The Cypriot government was preparing a bill Thursday night to restructure its second-largest lender, Cyprus Popular Bank PCL, in a last-ditch bid to unlock aid from the European Union and reopen the nation's banking system.
Emotions ran high as Cypriot bank workers gathered outside of Parliament in Nicosia on Thursday, fearful for their jobs and savings. WSJ's Matina Stevis reports via #WorldStream.
Cyprus was also planning wide restrictions on financial transactions when the banks reopen—deepening a freeze that has no precedent in the euro zone. The proposals would allow authorities to restrict noncash transactions, freeze check cashing, limit withdrawals and even convert checking accounts into fixed-term deposits.
The restructuring plan would start the process of gradually shutting Cyprus Popular, known locally as Laiki Bank. The bank's healthiest assets would be transferred to its larger peer, Bank of Cyprus PCL, while Cyprus Popular's unwanted loans and other assets would be shunted into another structure for eventual disposal, said people familiar with the plan.
The creation of a "good bank" and a "bad bank" could improve Cyprus's lot in two ways. First, creditors of the bad bank could be made to bear steep losses. That would reduce the amount of aid the Cypriot government needs to provide to the banking system. Second, by bolstering Bank of Cyprus, the plan could persuade the European Central Bank to continue providing liquidity to the country's financial system—which it has threatened to cut off.
Many of the details of the plan were unknown late Thursday. A Cyprus Popular spokesman couldn't be reached.
The trouble in Cyprus's banks has been brewing for years, but it turned acute Saturday when Cyprus and the euro zone agreed on a plan to impose a one-time tax on all bank deposits. It was met with furious public opposition and rejected by Parliament.
That has led to a complex standoff between Cyprus, the euro zone and the ECB. Until the impasse is resolved, the banks can't open because they would immediately face an exodus of deposits.
At the heart of the problem: The deposit tax was supposed to raise €5.8 billion ($7.5 billion), and Cyprus would use that money, along with promised aid from the euro zone, to recapitalize Cyprus Popular and Bank of Cyprus.
Without a recapitalization, the banks effectively can't open. That is because the news of a potential tax has spurred Cypriots en masse to try to pull money from their accounts. Electronic transfers are frozen while the banks are shut, but Cypriots are lining up dozens deep at automated-teller machines to suck out what they can.
Analysts say the deposit outflows will surge when banks reopen; this week, Panicos Demetriades, the governor of Cyprus's central bank, said the original plan for a bank levy could cause up to 10% of deposits to flee. As of the end of January, households and nonbank corporations had deposited €68.4 billion in Cypriot banks.
"Every day that the banks are closed is a wound," Mr. Demetriades said.
At the earliest, Cyprus's banks will reopen next Tuesday. Their last business day was March 15.
In theory, a commercial bank facing a run by depositors could turn to the central bank, its lender of last resort, for funding to replace what goes out the door.
But the banks need to post collateral in return for those funds. And the ECB doesn't normally accept Cypriot government bonds, which are junk-rated, as collateral.
So Cypriot banks have had to rely on a special emergency line of liquidity. On Thursday, the ECB threatened to cut that off on Monday unless the banks are recapitalized.
It isn't clear whether the proposed breakup of Cyprus Popular would be sufficient to end the standoff.
For one thing, Bank of Cyprus also needs to be recapitalized, and European authorities will insist that those needs are covered before it agrees to release the €10 billion in aid it has promised. Cyprus needs money both to recapitalize its banks and to cover the government's own financing hole.
The Cypriot banking problem has been difficult to solve, in part because of how the two big banks are financed. Both Cyprus Popular and Bank of Cyprus rely heavily on deposits, and have few other creditors who might absorb the pain of losses.
As of Sept. 30, the two banks had €46 billion in customer deposits, and Cyprus Popular had €10 billion in borrowings from the central bank. If deposits start to flow out rapidly, the central bank is essentially the only party capable of stepping in. Cyprus Popular and Bank of Cyprus could be vulnerable to deposit flight; at the end of 2011, the last period for which either bank has provided detailed financial data, 78% of their deposits could be quickly withdrawn by customers.
In a sign of the mounting liquidity pressures, the U.K.'s regulator this week warned Cyprus Popular's U.K. branch not to siphon funds back to its parent in Nicosia, said a person familiar with the matter.
But the central bank risks ending up being exposed to the bank's assets—mainly customer loans—in case of a failure. Both banks suffered huge losses on investments in Greece, and they are also exposed to property in Cyprus.
Meanwhile, on Thursday, Standard & Poor's cut Cyprus's long-term sovereign-debt rating to triple-C from triple-C-plus and said its outlook is negative.
Rumors of Cyprus Popular's imminent demise reverberated through the streets of Nicosia. At some of the bank's cash machines Thursday afternoon, dozens of Cypriots lined up to withdraw funds, a quintessential image of an unraveling financial system.
In the evening, hundreds of bank workers gathered outside Parliament to protest. "Hands off Laiki," they chanted, using the bank's Greek name.
Makis Adam, a 25-year veteran of the bank who was at the impromptu demonstration, said he plans to move to Australia with his wife and two children.
"We always wanted to be in Cyprus. I studied finance in Connecticut but came back here because I wanted to be home," Mr. Adam said. "The irony is that my job was to put companies in receivership. Now we're being put in receivership."
—Stelios Bouras
and Michalis Persianis
contributed to this article. Write to Charles Forelle at charles.forelle@wsj.com, Matina Stevis at matina.stevis@dowjones.com and David Enrich at david.enrich@wsj.com
