Cyprus, Aphrodite's Island, is in trouble. And it's trouble that could further set back sentiment in a eurozone that's already been damaged by last month's inconclusive Italian elections. Now Cyprus' parliament has rejected the terms of a €10 billion bailout from Brussels and instead may have turned to Russia for financial assistance.

The origins of the problems facing Cyprus have some striking similarities with the events that brought down Iceland and Ireland during earlier phases of the global financial crisis. More specifically, Cyprus is yet another example of a small economy made vulnerable by an outsized financial sector. As of mid-2011, the assets of the Cypriot banking system were the equivalent of 835% of GDP, while the assets of commercial banks with Cypriot parents amounted to some 500% of GDP. What made matters worse was the large exposure of those same banks to the crisis-hit Greek economy, in the form of holdings of Greek government bonds as well as loans to Greek residents, which stood at an impressive 160% of Cypriot GDP. Oops.

A further — and it turns out, rather important — part of the story is the fact that Cypriot banks have relied heavily on overseas deposits to fund their operations, with a hefty chunk of that money coming from Russia. Some estimates put the sums involved at considerably more than the current value of Cypriot GDP.

Last weekend, the EU and the IMF agreed a bailout deal with Nicosia which managed to leave nobody happy. The big problem was the proposed treatment of depositors, with the plan stitched together in Brussels providing not only for large depositors (that is, those with deposits bigger than the €100,000 deposit insurance cut-off) to be subject to a one-off 9.9% levy but also — and much more surprisingly — for small depositors (whose money is covered by the insurance scheme) to pay a 6.75% levy. Bailing in of small depositors has been widely and in my view quite rightly seen as a potentially dangerous policy blunder.

The backlash against the deal came both from small depositors — and Cypriot voters — who would have seen a share of their savings confiscated under the plan, as well as from Moscow, which expressed its own deep unhappiness with the proposed measures. This despite the common view that one reason for bailing in small depositors in the first place was Nicosia's own reluctance to levy an even greater impost on its foreign depositors.

Mind you, it's also widely believed that EU and in particular German determination to see depositors make a contribution came in no small part from Berlin's view of the politics of having German taxpayers bail out those same Russian investors. Der Speigel, for example, cites a German intelligence assessment claiming that the main beneficiaries of any European bailout would be rich Russians who had invested illegal funds. In the event, and despite talk of watering down the provisions affecting small investors, the terms of bailout failed to gain parliamentary approval and there's now widespread speculation that Nicosia will seek help from Moscow.

While this story still has some distance to run, there are already a couple of important lessons that can be drawn from events so far.

First, the original bailout package was a disaster-in-waiting. By in effect deciding to confiscate a proportion of insured deposits, the measure risked generating bank runs in Cyprus as depositors (once banks reopened) would try to pull their money out in order to escape any future confiscations. This would be bad enough if it were restricted to Cyprus, but the bigger risk is it could cause depositors in other vulnerable European countries to do the same, prompting a bout of destabilising contagion.

European authorities have asserted that Cyprus is a special case (much as they did with the different terms of the Greek bailout), and that there are no implications for other member economies. It's also true that Cyprus only accounts for tiny proportion of EU GDP. But even if any immediate contagion turns out to be limited, the measures could nevertheless produce an important change in expectations which risks complicating policy choices in the event of future crises elsewhere. More generally, the bungling of the deal has done nothing for confidence in the eurozone and its officials more generally.

Second, the nature of the bailout negotiations is yet another stark reminder of the limits to European solidarity. Given the ultimate solution to the eurozone's problems is going to involve significantly closer fiscal, financial and hence eventually political union, that's a potentially critical constraint.

Remember, one of the developments that eventually helped settle sentiment last year was the view that Germany had switched its position from being happy to see Greece exit the eurozone in order to 'punish' profligate Greeks and protect German taxpayers, to accepting that such a move would be a disaster for the eurozone as a whole. The treatment of Cyprus is in some ways reminiscent of the tougher line initially taken with Athens (perhaps aided in this case by the idea that the small scale of Cyprus lent itself to experimenting with a tougher stance, with only limited downside), and domestic political constraints have once again been shown to play an important role in constraining policy choices.

Photo by Flickr user @Poricinio