The Cypriot banking system is insolvent and desperately in need of a bailout. Like Ireland, this island banking system has expanded rapidly over the years and currently has assets equal to almost 7 times its GDP, making the system too big to fail, but also "too big to save." Funding needed to recapitalize the banks is currently estimated to be around 17B euros (almost 100 percent of Cypriot GDP) making it impossible for Cyprus to resolve its crisis alone. A 10B euro rescue package was recently negotiated, but the bailout package proposed by the Troika — made up of the IMF, the EU and the ECB — still leaves Cypriots to come up with a sizable sum. The question is what to do.
The recent bailout plan proposed by the government (yet rejected by the Cypriot parliament) sparked significant controversy globally because it required a depositor levy to "bail in" all depositors to help pay for the bailout. On the one hand, the proposal is seen as violating the deposit guarantee and risk leading to bank runs elsewhere in the Euro Area and beyond. On the other hand, the Cypriot government felt the need to turn to depositors because a full bailout is out of the question given their debt burden will already reach unsustainable limits even with the partial bailout; most of their sovereign debt is under English law and cannot be restructured; their banks have few bonds to be written down; and about half of their depositors are rich Russian depositors attracted by their favorable tax system.
I have written about how to design systemic bank bailouts before and many of the lessons are still applicable here. Governments should be prepared to act quickly and decisively in a systemic crisis. The idea is to impose costs on all responsible parties and move on as soon as possible. However, despite the urgency, the approach and the actions taken still need to be designed carefully to reduce conditions for moral hazard and the likelihood of a subsequent crisis. Hence the form the recapitalization should take is equally important. That is why the Cyprus depositor "haircut" discussion is crucial. So should the depositors pay? The answer depends on which depositors.
Clearly the burden of recapitalizing insolvent banks should not just fall on the Cypriot taxpayers. Limiting the government’s ability to shift losses and loss exposures to the general taxpayer as much as possible is an important principle in safety net design. Any recapitalization without extracting some claim from the owners of the institutions amounts to a transfer from taxpayers to shareholders, which is the group that keeps the residual value of the entity. That is why government assistance to the banks often takes the form of preferred stock.
Equally important, however, is to ensure incentives for private monitoring, or market discipline, which brings us to the question of whether creditors and depositors should pay. To accomplish market discipline, safety nets must be designed and managed in ways that convince large depositors, subordinated debtholders, and correspondent banks that their funds are truly and inescapably at risk. These are large, sophisticated creditors, and maintaining strong incentives for private parties to police bank risk exposures is especially important in contracting environments where accounting transparency and government accountability are deficient. Otherwise, the outcome is insurance-induced risk-taking, which economists call "moral hazard." Moral hazard occurs because sheltering risk-takers from the negative consequences of their behavior increases their appetite for risk, leading to even greater instability. The ability of Cypriot banks to attract large deposits despite continuing to have very large exposures to Greek firms, banks, and government, with their well known efficiency and insolvency problems is an example of such behavior. So now requiring these large uninsured depositors (and other creditors) — to take a haircut is actually good practice for limiting future moral hazard and preventing future crises.
But what about smaller, insured depositors? Asking them also to pay a share (6.75% for deposits up to 100,000 euro in this case) essentially amounts to ex-post co-insurance. While co-insurance for large depositors is likely to be beneficial in limiting moral hazard, for small, unsophisticated and uninformed depositors the market discipline benefit is likely to be marginal, but also potentially destabilizing. Importantly, introducing such a feature ex-post is a clear breach of the deposit insurance contract and further undermines public trust in banks and government institutions. Hence, not only this part of the haircut does not make sense, it also risks causing depositor runs in other countries. Such wide spread loss of confidence can have serious adverse consequences and needs to be avoided.
Demirguc-Kunt, Asli, Resolution of Systemic Financial Problems — How Should Spain do it?  — Let’s talk development blogpost June 11, 2012
Demirguc-Kunt, Asli and Harry Huizinga, "Are Banks Too Big to Fail or Too Big to Save? International Evidence From Equity Prices and CDS Spreads ," forthcoming, Journal of Banking and Finance.
Demirguc-Kunt, Asli, Ed Kane and Luc Laeven, Deposit Insurance around the World: Issues of Design and Implementation , Cambridge, MA: MIT Press, 2008.
Demirguc-Kunt, Asli, Ed Kane and Luc Laeven, "Determinants of Deposit Insurance: Adoption and Design," Journal of Financial Intermediation, 17 (3), July 2008.