| DUBLIN/NICOSIA, March 20
DUBLIN/NICOSIA, March 20 A small island on the
edge of Europe teetering under the weight of its bust banks.
Like Iceland and Ireland before it, Cyprus is battling to
prevent an outsized and overextended banking sector from
dragging the country into the ground.
Cyprus's parliament has overwhelmingly rejected a proposed
levy on deposits as a condition of a European bailout, throwing
the country's future into disarray.
But the experiences of Iceland and Ireland show that however
Cyprus decides to deal with its crisis, pain is in store.
While Reykjavik let banks fail and introduced capital
controls, making financing its economy difficult, Dublin
nationalised most of its financial sector, helping to quadruple
its debt burden and ensuring years of austerity.
Both countries are growing again, but underlying problems
remain with households in both nations still swamped in housing
debt, Irish unemployment stuck at 14 percent and Iceland fearful
of lifting its capital controls for fear of a damaging outflow
of foreign funds.
None of this suggests an easy way forward for Cyprus, with
its banks mortally wounded through involvement with euro zone
casualty Greece and its financial sector heavily exposed to
sometimes suspect money from Russia.
Cyprus' troubles stem from its exposure to Greece and the
huge losses its two largest banks, Bank of Cyprus and
Marfin Popular, had to stomach when euro zone leaders
agreed in late 2011 to write down the value of private-sector
holdings of Greek government bonds.
In total, Cyprus requires 17 billion euros, nearly
equivalent to its economy's annual output, to rescue its banks
and deal with the government's own bills.
Relatively small in the context of the Greek and Irish
EU-IMF bailouts, at 240 billion euros and 67.5 billion euros
apiece, for an island of just 1 million people it is a huge
burden and speaks volumes about how large and unwieldy its
banking sector had become.
Along with the aggressive expansion in Greece, which helped
Cyprus' banks to double the size of their loan books to around
72 billion euros in the last six years, Cyprus' banking sector
has ballooned on the back of inflows of Russian money, which
first started to arrive following the collapse of the Soviet
Union in 1991.
The banking sector is now roughly eight times the size of
the economy compared to 10 times for Iceland and over four times
for Ireland before their crises. Banks in both countries used
cheap funding to gorge on speculative investments.
High interest rates, low taxes -- in particular a double
taxation treaty with Russia -- and a shared Orthodox faith were
all factors behind the influx of Russian money and people, which
has seen the city of Limassol, the island's financial centre,
become known as "Lima grad".
It is estimated that of approximately 70 billion euros of
deposits in Cyprus, a third are held by non-residents and most
of those are believed to be Russian. Overall, deposits grew by
nearly two thirds over a six year period to the end of 2012,
according to data from the central bank in Cyprus.
On the face of it, the Cypriot banks' deposit-funded balance
sheets, with loan-to-deposit ratios of nearly 100 percent, are a
model for other systems. Irish and Icelandic banks' reliance on
wholesale money markets proved to be a death sentence when the
credit crunch struck.
But the size of the inflows have raised concerns in Germany,
in particular, that the island is a haven for money laundering
and tax evasion.
One Russian bank, Alfa Bank, estimates that $70 billion of
illegal capital flight from Russia in the past two decades may
have found its way to Cyprus.
Cyprus was the largest recipient of Russian direct
investment in 2011, totalling $121.6 billion out of $362
billion, according to Russian central bank data.
Moody's rating agency said last week that Russian banks had
about $12 billion placed with Cypriot banks at the end of 2012
and has estimated that Russian corporate deposits at Cypriot
banks could be around $19 billion.
Such concerns were behind a politically charged decision
last weekend to break with previous EU practice and impose a
levy on bank accounts as part of a bailout. This sparked outrage
among Cypriots and fear in financial markets that a dangerous
precedent had been set.
Alexander Apostolides, an economic historian at European
University Cyprus, said labelling Cyprus as a hotbed of shadowy
banking was unfair.
"It is a gross oversimplification," he said. "I'm pretty
sure there are some very dodgy accounts but I would be shocked
if they represented more than 1 billion."
"There are a lot of Russians here but there are also a lot
of Russians in London. If you took London out of the rest of the
UK wouldn't you say there was an overdependence on Russian
Despite Cyprus' banks exposure to Greece, deposits stayed
largely stable last year, partly due to the belief that savers
would not be hit and partly due to the high interest rates.
A depositor in Cyprus who put their money in the bank for
rolling periods of less than a year would have been paid
interest of almost 13 percent since the Greek crisis first
erupted compared to just over three percent in German banks,
according to Reuters calculations based on ECB data.
In the past ten days, however, as rumours first surfaced
about a hit on savers, an estimated 2 billion euros has been
withdrawn by Russian depositors, according to Thomas Keane,
co-founder of Cyprus-based law firm Keane Vgenopoulou &
Under the proposed terms of Cyprus' bailout, there will be a
tax on interest that deposits generate, which will likely be set
at 20-30 percent and Nicosia will have to shrink the banking
sector to an EU average of around 3.5 times GDP by 2018.
Iceland imposed capital controls to restrict the flow of
crowns and other currencies in and out of the country in 2008
and there are concerns Cyprus will have to do likewise when its
banks, currently closed, finally reopen.
"Even if a compromise solution can be found, confidence in
the security of bank deposits in Cyprus may have been fatally
undermined, especially among non-resident depositors who have
more choice about where to keep their money," said Tristan
Cooper, fixed income sovereign credit analyst at Fidelity
"This will likely prompt capital flight once the banks
reopen and may necessitate the sustained imposition of capital
controls in order to stem an escalating banking crisis. The
parallels with Iceland, which also had an outsized banking
system are worrying."