(Bloomberg) Europe’s drive to rescue Cyprus risks undermining a region-wide deposit guarantee plan, a key tenet in the battle to contain the debt crisis, and casts doubt on the ability of the weakest lenders to retain deposits.

Finance ministers reached an agreement on March 16 to force depositors at Cypriot banks, including those with less than 100,000 euros ($129,500), to share in the cost of the latest euro-area bailout. If approved by the country’s Parliament, that could undermine policy makers’ plans to harmonize national deposit insurance programs as they try to restore confidence in Europe’s financial system.

While Cyprus makes up less than 0.5 percent of the 17- nation euro economy, the move to tax bank accounts raises the specter of a slow withdrawal of deposits from banks in other European countries perceived as being at risk, money managers and analysts said.

“This will be the death knell for an EU Common Deposit Guarantee scheme,” Roberto Henriques, an analyst at JPMorgan Chase & Co. in London, wrote in a report to clients. “With this action, one of the stabilizing instruments will have been completely undermined in the current process and, in the future, we may see a very strong reaction in deposit flows in the event that a banking sector may experience stress.”

June Timetable
European leaders are working toward a June timetable to set minimum standards for individual deposit guarantee plans at the 27 member states, a key part of the proposals for a banking union that places regulatory authority in the hands of the European Central Bank.

“It is very clear in the commission text that savers who are covered by deposit guarantee schemes, because they have deposited less than 100,000 euros, should be excluded from the scope of any bail-in,” said Vicky Ford, a U.K. Conservative member of the European Parliament who is working on the law.

Cyprus’s depositors aren’t covered by deposit guarantee rules because the state is insolvent, German Finance Minister Wolfgang Schaeuble said today on Deutschland Radio.

“The media falsely created the impression that deposits are not safe in other countries,” Schaeuble said. “They are safe, though only on the proviso that the states are solvent.”

Schaeuble said Germany put pressure on Cyprus to impose the tax in exchange for a 10 billion euro loan. “Naturally, the Cypriot president tried to find a way around it, but there was none and so we said if this program is to be realized then this financial contribution is necessary,” he said.

Parliament Vote
Cyprus’s Parliament is scheduled to vote today on the agreement, which includes a one-time tax on depositors of 5.8 billion euros. Under the March 16 deal, account holders with deposits below the insured amount of 100,000 euros will be taxed at 6.75 percent, while those with more face a 9.9 percent levy. Those rates will probably be amended to ensure a higher burden falls on those with deposits of more than 100,000 euros, European finance chiefs said in a statement last night.

The deal “created a perception around potential action in Spain and Italy and placed banks in the periphery in a vulnerable position,” said Elena Ambrosiadou, who relocated her $1.4 billion hedge fund Ikos Asset Management Ltd. to Cyprus from London in 2005. “The overall result was an indication of serious weakness within Europe. I do not think this is the impression they wanted to give, but this is what people understood.”

Yields Rise
Borrowing costs in other debt-strapped nations rose. Italian 10-year bond yields climbed 2 basis points today to 4.66 percent at 9.45 a.m. in London after a 4 basis point jump yesterday. The rate on similar-maturity Spanish yields increased 2 basis points to 4.98 percent, a 6 basis point rise this week. The yield on German two-year notes yesterday dropped below zero for the first time since Jan. 2.

The bank tax in Cyprus was an alternative to imposing losses on senior bondholders, a step that was opposed by the Cypriot government, the European Commission and the ECB, Schaeuble said on ARD television Sunday night. Forcing bondholders to take losses would make it impossible for some euro-region lenders to issue bonds in the future, analysts said.

“This has broken the seal on guaranteed deposits,” said Ronny Rehn, an analyst at Keefe, Bruyette & Woods in London. “It won’t make it easier to reach an agreement on a guarantee scheme. In the meantime, if we get to another bailout stage the reaction of depositors could be more volatile. This precedent doesn’t help.”

‘Taboo’ Broken
If approved, the Cypriot tax would mark the first time that consumer bank customers have been forced to take losses since the euro-area crisis began, raising the possibility depositors will move their savings out of lenders in peripheral Europe.

“A taboo has been broken,” UBS AG analysts Thomas Wacker and Mads Pedersen wrote in a note to clients. “We are convinced that a number of further banks in the euro zone will face asset quality and capital issues in the next 12 months. These cases will likely be intensified by depositors being more inclined to withdraw deposits fast, and thereby increasing the likelihood for a bank requiring external support.”

Policy makers working on the bank resolution regime must decide whether depositors should rank higher or equal to bondholders in future bank failures. In Cyprus, senior bondholders will see no decline in the value of their holdings.

‘Depositor Preference’
That “runs completely counter” to the purpose of EU legislation on deposit guarantees, according to Elisa Ferreira, the member of the European Parliament leading work on the bank recovery and resolution directive for the Socialist group.

“We are calling for a depositor preference so that depositors would be the first to be repaid in an insolvency and would be bailed-in after senior creditors in a resolution,” she said. “What has been done goes completely against the spirit of the commission’s proposal on bank resolution.”

European policy makers said Cyprus is an exceptional case because of the high proportion of non-resident deposits and the size of the banking industry relative to gross domestic product. Cypriot banks had 68.4 billion euros in deposits from clients other than banks at the end of January. Of that, 21 billion euros, or 31 percent, were from clients outside the euro area, 63 percent were from domestic depositors, and 7 percent were from other nations within the euro region, according to data from the Central Bank of Cyprus.

Italian Tax
Deposits represented 172 percent of Cyprus’s GDP at the end of 2012, compared with 69 percent in Germany and 58 percent in Italy, where a tax on individuals’ wealth has been touted by lawmakers as a mechanism to reduce the debt-to-GDP ratio.

Italy used a special tax on deposits during the 1992 exchange rate crisis. When speculation circulated in 2011 that former Prime Minister Silvio Berlusconi’s government would introduce similar measures, many feared they would spark a bank run, causing the government to deny it was considering any such policy, Erik Jones, head of Europe for Oxford Analytica, an Oxford, U.K.-based consulting group, said in a note to clients.

“The Cyprus Parliament must oppose any measures to put this so-called tax on depositors under 100,000 euros,” said Sharon Bowles, chairwoman of the European Parliament’s Economic and Monetary Affairs Committee. “If they don’t, it calls into question everything the EU has been trying to do to protect ordinary depositors and taxpayers from bank failures for the past five years.”

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