The bailout of Cyprus, funded upfront by the depositors in Cypriot Banks, is another superb example of international political economy at work at Brussels. Brussels has killed three birds in one stone. First, it has created an impression that bailout of Cyprus is now complete. Second, it has hit at Russian Oligarchs who have stashed their wealth in Cyprus. Third, it has hurt Cameron, the British PM, who dared to challenge the EU. Cameron had to hurriedly announce a bailout of bailins. Thousands of British soldiers based in Cyprus, and having bank accounts in Cyprus, would have lost millions of Euros to this new dictate by Brussels. Now, the British government has been forced to make good these losses.
Excellent! Bravo! We have just seen a great piece of economic diplomacy at work. Now, the question is what happens to the concept of capital structure of a financial institution. The great innovation (or should we say, illusion) of first claim of depositors of the bank on the assets of the bank has been truly thrown out of window. This is not the first time that Brussels has acted in an arbitrary manner to throw the rules of international financial arrangements in disarray. The very first instance of arbitrary behavior by Brussels was seen in late 2008, when the Irish government was prodded to bailout Tier II bondholders of failed Irish Banks. Tier II bondholders are, as per definition of Basel Committee, risk participatory economic agents. However, they were bailed out in Irish Banks – forcing Ireland into economic disarray - in spite of having absolutely clean public finances before 2008. It was said that many Tier II bondholders of Irish Banks were from powerful Eurozone countries, and hence their bailout was of prime importance to Brussels. It is also possible that Tier II bonds of Cypriot banks are held by non-Russian, non-British entities. Hence, they are seemingly spared of immediate losses, in spite of getting paid for assuming the risks of subordination.
It may seem on the surface, that this arbitrary behavior of international power centers such as Brussels, makes the life of investors difficult, as they may be hit by an event, which legally should not happen, except in the event of a war (such as forcing of first loss on bank depositors in subordination to Tier II bondholders). However, this should not be case. Investors who realize that we are currently deeply into an economic warfare will do very well. It is important to realize that the current economic warfare is a result of multitude of forces, with the first being the hijacking of democratic institutions in many major countries by private lobby groups. The second force is the emergence of TBTF principle, first applied in the USA in 1984 for the failed bank, Continental Illinois. This has now become a universal monster, rendering undue perceptional preference subsidy to the larger global banks, to the tune of $300 billion per annum as per some estimates. The third force is the emergence of extreme banking leverage in the face of regulatory capture of banking regulators across many large economies. The fourth force is the emergence of unsustainable entitlement programs in developed countries. It can be argued that the fourth force is just a political counterbalance for the first force. Finally, the fifth force is preference to use monetary stimulus over real economic adjustments. These five forces mean that policymakers have too many balls in the air to juggle at any one time. Given these distractions, it is possible, for those with means and will, to bend and mend midnight policy pronouncements (usually all bailouts are a result of marathon meetings requiring superhuman abilities) to suit their narrow goals. Investors should keep this in mind, and try to be in the company of the unscrupulous mighty. Because, next time a crisis hits, the one with greater firepower is going to emerge a winner – never mind what the peacetime international economic conventions say on the rights of investors.