One of the biggest problems presented by the euro crisis has been the financial connection between the banks and their governments.
For the most part, the biggest holders of any country's sovereign debt are that country's own banking system. So, when the government comes under pressure in the sovereign debt markets, and the value of its debt decreases, it stresses the banks, who are holding so much of that debt on their own balance sheets.
In turn, when the banks have to be bailed out, the cost falls largely on the public. This increases the country's government debt-to-GDP ratio, causing its sovereign bonds to come under further pressure. It's a vicious cycle.
One of the big reasons banks can come under pressure in the first place, though, is because of deposit outflows. That's why deposit guarantee schemes are such a key component to further euro integration – people have to trust that their deposits are safe in Spanish or Italian banks, for example, or they will have no incentive to keep them there at the first sign of trouble.
That's also why Société Générale strategist Sebastien Galy said that the EU broke the "cardinal rule" in negotiating this bailout deal with Cyprus, which includes a sizeable depositor haircut for those with money in Cypriot banks.
Accounts with less than 100,000 euros will see 6.5 percent of their bank balances taken for the tax, while accounts with more than 100,000 are subject to a 9.9 percent haircut.
JPMorgan's Alex White writes in a note to clients, "It is difficult to over-state the extent of popular anger in Cyprus over the bailout deal which was pulled together on Friday evening."
And there may be further implications beyond Cyprus, says White (via Zero Hedge):
Has Europe bazookaed itself in the foot?
Even if we avoid a negative outcome this week, events in Cyprus invite broader questions about the region’s commitment, repeated ad nauseam since June to ‘break the feedback loop between sovereigns and banks’.
The IMF warned as recently as Friday that the Euro area lacked an effective deposit guarantee framework (before agreeing to a haircut that adroitly proves its point). The Cypriot package reinforces the fact that existing deposit guarantee schemes are only as strong as the sovereign which backs them; something which is unlikely to go unnoticed in the rest of the region (although we think specific contagion risks are limited near-term).
Other EU member states will likely be affected, there are significant numbers of UK depositors in Cypriot banks, some of whom the UK has now promised to protect (with echoes of the Icesave situation), and some potential contagion channels may not be obvious. It is notable that German policy-makers have been insisting on Cyprus’ significant ‘systemic relevance’ over recent days while pushing a package that may test it.
Cyprus still has to approve the deal in parliament, a vote White says is too close to call. Furthermore, it could be subjected to additional delays. Monday's bank holiday has already been extended to Tuesday.
In addition to the drama in Cyprus, it will also be important to watch peripheral countries for any signs that the deal is undermining confidence in those banks, given the fact that the EU has finally decided to go there – depositors have finally been "bailed in."
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