Slovenia is not Cyprus!

by George Hatjoullis

Slovenia is not Cyprus. At least it was not until the Cyprus bail-in took place. Now every member state in the eurozone is potentially like Cyprus. It rather depends on which decision model one believes operates; probability or uncertainty.

A selection of Normal Distribution Probability...

A selection of Normal Distribution Probability Density Functions (PDFs). Both the mean, μ, and variance, σ², are varied. The key is given on the graph. (Photo credit: Wikipedia)

In the probability model all risks are known and quantifiable. This model predicts that Slovenia is unlikely to have a sovereign debt crisis or banking crisis or need assistance from the ESM. Or so some assert. A notable exception is Moody’s, the rating agency, which has downgraded  Slovenia as a borrower from Baa2 to Ba1 and put the eurozone member state on negative watch. In other words, any other rating change is likely to be another down grade. Even in the probability model there is room for different probability assessments; a little uncertainty.

In the uncertainty model (or the real world as I like to call it) anyone exposed to Slovenia sovereign debt or banking must be having a hard think here. Slovenia is constantly in the media with talk of financial problems and Moody’s, which knows a thing or two about quantifying risk, calculates that the situation is drifting in the wrong direction. The inhabitants of the uncertainty world cannot calculate probabilities and have a sneaking suspicion that they have imperfect knowledge of the risks. Moreover, the constant assertion that Slovenia is not Cyprus is beginning to make many a little uneasy. The lady doth protest too much, methinks.

A Slovenian with a bank deposit above euro 100k may be forgiven for looking at Cyprus and wondering how much of special case it is. The European Banking Union is not yet in place but the prospect of including bank bail-ins is almost certain. This same Slovenian has the option of placing any excess euro funds with a bank in another member state. This is not a costless exercise but it is possible because, well, it is a monetary union!

Of course, if all Slovenians suddenly shifted uninsured funds to non-Slovenian jurisdictions then the much feared bank failure could be precipitated. The Emergency Liquidity Assistance from the ECB to Slovenian banks would suddenly jump. Moreover, ironically, in any consequent bank resolution there would not be any uninsured deposits to bail-in. The ESM would need to provide all bank recapitalisation.

An individual Slovenian with imperfect knowledge of the risks and the Cyprus example to hand might quite rationally shift uninsured funds out of Slovenia and into neighbouring jurisdictions even if she/he judged the risk of crisis to be low. The reason is that the consequences of a bail-in would be severe and it is possible, for a price, to avoid the risk. What is rational for an individual is not rational for all (often the case) as, if everyone does this, the probability of a banking crisis increases. Nevertheless, rational individuals operating under the uncertainty model might well take such risk aversive action and the reason is precisely because the Cyprus bail-in took place. The troika made Slovenia, and potentially all member states, a little more like Cyprus by their actions. They set a precedent, of which rational individuals will have taken note.

I know nothing of the specific situation of Slovenia as a sovereign or its banking system. These comments are not based on a probability assessment. These comments are merely an illustration of a how a rational individual might act to avoid a seriously adverse outcome even if he/she is reassured that the probability of the outcome is very small. It is an illustration of rational behaviour under uncertainty. It applies to measles and global warming as well as finance.

To complete the illustration please re-read (or read) my earlier blog; Cyprus bail-in; a surprise?. In this blog I demonstrate that there was a great deal of public information to warn depositors in Cypriot banks that a bail-in was a material risk. Some heeded the warning as is evidenced by deposit outflows. However, rather more did not heed the warning otherwise there would have been nothing to bail-in. The reason they did not heed the warning is because there was no precedent.

The good news for Slovenia is that it is unlikely the troika would be foolish enough to allow any further bank bail-ins prior to a fully fledged banking union being in place. Imagine what would happen if Slovenian banks were bailed-in at the expense of uninsured depositors. Under the uncertainty model any uninsured deposits in any suspect banking jurisdiction would suffer a major deposit outflow. Then where would the eurozone be.? So ultimately keeping uninsured deposits in the Slovenian banking system is an act of faith in the good sense of the troika.