“Over the weekend the European Union agreed to a 10 Billion euro bailout of member country Cyprus’ banking sector, but imposed as a condition of the bailout a 9.9% tax on all bank deposits above 100K Euros.[1]
On its face and in the abstract, this proposal is a horrible way to bail out a bank and an ailing economy, as it violates rule #1 of financial bailouts, namely “avoid bank runs.”
Not only does the proposal guarantee every Cypriot bank will suffer a run by all its depositors as soon as they open on Thursday, but every bank in Southern/peripheral/wobbly Europe – Spain, Portugal, Greece – has to wonder whether their depositors will do the same in anticipation of future similar bailout terms imposed by the European Union, and Germany in particular.
The fastest way to achieve a run on banks in weak countries is to suddenly punish depositors for leaving their money in the bank. Even to threaten to do so can create a self-fulfilling fear, one that leads quickly to bank runs.
The proposal also violates rule #1 of dealing with distressed banks, which is that depositors get treated better than bondholders. The European Union’s proposal to punish depositors – while bondholders suffer no losses – upends the traditional order of payment priority of bank liabilities.
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