The truth behind Cyprus’s bank catastrophe—Cypriot banks are really Greek banks in disguise

Cyprus’s over-stretched banks are at a breaking point. The IMF estimates that they need some €10 billion ($12.9 billion) in capital to stay on their feet, even after a €1.9 billion recapitalization by the Cypriot government in July 2012. Although the government has been doing its darnedest to keep Cyprus’s financial sector afloat, overburdened banks are still sinking into oblivion. But because Cyprus is widely considered an offshore tax haven for the Russian wealthy, European policymakers are unwilling to bail them out.

They should really reconsider that assessment, however. Although they may hold significant Russian deposits, a deeper dive shows that Cypriot banks really look a lot more like Greek banks, a few hundred miles across the Mediterranean.

Sovereigns in Europe still depend on domestic banks to fund them even when the banks are in trouble. The ECB extended cheap credit to Italian and Spanish banks in late 2011 and early 2012 specifically so they’d buy more of their government’s debt. (It worked.) Because of the close historical ties between Cyprus and Greece, Cyprus’s banks remained heavily invested in Greek government debt, too. With some €4.7 billion in Greek bonds at the end of 2011, Cyprus’s two largest banks—the Bank of Cyprus and Popular Bank (Laiki)—came in as some of the Greek government’s largest creditors. So when Greece went through its managed default they took the full brunt and lost €3.5 billion, equal to 20% of Cyprus’s GDP.

What’s more, Cypriot banks increased that exposure steadily, probably with the intention of helping out their pseudo-sovereign. A major Cypriot bank even purchased a large chunk of the last private placement (essentially, a private offering of bonds) Greece conducted before it defaulted, according to a market maker with knowledge of the deal.

The connection seeps through into the banks’ balance sheets: 27.8% of loans on the Cypriot banking system’s balance sheet—amounting to €18.9 billion—are actually extended to Greek residents. As it happens, 27% of all the loans issued by Cypriot banks—a total of €23 billion—are non-performing, a number that has spiked sharply since Greece defaulted. Greeks also account for 18.7% of total deposits in Cypriot banks. Although non-EU (read: Russian and eastern European) deposits account for slightly more, they take up only 9.7% of the loans.

“By June 2011, the exposure of domestic [Cypriot] banks to Greece amounted to €28 billion, or one-third of total assets and 170% of GDP. Of the €28 billion, government bonds amounted to €4.7 billion; the rest were loans to Greek residents,” the Institute of International Finance, which advises the ECB, IMF, and EU on international bailouts, found in a study.

And here’s what really crowns the problem: The bailout for Greece recapitalized Greek banks with €18 billion in funds from the ECB last May. But Cyprus’s banks, not being in Greece, got no similar aid.

So although it’s understandable why policymakers would want to try to tax Russian depositors, it’s clear they’re not the only cause of the trouble. Yes, the Cypriot banking system is too big because of all that Russian money. But the Russians weren’t the ones that hit it with huge losses. If EU leaders were able to understand Cyprus as a tiny offshoot of the Greek economy, however, it might be easier for them to arrive at a viable solution to its not so tiny problems.