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Cyprus troubles cast a shadow over deposit accounts

March 21, 2013

| MoneyRates.com Senior Financial Analyst, CFA

Cyprus is a small country, but the prospect of a Cypriot bank bailout made international headlines because of a disturbing proposal by European Union: It suggested Cyprus should pay for part of the bailout through a seizure of a portion of the country's bank deposits.

The proposal could not have done more to increase anxiety about the safety of banks, and to heighten tensions between the haves and have-nots of Europe.

The bailout proposal

At first blush, the proposal seems outrageous: The government of Cyprus would seize a portion of all bank deposits on the island to help finance the bailout. However, it becomes easier to understand when you realize that this is no ordinary banking system.

Cyprus has less than a million inhabitants, yet it attracts a disproportionate amount of bank deposits because it provides an offshore shelter for foreigners (in this case, largely Russians) who want to hide their assets from their own governments. Cypriot banks have been so attractive to foreigners that total deposits equal roughly eight times the island's Gross Domestic Product.

In one sense then, you could say that many of those who would pay the levy on Cypriot deposits were people who were trying to game the financial system in the first place. That may or may not be justified, but the bigger problem is that the notion of deposit seizures raises global doubts about the banking system -- exactly the kind of panic that bailouts are designed to avoid.

Lessons from Cyprus

The solution to this bank crisis is still to be determined, but already there are at least three lessons that can be gleaned from it:

  1. Asset seizures destabilize financial systems. Free market advocates preach over and over again that there are long-lasting negative effects on investment when countries nationalize corporate assets or otherwise arbitrarily seize property. It's ironic, then, that the economists of the European Union should make a proposal that amounts to something similar.
  2. It's never a good idea to let people see the sausage being made. All this worldwide angst and market disruption occurred not because these deposit seizures actually took place, but simply because they were proposed. It was probably premature to publicize something that had not yet been agreed to, because it triggered a run on the banks and a great deal of ill feeling without ultimately raising one penny toward the bailout.
  3. People -- including Americans -- may want to rethink offshore deposits. All savings accounts are not created equal. From the Cayman Islands to Cyprus, offshore accounts have been popular for everything from political reasons to tax evasion. However, leaving the stability and regulatory protections of the American financial system can have consequences.

Bank savings accounts are supposed to be the ultimate in stable and secure places to put money. With one proposal, the European Union has forced people the world over to question that assumption.

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