When a sovereign fails, its banks fail, and private sector losses are virtually assured. The question is who bears the burden. Roughly half the deposits in Cypriot banks, with assets five times its GDP, are of Russian, Greek, or British origin [1]. They were attracted by high deposit rates (roughly double EMU average) and a system tolerant of likely tax evaders.

>"This whole thing is entirely unfair for the people living in Cyprus. The average citizen had nothing to do with the banking sector stocking up on Greek debt, but now they have to pay for it."

Foreign deposits are flighty. The loan-for-austerity solution is too slow. The Cypriot financial minister has already noted "substantial outflows" from banks over the past few weeks [2]. Announcing a future tax would leave the burden exclusively on ordinary Cypriot depositors. This measure was intended to help the Cypriots, not burn them.

Further, the mark-downs on Greek debt is a proximal, but not the root, cause of the problem. The IMF warned Cyprus in 2011 to raise capital levels, potentially by slashing deposit rates - it did not. Ratings agencies chimed in, in 2012, that private sector losses would result if Cyprus did not increase contributions to bank capital. Complicating the situation is that 15-20 percent of Russian bank capital and nearly 10 percent of Russian corporate deposits sit in Cyprus - there was probably external pressure to keep the banks leveraged.

Pre-crisis, Cyprus stood out for its high growth (almost 4%) and low unemployment (low of 3.6% in 2008), despite a falling savings rate, rising labour costs, and a red hot real estate market following its accession into the eurozone in 2004 [3]. Today, we have a zero growth economy with a banking crisis that would have tipped its debt/GDP from 87% to 145%.

Cyprus needs a capital injection equal to half of GDP. This was never going to be painless.

>"So what do investors, businesses, and savvy savers do? They pull their money from banks in the troubled euro countries. No need to take the risk, even if it’s small."

This is unlikely - the EU banking environment is already highly re-patrimonialised. Non-financial corporate and high net worth deposits have already fled to the degree that they can. Domestic depositors are, for better or worse, less flighty (and savvy) than senior bank debt investors - hence the logic for preserving their latter at the expense of the former. Also Cypriot banks have very little senior bank debt (0.3% of assets for Laiki [4]). This is cruel, yes, and I sound with The Economist's criticism of the tax levied on minor accounts (those holding less than €100 000). But forced de-leveraging will be cruel.

Given the political constraints from Deutschland limiting the ability of the European Central Bank to launch into Fed-style monetary base expansion and its Landesbanks preventing euro-wide deposit insurance, the bank regulatory constraints imposed by a country relying on flighty deposits for financial stability, and the economic constraints of a highly-indebted nation in the middle of a geopolitical brouhaha between Greece, Turkey, and Russia slated for near zero growth in the near future, this is not a terrible deal. Note that Iceland, which was in a similar position in 2007, saw its economy crater by nearly 1/3 from 2007 to 2011, or about 9% annually. Peak (2007) to trough (2009), 3/5.

[1] http://blogs.ft.com/beyond-brics/2013/03/13/russias-cyprus-p...

[2] http://www.ft.com/intl/cms/s/3/83fb0dd2-8802-11e2-b011-00144...

[3] https://www.imf.org/external/pubs/cat/longres.aspx?sk=25382.... 2011 Cypriot IMF Article IV Consultation

[4] http://ftalphaville.ft.com/2013/03/16/1425732/a-stupid-idea-...