Political economy of a euro area banking crisis

On Saturday, 16 March 2013, the world woke up to the news of an unprecedented levy on bank deposits that was to be applied in Cyprus, a euro area country, which was agreed as part of its long-awaited bail-out agreement with Europe and the IMF. The levy was 9.99% for deposits over €100,000 and 6.75% for deposits under €100,000. Given that deposits under €100,000 are protected by deposit insurance schemes throughout the European Union, the levy instantly raised questions concerning the safety of bank deposits in Europe and sent shock waves to bank depositors throughout the continent. What was even more surprising was that the deposit levy was to be applied to all banks in the country, not just those that faced capital shortfalls. It was intended to raise enough revenue to shore up the island’s banking system and particularly for the recapitalization of the two largest lenders, Bank of Cyprus and Laiki, which had the biggest capital shortfalls. As such, it raised important questions relating to economic incentives, burden sharing and moral hazard. Why should insured depositors in healthy banks, for example, pay to bail out (uninsured) depositors in unhealthy banks? What are the implications for moral hazard if depositors who choose to invest in banks that are able to offer high deposit rates by taking excessive risks are bailed out by more cautious investors elsewhere? Why should small savers pay to bail out wealthy investors in failing banks? What kind of precedent would such peculiar distortions set for future bank bailouts in Europe? [From Introduction]