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The Republic of Cyprus takes up half of the island of Cyprus, located in the eastern end of the Mediterranean Sea. Most of its residents are of Greek origin, and Cyprus has been historically plagued by power struggles and other conflicts between Greek and Turkish residents.

The Republic of Cyprus joined the European Union in 2004 and joined the eurozone (i.e. adopted the Euro as its official currency) in January 2008. Not surprisingly, this has turned out to be a less than ideal choice (though one required by members of the European Union once they meet certain criteria) due to the financial crisis that started adversely affecting both the financial stability of the region and the Euro itself around that time.

For a while, Cyprus was riding out the crisis quite well- it suffered less severe adverse effects than the rest of the eurozone up until 2012 and grew faster than surrounding countries during that time. Unfortunately, Cyprus shares not only strong cultural ties to Greece but strong financial ties as well. Specifically, Cyprus is a large holder of Greek government and corporate bonds, so the sharp decline in the value of those assets had a particularly severe negative impact on Cypriot banks. In fact, the fact that the value of Greek debt was written down as part of the bailout deal for Greece actually meant that Cyprus was essentially pushed towards needing a bailout itself.

Cyprus Popular Bank and the Bank of Cyprus, two of the main financial institutions in the country, couldn’t withstand their losses and requested assistance from the Cypriot government. The country’s government, in turn, chose to nationalize Cyprus Popular Bank. Unfortunately, this didn’t solve the problem, since the Cypriot government couldn’t really afford the bailouts that it had enacted. Financial markets also made it difficult for the Cypriot government to finance the bailouts, since the interest rate on Cypriot government debt increased due to the country’s tenuous position. Therefore, the Cypriot government moved the problem up the financial food chain by asking the European Central Bank. the European Commission, and the International Monetary Fund for help.

Unlike a lot of previous bailouts, the original Cyprus bailout plan involved having depositors in Cypriot banks fund the bailout. Not surprisingly, this was quite a controversial provision, and there was a lot of debate regarding how to allocate this bailout tax to accounts. In fact, it was brought into question whether such a plan would even be feasible, since Cypriot bank deposits are insured and thus implicitly guaranteed to not be subject to loss of value. Such a plan would have, however, had the benefit of getting matched by 10 billion euros in bailout funds from the International Monetary Fund and the European Central Bank. The government tried to move this plan forward, but a vote was delayed and depositors started a run on the banks in order to avoid a potential bailout tax.

Taxing Cypriot bank accounts initially appeared preferable to raising regular taxes in order to fund the bailout because a significant fraction of depositors in Cypriot banks, especially high-value depositors, are not residents of Cyprus. (In other words, Cyprus was happy to have foreigners partially fund its bailout, even if it made the country a less attractive financial center in the future.)

To make matters more interesting, Russia offered Cyprus a loan with very generous terms in order to get its financial situation resolved. (This is potentially not unrelated to the fact that a lot of the high-value depositors in Cyprus are in fact Russian.) This loan was not as attractive as it seemed on the surface, however, since it seems that the loan was offered in return for the Cypriot government looking the other way regarding various tax evasion and arms dealing practices. In any case, the Cypriot government was left without an attractive solution to its problem, though possible options are an austerity program similar to what has been enacted in Greece, a new version of the bank deposit tax, or Cyprus’ exit from the eurozone (so that it can use its own currency that is not pegged to the Euro to cover its debts). Because the latter two of these options adversely affect the value of bank deposits, the Cypriot government has put capital controls in place that restrict the ability of depositors to withdraw their funds. As a result, some residents of Cyprus are even turning to the virtual currency Bitcoin to conduct business transactions.

At the time of writing, it appears that depositors in Cypriot banks could lose up to 60 percent of their assets’ value on deposits over 100,000 euros, with 37.5 percent of holdings over 100,000 euros becoming shares and 22.5 percent earning no interest and being subject to further write-offs. There is additional concern that such a plan will have negative repercussions for other countries, where depositors are concerned that such a bailout implementation could become the norm.