The Cyprus crisis and bailout drove European credit, equities, and the euro currency lower. Borrowing costs for other periphery countries such as Italy, Spain and Slovenia rose. Italy had a weaker than expected sovereign bond auction (even though the persistent political uncertainty in the country also had a major impact on that transaction).
It is reasonableto query why Cypriot banks could not have been provided liquidity by the ECB
However, on balance the market reaction may be said to have been relatively contained. It would be tempting to dismiss this resilience as reflective of the small size of Cyprus. It may also be argued that financial markets were somewhat reassured that, to a certain extent, the tail-risk event of Cyprus exiting the euro has for now subsided. However, it is also useful to try to understand the implications of the Cyprus bailout, particularly for investors in credit markets.
In the current version of the bailout agreement, Cyprus will receive €10 billion in exchange for wide-ranging adjustments to its financial system and fiscal policy measures. The Cyprus Popular Bank (or Laiki Bank) will be closed down, with the Bank of Cyprus surviving. Deposits in both banks of over €100,000 (not guaranteed by EU law) will be levied by up to 40 per cent. Following the justified anger at the measure, small investors were spared from the levy – deposits below €100,000 in Laiki Bank are being shifted to the Bank of Cyprus. There are capital controls including limitations on withdrawals and transfers abroad.
Generally, the nature of this bailout represents a shift to make the private sector incur a higher cost in relative terms compared to the public sector. Basically, whether it involves shareholders, bondholders, or even depositors, authorities are intent on as much as possible avoiding the transfer of bail out costs onto taxpayers. Cynically, it may be argued that this is considerably driven by the context of an election year in Germany.
More specifically to credit markets, the “bailing in” of depositors characterising this bailout, is a development that is likely to impact prospects for bonds of European banks. This was also evident in the market reaction so far.
The iTraxx Europe Senior Financial index, which reflects the costs of credit default swaps on banks (rising when investors become more risk averse with respect to bank credit, and vice versa) increased by more than 25bps when the bailout was announced. This represents a larger movement than the one experienced in other sectors and the wider market.
Investors are now aware that authorities are willing to make even depositors pay for bailouts, further weakening their own position in restructurings. In fact, losses are shared among shareholders, subordinated bondholders, senior bondholders, and uninsured depositors – in that ranking order. Basically, bondholders have been alerted that they are risking higher write downs on their bank bonds in future bailouts.
It was noted by some analysts that there seems to have been a degree of underestimation of how the losses on the assets of Cypriot banks, in combination with deposit flight, resulted in insolvency. If such a scenario plays out in Spain and Italy, where asset concerns could be focused on loan quality in countries mired in recession, it is worrying for investors. Again, markets are pricing an uptick in such risks. For example, the Intesa San Paolo 4.375 per cent due 2019 is currently yielding 4.5 per cent, more than 40bps compared to levels before the Cyprus bailout.
Lack of clarity on future measures and mixed signals have also added to the uncertainty. The comment by Jeroen Dijsselbloem, Dutch Minister of Finance and Eurogroup president, that the Cyprus deal could be a “template” for future bailouts, notably made headlines. On the other hand, several other politicians and other authorities have been claiming that Cyprus is a special case with extraordinary characteristics.
Even after allowing for the undesirability of using taxpayers’ money, it is reasonable to query why Cypriot banks could not have been provided liquidity by the European Central Bank, similarly to how the European Stability Mechanism will be able to recapitalise eurozone banks as from 2014.
Beyond the precarious state of Cyprus’ economy, the specific demerits of the way the bailout was structured, and the fact that policy measures continue to be driven solely by crisis events, we would expect the outlook for credit markets to weaken slightly. This is particularly the case for bonds issued by banks of other periphery countries.
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Curmi & Partners Ltd is a member of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The value of investments may fall as well as rise and past performance is no guarantee of future performance.
Karl Falzon is a credit analyst at Curmi and Partners Ltd.