Cypriot Banks on Brink in Icelandic Flashback

A small island on the edge of Europe teetering under the weight of its bust banks. Sound familiar?

Like Iceland and Ireland before it, Cyprus is battling to prevent an outsized and overextended banking sector from dragging the country into the ground.

Cyprus's parliament has overwhelmingly rejected a proposed levy on deposits as a condition of a European bailout, throwing the country's future into disarray.

But the experiences of Iceland and Ireland show that however Cyprus decides to deal with its crisis, pain is in store.

While Reykjavik let banks fail and introduced capital controls, making financing its economy difficult, Dublin nationalized most of its financial sector, helping to quadruple its debt burden and ensuring years of austerity.

Both countries are growing again, but underlying problems remain with households in both nations still swamped in housing debt, Irish unemployment stuck at 14 percent and Iceland fearful of lifting its capital controls for fear of a damaging outflow of foreign funds.

None of this suggests an easy way forward for Cyprus, with its banks mortally wounded through involvement with euro zone casualty Greece and its financial sector heavily exposed to sometimes suspect money from Russia.

Cyprus' troubles stem from its exposure to Greece and the huge losses its two largest banks, Bank of Cyprus and Marfin Popular, had to stomach when euro zone leaders agreed in late 2011 to write down the value of private-sector holdings of Greek government bonds.

In total, Cyprus requires 17 billion euros, nearly equivalent to its economy's annual output, to rescue its banks and deal with the government's own bills.

Relatively small in the context of the Greek and Irish EU-IMF bailouts, at 240 billion euros and 67.5 billion euros apiece, for an island of just 1 million people it is a huge burden and speaks volumes about how large and unwieldy its banking sector had become.

AGGRESSIVE EXPANSION

Along with the aggressive expansion in Greece, which helped Cyprus' banks to double the size of their loan books to around 72 billion euros in the last six years, Cyprus' banking sector has ballooned on the back of inflows of Russian money, which first started to arrive following the collapse of the Soviet Union in 1991.

The banking sector is now roughly eight times the size of the economy compared to 10 times for Iceland and over four times for Ireland before their crises. Banks in both countries used cheap funding to gorge on speculative investments.

High interest rates, low taxes -- in particular a double taxation treaty with Russia -- and a shared Orthodox faith were all factors behind the influx of Russian money and people, which has seen the city of Limassol, the island's financial center, become known as "Lima grad".

It is estimated that of approximately 70 billion euros of deposits in Cyprus, a third are held by non-residents and most of those are believed to be Russian. Overall, deposits grew by nearly two thirds over a six year period to the end of 2012, according to data from the central bank in Cyprus.

On the face of it, the Cypriot banks' deposit-funded balance sheets, with loan-to-deposit ratios of nearly 100 percent, are a model for other systems. Irish and Icelandic banks' reliance on wholesale money markets proved to be a death sentence when the credit crunch struck.

But the size of the inflows have raised concerns in Germany, in particular, that the island is a haven for money laundering and tax evasion.

One Russian bank, Alfa Bank, estimates that $70 billion of illegal capital flight from Russia in the past two decades may have found its way to Cyprus.

Cyprus was the largest recipient of Russian direct investment in 2011, totalling $121.6 billion out of $362 billion, according to Russian central bank data.

Moody's rating agency said last week that Russian banks had about $12 billion placed with Cypriot banks at the end of 2012 and has estimated that Russian corporate deposits at Cypriot banks could be around $19 billion.

Such concerns were behind a politically charged decision last weekend to break with previous EU practice and impose a levy on bank accounts as part of a bailout. This sparked outrage among Cypriots and fear in financial markets that a dangerous precedent had been set.

RUSSIAN CAPITAL

Alexander Apostolides, an economic historian at European University Cyprus, said labeling Cyprus as a hotbed of shadowy banking was unfair.

"It is a gross oversimplification," he said. "I'm pretty sure there are some very dodgy accounts but I would be shocked if they represented more than 1 billion."

"There are a lot of Russians here but there are also a lot of Russians in London. If you took London out of the rest of the UK wouldn't you say there was an overdependence on Russian capital?"

Despite Cyprus' banks exposure to Greece, deposits stayed largely stable last year, partly due to the belief that savers would not be hit and partly due to the high interest rates.

A depositor in Cyprus who put their money in the bank for rolling periods of less than a year would have been paid interest of almost 13 percent since the Greek crisis first erupted compared to just over three percent in German banks, according to Reuters calculations based on ECB data.

In the past ten days, however, as rumors first surfaced about a hit on savers, an estimated 2 billion euros has been withdrawn by Russian depositors, according to Thomas Keane, co-founder of Cyprus-based law firm Keane Vgenopoulou & Associates LLC.

Under the proposed terms of Cyprus' bailout, there will be a tax on interest that deposits generate, which will likely be set at 20-30% and Nicosia will have to shrink the banking sector to an EU average of around 3.5 times GDP by 2018.

Iceland imposed capital controls to restrict the flow of crowns and other currencies in and out of the country in 2008 and there are concerns Cyprus will have to do likewise when its banks, currently closed, finally reopen.

"Even if a compromise solution can be found, confidence in the security of bank deposits in Cyprus may have been fatally undermined, especially among non-resident depositors who have more choice about where to keep their money," said Tristan Cooper, fixed income sovereign credit analyst at Fidelity Worldwide Investment.

"This will likely prompt capital flight once the banks reopen and may necessitate the sustained imposition of capital controls in order to stem an escalating banking crisis. The parallels with Iceland, which also had an outsized banking system are worrying."