This is my go at summarising this. Obviously, if someone spots something fundamentally wrong with my analysis, please leave a comment. I don't profess to be an expert on the Cypriot financial sector.
Cyprus took a light regulatory touch to financial services, so its sector grew.
It gained a reputation for providing only the minimum level of scrutiny needed to comply with European banking rules, hence it tended to attract substantial deposits from Russians keen to keep their money away from Russian authorities.
Cypriot banks grew from this, but invested heavily in Greek public debt as a “safe” investment.
Greece approached bankruptcy, and the Eurozone (Germany) and Greece agreed on a bailout plan that meant its bond holder (those who lent money to the Greek government) would take approximately a 50% cut in their bonds. This shared the burden between Greek taxpayers and Greece’s creditors.
Cypriot banks have been hit by this “haircut” in their investments, effectively being on the edge of folding without ongoing liquidity support.
The ECB is willing to provide some of this, but is demanding that investors in Cypriot banks take their share. However, Cypriot banks issued few bonds, so simply demanding Cypriot bondholders take a cut wouldn’t be enough. So the suggestion was made to take a cut from those who loaned money directly to Cypriot banks – in the form of depositors.
This runs contrary to the pan-Eurozone guarantee for depositors up to 100,000 Euros.
The reason given for wanting to confiscate Cypriot depositors is because “most of them are Russian” and “we don’t know where their money came from”. Concerns that never translated into legal action, and which are at worst racist suspicions.
So now the Cypriot government faces its financial system collapsing. It is happening now because the previous, communist led, government kept its head in the sand until the election it knew it would lose.
The Cypriot government itself does not have high public debt or a serious budget deficit. It is not due to rampant overspending, but rather a banking sector that can’t cope with the bailout package for Greece demanding it write off substantial assets.
The Cypriot government is looking to the Russian government to save it, which from the ECB’s point of view means it wouldn’t be willing to provide ongoing liquidity, which means a real risk of a Euro exit, unless Russian support is substantial indeed (to the point where Russia would be the central banker for Cyprus, just think about that for a moment).
To get ECB support, it needs to find money from somewhere and could get it from a levy on deposits over 100,000 Euro.
If no solution is obtained by Monday and the ECB stops providing liquidity, Cypriot banks will collapse and the Cypriot government may choose to print its own currency to cover spending, meaning a disorderly exit from the Euro by a country that – in itself – did not have a budget.
Cyprus’s financial sector is finished, regardless of what happens. Local and foreign depositors wont trust its banks in most scenarios.
1. If Russia saves Cyprus, and it remains in the Euro, then it will likely mean a substantial withdrawal of deposits from Cypriot banks. They will shrink, and Cyprus will have a bunch of effectively Russian owned banks operating within the Euro. It is hard to see the ECB being willing to support this.
2. If Russia saves Cyprus, and it is forced to exit the Euro, then Cyprus will have a nearly worthless local fiat currency that does far more harm to depositors than a levy on Euro deposits. It is over for Cyprus’s financial sector, but it will become remarkably cheap to holiday and buy land in Cyprus.
3. If the ECB saves Cyprus, along with Russia (providing the Cypriot share), then Cyprus will have a shrinking financial sector. Russians will be looking elsewhere to put their money.
4. If the ECB saves Cyprus, with a bank deposit levy, then Cyprus will see a massive run on its banks, and the financial sector will be effectively finished.
5. If neither the ECB nor Russia bail out Cyprus, the banks will default, depositors may lose most of their money, it will be forced out of the Euro, and faces considerable civil unrest.
Who to blame?
- Greece, for being fiscally incontinent and being unable to pay back its debts.
- The Eurozone, for being unwilling to guarantee to Cypriot depositors what they guarantee to other Eurozone depositors, on grounds that it was never willing to address in the past.
- Cypriot banks, for being profligate lenders
- Cypriot depositors, for trusting the Eurozone and its government to ensure they avoid moral hazard.
- Authors of the Euro, for not anticipating the inevitable credit bubbles a pan-economic fiat currency, driven by German economic performance, would fuel.
What to watch?
Monday. The Cypriot Parliament and the ECB.
My bet is that Cypriots will be dealing entirely in cash in a week's time (they already increasingly are).
The Prodigal Greek has a great summary of the measures taken or soon to be taken, that will ensure this.