Market reactions to the banking crisis in Cyprus

BIS Quarterly Review  |  June 2013  | 
03 June 2013

(Extract from page 9 of BIS Quarterly Review, June 2013)

The insolvency of the two largest banks in Cyprus intensified negotiations between Cypriot and European authorities over official financial assistance in March. The banks had incurred large losses on Greek government debt holdings and on commercial property and mortgage loans extended to borrowers in Greece and Cyprus, while relying to a large extent on offshore deposits. Combined deposits at Bank of Cyprus and Cyprus Popular Bank (Laiki) amounted to €45.5 billion, alongside €0.1 billion in senior debt and €0.5 billion in subordinated convertible debt. The final rescue package prescribed the restructuring of Bank of Cyprus and the resolution of Laiki with 100% losses for shareholders and bondholders, with uninsured deposits above €100,000 also sharing in the burden. The measures were accompanied by a 10-day bank closure of Cypriot banks followed by withdrawal restrictions and capital controls.

The convoluted process of setting the terms led market participants to perceive that euro area bank resolutions could involve greater burden-sharing than had been the case in the past. The initial package of 16 March, and the willingness of political leaders to impose a "one-off stability levy" of 6.75% on insured deposits, caused considerable tensions that later subsided when a modified package sparing small deposits was agreed on 25 March. Between these dates, the Stoxx Europe 600 bank index fell by 7.6%, and the bank closure arrested the flight of deposits from Cypriot banks running at €3.9 billion (8%) since January.

Broader contagion from the Cypriot bank bail-in remained limited, however, and liquidity conditions stayed stable across markets. Banks in all euro area countries bar Cyprus recorded deposit inflows in March, totalling €85 billion. The episode led to a modest repricing of bank debt, with yields of euro area bank bond indices edging up for both junior and senior bonds. CDS spreads for senior and subordinated bank debt widened more noticeably, suggesting that participants in derivatives markets may have been more risk-sensitive to recent developments. Even as traders seeking out potentially vulnerable sovereigns pushed Slovenian 10-year bond yields near 7%, other peripheral euro area countries experienced little market pressure.

Several factors may have contributed to this somewhat muted market reaction. The first was a possible perception among market participants that the crisis in Cyprus, and the nature of its bank bail-in, was unique and small in scale. At the same time, perceived tail risk remained contained by continued monetary accommodation and backstop measures, such as the ECB's long-term refinancing operations and its readiness to purchase sovereign bonds, if needed, through the Outright Monetary Transactions facility. The resilience of bank debt in the cash market also reflected that a significant share of these securities was being held by institutional investors whose asset allocations tend to be adjusted more gradually. Combined with the fact that net issuance volumes of bank debt in many euro area countries were negative over the last two quarters, this difference in the composition and behaviour of market participants may have contributed to the muted price action observed in the cash market relative to CDS markets.