ANALYSIS-"Lex Cyprus" will set precedents for closer EU union

BRUSSELS, March 23 Sat Mar 23, 2013 5:30pm GMT

BRUSSELS, March 23 (Reuters) - Lawyers have a saying that hard cases make bad law.

Whatever happens this weekend on a bailout for Cyprus will set precedents for the euro zone's future banking union, investor confidence in the single currency area and political relations among European states.

Europe's political leaders, and their finance ministers, are having to decide in practice at breakneck speed on issues on which they have not yet agreed in theory.

Among those issues is whether euro membership is really irreversible for all member states, or only for countries deemed systemic, and what the true meaning is of the European Union's agreed guarantee of 100,000 euros in bank deposits.

"Lex Cyprus" will likely be a template for future bailouts, bank resolution and the protection - or not - of creditors and depositors, even if euro zone leaders swear on the bones of saints, as they did for Greece, that this is a unique case.

Some precedents have already been set in a chaotic week of stumbling crisis management.

For the first time, European leaders made clear they were willing to cut loose a member of the 17-nation currency area, leaving it to default and abandon the euro if it did not meet the conditions set for a financial rescue.

The European Central Bank said it would pull the plug on Cypriot banks kept afloat by emergency lending assistance unless Cyprus had a bailout in place by next Monday night.

Even though the ECB does not yet have supervisory authority over European banks, or powers to resolve failed institutions, it effectively acted as a resolution authority since withholding liquidity would have the same effect as withdrawing a banking licence.

A senior European Union official warned that in that case, the biggest banks would have to be wound down, and Nicosia would have to fend for itself and revert to issuing national money.

"If the financial sector collapses, then they simply have to face a very significant devaluation, and faced with that situation, they would have no other way but to start having their own currency," the official told Reuters on Thursday.

COMBINED ULTIMATUMS

The combined ultimatums from Frankfurt and Brussels may have been intended primarily to jolt Cypriots into accepting a levy on large bank deposits that lawmakers had rejected, but it sent a message that recalcitrant small countries can be expelled.

That is the opposite of what EU leaders sought to signal when they went the extra mile last year to grant Greece more time and money to keep it in the euro zone.

"Why did we say this for Cyprus when we didn't say it for Greece?" a euro zone central banker said. "Cyprus is 0.2 percent of the euro zone economy and Greece is 2 percent. Size matters."

Like other European policymakers quoted in this report, he spoke on condition of anonymity because of the acute sensitivity of the negotiations.

EU paymaster Germany, with a general election in September, was keen to show it could say "no" and stick with it after domestic critics complained that Berlin had been stampeded into previous bailouts by anxious euro zone partners.

Last week's EU-mandated attempt to impose a one-off levy on all bank deposits in Cyprus, rejected by the Cypriot parliament and subsequently disowned by euro zone finance ministers, set another precedent that caused an outcry among investors and many ordinary Europeans.

Stunned by the backlash, the ministers changed their minds within three days, blaming the Cypriot government for the plan to hit smaller savers, and said deposits below the 100,000 euro threshold should not after all be raided.

"I understand that electorates in Germany and northern Europe demand some sacrifice. However, when you accept a solution that basically expropriates 10 percent of deposits, you set a dangerous precedent," Vladimir Dlouhy, a former Czech economy minister and now international advisor at Goldman Sachs, told Reuters. "If we get into deeper trouble, God help us, they may try to take 50 percent."

The latest word from Cyprus suggests the levy on holdings of over 100,000 euros at Bank of Cyprus could go as high as 25 percent. Many of the accounts are held by Russians and other foreigners.

DAMAGE

The psychological damage may have been done.

There has been no bank run in Spain, Italy or Ireland, but depositors now know, if they did not suspect it before, that in extreme circumstances their savings in euro zone banks may not be as safe as they had imagined.

Tellingly, the International Monetary Fund urged the EU a week ago to press ahead with a common deposit guarantee, a red line for Germany which fears it will end up footing the bill.

The European Commission sought to distinguish between protecting deposits if a bank collapsed, in which case accounts of up to 100,000 euros were guaranteed by EU law, and "fiscal measures", from which there was no such protection.

Cypriots were not alone in seeing the levy as an attempted "bank robbery" rather than a tax, since it touched capital rather than income.

In reality, even the EU guarantee in case of a bank failure is less certain than it sounds, since there is no procedure so far for other euro zone countries to help a country that does not have the money to compensate depositors.

In the case of Cyprus, not only would accounts with more than 100,000 euros be potentially wiped out in a bank failure, but European officials say there is little chance the Cypriot state would be able to reimburse all "guaranteed" deposits.

Berlin, in particular, opposes the idea of mutualising national deposit insurance schemes and the European Commission has yet to put forward a proposal for a financial backstop for the planned European banking union.

One idea that may get around the German objection would be to require national resolution funds to take out reinsurance contracts with the euro zone's rescue fund, perhaps paying differentiated risk premiums.

If, as now seems likely, only accounts larger than 100,000 euros are hit in Cyprus, euro zone policymakers may be obliged by the public outcry to give stronger force to the deposit guarantee than they had originally intended.

In that case, the Cyprus outcome also risks upending the traditional hierarchy of claims in case of a bank failure, since big depositors will suffer a "haircut" but senior bondholders, of whom there are few in Cypriot banks, will not.

The Cyprus case does confirm another EU precedent in the treatment of small member states, which could have serious consequences for public support for European integration.

As with Ireland's repeat referendums on the EU's Nice and Lisbon treaties and Greece's two general elections last year, the bloc has a habit of pushing small states to vote again until they produce the desired answer.

When France voted against a European constitutional treaty in 2005, no one suggested the French be made to return to the polls. (Writing by Paul Taylor, editing by Mike Peacock)