Banks, Governments and Cyprus

A key point is at risk of getting buried in all the din surrounding Cyprus's deposit levy (apparently poised for parliamentary defeat). To me it comes through most clearly in the latest from the tornado-chasing (or front-running?) duo, Lee Buchheit and Mitu Gulati. 

One message of the Cyprus program is that bank liabilities must not become sovereign liabilities. It is consistent with Europe's imperative of breaking the bank-government cycle. The approach implies that banks' creditors may suffer while the sovereign's creditors are spared--even in a systemic crisis. This might happen on purely ideological grounds (No Bailouts, Ever), or when the sovereign has no money/no appetite to nationalize the banks, or when government debt is a huge portion of the banking sector's assets. Proponents of the levy believe that going after the government's creditors here is both pointless and bad for incentives. Best to keep the banks separate, and to attack the problem at the source.

My hunch is that this entire line of argument is farcical, because banks and governments are, and always have been, joined at the hip. The purported separation is an accounting cover-up.  The fact that the separation is accomplished by means of mega-financial repression underlines the irony.

Now to Buchheit-Gulati. Their preferred method for dealing with Cyprus effectively recognizes that both sides of a private bank's balance sheet are public policy constructs. On the liability side, they would extend deposits over EUR100,000 into five and ten-year CDs; on the asset side, they would restructure the domestic government debt. Presto, you have filled more than half of the program financing gap without touching insured depositors.

The Buchheit-Gulati way only makes sense when you think of banks and governments as communicating vessels, and work both sides of the bank balance sheet simultaneously, guided by a clear hierarchy of distribution policy priorities. They propose to suspend maturity transformation and redeploy fiscal resources in exchange for protecting small depositors. The current plan creates the illusion of only working the liability side of the balance sheet--Sending a Message to Debt. As Buchheit and Gulati point out, it gets you little when the rump deposits run for the hills and the government must step in anyway. Now that will surely do wonders for the government bonds on the asset side of the balance sheet. Cycle broken, crisis solved.

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For more on Cyprus, see Adam's coverage here, Jacob Kirkegaard here, Nicolas Veron here, Rob Kahn here, and FTAlphaville here.