BRUSSELS/NICOSIA European policymakers are split over how to handle a bailout of Cyprus, with Germany and some other countries pushing for bank depositors to bear part of the cost and many other member states worried such a move will cause a bank run.
Euro zone officials say momentum has built in recent days behind the idea of "bailing-in" Cypriot bank shareholders and depositors, although the specifics of how such an operation would be carried out have not been pinned down.
Discussion over the bailout will resume in earnest this week following the election of Nicos Anastasiades as Cyprus's new president on Sunday.
Germany, Finland and the Netherlands are among those who say taxpayers cannot be expected to go on financing euro zone bailouts, saying it is time for owners and depositors in risk-laden banks to accept losses on investments.
The concern is that announcing such a move will provoke the immediate, large-scale withdrawal of deposits from all Cypriot banks, where a large number of international investors, including many Russian and British companies, hold accounts.
Euro zone finance ministers will discuss options at a meeting in Brussels on March 4 but no decisions are expected, officials say, making a further meeting later in March likely.
Thomas Wieser, who heads the group of senior officials who prepare decisions of euro zone finance ministers, told Reuters last week an international bailout should be ready by the end of March.
While Cyprus is the euro zone's third smallest economy with annual GDP of only around 18 billion euros, a bank run could have repercussions across the single currency bloc and re-ignite the debt crisis, officials warn.
"We have to consider that risk," said one euro zone officials whose country is undecided about whether a bail-in of depositors is the right course of action. "It's a real option but some countries don't want it."
UNBEARABLE COST OF A BAILOUT
The difficulty with Cyprus is finding a way to make a bailout sustainable so any money leant to it is repaid.
The island needs up to 17 billion euros, including 8-10 billion to recapitalize its banks and 7 billion to repay loans and finance ongoing government operations. That is equivalent to virtually its entire annual GDP.
Such a rescue would increase Cyprus's debts to around 145 percent of GDP, a level considered unsustainable. Greece's bailout calls for it to cut its debt-to-GDP ratio to 120 percent by 2020, but that would also be unsustainable for Cyprus.
The International Monetary Fund and EU finance officials say Cyprus needs to cut its debt to 90-100 percent of GDP before the country is capable of paying back what it owes.
The alternative is to impose losses on investors in Cyprus bloated banking sector, which is more than eight times bigger than the economy. Doing so would greatly reduce the cost of the bank recapitalization and therefore the overall bailout.
The Cypriot banking system had deposits of 70 billion euros at the end of December, with a third of that held by non-residents, many of whom are Russian.
Olli Rehn, the European commissioner for economic affairs, has played down the idea of a bail-in of depositors, saying it is not the preferred option. But he still expects a far-reaching overhaul of the island's banking system.
"Our intention is to ensure a fair burden-sharing of the costs of restructuring and/or resolution of banks in accordance with EU state aid rules," he said last month via his spokesman.
One bail-in proposal that has been raised is to freeze all deposits over and above 100,000 euros -- the amount that is guaranteed by existing EU rules.
That sum would be held in an escrow account for 15-30 years, potentially earning very low interest, with the total used either as collateral against loans or to shore up the banks' capital base.
Another option is to impose a retroactive tax on deposits over 100,000 euros, which many depositors may be willing to pay if the tax is not excessive and allows them to keep funds in Cyprus, where the corporate tax rate is attractively low.
A third option that some officials have raised is to offer Russia, which lent Cyprus 2.5 billion euros in 2011, a debt-for-equity swap, with the loan exchanged for ownership of the Cyprus Popular Bank, one of the island's most indebted.
"There are a range of options but nothing specific has been put forward yet," one senior euro zone official whose country favors a bail-in said. "We're not at the stage yet of discussing how exactly it would be carried out."
For their part, Cypriot officials are determined there should be no bailing-in of depositors, fearing any such proposal will cause a flood of withdrawals and undermine the financial model underpinning the economy.
Instead, newly elected President Nicos Anastasiades has indicated a willingness to study the privatization of state assets and other measures to make a bailout pay for itself.
Another option would be to convince the Russians to extend their loan, which must be repaid in 2016, possibly for up to 5 years, or for Cyprus to turn to another close historical ally, Britain, to see whether it can offer a bridging loan.
(Additional reporting by Noah Barkin and Annika Breidhardt in Berlin and Jan Strupczewski in Brussels. Writing by Luke Baker, editing by Mike Peacock)