Past as Prologue - Cyprus and Violation of Seniority of Claims

Problems of the Cypriot banking system were largely due to ill-advised investments in Greek assets, complicated by the unusual capital structure of Cypriot banks. A “typical” bank’s capital is 15 percent equity, 25 percent debt and 60 percent deposits. When the bank gets into trouble, the first losses are taken by equity holders, followed by debt holders and only then depositors if the value of the first two stakes is insufficient. Deposits at Bank of Cyprus and Laiki comprised 83 percent and 86 percent of the capital structure, with nearly all the rest equity. (This should have been a major red flag for anyone exposed to these banks.)

By 2013, the banks were in trouble and it was clear that someone had to take losses. Insured deposits were paid in full. But uninsured deposits are senior creditors, and receive compensation together with other senior creditors insofar as assets remain after insured depositors have been paid. (This differs from the situation in the United States and other jurisdictions where uninsured deposits are super-senior and paid ahead of senior creditors. Contrary to some conspiracy-minded Internet musings, this is nothing new and is not confiscation but merely the seniority of claims.)

However, in 2013, Cyprus confiscated nearly half of uninsured bank deposits while over €9bn in liabilities to European National Central Banks (NCBs) was not touched. NCB loans were collateralized by Greek debt instruments. Any deficiency in collateral is an unsecured claim with the same standing as other claims, including uninsured deposits. Thus, funds remaining after paying insured deposits should have been divided among remaining claims, including uninsured deposits and NCB loans, not preferentially funneled to the latter.

Additionally, as a reward for expropriating uninsured deposits, the Troika extended €10bn on easy terms, and various other financial incentives were granted, allowing Cyprus to avoid default on its bonds. Thus, not only did the NCBs get paid in full, but also holders of Cypriot bonds, such as European banks and hedge funds, were made whole at the expense of depositors, since failure to redeem liabilities to NCBs would have led Cyprus to default.

Strictly speaking, this was not a sanction because it occurred before events in the Ukraine. Nevertheless, it is strikingly similar.

Returning to our four criteria, in this case the short-term damage was greater to the victim, namely depositors in Cypriot banks. Indeed many have justified this expropriation due to the shadowy source of the deposits (Russian mobsters) although in the 20 prior years no such qualms were expressed and many depositors were ordinary people and businesses. In any event, this does not validate violation of the rule of law and the sanctity of contracts.

In the longer term, the damage to the system is likely to be far greater. Not only is it a disincentive to deposits but also questions the role of banks as capital intermediaries, especially in an age where access to markets and innovations such as crowd sourcing are on the rise. The zeal of central banks to defend the financial system is understandable, since disruptions can have profound economic repercussions, including depression and even war, but at what cost? A very dangerous precedent has been set. If depositor funds are regularly used to recapitalize banks, the depositor base will quickly erode, which is in and of itself disruptive to the financial system.

These actions were perpetrated to protect the European banking system and unelected EU and ECB officials who made a conscious choice to inflate collateral values, violate the rule of law and sanctity of contracts to prop up Cypriot banks. Furthermore, there is strong evidence to suggest that Central Bank of Cyprus officials played down problems in the banking sector until after the 2013 presidential elections. Thus, on multiple levels infrastructure crucial to the functioning of capitalism was damaged to achieve short-term political goals.

Clearly this does not advance Western dominance in global economic affairs and gives pause to those considering entering economic relations with these institutions. If Cyprus becomes a template for resolution of problematic banks in the future, as many central banks and international financial institutions have suggested, the perceived safety premium of Western institutions will dissipate further. (One shudders to think what would have been the consequences if there was a levy on all deposits, as was originally proposed.) If confiscation of all deposits is insufficient to the task at hand, do we move on to senior secured debt to protect a more junior but politically favored creditor? If so, if contractual stricture and the rule of law are disregarded when convenient, who would ever make a deposit or loan to a bank?

Lastly, such actions do nothing to discourage the behavior that led to the problem in the first place. If anything, the takeaway is that such behavior, reckless lending in this case, is in the economic actor’s self interest, since he retains the upside and the downside is pushed onto depositors, creditors and taxpayers.

Economic Sanctions and Credit Cards – Destroying Financial Innovation

Thanks to subprime mortgages, MBS and other derivatives, financial innovation today has a negative connotation. However, this is due to misuse of the innovations, which in and of themselves offer great benefits in efficiency, allocation of risk and cost of capital.

A great financial innovation is the credit card. It allows you to buy almost anything, anywhere in the world, obviating the need for cash, which has negative carry and the risk of loss (and perhaps bodily harm) and drastically cuts down frictional costs, e.g. prepayment, guarantees and currency conversion. They have increased the people’s wealth as well as the quantity and quality of leisure time. Credit cards have become so ubiquitous, with 7.5 billion outstanding and 149 billion transactions per year, that it is hard to imagine modern life without them, although they only appeared a half century ago and achieved widespread use only in the 1980s.

On March 20, 2014, the U.S. government imposed sanctions on Arkady and Boris Rotenberg for “providing material support to Russian government officials,” i.e. being part of Putin’s inner circle. (Interesting to note that neither has been charged with any crime and were not involved in the Ukraine at all. If using political influence to gain economic advantage is a crime then legions of Western businesses and businessmen should be in the dock. Is K Street to be razed?) The next day, Visa and MasterCard stopped processing transactions of cards issued by SMP Bank, which was majority owned by the Rotenbergs. The bank itself was not sanctioned until later. More importantly, all but a handful of the bank’s 170,000 cards were issued to ordinary people, largely employees of the brothers’ construction and other companies.

Thus, in this case, the greatest harm was inflicted on ordinary Russians who have nothing to do with the government of Russia, Ukraine or the United States, but nevertheless lost access to their money as a result of sanctions. Those hawking sanctions try to make the case that the anger of ordinary people suffering will be directed at the government and the inner circle, but it is clear that they blame those who approved and implemented the sanctions.

In the longer term, damage to the initiator can be much greater, and in this case erodes U.S. credit card dominance. As it is, the fastest growing credit and debit card company in the world, both in terms of transactions and cards issued, is China’s UnionPay, which was already set to be a major challenger to Visa and MasterCard due to its dominance in settlement and payment services in the world’s largest market. Western readiness to sanction credit cards no doubt served as a wake call to China and others and will lead them to redouble their efforts.

Globally, UnionPay is likely to be a major beneficiary of the sanctions. In Russia, its plan to reach 2 million cards by 2016 from under 100,000 currently look more realistic given the external environment and that several top 20 Russian banks have already begun issuing UnionPay cards. Even if required by law, such suspensions of service should help UnionPay eat into Visa and Mastercard’s 90 percent Russian market share.

Russia is even launching its own credit card, “Mir.” Although it would likely be limited to domestic use for the foreseeable future and is unlikely to capture significant market share, it is negative for Visa and MasterCard, which have invested heavily in Russia due to low penetration (only 30 million cards issued) and high GDP per capita. While Russia is unlikely to expel Visa and MasterCard, they will face more scrutiny and costs, whether in terms of compliance and audit, or requirements to deposit cash at the Russian Central Bank (RCB), all of which will adversely affect the bottom line. Additionally, the RCB now requires all domestic transactions to be cleared through the National Payment Card System (NPCS), depriving Visa and Mastercard of an important source of revenue and information.