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It has been widely recognized that a critical challenge Europe faces is a monetary union without fiscal union. Yet the Cyprus crisis demonstrates is that monetary union is not complete.

The capital structure of Cypriot banks is relatively unique. As a tax haven, its banks were funded primarily by deposits not bonds or wholesale funding as other banks. European and Cypriot officials were willing to tax depositors. Many claimed that this was illegal because of the existence of deposit insurance. Rather than allowing the insolvent Cypriot banks from failing, which would have triggered the deposit insurance, officials imposed a tax. When a confiscation of savings was challenged in Italy in the early 1990s, the legality was upheld. This is to say that the precedent is that a deposit guarantee does give savers immunity from a capricious tax.

If deposit insurance would be triggered, Cyprus does not have the funds to make good on it. This is a critical flaw. The protection offered by deposit insurance is only as strong as the provider of the insurance. There is no EU-wide deposit insurance. Each country is responsible for their own.

Can you imagine that responsibility for the deposit insurance in the US would fall to the states instead of the federal government? It is simply not viable. Yet within EMU, the creditor nations rightfully fear that a euro area wide deposit insurance would be a backdoor for fiscal transfers as the countries with strong banks would end up subsiding the weak and/or lax banks.

The euro area banking system remains a patchwork of different rules, customs and expectations. Part of the problem is that the euro area is over banked. In the coming years, consolidation and concentration among retail banking seems necessary, even if conflicts with the other thrust of limiting or reversing the "too big to fail" in the financial sector.

That said, contrary to fears over the weekend, there has not been a run of depositors from banks in the euro area periphery. The sovereign bond markets in the periphery had sold off earlier in the week, but have stabilized. This is true even for Greece, which before today had seen its 10-year bond sell off for seven consecutive sessions, with yields rising about 125 bp over that period.

It is interesting to note that the central bank of New Zealand reiterated earlier today that depositors need to recognize that deposits are not guaranteed in New Zealand. This did not spur a market reaction or a reaction among depositors. New Zealand is considering a new set of policies (Open Bank Resolution) that would allow a quick and orderly resolution of a failed bank. It allows for insolvent banks to continue some operations, while shareholders, creditors and depositors would bear a proportion of the losses. We note this not as a defense for Cyprus' initial willingness to tax small depositors, but rather to point out that there are different institutional arrangements that possible.

One sign of anxiety has been the increase in the basis swap, which is the cost of swapping euro for dollars. There are two ways to read it. The first way is to see it as widespread flight from the euro as the re-denomination risk rears its ugly head. The increase in the swap rate reflects demand for dollars. The second way to read it is that the price was marked up to reflect the changed risk profile. Our best information suggest some strong banks, outside of the euro zone, did lock in dollar funding for 2-6 months and this raised the cost of the cross currency swap for weaker credits.

There are some who see the Cypriot crisis as a profound blow to the credibility of European officials. We do not share that conclusion and see some positive outcomes, including making consolidation in retail banking sector more likely. In the national division of labor, Cyprus found a niche as a tax haven. This is not particularly helpful for monetary or banking union in Europe. Cyprus will have to find another nice. It would like to be a commercial and financial center that would help facilitate trade the natural gas that lies off its coast. This is still to be seen.

European officials' willingness to force at least some depositors to participate in the burden sharing shows a greater willingness to broaden out the participation in future aid packages. Recall that in Ireland's case the Troika argued against senior bank bond holders taking a haircut for fear of setting a dangerous precedent. Of course, this means punishing the innocent along with the guilty, but that has been generally true throughout the policy response to the crisis.

We noted back in mid-January that the risks to Cyprus leaving EMU were greater than the market appreciated. This was an important assessment from us as we tended not to place high odds of a Greek exit in 2011-2012 even though speculation elevated. In recent days, we had thought that some compromise would be found. It still remains elusive at this late date.

Without a deal that would allow the recapitalization of Cypriot banks, the Troika is insisting that the Bank of Cyprus and Popular Bank are shutdown. Early rumors that a Russian bank would purchase the latter have been denied. Reports suggest that the Cyprus central bank is preparing proposals for capital controls, ostensibly so the banks can re-open. This is also what may be required if Cyprus were to leave the union. Greece remains the vulnerable to a collapse of Cyprus banks.

From a larger perspective, European officials may find a silver lining in a potential Cyprus exit, even if that is not their first choice. It would likely be seen as a warning shot to other peripheral countries, for example. However, what they have to be careful of, given the incomplete monetary union is Latvia, which is set to join EMU on 1 Jan 2104 does not replace Cyprus as a tax haven/hot money center.

Source: EMU = Not Enough Monetary Union