When Prime Minister Gillard met IMF Managing Director Lagarde at the Bo'ao Conference last week, her opening gambit was to praise the IMF for sorting out the Cyprus problem.

This is, to say the least, puzzling.

Cyprus was an unmitigated mess which leaves a lasting legacy on the frail European situation. While there are other guilty parties, the IMF has a clear role: amid the political imbroglio, it is the one player that can use its powerful position to ensure a minimal standard of sensible policy-making. In this it failed.

The issue at stake is how banking failures should be sorted out. It is universal practice that small depositors should get back all their money. The usual rationale is that, otherwise, there will be widespread bank runs. The nature of bank balance sheets means that an abnormal level of withdrawals can trigger failure because their assets, even when sound, are illiquid.

Of course this argument applies to larger deposits too. These depositors have more to lose and are likely to be better informed, so they will run even more readily. Why not guarantee them too?

The usual argument is that this gives rise to 'moral hazard': if all bank funds are guaranteed, then bank management will be less prudent in their lending, equity backing, and liquid provisioning. Thus the deeper logic is that small depositors ('widows and orphans') are protected for social reasons while larger depositors are left unprotected so they can provide some discipline on banks.

Policy-makers always live in the hope that things won't get to this stage. If vulnerabilities can be identified before the bank is insolvent, then the central bank can keep the bank afloat while the liquidity problems are sorted out.

If the bank is insolvent, authorities have to decide if the bank can be closed without setting off a run. Can the public be convinced that this bank's problems are idiosyncratic? If so, the larger depositors can be given a haircut to help fund the bailout. If not, the authorities have a systemic crisis on their hands, and the only way to stem it may be to change tack and offer a guarantee to all depositors. If the crisis is going to last for more than a few weeks, the bond-holders may have to be guaranteed as well (otherwise they will run as soon as their bonds mature).

Thus it is not amazing that, until Cyprus got into trouble, all European bank depositors (big and small) and bank bond-holders have been bailed out, starting in Ireland.

Of course there is a downside. The more this happens, the greater the moral hazard legacy left behind: henceforth the discipline on bank management is reduced. This is hardly an ideal outcome and much head-scratching has gone on to find a better solution. More bank capital, faster identification of vulnerabilities, and contingent capital (bonds which become equity in a crisis, to help fund the bankruptcy) have all been explored.

On top of the moral hazard issue, 'crisis fatigue' has set in. Taxpayers are getting restless. It's one thing to bail out the widows and orphans; it's another to help fat cats in tax havens. The Germans feel this most strongly.

These unresolved issues came to a head with Cyprus. The required bail-out was not huge, but the European Union was not ready to foot the whole bill, so the residual had to be met from somewhere. Cyprus, anxious to retain its status as a favoured tax haven for Russians, was reluctant to make the bigger depositors bear all this residual cost.

But to attempt a solution which gave a haircut to the small depositors seems to be the height of folly. It's true that this 'solution' only lasted a few days, but by being prepared to contemplate the unthinkable, the damage has been done. Imposing capital controls in Cyprus adds to depositors' skittishness.

The fragile ambiguity that holds flighty depositors in place now has an added element of concern. The Humpty Dumpty of faith in banks is going to be hard to put back together, not just in Cyprus but in the peripheral countries where the big risks lie. The European crisis is not over yet. Greece, Spain, Portugal and perhaps Italy and Ireland will require more debt relief at some stage. Bank depositors will wonder whether they might be part of the solution.

Photo by Flickr user smokeghost.