Forget the Cypriot deposit haircut: Bank failure isn’t the only risk of investing

 
Ryan Bourne
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FRONTLINE ECONOMICS

THERE has been widespread condemnation of the perceived unfairness of those with over €100,000 on deposit in some Cypriot banks facing a levy on their savings. After the final deal was announced, there were suggestions of a haircut of between 30 and 40 per cent. Now the figure could be substantially higher. But it’s important to remember that the risk of a bank failure isn’t the only risk of investing.

Imagine a wealthy Cypriot called Michaelis, who back in January 2007 had €200,000 and was deciding whether to put it into a bank in the UK or into one of the affected Cypriot banks. If he’d put his money into the UK, his euros would have given him about £132,600 to deposit. According to the Bank of England, if each year he had invested that money into a one-year fixed bond, he’d have seen an overall nominal return by March 2013 of around 23 per cent – leaving him with £163,300. In real terms, this gain would only be around 2 per cent, because of the roughly 21 per cent increase in the price level which we have seen in that time. And if he decided to change his £163,300 back to euros now, the fall in the value of the pound would mean that he would only be able to convert this into €191,100. The long and short of this is that, in real terms, and once the exchange rate effect has been taken into account, Michaelis would have lost 21 per cent of his original euro outlay.

Suppose instead that he’d invested €200,000 in the Cypriot bank. According to the Central Bank of Cyprus, if each year he had deposited that money with agreed maturity for up to one year, he’d have seen an overall nominal return to the end of March 2013 of around 32 per cent – leaving him with about €264,500 in early April 2013. Now he’d suffer from the haircut on everything over €100,000 and, using the 30 per cent figure as illustration, he would be left with around €215,100 – or an overall nominal gain of just 7.5 per cent. In real terms, once inflation is considered, this would amount to a loss of around 8 per cent.

The bottom line is that, in euro nominal terms, Michaelis would still be ahead if he’d left the money in Cyprus, and behind if he’d put his money in the UK because of the exchange rate effect. In real euro terms, a depositor in the UK would be down 21 per cent compared to a fall of 8 per cent for someone who’d deposited in the Cypriot bank, even with a 30 per cent haircut.

Now this result is, of course, dependent on the change in the value of sterling and the time period examined. But it highlights a crucial point: namely that all investments of large sums of money are extremely risky. While a haircut is directly observable and therefore resonates emotionally, the risk of your bank failing is only one risk an investor faces, alongside interest rate risk, inflation risk and exchange rate risk. Given that we don’t insulate investors from these latter risks, it’s unclear why it should be regarded as any more unfair for investors to not be protected when the bank they deposited in fails.

Ryan Bourne is head of economic research at the Centre for Policy Studies.