So it now looks as though Cyprus, a bucolic island of some 860,000 people in the heart of the Mediterranean, really does matter.

Here’s how things stand: Bullied by the the European Union, the ECB and the IMF (the unholy trinity of neo-liberalism), Cyprus has now agreed to impose a levy of 20 to 25 percent on large bank accounts as it seeks to overcome final obstacles to a financial rescue and avoid a chaotic bankruptcy. The levy would be applied to deposits exceeding €100,000 at the country’s largest bank, Bank of Cyprus. In exchange, account holders would receive shares in a restructured bank, although government officials have acknowledged that this would imply sharp losses.

The principle of deposit insurance, at least up to 100,000 euros, appears to be upheld. It looks like only the uninsured deposits above that threshold will be taxed. So can we now go to sleep comfortably, knowing that we don’t have to stick our hard-earned savings into what the Financial Times’ John Dizard termed “Banco de Mattress”?

Almost certainly not.

Regardless of the ultimate form this bailout takes, it is increasingly hard to view Cyprus as a “one-off,” which has no implications for us here in the US. What Cyprus has demonstrated is that even with deposit insurance, your deposits are not in fact a risk-free guaranteed asset, but actually simply another branch in the creditor tree in relation to your bank if it fails. That was made abundantly clear by no less than the Bank for International Settlements (BIS), the central bankers’ bank back in the heart of the financial crisis. The BIS noted that bank failures had become increasingly expensive for governments and taxpayers and therefore recommended an “Open Bank Resolution,” which would ensure that, as far as possible, “any future losses are ultimately borne by the bank’s shareholders and creditors." (See primer on the Open Market Resolution concept by the Reserve Bank of New Zealand.)

Why does this matter? Because, you, as a depositor are legally considered a “creditor” of your bank, not simply a customer who may have entrusted your entire life savings with the very same institution. As Wikipedia notes:

In most legal systems … the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer in turn receives an asset called a deposit account (a checking or savings account). That deposit account is a liability of the bank on the bank’s books and on its balance sheet. Because the bank is authorized by law to make loans up to a multiple of its reserves, the bank’s reserves on hand to satisfy payment of deposit liabilities amounts to only a fraction of the total which the bank is obligated to pay in satisfaction of its demand deposits.

What banks do with your money is far more germane than you might have thought. They not only can blow up the institution through the creative use of toxic derivatives, but could well get you standing in the queue waiting to get paid out if the range of their activities are not strongly circumscribed.

True, it looks like the small depositors in Cyprus now will in fact receive their deposit insurance guarantees. But how credible is a guarantee coming from a country that doesn’t create its own currency? That, by the way, is the problem afflicting all of the countries in the Eurozone. At least in the US, Canada or the UK, such deposit insurance guarantees can be made credible because they are ultimately backstopped by the issuer of the currency. Not so in Cyprus, Spain, Portugal, even France or Germany, because they gave up their currencies for the euro, which is now issued solely by the European Central Bank (ECB). A European-wide system of deposit insurance which does not have the explicit backing of the ECB is as problematic as, say, New York state seeking to backstop all of the deposits of the American banking system without the US Treasury behind it.

That institutional peculiarity aside, the Cyprus experience demonstrates that deposit insurance is something ultimately built on trust between a people and its government. When the government arbitrarily undercuts the promise of insurance via tax or other forms of expropriation, it further undermines the stability of the banking system. Yes, governments should do all that they can to avoid bailouts which include penalties against depositors (both insured and uninsured). But the best way to do that is not to create ill-conceived bailout packages in the middle of the night in response to a financial crisis. The thing to do is to restrict the range of activities that created the crisis in the first place. Rather than creating an increasingly complex regulatory system in response to a bunch of newfangled products, which bankers constantly game, we should remember that banks' primary functions should be to facilitate a payments system and provide loans to credit-worthy customers. Attention should always be focused on what is a reasonable credit risk and that should be the starting point for true financial reform.

So in an ideal world, how should we do proper financial reform and prevent the recurrence of another Cyprus? In the first instance, the banks:

should only be permitted to lend directly to borrowers. All loans would have to be shown and kept on their balance sheets. This would stop all third-party commission deals which might involve banks acting as “brokers” and on-selling loans or other financial assets for profit.

should not be allowed to accept any financial asset as collateral to support loans. The collateral should be the estimated value of the income stream on the asset for which the loan is being advanced. This will force banks to appraise the credit risk more fully.

should be prevented from having “off-balance sheet” assets, such as finance company arms which can evade regulation.

should never be allowed to trade in credit default insurance. The banker should profit in the success of the borrower, not speculate on his potential for failure. That means “hedging,” such that it occurs, is done via good old fashioned credit risk assessment, not toxic derivatives. If the customer is a bad bet, then don’t extend the loan!

should be restricted to the facilitation of loans and not engage in any other commercial activity.

The government can also play a role here by dampening demand for credit by increasing the price of reserves and/or raising taxes/cutting spending.

The issue then is to examine what risk-taking behavior is worth keeping as legal activity. Governments should ban all financial risk-taking behavior that does not advance public purpose (which is most of it), as well as legislating against derivatives trading other than that which can be shown to be beneficial to the stability of the real economy.

Given the importance of financial needs in order for the economic process to start, financial institutions are essential components of the system at all stages of the economic process in order for the economy to grow properly. But the paradox is that for a proper functioning free market economy, the banks have to be tightly regulated. Otherwise, an unshackled financial sector will engender instability, in particular, by promoting the position-making desk (i.e. traders) and reducing the role of the loan-officer desk.

Absent regulation which severely curtails the dangerous practices of financial institutions systemic instability will be an ongoing problem, and our deposits may well be safer hidden in our collective mattresses. Simply trying to respond to each financial crisis by layering on an increasingly complex set of new regulations doesn’t work (as Dodd-Frank is already demonstrating). Indeed, many rapidly become obsolete, because they are insufficiently flexible enough to deal with financial innovations. Innovations are usually used by financial institution to bypass existing rules so unless innovations can be accounted for as they appear, regulations will not work properly to prevent the growth of financial fragility induced by the growth of leverage and/or the decline in the quality of leverage. The end result of the latter is an ever more complex banking system, constantly prone to financial disasters and, ultimately, threats to your very deposits.

Of course, in our current political environment, none of this seems remotely possible short of another major financial crisis. But there will be another one; you can bet on that. Every time we dismantle yet more seemingly “anachronistic” regulations in the interests of “free markets,” we put more and more depositors and taxpayers at risk a la Cyprus. This tendency becomes all the more strong in today’s context, where mega-financial institutions, with lobbying power and key positions in governments, can prevent the implementation of rules to curtail effectively the growth of financial fragility, as they clear have done in the European Union as well as the US.

Over a long period of stability, this change in the state of mind leads to deregulation, de-supervision and de-enforcement of existing laws, which promotes moral hazard. Thus, contrary to what the usual haters of government argue, it is not the existence of a government and a central bank acting as lender of last resort that is the source of moral hazard. Rather, it is the simplistic belief in minimal regulation and free-market fundamentalism which has led to yet more complacency, leniency and ignorance of existing laws, which in turn has led to massive frauds and moral hazard.

Until we get serious about aligning banking activities again with broader public purpose, you should expect more Cyprus-type eruptions in the future.