From US News

Cyprus Trod Where None Had Dared

So we managed to save Cyprus! Early today, they got the euro 10 billion bailout deal at the 11th hour, thereby preventing a Cypriot banking system collapse and a possible eurozone exit. As part of the deal, the second largest bank in Cyprus, Laiki (or Popular) Bank, will be closed and depositors who hold more than euro 100,000 will experience large losses.

Common sense seemed to have prevailed and this new deal safeguards and guarantees all deposits under euro 100,000. In return for the rescue money, Cyprus must reduce both its debt and banking sector, privatize state-owned assets, and put into place structural reforms.

This will not save the Cypriots from a deep recession, soon to be followed by a Greek-style near-term economic and social cataclysm. Much more significant, however, is the fact that this latest eurozone financial crisis and resulting bailout negotiation has all the basic ingredients to generate a new systemic risk in the financial markets—it has undermined the faith of southern small savers in their own local banks. The Europeans might have done some real damage, as the local banking systems in southern eurozone countries could be more or less effectively wrecked for the near-term. Ironically, once again, one of the smallest countries in Europe is the catalyst.

Since the 2007 crash, American and European financial crises management has had two fundamental tenets. First and foremost, the small depositors (US$100,000 or euro100,000 or less) must be protected in any bailout. Second, the troubled banks' investors i.e. the financial institutions which lent money to the banks (usually by buying up bank bonds) typically take the hit (known as a haircut) for their risky investments.

This is based on the straightforward logic that large financial institutions understand and are knowledgeable about the risk off their investments i.e. lending to a bank, and therefore should participate in the pain of a rescue package. The small depositor, however, does not have any notion of how much risk his or her bank is taking at any point in time. Small depositors simply trust their government regulators to make sure that the banks are reasonably safe. Thus, it is unreasonable to hold small depositors accountable for the risky behavior of financial institutional investors and banks.

There are very good reasons why these tenets must never be violated. First, even the hint of the suggestion of using small savers to bail out banking institutions and their shareholders and bondholders is reckless at best. This will result in only one thing: undermining the belief and faith of small depositors in the local banking system. That damage is difficult to undo and has a myriad of negative consequences for an economy. (Not to mention that it is generally perceived as patently unfair to hold small depositors responsible for bailing out large institutional investors.)

The initial Cyprus bailout package last week violated this primary tenet. This is a first for the eurozone. The original agreement mandated that small depositor's savings would be taxed and used in the financing of the Cyprus bailout package. This led Cypriot small savers to take to the streets and demand that their savings not be touched, which in turn led to wholesale chaos, ATM runs and the entire nation's banking system being shut down for a week. The small depositors forced the Cypriot government to renegotiate with the "troika" (European Commission, International Monetary Fund, and the European Central Bank). The final agreement to bail out Cyprus was reached early this morning leaving small depositors safeguarded at least for now.

However, the damage has been done. The invisible line was crossed. Not only will it be a long time before small savers in southern Europe trust their own banks again, but foreign investors will be very reluctant to park their money in Mediterranean banks. In Cyprus, what's left of the euro 31 billion Russian deposits will fly out the moment capital flight restrictions are lifted. No foreign investor is going to take the risk anytime in the near future of parking large sums of money in local banks in Greece, Portugal, Cyprus, or perhaps even Spain and Italy. This effectively bulldozes local banks in the southern eurozone for the near future.