Tuesday, March 19, 2013

Stanford's Myron Scholes and Darrell Duffie Assess the Fallout in Cyprus

Two scholars explain what could happen next in Nicosia — and the rest of Europe.


"It sets a precedent that the EU authorities might, in the future, confiscate some of the deposits of eurozone banks."

Darrell Duffie, professor of finance, Stanford Graduate School of Business

On Monday, March 18, as policy makers grappled with Cyprus' precarious financial situation, we asked Nobel Laureate Myron Scholes and finance professor Darrell Duffie to assess the situation, and explain where Europe could go from here. 


Will the move on bank deposits create a run on Cypriot banks?

Scholes: The move to tax deposits has already fostered a run on the banks. And, it could spark a run on other banks in the periphery countries — in particular, Greece. The German, IMF, and EU requirements indicate that Germany is not willing to sign blank checks any more. German citizens are up in arms about all of the bailouts and worried about the lack of those in the periphery to balance their budgets through austerity plans. Germany wants to get its money back. They do not consider their support as a gift (although it well might be).

Could it undermine confidence in other EU periphery countries?

Scholes: Depositors in the periphery will now become less sanguine about leaving money in banks in other weak countries. Obviously, unanticipated inflation is another form of a wealth tax (and also amounts to a tax on deposits). Inflation has been a common route to tax savers in many countries and to reduce the value of debt.

We have had an indirect tax on wealth and deposits in the United States. If Federal Reserve Chairman Ben Bernanke and the Federal Reserve Bank's actions keep interest rates below market rates and finance the Treasury's debt, this is taxing current and future generations. Deposits here are taxed through lower-than-market interest rates. And, savers (pensions) are taxed similarly. This is a tax on wealth without representation. It supposedly transfers wealth to growth activities and employment through the bank.

Why was the European Union’s bailout of Cyprus, which included a levy on Cypriot bank deposits, so alarming to markets?

Duffie: It sets a precedent that the EU authorities might, in the future, confiscate some of the deposits of eurozone banks. They haven’t ruled that out, and this action increases the risk of a run the next time something like this happens.

The idea that depositors might lose some money had been discussed in the press in recent months. But the idea that this levy — they call it a tax — would even apply to small depositors is surprising. This is the reverse of normal deposit insurance, where you want to prevent depositors from running by allowing them to be confident so that at least small depositors will be safe.

Was there a better alternative?

Duffie: They should have left deposits of under 100,000 euros untouched, and imposed a higher levy on deposits above 100,000 euros. The normal way to do this would be to start with the bank creditors and then move to the very large depositors. They have deposit insurance, but they don’t have a deposit insurance fund that’s strong enough to back this.

How is this likely to play out?

Duffie: I think they will lower the tax on smaller deposits. They will probably need to do that to get this measure through the Parliament. There’s a possibility that the Parliament still wouldn’t pass it, even if small depositors were protected, which could lead to default and would be messy. … But there is still some time for this to play out. This is a game of poker behind closed doors.

There’s some question about what happens when banks open again. When the banks open it won’t be surprising if many people try to withdraw their deposits. But that’s not so bad compared to what would happen if depositors in other peripheral eurozone countries get worried about their assets as well.

With respect to deposits in other countries, this could, at some future date, increase the likelihood of a run.

Darrell Duffie is the Dean Witter Distinguished Professor of Finance, at the Stanford Graduate School of Business.

Myron Scholes is the Frank E. Buck Professor of Finance, Emeritus, at Stanford Graduate School of Business.