The last few days saw Cyprus take center-stage in markets across the globe as investors found themselves facing renewed fears of the precarious debt situation in the Eurozone spiraling out of control. For the uninitiated, it would seem rather strange that an obscure island nation with a population of under a million could hold the world economy hostage. The size of Cyprus’ economy is less than a tenth of Greece’s.  And this would mean that the effort needed to prop up the country’s economy would be much less than what was needed for Greece.
So what is it about Cyprus that is putting it on par in terms of scaring the market with other peripheral nations like Spain and Italy?
The reason for the furor is the decision of other euro-member nations to impose a levy on bank deposits in Cyprus as a part of the €10-billion ($13-billion) bailout. ((Cyprus Bank Deposits to Be Taxed in $13 Billion Bailout, Bloomberg, Mar 16 2013))
This unprecedented move essentially scraps one of the biggest unwritten rules of banking – of safe-guarding the money deposited by customers even under the worst economic situation. The fact that the stronger member nations believe that bank deposits in a debt-ridden country should bear the brunt of a downturn would mean that the peripheral Eurozone nations will very likely face a similar levy in the future. Such a scenario prompts customers to clear their deposit accounts from a bank run in the region, to avoid the levy – something that will only make economic recovery in the troubled region even more difficult, if not impossible.
Here’s How The Proposed Levy Works, And What It Will End Up Doing
Picture this. You receive a letter from your bank stating that the bank is going to deduct a part of your savings account because it has been instructed to do so by the government. There isn’t much you can do in this situation besides emptying your account and bringing all the cash home. When everyone does this, it leads to a run on the bank, which spreads panic throughout the financial sector.
This is exactly what the bank levy seeks to do for all deposits in Cyprus. If the deposit is less than €100,000 (~$130,000), then the levy will be 6.75%, and for higher deposits the customer will lose 9.9% of the total amount.  Even as the country’s government ponders on whether or not to accept this onerous condition for its bailout through a vote that has been postponed until Wednesday, people have been frantically withdrawing their money – forcing the banks to remain closed.
Impact On Global Banking Sector As A Whole, And In Europe In Particular
The banking sector thrives due to people’s fundamental belief that there assets are safe with the bank. When banks fall out of favor with the public at large, there is a ripple effect seen across the entire economy as lending takes a hit, which in turn throttles businesses – small and big. And the fear of such a levy being imposed on other nations in the region is driving customers in other euro-member nations to secure their money.
Needless to say, banks in the European region would be hurt the most by such loss of faith and rapid withdrawals of deposits which help support the backbone of most banks capital base. This is why the largest European banks including Deutsche Bank (NYSE:DB), Barclays (NYSE:BCS) and RBS (NYSE:RBS) lost a significant part of their value over trading on Monday. Banks in the U.S. also closed the day lower, with the KBW Bank Index losing 1%.Notes: