Grey matters

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The Cyprus debt: Perfect crisis and a way forward, Wharton Working Paper No. 13-09
Stavros A Zenios

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The Cyprus crisis is one of the most complex in the Eurozone – although in absolute terms it is a minor crisis. An analysis of the ongoing developments from different perspectives leads to the conclusion that we are witnessing a ‘perfect crisis’ at the confluence of sovereign debt and banking crisis together with debt overhang of business and households and a severe decline of competitiveness. As a result CY has amassed a large external debt that cannot be repaid, no matter what fraction of the country’s real domestic economic output is appropriated through austerity measures. Hence, fiscal austerity leads to deflationary stagnation and alone does not work. We advocate a policy response that addresses multiple dimensions of the problem with policy options of (1) austerity deleveraging, (2) structural reforms, (3) financial innovations, (4) partial privatisations and (5) debt restructuring. These options are drawn from lessons of what worked well, and what not, in crises of other countries and these lessons are summarized in lieu of conclusions.

CFR comment:
With the drama of the Cypriot banking crisis fresh in our minds, it is easy to forget that Cyprus has broader economic problems. The author, with an appointment at both the University of Cyprus and the University of Pennsylvania’s Wharton School, is well equipped to give a careful examination of the origins of the Cypriot crisis. Zenios concisely and bluntly sets out the problems that led to the crisis.


Friedrich Hayek on monetary and banking systems reform, Universidad Francisco Marroquin (13 Jan., 2013)
Adrian O. Ravier

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Throughout his life, Friedrich Hayek worked towards prescribing a monetary policy under which the world economy would again enjoy the stability it had known under the classical international gold standard system. This paper outlines three banking and monetary systems that were pivotal in the history of banking and closely scrutinised by Hayek. This paper outlines those systems, summarises Hayek’s comments on each and then discusses the recent literature on the subject in light of Hayek’s influence.

CFR comment:

This brief (15 pages) survey of Nobel Prize winning economist Friedrich Hayek  summarises the Austrian approach to banking and money in an accessible way. Regulators aren’t likely to adopt a Hayekian approach any time soon, but thinking through banking reform from an Austrian perspective is a useful way to assess the measures they do take.


Beware of German gifts near their elections: How Cyprus got here and why it is currently more out than in the Eurozone (3 May, 2013)
Alexander Apostolides

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Key points:

  • The situation in Cyprus arose due to banking overreach, insufficient regulation, excessive government deficits, poor debt management and collateral damage from previous Eurogroup bailouts.
  • The amount needed is small in absolute values, but large relative to the size of the economy. The Troika was unwilling to fund more than 10 billion euros.
  • Extreme delay from the departing Christofias government and persistence from the Troika led to the bailing-in of depositors to cover the gap. An attempt to spread the pain by suggesting a “shares-for-deposits swap” for all Cypriot depositors, (bailing-in even insured depositors) was defeated in the Cypriot parliament.
  • In subsequent negotiations, insured depositors were unharmed: uninsured depositors in the largest two Systemically Important Financial Institutions, Laiki Bank and Bank of Cyprus were affected.
  • Local debt default and forced rollover are part of the bailout, but as it currently stands, holders of external debt are to be paid in full. The exception is the Russian Federal Republic: the Troika has demanded that Cyprus negotiate a restructuring of that direct government loan.
  • As a result of the above actions, Cyprus is left facing an unprecedented economic depression; the link between weak financial institutions and a weak state has not been broken, making a second bailout very likely.
  • Cyprus has capital controls, deteriorating financial situation and needs to defend itself against local and domestic lawsuits that might overturn decisions. Cyprus is still dangling precariously from the Euro exit cliff.

CFR comment:
A valuable local perspective on the Cypriot banking crisis which identifies the many problems the “bail in” caused in the Cypriot economy.


The Great Leveraging, BIS Working Paper No. 398 (Dec. 2012)
Alan M. Taylor

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What can history can tell us about the relationship between the banking system, financial crises, the global economy, and economic performance? Evidence shows that in the advanced economies we live in a world that is more financialized than ever before as measured by importance of credit in the economy. I term this long-run evolution The Great Leveraging and present a ten-point examination of its main contours and implications.

CFR comment:
This paper, which includes perceptive discussant comments from Barry Eichengreen and Y.V. Reddy, focuses on five facts and five lessons from the financial crisis, and is a terrific summary of the lessons of economic history for financial crises. A worthwhile read.


Bagehot was a shadow banker: Shadow banking, central banking, and the future of global finance, (22 Feb., 2013)
Perry Mehrling, Zoltan Pozsar, James Sweeney and Daniel H Neilson

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At the heart of both the modern shadow banking system and the 19th century banking system described by Walter Bagehot is the wholesale money market, with the central bank providing a liquidity backstop. We characterise shadow banking as “money market funding of capital market lending” and construct a model of such a system with dealers making markets and setting prices for funding and risk. Using this model, we describe the secular expansion of the market-based credit system and its rapid collapse during the global financial crisis. The model also clarifies the economic functions of the market-based credit system, the role of the central bank in such a system, and the global character of US dollar funding markets.

CFR comment:
A thoughtful analysis of how finance works, which focuses on the crucial role played by “shadow banking” in modern finance.


Regulating banking bonuses in the European Union: A case study in unintended consequences, USC CLEO Research Paper No. C13-8
Kevin J Murphy

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On 27 February 2013, the European Union (EU) reached a provisional deal to limit the amount of bankers’ bonuses to the amount of fixed remuneration (ie, a one-to-one ratio); the cap could be increased to 2:1 with the backing of a supermajority of shareholders. I demonstrate that the pending EU regulations restrictions will: (1) increase rather than decrease incentives for excessive risk taking; (2) result in significant increase in fixed remuneration; (3) reduce incentives to create value; (4) reduce the competitiveness of the EU banking sector; and (5) result in a general degradation in the quality of EU investment bankers, thereby decreasing access to capital and increasing the cost of capital in the European Union.

CFR comment:
A terrific analysis of how some post-crisis banking reforms are going to further screw up banking.


Using a sledgehammer to crack a nut: Why FATCA will not stand, Wisconsin Law Review 2013(1): 205-236
Frederic Alain Behrens

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The Foreign Account Tax Compliance Act (FATCA) became law in 2010 and is an important development in combating income tax evasion. Under FATCA, American individual and corporate taxpayers must provide comprehensive information to the Internal Revenue Service (IRS) regarding foreign bank accounts. In addition, a more controversial part of FATCA requires foreign banks to report directly to the IRS certain information about financial accounts held by American taxpayers.
These drastic changes in American tax policy are alarming to the international financial community. International banks are forced to implement expensive compliance programmes to satisfy the information reporting requirements. An increasing number of foreign financial institutions will no longer want any involvement with American citizens or investments. Furthermore, Americans living abroad might be forced to denounce their American citizenship in order to gain access to insurance and basic banking options.
In response to the unilateral imposition of FATCA, foreign governments and banks may lobby for its repeal. This comment examines factors in the global movement to repeal FATCA and suggests several workable solutions that would be agreeable to the United States and foreign nations. Specifically, this comment suggests how investment income withholding and increased IRS enforcement actions are a better solution to prevent income tax evasion.

CFR comment:
US legal journals publish student “notes” and “comments” from among their staff. These often vary widely in quality. This comment is well-done and sketches the many problems created by the US FATCA. Most interesting is its outline of the potential for improvements to the statute that would simplify compliance. These include raising the threshold amount for reporting and exemption of some transactions and extension of deadlines and provision of more detailed procedures for financial institutions. It also explores the conditions necessary for a wholesale repeal.


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Andrew P. Morriss

Andrew P. Morriss, Chairman, is the D. Paul Jones, Jr. & Charlene Angelich Jones – Compass Bank Endowed Chair of Law at the University of Alabama School of Law. He was formerly the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois,Urbana-Champaign. He received his A.B. from Princeton University, his J.D. and M.Pub.Aff. from the University of Texas at Austin, and his Ph.D. (Economics) from the Massachusetts Institute of Technology. He is a Research Fellow of the N.Y.U. Center for Labor and Employment Law,and a Senior Fellow of the Institute for Energy Research, Washington,D.C., as well as a regular visiting faculty memberat the Universidad Francisco Marroquín,Guatemala. He is the author or coauthor of more than 50 scholarly articles, books, and bookchapters, including Regulation by Litigation (Yale Univ. Press 2008) (with Bruce Yandle and Andrew Dorchak), and is the editor of Offshore Financial Centers and Regulatory Competition (American Enterprise Institute Press 2010).

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