Ever since the collapse of Lehman Brothers, the inviolability of financial institution debts has been the watch-word of financial crisis management in the West but Cyprus and the European Union are about to try another path.
What happened, essentially, is that the Cypriot banking system needs a bailout. But the Cypriot banking system is large relative to the (small) size of the Cypriot economy. So a big government bailout would just create a public sector debt crisis. Consequently, Cyprus needs to tap the larger European Union (i.e., mostly German) bailout fund. And with an election coming up in Germany, Angela Merkel was feeling in a less generous mood. The most straightforward way to reduce the cost of a bank bailout is to simply not give people 100% of what they're owed. In other words, make creditors take a "haircut."
But formal haircutting of bank creditors is still considered too hot and too likely to provoke panics and runs. So what they've come up with is a de facto haircut.
The bailout will be paid for, in part, through new higher taxes in Cyprus—austerity, in other words. But the specific tax in question will be a one-off wealth tax. And not just any wealth tax, but a wealth tax specifically levvied on bank deposits. A tax of 9.9% on deposits over €100,000 and 6.75% on deposits below that level. This will raise €5.8b to help defray the costs. Is this in any real way different than depositors taking a haircut? No. But for whatever reason the relevant officials seem to prefer to phrase it this way. And now the question is how many Spanish and Italian people are going to look at this precedent and try to shift money out of local banks.
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