Europe Has A Week To Prevent Another Lehman

Cypriot banks are closed, all bank deposits are frozen including the Russian government’s, and there is no obvious way to unfreeze them. Russia is becoming very annoyed. The ECB has given Cyprus until Monday to agree to a bank recap. Otherwise it says that it will withdraw emergency liquidity and the Cypriot banking system will collapse. A Cypriot banking collapse would be a Lehman Event.

Since there are no real deadlines in Euroland, this is most likely feint by the ECB to force Europe to step up. One solution might be for the ESM to guarantee the ECB’s exposure pending a bailout agreement. The ECB isn’t allowed to lend to insolvent banks.

Europe is finally realizing that a Cypriot banking collapse would pose a systemic risk to the eurozone. The Telegraph:

“Jeroen Dijsselbloem, the Dutch finance minister who chairs meetings of eurozone ministers, warned that Cyprus poses a "systemic risk" to Europe's economy and banking sector, meaning a bank meltdown there could plunge other European countries into a new crisis. "In the present situation I think there is definitely a systemic risk and I think the unrest of the last couple of days has proven this, unfortunately," he said.” (03.21.13)

A Cypriot banking collapse would lead to a general pull-back of deposits in Club Med banks (including Italy) by foreign and domestic institutional depositors. The risk in these countries is not that an individual bank will fail, but rather that all deposits will be frozen and rescheduled and/or redenominated. This means that the entire country must be redlined, not just weak banks. Domestic institutional creditors are as much at risk as foreigners.

The finance ministers have reportedly started to discuss capital controls as a way to prevent contagion from a Cyprus collapse to the rest of Club Med. What could this mean in practice? Are they really contemplating capital controls for the Club Med countries? This would violate a whole lot of laws, and would mean the effective end of the eurozone as a single monetary zone. (The US and and a number of other countries use the US dollar as their currency, but they are not a single monetary zone.)

If capital controls are imposed in any of the Club Med countries, they will have to be imposed on many of them, because of the risk that they will be imposed later. Capital controls in an economy like Italy would be a financial event similar to Austria in 1931.

Unless a Cypriot banking collapse is averted, it will be another Lehman Event, perhaps even a Minsky Moment. In retrospect, none of the reasons for allowing Austria’s banks to default in 1931 were very persuasive. None of Hank Paulson’s reasons for allowing Lehman to go bankrupt are persuasive. And none of the reasons being given for Cyprus to go under are persuasive either. The cost of a cleanup from Cyprus would be a multiple of the cost of buying the entire country.

Ultimately, this is a problem that land squarely on Merkel’s desk. Only she (and Schaueble) have the power to force (permit) a resolution. I am confident that this is being made clear to her as we speak (by Medvedev and others). Personalities matter in financial crises. At this juncture, it is very unfortunate that Tim Geithner has left the scene. Right now, the only authoritative American voice in Europe is Ben Bernanke, who isn’t allowed to make policy recommendations.

The world has about a week to prevent the Cyprus crisis from infecting southern Europe. If it fails, the market impact will be quite remarkable.