How Cyprus—and Russian Gangsters—Could Harm Your 401(k)

Another remote financial crisis now threatens investors.

Historic Bellapais Abbey in Kyrenia, Northern Cyprus.

Would you keep your money in the bank if the government suddenly announced it was taking 5 or 10 percent of your savings?

Most people wouldn't, which is why the tiny southern European nation of Cyprus is now facing a widespread bank run that threatens the financial markets in Europe and even here in the United States.

In a crisis similar to Ireland's bank meltdown in 2010, the two biggest banks in Cyprus are on the verge of collapsing, with losses so big the government can't afford to bail them out. So the whole nation requires aid from Europe, similar to the aid Ireland got to help recapitalize its wrecked banks.

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The problem is that bailout fatigue in Germany, Finland, the Netherlands and other European nations has made taxpayers increasingly unwilling to fund bailouts for other members of the euro zone, and more willing to risk the ramifications of the euro zone splintering.

There's another juicy complication: Cyprus is the Cayman Islands of Europe, a lightly regulated offshore banking center that attracts a lot of money from people from who don't like to answer questions. As much as half of the money in Cypriot banks belongs to Russian oligarchs dodging taxes, some of it probably illicitly gained. So if Europe were to bail out Cyprus in the usual way, European taxpayers would essentially be aiding Russian billionaires, including some criminals.

That's how European policymakers hatched the idea of "taxing" deposits in Cypriot banks, which basically means skimming something off the top to help keep the banks alive. The plan would exact a higher tax on larger accounts, but would still take a cut from small accounts that are supposed to be protected by the type of deposit insurance the FDIC extends to U.S. bank accounts. It's almost like paying protection money to a government that's supposed to protect you for no additional fee.

The plan hasn't been approved yet by parliament, but any threat to the sanctity of bank deposits will compel people to take their money out of banks, which European policymakers surely realize. The gamble they seem to be making is that a banking shock will remain contained to Cyprus, without spreading to the broader European financial system.

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But the whole plan could backfire if bank customers in Greece, Spain, Italy or other troubled European nations start to worry that their deposits could be subject to a similar tax. If that happens, tiny Cyprus—with an economy less than one one-hundredth the size of Germany's—could be the spark that finally ignites a European financial meltdown. Some commentators are already comparing the Cyprus bank tax with the assassination of Archduke Ferdinand in 1914, which touched off World War I.

For the last six months or so, global financial markets have been shrugging off worries about Europe's debt woes. But investors are now paying attention to Cyprus and getting nervous once again. Stocks have fallen and interest rates on riskier types of bonds have risen. The question now is whether the initial reaction to the Cypriot bank tax is the beginning of a bigger stock-market pullback, or just a pause by battle-hardened investors who have grown accustomed to occasional shocks.

Many market watchers have been expecting a modest stock-market correction, after an impressive four-month run in which the Dow Jones Industrial Average hit several new all-time highs. Cyprus could be the trigger.

"If the Eurozone sovereign debt crisis flares up substantially again over the coming months, depositors will feel increasingly uncomfortable about leaving their money in banks," forecasting firm IHS Global Insight advised in an analysis. "This could then lead to a destabilizing withdrawal of credit from banks that exacerbates the problem."

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The European Central Bank, like the Federal Reserve, can take steps to limit the spread of any financial contagion. But every move carries risks, and it's possible that European policymakers could tacitly allow Cyprus to slip out of the euro zone altogether. The crunch point could come in June, when Cyprus is likely to default on debt payments due, if the European bailout doesn't go through.

Many investors have been hoping for a dip in stock markets as a chance to buy discounted shares before the global economy starts to recover in earnest later this year and next. So a drop in stocks may only be temporary, as has been the case many times before when troubles in Europe have spooked investors. After all, a nation as tiny as Cyprus could never bring down Europe's entire financial system. Right?
