Cyprus Bailout Highlights Systemic Risk

    We wrote earlier in the year that the European wildcard in 2013 was the tiny island of Cyprus, whose banking system had become bloated relative to the overall size of the economy.  Despite Cyprus being less than 1% of the total Eurozone economy, news there over the weekend will have far reaching implications.   Advantageous deposit terms led to massive inflows into Cyprus banks from foreigners, mainly Russians, who saw higher deposit yields as a way to improve returns on their savings.  Total bank deposits currently stand at 70 billion euros, which is three times the size of the Cyprus economy.  The banks used these deposits to invest in Greek debt and for loans to Greek individuals and businesses.  The erosion in value of these Greek assets has led to bank failures across Cyprus, and the need for yet another bailout.  The difference in this bailout relative to others that preceded it is the inclusion of insured bank depositors in the bailout plan.  Under the current plan, depositors with balances under 100,000 euros will pay a 6.75% tax on their deposits (these deposits were considered insured in a program similar to FDIC insurance), while those with more than 100,000 euro balances will pay a 9.9% levy.  Interestingly, bank bondholders will not face a write-down on their assets.  This plan sets a precedent for depositors being exposed to a decline in the value of their assets and creates a fear that bank runs may take place in weaker financial institutions across Europe.  This story is likely not over and changes to the plan may take place.  What is likely is an uptick in volatility across the European financial markets, and potentially U.S. credit markets.  Our clients have no exposure to Cyprus or European banks in general.  Any ensuing market volatility that may arise from this will be taken advantage of to buy fundamentally sound credits at what could be discounted prices.