Introduction:
As the dark clouds gather over Cyprus, the mini-state which accounts for 0.2 per cent of the eurozone, but which looks as if it is going to unleash the greatest financial bombshell to hit the euro-member states in its history. Cyprus is a classic example of a small island economy trying to punch above its weight (many of us may remember Iceland and even Ireland, part of a small island, as other examples) and which eventually stepped on a financial banana skin.

Basically, ignoring for the time being the German bullying of Southern European states, allowing a single product or service to dominate an economy is highly risky which is more so if those  responsible for monetary policy do not put aside something in the good times for the inevitable rainy days. In the case of Cyprus, the central bank authorities and politicians clearly thought that being an offshore financial centre was enough to build its citizens prosperity. However, offshore banking is not a development model, but rather a quick and easy way of making money with eyes half opened.

For good examples of this, just take a close look at Bermuda, the Cayman Islands, Gibraltar and a number of American states. Given this, it was clear, even to Cypriot banking officials, that the 20000 wealthy Russians who chose to settle in the small, troubled Mediterranean island and bring with them Euros20bn, were not there for the weather. Neither are the Lebanese, Israelis, and numerous Northern European expatriates.

Similarly, in much the same way, account holders using HSBC’s various Latin American branches to deposit millions of dollars in savings were not using the bank because of the sophisticated culture of its Britishness.
In both cases they were using the system because of the ease of laundering money, a fact admitted by HSBC when it agreed to pay the US authorities million in punitive fines.

Equally, in Barbados we have financial regulators and criminal justice authorities who sit idly by and allow banks and shadow banks to fund, or administer funds for some of the most dishonest characters to buy over-valued property for multi-million dollars on the rather dubious grounds that they love the sea and sun. This, I suggest, is an area of business crying out for greater scrutiny from the authorities – regulatory and criminal.

The Cypriot authorities had allowed the Russian oligarchs to colonise Limasol to the extent that it was known as little Moscow. For Limasol, read the West Coast. Russians began to see Cyprus so much as its offshore haven, that traffic, private and official, between the two capitals had become routine. On the other hand, oiled by this largesse, Cypriot banks over-extended themselves with investments in Greek banks, even at the height of the Greek banking tragedy. It was a system waiting for a hard fall.

For all this shadows can be seen in the Barbados economy: an over-dependence on tourism, no Plan B if tourism ran in to trouble, as it has; the best residential areas in the country have been colonised by foreigners in the vain hope that they will make a major contribution to the nation’s economy, which they do not; and banking regulators and ministry of finance officials, so addicted to the false god of foreign reserves, that instead of seeing people with all their vulnerabilities, all they see is foreign earnings.

To some observers, the central bank’s financial stability risk assessment should include a countercyclical capital buffer, sector-specific capital requirements, structure-specific capital requirements (ie branches of overseas banks should be required to have a higher capital placement with the central bank than a subsidiary, which should be regulated as a Barbados-domiciled bank).

The Cyprus Lesson:
Banks have business models which are unlike normal non-financial enterprises in that their assets are far smaller than their liabilities. At the height of the 2002-2007 global excesses, some banks had assets of as low as six per cent of their liabilities, whereas for most non-financial enterprises the average is about 30 per cent assets to liabilities, or even higher.

However, banks take a risk that all (or the majority) of depositors will not demand their savings at the same time, leading to a run on the bank, as happened to Northern Rock and at various times in Argentina, and which is threatened to happen in Cyprus until the government ordered the banks closed for a ten-day period for fear of such a run. It is also pertinent to remind people that at the time of the collapse of Lehman Brothers the giant US bank wholesale bank had assets of US$600bn – more than the GDP of many middle market developing nations, but had massive counterparty liabilities. The basic lesson, for Lehman Brothers as for small family-run businesses, is that cash is king, cash flow is vitally important for many business.

With retail banks the burden of risk should fall rightly on shareholders, the owners of bonds and even the wealthy savers and investors; but, even if a formal deposit insurance scheme is not in place, it is still implied that small savers’ money would be protected. The prevention of bank runs is a fundamental strategy in stabilising the economy, as Douglas Diamond and Philip Dybvig have reminded us (“Bank runs, deposit insurance and liquidity, Journal of Political Economy, 1993). That is a further burden on the public sector balance sheet.

The Cyprus government, under pressure from the European Central Bank, the IMF and the European Commission, the so-called Troika, acting as collectively as agents for Germany, tried to reduce this level of protection to Cypriot depositors with savings of Euro100000 or more, a relatively modest amount, with an average eight per cent haircut. In principle, there is nothing wrong with a government imposing a one-off levy on the wealthy. After all, they too must carry some of the load. Many believed, however, that the real target was the group of super-rich Russians and their Euro20bn savings, which infuriated the Kremlin. The Kremlin believed the Germans were unfairly targeting the Russians, using the ECB as an agent.

The threat to Barbados is not the imposition of such a haircut, since Barbados is not a member of any monetary union and its central bank is independent. The real threat however, apart from a paucity of ideas, comes from the shadowy figures of hedge fund and private equity players who stalk the corridors of international lenders looking for rogue sovereign debt to buy At knock-down prices, then to sue the troubled states in US or European courts, as the Argentinians have found out to their cost.

As the Cyprus government has found out, hiding under the umbrella of a super-state is no option when the guns are trained on the way these small states are managed. Banks are not just any business that can easily be made bankrupt. They are different, they provide a public function through their payments systems, allowing salaries to be paid direct in to accounts, they pay utility bills and standing and direct orders and they provide other essential services to business and the public sector.

Analysis and Conclusion:
The basic lessons for micro and medium states remain prudent management of the macro-economy. Despite regular rhetorical references to economic growth, there is no clear easy path to achieving long-term growth, increased competitiveness or job creation, unless they first start with improving public sector efficiency. To do this, governments, whether Cyprus or Barbados, must implement radical structural reforms, including new policies on labour flexibility, which so far key spokespeople have resisted implementing. However, despite the background noise, there is a risk of over-exaggerating the banking problems in Cyprus and their impact on the global economy, and similar small island states. As Jim O’Neill of Goldman Sachs has reminded us, China produces an economy the size of Cyprus (in GDP terms) every week.

The Cypriot problem will eventually be resolved by the European Central Bank, but for those of us in Barbados, there is no magical solution. Barbados has not got the sophisticated financial architecture to play a central role in the global, or regional, economy. This remains the case even though politicians and policymakers have reached a consensus that our fractured economy should be involved in offshore banking and shadow banking centre. Objectively, this is over ambitious. Capital flight is now the big risk, and as I write this Cypriots are no doubt rushing to their banks to withdraw what little they have saved to hide it away under their beds. They no doubt will reason that what purchasing power they lose in an inflationary environment would be better than an eight per cent levy, even if (for now) it is a one-off.