The European Union is back making mistakes and showing its best efforts at poor crisis management. There are many reasons why the decision to bail in bank depositors makes sense in the case of Cyprus. But the stability of the euro area is not one of them.

It is not difficult to argue that Cyprus could be a special case, as the banking system is more than 3 times the size of the economy, and most deposits are from foreigners (and it has been broadly seen as a tax heaven and shelter). But these idiosyncrasies would make for an argument if this were an isolated exercise. The EU is not out of the woods yet, and anything that can push Spaniards or Italians to withdraw their deposits is bound to be a bad idea. True that bank runs were predicted a few times before and did not materialize, but that does not make for an argument to play with fire yet again.

There appears to be three scenarios at the moment, based on the limited information on a fluid situation: A) Cypriots vote for some kind of deposit taxation scheme, and re open banks; B) Cypriots vote for a deposit taxation scheme but restrict deposit withdrawals; C) Cypriots reject any EU plan based on taxing deposits.

In scenario A, the most likely outcome once banks re-open is for massive withdrawals, in which case either the ECB plays its role and funds them, or lets the banks implode. If the run is funded, but depositors remain unconvinced that leaving their haircut assets in the same banking system makes sense, then the final bill for the ECB would be several times the 7 billion euros the EU attempted to save by bailing in depositors. Thus, not a very intelligent plan in the first place, despite the fact that in principle and in paper it does make sense.

In scenario B, Cypriots’ anger would attract enough attention from Italians and Spaniards to make them wonder what is the upside of leaving their cash in banks (almost zero interest rates) while the downside is to eventually get taxed à la Cypriots were. Not a difficult decision, especially if the bank run mentality gets triggered by a skeptical bunch with initiative.

In scenario C Cyprus is practically out of the euro, which means the EU saves money it would have spent in bailing out a very small economy which can be argued to be special, or not relevant.

There are other scenarios, always. But scenarios A and B (and potentially C) would increase depositors’ angst in the rest of the EU, increasing the probability that a broad euro area deposit guarantee (most likely by the ECB) is established sooner than expected. We had raised the need for such measure a long time ago (first in September 2011, then specifically in May 2012; click on dates to read). The EU decided it should first centralize regulation and supervision of banks, which makes sense. However, the mistakes on Cyprus could accelerate the need for a deposit guarantee sooner than that.

From a portfolio allocation point of view, we are not over-reacting, staying put in our still conservative stance. But alert to what could be a series of significant events, in either direction.

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