IV. Reflections on the Cyprus Bailout

This page provides a broad summary of the run-in to the bailout. 

See here for my papers on the demise of  Laiki/Cyprus Popular Bank - Not So Lucky Laiki - timeline of developments - Laiki Timeline - and the peculiar nature of the Cypriot economy - the Icarus Economy

For a useful summary from Cyprus see Fiona Mullen of Sapienta Economics. Mullen is one of the best commentators on the Cyprus economy and less inclined to hyperbole and knee-jerk defensiveness than some people who should know better.

Cyprus delays the showdown


Ex-Cypriot President, Demetris Christofias was determined to delay the crisis in 2012 and endlessly sought alternatives to an EU bailout and assistance with the growing banking problem. He was due to step down from the presidency in February 2013 and did everything he could to stop his party, AKEL – the Cypriot communist party - carrying the can for the crisis.


Laiki Bank

When in power Christofias secured a €1.8bn state bail-out of Laiki (Cyprus Popular Bank) and signed a €2.5bn loan from Russia. He undertook increasingly desperate attempts to find other non-EU sources of loans, including China, to no avail. When the public cash started to run out the government began to raid state-owned utilities for cash to keep the ship of state afloat.


On that initial Cyprus bank bailout: Cyprus banks faced strong headwinds after the Greek bond haircut. They held €22bn of Greek enterprise and individual debt.  Their large holdings of Greek state debt resulted in a €3bn haircut following the PSI – private sector initiative – write down of these debts.


Cyprus Popular Bank (CPB) Laiki, the country's second largest, could not raise sufficient capital to cover its share of this loss - €2.3bn - (FT Hope, 15 May 2012 and 05.06.12) and a €1.8bn share issue (equivalent to about 12 per cent of the island’s GDP) was underwritten by the Cyprus government. (Popular's Greek management team resigned under pressure from the Cyprus Central Bank as they were held responsible for exposure to the Greek debt and for a sharp rise in non-performing loans in its Greek branches (FT Hope, 15 May 2012). 


CPB's largest shareholders are Dubai Holdings (17-18%), the Greek-based Marfin Investment Group (which also provided the bank's senior management team) and the Cypriot family-owned Lanitis group (4-5%).


Popular was unlucky or imprudent or both because by being based in Cyprus it was not eligible for recapitalisation under a €48bn rescue package for Greek banks included in the country’s second EU/ECB/IMF bailout (FT Hope, 15 May 2012). For some reason Popular's Greek subsidiary converted to a branch in 2011 thus shifting the liability for recapitalisation from the Greek to Cypriot authorities (see Gabriel Sterne 2012  background note at Exotix). In retrospect this looks like a disastrous decision (see also Wall St Journal on expansion into Greek markets and my paper on the demise of Cyprus Popular Bank here).


THE UK's new financial regulator, the Prudential Regulation Authority, ( a unit of the Bank of England) has decided that Laiki bank depositors in the UK will be covered by the UK's deposit protection scheme (up to £85,000 at least).  This is being justified on the grounds that the Laiki UK banking operations are being rolled into the UK operations of the Bank of Cyprus, in line with the bailout in Cyprus.


This protection is being afforded even though Laiki's UK operations were run as a branch (rather than UK-based subsidiary) operation and were not covered by the UK deposit protection scheme (see FT Jenkins 2 April 2013).  Laiki UK's 15,000 deposits are valued at £270m (Daily Telegraph 2 April 2013).


The FT  says Laiki UK 'was popular because of the high interest rates it paid out on fixed bonds.' (see FT Jenkins 2 April 2013).


(For a detailed insider account of events at Laiki between 2011 and the bailout from Reuters see ekathimerini 2 April 2013 and my paper).


Bank of Cyprus

The Bank of Cyprus (not to be confused with the island's central bank) announced it needed €500m to make up its capital requirements in 2012 (Cyprus Mail 28.6.2012). 


An  article in the New York Times (31 March 2013) details the way in which BoC withdrew from Greek bonds in 2010 only to plunge back into the market in early spring 2010 in what the article claims was in essence a bet on the difference between the buying price for the bonds at 70 cents in the Euro and the loss on the bonds when that occurred.  The paper quotes a Cypriot banker familiar with the transactions,


“This was pure speculation — European banks like Deutsche Bank were desperately trying to get rid of these things.”


When Greek bonds were written by 75% in March 2012 BofC lost €1.6bn - 4.4% of its assets.


The FT has drawn attention to the over-extension of Laiki  in Greek bonds and corporate lending. It quotes Lambros Papadopoulos, an independent analyst,


“It got into trouble because of very aggressive expansion mostly in Greece. The balance sheet got overstretched and then Greece went wrong.”


It also refers to other analysts who say that Laiki’s move into the Greek corporate market was badly timed as it sought to expand just as recession hit (FT Hope 22nd March 2013).


Interestingly Fitch, the ratings agency, says that the reason for the BB+ to BBB- downgrade of Cypriot sovereign debt in 2012 was in part down to the deteriorating position of Cyprus's banks in Greek corporate and household markets.


‘This is principally due to Greek corporate and households exposures of the largest three banks, Bank of Cyprus, Cyprus Popular Bank (CPB) and Hellenic Bank and to a lesser degree the expected deterioration in their domestic asset quality.’ (Fitch quoted in FT David Keohane Blog 25 June 2012 - see also FT Hope 22nd March 2013 for the reckless expansion of Laiki).


Some small savers (17,000 of them in total) who invested in the PBC and BofC convertible bond issue above (posting a return of 7%) protested outside the BofC's HQ  at the end of January 2013 as threats emerged that they might be sacrificed as part of a haircut on the banks' creditors as part of the EU bailout of the banking sector (see FT Jan 31 2013). There protests were in vain. They were sacrificed.


(This is very similar to the fate of Bankia customers/investors in Spain – who’s shares were recently written down to €0.01 after being aggressively sold the shares as savings account equivalent risks. See FT Buck 22nd March 2013).


At this point President Christofias dismissed the head of Central Bank of Cyprus, Athanasios Orphanides, in April 2012 after he had openly criticised the government. Asked in 2012 if he had any regrets since he had become  governor in 2007, Orphanides said:

"I strongly feel personally responsible for failing to convince President Christofias and his economic advisers from the end of 2008 on how badly the economy was deteriorating and the significance of taking immediate measures to fix the situation. I feel personally responsible for failing to convince them of the seriousness of the situation" (Cyprus Mail 3 May 2012).


He was replaced by Panicos Demetriades, a professor of financial economics at Leicester University (FT Hope April 29th 2013).


Piraeus Bank and the fate of Cypriot branch networks in Greece

The Greek bank Piraeus Bank (FT Hope 22 March 2013) bought up the Greek operations of Cyprus Popular Bank (Laiki), Bank of Cyprus and Hellenic Bank, as well as the Investment Bank of Greece (IBG), a Laiki subsidiary – in all 312 branches for €524m (Ekathimerini 27 March 2013).  Piraeus expects to close half of its expanded network of 1,600 branches (FT Chaffin 26 March 2013).


Piraeus Bank - which took over the 312 Greek branches of Cyprus bank's in March 2013 as part of the bailout - was a direct beneficiary of the EU recapitalisation of Greek banks in May 2012 and received €4.7bn bonds from the European Financial Stability Fund via the Hellenic Financial Stability Fund in May 2012 (FT Hope 28 May 2012).


These bonds were designed to act as collateral which would allow the banks involved to regain access to the ECB’s liquidity operations at cheaper rates than under the Emergency Liquidity Arrangement. This mechanism was denied banks in the Cyprus bailout.


The Greek finance ministry also pledged to inject €1.5bn of new capital into the combined Greek operations of the Laiki and BofC banks before they were taken over by Piraeus Bank.


The EU presidency and Vasilikos Explosion

Two factors complicated the developing situation in Cyprus. Firstly, the country assumed the six-monthly rotating presidency of the EU in July 2012 and bailing-out the country in the presidency would have been, to say the least, embarrassing. And secondly and  earlier, on 11th July 2011, a massive explosion of confiscated armaments killed thirteen and knocked one of the Republic’s two power stations out of action.


This led to a political crisis that resulted in the resignation of the island's Foreign Minister, Markos Kyprianou. (See FT 28/07/2011, Cyprus Mail, 10/07/2012).


The arms and explosives - 98 containers in all- had been confiscated from a Cyprus-flagged ship sailing between Iran and Syria following a US tip-off that the ship was breaking international sanctions against Iran. The containers were stacked at Evangelos Florakis Naval base next to the Vasilikos power station. Apparently an internal investigation showed that UN inspections of the cache had been three times delayed by the Cypriot government (FT 03.10.11. and 10.07.2011)


A cabinet-led non-binding enquiry into the incident by a cabinet-appointed lawyer, Polys Polyviou, concluded that the President, Demetris Christofias and his foreign and defence ministers were responsible for the blast. The ministers resigned but the President refused  to accept the findings of the enquiry.


Since then former Foreign Minister, Marcos Kyprianou, former Defence Minister, Costa Papacostas, former National Guard deputy chief Savvas Argyrou, the  fire service chief, Charalambos Charalambous and Andrea Loizides, the commander of the disaster response squad, have been charged with manslaughter and cause of death by negligence. The court proceedings are ongoing (Cyprus Mail, 12 July 2012).


Returning to economic crisis, President Christofias vowed that he would not sell Cyprus’s workers down the river (with their thrice yearly cost of living increases) nor agree to a programme of privatization. So he temporized and sought short-term solutions that kept the show on the road. Eventually with the downgrade of Cyprus bonds to junk status Cyprus was obliged to seek a bailout from the EU (25 June 2012).


Perhaps Christofias’s and AKEL’s calculation was to step aside from government and let the centre-right Democratic Rally (DISY) party led by Nicos Anastasiades do the dirty work of restructuring in the hope that AKEL would return to power at the following elections with the new gas fields discovered in the Levant basin in full operation and providing the funds to write off the crisis as someone else’s nightmare (see FT Barber 19th February).



Back in Brussels

The EU and member governments were aware that an unsustainable situation was developing in Cyprus. Ollie Rehn, the EU’s top economics official, approached Cypriot President Christofias in November 2011 to sound out the Cypriot government on a possible bailout (FT Spiegel, Hope, Peel, 22nd March 2013).


It is said that Angela Merkel regarded the Cyprus situation as number one issue in the EU back in 2012 but without the co-operation of the Cypriot government there was little that the EU could do to force the situation.


Commission and member state levels of exasperation with Cyprus were already high. Cyprus had only been accepted into the EU at the insistence of Greece, which had threatened to veto all other accessions until Cyprus was a member.


EU officials and member states believed that Cyprus’s accession would lead to a positive approach from the Republic of Cyprus to the peace proposals for the divided island under the Annan Plan. But no sooner was Cyprus in the EU than the government recommended rejection, rightly or wrongly, of the plan in a referendum. Apparently EU officials were livid about this and felt that they had been taken for a ride (see FT Rachman March 18th 2013).


Cyprus’s continued propensity to support Russian foreign policy initiatives at the UN did not help (see votes over Kosovo and the break–up of Georgia  FT Barber 22nd March 2013). Concerns over money laundering and Cyprus’s tax haven reputation were also growing, a situation not helped by the way in which Cyprus’s Laiki bank (see FT Hope 22nd March 2013) had provided a conduit for suitcases-full of Slobodan Milosevic’s cash in defiance of UN sanctions.


From the EU side of the equation the Cypriot request for a bailout came on the back of growing frustration with Cyprus and the delight that President Christofias seemed to show in thumbing his nose at the European project whilst taking what structural funds were on offer ( which were €30m for Objective 2 2004-6  and a €640m phasing-in allocation for 2007-13 ( see Cyprus: Cohesion Policy strategies and programmes) to upgrade Cyprus’s infrastructure and institutions. Actually Cyprus was a net contributor to the EU budget in 2009 at €27m (Wikipedia: Budget of the EU).


The elections held in early 2013 were almost entirely focused on the issue of the bailout.


Once Nicos Anastasiades had won the elections comfortably the EU/IMF/ECB were determined to move quickly and forcefully to bring the simmering issue of the bailout to a conclusion. However, as we shall see, they no longer spoke with one voice.


German Ways

Unfortunately for Cyprus the obfuscation and delays of the Christofias presidency had placed the negotiation of the bailout smack bang in the middle of the German political cycle.


The SPD and Greens, seeking a 'wedge issue' to differentiate themselves from Merkel’s CDU, did an about turn on its criticism of the meanness of previous bailouts and decided to aggressively campaign for more stringent bailouts. According to the FT, 'both SPD and Greens declared that Cyprus must abandon its current “business model” of providing a tax haven for wealthy Russian depositors in particular, before they would approve any rescue' (see FT Quentin Peel 18th March 2013).


This change of policy six months away from the German elections was disastrous for Cyprus and led to a competition to see who can impose the toughest conditions and rhetoric on Cyprus in German politics and in the media. Such electioneering and the emergence of an anti-European party in Germany has,


‘reinforced a deep-seated national conviction that moral hazard must be avoided by forcing private investors to share the costs of failure with taxpayers.’(FT Quentin Peel 18th March 2013).


At this time the orthodoxy of austerity and budgetary rectitude was hardening across Europe - particularly in Germany, the Netherlands, the UK, and within the IMF. The shift in position of the SPD and Greens may have been tactical but it seemed unlikely they would reverse that position after the elections (which in the event they lost).


Cyprus has undoubtedly been treated harshly but this may be more a sign of a general hardening of positions in Germany, the IMF, the Netherlands, the emergence of a stronger coalition of 'haircutters' (the 'High Priest' in the IMF, the German and Dutch finance ministries, Brazilian concern over 'soft' loans to EU members etc- see below) and the weakness of oppositional voices and narratives within the EU and EC rather than a particular determination to 'get Cyprus '- although size clearly does matter in these things.


Russian Friends

The position of Russia in all this is puzzling. In Cyprus there is a view, demonstrated by recent Russian flag waving protestors outside the Cyprus parliament, that Russia is Cyprus’ ‘friend’.


Yes, there are up to 40,000 Russians and Pontic Greeks living in Cyprus, concentrated in Limassol. Yes, Russia and the Ukraine and Balkans are important sources of Cyprus’s vital tourist industry. And yes, tiny Cyprus is the biggest source of Foreign Direct Investment into Russia (see my Russian Connection page.) And yes Bank transfers between Russia and Cyprus last year totalled more than $250bn. (FT Hope 22nd March 2013). And yes, Russia did put in place a €2.5bn loan to Cyprus.


But if anyone thinks this was charity or friendship or solidarity they are surely mistaken.


Whilst Prime Minister Medvedev was complaining to the press that the EU was acting like a ‘bull in a china shop’ other members of his administration were in back-channel and secret talks and communication with the European Commission informing it that they had no intention of extending further loans to Cyprus or ‘helping’ one of its ailing banks (FT Spiegel, Hope, Peel, 22nd March 2013).


(Interestingly,  a Russian fund is the largest shareholder of the Greek Piraeus Bank (FT Hope 22 March 2013) which bought up the Greek operations of Cyprus Popular Bank (Laiki), Bank of Cyprus and Hellenic Bank, as well as the Investment Bank of Greece (IBG), a Laiki subsidiary – in all 312 branches for €524m (Ekathimerini 27 March 2013) Piraeus expects to close half of its expanded network of 1,600 branches (FT Chaffin 26 March 2013).


Finance Minister, Michalis Sarris, was sent to Russia in March 2013 to get help and  given a frosty reception on the day he arrived in Moscow and was then left to wait for a full day on Thursday until a meeting at 9.00pm by which time he knew the game was up.

At the time Reuters reported that, ‘perhaps the most disastrous episode in a week of blunders and miscalculation was the Cypriot attempt to persuade Russia to provide alternative finance’.


This expedition to the ‘Russian friends’ wasted time and burnt up what remained of Cyprus’s political capital in Brussels and Berlin. Even then, according to the Reuters article above,


‘Anastasiades and his team seemed not to comprehend when they arrived in Brussels on Sunday the magnitude of the collapse they were facing’.


As an aside, Russian’s leader of the opposition, Alexei Navalny, joked that if Cyprus were to nationalize its banks it would own the entire Russian Federation (FT February 6th 2013). And they have been some rating agency concerns on the potential knock-on impact of Russian depositor losses in Cyprus on Russian banks (FT 19/3/13).


At the end of the day, Russian/EU relations will always take precedence over any ‘fraternal feelings’ between Russia and Cyprus. This was perhaps evidenced in the rapid make-up between Prime Minister Dmitry Medvedev and Jose Manuel Barroso after the ‘bull in the china shop’ outburst that was presumably choreographed for a particular domestic audience and for foreign policy posturing.


It is true that Cyprus has a geo-political importance for Russia, particularly were Russia to lose its only Mediterranean naval base at Tartus in Syria (a concern that lies behind Russia's intransigent support for the Assad regime in Syria), and the recently discovered Cyprus gas reserves (some put the figure at $80bn) might be of interest to Gazprom. But as Tony Barber said in his impressive tour d’horizon of the geo-strategic interests at play in the Eastern Mediterranean, Cyprus lies at the heart of,


a combustible region where the military, diplomatic, energy and financial interests of at least half a dozen powers collide.’ (FT Barber March 22nd 2013).


The bank bailout resulted in the closure of Laiki/Cyprus Popular Bank and its division into a good and bad bank. The good bank operations are being transferred to Bank of Cyprus. BoC depositors with over €100,000 face haircuts of up to 60%.


The Cyprus government estimates 19,000 depositors at Bank of Cyprus will be affected, many of whom analysts believe are Russian individuals and small and medium businesses. The Wall Street Journal (Bouras, 1 April 2013) reported that 'Most major Russian companies have said they had limited exposure to the situation in Cyprus'.


The IMF/Commission Bust-Up

Cyprus has also been unlucky in that relations between the IMF and the European Commission have become fractious. This resulted in the IMF and Commission for the first time in the eurozone’s three year crisis going into the March 15th emergency European Finance Ministers' meeting without a joint recommendation.


The hard line adopted by the IMF with regard to the Cyprus bail-out caused one Eurozone official to comment that the ‘ayatollahs on the Fund’s staff’ were back in control after the more relaxed deal-making style under Dominique Strauss-Kahn’s leadership. In particular, the 'High Priest' of the Fund, Siddharth Tiwari, the head of the Strategy, Policy and Review Department had been restored to power since the departure of Strauss-Kahn. The FT suggested that as a long time Fund insider Tiwari was 'not inclined to give Europe special treatment'. In this he was backed by some members on the IMF's executive board, particularly Brazil, who have questioned the Funds 'risking so much on questionable programmes for rich European countries' (FT Harding March 27th 2013).


On rich European countries and just how rich or not is Cyprus?

In 2009 a Eurostat report of EU regional GDP put Cyprus's GDP per capita at purchasing power standards at €23,500 (which was 99.9% of the EU 27 member state average).

This was above the following regions in the UK: NE, NW, and SW England, Yorkshire and Humber, East and West Midlands, Wales, the Highlands and Islands of Scotland and Northern Ireland. The total for the UK is 110% of the EU average but this is largely accounted for by London (189%), the South East (116%) and Scotland (107%).

The lowest scoring region in the UK is West Wales and the Valleys at 68.4% and Cornwall and the Isles of Scilly at 71.9% The lowest regional GDP figure recorded in the EU in 2009 was Severozapaden in Bulgaria at 27% of the EU average.


The New Reality

After the first rejected Cyprus bailout one senior EU official “The troika model has become dysfunctional,” (FT Spiegel 24 March 2013). One source close to the IMF later said of the Commission, “They have this attitude that they are there to save the authorities in every country and it’s just a question of buying time, not a question of solving the problem.”


The FT reported that insiders believed the divergence between the IMF and Commission was,


‘all but inevitable and stems from a nasty experience with Greece, the arrival of Christine Lagarde as managing director, and pressure from emerging markets not to give Europe special treatment.’ (FT Harding 27 March 2013).


Cyprus’s lack of political and economic heft, allies and goodwill exposed it to the combined force of Germany, the IMF’s emerging 'tough-love' bail-out line and the born-again zeal of the leader of the Eurogroup of finance ministers, Jeroen Dijsselbloem.


The disastrous ‘everyone pays’ bail-in of the first Eurogroup meeting seems to have emerged as a particularly unpleasant compromise.


This was fought out between the IMF/Germany hardline bail-in and bank restructuring option with its harsh losses for large depositors and bondholders and the EC and ECB’s worries that a hit on large depositors ‘would cause more problems than it solved, panicking investors, sparking a bank run and devastating the Cypriot economy’- which, on the face of it, is what seems to have happened.


As the Friday March 15th meeting of European finance ministers approached tensions between the German/IMF and the EC/ECB positions worsened. Berlin saw the Commission as ‘always spending other people’s money’ whilst the IMF was seen as using Cyprus as an economic ‘test bed’. By the time the meeting started positions were fixed.


Said one official close to Dijsselbloem, “They had been farting around for months. …They would never, ever come together. We had to light a stick of dynamite and say: it’s burning.”


It seems that Dijsselbloem did just that.


Jeroen Dijsselbloem, from the Dutch Labour party, with a commitment to fiscal discipline, was the default choice to replace Jean-Claude Juncker’s as the eurogroup of finance ministers president.  The German's had backed him and made his position secure despite initial French and Spanish opposition.  And his appointment helped bring about a fundamental shift of power within the Eurogroup of finance ministers. 


This has allowed Berlin to realise its preferred strategy of foisting the burden of bailouts on private investors which had hitherto been blocked by Paris and the European Central Bank (FT Steinglass Spiegel 29th March 2013).


It seems Dijsselbloem may not be as enthusiastically wedded to austerity as it first appeared. Civil servants in the Dutch system wield considerable power and despite growing cries of protest senior officials at the finance ministry and central bank are aggressively in favour of austerity.


Although Dijsselbloem has backed austerity it may be because he has had little choice. The Dutch Labour party has struggled to re-establish a reputation for fiscal prudence after it presided over high budget deficits and low growth in the late 1970s (FT Steinglass 31 March 2013).


The Cyprus team went into the first bailout meeting with a desire to minimize claims on large depositors (the fact that President Anastasiades’ family law firm includes two Russian billionaires amongst its clients may not be coincidental - see FT Spiegel, Hope, Peel, 22nd March 2013).


President Anastasiades apparently alienated most people in the meeting by his ‘emotional reactions’ and his strained relations with the respected Cypriot finance minister, Michalis Sarris. (Sarris announced his departure from the government on April 2nd 2013).


On the eve of the Cyprus parliament’s vote on the first bail-out the next Tuesday (19th March) ‘EU officials had convinced themselves that Mr Anastasiades would not put his country at risk to protect wealthy holders of big bank accounts.’ But they were wrong. (FT Spiegel, Hope, Peel, 22nd March 2013).


The rest, as they say, is history. The Cypriot parliament rejected the Bailout to wide acclaim and general agreement on the island that it was an unjust and even unconscionable solution.


But five days later the IMF/German line came to prevail in spades with a radical restructuring of Cyprus’s financial sector. Laiki bank will disappear and the Bank of Cyprus will be a shadow of its former self. For the time being at least, the Russian ‘turnaround’ trade will disappear and Cyprus will probably never again be the main source of Russian Foreign Direct Investment.


A reduction of GDP of between 15 and 25 per cent is forecast. Cyprus and Cypriots are tough and adaptable people, used to the shocks imposed on them from outside and within. But this will take much resolve, and result in much hardship, before it is over.

Post script: the predictions about the falls in GDP in Cyprus were way off.  GDP fell 5.4% in 2013 and is now (September 2014)  expected to fall of 2.7% and 1.3% in 2014 and 2015 respectively before returning to growth in 2016.

The unemployment rate has risen sharply and stood at 15.9 per cent in 2013 and was expected to rise slightly in 2014 and 2015 to 16.3% before beginning a very gradual descent. 

The current crisis effecting the economy is the parliament's unwillingness to pass a bank debt foreclosure bill which in August 2014 was jeopardising the entire and very fragile Cypriot banking system. At that time the banking system had a massive €16.7bn of uncovered non-performing loans, an amount equivalent to the entire GDP of Cyprus.