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Cyrpus's second-biggest bank, Popular Bank (also known as Laiki) will be unwound, wiping out shareholders and bondholders.YORGOS KARAHALIS/Reuters

Cyprus was always going to get the European Union's take-it-or-leave it deal. But this is clearly one case where the medicine is as bad as the disease. The tiny island that is equally attractive to Russian oligarchs as it is to sun-starved British tourists faces losing its status as the Mediterranean's premier financial services centre and a deep recession, perhaps depression. Cyprus's long, vulgar party is over and a second bailout is not out of the question.Who won the standoff? Cyprus is getting bailed out and will avoid an outright banking collapse that would have sent it barreling out of the euro zone. But the EU (read: Germany) is the real victor. It, with the International Monetary Fund at its side, got away with relatively cheap bailout, one that will see wealthy bank depositors take a severe hit.

The bailout also delivered the message that the EU now considers nothing sacrosanct, including banks and bank deposits, when rescue missions are mounted. The message: The home country can pick up the tab for reviving dying banks. Beware Spain and Italy and any other EU country contemplating a suicide run.

The Cyprus deal ended like other bailouts. Threats were issued, a deadline was set and negotiations went through the night to produce the outline of an agreement, though one lacking in detail. For Cyprus, the agreement came in Brussels early Monday morning. If it had not come, the European Central Bank would have cut off emergency liquidity injections to the Cypriot banks, which have been closed since March 16. Without that lifeline, they would have collapsed instantly on Tuesday, when they are scheduled to reopen.

Cyprus is to get €10-billion ($13-billion U.S.) from the EU and the IMF. In exchange, the country's second biggest bank, Popular Bank (also known as Laiki Bank) is to be unwound, wiping out shareholders and bondholders. Popular will be split into a "good bank" and a "bad bank." The former will get the viable assets and insured deposits, that is, deposits up to €100,000. The rest, including deposits over €100,000, will go into the latter, with no assurances that the wealthy depositors will get any of their money back, though a 100 per cent wipe-out seem unlikely.

The good bank will then be merged with the No. 1 commercial player, Bank of Cyprus, which is to be recapitalized by whacking the bondholders and uninsured depositors. The amount of damage they are to suffer is unknown, but various reports said the uninsured depositors could lose 30 per cent to 40 per cent.

The raw amounts are staggering. Reuters said the Cypriot banks hold €68-billion in deposits, of which €38-billion are in accounts of more than €100,000. While some of the deposits are held in Russian banks in Cyprus, there is no doubt that Russians who use Cyprus to park their cash face billions in losses. Even worse, they may not be able to get any of their funds out of the country, thanks to capital controls.

In other words, even their "safe" euros will not be safe. If their euros are trapped in Cyprus, they can't be spent and if they can't be spent, they, in effect, will have no value until the capital controls are eliminated. That could take months or longer.

The game of brinksmanship was tense and Cyprus put up a good fight. Even though it capitulated in the end, president Nicos Anastasiades had a fairly strong negotiating position. If the Cypriot banks were allowed to collapse, Cyprus's exit from the 17-country euro zone would be assured and the country would be cast adrift, only to be scooped up by Russia or Turkey, both of which covet Cypriot natural gas. Cyprus's offshore fields have vast amounts of reserves, potentially making it a formidable player in the geopolitics of European and Middle East energy. The EU would rather have first dibs on that gas.

Cyprus even sent its finance minister to Moscow last week to negotiate new loans – Russia had lent the country €2.5-billion in 2011. The mission failed, but we don't know why. There is little doubt that Russia was not prepared to bail out the country unless state-controlled Gazprom got a piece of the Cypriot gas action. Cyprus apparently was in no position to offer those rights; even if it were, the EU would have read the riot act to Cyprus.

In the end, the EU's position was more powerful. Since Cyprus was tiny – its economy accounts for 0.3 per cent of euro zone gross domestic product – the EU could theoretically afford to cut it free, even if it did not want to set a euro zone exit precedent. And Germany was in no mood to protect wealthy Russians in a country with an inglorious reputation for money laundering. The EU's main mistake was backing, at least initially, a proposal that would have seen insured depositors take a 6.75 per cent haircut to help bail out the banks. The idea of taxing the poor was considered repulsive and the Cypriot parliament nixed the proposal early last week.

Cyprus will suffer. Its status as an offshore banking sector is now in doubt because confidence has been broken. Money goes where it is treated best – that is, taxed the least – and billions will flow out of the country when the capital controls are lifted. The Cypriot economy, already in recession, will sink. Société Générale said Monday morning that it sees Cypriot GDP dropping by 20 per cent by 2017, which would put the economy into depression territory. The country will be in limbo until 2019 or so, when the first gas is scheduled to be produced.

Germany is happy. It has put Europe on notice that bailouts still come with severe conditions and that previously untouchable areas – notably bank deposits – are no longer untouchable. Germany is saying that the European taxpayer will do only so much to repair a broken country. Countries that make big mistakes will have to pay for those mistakes.