Nervous shareholders turn away as confidence in European banking system dealt yet another blow

Should Cyprus 's two largest banks – Laiki and Bank of Cyprus – fail, the casualty list could include other Eu ropean banks. Shareholders will be wiped out. The situation for the banks' creditors is not as clear-cut. At present there is no effective legal structure in Cyprus to wind down banks.

The first step in a bank wind-down is to determine the level of losses. Loans to Greek customers contain huge losses. However, if these loans are sold in a quick-fire sale, additional losses will emerge. Any wind-down solution will therefore attempt to examine if a structure can be developed so that the additional damage from a quick-fire sale is contained. Already, there is talk of setting up a bad bank similar to Ireland 's Nama so that the sale of loans can take place in an orderly manner.

Once the losses are determined the next question is who gets hit first? The financing of Cyprus banks includes shareholders, subordinated lenders, the inter-bank market, large depositors and small depositors. After shareholders, subordinated lenders are hit. This group ranks before shareholders but after depositors and is therefore second from the bottom.

According to EU rules, known as the Basel Accord, banks should typically have shareholders' funds worth 4 per cent of assets and subordinated lenders comprise an additional 4 per cent. It follows that if the losses on the assets are less than 8 per cent the depositors in Cypriot banks need not worry. To deal with excess losses over 8 per cent, a distinction is made between insured and non-insured liabilities.

Protection scheme
As in most countries Cyprus offers a deposit protection scheme (DPS). Here the Central Bank has a dedicated fund which is designed for small deposit holders and current accounts (in all currencies) under €100,000. In deciding the level of cover the limit applies to the aggregate of all deposits and any liabilities are offset. So, if a customer has two deposit accounts – one for €34,000 and one for €28,000 – and also has an overdraft of €8,000, the compensation is the net figure of €54,000.

Large deposits are excluded from protection as are inter-bank deposits, accounts of pension funds, insurance companies and government departments. Furthermore, it appears that the burden falls on the Cyprus Central Bank. So, for instance, if one customer has a deposit of €30,000 and a second has a deposit of €120,000, both might get say 30 cents in the euro if the bank is wound up but the first depositor will get an additional €21,000 from the DPS scheme which will in effect be payable by the Cypriot Central Bank.

Understandably, German ministers are anxious to ensure that their voters will no longer pick up the tab for failed Europe an banks but the attempt to undermine the DPS and plunder the accounts of innocent deposit holders may have unintended consequences, including the potential drying up of funds from Russia into the European banking system. A default by any European bank will of course compound the problem.

Safe haven
By permitting banks to fail, the EU hopes that banks in Cyprus and the rest of Europe will realise that ECB emergency liquidity assistance (ELA) is designed to alleviate the temporary difficulties of solvent (as opposed to bankrupt) banks. However, the failure of the two top Cyprus banks will mean that the EU will almost certainly not recover the ELA assistance already given. Furthermore, Russia's large depositors will no longer see European banks as a safe haven for their cash, causing more liquidity stress for banks and ironically more ELA funding. Even profitable banks could suffer.

Banks need both shareholders and depositors to survive. Depositors feel secure if there are sufficient shareholder funds to absorb losses even in stressed situations. Irish banks regularly undergo EU-designed stress tests to reassure depositors that there is enough cushion to absorb losses even in stressed situations. The reality is that EU regulation has not worked that well in the past. Irish banks for instance followed EU rules and claimed that they were profitable and well financed while bankrupt.

Shareholders are turning away, depositors feel vulnerable – their confidence in the European banking system taking a treble blow.

The shortage of shareholders is one problem. Second, as the Bank of England has observed, the level of losses is still uncertain, and third, the EU has attempted to undermine deposit protection by raiding the accounts of innocent customers when their own rules fail to contain reckless banking. The high salaries and bonuses bankers still receive despite losses is hardly restoring confidence. Neither is the prospect that European banks who lent to Cyprus must take another hit.