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The Cyprus egg has been cracked!

Cyprus is the third largest island in the Mediterranean (3,572 square miles) with a population of roughly one million people.

Its gross domestic product is minuscule in terms of the Eurozone, estimated to be around $24 billion.

Although many may think this island's diminutive stature makes its current issues seem trivial, the situation has long lasting and far reaching implications. Now that the egg has been cracked, we are exposed to the messy consequences.

The mess I speak of has to do with the results of a recent European summit where it was agreed to confiscate depositor funds in Cyprus under the guise of a “stability levy” or tax.

The original idea was for a 6.7 percent levy on deposits of 100,000 euros or less and a 9.9 percent levy on all depositor balances in excess of that.

It was effectively, in my opinion, a form of legalised robbery to provide a financial rescue for Cyprus.

Ultimately it was a VERY bad idea.

This has essentially shattered any trust in the safety of deposits and suggests that Eurozone creditors consider all assets fair game in bailout negotiations. Capital flight risk from Cyprus has increased and capital controls will likely remain for some time.

The Cyprus Deposit Protection Scheme (DPS) was established in September 2000, in accordance with Article 34 of the Banking Law of 1997 as subsequently amended with the Establishment and Operation of the Deposit Protection Scheme Regulations of 2000 to 2009.

In accordance with these Regulations, a Deposit Protection Fund was established which operates as a separate legal entity administered by a Management Committee.

The purpose of the DPS is to provide protection to deposits and compensate depositors in the event that a member bank is unable to repay its deposits.

The DPS covers deposits denominated in all currencies. Participation in the DPS is compulsory for all banks authorised by the Central Bank of Cyprus and the Cyprus branches of foreign banks.

The DPS does not cover deposits of branches of banks established in European Union Member States.

These deposits are covered by the corresponding deposit protection scheme established in the country of incorporation.

Unfortunately, the Cyprus banks became insolvent when they doubled down on their Greek investments.

The bank losses are much larger than the assets accumulated in the DPS since 2000 and the Cyprus government does not have enough money to make up the multibillion euro shortfall. The European Central Bank has insisted that all depositors along with other investors must take a hit in order for Cyprus to receive a rescue package.

How does this affect Bermuda?

In Tony Barber's article in the Financial Times, he aptly states: “Cyprus reminds us that trouble caused by islands is often inversely proportional to their size…”.

Bermuda's banking industry, much like Cyprus's, is very large compared to its GDP.

Bermuda's bank assets and deposits are roughly four times its GDP, compared to more than eight times GDP in Cyprus. If you exclude foreign owned banks, Cyrpus bank assets are only 1.6 times GDP (according to IMF data).

Bermuda does not have any deposit insurance.

This programme is in the works but as of today there is no insurance.

At the end of the day, what this means is that deposits held in Bermuda banks are only as safe as the bank currently holding them.

According to the BMA's recent third quarter Banking Digest (www.bma.bm/publications, the ratio of cash and cash equivalents held by banks to total deposits was 26.8 percent (compared to only ~13 percent for North American banks).

The 'funding gap', or the difference between total loans and total deposits divided by total assets, is negative 47.6 percent, compared to roughly negative 22 percent in North America (where the lower the number the better).

Like most banks, there is no way Bermuda banks could return funds to depositors if they all asked for them at the same time, but their liquidity and capital ratios at this stage are very strong.

Thus, it's essential that the integrity of, and trust in, the banking system remains high.

Unfortunately, what Cyprus has shown us is that trust and security is not sacrosanct, and there is always a risk of political blunders in countries that are under a great deal of fiscal stress and pressure.

Where do we go from here?

I would argue that the risk associated with European deposits just increased and should be compensated with higher forms of incentives: in this case higher interest rates. In a world of free flowing assets, depositors should now begin to demand more interest on deposits held in riskier jurisdictions and institutions.

Time will only tell how this evolves.

Eurozone politicians have called into question the whole concept of deposit-insurance commitments throughout Europe.

This may be associated with various nations' inability to tackle their fiscal deficit. Any growing fiscal burden only hastens the need to limit the size of government expenditures to GDP and generate sufficient revenues to fund a government.

Failure to do so can actually put all the nations' citizens' nest eggs at risk.

Nathan Kowalski is the chief financial officer of Anchor Investment Management Ltd. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Past performance is no guarantee of future results.

A sign at a branch of bank of Cyprus reading in Greek, 'In light of the emergency restrictive measures, you can withdraw up to 300 euro either from the tellers or the ATM,' as people are reflected on the glass in central capital Nicosia, Cyprus, on Saturday

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Published April 01, 2013 at 9:00 am (Updated April 01, 2013 at 9:35 am)

The Cyprus egg has been cracked!

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