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What Caused the Cyprus Banking Crisis?
By Mel Miller

By Mel Miller, Chief Economist

While there were many contribution factors to the crisis in Cyprus, I want to focus on the most obvious cause—the basic accounting formula.  Assets=Liabilities + Capital. Couple the formula with lack of regulation and the groundwork is laid for a banking crisis.

In simple terms, the basic cause of the Cyprus banking crisis was rapid growth in liabilities (deposits). Banks that desire to grow rapidly end up relying on non-core deposits which then must be invested in assets (loans and bonds). Cyprus banks became the go-to depositories for the region and beyond, even to the point of seeking deposits from wealthy Russian individuals. Cyprus is a tax haven for the wealthy.

Why is this growth of non-core deposits dangerous? Basically the funds must be invested. In the case of the small economy of Cyprus, the money banks had to lend spurred a housing bubble, which as we know, can collapse at some point. Also, in an attempt to invest the deposits to make a spread (profit), the Cypriot banks invested in Greek sovereign debt and Greek commercial loans. When Greece was forced to write-off 50% of the value of its debt to obtain a bailout, the die was cast for Cyprus. The asset write-offs were charged directly to Capital devastating an already low capital base.

Many community banks in the U.S. collapsed in the Great Recession for the same reason. Not satisfied with seeking core deposits from known customers, they obtained brokered CDs, and then invested in brokered loans in rapidly growing areas of the country, like Arizona, Florida, and Nevada. When loans outside their lending area became a concern, many banks invested in risky non-insured CDOs (Credit Default Obligations) and CMOs (Collateral Mortgage Obligations).

Community banks in the U.S. are now limited to approximately 20% non-core funding and are much stronger than before. Unregulated growth can cause problems—and it did in the last financial crisis. Cyprus is now dealing with a similar problem, and their “solution” of taxing liabilities (large depositors) to restore capital to acceptable levels is risky and could result in bank runs. We shall see…

Posted: April 9, 2013