DP9993 What Happened in Cyprus?

Author(s): Alexander Michaelides
Publication Date: May 2014
Keyword(s): bail-in, banking crisis, cost of inaction, Cyprus, European sovereign debt crisis, fiscal imbalances, sovereign debt, stress tests
JEL(s): E00, E62, G00, H63
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9993

This is a case study of how a country nearly reached bankruptcy in March 2013, within five years from entering the Eurozone. The magnitude of the requested assistance is extremely large relative to GDP (100%) and studying this event provides useful lessons for avoiding such crises in the future. The crisis resulted from a worsening European economic environment (especially in Greece), bad choices with regards to public finances, weak corporate governance within the local banking sector, inadequate and/or difficult regulation of cross-border banking, worsening competitiveness, and bad political decisions at the European and, especially, the local (Cypriot) level. Local politics, reflected in short term political calculations and/or inadequate understanding of the magnitude of the crisis, delayed corrective action for 18 months until election time, making a bad situation almost impossible to deal with. Overconfidence can be one behavioural explanation for why local politicians ignored the dramatic costs of inaction.