No doubt by now you’ve learned about new crisis in Europe. Instead of being a major country, or even a medium sized one, it’s one of the smallest. Cyprus only has about a million people which is significantly bigger than Iceland, but only about the size of Dallas. There’s no reason why anything that happens there should create panic in markets around the world. That’s what EU regulators thought at least when Cyprus’s bailout was being negotiated anyway. But let us not get ahead of ourselves. First we need to see how Cyprus got here.

Cyprus as a country opened themselves up for allowing foreign depositors to keep their money in their banks. Cyprus had way more in deposits than Cypriots could ever borrow so the money was invested elsewhere, like in Greek bonds. As soon as the Greek debt was negotiated, Cypriot banks knew they were in trouble. By the time a bailout was negotiated for Cyprus, countries like Germany were tired of picking up the tab. So part of the deal is that all deposits held in Cyprus will be subject to a tax which is basically a wealth tax. How would you like if to bail out US banks you had to fogoe 10% of all the money you had in your checking account?

Cyprus is Europe’s Lehman moment.

If you don’t remember Lehman Brothers I’m not surprised. They were a major Wall Street player and when they failed, the regulators decided to let them die. No bailout. Sounds nothing like Cyprus right? Right.

But there are parallels. Up until Lehman’s failure there was precedent that any bank in financial trouble would get absorbed into the system. The government was playing broker in many cases or lender of last resort. But by the time Lehman came around they’d said enough. Let it die. Well that set off a string of panics and failures that ultimately lead to TARP. In hindsight, the failure of Lehman set a precedent that the government could let the financial system collapse.

Cyprus has its own precedent. Until now, when when countries and banks needed bailouts it was investors that got screwed. Citizens felt the pain through austerity but their savings were preserved. Now, Europeans can fear that even their bank accounts may not be safe. A straight haircut of wealth is not a happy proposition. And like Lehman the news has set off a string of fear. If Greece needed a new bailout, this could be a new mechanism that might be on the negotiation table. Everyone would pull their money out of the banks, making the continent insolvent.

Unlike Lehman, Cyprus is not systemically important to the greater economy. But like the failed company, the actions taken by those deciding their fate have set off a string of new fears. Cyprus has yet to approve of this plan, and based on the backlash we’ve seen so far they may not ever do so. A new bailout would need to be designed, but it’s not clear how it would work.

Even if you don’t think Cyprus is relevant to your day to day life (you’re right, it isn’t), it’s important to understand why people have panicked. Any country or company that overstretched itself needs to feel the pain that comes from that. But not so much that it sets off a chain reaction that makes things worse for everyone.

Image: Concrete Forms

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categories: banking, economics