Tiny state's disaster belies big lessons for banking

This is the story of Cyprus, a nation which, in return for avoiding bankruptcy, has now agreed to the destruction of its banking system, accounting for about 10 per cent of national wealth. And although no two countries are the same, how Cyprus ended up in this tragic situation and how this squalid episode could have been averted remains a tale of crucial importance to all small and medium-sized countries.

The Cypriots may detest being reminded of this, but the fact remains that when they recently came cap-in-hand to Europe, they attracted no sympathy. For early on in its existence, Cyprus flunked its most essential national test: that of maintaining harmony between the majority ethnic Greeks and minority Turkish population. The result was a 1974 coup fomented by Greece, followed by a military intervention from Turkey that divided the island along sectarian lines.

Since then, the Cypriot Greeks have held the rest of Europe to ransom in their obsession to regain their lost land, preferably without re-absorbing the Turkish minority. The Greek-dominated Cypriot government rejected a 2004 plan sponsored by then UN secretary-general Kofi Annan to reunite the island. And it blocked every effort to forge an urgently needed strategic relationship between Europe and Turkey. Cyprus’ behaviour exasperated the European Union for decades. Those Cypriots who now bemoan the lack of solidarity from Europe are well-advised to recall that their government offered little solidarity to the rest of the continent.

Still, none of this should absolve EU leaders from their own responsibility. For the path that led to Cyprus’ current crisis – big banks bereft of money, a government in disarray and citizens filled with angry despair – goes back to October 2011, when EU finance ministers, supposed guardians of financial discipline, decided at a secretive meeting to slash the value of Greek bonds in order to reduce Greece’s debt. That “haircut” was bound to affect Cypriot banks, which held large amounts of Greek bonds. 

In fact, EU governments turned a blind eye to the subsequent cover-up. Repeated health checks by the European Banking Authority before the Cyprus crisis revealed significant concerns about banks in Spain, Greece or Austria but not a single one in Cyprus, despite the fact that as early as January last year the European Central Bank was providing “emergency loans” worth 430 million euros to Laiki Bank, whose recent collapse pulled down the entire Cypriot economy. The idea that, somehow, Europe was surprised by Cyprus’ impending bankruptcy should be dismissed for what it is: patent nonsense.

And equally nonsensical is the argument that Cyprus had to suffer because its banks shielded illicit money from Russia. The really big Russian oligarchs have had no trouble buying football clubs in Britain or yachts and palaces on the French Riviera. The top oligarchs were also invited to sit on the boards of German oil and gas companies. Cyprus’ “sin” was not that it attracted doubtful Russian money but that it served as home to the cash of the small fry rather than the big fish, people who could be ignored and whose deposits could be wiped out.

But the real explanation for the almost obsessive desire to punish Cyprus is that Germany, which acts as Europe’s ultimate bankroller, increasingly treats the euro crisis as a religious morality play between the supposedly serious nations of northern Europe who work hard and save, and the allegedly flippant, lazy countries of southern Europe who live on borrowed cash. So, no money is advanced unless the recipients are made to suffer penance and flagellation in public, in the most humiliating circumstances.

Underlining this morality play is also a prevailing sense of hatred about global banking centres. This is partly due to envy: Paris and Frankfurt tried to become such centres but, since both failed, the French and German governments like to dismiss other bank centres as mere “tax havens”, supposed dens of iniquity.

The hatred of banking centres is also buttressed by the prevailing mood among ordinary Europeans, who increasingly want banks to act as just glorified safekeeping vaults, safeguarding hard-earned pension savings and occasionally lending to family-owned businesses, preferably at zero interest rates and without taking any risk. European leaders know that’s primitive economics, and that some famously conservative banks can be just as reckless.

Both the French and German finance ministers took great pleasure in dismissing Cyprus as a “casino economy”. It was an unnecessarily offensive remark, but one which presumably played well with voters back home.

The result was not a bailout, but utter destruction. Cyprus’ debt will rise to 120 per cent of its national wealth. The country has lost its core banking industry and has nothing to replace it with: it cannot hope to claw its way back to viability with a tourist boom because the euro has made it shockingly expensive. But it cannot leave the euro either, because nobody would prop it up. Ultimately, Cyprus was crucified because it was small: its fate did not matter, so European leaders enjoyed kicking it about.

But, far from providing an ominous warning about the inherent vulnerability of all small nations, Cyprus can offer them a salutary, constructive lesson.

The fact that Cyprus had a banking sector eight times bigger than the national economy should not be viewed as a source of weakness: Switzerland thrives on higher multiples than that, as does Luxembourg where bank assets are 22.5 times the size of the tiny state’s economy. What may be required, however, is to improve the capital ratios of the banks, to increase the cushions they have if some of their investments turn sour. Top-notch banking supervision is also a must. But none of this suggests that a banking centre cannot remain much bigger than the country in which it is located.

Furthermore, a nation can compensate for its small size through good governance, harmonious ethnic relations at home, the avoidance of disputes with neighbours and the cultivation of a positive image.

Small nations may also need larger-than-usual currency reserves, and should also retain some mystery about the true value of their national financial assets, if only in order to keep others guessing about the muscle they can muster in times of need. For, as Cyprus’ experience illustrates, nobody will be willing to pick them up should they stumble. 

“Better die on your feet than live on your knees,” one defiant placard among the throngs of protesters in Nicosia read last week. Sadly, that’s no longer an option for Cypriots, who are already on their knees and may not survive the economic ordeal either. Yet there’s no reason other nations should ever repeat Cyprus’ sad experience