Cyprus Tries the ‘Good Bank, Bad Bank’ Strategy

Protestors shout slogans against EU at protest outside a Eurogroup meeting at the European Council building on March 24, 2013 in Nicosia, Cyprus. Talks between the the International Monetary Fund (IMF) and European Union (EU) continue as the country seeks to agree terms to a bailout for its ailing banking sector. Failure to do so is seen as exposing the country to having to leave the eurozone.
The scene in Cyprus. Photo: Milos Bicanski/Getty Images

Students of recent financial history may remember that in 2008, as Lehman Brothers was beginning to circle the drain, CEO Dick Fuld proposed a novel strategy to save the bank by spinning its toxic real estate assets off into an entirely new corporate entity, known as “SpinCo,” which would in theory allow the bank to find a buyer for the “clean Lehman” while letting the rapidly deteriorating mortgage assets run their course.

The “good bank, bad bank” strategy never wound up being implemented at Lehman, owing to some not-so-minor concerns with how to value and give proper equity support for SpinCo’s assets. But it’s a model, in some sense, for what happened in Cyprus over the weekend.

The deal struck last night to save Cyprus’s banking sector is better explained, among other places, here, here, and here. But the rough outline is this:

  • The troubled Laiki bank (which is the second-largest in Cyprus) will be killed off, and Laiki deposits over under 100,000 Euros will be shifted over to the Bank of Cyprus, which will become the designated “good bank.”
  • Small depositors are saved. Cyprus agrees not to tax people with less than 100,000 Euros in insured deposits, as it had previously proposed over massive objection from the Cypriot public.
  • Big depositors are hosed. Non-performing loans and deposits of over 100,000 Euros at both banks will be severely taxed to help pay for Cyprus’s part of the bailout. Nobody knows how much they’ll be taxed, but it will be bad — uninsured deposits at “good bank” Bank of Cyprus will take a haircut of up to 40 percent, while big deposits at Laiki could be almost fully confiscated. Some of these deposits belong to well-do-to Cypriots, but as many as two thirds are from Russian mobsters and oligarchs. As Felix Salmon puts it, “This was not a good weekend for Russian billionaires.
  • Some basic capital controls will kick in to prevent a total run on Cyprus’s banks. These controls won’t last forever (or even necessarily into next week), but they’ll help stem the immediate flight of deposits.
  • In exchange for dramatically shrinking its banking sector, Cyprus gets the $13 billion aid package it always wanted.
  • Cyprus stays in the Euro (for now).

It’s a bit apples-to-oranges to compare what happened at Lehman to what’s happening in Cyprus. Lehman’s problem was excessive exposure to an exploding mortgage crisis; Cyprus’s problem is a runaway and corrupt banking sector that has been content to serve as a money haven for rich Russians, and huge natural gas reserves that can’t be tapped for profit quickly enough.

Still, some of the same concerns apply. It’s hard to see Cyprus’s “good bank” faring as well as hoped; as Tyler Cowen notes (No. 7), you’d sort of have to be crazy to want to keep your money in the Bank of Cyprus, since Cyprus’s economy is expected to get such a severe shock in the next couple of years that another bailout and further depositor taxes may be necessary.

Likewise, it’s hard to see that spinning off a “bad bank” will solve what ails Cyprus. Yes, the nation will get its bailout money, but its long-term structural challenges still remain. Russia will likely look elsewhere for its banking needs, capital controls will effectively devalue Cypriot Euros, and the probable double-digit hit to GDP will lead to greater unemployment and social unrest.

This is not a small part of the equation. As I saw last week with my random Cypriot Q&A, ordinary people in Cyprus are fed up and suspicious. They feel sold out by their politicians, and even if their deposits aren’t being taxed, they’ve lost their trust in the banks. Many of them want to leave the Euro, and will agitate on behalf of politicians who support an exit. As Pawel Morski puts it, “The combination of laying waste to the financial sector and tearing up the savings of thousands of residents means that Cyprus won’t return to current levels of output for a decade, a funeral pyre which bears comparison only with Greece.

Ordinary Cypriots didn’t get to vote on the bailout plan — in fact, nobody in Cyprus did — but they’ll have their say soon enough. And I suspect that they’re not going to abide the terms of the deal nearly as well as EU leaders think. What we see in Cyprus, months or years from now, might be the same thing we saw with Lehman’s “good bank, bad bank” plan in 2008 — a novel bit of financial engineering that is supposed to fix everything, but gives way to panic and collapse in the end.