UPDATE 2-Cyprus Finance Minister says bank deposits will be protected
* Cyprus says bank deposits sacrosanct
* Lenders start new contacts to craft bailout deal
* Government wary on central banker's deposit levy idea
NICOSIA, March 6 (Reuters) - Cyprus insisted on Wednesday that people holding money in its banks - many of them Russian and British - must not take a hit in efforts to repair the island's shattered finances.
Attempts by Cyprus to secure aid have been complicated by concerns about how the island could afford to pay back a debt burden which could potentially reach 17 billion euros ($22 billion) - almost the size of its economy, one of the euro zone's smallest.
While euro zone finance ministers have pledged to agree a bailout by the end of this month, little detail has emerged on how the rescue will be financed.
Representatives from the "troika" of lenders - the International Monetary Fund, the European Central Bank and the European Commission - started new contacts in Nicosia on Wednesday to clinch a deal.
Ideas for making Cyprus's debt sustainable have ranged from privatisations and securitising potential natural gas reserves to more extreme scenarios - ruled out by Nicosia - of depositors in Cypriot banks helping to pay for the cost of the rescue.
German officials, backed by the Netherlands and Finland, have pushed for depositors in Cypriot banks, which include many Russian and British business people, to help pay in a process known as a "bail-in".
Nicosia and other euro zone nations say such a move could threaten economies throughout the bloc.
"We have repeated in the most categorical manner that this is not an issue for discussion. It would be catastrophic for Cyprus, and for the euro zone" said finance minister Michael Sarris.
"I believe that message is gradually getting through, even to those who may have considered it a possibility."
While lenders and Cyprus grapple with ideas on how to balance the books, a suggestion by the Cypriot Central Bank governor of a temporary levy on capital gains from deposits appeared to get short shrift from authorities.
Central bank governor Panicos Demetriades, who is also a member of the Governing Council of the ECB, told the Wall Street Journal in an interview published on Tuesday that Cyprus could install a special levy on capital gains from bank deposits to help finance the restructuring of its banking sector. [ID:nL6N0BXH9V}
Sarris, appointed by Cyprus's new conservative President Nicos Anastasiades after winning power in a February 24 election, distanced himself from the comments.
"The cornerstone of confidence in the banking system is the integrity of deposits," Sarris said, referring to an unwavering policy throughout Europe during the debt crisis. "So with that in mind, one has to look at whether it could have a negative impact."
Demetriades was quoted as suggesting a "special solidarity levy" for Cyprus would only be applied for three years and could generate as much as 150 million euros a year.
Cypriot banks, badly burnt when their holdings of Greek government debt were written down in early 2012, need anything between 6 and 9 billion euros to recapitalise, according to an independent asset review. In addition, authorities need 7.0-7.5 billion euros for general government operations and to finance existing debt.
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