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The Cypriot catastrophe shows just how far away the euro zone is from creating its much-touted "banking union." There was no euro zone supervision of Cyprus' big banks, no transnational approach to put them into controlled bankruptcy, no common deposit insurance and no flow of bank rescue funds from abroad.
Instead, there was weak supervision by the Central Bank of Cyprus and a mad scramble to carve up the banks' assets on national lines. Nicosia was left to shoulder the whole cost of protecting small depositors and the euro zone said that none of its bailout cash could be injected into the troubled banks.
Optimists hope the fiasco will provide the euro zone with the impetus to complete its banking union. But it is equally possible that core countries such as Germany, Finland and the Netherlands will become even more reluctant to absorb the liabilities of bust peripheral banks.
Indeed, Jeroen Dijsselbloem, the Dutch finance minister who runs the Eurogroup, suggested last week that the treatment meted out to Cyprus could be a model for other bailouts – though he later said his words had been taken out of context.
Last summer at the height of the panic over Spain's banks, the euro zone embarked on the initial step towards banking union. The idea was to break the "doom loop" under which weak banks were dragging down weak governments and vice versa. Leaders agreed that the European Stability Mechanism (ESM), the zone's bailout fund, could be used to recapitalise bust banks – but only once an effective supervisory mechanism was in place. The European Central Bank was chosen to be that supervisor.
No sooner had the core countries agreed to this deal than they started having remorse. The Spanish panic died down after Mario Draghi, the ECB president, promised to do whatever it takes to preserve the single currency. Germany and its allies then made clear the ESM could not bail out banks with legacy problems, meaning it was no use for the current crisis.
Meanwhile, the ECB's supervisory mechanism is unlikely to be operating until the middle of next year. What's more, a single supervisor on its own doesn't make a full banking union. At minimum, a single "resolution" mechanism is also needed. Resolution is a euphemism for controlled bankruptcy.
Many analysts also think common deposit insurance is required. In the euro zone, deposits of less than 100,000 euros are supposed to be guaranteed by national schemes. In the wake of Cyprus' crisis, the Eurogroup re-emphasised that these savings should be protected. But Germany and its allies are dead set against a euro-wide deposit insurance scheme.
On the other hand, the European Commission is working on legislation that will require countries to have harmonised national resolution mechanisms. This will also pave the way for bondholders to be "bailed in" when banks are teetering on the brink, so minimising the need for taxpayer bailouts.
Euro zone leaders have also given the green light for setting up a single resolution mechanism. This is vital not least because the ECB won't be able to supervise properly if there's no authority to which it can hand over a bust bank. The European Commission is supposed to come up with a plan this year with the idea that legislation will be passed before the European elections in June 2014.
The snag is that it's devilishly difficult to set up such a resolution authority, as Nicolas Veron and Guntram Wolff point out in an excellent paper from the Bruegel think tank – not least because it is hard to find the basis for such an authority in the current treaties.
What's more, there is no agreement on how this authority should fund bank failures if there isn't enough capital to take the hit. One idea, imposing levies on the industry, won't raise enough money for a long time. Meanwhile, core countries will be reluctant to deploy the ESM, unless Germany's position softens after its elections in September.
This was the context in which the Cypriot banking crisis took place. Nicosia was small enough to be bullied and with which to attempt an experiment.
The core countries took a hard line that no taxpayers' money could be used to bail out the banks, meaning large depositors will face big losses. Meanwhile, Cyprus was forced to sell its large banking assets in Greece to protect Athens from contagion. This led to Greek depositors being treated much better than their Cypriot counterparts – a type of discrimination that would not happen in a proper banking union. As Mervyn King, governor of the Bank of England, once memorably said: banks are "global in life but national in death."
Dijsselbloem's idea that Cyprus should be a model is not sensible – because its banking system was unusual in being so large relative to the size of its economy while having only a small sliver of bondholder capital. But the Eurogroup president was onto something when he said creditors rather than taxpayers should bail out bust banks.
However, to make this idea workable without causing chaos among depositors, lenders must first be required to build up a fat buffer of "bail-in" bonds which can take the strain when banks get into trouble. The European Commission's plans wouldn't require this until 2018 and it hasn't specified how big such a buffer should be either. After Cyprus, it needs to get its skates on.