NICOSIA (Reuters) - Major depositors in Cyprus's biggest bank will lose around 60 percent of savings over 100,000 euros, its central bank confirmed on Saturday, sharpening the terms of a bailout that has shaken European banks and saved the island from bankruptcy.
Initial signs that big depositors in Bank of Cyprus would take a hit of 30 to 40 percent - the first time the euro zone has made bank customers contribute to a bailout - had already unnerved investors in European lenders this week.
But the official decree published on Saturday confirmed a Reuters report a day earlier that the bank would give depositors shares worth just 37.5 percent of savings over 100,000 euros. The rest of such holdings might never be paid back.
The toughening of the terms will send a clear signal that the bailout means the end of Cyprus as a hub for offshore finance and could accelerate economic decline on the island and bring steeper job losses.
This move has extremely deflationary consequences for Cyprus in particular and Europe in general.
The loss of confidence in the banking sector globally is in danger of growing, encouraging individuals to pull their cash from any institution that is perceived to be weakening.
In this scenario, if it continues, bank's capital is gradually eroded away at the same time velocity of money in the general economy falls steadily.
As students of economics know, the inflation rate can be determined by two factors; the supply of money (& credit) and the velocity of that money supply.
Once savers begin to lose faith in banks, savings are pulled out of the system and are no longer available to be lent by financial institutions. The effect this has is to drive down the velocity of money (& credit) in the overall economy.
Any substantial move by savers to hide their money from confiscation has the potential to begin a domino effect of collapsing velocity and pushing an economy into deflation.
While the EU is playing hardball with Cyprus, the moral hazard of their actions could be vastly larger than ever anticipated.
I would be wise to take appropriate precautions, as all central banks seem to act in harmony.
Given the seriousness of the consequences, we will continue to report on these developments as they arise.