Cyprus Banking Crisis: The Endgame Begins

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Petros Karadjias / AP

A woman waits as two people use the ATM machines in central capital Nicosia, Cyprus, on March 22, 2013.

The ultimatum has been issued: the E.U. is pressuring Cyprus to end its standoff over a proposed financial-rescue package and agree to new terms very rapidly — or face bankruptcy. Cyprus is scrambling to respond with a revised plan that would shield small depositors, but it still needs to finalize details and then win approval from the E.U.

Two days after the Cyprus parliament overwhelmingly rejected the bailout, which would have taxed the deposits of all bank-account holders, the E.U. hit the island with a one-two punch. The first blow was a brief two-line announcement from the European Central Bank (ECB) that it would stop providing emergency liquidity assistance to Cypriot banks on Monday, March 25, unless the island nation agreed to a bailout deal with the E.U. and the International Monetary Fund before then.

The announcement was a blunt attempt to force Cyprus’ hand, mainly because the tiny nation’s biggest banks have racked up heavy losses from soured loans to Greece and are dependent on liquidity from the ECB. Cutting off that financial lifeline would push them into bankruptcy, perhaps even taking the government with it, because the banks’ assets are estimated by Standard & Poor’s to be five times the size of Cyprus’ economy. “Neither the bank shareholders nor Cyprus’ government appear able on their own to meet the banks’ pressing capital needs,” S&P said in a statement announcing it was lowering the island’s long-term credit rating to CCC from CCC+, judging the financial outlook to be “negative.”

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The second blow was a conference call by the so-called Eurogroup, comprised of finance officials from the 17 nations that have the euro as their currency. A statement after the call made it clear that the E.U. would not back down on its key condition for a $13 billion rescue, namely that Cyprus itself put up $7.5 billion. The Eurogroup called on the Cyprus government to put forward a new proposal “as rapidly as possible.” However, the statement made clear that the E.U. no longer was insisting on all bank-account holders being taxed. The group “reaffirms the importance of fully guaranteeing deposits below 100,000 euros in the E.U.,” the statement said. The original bailout proposal agreed upon with the Cyprus government last weekend called for bank deposits of less than that amount, the equivalent of $130,000, to be taxed at a 6.75% rate, while deposits higher than that threshold would be taxed at a 9.9% rate.

That deal sparked howls of protest in Cyprus and across Europe because it appeared to many to be a case of asset confiscation. Russia’s Prime Minister Dmitri Medvedev went so far as to denounce the move as akin to the behavior of the Bolsheviks in Soviet Russia. In Europe, it also was seen as running counter to the E.U.’s policy goals; one of its priorities this year is to create a pan-European banking union that includes a system of deposit insurance for bank accounts similar to the FDIC program in the U.S.

What’s increasingly clear in the short run, though, is that Cyprus has few choices aside from drawing up a new proposal that is acceptable to both the E.U. and the IMF. A flurry of diplomatic initiatives to entice Russia to come to the rescue failed to produce anything other than Moscow’s harsh words about European behavior. Since the collapse of the Soviet Union, Russia has turned Cyprus into its offshore tax haven of choice, accounting for as much as one-third of the 68 billion euros ($88 billion) deposited in the island’s banks. Russians with big accounts would have been hard hit by the planned onetime levy. Banks have been closed all week to avoid a run and will remain shuttered until at least Tuesday. ATMs have continued to dispense cash, though many banks have capped the amount able to be taken out, leading to extensive lines and frequently empty machines.

(MORE: Viewpoint: Why the Money Woes of Tiny Cyprus Loom So Large)

Details of the alternative plan Cyprus is likely to propose to its European partners are yet to be finalized. Parliament was supposed to vote on a package of measures on Thursday evening but postponed the vote until Friday morning. There are three key components, according to E.U. sources and Cyprus media reports: the creation of a special, privately held “national solidarity fund” that would consist of a grab bag of assets, including gold reserves and natural gas revenues, and which would issue bonds. A significant restructuring of the Cyprus banking sector is also planned, with the creation of a “bad bank” that holds the soured loans and the possible merger of banks with “good” assets. Finally, parliament is expected to approve the imposition of stringent capital controls for when the banks reopen next week, to prevent a massive capital flight that could destroy the banking sector.

The plans are being masterminded by President Nicos Anastasiades and the central-bank governor, Panicos Demetriades. One of the main concerns is how to deal with the reportedly weakest bank, Laiki Bank, the second largest lender. Demetriades said the proposed new law to be considered by parliament on Friday would enable Laiki “to continue to provide banking services to its customers when banks reopen Tuesday.” Until an agreement is reached between Cyprus and the E.U., though, Cypriots’ hope — and savings — rests in the hands of a government that’s garnering less and less trust with each passing day.

MORE: IMF Chief: Economic Meltdown in Cyprus Could Have ‘Contagion Risks’