Edwin M. Truman’s interview on Peterson Perspectives and Interviews on Current Issues says that European authorities miscalculated by looking to depositors, rather than bondholders, in funding the bailout of financial institutions in Cyprus. In return for 10 billion Euro ($13 million) bailout, the European Central Bank and the International Monetary Fund looked to Cypriot depositors to kick in 7 billion Euros in return for bailing out financial institutions that were on the brink of bankruptcy. This was unusual because typical bailout terms involve either losses to bondholders or fiscal promises from governments themselves. Of course, asking the government to place a down payment in return for a bailout would entail raising taxes on their people, which would be politically unpopular. In fact, the Cyprus parliament rejected the deal and is currently seeking to revise the bailout terms.
Specifically, the 7 billion Euros would be raised by taxing all depositors with funds less than 100,000 Euros at 6.75% and 9.99% for depositors holding 100,000 Euros or more. Even though large depositors will be taxed at a higher rate, the difference is small, so the tax burden falls heaviest on low- and middle-income earners.
When Truman was asked why Europe authorities did not ask bondholders, who held the debt of declining Cyprus banks, he inferred that it would not raise enough external funding to make it palatable for them to agree to the bailout. Specifically, he said that asking bondholders to take a 10% loss on their bond investments would be inadequate. The risk in asking them to take a much larger cut would be the risk of losing critical access to foreign capital, which could result in even more turmoil in Europe.
Another option available to the Europe is to give Cyprus a no-strings attached bailout, but that would have moral hazard implications. Moral hazard is where current actions will lead to riskier actions in the future. If they are bailed out, what is the incentive to affect change within their banking and political systems and prevent it from occurring again? It would also be unfair to Greece, Ireland, and Portugal, who received bailouts at a high political cost.
The most likely solution would be to force Cyprus to raise taxes in the future in order to pay off the bailout. That is what occurred in Greece, Ireland, and Portugal. This is the probable scenario in any revised bailout. This was not pursued initially because Europe saw an opportunity for immediate repayment by taxing deposits that were already on hand. However, they did not anticipate the political fallout and turmoil that this caused. Consequences included declining faith in banks as depositors rushed to take their deposits out of the banks, which forced Cyprus to freeze all bank accounts to prevent a severe run on banks. Also, there are possible legal ramifications with this move.
Of course, Cyprus could reject all bailout terms and risk banks failing and lead the government toward bankruptcy. In this scenario, depositors and bondholders would potentially lose everything. Therefore, Cyprus authorities are counting on more favorable terms because they know this scenario would be crippling to Europe and result in unknown market turmoil.
This is yet another unfortunate event that cannot help a Europe that is in economic decline.