Everyone knew that Cyprus would be a tough nut to crack, but few expected this tiny island to be the one country to stand up to the so-called troika of international lenders (the EBC, IMF, and European Commission) and reject a bailout offer.

To be clear, the potential consequences for Cyprus of its bravado are dire. Cyprus has until June to redeem its next government bond, but could face financial collapse before then. If this happened, the only way to save its banks and its economy would be to print money and leave the euro area—something no Cypriot parties favor.

How to stop a banking melt down

Luckily, this needn’t happen. When Cyprus’ depositors heard that euro area policymakers had agreed to confiscate some of their deposits overnight, they rushed to withdraw their savings from the banks. In anticipation of this, policymakers declared a bank holiday in Cyprus and limited electronic transfers. Banks are due to open on Thursday, but it is highly likely that the bank holiday in Cyprus will be extended until next week.

When Cypriot bank doors do open again, we can expect a bank run. To stem this, the ECB will do two things. First, it will impose more capital controls on Cypriot banks. Second, the ECB will probably ramp up its emergency liquidity assistance (ELA) to Cyprus. As deposits flee from Cyprus, the ECB will likely plug the gap with cheap liquidity, effectively financing the bank run.

The ECB warned last Friday that it would cut Cypriot banks off from ELA if no bailout decision was agreed. However, at its bimonthly meeting on Wednesday the ECB governing council decided to delay a vote on shutting down Cyprus’ ELA program until alternatives for a bailout had been explored.

Capital controls and ELA financing can buy Cyprus time, but the country will still need to find more than 17 billion euros to meet its financing needs. The original bailout deal involved 10 billion euros in loans from the troika. These loans are still on the table, but Cyprus must find at least 7 billion euros more.

Where to find more bailout money

The best option would be for the Cypriot government to revisit the bailout program already offered to it. According to this program, 5.8 billion euros would need to come from a one-off tax levy on depositors. This was controversial for various interest groups. Depositors with over 100,000 euros are uninsured and under the original bailout plan were subject to a 9.9% tax on their savings. Many of these depositors are Russian and have stashed their money in Cyprus given the country’s extremely low tax rates. Imposing a significant levy on their deposits would drive wealthy Russians away from the island, and in doing so would severely undermine a key source of bank funding and investment in Cyprus over the past few decades. Depositors with under 100,000 euros are insured, and under the original bailout plan were subject to a levy of 6.75%. Confiscating insured savings overnight meant making a mockery out of European deposit guarantee schemes.

Given that a deposit levy has now been put on the table, Russian depositors are going to withdraw their money regardless of whether it is ever actually imposed. The Cypriot government should accept that the damage has already been done; Cyprus has already lost its tax haven status and should tax uninsured depositors more so that the government can generate 5.8 billion euros in savings without having to tax insured depositors. So far, the Cypriot government remains stubbornly protective of its status as a taxhaven, so this option seems unlikely though not impossible. After all, Cypriot members of parliament may have just been posturing when they voted down the bailout rather than signing a suicide pact.

Another option is for Cyprus to go back to the troika to ask for an additional 7 billion euros. The troika is very likely to reject such a request for the same reason it did previously: loaning Cyprus 17 billion euros would make Cyprus’ sovereign debt burden unsustainable. This is even more the case now given developments over the past few days, which will undoubtedly inspire deposit and capital flight from Cyprus, causing GDP to contract more than had originally been expected.

A third source for funding is Russia. Russian support could not come in the form of a loan because, like additional troika funding, that would render Cyprus’ debt burden unsustainable. But Russia might offer cash in exchange for gas exploration rights or a naval base in the Mediterranean. The latter is particularly important for Russia given that its only naval base in the region is currently in Syria and risks being shut down.

A final option is for Cyprus to cobble together some amalgamation of these other sources of funding and dig up extra money itself. By imposing losses on unsecured senior bank debt and raiding national pensions, Cyprus could generate a few million euros for a bailout. The church has also pledged its wealth to the country, though this is unlikely to significantly plug Cyprus’ 7 billion euros gap in the bailout.

The damage is done

While Cyprus still has options for avoiding financial and fiscal melt down, the country’s original bailout deal has already set a dangerous precedent for the region by introducing depositor levies as part of the euro area’s toolkit for handling countries when they get into trouble. Imposing losses on insured deposits completely undermines deposit guarantee schemes in Europe, and in doing so also undermines the creation of a banking union, as the former is a prerequisite for the latter.

By making depositors feel their money is not safe in a bank, euro area policymakers have also significantly increased the risk of a bank run in the euro area. Since last September, the markets have been infused with euphoria and complacency as a result of the EBC’s bond buying program. However, Cyprus has just brought to light the Achilles heel of the bond buying program: no amount of central bank bond buying can mitigate the impact of a bank run on a country’s financial services industry or economy.

It is not too late for Cyprus to cobble together a deal to alleviate its immediate financial and fiscal woes. Even if Cyprus does manage to negotiate a deal with the troika and/or the Russians, it is too late to erase the dangerous precedent set by the tiny island’s original bailout offer. Throughout the euro area crisis, most analysts have been more worried about the larger peripheral countries of Spain and Italy given the systemic risk they pose to the entire region. Accounting for less than 0.2% of euro area GDP, however, Cyprus has just proven that as far as the euro area is concerned, size does not always matter.

Megan Greene is a senior fellow with the Global Business & Economics Program at the Atlantic Council.

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