The liquidity lifeline of Cypriot banks has become a noose. The country's central bank helped keep Laiki afloat with some ^9 billion of so-called emergency liquidity assistance, before the bank was wound down as part of Cyprus's Euro zone bailout. Those ^9 billion have been dumped on Bank of Cyprus, the larger rival that will absorb Laiki's good bank. It's learning about the downside of ELA the hard way.
Cypriots may wonder why Panicos Demetriades, the central bank governor, has agreed to lumber Bank of Cyprus with the other bank's ELA. As a last-gasp option, that type of funding is expensive. It will leave Cyprus' only large bank with even fewer earnings to protect its capital base, which will be heavily eroded over the next few years as the economy tanks. A friendlier option would have seen the ELA left in a bad bank, alongside Laiki's uninsured deposits and stinkiest loans. ELA is protected by large haircuts - up to 75 per cent - so even if losses from the windup were large, collateral would have provided an offset.
Yet, leaving the ELA in the bad bank could have increased the Cyprus government's debt burden. Unlike the European Central Bank's more conventional liquidity support operations, ELA is a liability to the national central bank, and thus its own government, not to the ECB. Given it is worth more than 60 per cent of GDP, and given that losses in the Laiki bad bank could be painful, the bad bank option might have meant Cyprus swallowing more losses.
As such, Demetriades decided to dump ELA on the only healthy bank. Following the expected hit on uninsured depositors, Bank of Cyprus is likely to hold a 15 per cent core Tier-I ratio in the short term, according to a person familiar with the situation. The extra buffer, at the expense of its own large depositors, is not only to protect the bank from future losses on its exposure to the Cypriot economy. It is also to ensure that the country's central bank will get paid back.
This all sticks in Cypriots' craw, not least because a big chunk of the ELA was taken out by Cypriot banks' operations in Greece, which have been sold to Piraeus. The only other way to avoid the huge liability that Cypriot taxpayers are taking on through Bank of Cyprus would have been to leave the Euro zone. Not an attractive option either.
