Cyprus Shows Trust in ECB is Misplaced

Ever since European Central Bank President Mario Draghi said last July that the bank will do whatever it takes to preserve the euro, complacency has pervaded Europe’s single-currency area. Markets have weathered potential crises in Italy and Spain with surprising calm, secure in the knowledge that the ECB will save the day if needed.

This was always a false assumption, as events in Cyprus have made clear. There are significant limitations to the support the ECB is willing or able to offer, even to such a tiny island economy whose needs are easily affordable.

The ECB relies on two primary mechanisms to help euro-area countries in crisis. The first, emergency liquidity assistance, allows a country’s banks to access cheap funding from their national central bank, even when all they have left is low- quality collateral that doesn’t meet the criteria for the ECB’s standard liquidity operations. This emergency facility has helped a number of countries make it through liquidity squeezes over the past few years, keeping banks in Belgium, Greece and Ireland on life support since the beginning of the crisis in 2008.

The ECB has kept Cypriot banks alive in this way, too, providing about 9 billion euros ($11.6 billion) of financing to date. The ECB threatened to cut Cyprus off, however, if a bailout deal wasn’t agreed on with the so-called troika of international creditors — the ECB, the IMF and the European Commission — by March 26.

In response to the ECB’s threat, the Cypriot parliament passed a bill on March 22, allowing for capital controls. Emergency ECB funding would have plugged the gap in bank balance sheets created by deposit flight. Without this funding, deposit flight would have to be stemmed by force of law to prevent the island’s banks and economy from imploding. This is a serious line for a euro-area country to cross: Capital controls are legal under extraordinary circumstances, but they go against the notion of freedom of goods, labor and capital that is the principle tenet of the European currency union.

To read the rest, please see the original piece on Bloomberg View.

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3 Responses to Cyprus Shows Trust in ECB is Misplaced

  1. Michael Gauss says:

    Megan, just how lax were the Cypriot bank regulations in the first place? How easy was it to open an account? Were there any checks on large money movements like in the US?

  2. Pavlos says:

    Agreed. Moreover, a euro of deposit (M1) in any bank has to be the same as in any other EZ bank. Otherwise, we either don’t have a single currency or we don’t have a banking system. In fact what we have is a single M0 but an opaque system of balkanized M1 pseudocurrencies, where banks in different regions are subject to different and unpredictable liquidity and risk premia. When a nominal amount is transferred across a risk boundary, say Greece to France or vice versa, it appreciates entering the low-risk region and depreciates going out.

    This is hugely unjust and dysfunctional. The problem is basic, and has to be solved either by guaranteeing M0-M1 partity unconditionally arcoss the zone or by reintroducing exchange rates on M1. I don’t know if it would be practical to keep a unified M0, for the convenience of travellers and trade, but formally break the union for M1 and let deposits be locally denominated and float.

  3. Spartan says:

    I do agree that these capital controls and the taking of deposits is a serious limitation that indicates a look alike “eminent domain” principle. It is wrong, unlawful and unfair for the depositors. The main issue, however, is why the banks had no funds? Are really the deposits there? Any accounting? To me , it looks like the “old Wild West.”

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