The cost of equity

Cyprus depositor share swap looks like a raw deal

The Cypriot government's proposed forthcoming share swap looks like a raw deal. Insured and uninsured depositors, respectively facing losses of seven per cent to 10 per cent on their savings, are to be offered shares in soon-to-be bailed out lenders like Bank of Cyprus, Hellenic Bank and Cyprus Popular Bank. That doesn't look like a good trade.

It's unclear what Cypriot banks will look like after their bailout. The banks dispute initial shortfall estimates of euro 8 billion to euro 10 billion. On the bright side, depositors should hold shares in banks with a relatively strong nine per cent core Tier 1 ratio. And, the requirement to offload Greek exposure as part of the restructuring isn't all bad: CPB's non-performing loans there are now at an eye-wateringly high 40 per cent.

The catch is that the newly amputated Cypriot lenders would be more exposed to their splintering economy. Even before factoring in macroeconomic shocks from the trauma of the tax on deposits, the domestic economy will contract by two per cent in 2013, pushing non-performing loans at CPB and BoC above 17 per cent. Meanwhile, Cypriot banks fund eight per cent of their lending via expensive emergency liquidity assistance from their own central bank, according to Morgan Stanley. Both will hit profit.

With better capital buffers, Cypriot banks may warrant a more generous valuation than their average 0.2 times book value. But aside from the likelihood of losses in a shrinking economy, bank investors can't be sure that the government will be competent enough to engineer a serious economic turnaround. The new shares would have to trade much above half their book value to make investors whole on their euro 5.8 billion - which they previously held in the form of (supposedly) much safer deposits.

The best hope for making disgruntled depositors whole may not be their bank stakes. In a highly bullish scenario the annual income from potential new gas fields in Cyprus' waters could reach euro 1.6 billion, Morgan Stanley reckons. An idea would be to offer depositors a share of the future revenue - which could also serve as an incentive to keep the money in the bank when branches reopen. Without the gas sweetener, depositors may have to wait a long time to break even.