Why Cyprus matters to U.S. investors

March 18, 2013, 7:07 PM UTC

FORTUNE — The terms of the Cypriot “bailout” announced late Friday are simply atrocious and should be revised to protect small depositors to avoid potentially crippling bank runs from popping up across Europe. Forcing bank losses on account holders who believed their money was protected by government-backed deposit insurance violates one of the most sacred of trusts between a bank and its customers. As such, the agreement, if it stands, threatens to crash the entire Cypriot banking system, which could have dangerous effects for banks across the European Union, as well as for investors on Wall Street, who have bet billions of dollars backing EU banks and sovereign notes.

Indeed it appears that Cyprus isn’t going to roll over to the bailout demands of the International Monetary Fund and the Eurogroup after all. Cypriot lawmakers announced midday on Monday that they would postpone voting on the package. The speaker of the Cypriot parliament said that the vote would be delayed until Tuesday evening, but there is talk that the vote could be delayed until Friday. The sooner the Cypriots come to an agreement with the Eurogroup, the better, as fear of a potential systemwide EU bank run sent stocks falling across the globe on Monday. Japan’s stock market fell 2.7% overnight, while stock markets across Europe opened down as much as 2%, with the markets in Italy and Spain hit the hardest. Investment banks across Europe were also down, with shares in Deutsche Bank (DB) down 3.3% and Barclays (BCS) falling almost 5%.

The bailout proposed Friday is actually more of a “bail-in,” as it forces depositors to contribute a large chunk of the funds needed to stabilize the nation’s banking system. There is to be a “stability levy” of 6.75% on all bank deposits less than 100,000 euros and 9.9% for those above 100,000 euros. That is in addition to a bevy of growth-killing austerity measures which will undoubtedly keep the Cypriot economy in recession for quite a while.

MORE: Former London Whale boss: I was misled

As a refresher, Cyprus had been shut out of the international financial markets for nearly two years thanks to a banking crisis that froze its economy. Cypriot banks invested heavily in Greek sovereign debt, thinking that their sister-nation’s bonds were as good as gold. They weren’t, and when the EU forced Greek debtholders to take a massive haircut on their holdings, Cypriot banks locked up lending in the nation.

The falling bailout dominos created a 4.5 billion euro or $6 billion hole in the Cypriot banking sector. The culmination of other bad bets forced the government of Cyprus to go cap-in-hand to the EU seeking a $23 billion bailout of its troubled banking sector. That may not seem like a lot of money, but it is roughly equivalent to Cyprus’s entire GDP, so it is quite a large number for them.

Now, the deposit grab will raise around 5.8 billion euros or $7.6 billion, which is just a fraction of what is needed to fill the hole in the Cypriot banking system. Another 10 billion euros will come in the form of a bailout from the Eurogroup and the IMF. The government will probably need to come up with the rest but it is unclear where it will get the money at this point.

While it might seem logical to force all depositors to help finance the bailout, at least in part, it really isn’t. First, depositors were under the impression that the government would protect their savings up to 100,000 euros per account. This is what kept Cypriot banks from totally collapsing years ago as everyday Cypriots kept their money in their checking accounts. By violating that agreement, the trust that bank customers had in the financial system goes right out the window. That is why you saw Cypriots trying to withdraw cash en masse from ATMs over the weekend. It has now become safer to keep your money under your mattress than in a bank.

This lack of trust in the banking system could spill over to other eurozone countries where a bailout seems imminent, most notably in Italy. The consequences of a bank run in Italy would be disastrous to say the least and could set off a cascade of bank runs across the eurozone. Wall Street is heavily invested in bank debt across the continent. If banks begin falling, the loss will be felt here in the U.S. The economic decline in Europe would undoubtedly cause U.S. investors to start pulling their money out of the markets as was the case in Asia this morning when it was unclear whether or not the bailout would go ahead in its current form.

MORE: Why higher mortgage rates will help the housing market

There are many ways that this situation could have been handled, none of them pretty. One would have been to force the government of Cyprus to swallow the bank losses, as Ireland did in the early days of the banking crisis in 2008. That solution wasn’t applicable for Cyprus, though, as the losses were too great for the nation to service. A second option would be to force the Eurozone to essentially gift the money to the Cypriots. Northern European nations would ultimately bear the cost of much of the bailout, which is arguably chicken feed compared to the cost of the bailouts of Greece and Spain. But with elections looming in Germany this year such a move proved politically impossible.

Cyprus needs a long-term solution to its banking mess, or else it will never get out of this economic funk it has found itself in. Forcing losses on all depositors only makes the situation worse. Indeed, this bailout is unprecedented. Of the 47 banking crises since 1970, only 17 required that depositors share in the losses, according to Nomura. Of those 17 losses, though, none involved a blanket-wide levy on all depositors for the simple reason that it could spark a run on the bank. Instead, bank levies impacted just the largest depositors who wouldn’t necessarily pull their money out as would be the case with small time depositors who live paycheck to paycheck. Large depositors and bank debt holders who would see vicious haircuts could be enticed to keep their money and investments with the bank in exchange for a variety of carrots, ranging from bank equity to government IOUs.

Shifting more of the losses onto the larger bank depositors and to bank debt holders seems to be the best way to solve, or to at least patch up, the damage done over the weekend. There is talk of lowering the bank levy for depositors with less than 100,000 euros to between zero and 3%, with a subsequent increase in the levy for those deposits over 100,000 euros to 13%. In the long term, though, the Eurogroup should move quickly to pass rules creating a banking union with a unified European deposit insurer, similar to the FDIC in the U.S., so as to erase depositor fears that they may wake up one morning and see that the government just absconded with a chunk of their savings.