DUBLIN/LONDON - Though the implosion of Cyprus's bloated banking system has put other euro zone economies with outsized financial sectors such as Luxembourg and Malta in the spotlight, loan quality is the real litmus test of a country's financial stability.
Attracted by low taxes, high interest rates and light regulation, foreign deposits, largely from Russia and other former Soviet states, pumped up the Cypriot banking sector to nearly eight times annual economic output, more than double the European average of around 3.5 times.
Stripping out Russian banks and other international lenders, the three Cypriot banks for which the state was liable had assets amounting to more than five times Gross Domestic Product (GDP), a huge proportion for an island of just 800,000 people.
What caused the problem, however, was that Cyprus's two main banks used the gush of deposits to gamble on the Greek economy, leaving them horribly exposed when Europe imposed losses on Greek sovereign bonds. The implosion of the Greek economy rotted their loans to that country.
"Banks don't fail because they are big. Banks fail because they make bad lending decisions," said Frank Gill, director of European sovereign ratings at Standard & Poors.
"It is important to understand that the Cypriot banking crisis was born on the asset not the liability side of the balance sheet."
Bank of Cyprus's non performing loans shot up to 17 per cent of its total book at the end of September last year.
Cyprus Popular Bank, known as Laiki, which is being shut down as part of the Cypriot bailout, almost quadrupled its loan loss provisions to 400 million euros in the third quarter of 2012.
BIG SECTOR, SMALL DUCHY
Officials from Luxembourg, anxious to protect the country's reputation as a hub for international capital, are quick to draw the distinction between their risk exposure and Cyprus's.
Though it has the largest banking sector in the euro zone, at an eye-watering 22 times GDP, and a population of only just over half a million people, roughly equivalent to Tucson, Arizona, the Grand Duchy is keen to emphasise that its banks are healthy and its liabilities much smaller than they appear on paper.