Bank robbery!’ screamed the Daily Mail’s headlines, but such hyperbole barely reflected the widespread outrage over the clumsily executed plan by the ‘troika’ of the European Union, International Monetary Fund and European Central Bank to skim a percentage off deposits in the country’s banks to help pay €5.8bn towards the €17bn ($22bn) bailout rendered necessary by the impending bankruptcy of banks in Cyprus. The tax-haven island has sucked in so much hot money in recent years, largely from Russia, that the financial sector had grown to nearly eight times the size of the island’s economy.

The eurozone’s third-smallest economy, accounting for just 0.2% of the 17-nation bloc’s GDP, was poised to be the first to leave the currency union if agreement could not be reached-the ECB had threatened to cut off funds propping up Cypriot banks, which would have forced the island’s exit from the euro. If that happened, it was feared the ‘contagion’ could prompt bank runs in other fragile member states such as Italy and Spain, which threatened far greater chaos if their own financial systems collapsed. As this column went to press, however, a last-minute deal had been reached with savings above €100,000 likely to lose about 30%. The FT said: ‘The eurozone has effectively defaulted on a deposit insurance guarantee.’

Despite savings below this threshold being guaranteed by the EU since the darkest days of the financial crisis, to instil confidence in the continent’ banks, the troika’s plan had envisaged a levy of 6.75% on accounts with less than €100,000 and 9.9% on deposits above that. As the Economist put it, ‘Cyprus chose to inflict much of the pain on grandmothers’ savings so as to limit the losses of Russian oligarchs.’ In return for the levy, savers would get shares in the banks, dubbed ‘bailing-in’ (another idea was for offshore gas reserves to become collateral for a stability fund). With angry, fearful crowds gathering outside parliament, the Cypriot government kept banks closed for fear of a run on deposits. The plan was rejected by a 36-0 vote by MPs, despite a proposal to exempt those with less than €20,000.

Cyprus then turned to Russia for a €5bn loan, which was rejected, amid reports that the Kremlin wanted stakes in Cypriot banks and gas fields, or even a naval base, in return for a bailout.

Some analysts questioned Cypriot MPs’ rejection of the EU plan. Nikos Chrysoloras, of the Greek daily Kathimerini, said: ‘The main demand of this “parliamentary revolt” was that Cyprus remain an offshore haven. In exchange, the Cypriot government seemed willing to offer so many concessions to Moscow as to effectively turn the island into a Russian overseas territory.’

A crucial point in this sorry saga is that it was the banks’ debt that was unsustainable, not the national debt. And as Chrysoloras points out, the holier-than-thou northern eurozone nations that pushed such punitive terms on Cyprus, such as Germany and Finland, had nearly been brought down by their own debt and misguided policies in the not-too-distant past.

In an effort to crack down on tax evasion and money-laundering, which had seen offshore deposits balloon to $2.7tn globally, major economies have begun to target leading tax havens, such as Switzerland, Liechtenstein and the UK’s Channel Islands. An intriguing study by economists at the Paris School of Economics and the University of Copenhagen last year found that any such moves towards transparency and banking probity meant a big hit for that territory’s banks. Between 2007 and 2011, for example, Cyprus signed only two compliant treaties-and saw a 60% jump in its deposits. Guernsey, however, signed 19 such treaties and experienced a 15% fall. The study found that each additional treaty signed by a tax haven led to a decrease of 3.8% of deposits in its banks.

Foreign deposits in Cyprus banks accordingly leapt more than 60% over the past five years, thanks to inflows of hot money from Greece and Russia, attracted by high interest rates and the banks’ unfussy attitude to the money’s provenance. The stage was set for a financial meltdown after the banks then invested that money in high-risk securities such as Greek bonds in order to keep offering high interest rates.

A report on Russia by Global Financial Integrity (GFI), a US organisation monitoring cross-border flows of illegal money, found that Cyprus was both the largest source and destination of Russian foreign direct investment from 2009-11. Cyprus ‘invested’ $129bn into Russia in 2011 alone, more than five times Cyprus’s GDP of about $24bn.

GFI’s chief economist, Dev Kar, noted that: ‘It is unlikely that Cyprus can manage to make such large investments in Russia unless those investments were financed through illicit assets from Russia.’ In other words, Cyprus had become money-launderers for the Russian mafia.