BRUSSELS – The root of the problem in Cyprus is well known. Its two major banks had attracted huge deposits from abroad, largely from Russia, and presumably mostly from individuals who wished to escape scrutiny at home or elsewhere. The proceeds were then invested in Greek government bonds and loans to Greek companies. When Greece imploded, the investments turned sour, and the Cypriot banks that had engaged in this strategy became insolvent.
Given this situation, the logical choice for the country should have been clear: if the government wanted to survive, foreign depositors must bear part of the losses. It is thus difficult to understand why the Cypriot government was at first so reluctant to inflict any losses on depositors.
But the solution that was eventually agreed makes sense: the country’s two largest banks are effectively resolved. Their bad assets will be separated and wound down over time. Neither the Cypriot government nor European taxpayers will put any additional funds into these banks. The losses that remain after the bad assets have been disposed of will thus have to be borne by the banks’ uninsured creditors, which in this case means those with deposits of more than €100,000 ($130,000).
Although Cyprus is too small to matter for global financial markets, the crisis there could turn out to be an important precedent guiding how European policymakers deal with future banking problems. In particular, it could affect current plans for a “banking union,” which needs three elements: a single supervisor, a common resolution authority, and a credible system of deposit insurance. The Cyprus crisis holds important lessons on all three counts.