Cypriot bailout terms welcome but further crises loom unless systemic action taken

From an Irish perspective the most remarkable aspect of events in Cyprus is how they represent a complete reversal of Eu ropean policy from the approach adopted towards Ireland.

In 2008 the Irish government offered a blanket guarantee to the creditors of Irish banks. By 2010 it was apparent that honouring this guarantee was ruining the creditworthiness of the Irish sovereign.

At that time Europe 's approach was to do everything possible to protect bank creditors. The European Central Bank provided enormous loans to Anglo Irish Bank to ensure bondholders and depositors got their money back; it is the repayment of these loans by Irish taxpayers that landed us with the dreaded promissory notes. Even after Ireland's banking problems landed it in a bailout, the European authorities used all their powers to ensure even unsecured, unguaranteed senior bondholders were repaid.

The thinking at the time in Europe was they didn't want to "roll the dice" and find out what would happen across the EU if bank creditors lost money. The memory of former US treasury secretary Hank Paulson 's decision to let Lehman Brothers go bankrupt was uppermost in European minds and they weren't going to let a small Irish bank threaten financial stability.

Fast-forward to Cyprus in 2013: Cyprus’s two main banks are insolvent because they purchased large amounts of Greek bonds (partly because they accepted assurances from euro zone leaders that there would be no default on these bonds).

Apparently now believing the approach taken in Ireland was misguided, euro area leaders have reacted in a completely different fashion. The ECB refused to continue providing more credit to bust Cypriot banks and the euro group of finance ministers refused to provide loans to fund Cyprus’s budget deficit unless a condition was met: that Cyprus’s banks be returned to solvency by writing down their obligations to creditors.

Unwise and damaging
Most of the discussion about Cyprus over the past week has focused on certain aspects of the initial plan. The suggestion of imposing a levy that hit small savers covered by deposit guarantee as well as creditors of Cypriot banks that were not insolvent was unwise and hugely damaging to the credibility of Europe's deposit insurance programmes.

These initial design flaws have been rectified. The two insolvent Cypriot banks are being put through resolution procedures that will see equity holders and bondholders lose out and uninsured deposits subjected to a hefty write-down. Insured depositors will get their money back and those who have accounts with solvent banks will not be touched.

These revisions to the plan are welcome. If bank creditors are to lose money it is appropriate that this occurs through a fair and transparent resolution structure that wipes out equity first, then bond investors and uninsured depositors, while respecting deposit insurance. Still, it is important to recognise that the principle set out by the euro area leaders has been stuck to: bank creditors are no longer sacred in Europe, not even depositors.

After this weekend's deal, one might have expected the usual guff from EU leaders about Cyprus being unique and creditor losses never happening elsewhere. Somewhat refreshingly, however, Jeroen Dijsselbloem, the new head of the euro group of finance ministers, candidly admitted yesterday that the approach taken in Cyprus will provide a template for dealing with insolvent banks in the future. Dijsselbloem suggested that creditor write-downs should avoid the need for the euro area's bailout fund, the European Stability Mechanism, to ever be used to recapitalise banks.

So Europe’s leaders have decided to roll the dice on bank creditors after all. Time will tell how this call works out. Over the next few months large investors are likely to be extremely skittish about parking their money with banks rumoured to be in difficulty. The probability of silent bank runs of the kind that brought down the Irish banks in 2010 has been distinctly raised.

Common approach
Ideally, Europe would now fast-track its plans for a common supervisor and a common approach to bank resolution and then use these powers to deal with problem banks once and for all. A systemic approach to sorting out banking problems throughout the euro area that featured large creditor write-downs would be tough on those who lose money. However, it would allow a cleansed and recapitalised banking sector to get back to doing what it is supposed to do: providing a safe place for people's money and allocating that money towards sound investments.

Unfortunately, the euro area doesn’t do “fast track” or “systemic”. Slow and chaotic provides a better description of the policy process. The combination of weak banks, skittish depositors and on-the-hoof policymaking does not bode well for the next phase of the euro crisis.

The euro may emerge from this crisis with a recapitalised banking sector governed by tough rules that see noninsured investors aware there is no government safety net to rescue them. But one can envisage other outcomes.

Tenuous euro
The political lobbies against write-downs for uninsured deposits in Italy and Spain would likely be very powerful. The introduction of capital controls into Cyprus shows how tenuous the single currency now is. A euro in a bank in Cyprus is patently not the same thing today as a euro in a German bank. Without a systematic approach to restoring Europe's banks to health, the next crisis may see a country leave the euro and the whole project unravel.

And what of Ireland? Does the Cypriot deal help or hurt Ireland’s chance of getting a retrospective deal compensating for the cost of recapitalising our banks? I think the chances of such a deal have been downgraded from slim to none.

Europe may now be admitting that its approach to Ireland was incorrect. But our politicians also played a crucial role in bailing out the banks: nobody forced the Irish government to pass a blanket guarantee (a guarantee for which Fine Gael voted). So the moral argument for retrospective compensation may have improved a bit but there is perhaps less sympathy out there than Enda Kenny would hope for.

More importantly, events in Cyprus have been driven by "bailout fatigue". Voters in Germany and elsewhere have grown tired of lending money to Europe's periphery, never mind giving it away. So, morality aside, a compensatory deal for Ireland is not on the cards.

Karl Whelan is professor of economics at University College Dublin