The Cypriot banking system, long waiting to collapse from financial exhaustion, finally succumbed over the weekend. The deal that was initially struck (since rejected by the country’s Parliament under popular outcry, though they will have to strike a deal of some kind soon) was widely seen as inequitable[1], because retail depositors (people like you and me) with less than EUR100,000 in the bank would instantly lose 6.75% of their ‘money’, in current accounts or savings accounts. This is known as ‘bailing in’ the depositors (in order to ‘bail out’ the banks!).

Imagine if this had happened in the UK when Northern Rock collapsed. Depositors of all UK banks would likely have queued around the corner to withdraw their ‘money’ (i.e. exchange their deposits for cash) prompting a general run on all the banks, not just on Northern Rock. In the event the UK government stepped in to guarantee our deposits.

Now, granted a difference in Cyprus compared to the UK is that probably[2] all the major banks have horrible balance sheet positions, whereas in the UK at least some (e.g. the more prudent building societies) arguably did not.

Nevertheless, even if a wider range of UK banks been in a similar situation to Northern Rock, I still expect the UK government would have guaranteed deposits up to a similar amount (now £85,000 per depositor) and would not have dared to ‘bail in’ depositors below this level (i.e. small-to-medium depositors). Why? Because the depositors are also, for the most part, the voters who would savage them at the next election.

So why did Cyprus bail-in small depositors? Probably because a large proportion of the deposits in Cypriot Banks are owed not to Cypriots but to big overseas investors, especially Russians using Cyprus as a place to park illicit money out of sight and reach of their own tax authorities.

A Russian depositor would typically have far larger deposits (say millions of Euro) than Cypriot retail depositors. Now in the UK, large depositors like this (who represent a very small proportion of the electorate) are given fair warning that they will lose all their money above the £85k threshold (in any one bank) if the bank fails. If you have a bit more than this, you can spread it around different banks. But if you have multi-millions then there simply aren’t enough banks and you have to accept that not all your deposits will be guaranteed.

By analogy to the UK, if you were the Cypriot Finance Minister, you would be forgiven for thinking that the large Russian depositor should take the hit while smaller local depositors (who voted your party into office) have their deposits guaranteed. That is, until you get a call from Vladimir Putin (as in fact did happen) threatening to nuke your puny little island to the bottom of the Mediterranean (or punish your country with the tools of international trade, finance and diplomacy) unless you give his Russian mafia buddies back most of their money[3].

Where are you going to get that money? Off the small retail depositors. Robin Hood in reverse.

What’s happening here? Different groups of depositors get different treatment in a banking crisis, based on who they are and what retribution they can impose.

In other words, in finance[4] particularity of person and relationship matters. If you are a Russian mafia boss, then as a depositor you probably have many ways to pressure Putin (and few qualms about doing so) to pressure the Cypriot Finance Minister to effectively take money from retail depositors and give it to you (by taking less from you and more from retail depositors than one would normally expect). If you are a Cypriot small retail depositor then you have your vote, but that a ways off, and you can’t afford to see the Russians screw your country in the meanwhile and you have little means to stop them.

Yet particularly of person and relationship is largely absent from canonical financial theory. In that theory every agent is distinguished effectively only by their asset holdings and every relationship is defined solely by the financial contracts between agents. Time to reframe finance.