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Monday, March 18, 2013

Chapter 11 Comes to Cyprus; Depositors Seek Critical Vendor Treatment

Cyprus bailout terms are in flux this morning, but the inclusion, in the terms announced over the weekend, of a one-time tax on depositors of 6.7% to 9.9% of the amount on deposit are producing major concerns over the safety of bank deposits throughout the eurozone and European bank stocks have been hit hard by the worries.

They call it a "tax" but it's also a default and a restructuring.  If you deposit 100 dollars and only get back 93 of them, that's a default in payment.  The mechanics of how that happens is a matter of form, but in substance, there has been a payment default.

Cyprus's banking sector appear to have acted as a financial hub that, in oversimplified fashion, took in deposits from Russian oligarchs far in excess of what could be loaned productively in Cyprus, and invested the surplus in Greek bonds.  Greek being itself insolvent, those bonds were haircut quite a bit in the Greek bailout, because they were held by "the private sector" and here we have the second order effects coming into focus.

It appears deposits up to 100,000 euros were insured but the insurer appears to be a government that is insolvent and unable to pay the insurance it held out.  So the various supranational organizations that are willing to bail Cyprus out are willing to do so in part but are also apparently trying to set an example for the future regarding the moral hazard of a poorly managed financial sector.

One thing that gets overlooked in most of the press reports is that the depositors will receive shares in the bank equal to half the value being deducted from their accounts.  This is why I refer to "Chapter 11" in the title of this post. This is the kind of thing that we might see in a chapter 11 - claims being converted to equity.  This is a very novel and potentially promising development for European restructurings in principle.  There is a lot of outrage being expressed about the confiscation of private property, and to some extent it's well deserved.  A government that borrows money and doesn't pay it back has indeed confiscated it.  But if it replaces the property taken with equal value, that is a different thing entirely so I hope that concept will be preserved in the renegotiation as it will be very useful over the long run of restructurings to come.

The problem, however, is that many depositors are feeling quite offended by the loss of principal, which was not a risk they thought they were taking.  Those of us who work on chapter 11 restructurings know this expression of bewildered outrage over a perceived injustice quite well.  We see it all the time, small investors who did not understand the risks they took in extending credit or buying equity in a firm that becomes insolvent and want special treatment.

The general philosophy of chapter 11 and bankruptcy in general is that special treatment is disfavored and losses should be spread ratably.  So we might say to the depositors, tough, you need to bear your share and you're lucky, frankly, you're not being wiped out much more.

However, some classes of creditors in chapter 11 do get special treatment.  One such class is "critical vendors", those whose continued business dealings with the firm are essential to keep it operating and generate value for other constituencies.  Because deposits are by far the cheapest way to fund a banking sector, and the largest proportion of its funding, I think depositors have a good argument for critical vendor status.  Getting deposits and being able to keep them over the long haul is essential to a bank's ability to lend money and that, for better or worse, is the main way economies function.  If the depository base becomes unstable because of a loss of confidence, whether we are talking about Cyprus or the Eurozone as a whole, then there could be significant harm to the functioning of the banking sector as a whole and thereafter the economy as a whole (in Europe, the financial sector is a much larger proportion of GDP than in the US).

One aspect of chapter 11 that is not being implemented in the Cyprus restructuring is a vote by the depositors on the conversion of some of their debt to equity.  But treating them as critical vendors and leaving them unimpaired would also avoid that sense of unfairness.  

In sum, although I think the idea of transforming claims to equity as part of the bailout is a positive addition to the policymakers' toolbox, I think the same policymakers would be wise to consider the knock-on effects for the banking sector across the Eurozone of the approach being taken to depositors and, as long as they are borrowing US chapter 11 techniques, recognize the utility of the "critical vendor" concept in respect of depositors.