The Cypriot confiscation of insured deposits should teach the euro area a lesson: European Union-wide deposit insurance ultimately backed by the European Central Bank can't come too soon.

Cyprus, a small island nation in the Eastern Mediterranean that had become an offshore banking haven, is imposing a one-time levy on bank depositors to defray the cost of a coordinated European bailout. The details aren't settled and are still being negotiated by the Cypriot parliament. The initial plan was that all deposits of less than 100,000 euros ($129,330) would be hit with a 6.75 percent levy. Deposits above that would face a 9.9 percent cut. Depositors were to be given equity in banks and natural-gas bonds as compensation.

The main lesson here is that the responsibility for deposit insurance should lie with the currency issuer.

Deposit guarantees, like the integrity of sovereign debts, ultimately depend on the ability of governments to issue currency. If a central bank’s capacity to provide emergency liquidity and reserves to banks is constrained -- as it is for the national central banks in the ECB system -- then so is the credibility of its deposit insurance. In the case of a severe banking panic, central banks need the power to create money to satisfy the surge in demand for currency. 

The ECB was created in 1998, but deposit insurance remains a national responsibility. National deposit insurance ties the solvency of the banks to the solvency of governments. That linkage has proved central in Europe's financial difficulties, and it needs to be broken. Cyprus may be an extreme case, but the slow run on deposits in Irish and Greek banks -- what economists have called a “bank jog” -- shows that the lack of euro-area deposit insurance is also causing problems elsewhere.

The EU has talked about EU-wide deposit insurance, but it has been slow going. In a sense, the ECB already conceded the point. When ECB President Mario Draghi pledged last year to do “whatever it takes” to prevent a breakup of the euro area, he made the ECB the de facto backstop for deposit insurance. The problem is, that declaration left room for uncertainty, and the whole point of deposit insurance is to dispel risk.

Accepting the obligation ambiguously is the worst of both worlds. Europe may end up paying, but in the meantime it has failed to prevent runs. 

A large share of Europe’s troubles comes from incomplete financial integration. Europe-wide deposit insurance should be part of a euro-area banking union that includes an authority to regulate banks and resolve failures. Europe’s governments agreed to create a single bank supervisor for the euro area last year, but the plan is a long way from being implemented. Europe needs banking union now.

(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)