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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)
By Neil Unmack
LONDON, March 28 (Reuters Breakingviews) - European officials are hurriedly denying that the Cypriot bail-in is a “template”. Markets know otherwise. The good bank/bad bank model adopted in Cyprus shows how banks can be recapitalised without government funds whilst protecting insured depositors – thanks to senior bondholders and uninsured depositors taking losses. It’s the right model for the future. For now, it worsens life for Europe’s weak banks.
Credit spreads jumped on Cyprus’ first bailout proposal even though it spared senior bondholders. They rose further after senior debt was bailed in as part of the revised bailout proposal, which the head of the Eurogroup of finance ministers commended as the way to tackle bank failures. Investors cannot afford to believe the swift retraction of that comment. Indeed, the back-peddling has not brought spreads down.
Hopes for direct recapitalisation of banks by the European Stability Mechanism bailout fund are history. Investors naturally worry that senior debt could end up recovering very little after default, possibly nothing, particularly if banks now fund themselves more heavily through non-bail-inable debt, such as insured deposits and central-bank funds.
Bank credit spreads may not have much further to go. Fitch Ratings reckons the historic five-year average bank-failure rate is just over 7 percent. A credit default swap spread of just over 140 basis points should therefore compensate for the credit risk, assuming zero recovery. The Markit iTraxx index puts the cost of insuring senor-ranking financial debt at about 200 basis points over five years – comfortably pricing in the risks for the providers of credit protection, at least for the strongest banks.
Bail-in was always a question of when, not if. The end result should be safer, smaller banks, stronger governments and fewer taxpayer-funded bailouts. But in the short term, it will exacerbate euro zone tensions. Weaker banks, particularly those in southern Europe, face higher funding costs and greater pressure to shrink, hurting the economy. A new sovereign-bank doom loop could emerge. Corporate depositors in peripheral economies know they risk bail-in if their government seeks a bailout and is forced, like Cyprus, to haircut them. They may panic when sovereign yields rise, causing runs – and bailouts.
For the euro zone to hang together, extra support - be it cheap liquidity, or bond buying or bailouts - is inevitable. The European Central Bank is going to have to work harder.
- The Markit iTraxx index of credit default swaps tied to senior financial institutions' debt reached 200 basis points on March 27, up from 143 basis points on March 15, before the Cypriot bailout and the highest level since October last year. The index largely comprises swaps ties to bank debt. A rise in credit-default swaps signals an increase in perceived riskiness.
- Jeroen Dijsselbloem, head of the Eurogroup of finance ministers, said in a March 25 interview with Reuters that the resolution of Cypriot banks would be a template for restructuring euro zone banks. The terms of the bailout require uninsured depositors and unsecured bondholders of Laiki CPBC.CY to take a haircut, or so-called bail-in. He later rowed back from the comment.
- “If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?” Dijsselbloem said in an interview with Reuters. “If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders”, he said.
- Reuters: Cyprus reopens banks under tight restrictions [ID:nL5N0CK115]
- For previous columns by the author, Reuters customers can click on [UNMACK/]
(Editing by Chris Hughes and Sarah Bailey)
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