Europe Bails Out Cyprus

The news on the Cyprus bank bail-out is that in its final iteration it is a lot closer to just letting the banks fail.  The question I have is, why didn't they go all the way?

The basic outlines of the deal, struck Sunday night, are here in the Guardian (and in many other sources):  Bank Laiki is being closed.  It's insured depositors will get their 100,000 euros, and above that depositors will lose much or all of their savings.  Bank of Cyprus will be "heavily restructured," so the details of who will end up where are much murkier.  Presumably, the 100,000 euro deposit guaranty will also be honored.  Oh, and the ECB coughs up 10 million euros.  Presumably the latter is "needed" because the tiny government of Cyprus does not have the money to pay off its 100,000 euro deposit guaranty.

This deal is much closer than the previous versions to what would have happened if the banks just failed under the existing rules and with no bailout.  In the "just fail" scenario, I would think that the under 100,000 euro depositors get paid until the government of Cyprus runs out of money.  Remaining unpaid depositors, both under and above 100,000 euros, become equity of the restructured bank.  Non-depositor creditors and prior equity get wiped out.

There are lots of reasons why the "just fail" scenario is preferable.  In the "just fail" scenario, prior management has no right to continue, and the prior depositors, as new equity, can hire new people with a new approach.  In the "just fail" scenario, the cents on the dollar going to uninsured depositors turns on how under water the bank is, thus giving depositors the next time around an incentive to monitor the finances of the bank they invest in. 

So why not go that route?  It's the same story heard in the Greece/Spain crises over the past few months.  As articulated by Michalis Sarris, Cyprus' Finance Minister:

It's not that we won a battle, but we really have avoided a disastrous exit from the eurozone.

Good threat Mr. Sarris.  But why exactly would Cyprus exit the euro?  None of the U.S. states that defaulted in the 1840s tried to exit the dollar.  (And at the time many thought they had a right to exit if they wanted.)   Frankly, I don't believe for a minute that Cyprus would have done it.  The benefits of being in the euro are too great.  Yes, you have to roughly balance your budget and not take on obligations far in excess of your GDP to foreign bank depositors.  That's the regime under which the U.S. states operate, and it's the best thing that ever happened to them.  The Eurozone's problem is that other countries, mostly Germany, are so committed to the concept of maintaining the euro that they cave at these threats.  My bet is that even if Cyprus had tried an exit, it would quickly have come crawling back, an event that would have greatly strengthened the euro.

Well, at least this one wasn't a blank check.  The question is whether there was sufficient requirement of risk bearing to avoid providing the incentives for a bigger crisis the next time.