It will take considerable time before the full ramifications of the recent Cypriot deal are known. However, some commentators have suggested that the Cypriot solution could be a blueprint for addressing other euro area banking problems, including situations such as Ireland’s. Careful analysis of the similarities and differences between these two cases is useful.

Although the economies of Ireland and Cyprus are small, both had allowed their banking sectors to expand far out of line with the scale of the economy and to become insolvent. In Cyprus's case, this reflected the massive build-up of a "lightly regulated " offshore-banking sector that invested very heavily in Greek assets (notably sovereign bonds) . The Irish banks' growth also resulted from huge amounts of foreign inflows that ended up invested in the property boom. When the bubble burst, this too proved completely unsustainable.

Two interrelated issues are at stake in dealing with banking insolvency. First, who should shoulder the bill for the losses?

Second, how can the damage to confidence in the financial and payments system domestically and elsewhere be minimised?

The first aspect – who should pay – is ultimately political in nature. Borrowers argue that they were victims of a lax domestic (and euro-wide) financial regulatory system – which prevailed in Ireland and Cyprus – that permitted money to be “shovelled” at them. Lenders retort no one was forced to accept these funds and that (again true for both Cyprus and Ireland) many people benefited greatly while the boom lasted. Both sides have an element of right on their side.

In Cyprus's case, Germany and other official creditors refused to contribute more than a fixed amount to the rescue, lest this would involve a bailout of Russian deposits of highly dubious provenance. Moreover, a bailout of the Cypriot banks would have resulted in an unsustainable debt burden, leading inevitably to a sovereign debt write-down. For the same reasons, the International Monetary Fund was not willing to pony up additional cash.

Saddled with debt
The European Central Bank also refused to continue emergency lending to a clearly insolvent banking system. Apart from legal constraints, the ECB had learned only too well from the experience with the Irish promissory notes that it would likely end up saddled with a long-term debt.

The “only” solution was the “confiscation ” of over 50 per cent of large deposits held at the two major banks. Russians (as well as many Cypriots ) would have to pay dearly. This meant the demise of Cyprus as an offshore financial centre, an outcome that did not elicit much sympathy, especially in view of Russia’s heightened anti-western posture recently.

Unlike in Cyprus, the underlying insolvency (as opposed to illiquidity) of the Irish banks was not recognised at the time of the Irish government guarantee in September 2008 . Thus the question of “who should pay” did not arise initially.

No depositors or senior bondholders have ever been “burned” in the Irish case. At the time of the guarantee in September 2008, the equal legal protection afforded to both these categories of obligations was a significant complicating factor. Also, Ireland did not have a special bank resolution regime (introduced in Cyprus just before its agreement was finalised).

The full payout to senior creditors has caused a major increase in the Irish debt owed to the EU-IMF and the ECB, and achieving debt sustainability is not assured. However, Ireland’s debt burden, while large, is most likely less than Cyprus would have incurred if it had secured the full troika financing requested initially.

Apart from burden-sharing aspects, the differential treatment of the two situations owed much to pragmatic considerations. The burning of Cyprus’s bank creditors, given their composition, might be viewed as a “one-off” gamble. In contrast, in Ireland’s case, it was concluded that a similar approach, discussed actively at the time of the bailout in late 2010, would be damaging domestically and for the euro area (and even globally).

What might have happened in Ireland if a burning of senior creditors had been adopted at some stage will always remain a matter of conjecture. However, there is no doubt that the approach adopted in Cyprus, which leaves banking confidence in tatters, will be enormously costly for Cyprus itself.

EU commissioner Olli Rehn’s comment that “Cyprus was now on the path to recovery” is somewhat fanciful – the economy faces dramatic falls in gross domestic product and increases in unemployment exceeding significantly even those that Ireland has experienced.

Imminent collapse
Those who have strongly criticised the Irish bank guarantee of September 2008 would do well to take due account of these costs. The guarantee was granted first and foremost with the best interests of Ireland in mind at the time, given the risk of an imminent banking collapse ("taking one for Europe", so as to prevent euro area contagion, was not the main goal).

In sum, Cyprus has ended up being treated differently from Ireland because the affected creditors are different and thus also the contagion risks. The troika’s appetite for risky lending to highly indebted euro sovereigns has diminished in the interim.

While the approach taken for Cyprus may be the least-cost option available, it is highly questionable whether it should serve as a model for elsewhere. Clearly, depositors should pay greater attention to what banks are doing with their funds, and regulatory failures such as in Cyprus and Ireland cannot be allowed to recur. However, to retain the confidence of savers and investors , the “burning” of depositors must be considered strictly as an exceptional instrument in a bailout toolkit.

Donal Donovan was a staff member of the IMF from 1977-2005, before retiring as a deputy director. He is a member of the Fiscal Advisory Council and co-author, with Antoin Murphy, of The Fall of the Celtic Tiger: Ireland and the Euro Debt Crisis , to be published by Oxford University Press