The Cyprus difference: the eurozone can't unring the bell on bank deposits.

• Author: Elliott, Douglas J.

Sometimes a small island can make a big difference to the course of history. Cyprus may be one of those cases, as a result of the debacle of the first bailout deal and its metamorphosis into a much improved, but still risky, revised deal. It sometimes strikes me that the eurozone's leaders are like Russian roulette addicts. Several times now they have metaphorically loaded a bullet into one chamber of the revolver and spun it, creating or aggravating a very risky situation that required a summit to work into the wee hours of the morning to craft a deal. Having done this several times while surviving the pull on the trigger, they seem to be convincing themselves that the revolver will never fire. I believe an underlying cause of the terrible original proposal for Cyprus was a level of official complacency that the overall euro crisis was winding down and therefore it was possible to take a little risk with financial stability.

The first Cyprus deal was a total fiasco for which no one will currently admit responsibility. (If there were not so many witnesses, I am sure a number of officials would deny even being at the negotiating table.) It started falling apart upon first contact with reality. The revised deal is much sounder, but it leaves us with two major problems for the euro area as a whole and a disaster for Cyprus.

The best news is simply that an agreement of any kind was reached, allowing European support to flow to Cyprus and preventing, for now anyway, the possibility of an exit from the eurozone. It is also very good news that insured bank depositors in Cyprus will be protected after all, eliminating a terrible precedent with repercussions across Europe. Further, there are real advantages to inflicting large losses on the uninsured depositors and the bondholders of the two largest Cypriot banks. This is by far the strongest message Europe has ever sent that people must pay attention to the strength of the banks with which they deal. It brings the hope that market discipline will finally be a significant aid to outright regulation in ensuring that European banks act prudently at all times.

The first risk is the flip side of passing losses on to those who put their money in banks. In practice, Europe has a long tradition of protecting all depositors, not just the insured ones, and, in most cases, the bondholders as well. For example, the much vaunted, and highly successful, Swedish bank rescues included guarantees for all...