A much better alternative for Cyprus

In his Reuters blog, Felix Salmon eviscerates Andrew Ross Sorkin's argument for why the current Cyprus bailout proposal with its violation of deposit guarantees is ok and touts the benefits of a bailout proposal put forth by Lee Buchheit and Metu Galati.

At first blush, the Buchheit/Gelati proposal appears like an elegant solution.  It leaves untouched all deposits covered by the deposit guarantee and terms out all the other depositors.  To make being termed out acceptable, they propose securing these termed out deposits against future Cypriot gas revenue.

There is only one wee problem with this solution.  By securing the deposits against future Cypriot gas revenue, it protects the banks from any consequences of their actions.

The cost of the bailout falls on the Cypriot taxpayers.

They are the ones who, if there is gas revenue, pay off the termed out deposits as gas revenue that could be used to support social programs or lower taxes instead flows to the depositors.

They are the ones who, if there is no gas revenue, are left to pay off the termed out deposits.

Fortunately, the problem with this solution is easily fixed.  Rather than secure the termed out deposits with Cypriot gas revenue, let the banking system operate as it is designed.  Let the banks absorb the losses on all the excess public and private debt.

While the banks have low or negative book capital levels, they can continue to operate because of the existing deposit guarantee and access to central bank funding.  The deposit guarantee effectively makes the Cypriot taxpayers the silent equity partners of the banks.  Silent equity partners who happen to have the future gas revenues.

Over time, the banks can generate the earnings to pay off the termed out deposits and rebuild their book capital levels.  While this is going on, there won't be any banker bonuses paid in cash.

Everyone wins.  There is a haircut on uninsured depositors, including those who laundered money.  The bankers are held responsible for their actions.  The Cypriot taxpayers are not asked to explicitly bailout the banks.