INTERVIEW-Banks could be obliged to set Libor rates
* Alternatives to Libor to be found for some contracts
* Cyprus case may be watershed where Berlin stands firm
* Politics, long-term euro vision shape Merkel stance
* German assumption remains that Cypriots will buckle
By Noah Barkin
BERLIN, March 20 For three years, the euro zone crisis has played out according to a familiar pattern: German Chancellor Angela Merkel took a rock-hard line towards struggling southern states only to buckle at the last minute and offer aid when disaster threatened.
No longer. With Cyprus, a tiny Mediterranean island that for Berlin exemplifies much of what is rotten with Europe's currency bloc, this pattern may be finally breaking down.
In public statements and private conversations, top German officials led by wheelchair-bound Finance Minister Wolfgang Schaeuble are sending strong signals that, this time, they will not blink.
The bailout offer for Cyprus agreed on Saturday in Brussels, which would force big losses on depositors in the island's oversized banks and perhaps shatter the shaky financial foundation on which its economy is based, looks final.
If Cyprus rejects it, Germany may be prepared to accept the risks associated with a banking collapse and a disorderly debt default that might ultimately force Cyprus out of the euro zone.
"Cyprus may be the end of muddle through," JP Morgan analyst Alex White said in a research note. "Germany appears ready to live with the consequences of Cyprus stepping out of Europe."
The German line, spelled out by Schaeuble to his euro zone counterparts late last week, is simple.
Unless Cyprus comes up with a 7 billion euro contribution from its banking sector, Berlin will not approve desperately needed aid of 10 billion euros from Europe's rescue mechanism.
In a vote on Tuesday, the Cypriot parliament overwhelmingly rejected that offer. The country's banks, dependent on emergency liquidity from the European Central Bank and shut since Monday, may be unable to reopen until a deal has been ratified.
The assumption in Berlin, spelled out by a senior official this week, is that the Cypriot government and parliament will back down once the bank closures start wreaking havoc on the island's 18 billion euro economy.
But if Nicosia doesn't flinch, it would be wrong assume that Germany will.
First, a loose consensus has formed in Berlin over the past months -- reinforced by muted market reaction to the crisis this week -- that a collapse of Cyprus would not have devastating contagion effects on the rest of the euro zone.
Schaeuble has openly questioned for months whether Cyprus is "systemically relevant". Recently he has been joined by other prominent politicians in Germany's ruling parties.
"Given the instruments we now have at our disposal, I think it would be manageable," Rainer Bruederle, parliamentary leader of the Free Democrats (FDP), told reporters on Wednesday when asked about the risk of Cyprus going bankrupt.
Second, there is an overwhelming feeling in Berlin that the Cypriot business model -- built on attracting foreign money with low taxes and loose regulation -- is not only deeply flawed but also at odds with the currency bloc's economic values.
This conviction transcends party lines, even in an election year.
The opposition Social Democrats (SPD) and Greens criticised the government for backing an EU plan to make smaller savers in Cypriot banks share the burden. But they do not dispute the substance of its demands that big depositors must suffer losses.
Any Cyprus deal will need to pass through the lower house of parliament. Six months before the election, Merkel has no hope of pushing a watered-down deal through the Bundestag, officials close to her say.
In the case of Greece, Merkel equivocated for months before concluding that a default was too risky for the currency bloc.
With Cyprus, the opposite has happened. Officials say Merkel would face greater political risks if she backed down than by standing firm, even if it means chaos on the streets of Nicosia.
"No one but Cyprus is to blame," Schaeuble said in a combative appearance on German public television. "Its business model doesn't work anymore and it must be restructured. There is no way around this."
Top-selling daily Bild, often a close gauge of the public mood, railed against "ungrateful" Cypriots on Wednesday for making Germany a "bogeyman" despite Berlin's readiness to pay the largest share of any bailout.
"If the future of Europe wasn't at stake there would be only one reasonable response: do your dirty work alone," Bild commentator Hugo Mueller-Vogg wrote in a column next to protest pictures from Nicosia of Merkel dressed in a Nazi uniform.
A more fundamental reason why Berlin feels compelled to stick to its guns has to do with Merkel's own view of the causes of the euro crisis and her longer-term vision of what it will take to pull Europe out of it.
According to this analysis, either Europe becomes more like Germany -- competitive, industrialised, innovative and frugal -- or it is doomed to mediocrity in a globalised world dominated by more nimble powers like China.
Cyprus, with an economic model that relies on super-sized banks stuffed with billions of euros in foreign money, mainly Russian and British, is a poster child for all that is wrong in Europe and must now change, the Germans believe.
Because of its small size -- the city of Berlin alone has three times the population of Cyprus -- it also happens to be the perfect test case for Merkel's "adapt or fail" paradigm.
Analyst White of JP Morgan believes Germany's hard line on Cyprus may end up as a watershed moment for Europe in which Berlin signals to other members, including bigger states like Italy and France, that it is prepared to take a much tougher line on aid if it does not get its way on reforms.
"We think Germany is increasingly prepared to say 'no' in an extreme environment and to deal with the consequences," he said. (Additional reporting by Annika Breidthardt and Paul Taylor; Writing by Noah Barkin; Editing by Paul Taylor)
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