Credit FAQ:

The Cyprus "Bail-In" And Its Aftermath

Primary Credit Analyst: Moritz Kraemer, Frankfurt (49) 69-33-999-249; moritz_kraemer@standardandpoors.com Secondary Contact: Benjamin J Young, London (44) 20-7176-3574; benjamin_young@standardandpoors.com

Table Of Contents
Frequently Asked Questions Related Research:

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Credit FAQ:

The Cyprus "Bail-In" And Its Aftermath

On March 19, Cyprus' parliament rejected the conditions of the multilateral assistance program (Program) attached to a 10 billion loan agreed on March 16 between Cyprus' government and eurozone (European Economic and Monetary Union) members, in coordination with the International Monetary Fund (IMF) and the European Central Bank (ECB). Under the Program, complementary financial resources of an envisaged 5.8 billion were to be raised through what has been described as a one-time "Financial Stability Levy" on deposits in Cyprus' banks, including on smaller deposits below 100,000 covered by Cyprus' Deposit Insurance System. After its announcement, the Program was vocally opposed both within and outside Cyprus. When it was submitted to Cyprus' parliament for ratification, the Program failed to secure any votes. This was the first time an EU financial support package had been rejected by a European parliament, be it in a creditor or borrowing country. Standard & Poor's Ratings Services takes this opportunity to provide its views on questions that investors and others have asked about the Program, its rejection by Cyprus' parliament, and what these events could foreshadow.

Frequently Asked Questions

What was the situation in Cyprus that led to the Program? Broadly, what were the Program's terms?
Cyprus' large indigenous banking sector (total assets exceed Cyprus' GDP by about five times) has lost access to the capital and wholesale funding market. In addition, the sector continues to suffer losses due to its deteriorating credit quality, in part because of its large exposure to Greece's public and private sectors. According to ECB data, Cypriot banks accounted for just 0.3% of eurozone assets in mid-2012, but for 5.1% of eurozone impairments. Cyprus' banks have required repeated capital injections and eurosystem liquidity support via the Emergency Liquidity Assistance (ELA) program. The current official estimate is that Cyprus' two largest commercial lenders will together require 10 billion (56% of 2012 GDP) in capital injections. Because the government has been locked out of the capital markets since 2011, it is running out of resources to fund its own outlays, let alone to recapitalize its banks. A multilateral financial support program has become seemingly unavoidable, and negotiations between Cyprus and its European partners have intensified since the presidential elections in late February 2013. Cyprus' already-high level of sovereign debt complicated the negotiations. To secure its funding needs during the prospective Program period, Cyprus would have required an estimated 15.8 billion of official loans (close to 90% of GDP). These loans would have increased sovereign debt to about 150% of this year's GDP. The so-called Troika (the European Commission, the IMF, and ECB) considered such a debt load unsustainable and therefore contravening key principles of IMF financing. Since several EU governments are understood to be reluctant to provide European Stability Mechanism (ESM) loans without IMF involvement, Cyprus' funding needs had to be reduced by bailing-in (i.e., requiring contributions from) other creditors.

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Credit FAQ: The Cyprus "Bail-In" And Its Aftermath

We believe that European policymakers were reluctant to restructure Cyprus' sovereign debt, as the Greek sovereign default in 2012 was also meant to be a one-time event. A Greek-style sovereign restructuring would, in our view, not adequately address Cyprus' needs: we estimate that about one-third of the 6.3 billion (35% of GDP) of long-term securities that could be restructured is held by domestic banks, with another quarter of Cyprus' debt stock held domestically by asset managers, including pension funds. A default by Cyprus would therefore increase its cost of recapitalizing the financial sector, while most likely triggering protests from the public and private pension funds (many connected to trade unions) that have invested heavily in Cyprus' sovereign debt. As Cyprus' banks' balance sheets are predominantly deposit-financed, bailing in the bank bondholders would not have been sufficient to reduce the additional government debt to the 10 billion we understand the Troika believes will be the upper limit to ensure a sustainable public debt ratio (about 120% of GDP by our estimate, but likely to rise as we anticipate depressed economic conditions over the medium term).

2. What led to the Program's rejection by Cyprus' parliament?

While the need for an agreement seemed apparent, some of the Program's terms proved controversial. Holders of Cyprus' junior bank debt (estimated to be about 1.4 billion), were bailed-in and would have lost their investments in full--although senior bondholders (who were estimated in September 2012 to hold less than 200 million) were unaffected. Under the Program, depositors in Cyprus' banks would have been subjected to a one-time "financial stability levy" of 9.9% on their deposits (with a reduced rate of 6.7% for deposits under the deposit insurance threshold of 100,000 per account), in exchange for bank equity. Banks in Cyprus were to be closed until the Program became law. Cyprus' parliament was expected to enact the Program on March 20. But as achieving majority support remained elusive--despite promises of reducing the burden for small savers at the cost of large depositors--the vote was postponed and the bank closure was extended. Eventually, lawmakers voted against the Program. While some observers had predicted the Program's depositor bail-in (given the lack of other liabilities on banks' balance sheets and the fact that most large deposits are believed to be held by nonresidents), Standard & Poor's believes that many Cypriots viewed the Program's deposit levy as a form of partial expropriation. The deposit levy effectively subordinates small local Cypriot depositors to Cyprus' sovereign and bank creditors, and to depositors in Cypriot banks' foreign subsidiaries. Were the Program enacted, it would have been the first time that European policymakers bailed in deposits benefitting from EU-required deposit insurance. We also consider it likely that parliamentarians rejected the Program in part because of a sense that Cyprus' difficulties were not so much because of homegrown problems but were fueled by Greece's economic troubles and its sovereign default. Unlike their Greek competitors', Cypriot banks' operations in Greece were not recapitalized under Greece's EU-IMF loan arrangement. According to press reports and other comments, we conclude that Cypriots also may have felt that undue external pressure was exercised on them: while no official statement by the ECB had been made until after the parliamentary vote, it was understood that the ECB would withdraw ELA support for Cyprus' banks if no Program ensuring Cypriot banks' solvency can be enacted (a subsequent ECB press release of March 21 formally confirmed this stance). We believe that ELA withdrawal would lead to an almost immediate collapse of the national financial system. By our accounting, the Program's failure to achieve passage is the first time a European legislature has rejected a financial-assistance agreement negotiated by that country's executive. It appears that when the Program for Cyprus

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Credit FAQ: The Cyprus "Bail-In" And Its Aftermath

was agreed, there may have been a misapprehension of certain political and social realities--a misapprehension that could rekindle questions about the effectiveness of current and future European crisis management. After the Cyprus precedent, similarly situated national governments could encounter opposition from their own parliaments. We also believe that the experience in Cyprus illustrates the risk of complacency in the wake of reduced bond market pressures. We have highlighted this as one of the key challenges to overcome in 2013 (see "The Eurozone Debt Crisis: 2013 Could Be A Watershed Year", published on RatingsDirect Global Credit Portal on Jan. 9, 2013).

3. What are the implications for the sovereign rating on Cyprus?

In December 2012, we lowered the long-term sovereign rating of Cyprus to 'CCC+' and assigned it a negative outlook. At the time, we stated that "we see at least a one-in-three chance that we could lower the ratings again in 2013, for example if official assistance is not forthcoming, leaving the Cypriot authorities few choices apart from restructuring financial obligations. We could also lower the ratings if we believe the government is not able to fulfill the conditions of a Troika program." (See research update titled "Cyprus Rating Lowered To 'CCC+' On Intensifying Liquidity Risks And Burgeoning Debt Burden; Outlook Negative", Dec. 20, 2012). The events of the past week have in our view considerably increased the likelihood of that downside scenario materializing. Accordingly, we have lowered the rating on Cyprus to 'CCC', reflecting our view that the risk of a disorderly credit event is rising (see research update "Cyprus Long-Term Rating Lowered To 'CCC' On Rising Risks To Financial And Economic Stability; Outlook Negative", published on March 21, 2013). The failure of Cyprus' government to obtain a financing program soon could lead to a further downgrade. Alternatively, the provision of sufficient financing to recapitalize Cyprus' domestic banks and meet this year's public-sector borrowing needs could stabilize the current rating.

4. What could happen next?

We believe that the negotiations between Cyprus and the eurozone will continue. Without outside support we believe that Cyprus will likely default in or before June, when a 1.4 billion sovereign bond matures. Since the onset of the eurozone crisis, there has been no precedent for such a second round of negotiations. Both Cyprus and the eurozone have much to gain by concluding a politically viable agreement. Apart from contagion risks, the failure to agree could rekindle questions about the effectiveness of current and future European crisis management. In this light, we believe European policymakers might be forced to adopt an approach more accommodating to Cyprus' political constraints, although policymakers may be wary of creating precedent that could encourage other program countries to make additional demands for support or leniency. Moral hazard is a concern: if Europe's policymakers are having such difficulties with the eurozone's third-smallest economy (accounting for less than 0.2% of eurozone GDP, Cyprus is ahead only of Malta and, for now, Estonia), what lies in store for negotiations with systemically more significant sovereigns? Policymakers' next steps will have an importance well beyond the immediate issue with Cyprus and could illuminate where eurozone crisis management is heading. The ECB's formal declaration to discontinue "the current level" of ELA after Monday (March 25) unless "an EU/IMF programme is in place that would ensure the solvency of the concerned banks" has set an effective deadline. According to media reports, the leaders of political parties in Cyprus have agreed on an alternative plan that would spare the insured deposits. We understand that Laiki, Cyprus' second-largest bank, is to be restructured and a "bad

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Credit FAQ: The Cyprus "Bail-In" And Its Aftermath

bank" to be spun off. But the key component of the alternative plan is understood to be a "Solidarity Fund", which would issue bonds secured by state assets to raise the 5.8 billion required. The Fund is reported to include the securitization of Church assets, national pension fund contributions, with a possible reinstatement of the deposit levy above the insured threshold. While the contours of the plan remain sketchy, in our view, receiving the necessary approvals could still prove challenging. The Cypriot parliament did delay a vote on the new plan by a day to Friday (March 22). In case of adoption, the package will still need to gain Troika approval, which we do not consider as assured. Most importantly, assessing the real value of the assets backing up the Solidarity Fund could be difficult. The bonds raised by the funds could also be seen as increasing the debt burden of Cyprus beyond what the Troika considers sustainable levels. Furthermore, approval by the Troika could take some time, possibly beyond the current ELA deadline set by the ECB. As in other situations, returning to the negotiating table can carry benefits--even if, at the moment, they appear uncertain. In Iceland, for example, an international agreement was reopened and renegotiated following the financial crisis brought on by its banking sector. The Icelandic government faced a lengthy dispute with The Netherlands and the U.K. over liability for the insured depositors in Icesave, a subsidiary of a failed Icelandic bank. In late 2009, the Icelandic parliament approved an agreement, but the president did not sign it into law. Eventually, the agreement was defeated by referendum. At the time, there were significant anxieties about the financial consequences of the breakdown. In retrospect, it appears that Iceland achieved a better outcome than had the referendum passed.

5. Could Russia support Cyprus and render European conditionality redundant?

The fact that much of the nonresident deposit base in Cyprus' banks is believed to originate in Russia and other CIS countries has led to speculation that Russia, with its strong federal balance sheet, might enter as a "white knight" and lend to Cyprus on more palatable terms than the eurozone governments, a possibility we currently view as unlikely. We expect the Russian government would likely have similar concerns as the Troika about Cyprus' debt sustainability. Russia loaned Cyprus 2.5 billion (14% of GDP) in late 2011. We believe that the Russian government probably intended the loan as a short-term aid, helping to stabilize Cyprus (and related Russian financial interests) until Nicosia could agree to a program. Attempts by Russia to lend an amount less than the 15.8 billion that Cyprus requires would again raise question about which depositors would be bailed-in so as to cover funding needs, and in what proportion. We surmised that if many Russian depositors in Cypriot banks have deposits above the 100,000 deposit insurance ceiling, Russia's interests could be served by minimizing any levy on big depositsbut this could suggest a larger levy on amounts under the 100,000 ceiling (affecting many Cypriot residents), a regressive redistribution of the burden that we cannot see getting parliamentary approval. The wild card would be any willingness of Cyprus' government to sell to the Russian government a financial interest in offshore gas fields discovered in 2011. Nevertheless, all things considered, we believe that Russian financial support, were it to be forthcoming, would be a stopgap measure while the negotiations with the eurozone continue.

6. Does Standard & Poor's believe that Cyprus will leave the eurozone?
We have previously said that the likelihood of a sovereign leaving the eurozone is remote. In the case of Greece, the incentives to exit appear to have diminished (see "Top 10 Investor Questions On The Eurozone Sovereign Debt Crisis," published Feb. 19, 2013).

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Credit FAQ: The Cyprus "Bail-In" And Its Aftermath

However, the events of the past week are unprecedented. If an agreement is not reached, Cyprus' authorities may be forced to keep banks closed for longer or introduce direct capital and withdrawal controls to stem bank runs and capital flight. Not even Greece had to resort to such measures. In this scenario, the population's support could disappear for a currency that cannot be used to meet its financial needs. We believe that the new president's authority and popularity has diminished, especially in light of his election promise not to bail-in depositors. This may lead to Cypriots looking to other leaders who may offer seemingly more attractive and populist solutions, including exiting the eurozone. According to media reports, the leader of Cyprus' Orthodox Church, Archbishop Chrysostomos, has encouraged Cypriots to abandon the euro. Opposition politicians, including the former Presidential candidate Giorgios Lilikas (who attracted a quarter of the vote in last month's first round election), are reported to have expressed similar views. Indeed, an opinion poll published on March 21 seems to suggest that two-thirds of the population would currently favor their country's exit from the eurozone. While a eurozone exit may look more likely today than a week ago, we do not believe it would help solve the country's financial problems. When the possibility of Greece leaving the eurozone was discussed last year, we viewed this outcome as unlikely and expressed the view that an exit would have had detrimental consequences, exacerbating Greece's social, economic, and financial challenges (see "Credit FAQ: Sovereign Rating Implications Of A Possible Greek Withdrawal From The Eurozone," June 4, 2012). In our opinion, the same holds for Cyprus. Cyprus suffers from a sizable twin deficit in its fiscal and current accounts, which would require external financing. This deficit could be exacerbated by the capital flight that generally follows after the introduction of a new--typically rapidly depreciating--currency. Financing for Cyprus appears uncertain as financial markets and official funding are effectively closed. And without funding for imports, Cypriot daily life could face severe disruptions given Cyprus' dependence on imported food, fuels, and pharmaceutical products. In recent years, the trade deficit has been more than 20% of GDP. This deficit has customarily been partially offset by Cyprus' high financial and business services surpluses (which has averaged about 12% of GDP). Nevertheless--on the assumption that CIS-based deposits withdraw from the system--Cyprus' services surplus could be materially affected. This loss (with knock-on effects on financial sector employment) would imply that current account financing needs would rise still higher. In our view, these factors could lead to social unrest. And while Cyprus' export sector is much larger than Greece's (about 40% versus 25% of GDP), Cyprus is more dependent on tourism than Greece. Like Greece, Cypriot tourism is import-intensive and might suffer a reputational setback from the economic crisis and dissolving social cohesion. While Cyprus' banking sector may be having difficulty staying solvent and liquid, its financial situation would likely deteriorate further following a currency exit and a depreciation. The large euro-denominated deposit liabilities would be even more difficult to sustain if the (new) local currency were to devalue. A collapse of the financial sector would be hard to avoid in our view, potentially eradicating a large part of the savings of Cypriot citizens.

7. How does Standard & Poor's assess the contagion risk from Cyprus?
Several commentators have raised concerns that the bail-in of insured depositors could lead to renewed capital flight, and outflow of deposits, from other financially-weaker eurozone sovereigns. Deposits in these countries have stabilized following the ECB's announcement on outright monetary transactions in September 2012. But confidence may

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Credit FAQ: The Cyprus "Bail-In" And Its Aftermath

disappear and Cyprus could be a trigger to a new round of reverse flows, further intensifying the diverging monetary and financial trends across the eurozone and jeopardizing stable funding for weaker sovereigns and their banking systems. To the extent that the Program's financial levy on depositors may foreshadow other similar "wealth taxes", such potential deposit flows could further weaken eurozone sovereigns. While this contagion risk exists, we would also stress that we assess Cyprus' banking system as structurally very different from others in the eurozone, both in terms of relative size and funding structure. Cyprus' banks have not only more-severe asset quality problems, but also no large amounts of equity or junior and senior creditors that serve to protect depositors. And no other eurozone sovereign has a banking system where the financial sacrifices resulting from a deposit bail-in would be borne largely by nonresident depositors. We are therefore of the opinion that the idea of bailing-in depositors had more traction in Cyprus than elsewhere. Politicians' claims that "Cyprus is a special and unique case" ring true in that sense. The outright parliamentary rejection of the depositor bail-in means in our opinion that it's highly unlikely that this policy recommendation will reappear in other countries. We find it hard to imagine any other parliament would approve such a measure after the Cyprus experience. In our view, the insured deposits in other peripheral countries may therefore be not any less safe than they were before the currently aborted attempt to tax them in Cyprus.

Related Research:
Cyprus Long-Term Rating Lowered To 'CCC' On Rising Risks To Financial And Economic Stability; Outlook Negative, March 21, 2013 Top 10 Investor Questions On The Eurozone Sovereign Debt Crisis, Feb. 19, 2013 The Eurozone Debt Crisis: 2013 Could Be A Watershed Year, Jan. 9, 2013 Cyprus Rating Lowered To 'CCC+' On Intensifying Liquidity Risks And Burgeoning Debt Burden; Outlook Negative, Dec. 20, 2012
Additional Contact: SovereignEurope; SovereignEurope@standardandpoors.com

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