Systemically significant banks cannot be a little bit insolvent

Tracking risk appetite across bipolar asset markets

WEDNESDAY MARCH 20, 2013       11:16:00 GMT

In the unfolding Cyprus on the brink saga a comment yesterday (March 19th) by the governor of the country's central bank struck a discordant note. He claimed that when the island's banks re-open (when that might be still remains unclear at the time of writing this) there was a suggestion that distressed deposit holders might withdraw 10% of their deposits. It is unclear where that percentage estimate came from but the suspicion is that the number was just plucked out of thin air. The reliability of such an estimate raises an issue that can be summarized as follows:

When circumstances become critical there is no longer a continuum for trust -> distrust or solvency -> insolvency. After a certain tipping point there is a dramatic discontinuity in the willingness to consider mitigating factors or compromises in the judgments we make. We may start out, if transactions are small and inconsequential, in overriding any discomfort that we may be experiencing about having to make a critical decision as to whether to trust the solvency or ability of counter-parties to honour their obligations. However once we move beyond a certain threshold and when more critical circumstances (the risk that one's life savings might be lost) present themselves to us there is absolutely no propensity to tolerate doubts or mistrust. The discontinuity a jump from a linear to a non-linear method of weighing up the risks/benefits of having trust in a counter-party (or bank).

As an example, in September 2008 counter-parties that were dealing with Lehman Brothers completely lost trust in the company, refused to fund it in the money markets, and quite rapidly the overall market realized that the company was insolvent. Traders and investors were no longer prepared to tolerate self-serving statements from the company’s CEO and its management team that its balance sheet was sound and that it could fund itself. There was a total breakdown in trust of the company’s declarations regarding its financial position. In such circumstances, there are no degrees of solvency – a company, especially a bank, either is solvent or it is not – there is no halfway house. It is this unwillingness to tolerate any ambiguity regarding solvency that explains why companies can be full of employees in opulent offices one day and then bankrupt the next with the employees walking out of those same opulent offices with cardboard boxes with their hastily packed personal possessions.

The real catch 22 for the Cypriot central bank and the chances that a white knight (ECB, Russia) might ride to the rescue was neatly summed up in this remark which came from FT Alphaville's insightful commentary this morning. Alluding to the iconically absurd Monty Python sketch about a deceased parrot the article raises the real question mark about the survivability of Cyprus as on offshore financial haven.

Already risk managers in London are sending internal mails quietly removing Cypriot counter-parties from acceptable trading lists. As go the deposits, and the trading entities so go the jobs in law and accountancy. Even if the system survives, the sector looks very vulnerable. No, Cyprus The Financial Centre is not resting, it’s shuffled off this mortal coil, run down the curtain and joined the bleeding choir invisible.

The article's conclusion has a question which should resonate through Berlin Brussels and Moscow

Why bother to protect foreign deposits if they’re on their way out already?