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Eurozone officials say momentum has built in recent days behind the idea of "bailing-in" Cypriot bank shareholders and depositors, although the specifics of how such an operation would be carried out have not been pinned down. Germany, Finland and the Netherlands are among those who say taxpayers cannot be expected to go on financing eurozone bailouts, saying it is time for owners and depositors in risk-laden banks to accept losses on investments. The concern is that announcing such a move will provoke the immediate, large-scale withdrawal of deposits from all Cypriot banks, where a large number of international investors, including many Russian and British companies, hold accounts.
While Cyprus is the eurozone's third smallest economy with an annual GDP of only around €18 billion, a bank run could have repercussions across the single currency bloc and re-ignite the debt crisis. The difficulty with Cyprus is finding a way to make a bailout sustainable so any money leant to it is repaid.
The island needs up to €17 billion, including €8-10 billion to recapitalise its banks and €7 billion to repay loans and finance ongoing government operations. That is equivalent to virtually its entire annual GDP. Such a rescue would increase Cyprus's debts to around 145 per cent of GDP, a level considered unsustainable. Greece's bailout calls for it to cut its debt-to-GDP ratio to 120 per cent by 2020, but that would also be unsustainable for Cyprus.
Olli Rehn, the European commissioner for economic affairs, has played down the idea of a bail-in of depositors, saying it is not the preferred option. But he still expects a far-reaching overhaul of the island's banking system.
One bail-in proposal that has been raised is to freeze all deposits over and above €100,000 - the amount that is guaranteed by existing EU rules. That sum would be held in an escrow account for 15-30 years, potentially earning very low interest, with the total used either as collateral against loans or to shore up the banks' capital base.
Another option is to impose a retroactive tax on deposits over €100,000, which many depositors may be willing to pay if the tax is not excessive and allows them to keep funds in Cyprus, where the corporate tax rate is attractively low. A third option is to offer Russia, which lent Cyprus €2.5 billion in 2011, a debt-for-equity swap, with the loan exchanged for ownership of the Cyprus Popular Bank, one of the island's most indebted.