Reuters Breakingviews delivers agenda-setting financial insight. Its global correspondents react to stories as they develop, delivering sharp and provocative commentary on big financial news as it breaks.
European officials are hurriedly denying that the Cypriot bail-in is a "template." Markets know otherwise. The good bank/bad bank model adopted in Cyprus shows how banks can be recapitalized without government funds whilst protecting insured depositors – thanks to senior bondholders and uninsured depositors taking losses. It's the right model for the future. For now, it worsens life for Europe's weak banks.
Credit spreads jumped on Cyprus's first bailout proposal even though it spared senior bondholders. They rose further after senior debt was bailed in as part of the revised bailout proposal, which the head of the euro group of finance ministers commended as the way to tackle bank failures. Investors cannot afford to believe the swift retraction of that comment. Indeed, the back-peddling has not brought spreads down.
Hopes for direct recapitalization of banks by the European Stability Mechanism bailout fund are history. Investors naturally worry that senior debt could end up recovering very little after default, possibly nothing, particularly if banks now fund themselves more heavily through non-bail-inable debt, such as insured deposits and central bank funds.
Bank credit spreads may not have much further to go. Fitch Ratings reckons the historic five-year average bank failure rate is just over 7 per cent. A credit default swap spread of just over 140 basis points should therefore compensate for the credit risk, assuming zero recovery. The Markit iTraxx index puts the cost of insuring senor-ranking financial debt at about 200 basis points over five years – comfortably pricing in the risks for the providers of credit protection, at least for the strongest banks.
Bail-in was always a question of when, not if. The end result should be safer, smaller banks, stronger governments and fewer taxpayer-funded bailouts. But in the short term, it will exacerbate euro zone tensions. Weaker banks, particularly those in southern Europe, face higher funding costs and greater pressure to shrink, hurting the economy. A new sovereign-bank doom loop could emerge. Corporate depositors in peripheral economies know they risk bail-in if their government seeks a bailout and is forced, like Cyprus, to haircut them. They may panic when sovereign yields rise, causing runs – and bailouts.
For the euro zone to hang together, extra support – be it cheap liquidity, or bond buying or bailouts – is inevitable. The European Central Bank is going to have to work harder.