By Paul Carrel
FRANKFURT (Reuters) - The European Central Bank is prepared to cut off funding to Cyprus and let the Mediterranean island succumb to financial meltdown if it has to, confident it has unlimited firepower to protect the rest of the euro zone.
Cyprus propelled the 17-nation bloc into uncharted waters on Tuesday by rejecting a proposed levy on bank deposits as a condition of a 10 billion euro (8.56 billion pounds) EU bailout.
Without the aid, much of it to recapitalise Cypriot banks, the ECB says they will be insolvent, and it requires banks to be solvent for them to receive central bank support.
Denied these funds, Cyprus would be left staring into a financial abyss.
For the rest of the euro zone, the ECB has a suite of policy tools at its disposal to prevent contagion - with bond purchases and unlimited liquidity offers to the fore.
ECB chief Mario Draghi has his ability to create new policy tools constrained by resistance in Germany, where business newspaper Handelsblatt last week ran a front-page picture of him under the headline: "The poisoned gift: how ECB President Mario Draghi is saving the euro and ruining savers".
Bundesbank chief Jens Weidmann opposed Draghi's bond-buy plan - he sees it as simply financing governments - but he is open in principle to funding measures like the so-called LTRO the ECB used a year ago to funnel banks 1 trillion euros of cheap money.
Given that, the ECB probably has no need to dream up new crisis measures and before it even deploys its existing ones, it will try to work with governments to reassure bank depositors.
"The contagion risk is a run on banks in other countries," said Andrew Bosomworth, senior portfolio manager at Pimco, the world's largest bond fund.
"Verbal intervention from the ECB and governments can help, such as a commitment that guaranteed deposits are sacrosanct. Operationally, it also means keeping the ATMs full."
Draghi calmed markets last July by promising "within our mandate, the ECB is ready to do whatever it takes to preserve the euro". He backed up that vow by unveiling a plan to buy countries' bonds if they met certain conditions.
Now, a reassuring message to depositors needs to be supported with efforts to make sure the euro zone financial system is lubricated properly.
The ECB is already offering banks unlimited liquidity with loans up to 3 months, and reserves the option to provide them with more funding certainty over a longer horizon by laying on another 3-year funding operation, as it did a year ago.
In a statement issued late on Tuesday, the ECB underlined its position: "The ECB reaffirms its commitment to provide liquidity as needed within the existing rules."
Draghi has also deployed his lieutenants to reassure depositors, with ECB policymaker Joerg Asmussen saying no other euro zone country has a banking sector like Cyprus.
Deutsche Bank economist Gilles Moec said the ECB commitment to provide liquidity, combined with Asmussen stressing that Cyprus's banking sector is unique, showed it was ready to support healthy banks in the rest of the euro zone.
"The subtext is 'we reaffirm that we cannot fund a bank that is insolvent'. You can also read it as: 'as long as a bank is solvent, we will continue to provide liquidity'," Moec said.
So far, there have been no signs of bank customers getting worried elsewhere in the euro zone, part of a worst-case scenario that could also see a spike in government bond yields.
To guard against a bank run, euro zone national central banks must make sure bank notes are available to stock up cash machines - though the ECB and euro zone policymakers will be hoping Cyprus can still agree a rescue and no such scenario comes to pass.
For a spike in bond yields, the ECB could use its new bond-purchase plan - dubbed Outright Monetary Transactions (OMT) - to buy potentially unlimited amounts of a country's bonds and push down its borrowing costs.
The catch is that a country must first agree to an aid plan of reforms and austerity measures. The Cyprus case has highlighted just how difficult agreeing such a programme can be.
"Even if the principle of OMT is still there and valid, all the drama about Cyprus may remind people that the bar to get OMT is actually higher than they probably think," said Moec.
By stressing that it stands ready to provide liquidity "within the existing rules", the ECB is standing firm.
The central bank is not ready to bend for Cyprus.
As its governing council gathered for a mid-month meeting on Wednesday, Asmussen pressed Cyprus to agree to an aid plan:
"We can provide emergency liquidity only to solvent banks and ... the solvency of Cypriot banks cannot be assumed if an aid programme is not agreed on soon, which would allow for a quick recapitalisation of the banking sector."
With Cyprus sovereign bonds ineligible for use as collateral for ECB refinancing operations due to their low credit ratings, the Cypriot central bank is providing banks with Emergency Liquidity Assistance (ELA).
These emergency loans are more easily available, but the ECB's Governing Council must approve provision of ELA. It reviews banks' eligibility every two weeks and needs a two thirds majority to stop these funds.
"If really need be, the euro zone would likely choose to let small Cyprus go and focus on containing the damage instead of softening the conditions to such an extent that much bigger countries than Cyprus could be encouraged to reject their own current bailout terms," said Berenberg Bank's Holger Schmieding.
(Writing by Paul Carrel, editing by Mike Peacock)