So much for the idea that tail risks are off the table.
The whole point of tail risks, those low-probability but high-impact outcomes that seemed all too common in the depths of the financial crisis, is that they are hard to see coming. The idea that Cyprus, a nation with a population the size of Calgary and 0.2 per cent of the European economy, could be the starting point for a broader European bank run is nothing if not a reminder of that.
The overarching narrative in 2013 has been, with apologies to Donald Rumsfeld, that the unknowns are largely known. The tail risks, the storyline goes, have abated and we are now into a slog of steady problem solving. Europe just needs to muddle through, China is into a soft landing, and the U.S. will find a way to deal with its budget woes.
That belief has allowed stocks to climb, led to a softening in the risk-off trade that fuelled gold, and has even convinced some corporations to get back in the deal-making game.
However, that notion rests on the idea that bureaucrats and policy makers in Europe, a new leader in China, and the impossible-to-predict U.S. Congress will continue to make logical decisions that don't have unintended consequences.
In other words, the biggest tail risk remaining may not be a hidden problem on a bank balance sheet, or in a derivative structure, but simple human error. In this case, it may yet prove to be the inability to gauge world reaction to a measure such as a confiscation of insured deposits in a tiny island nation.
By all accounts, it appears that negotiators from the European Union, the International Monetary Fund and the European Central Bank demanded that depositors in Cyprus pay to help recapitalize the country's banks. There were good reasons for doing so, as taxpayers in the rest of Europe want to see a contribution from Cypriot bank creditors, and depositors are basically the only place to turn. The banks have next to no bonds outstanding.
However, when the Cypriot government proposed doing that by taking money from depositors whose accounts were insured against loss, as well as those from bigger accounts that were not insured, it seems the exhausted representatives from the so-called Troika failed to connect the dots and to note the larger ramifications. Or they did, and decided to risk it anyway. Only belatedly Monday did they appear to back off, with a double-speaking statement that they said "reaffirms the importance of fully guaranteeing deposits below €100,000" while leaving open the possibility that Cyprus may still levy a tax on those deposits.
Paul Krugman wrote of the original plan that "it's as if the Europeans are holding up a neon sign, written in Greek and Italian, saying 'time to stage a run on your banks!' "
The insured-deposit levy in Cyprus has not devolved, as yet, into the contagion that worried commentators were predicting going into Monday. Markets held quite firm Monday. There were no pictures of queues at withdrawal windows in Rome or Lisbon or Madrid.
But there are a lot of smart people in Europe saying the situation could still break that way, if one of those countries gets to a point where such a levy would be on the list of things to try. Plenty of analysts have been trotting out Bank of England governor Mervyn King's line that it may not be rational to start a bank run, but it is rational to participate in one.
Suki Mann, a credit analyst at Société Générale, wrote that "this takes in the piecemeal on-the-hoof policy response, the fragmentation of that policy, still diverging economies and funding levels which clearly show that everything is very much evolving. It's scary stuff. We should not dismiss a catastrophe."
Markit, which analyzes credit markets, wrote that "the fears of contagion are not has heightened as we saw in previous episodes of market turmoil. Nonetheless, all eyes will be on Cyprus over the next few days, and it has the potential to grow into a material negative catalyst."
UBS analysts, according to EuroMoney, wrote that "clearly this provides a catalyst to start a bank run at a point when the impact of such is most likely to be catastrophic for the economy involved."
Reuters quotes Michael Michaelides, a rates strategist at RBS, as saying: "If I were a depositor in Spain, I would be much more inclined to put my money somewhere else." In his view, "it doesn't need to be an immediate reaction. What you can see is that if any of the sovereigns were to get in trouble, then the chances of there being a deposit flight at that time would be much higher."
So because of Cyprus, there is now a heightened risk of a bank run in Europe. But there is also a welcome reminder that tail risks don't really go away; investors just tend to find ways to minimize and rationalize them when optimism becomes the dominant tone. The unknowns remain, and you never know where.
(Boyd Erman is a Globe and Mail Reporter & Streetwise Columnist.)
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