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There is an intense debate on the possibility of bailing-in bank shareholders and lenders of troubled financial institutions (ie forcing investors to take losses), or relying on taxpayers to take the hit. For example, in a Charles Goodhart from LSE argued against, while Matt King from Citi in favour of bailing-in. The main arguments against bailing-in, and therefore in favour of bailing-out from taxpayers’ money, are that otherwise investors would demand a higher return when investing in a bank, and lenders would flee at the first sign of trouble. The main arguments in favour of bailing-in are:

·         private sector losses should be absorbed by those who took the risk;

·         it is unfair to burden all taxpayers for the result of risky banking businesses;

·         an eventual public bail-out even increases banks’ inclination for running risky businesses;

·         and bank rescues can endanger fiscal sustainability.

The current Cypriot banking mess is a prime case for at least the last point. According to news reports, for a full publicly financed bank rescue, the official lending programme to Cyprus should be €17bn (which is almost equal the €17.5bn GDP forecast for 2013), of which €10 billion would be used for banks. News reports suggest a public debt to GDP ratio peaking at about 150% of GDP. Clearly, such a high public debt ratio may prove to be unsustainable, especially if growth forecast will disappoint again.

What are the options? Reportedly, bailing-in in Cyprus cannot be sufficient without bailing-in depositors with deposits over the guaranteed €100 thousands and . But in that case, there is a fear from a deposit run in Cyprus and other countries with fragile banking system. , is a mild form of bailing-in depositors. All alternatives would burden the Cypriot taxpayers (or other euro-area taxpayers if Cyprus defaults sometime after the bail-out). For example, increasing various taxes, using privatisation revenues or revenues from the , would use taxing or the national wealth to bail-out banks.

But is bailing-in really so disastrous? Let us draw some lessons from Denmark. It is less known that in 2011, in two middle-sized Danish banks, Amagerbanken and Fjordbank Mors, depositors with net deposits over the guaranteed €100 thousands also faced a haircut.* Even senior creditors had to face a haircut. Certainly, this had an impact on other banks in Denmark: Moody’s lowered the ratings of Danish banks due to less implicit state support and spreads and which these banks can borrow went up. Yet the resolution “shocks” were absorbed and there was no contagion for deposits in other countries.

How could Denmark do this? Since October 2010, Denmark has an effective resolution regime. Failed banks are resolved over the weekend: the bank closes on a Friday afternoon and a new bank is opened at 10am on the next Monday at the distressed bank's premises, carrying the “healthy” part of the failed bank and continuing to service credit cards, loans, deposits, etc, which were transferred from the failed bank. Shareholders and unsecured lenders are bailed-in in the first place and a special company called Financial Stability Company manages the mess of the distressed assets and the corresponding liabilities of the failed bank.

The comparison with Denmark is limited, I know. Cyprus does not have in place such a powerful resolution framework for bailing-in private lenders. Enacting an ad hoc legislation to this end, as well as its execution over a weekend, could be difficult. In Denmark the issue in 2011 was two middle-sized banks, while in Cyprus most of the banking system is in trouble, including the two biggest banks. And Denmark has a larger and presumably more resilient economy than Cyprus. But there is a similarity as well: the bank assets/GDP ratio is rather high in both countries: about 4 in Denmark and about 8 in Cyprus; even the Danish figure is well above the euro-area average.

The question for Cyprus: should Cypriot (and probably other euro-area) taxpayers bear the brunt of bank rescues or unguaranteed depositors should take a hit as well? In my view, there is a clear case for bailing-in unguaranteed depositors as well, because of the four bullet-pointed principles listed above and at the same measures should be taken to limit the potential adverse effects on Cyprus and elsewhere. When the bank capital shortfall is about 50% of GDP, as in Cyprus, one cannot talk about financial stability anymore and urgent action is needed.

Concerns about money laundering delayed the negotiations for the financial assistance of the country, which in turn delayed the resolution of the Cypriot banks. But since there are talks about a possible bail-in of unguaranteed deposits, in January 2013 deposits in Cypriot banks declined by about €2bn and I expect that even more have left during the past few weeks. This means that the pool for bailing-in is drying-up quickly and hence urgent action is needed.

The Cypriot government forcefully rejects any calls for bailing-in depositors. Certainly, they cannot do else; otherwise the bank run would accelerate immediately. The Greek government, along with the troika of the European Commission, European Central Bank and the IMF, have also long denied the need for restructuring Greek public debt in 2010-11, which has just exaggerated the problems.

For Cyprus, the government has to decide now whether to bail-in unguaranteed depositors or charging taxpayers and risking sovereign default. by demanding bailing-in, according to news reports, but since European partners may not favour such an action, they may provide financial assistance to Cyprus without the IMF. Instead, Russia, which has strong interests in Cyprus, may contribute to the bail-out financially either by extending the current €2.6bn loan that would otherwise expire in 2016 (and possibly lower its interest rate from the current 4.5% per year), and/or with a new loan. In my view, defying first principles, charging taxpayers and risking a sovereign default would fight back. I a quick action is needed for bailing-in private creditors, including unguaranteed depositors, supported by an ad hoc legal solution.

What about the impact on other countries? True, depositors in unsafe banks may consider their unguaranteed deposits unsafe. But the proper response is not charging the Cypriot (and possibly other euro-area) taxpayers with the Cypriot bank losses due to bank fragility in other countries, but to strengthen banks in other countries immediately. And let’s not forget that Denmark has already bailed-in depositors and senior creditors and the EU has not collapsed afterwards.

* Except for certain special deposits, which are fully covered by the Danish deposit guarantee fund, such as certain pension-savings accounts, children's savings accounts, lawyers' client accounts and certain accounts stemming from property transactions and mortgaging.