I’m not an expert on what’s going in Cyprus by any means, but let me just jot down a few points.
Cyprus allowed its banking system to grow to eight times the size of the economy, meaning that there was no possibility of making good on FDIC-style insurance if the entire banking system failed using domestic resources only; they would require foreign aid. Once you say that, you recognize that “insured” depositors were really beggars. And beggars can’t be choosers.
Cyprus’s banking system got so big in part due to a very large influx of foreign deposits, particularly from Russia. Iceland got into a similar fix in 2008 with an influx of money from Britain and the Netherlands, which Icelandic banks invested in risky securities. The Icelandic banks failed, and the Icelandic government pointedly refused to honor insurance of foreign-owned accounts. In other words, they discriminated dramatically in favor of Icelandic citizens. Cyprus declined to do this.
Why did Cyprus decline to follow Iceland’s example, and choose to punish both domestic and foreign investors? The likely reason is that Cyprus was trying to preserve its status as a banking haven, and discriminating dramatically against foreign depositors would pretty much shut that business down. So Cypriot savers are being taxed in order to preserve Cyprus’s banks ability to continue to market their services to foreign depositors.
Why might Brussels also have preferred Cypriots to take a big share of the pain, rather than focusing on foreign depositors? Well, think of the precedent that the alternative would have set within the Euro zone. Do the Germans really want to suggest that the right way to deal with a financial crisis is to maximize the pain born by foreign investors? In general, a more nationalistic approach is much more workable when you control your own currency, which you can devalue as necessary to cushion the pain of default, and which you can even limit the convertibility of to prevent capital flight (as Malaysia did during the Southeast Asian crises of 1997).
The Cyprus bailout is an ugly deal that in many ways privileges “undeserving” parties. Greek depositors pay nothing while Cypriot depositors take a haircut; uninsured Russian depositors get a haircut instead of being wiped out before insured depositors get hit; investors in Cyprus’s sovereign debt don’t get hit even though properly a foreign bailout of a national banking system is indistinguishable from a bailout of the sovereign (since, if the sovereign bailed out the banking system, it would need a bailout itself to remain solvent – see, e.g., Ireland, which did exactly that). Most notably, the terms appear to be designed to preserve the viability of a banking industry primarily oriented towards “hot” foreign money, which is probably not in the long-term interests of most Cypriots. But ugly deals are what you’d expect to get when powerful creditors get into a room with weak debtors, and when the debtors’ representatives have a degree of conflict of interest.
The only solution to the series of ad-hoc solutions to financial crises within the Euro-zone is institutional reform: not only a central European regulatory authority but a central fiscal authority. But such institutional reform would probably also make Cyprus’s oversized banking system impossible, and would further limit Cyprus’s sovereignty, subordinating it more comprehensively to Brussels. I would be surprised if recent events make Cypriots, or the citizens of other peripheral countries, more amenable to such reforms than they were before.