Banking group warns of Cyprus becoming model

A global banking group warned Wednesday that the Cyprus approach, of hitting depositors and creditors when banks fail, would likely become a model for dealing with collapses elsewhere in Europe.

"Investors would be well advised to see the outcome of Cyprus... as a reflection of how future stresses will be handled," the International Institute of Finance, which represents more than 400 leading banks worldwide, warned in a report on the bailout of the island nation.

In the Cyprus case, creditors and large depositors of the two leading banks are being forced to take losses as part of a government and European Union-International Monetary Fund rescue of the country's financial sector.

The "haircut" will affect only uninsured depositors holding more than 100,000 euros ($127,000), but could be steep in the case of Laiki Bank, the second largest on the island, which has teetered on the verge of failure.

The IIF, which was deeply involved in crafting Greece's rescue, called the Cyprus approach "a very marked shift in strategy from earlier on in the Euro Area crisis."

The previous strategy, as applied in the case of Ireland's at-risk banks, was to provide blanket guarantees of protection to senior creditors and all depositors.

That meant, however, that after shareholders were wiped out, the rescue costs were essentially shouldered by the government.

In Cyprus, the EU and IMF offered a 10 billion euro bailout loan to Nicosia but adamantly insisted that the government not take on the brunt of the bank failures, which would elevate the risk of a sovereign default.

"It remains to be seen whether this desire to pass the burden for financial support of the banking sector on to bank creditors is a new approach to be applied generally across the Euro Area, or a one-off solution to be applied just in the very special case of Cyprus," the IIF said.

But the group noted that the rescues of banks in Ireland and Spain are still hampering their governments' ability to rebuild their own finances.

Moreover, the IIF said, the two examples made clear that the efforts to shift the burden of bad bank assets to the EU bailout fund are "unlikely to be successful."

Nevertheless, it said, the Cyprus approach will still deeply damage the overall economy -- the IIF forecast up to a 20 percent contraction through 2015 -- and leave the government's ability to service its debt at risk.

A key objective of the EU-IMF rescue was to provide enough funds to stave off the threat of a government default "but not increase Cypriot debt by so much as to make it evidently unsustainable over the medium term," the IIF said.

"It remains to be seen whether the second is possible, however."