The principle of “bailing in” a troubled bank’s creditors, so that taxpayers are left to pay a smaller part of the rescue’s cost, is good. Cypriot banks borrowed little in the form of senior bonds, so bailing in those particular creditors wouldn’t defray much of the bailout’s planned bill of 17 billion euros. Instead, the banks relied heavily on deposits, including high- value deposits made by Russians and other foreigners seeking a tax-friendly jurisdiction.
In this case, bailing in creditors had to mean bailing in depositors. But this fails to explain why senior bondholders were excluded from the deal and above all why the levy was applied to insured, and not just uninsured, deposits.
It’s the very opposite of what makes sense. You want bank bondholders to be concerned about the safety of their investment, so that they exert some discipline over the banks, and you want small depositors to rest easy about the safety of their savings so that an uncontrollable run doesn’t destroy a solvent bank. The initial deal sheltered bondholders and punished small savers.
The Cypriot economy is tiny — less than half a percent of the euro area’s gross domestic product. Even if worse comes to worst, the direct fallout for the rest of Europe will be minimal. Perhaps that accounts for this weekend’s absurdity. Nonetheless, the readiness to repudiate the principle of deposit insurance is knowledge that can’t be unlearned or confined to one “special case,” and it will make managing the next EU banking crisis more difficult.