Cyprus rescue marks "game-changer" for Europe's banks

If the bailout of Cyprus is a template for European rescue deals it marks a "game-changer" for banks that could raise funding costs, see deposits shift more quickly and delay the prospect of higher dividends.

Europe signaled this week that large depositors would shoulder part of the cost of future bank bailouts after savings over 100,000 euros were targeted in the Cyprus rescue package. That sent bank share prices falling and pushed up the cost of insuring bank debt against default.

"Bail-in is thus replacing bail-out. As a consequence, the cost of bank funding will increase, bank deposits will become less sticky, and banks must hold more equity capital to reassure their creditors," said Nick Anderson, analyst at Berenberg.

"The elephant in the room has been spotted at last."

Jeroen Dijsselbloem, head of the Eurogroup of euro zone finance ministers, said on Monday that in future, the currency bloc should first ask banks to recapitalize themselves, then look to shareholders and bondholders and then "if necessary" to uninsured deposit holders.

"Now that the crisis is fading out, I think we need to dare a little more in dealing with this," he said.

In addition to big depositors, senior bondholders in Cyprus's second-largest bank, Laiki, will be wiped out and holders of senior paper in the largest lender, Bank of Cyprus, will also be hit.

In previous packages for Greece, Ireland, Portugal and Spain, leaders were unwilling to force losses on either senior bondholders or savers for fear of prompting flight from banks across the region.

Under new EU regulations, senior bondholders would bear part of the cost of future bank bailouts but that provision is not due to be enforced before 2015. Non-euro zone member Denmark is the only EU state to impose losses on senior bondholders in recent years, but after its banks were shut out of debt markets in 2011 it has moved to limit the likelihood of such losses.

Europe's banking index was down nearly 0.6 percent by 9:10 a.m. EDT, adding to a 1.9 percent fall on Monday and putting it on course for a fourth successive daily fall.

Banks in Italy and Spain, two countries at the heart of the euro zone crisis, were among the biggest fallers with UniCredit and Spain's BBVA down over two percent. Italian regional lender Banca Carige had slid over three percent.

The cost of insuring European banks' senior bonds against default rose, with the Markit iTraxx senior financials index widening 14 basis points to 181. The index for subordinated bonds - riskier as they rank behind senior debt if a bank is wound up - widened 20 basis points to 302 basis points.

Critics of the action on Cyprus said it had re-established the link between weak banks and weak sovereigns and could scare depositors, but others said it was long overdue.

"Finally the EU is doing the right thing. If you take risk, if you're an equity holder, a bondholder, or an uninsured depositor, you should be at risk," said Simon Maughan, analyst at Olivetree Securities. "It is the bailing out of the bondholders that has been the biggest problem throughout these bailouts."

Maughan said there were still risks in Spain, Italy and possibly France. "The only way to deal with them would be to make the investors that put money in the first place to front up," he said.

"WAKE-UP CALL"

Deposits above 100,000 euros have been at risk since the level of guarantee was raised and reinforced during the 2008/09 financial crisis. Cyprus is a reminder that above that level depositors are effectively unsecured creditors.

Savers are more likely than ever to spread their cash around, analysts said.

"It's a wake-up call... and deposits are likely to be more fluid if you see a risk emerging," Maughan said.

"It is now rational for ... depositors to move their money to stronger non-Euro zone banking jurisdictions such as the UK or Switzerland," said Andrew Lim, analyst at Espirito Santo.

Mike Harrison, analyst at Barclays, said the Cyprus events could also speed up plans for countries to establish pre-funded schemes for deposit insurance.

"This could be a catalyst to more harmonization of the pre-funding of the scheme," he said.

Bondholders are likely to be more alert to risks too.

"The concept of bail-in appears to be happening quicker than perhaps people had anticipated. It feels that with Cyprus it is potentially now grinding closer in theory and in practice," Harrison said.

That is likely to increase volatility, especially for banks seen as more at risk, and result in greater differentiation in borrowing costs for strong names like HSBC versus more risky banks such as Italy's Monte Dei Paschi, which has received a 4 billion euro Italian state bailout.

The yield on Monte dei Paschi's senior debt rose 41 basis points to 5.16 percent early last week after an initial plan to tax Cyprus bank deposits was announced. It has since bounced around from 4.80 percent on Monday to 5 percent on Tuesday. In contrast, senior debt for HSBC remained steady at around 1.5 percent.

Banks may have to hold back on lifting dividends if investors demand they hold another buffer on top of minimum capital requirements, analysts said. That could dent hopes of a possible rise in payouts this year.

But most banks are already under pressure to hold back on payouts until they have a comfortable capital cushion, and rules continue to differ across countries. Norway, for example, took action last week to raise its already high capital requirements and implement them before most other European countries.

(Additional reporting by Aimee Donnellan at IFR in London; Editing by Carmel Crimmins and Peter Graff)