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Fear and loathing in Cyprus, Brussels, Berlin, Moscow…

Cyprus’s need for a bail-out has been known for months. A week ago, no one in financial markets was worrying about it. Suddenly, the precipice metaphors are getting wheeled out again. The botched series of attempts to spread the pain to Cypriot depositors are perhaps the clumsiest own goal of the crisis so far. But what did the planners get wrong — and did they get anything right?

Cyprus says it was Wolfgang in Germany who came up with the bank account wheeze, but Wolfgang says it was the Cypriots, the EC and the ECB. Jörg at the ECB says it wasn’t him, and Vladimir says whoever it was, he’s now thinking twice about that €2.5bn loan. The people on the street blame Angela, mostly, but Nicos told Olli that he doesn’t like her much either.

You couldn’t make it up, and yet there it is. An unholy mess, and everyone’s to blame.

Europe wants Cyprus to pay €7bn towards its €17bn bail-out, which is, in GDP terms, the biggest yet of the eurozone crisis. Some of it can be generated by our old friend austerity, the Cypriot people are told, but that leaves another €5.8bn to be found.

For the moment the outrage has mostly been focused on where the money should apparently not come from. It’s understandable that the first reactions were extreme — both from Cypriots waking up to the prospect of a wealth tax on even meagre deposits, and from market participants panicking about the prospect of contagion.

But a sober assessment of the situation is needed: not all of what has been proposed is lunatic.

What’s wrong...

One element certainly is, however. Unusually, in the context of European banking, there is not much senior or subordinated bank debt in Cyprus. But there is a bit — perhaps €1.7bn of the former and €1.6bn of the latter. That’s not much, but it’s a great deal in the context of the €5.8bn being sought.

That these investors have so far been left untouched is a scandal, pesky English law documentation or not. Communicating harsh measures is always going to be tough, but it is made infinitely tougher when a scheme already deemed unfair is made to look unequivocally so.

And talk about mixed messages: why bleat on about the need for bondholders elsewhere to take their share of the pain if you can’t be bothered to stick to creditor hierarchies here?

Next up is the thorny issue of uninsured and insured deposits. As elsewhere in the EU, bank deposits in Cyprus are, in theory, protected up to €100,000. But the bail-out as originally formulated hits everyone — from Russian oligarch to Cypriot street-sweeper.

Forcing even the very poorest to stump up was woefully stupid. The marginal impact of relieving those at the bottom of the heap of any responsibility would have been minimal — and would have made the plan much more palatable.

The incentives offered to try to prevent bank runs — equity in the banks and an as-yet nebulous gas revenue-backed government bond — are not the sort of thing to settle the nerves of your average depositor worried about his or her life savings.

It seems clear that the powers that be are itching to teach a painful lesson in the consequences of wantonly allowing a banking sector to balloon beyond the capability of the host sovereign to support it. Cyprus’s banking assets are eight times the size of its economy.

That a large chunk of the money being hit belongs to rich Russians — some €30bn of it, by some estimates — doubtless makes teaching that lesson all the more tempting to some. But what a childish motive.

Sniping that much of the Russian money is dodgy is a bankrupt argument. If you suspect that, get some evidence and prosecute. More defensible is to ask whether eurozone money should be used to look after the interests of rich folk from outside the single currency zone.

Still, the risk now is that Russia gets to call the shots if Cyprus fails to get even a revised deal approved by its parliament and the EU decides it has had enough. If dealing a blow to Russia was any part of the plan, it may have backfired spectacularly.

Could the ECB and other EU institutions have done more to prevent the situation from degenerating this far? In case anyone has forgotten, banking union doesn’t exist (yet), and the ECB isn’t (yet) the super-supervisor for the region. Where was the Cypriot regulator in all of this?

Such questions do not get us very far now, though. Banking union and a common deposit insurance scheme look further away than ever in the light of what has happened.

...and what’s not

So what was right with the plan? Well, the fact remains that the country is bust, and therefore so is its deposit insurance scheme. Depositors might not like losing money, but protesting that they were insured means little when the insurer can’t pay out. And even with a full bondholder bail-in, there is simply not enough money. The alternative, after all, is bankruptcy for the country’s top two banks.

We are left, therefore, with the conclusion that it is not the principle of depositor bail-in that is flawed, but its implementation in this case.

That, at least, now seems to have been understood. At the time of writing, the latest iteration of the proposal envisages exempting those with savings of below €20,000, who had previously been stung for a 6.75% levy. That charge remains for deposits up to €100,000, with a 9.9% tax up to €500,000 and perhaps another higher tier above that.

This looks more progressive, but is still not certain to be passed by Cypriot politicians. Bondholder bail-in would add more flexibility to these levels, perhaps enough to get agreement. It is surely worth trying, even at this late stage.

Even that will not take away the great fear: contagion. As things stand, insured bank deposits have been shown to be more risky than senior and even subordinated debt. Whatever their next move on Cyprus, European institutions must now spell out exactly what may and may not be expected of depositors in other countries where banks are struggling – and what their justification is for the baffling actions around Cyprus.

The ECB may be required to give another assurance of liquidity support, but already that may not be enough.

Since he uttered the words, Mario Draghi’s pledge to do “whatever it takes” has been shorthand for the ultimate expression of succour. After the events of this week, it sounds more like it was a threat.

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