By Alexander Apostolides on January 21, 2011

Lessons from 1929: Private Banks and Central government should not come any closer.

Kathimerini announced today that Cypriot banks will contribute 60 million Euro to the government’s “economic plan”, which effectively means that Cypriot banks will shoulder a great part of the state’s upcoming borrowing needs. As a result the Cypriot state will avoid borrowing money from the international community and thus spare the humiliation of much costly loans due to the continued downgrades of our credit worthiness, at least until after the parliamentary elections,

This is a very worrying development for Cyprus as a whole. The Cyprus banks, already battered by international concerns over their exposure in economies such as Cyprus and Greece, have opted to aid a government who is also battered by credit rating agencies for the failure of tackling its runaway wage bill. Each could separately tackle their issues with tough and painful decisions. But instead of the banks and the government will entwine their problems, creating the conditions for a potential economic meltdown.

The more the banking sector, which is under stress, is helping a government who is failing to put its finances in order, the more we run the risk of the financial system collapsing if (and thankfully it is still a very remote if) the government is unable to repay its loans.

Perhaps more subtly, this kind of close relationship of the banks’ and government’s balance sheets also raises other concerns. How can the state adequately monitor the banking sector, when it is indebted to the domestic banks for its immediate fiscal survival? We live in a country where bank changes are levied even in cases without any economic reasoning (such as having a pre-payment charge on a variable interest loan) but the state may be unwilling to ensure the rights of banking consumers if the sector offers relief to its immediate funding needs.

An example of the problems of such a close relationship was the situation with Greek banks to the Greek state during the Great Depression. As the banks became ever more exposed to covering the growing debt of the state, their executives took a greater part in running the economy, resulting to bankers controlling the most profitable aspects of the economy in the name of the government, resulting to a post-depression Greece that was oligarchical, cartelised and undemocratic.

Although we are far from this situation at the present, it would be preferable for both the Cypriot banks and the Cypriot government to tackle their separate issues individually and thus insulate the economy both from a (remote) economic meltdown and an excessive control of the economy by the banking sector.

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