The latest European plan to prevent the collapse of the banking system in Cyprus is a big improvement over the first disastrous attempt to address the crisis. But the deal, reached over the weekend, will still impose harsh austerity on the people of Cyprus and could further sap public confidence in the banks of other weak European economies, like Spain and Italy.

Policy makers have sensibly abandoned their misguided plan to tax all bank deposits, including balances of less than 100,000 euros, or almost $130,000, that were supposed to be guaranteed. Instead, they will now restructure the country’s two biggest and most troubled financial institutions, Laiki Bank and Bank of Cyprus. This is a fairer approach because it does not penalize small savers and account holders at healthier banks.

Policy makers acknowledge that they have to impose tough capital controls in the next 48 hours to make sure depositors from Russia and elsewhere do not withdraw the billions of euros they have stashed in Cypriot banks when they open on Thursday for the first time in nearly two weeks.

Under the new plan, Cyprus will wind down Laiki Bank by transferring some of its assets and all deposits of up to 100,000 euros to the Bank of Cyprus. Customers of Laiki, the weaker of the two, with more than 100,000 euros could lose most of that money, and its bondholders and shareholders will be wiped out. Account holders at the Bank of Cyprus will be hurt less, but up to 40 percent of their deposits above 100,000 euros could be converted into shares in the bank.

By agreeing to this plan, the government of Cyprus will receive 10 billion euros from the 17 countries that use the euro and the International Monetary Fund. The money is supposed to help the country cope with the severe recession by financing government programs and refinancing debt held by private investors. Some economists say the crisis could cause the economy of Cyprus to shrink by 20 percent to 30 percent in the next few years.

Though it is better than the initial plan, the new agreement does not inspire much hope. It represents the latest in a series of slapdash and last-minute European efforts to prevent financial Armageddon in one country or another. Many analysts have noted that this deal leaves the government of Cyprus with an impossibly high debt burden, about 140 percent of its gross domestic product, and will impose many years of hardship and pain on its people and its economy.

For Spain, Italy and other troubled euro zone countries, Cyprus is an unnerving example. Individuals and businesses in those countries will probably split up their savings into smaller accounts or move some of their money to another country. If a lot of depositors withdraw cash from the weakest banks in those countries, Europe could have another crisis on its hands.

The way to prevent financial catastrophes like this is to impose strong centralized regulations on all banks and recapitalize or restructure weakened ones. Most important, the policy makers need to scrap austerity programs that are making it nearly impossible for the European economy and financial system to recover.

New York Times

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