Peter Jones: Cyprus may prove an alarm call

Several, I think, some of which are bad news for Alex Salmond and one, rather surprisingly, which is better news for his independence project.

Let’s go back to the basic problem. Cyprus has three big dominant banks which collectively had assets (loans) of £108 billion, but liabilities (deposits) of £61bn.

A large amount of the loans were in Greek property and government bonds. Much of the property loans have gone sour because of Greece’s economic crisis and, as part of the recent deal to ease Greece’s sovereign debt crisis, Greek government bonds have halved in value. So Cyprus’ banks became insolvent and needed a bailout of £14.5bn.

It was impossible for the Cypriot government to borrow the money because it is shut out of the capital markets and its economy, with annual GDP of about £16bn, is too small to tolerate what would have been a rise in sovereign debt levels to about 145 per cent of GDP.

The deal which has emerged now looks more like the Icelandic solution of letting the banks go bust. One bank – Laiki – is to be broken up into good and bad bits and holders of more than €100,000 in deposits in it will lose perhaps half their money. But Cyprus does not have the advantage that Iceland had – its own currency, the devaluation of which by some 50 per cent has greatly assisted recovery. Devaluation is not possible for Cyprus unless it chooses to exit the euro.

Iceland also only guaranteed the bank deposits of its citizens. Foreign deposit-holders would have seen their money evaporate had not their governments (British and Dutch mainly) guaranteed the money. It is, incidentally, still not certain whether Iceland will get away with this as its government is having to fight a case brought against it by the Dutch and British governments through European Economic Area rules.

Cyprus, though it was certainly prepared to see foreign deposit-holders lose some money, was not prepared to go the whole hog because that would have meant being thrown out of the EU. It would also have enraged Russia whose citizens own about a third of Cypriot deposits.

Vladimir Putin, who has already bailed Cyprus out with a £2.1bn loan repayable in 2016, is not someone you mess with if you are a tiny island. He is still going to be pretty angry about the losses, but since much of the Russian money was in Cyprus to escape paying Russian taxes, he may be smirking privately. The outcome may also give him leverage to force Gazprom into the exploitation of Cyprus’ recently discovered offshore gas reserves estimated to be worth between £4bn and £27 billion.

But the general outcome for Cyprus is pretty dire. This can only worsen its recession and wreck its financial services industry. If there is a glimmer of light, it is the gas reserves and perhaps also the unintended consequence that there may be a renewed push to re-unite the island, divided since the 1974 Turkish invasion.

All these special factors – small size, relative poverty, division, Russian money – you may think, means that what has happened in Cyprus is of no relevance to Scotland at all. But the one factor that does matter is that it is, or rather was, a small country with a banking sector that was far too big for its economy, the same problem which struck down Iceland and Ireland.

An independent Scotland faces the same problem. Current GDP (with a share of oil) is £151bn. The assets of RBS at the end of 2012 were £870bn. The assets of Lloyds Banking Group, which has its legal headquarters in Edinburgh, were £512bn. Together, the two banks’ balance sheets are nine times Scottish GDP.

By the yardsticks of Iceland when it went bust (bank assets six times GDP) and Cyprus (bank assets seven times GDP) an independent Scotland, superficially at least, would be more exposed to bank risk than either of these states.

I say superficially, because both Icelandic and Cypriot banks had very limited retailing operations outside their domestic economics, but in contrast only about 10 per cent of RBS and Lloyds banking work is carried out in Scotland.

That means that in the event of a new crisis affecting either of these banks, the bailout would most certainly involve both Scotland and the rest of UK, the model the SNP has said would prevail. The trouble is that there is no agreement from David Cameron on this.

The good news for Mr Salmond is that the Cyprus crisis makes it more likely that Mr Cameron will have to say something about this in advance of the referendum. This is because of the crazed idea, now abandoned, that Cypriot depositors with less than €100,000 should pay 6.75 per cent of their money towards the bail-out.

It is not clear whether this impost was suggested by the troika of the EU, the IMF and the European Central Bank or, more likely, that a panicking Cypriot government came up with it. Regardless of who was responsible, it has put loss of deposits in the event of a bank failure into people’s minds everywhere.

If Scottish independence starts to look possible, and Scotland’s banks still do not look robust, then there is a risk of a highly destabilising exodus of capital. That would be disastrous for Scotland and Mr Salmond’s hopes. But as people may choose to get their money out of the UK altogether until things settle down, it could also be damaging for Mr Cameron.

Of course, the banks could just take some of the pressure off themselves by shifting their legal headquarters to London. I presume Mr Salmond doesn’t want that. But what he will need to do is to nail down as tightly as possible the regulatory and prudential banking regime that would prevail under independence to prevent any uncertainty.

And much though Mr Cameron has said there will be no pre-referendum negotiations, the Cypriot crisis also makes it more likely that his government will have to say something as well. Financial and banking markets are now so spooked that it is in the national economic interest to show that there is a stable path for banking in the UK after independence if Scotland votes for it.