The Cyprus Bailout Does the Unthinkable, Vaporizes Bank Deposits

Bailout terms in Europe are getting tougher.

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Cyprus Finance Minister Vassos Shiarly speaks to reporters during a press conference at the Finance Ministry in the Cypriot capital Nicosia on Wednesday, June 27, 2012.

Apparently folks can stop worrying about the financial crisis in Cyprus. But there's one startling development in the tiny island nation that's worth paying attention to.

[AP: Russia Moves to Restructure Loan to Cyprus]

European leaders have stayed true to form by nearly forcing Cyprus out of the eurozone, then negotiating a last-second deal that keeps it in while imposing onerous bailout terms. While Cyprus is puny, there's one twist to the bailout that raises the stakes for banks and their customers all across Europe.

Unlike an earlier plan that would have "taxed" bank deposits, no matter how small, the new bailout protects all deposits up to the insured limit of €100,000. But above that limit, depositors with accounts in Cyprus's two biggest banks—both essentially insolvent—will lose some of their money, which will be used to help pay the bailout costs. Officials in Cyprus have estimated that depositors could lose 30 percent of their money above the insured limit.

That's something that has never happened before. "This is a precedent-setting event for the euro area," says Jacob Funk Kirkegaard of the Petersen Institute for International Economics. "It is the first time uninsured depositors will face losses in a euro area bank restructuring ever."

While the limits on insured deposits are clear, regulators in both Europe and the United States have in practice protected virtually all bank deposits, to prevent panicky withdrawals by people whose accounts exceed the insured limit.

During the 2008-2009 U.S. financial meltdown, several big banks failed, but deposits were typically transferred promptly to another bank, with no losses, even above the insured limit. And the FDIC raised the limit from $100,000 to $250,000 to add a measure of confidence to the system.

[STUDY: Cyprus Better for Foreign Investors Than America]

Depositors in Cyprus whose accounts exceeded the €100,000 limit clearly felt their money would be safe, which is why there was no major outflow of funds until the draft plan to confiscate some portion of bank deposits surfaced. That forced Cyprus to close its banks, allowing withdrawals of just a few hundreds euros per day from ATMs.

The biggest losers under the new rules will most likely be wealthy Russian who stashed cash in Cyprus to take advantage of low taxes and lax oversight.

The Cyprus bailout ought to prevent a financial panic from spreading to Greece, Spain and Italy—which is why it was such a high priority—but it could also prompt some money shuffling at European banks as wealthy customers make sure they're not exposed to possible losses above the insured limit.

Another key element of the Cyprus bailout is that senior bondholders in the two big troubled banks will bear losses, along with depositors. European regulators have generally tried to protect bondholders, although the holders of Greek sovereign debt took a major loss during a 2012 restructuring.

In that regard, European bailouts are beginning to look more like the wind down of failing banks in the United States, which often entail losses for bondholders.

[READ: The New Underground Economy]

The severe terms of the Cyprus bailout will depress the tiny nation's economy for years, but they may also signal increased resolve among European leaders who have long been criticized for coddling banks and their investors. And they will surely help bank customers better understand what deposit insurance really means.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.