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What’s the Next Step for an Economy Trying to Stem a Bank Run?

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For the last few days, banks in Cyprus have had to close their doors to customers during a parliamentary election pertaining to whether or not personal savers will wake up to see as much as 10% of their money vanish towards a ‘deposit levy’, issued by the government to bail out a struggling financial system. As ATMs ran empty, and funds transfers were frozen, the country was the epitome of a bank run.

Euro Symbol, Frankfurt, Germany.From there, savers are expected to have access to their funds again shortly, but at what cost? In order to prevent the complete collapse of the deposits underlying the loans outstanding from the banks, it is expected that a variety of mechanisms are going to be put in place to stem the outflow of funds. Specifically, the sorts of capital controls that were famously present in countries like Nigeria and Argentina during their low-points are expected to have some serious implications for personal savers in Cyprus.

Capital controls are mechanisms put in place by banks to prevent them from running out of money. Plainly speaking, if a bank is out of money, it needs to start calling in loans to make sure that they have cash on hand to pay out depositors looking for their money. The issue behind such a circumstance is that most borrowers do not have enough money on hand to cash out of their mortgage with a month’s notice, and wouldn’t be able to sell their house into a flooded market in such a short timeline, let alone for enough money to pay out their mortgage.

In order to try and prevent such a situation from happening, restrictions are sometimes placed on the amount of money that a saver is allowed to withdraw from their account every day, or slowing down transactions that are leaving the country.

The end result is that the restrictions buy the bank some time to find liquidity either through loans that can actually be called in, or through the acquisition of bridging capital to finance the timing issues between the need for money now, and the availability of it later. Unfortunately, the issues surrounding such a policy are mainly that it encourages people to begin withdrawing as much money as possible from their banks, for fear that the bank might run out of money entirely before theirs can actually be withdrawn. The end result is a situation that only prolongs the capital flight process, and still leaves the bank in a particularly distressed situation.

Historically, capital control mechanisms have been seen implemented during financially distressed periods of hyper-inflation, as a means of shifting a small portion of a financial burden onto savers, and away from the government that is printing money and causing problems in the first place. The end result is then that the funds in these bank accounts effectively become worthless over time, as the hyper-inflation mechanisms take their course, and dilute the value of a person’s savings out to nothing.

However, the interesting thing to note about the situation in Cyprus is that the government is not actually in a position to enter a period of hyper-inflation to drown out its debt load because of its membership to the Euro-zone (i.e. it can’t print money).

This creates an interesting situation where it is that capital control (if carefully implemented) could actually create a meaningful benefit. Specifically, by placing controls that restrict the movement of large sums of money that are being transferred, and especially those transactions leaving the country, the government could effectively slow down the surrounding economy of Cyprus, while improving short-term liquidity for banks to deal with their personal savings crisis. The end result would potentially buy the banks some more time to bridge their financing gap, maintain their funding status for the shorter term, and hopefully forego the implementation of a deposit levy.

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