Imagine finding out one morning that the federal government was going to drain 6.75 percent to 9.9 percent of your bank account balance to cover a bank bailout.
That's exactly what was slated to happen to depositors in the island nation of Cyprus, who were being asked to foot the bill for a bailout of the country's oversized banking industry. Under the plan, depositors with more than 20,000 euros in the bank would have been hit with a special tax, despite what was supposed to be up to 100,000 euros worth of deposit insurance.
The haircut for depositors was put forth as a condition for the bailout by the European Union as a condition for supplying the funds for the bailout, says Mark Williams, a professor of finance at Boston University, former Federal Reserve Bank examiner, and author of "Uncontrolled Risk," a book about the collapse of Lehman Brothers.
After a public outcry, the parliament of Cyprus rejected the deal, which would have been terrible for both depositors and the stability of the banking system, Williams says.
"It's a clear example of politicians making rash decisions without understanding the implications of capital markets, and also how banks are intertwined within our capital markets," Williams says. "Savers and depositors themselves provide basically the lifeblood that allows the banking system to function. As soon as they start getting penalized, then that actually undermines the credibility of our banking system and it creates bank runs."
Had the plan been implemented, it's likely Cyprian depositors would have withdrawn their cash as soon as they could and put it into hard assets such as gold, slowing the country's economic growth. Ironically, that would have made it less likely to be able to pay back the bailout funds, Williams says.
"(The European Union) cut their nose off to spite their face," he said.
Fortunately, even if banks in the U.S. need another bailout, its unlikely depositors would face a plan similar to the one rejected by the Cyprian parliament, especially in light of the resulting turmoil in financial markets.
"The Cyprus case study will be used to actually counter any movements that would go toward penalizing depositors," he says.
In fact, the Federal Deposit Insurance Corp. strictly prohibits banks from directly passing on the fee they pay for FDIC insurance to depositors, he says.
What do you think? Would you withdraw your cash from a bank account to avoid a "bailout tax"? Are depositors the ones who should pay when banks fail?
Follow me on Twitter: @ClaesBell.