The European Union’s astonishing fumbling over Cypriot banks has both immediate and longer-term implications. On March 21, when the banks are due to reopen, the question is whether a run will destroy the Cypriot banking system. If that can be avoided, the next question will be what’s left of the EU’s plans to reform its system of bank supervision -- and what happens the next time an EU bank gets into trouble.

The danger of a run is real. This past weekend, the government of Cyprus and its financial backers, the EU and the International Monetary Fund, settled on a bailout formula for troubled Cypriot banks that included a 6.75 percent levy on insured deposits. The ensuing outcry prompted a revision to the deal that will curb or eliminate this provision before the banks reopen. But the message has already been sent: In the EU, insured deposits aren’t safe.

One can only marvel at this turn of events. Earlier in the financial crisis, Europe’s governments recognized that stronger deposit insurance was a vital part of shoring up their banking systems. They agreed to guarantee deposits of as much as 100,000 euros ($130,000). Last weekend, with the IMF (unbelievably) on board, they decided to renege on that commitment.

Bailing In

The principle of “bailing in” a troubled bank’s creditors, so that taxpayers are left to pay a smaller part of the rescue’s cost, is good. Cypriot banks borrowed little in the form of senior bonds, so bailing in those particular creditors wouldn’t defray much of the bailout’s planned bill of 17 billion euros. Instead, the banks relied heavily on deposits, including high-value deposits made by Russians and other foreigners seeking a tax-friendly jurisdiction.

In this case, bailing in creditors had to mean bailing in depositors. But this fails to explain why senior bondholders were excluded from the deal and above all why the levy was applied to insured, and not just uninsured, deposits.

It’s the very opposite of what makes sense. You want bank bondholders to be concerned about the safety of their investment, so that they exert some discipline over the banks, and you want small depositors to rest easy about the safety of their savings so that an uncontrollable run doesn’t destroy a solvent bank. The initial deal sheltered bondholders and punished small savers.

The Cypriot economy is tiny -- less than half a percent of the euro area’s gross domestic product. Even if worse comes to worst, the direct fallout for the rest of Europe will be minimal. Perhaps that accounts for this weekend’s absurdity. Nonetheless, the readiness to repudiate the principle of deposit insurance is knowledge that can’t be unlearned or confined to one “special case,” and it will make managing the next EU banking crisis more difficult.

At the end of last year, after the obligatory all-night sessions and amid the usual self-congratulation, EU governments agreed to move toward a historic “banking union.” With details to follow, they decided to create a single banking supervisor (housed within the European Central Bank) and to work toward a common resolution system for troubled banks and a single deposit-guarantee framework for the euro area. On March 19 Brussels negotiators agreed to inch this plan forward.

What this most recent fiasco suggests, however, is that the political basis for enhanced financial cooperation simply doesn’t exist -- and that EU governments are deluding both themselves and the financial markets when they say it does.

Precisely because Cyprus is so small, it could have served as a model. Its banks need restructuring -- so why not separate good assets from bad and put the latter in a “bad bank,” funded partly by the banks’ owners and creditors, partly by Cypriot taxpayers and partly by the rest of the EU? This way, as quickly as possible and at the least overall cost, you bring the banking system back to health.

Compelling Interest

Europe has a compelling collective interest in a system that can achieve such results. The plan for a banking union recognizes this collective interest -- and implicitly accepts, for example, that taxpayers in Germany have a big stake in the soundness of banks in Italy, and vice versa. Yet in the Cyprus discussions, which Germany’s government appeared to dominate, the only aim was to limit the exposure of EU taxpayers to the trivial upfront cost of the rescue.

Germany’s government apparently took the view that the details of the plan -- including whether deposit insurance in the EU really means anything -- were for Cyprus alone to decide, and all that mattered was that the burden on German taxpayers was minimized. It’s as though the stability of the wider EU banking system didn’t even come up.

Some would criticize Germany and its northern European allies for a lack of euro-area solidarity -- and of course they’d be right. What’s harder to excuse, or even understand, is the failure of Germany’s leaders to see where their country’s own interests lie.

It’s one thing for Germany’s government to insist on fiscal discipline in the rest of Europe -- or to promise, in an election year, that the citizens of countries getting bailout money will pay a price for their own leaders’ failures. It’s another to press that argument even to the point where Germany’s own interests are set back.

Cyprus is the clearest possible instance.

A rescue that would have achieved a restructuring of Cypriot banks on lenient terms for the country’s citizens would have cost German taxpayers next to nothing. It could have provided a model for the next phase of financial cooperation, to which Germany is supposedly committed. After a series of calamitous financial missteps, it would have confirmed that the EU is finally getting on top of its problems.

The problem isn’t that Germany and its EU partners were selfish. It’s that they were stupid.

(Clive Crook is a Bloomberg View columnist. The opinions expressed are his own.)

To contact the writer of this article: Clive Crook at ccrook5@bloomberg.net

To contact the editor responsible for this article: James Gibney at jgibney5@bloomberg.net