Rolling the dice to save Cyprus

The task of imposing losses worth about 5.8 billion euros ($7.5 billion) on lenders to the Cypriot government and depositors with the country's banks was never going to be an easy one. That effort has now led European Union to its latest impasse.

In marathon negotiations, the Cypriot government, under the supervision of the European Commission, European Central Bank and the International Monetary Fund, agreed to a one-time "tax" on bank deposits. But despite an amendment to exempt accounts containing less than 20,000 euros, the Cypriot parliament overwhelmingly rejected the plan, leaving Cyprus - and EU - in limbo.

In fact, large depositors are not unlike senior bondholders, and the proposed haircut was a small but welcome step forward. But, because it did not go far enough, a hole remained. There were other options. Lee Buchheit, a veteran sovereign-debt attorney who should have been in the negotiating room, and Mitu Gulati of Duke University have proposed an elegant "reprofiling" of Cyprus's 15 billion sovereign debt that would instantly reduce the financial pressure on the country. But such considerations were off the table well before the deliberations began.

Instead, the initial decision was to confiscate just under 3 billion euros from accounts containing less than 100,000 euros - the cutoff for deposit insurance. Make no mistake; this would have been the greatest policy error since the start of the global financial crisis five years ago.

Indeed, the proposal amounted to a rupture with the near-universal agreement that small depositors should be considered sacrosanct. After all, televised news footage of panicked depositors in long queues outside banks and at ATMs can cause immeasurable financial damage far beyond a country's borders.

Historians will argue whether forcing Lehman Brothers into bankruptcy in September 2008 precipitated the subsequent global financial crisis. Vincent Reinhart, formerly of the US Federal Reserve and now at Morgan Stanley, has argued that the Lehman decision was correct (the error came earlier, with the bailout of Bear Stearns, which created an expectation that all banks would be bailed out). Private risks must be privately borne.

By contrast, the proposal to impose losses on small Cypriot depositors had no redeeming justification whatsoever. As in Ireland, the most vulnerable were being asked to take the hit, while large depositors were let off lightly and other lenders were to be spared. But it gets worse.

There has never been an official explanation of why lenders to a sovereign should not share the pain, despite the "no bailout" principle on which the eurozone was founded. Most observers cite the authorities' concern that if any sovereign does not honor its debts, all sovereign borrowers will be penalized. But such contagion risk is trivial compared to the wildfire that could be ignited by imposing losses on small depositors.