Five years after the greatest financial crash in history, the banks are still creating chaos

Felix Martin's "Real Money" column.

Photograph: Getty Images

Banking institutions are more dangerous than standing armies,” wrote Thomas Jefferson in 1816. The president of Cyprus, Nicos Anastasiades, has just joined the growing line of European politicians who have come to the same conclusion. Cyprus is the latest European country to be brought to its knees by its banks. It is time governments started thinking more seriously about why this is the case and what should be done about it.

Cyprus’s is a story with more angles than Euclid’s Elements, from its unfinished civil war and its strategic naval bases to its status as Russia’s own private Channel Island and its prodigious untapped gas reserves. But the essence of the current crisis is all too simple. Cyprus has big banks: seven times the size of its economy, at the last count. These big banks have a big problem. Their assets, the loans they have made and the bonds that they own, are not worth what they thought they were. The reason could hardly be more ironic. In 2012, their portfolios included a lot of Greek bonds. When Greece pulled off its EU-approved default, they had to swallow a loss of about 75 cents in the euro.

Now if you or I had owned Greek bonds, we would have owned them outright. We’d have lost our shirts in the default but that would have been that. Banks, however, are not like you or me. They fund the assets they own by issuing their own bonds and by taking deposits. They have fixed liabilities, in other words – a lot of them. So when they are forced to book a large and unexpected loss, there is a problem. All of a sudden, their liabilities are larger than their assets. Their balance sheet does not balance. Barring external support, they are bust.

What should be done when big banks go bust? The purist’s answer is that they should be placed in bankruptcy just like any other company. Those who provided capital to the failed bank would take losses according to the legally mandated order of precedence. Equity shareholders lose out first. If the losses are more than the bank’s equity alone can absorb, those who have provided capital by buying its bonds or making large-scale deposits must also take a hit. The only people whose money is safe even if the bank’s assets shrink to zero are its small depositors, for whom statutory insurance will save the day.

This purist’s approach is, on the face of it, the only fair one. After all, why should taxpayers bail out a bank’s shareholders, bondholders, or wealthy depositors if something goes wrong? It was the strategy adopted by Iceland, another country with a hypertrophied banking sector, in the face of its financial crisis in 2008. Rather than bail out its banks, Iceland liquidated them. The shareholders were wiped out. Small depositors were paid out from the good assets. The bondholders were left to wring what they could from the bad ones.

Other countries opted not to be purists, though, as we in Britain know only too well. In early 2008, our government also issued solemn warnings that taxpayer bailouts would wreck financial discipline. When it became clear that three of Britain’s largest banks were insolvent, however, our leaders realised that things were a little more complicated. The big banks are important British employers, exporters and taxpayers. What’s more, the rest of the economy depends on them for credit and payments. Allowing the big banks to fail would be sacrificing Britain’s economic future on the altar of an abstract financial ideal. Bankruptcy was out of the question.

Instead, it was bailouts all round, and all on the taxpayer. The partial nationalisation of RBS and Lloyds obliged shareholders to take a hit but bondholders and depositors were left untouched. The rationale was to minimise the loss to the British taxpayer. Nationalisation would certainly cost money; but the cost in lost growth and lost tax revenues if bank bankruptcies had been permitted would have been even worse. Pragmatic macroeconomic reality trumped noble financial principle.

Such is the context of Cyprus’s plight. The German government and the International Monetary Fund argued in favour of the purist’s approach. The fair thing to do is to stick to principles and liquidate the banks: Cyprus should become a second Iceland. The Cypriots, meanwhile, would have preferred to become another Britain, and so preserve their flagship industry and avoid economic oblivion. On Sunday 24 March, the Icelandic approach prevailed. Negotiating an EU bailout is a game that lasts a few tortuous weeks, and then the Germans win.

Being the purist’s solution, it will be scrupulously fair – and economically disastrous. Cyprus will be finished as a financial centre, its people can look forward to a deep recession from which there will be no swift recovery, and those who hold its sovereign debt can start worrying about a default and restructuring in a couple of years. But for the time being, victory can be declared and we can all be told to continue on our way, because there is nothing more to see.

These plot details of the latest episode of the eurozone soap opera starring the selfstyled model states of northern Europe and the mañana republics of the south are mostly a distraction, however. The real disaster exposed by the Cyprus debacle is that five years after the greatest financial crash in history, neither the EU nor any other jurisdiction has done anything serious to fix the structure of its own banking system. We remain lumbered with banks so large and complex that sticking to fair principles and winding them up when they are bust is self-defeating. It is a poisonous recipe for perpetual bad faith. There has been enough argument about how to treat the symptoms. Cyprus is a reminder that the time has come to treat the disease itself.

Felix Martin is a macroeconomist and bond investor. His book, “Money: the Unauthorised Biography”, is out in June