The Independent Market Observer

3/18/13 – Is Cyprus the New Greece?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Mar 18, 2013 9:13:35 AM

and tagged Market Updates, Europe

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This will be a short post because I’m down in New Orleans at the Chairman’s Retreat conference. Commonwealth’s conferences offer absolutely wonderful content—my “Good Habits” post a while ago was based on an earlier one—and are a great deal of fun because of the people who attend.

I can’t focus on this right now, though, because Europe has come back with a vengeance as a risk factor. A bailout for the Cypriot banking system has been proposed, one that would whack individual depositors for the first time ever.

This is a big deal. Deposits are the core of any banking system—without them, banks have no money to make loans. By taking money away from individual depositors, from mom and pop, the Cyprus proposal could blow up the European banking system.

A similar situation helped tip the U.S. into the Great Depression. At the time, there was no deposit insurance; when banks failed, depositors lost their money. It’s no surprise that, at the first whiff of trouble, people wanted to withdraw their money from the banks, which often couldn’t pay, as they had the money out in loans. Many solvent but illiquid banks failed because of the bank runs. The classic example is the movie It’s a Wonderful Life, with Jimmy Stewart as the small-town banker.

Now, Europe has explicitly proposed putting depositors’ money at risk in the banking system. With the Cypriot bank rescue as a precedent, depositors in any country perceived as at risk—which includes Italy and Spain, among others—would expect that, if things get worse, their deposits could be in jeopardy. What would you do?

What I’d do is start to pull money out of my bank and my country’s banking system—exactly the opposite of what’s needed in Europe. As banks lose deposits, they have to pull loans in. As banks pull loans in, business contracts. As business contracts, unemployment increases. That’s exactly what happened in the Great Depression here in the U.S.

Deposit insurance was created to deal with this problem, and to erode it puts the banking system at risk. The last thing in the world the European banking system needs is more risk, or even the perception of risk.

The effects of this proposal are now propagating throughout the financial markets. The bailout has been postponed, and it’s uncertain whether it will go through. Make no mistake, this is a big deal. In fact, it could be what finally starts to break the European banking system.

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