Lessons from Cyprus: Investors Should Have Known
The banking crisis in Cyprus serves as a reminder of three dangers that are often overlooked by investors until it’s too late: liquidity risk, political risk, and size of market risk. When a country’s economy is expanding, foreign capital tends to flow freely. Investors are so intent on putting money to work and taking advantage of low taxes and lax regulation that they don’t focus on any of these risks. They also don’t think about how they’ll get their money back out if there’s a problem.
In good times, there’s plenty of liquidity, and the rule of law, even in emerging markets, functions reasonably well. Contracts are honored, and even lax regulation doesn’t pose an immediate threat. However, in bad times, liquidity disappears and contracts and regulations have a tendency to be modified or ignored. Clearly, liquidity and political risk are at work in Cyprus. Investors, particularly non-citizens, have discovered that they can’t get their hands on their money. Furthermore, some of their money is going to be taken away as part of the restructuring of Cyprus’s banking sector.
Russian investors, fearing the weaknesses of their own legal system, thought that Cyprus, as a member of the Eurozone, would treat them equitably. Cyprus was supposed to be an offshore haven. It shouldn’t be surprising that European and Cypriot politicians and banks are prepared to inflict a greater pain on foreign investors than their on own citizens. There’s a lesson in this for all of us who invest overseas. While we can probably redeem all our capital under normal circumstances, this isn’t likely to be the case in a crisis. While difficult to measure and foresee, political risk is real.
I don’t feel too sorry for the foreign investors facing losses on their bank deposits in Cyprus. In this instance, I am not talking about the potential that some of the Russian money might be from illegal sources. Rather, the Russian and other foreign investors should have known better. Credit in Cyprus was three times the country’s GDP, which means that Cyprus had way more capital than it could deploy in its local market. In fact, no other economy came close to Cyprus’ ratio of capital to GDP. With insufficient opportunities on the island, Cypriot banks invested much of the capital in Greece. Foreign investors have known for years that Greece faced huge problems, and yet they kept their money in Cypriot banks. Iceland, another small economy, experienced a similar phenomenon in 2008. Foreign investors had plenty of warning.
Again, there’s a more general lesson for all of us. When any financial institution has far more capital than it can invest in its core markets, the institution tends to get into trouble. For example, right here in North Carolina many of our community banks had more capital than they could invest in their local markets. As a result, they decided to invest in vacation communities in the mountains, condominium projects along the coast, and participations in shopping centers in the southwest. This strategy didn’t end well. While the FDIC protected the banks’ depositors, their shareholders suffered.
As of this morning, Europe and Cyprus have come to a tentative resolution. The solution will be painful for foreign investors and put a major crimp in Cyprus’s economy. Fortunately, this crisis is small and shouldn’t bring down any other markets. Nonetheless, Cypress offers lessons to all of us.