Wednesday, May 8, 2013

Cyprus and Resolution Authority

Holman Jenkins has a revealing Cyprus update in today's Wall Street Jounal. For those of you who haven't been following the news, Cyprus' banks failed, borrowing huge amounts of money and investing it in Greek debt (yes).  Cyprus was bailed out by the EU after a chaotic week, including an agreement that large depositors would lose some money, called a "bail-in."

Since us economists have been saying that unsecured creditors and uninsured depositors should lose money when banks fail, it was sort of a watershed moment. I expressed some reservations at the political, discretionary, and chaotic nature of the bail-in. It turns out I underestimated that nature.

From Holman:
A few weeks ago, the Central Bank of Cyprus published a curious set of "clarifications for the better understanding of the resolution measures." The principle of a bail-in—that uninsured creditors should suffer losses before taxpayers are on the hook—turns out to contain a few lacunae. "Financial institutions, the government, municipalities, municipal councils and other public entities, insurance companies, charities, schools, and educational institutions" will be excused from contributing to the depositor haircuts, though insurers later were removed from the exempt list.

There will be no haircut on the €9 billion ($11.8 billion) the European Central Bank injected, for political reasons, in 2012 to keep Cyprus's Laiki Bank temporarily afloat—€9 billion that has now somehow become a liability of Bank of Cyprus depositors, whose losses are bigger as a result.
We should mention another possible offense, in a sense, against creditor priority in reports that certain connected customers withdrew funds just before the haircuts. A daughter and son-in-law of Cyprus's president seem to make a good case that their transfer of €10.5 million to a London bank was a coincidence, but then they proffered a "voluntary haircut" anyway via a donation to a church fund for the poor. Hmm
we have to chuckle when legislators on Capitol Hill talk about ending "too big to fail"—as if there is any chance of stopping politicians from bailing out whatever institutions politicians decide their own interests require bailing out, or any chance of imposing legal order on what are invariably chaotic, highly politicized decisions in the heat of crisis.
Cyprus turns out to be a good template after all. Modern financial systems may be incompatible with the rule of law that mankind has labored so mightily to build over the centuries.
This all matters for our financial "reform." Recall, lots of financial institutions were bailed out in 2008-2009, meaning really that their creditors were bailed out. (Normally, when an institution fails, who gets what is determined by bankruptcy law; the creditors become the new owners, the institution is suddenly recapitalized, and either continues or is carved up depending on what makes more sense to the new owners.)

On the theory that "bankruptcy doesn't work for big banks" the Dodd-Frank law posits a "Resolution Authority," composed of Administration officials, that will sit in the place of bankruptcy court and decide who loses money, with pretty much discretion to do what they want. To get paid off, make sure you persuade the "authority" that you losing money would be a "systemic" danger. It might help to have your campaign contributions up to date. I wrote about that danger in a Regulation article here.

The GM bankruptcy here is a small template. As Holman points out,  when politicians and political appointees have great power to decide who gets money and who doesn't, watch out. Oh, no, I forgot; our political appointees are so much more uncorruptible than the Eurocrats that sort of thing can't happen here. (That was a joke)

His last two paragraphs are better than anything I can write. Go read them again. My one disagreement: Modern financial systems are fine. Modern political systems have abandoned rule of law in favor of a monarchic rule by discretion of appointed bureaucrats. That is incompatible with any financial system.


  1. "Modern financial systems may be incompatible with the rule of law that mankind has labored so mightily to build over the centuries."

    Someone please tell that to Bob Rubin and Alan Greenspan.

    "On the theory that "bankruptcy doesn't work for big banks" the Dodd-Frank law posits a "Resolution Authority," composed of Administration officials, that will sit in the place of bankruptcy court and decide who loses money, with pretty much discretion to do what they want."

    Bankruptcy works fine for banks (big or small) that do not depend on deposits as a funding mechanism and are not crucial to the federal government funding its deficits.

    Why is deposit funding different than debt or equity funding? It comes down to responsibility for the lending / investment decisions that a bank makes. A depositor (unlike a shareholder or bondholder) has no legal claim on the profitability or liquidation value of a bank. As such, the depositor should be expected to be held harmless when a bank makes poor decisions.

    Second, bankruptcy doesn't work for primary dealers because a bankruptcy by one or more of them ( Merrill Lynch, Lehman Brothers, etc. ) can put the ability of the federal government to fund deficits at risk.

    1988 - 46 primary dealers
    2011 - 21 primary dealers

  2. In the new Dodd-Frank, exchange clearinghouses are able to borrow at the Fed window in time of emergency. Think about the economic incentives there. Imagine a 2008 or LTCM melt down on steroids, where customers defaulted at exchange clearinghouses and then the exchanges got in line at the Fed window for cash.....

  3. All the above problems are solved by full reserve banking. Under full reserve, depositors have to choose between, first, having their money lodged in a 100% safe fashion (e.g. at the central bank). That money is instant access, but it earns no interest.

    Second, depositors can opt to act in a commercial manner: i.e. let their bank lend on their money. But in that case there is no taxpayer backing – it’s not the taxpayers’ job to subsidise commerce.

    That has the following consequences:

    1. It’s impossible for a bank to suddenly fail, though the value of depositors’ stake in a bank can drift downwards when a bank makes silly loans.

    2. There is no need for bribe hungry politicians to decide who gets saved by taxpayers.

    For more details on full reserve see Laurence Kotlikoff’s works or see:

  4. Why is it so difficult for economists to draw the right conclusions from "to big to fail"? If those banks are too big, just make them much smaller. Their size is already a huge sign of market failure. Huge companies are always a sign of non-working markets since true markets would favour small efficient companies over big burocratic combines. As soon as markets are influenced by modern feudal privelege systems, like copyright, patents - or in case of banks - access to central bank money, things go wrong. Just stop all that and resize banks and companies to a non-feudal size.

    1. Economies of scale and scope.


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