The legal reasons against the deal to confiscate part of bank accounts in Cypress seem to have been missed by Eurocrats. While they were at it, they also missed powerful reasons why their actions might undermine the financial system. There are ways to make failing institutions and the shareholders and some account holders pay that are legal and in line with international business law. Unfortunately for depositors these other methods could be much more costly.
There are several reasons the scheme to simply take a percentage of the deposits in the banks is legally questionable.
Retroactivity – The principals of most advanced legal systems prohibit creating retroactive laws. Laws cannot be written today to cover a situation yesterday. Yet this law would apply retroactively.
Violates Deposit Guarantee – Deposits in all Euro Zone banks are insured up to 100,000 Euros. This simply breaks that guarantee.
Equal Treatment Under the Law – All other Euro Zone savers have been spared being taxed on their deposits. Confiscating part of Cyprus bank accounts is radically different treatment.
High Threshold for Confiscation – Almost all modern legal systems allow governments to confiscate property in some circumstances. Often it is done with compensation. Almost always it is done with a clearly prescribed legal process and a chance to challenge the government.
Banking and Confiscation
Banks and money are based on trust. Neither work, if trust is gone. The foundation of most banking systems is this trust. Any time there has been a failure of trust there has been a run on the banks. And nothing demonstrates the unique position of banks in our economic system. If there is a run on the banks the economy can grind to a halt.
This is why banks are singled out for special treatment of all businesses. They are subject to detailed regulation. They must keep enough money set aside to keep them safe. Everything is done to promote the idea that they are safe. There is even deposit insurance to allow people to trust the banks to keep their deposits safe up to a certain level.
Security is threaten by confiscation. Who will believe in the deposit guarantee if it can be broken? If broken here what about Italy, Spain and Portugal? Runs there would be devastating.
What could have been done?
First the Euro Zone could give Cyprus the same deal as it gave other countries: Money for austerity. However there seems to be no mood for that. And these actions did not really fix the fundaments at the banks.
They could kick Cypress out of the Euro Zone. There is no legal mechanism for that and probably no due diligence to the economic consequences. If it were safe for the world economy they could be left on their own and deal with it as Iceland did but probably at a higher cost then staying.
The other option is a legal restructuring of the problems banks. This has been a major topic of debate in the United States about how to treat the largest “too big to fail banks.” However the U.S. has had laws that guided the restructuring of most banks for decades.
The U.S. government agency keeps track of the health of banks. When one is ready to fail, it goes in, usually on a Friday night, seizes the bank and tries to merge it with another which buys up the assets including deposits. The bank reopens Monday under a new name. Depositors with savings under the insurable limit are safe. For owners, shareholders and bondholders all bets are off. Even if all efforts are made to preserve value it is still in effect a bankruptcy.
This is the difference between the U.S. and Europe. Investors and large depositors know there is a risk. And they decide whether to take it. They know the rules are clear.
With the Euro Zone the rules are not clear. Europe has been debating regulating banks at the Euro level and have not put any structure in place. They have therefore been left to improvise and come up with solutions that have serious negative legal and economic consequences.
What was done? Something on the lines of legal restructuring.