay back $20 of that $100…you’ll never see the rest of it. And this has been approved by powers bigger than you so you lose any rights to contest that decision
So these big Cypriot banks suddenly had a lot fewer assets than they used to have. This bankrupted them. Could they have continued to operate anyway? One can imagine a period during which assets are used to continue to make payments on their debt, but eventually, the assets become depleted. They may have already reached this state of affairs in March. I don’t know. Eventually, the bank would be left with only the liabilities, which, of course, could not be repaid.
What are your Expectations when you put your Money in the Bank?
All banks have a contract with its depositors. The depositors expect to be able to pull their deposits out of the bank at some point. There are types of deposits such as Certificates of Deposit where you either have to wait until the term is up or you’re hit with a penalty. But you still have the reasonable assumption that your money is safe and you will eventually be able to get it back to use however you choose.
Now that we’ve witnessed this development in Cyprus, you can throw that whole idea out the window. The possibility that you might not be able to withdraw your money from the bank has always been there, but now we have seen it happen. Banks have now actuallyconfiscated the money of its depositors. This has changed the relationship between depositors and their banks.
Have you ever even thought of the possibility that one day you may head to the bank and find that it is closed for a “banking holiday?” What kind of situation would that put you in?
Did you realize that you are a creditor of the bank that holds your deposits? Your deposits are assets to you and liabilities to the bank. When an entity becomes bankrupt, it cannot repay its creditors. There’s no money there to pay with. Generally, the entity ceases operation before it actually reaches 0 in assets. The “state” takes control and sells the remaining assets and divides the proceeds amongst the creditors in a certain priority order.
Although this is how bankruptcies are handled for other businesses, it is not how bankruptcy is handled for banks because it takes too long. They can’t tie up depositors’ money for several years. The situation must be handled quickly so depositors can get back what’s left of their money.
The Pecking Order of Losers
Some deposits in the banks in Cyprus had insurance. These were the deposits of less €100,000. The depositors who had more than €100,000 at the banks were exposed and were the ones who had some of their money confiscated. When you think about it, this makes sense. If you were insured, your money was still all there.
Here’s the order in which the bank’s creditors were wiped off the books:
- Shareholders of the bank
- Those who loaned money to the bank through some kind of debt instrument such as bonds
- Uninsured depositors.
The European Central Bank (ECB) has stated that this is how future crises in other European nations will be handled. The precedent has been set.
I think we can all agree that it is scary and uncomfortable knowing that depositors can lose their deposits in a bank. However, once I stepped back and thought about it, it makes sense. If you don’t have insurance, you take the risk of losing your money. That’s the whole point of the FDIC in the U.S. If you keep your money in an account that is not insured (e.g. a brokerage account), then you run the risk of losing it. It’s like wrecking your car and not having insurance that covers replacement or repairs. Would you be surprised if you had to pay for the repairs or the new car yourself? No, I don’t think so.
As far as shareholders, I’ve owned shares of a company that went bankrupt. I was not happy, but I was not surprised that I couldn’t sell the shares to recover my investment. That’s the risk you take when you buy stocks. That’s why you do some research on the company before you buy shares in it.
When you make a loan to a business or a person, you assess that person/business and its ability to repay you. It’s just part of the process. The entities that loaned money to the bank made a judgment that ended up in them losing what they loaned to the bank.
How to Protect Your Deposits
The Cypriot bank crisis has raised our awareness that we have to perform due diligence on our banks before we give them our money. As with any business, we should give our business to the company that treats us the best and delivers the goods we expect. If we eat at a restaurant and are treated poorly or don’t like the food, we don’t go back. In the case of banks, once they have confiscated our money, it’s a bit late to make the decision not to bank there. It would be wise to perform due diligence on the bank before we deposit our money there.
If you think this couldn’t happen in the U.S. or the country you live in, think again. The banks in the U.S. have made risky loans not only to sovereign governments, but also to homebuyers. They also play in derivatives markets. So far, the taxpayers have had to bail out the banks, thereby saving the shareholders, creditors, and depositors.
In the U.S. we have the FDIC to pay us back if we keep the amount on deposit in any one bank under $250,000. Then the question becomes: how solvent is the FDIC? I’ll leave that question out there for you to consider.
Another question is: how do we perform due diligence on the banks? Will they really share enough information with us so that we can tell if they’re making risky investments? Probably not.
When it comes to choosing a bank, you’ve probably used some of the following considerations to choose one: convenience, fees, customer service responsiveness, interest rates they pay, products offered such as CDs and loans, etc. Now another consideration should be added to the list: likelihood that the bank will return all of your money to you.
Factors to Consider when Choosing a Bank
You could look at bank balance sheets. I just found one for Bank of America on the Internet, so they are available to the public. Finding the details of their liabilities and assets could be more challenging. I don’t think enough information is provided in the balance sheet I found to determine what level of risk they are taking.
An alternative to requesting detailed information from the bank yourself is to consider using a service I’ve been using; it is called Weiss Watchdog and is part of Weiss Research. The Watchdog service provides rating information about banks and insurance companies as well as a lot of other companies you may be considering investing in. I personally feel more comfortable using this service than trying to figure out the stability of banks myself. I actually changed banks/credit unions because of the ratings provided to me by the Weiss Watchdog service. It’s free, by the way.
How to Protect Your Money
You may also want to start thinking outside the box. Although storing cash under your mattress is probably not the answer, certainly holding some cash in a fireproof waterproof locked box is a viable alternative. At a minimum, I like to have enough there to get by for a month. More is better, but it also exposes you to the risk of theft.
In addition, I like the idea of diversifying among multiple banks in multiple countries. This is what I’m currently doing. I really want to invest in more real assets, but haven’t found the right real estate in other countries yet. It takes time and money to explore investments in other countries. And it requires you to find someone who you can trust to manage the investment if you’re not going to be there to manage it yourself.
I’m seriously considering putting any additional money I save into precious metals. I don’t want to put too much in metals, and yet I feel it is more dangerous to put more into any sort of paper asset…there’s too much counter-party risk.
Other Impacts on the People of Cyprus
From the articles I’ve found on the Internet, it’s hard to tell if all the banks were closed for 12 days or only the two big banks that were bankrupt. What I learned is that people could only withdraw €100 per day from ATM machines during the 12 days that the banks were closed. Once the banks re-opened, people were allowed to withdraw €300 per day, but no checks were being cashed. People were limited to only taking €1000 with them if they were traveling outside the country.
Really think about how it would impact your life if this happened to you. Cyprus is most likely only the tip of the iceberg. Do you have some other assets somewhere else that would allow you to rebuild your life if a large chunk of your bank account was confiscated?
Yours in prosperity,
Sophia Hilton (A Savvy Woman)