Contagion may return after a perilous precedent is set

The messy bailout of Cypriot banks should terrify traders

IT WAS good while it lasted. The stability of Europe’s banking sector since last July allowed traders to hope that the worst of the Eurozone crisis was behind us. The STOXX Europe 600 Banks index had risen by almost 50 per cent since then.

But the wretchedness of policymakers – who are tapping depositors in Cypriot banks for €5.8bn (£4.96bn) to help finance a banking bailout – has shown its ugly head again, and threatens to plunge Europe back into turmoil.

Although politicians may still change the composition of the deposit levy, and whether it should hit deposits under €100,000 (which were previously assumed to be insured), the pertinent question is now whether the lack of a solution to Cyprus’s problems will reignite contagion in Europe.

Chris Scicluna of Daiwa Capital Markets said that the debacle has the potential to be a “major cock-up”. And equity investors gave a damning verdict, as bank shares ended yesterday in the red. Both Société Générale and BNP Paribas lost around 3 per cent. Barclays and RBS shed around 4.4 per cent and 3.4 per cent respectively. German banks weren’t immune, as Deutsche Bank fell by 2 per cent.

Demand for safe havens seems to be back in vogue too. Gold rose above $1,600 per troy ounce. Even the yen showed that it has not lost its safe haven appeal, rising 2 per cent against the dollar. And German 10-year debt was pushed to its lowest levels of 2013.

However, some were sanguine. Lex van Dam of Hampstead Capital described the episode as a “storm in a teacup,” saying that the dip was an opportunity to buy bank shares. There may be logic to this.

Banks are better capitalised to weather shocks, after the European Central Bank poured €1 trillion of liquidity into the market (of which, banks have only repaid just over one-fifth). And the Bank’s untested outright monetary transactions (OMT), where it will buy bonds of distressed nations, removes the risk of a yield spike, and mitigates the risk of contagion by providing a safety net. Italian and Spanish 10-year bond yields only rose fractionally, staying within their recent ranges, underscoring the point.

Also, the euro has not collapsed. It failed to fall beneath $1.2880 against the dollar, a key support level, suggesting that traders are taking a wait-and-see approach.

But it is still far too early to discount the possibility of destructive contagion. The full market reaction will only unfold after Cyprus’s parliamentary vote on the proposals later today.

Cyprus cannot afford to bail out its banks alone. Its current debt-to-GDP ratio sits at 86 per cent, and a bailout would push that figure to a likely unsustainable 145 per cent. This would introduce the possibility of “haircuts” on Cypriot sovereign debt, further damaging the banking sector.

If the vote fails to pass, there is the risk of a market backlash; it will raise the chance of a disorderly bankruptcy of Cyprus and its banks. Then we may see a more meaningful move in the euro, European bond yields, and a further hammering of European banks.

A terrifying precedent has been set. Barclays said that the potential structure of Cyprus’s bailout “further erodes bondholder protection at European banks,” adding that it reveals “a trend of negative events.” Even though Cyprus’s share of Eurozone GDP is small, at 0.2 per cent, the main risk to investors seems to be the uncertainty about how Europe’s policymakers will handle forthcoming crises.

There has been little consistency between the bailouts of Greece, Ireland, Portugal. And with the spectre of a bailout of Italian and Spanish banks, which still appear vulnerable, investors and depositors – in fact, anyone with a stake in European banks – should be very concerned.