Europe’s handling of a bailout for Cyprus is looking more chaotic by the minute. Negotiations have descended into a three-way game of chicken among the island nation, Russia and the euro area’s leaders.

The initial plan to make insured depositors pay for part of the bailout was terrible. The Cypriot parliament rejected it, and now the European Central Bank has set a deadline of March 25, warning that unless a new deal is reached it will pull the plug on the funding that’s keeping Cyprus’s banking system alive.

What’s amazing about this fiasco is that Europe’s leaders had almost a year to think about how to avoid it. Ever since Greece restructured its government debt, which made up a large share of Cypriot banks’ investments, it has been apparent that the banks would need a major recapitalization. With some preparation, Cyprus could have offered an excellent test of a euro-area banking union, in which the ECB would step in, force losses on the Cypriot banks’ creditors and quickly reopen the banks under new ownership.

As things stand, Europe is facing two extremely undesirable outcomes. Cyprus could fail to respond to the ECB’s ultimatum, triggering a banking collapse, an exit from the euro and all the unknowns of contagion that implies. Alternatively, Russia could produce most of the 5.8 billion euros ($7.5 billion) Cyprus needs to secure a bailout, and in exchange get a chunk of the country’s natural gas reserves and significant influence over a member state of the European Union.

If Cypriot banks are allowed to fail, the financial health of the entire euro area will be put at risk over the insignificant sum of 7 billion euros ― the difference between the 10 billion euros that the euro area is willing to lend and the 17 billion Cyprus needs. A deal with Russia’s state gas monopoly OAO Gazprom would potentially undermine years of efforts by the European Union to cut its energy dependence on Russia.

Russia, a reluctant player, is being asked to provide about 5 billion euros in exchange for rights to explore Cypriot waters. Cyprus says it has 60 trillion cubic meters of gas reserves, but they are uncertain and subject to legal challenge by Turkey.

Russian leaders also feel blindsided. Euro-area leaders have for months been trying to persuade them to provide more of the bailout than the 2.5 billion euros they already lent to Cyprus. The proposed raid on Cypriot deposits would in effect seize the money that leaders in Moscow refused to give.

Letting Cyprus fail would have significant potential costs for Russia, too. Moody’s Investors Service estimates Russian exposure on the island to be about $60 billion, $31 billion of which is in bank deposits. That money would probably be frozen, and an important cog in the functioning of many Russian companies would stop turning.

The best available solution remains a bank restructuring that puts most of the burden on uninsured ― largely Russian ― depositors, who might lose 15 percent to 20 percent of their balances. The best way to get a deal would be for all three parties to negotiate it together. It might also make sense to involve Turkey and the occupied north of Cyprus. Both have a financial interest in moving toward reunification, as well as in gas deposits around the island.

The wider lesson is that Cyprus and the other euro-area countries wouldn’t be in this position had they moved more quickly to put in place a banking union and other mechanisms to fix the euro area’s design flaws. Until they do, the currency zone will remain vulnerable to crises in even the smallest and most financially insignificant of its member countries

(Bloomberg)