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The levy on bank deposits that Cyprus has announced sets two precedents, and only one of them is uniformly bad. It will be redrafted, but not to eliminate a deposits tax entirely: the rescue of Cyprus may eventually be remembered as the moment when European bank depositors realised that they have a role to play in the recapitalisation of the European financial system.

Cyprus' original plan was to introduce a one-off, tiered levy on bank deposits to raise €5.8 billion ($A7.2 billion) as its contribution to a €17 billion rescue package. Accounts of up to €100,000 were to be levied at a rate of 6.75 per cent, and accounts of €100,000 and more were to be levied at a rate of 9.9 per cent.

The levy on deposits of €100,000 or less is a bad precedent, because EU member nations all have a blanket deposit guarantee for amounts up to €100,000 in place, and have had since the global financial crisis peaked.

It is possible to mount a lawyerly argument that the guarantee is not being trashed because the levy will come with equity in the banks, and, possibly, a share of returns from Cyprus' gas reserves, but that would be sophistry.

Cyprus has a debt-to-GDP ratio of about 127 per cent, and its over-sized banking system is weighed down by bad Greek loans and stuffed with overseas deposits, from Russia in particular. Greece, Ireland and Portugal have also received rescue funding from the European Union, the International Monetary Fund and the European Central Bank, but this would be the first time that bank deposits have been tapped as part of the rescue process.

EU leaders are saying now that Cyprus overstepped the mark by proposing to levy guaranteed deposits of €100,000 or less. The big Cyprus banks face bankruptcy, however, and they have not been big secured borrowers in their own right, preferring to fund themselves with deposits, including money from Russia and elsewhere that has been exported for possibly dubious reasons.

There is no collective of hapless bank bondholders that can be prodded and pushed into debt write-downs that would shore up bank balance sheets, in other words, but there is a €70 billion deposit pool: all this was known as Cyprus talked to the EU, the IMF and the ECB about a bailout, and the discussion was about the design of a deposit levy, not about whether a levy should be imposed.

The Cyprus government is being attacked on all sides. The levy is ''unfair, unprofessional and dangerous'', according to Russian President Vladimir Putin. Russia's finance minister has threatened to pull a €2.5 billion loan to Cyprus that Russia advanced last year, and a retail run on Cyprus' banks has only been avoided because the banks have been shut down temporarily. Markets around the world have retreated, and European Central Bank officials and EU finance ministers are simultaneously swearing that the mess is not their fault and insisting that Cyprus must somehow contribute €5.8 billion to its own rescue.

Cyprus would have to boost the levy on deposits above €100,000 to about 16 per cent to raise €5.8 billion if it exempted deposits of €100,000 or less. The EU guarantee on bank deposits up to that limit exists, however, and it needs to be protected to keep Europe's recovery and the market's recovery on track. If it is overlaid by a levy that creates a loss for those depositors, it becomes meaningless, and the fuse paper on a retail deposit run is lit. It might be confined in the short term to Cyprus, but it would prime the entire European economy for the same thing if and when the sovereign debt crisis flares again: Spain would be most at risk.

The more enduring precedent that Cyprus's bailout sets is that European bank deposits are not completely quarantined from bailouts, and arguably should not be. There is no logical reason why reconstruction write-downs cannot extend to deposits that are not guaranteed if lenders have taken write-downs and balance sheet repair is still needed. The rehabilitation of Europe is likely to require other deposit ''bail-ins'' before it is over.

Here in Australia, deposits of up to $250,000 are guaranteed. Deposits above are technically unprotected, but in practice the principal is safe. The big Australian banks are in rude health. They have taken over distressed competitors in the past to protect the system, and could do so again if necessary, and from 2015 onwards they will have a deep liquidity facility with the Reserve Bank to allow them to meet cash withdrawal surges if they occur.

European bank deposits, on the other hand, carry balance sheet reconstruction risk that varies from bank to bank, and from EU member nation to EU member nation. As long as Europe's underlying retail deposit guarantee isn't fatally undermined, the markets will presumably note that fact, adjust pricing accordingly, and move on.

mmaiden@fairfaxmedia.com.au