By Carmel Crimmins and Sinead Cruise
DUBLIN/LONDON (Reuters) - 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
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 emphasize that its banks are healthy and its liabilities much smaller than they appear on paper.
"In all the articles of the last few weeks, you have this famous bar chart measuring the size of the financial sector against GDP. It is not the way it should be looked at," said Marc Saluzzi, chairman of the Association of the Luxembourg Fund Industry.
"If you look at Luxembourg, our center is much more diversified; it is run by 142 banks, which are essentially subsidiaries of very large foreign banks, with solvency ratios above 15 percent. We are agents and not principals."
Stripping out international banks, the core of Luxembourg's financial system is based around three banks - state-owned BCEE, BGL BNP Paribas
"Like the Cypriot banks, they do have fairly large external assets," said Gill of those three banks. "Our estimate is just under 100 billion euros of external assets, which is 45 percent of GDP, but these are almost exclusively holdings of tradable, financial, highly liquid assets, securities they could realistically convert into liquidity almost instantly.
"They are not claims on an insolvent economy."
According to the IMF, just 0.4 percent of loans in Luxembourg were non performing as of June last year.
After Luxembourg, Malta has proportionately the next largest financial sector in the euro zone, at around eight times the country's GDP.
But this statistic is misleading.
Stripping out international banks including some Turkish lenders that book a lot of their loans through Malta for tax reasons and do not take domestic deposits or lend domestically, the local banking sector has assets equivalent to under 300 percent of GDP and is dominated by two lenders - Bank of Valletta and HSBC Malta.
If trouble hit, HSBC Malta would likely have the support of its parent HSBC
Malta's domestic banks had non-performing loans equivalent to 8.2 percent of the loan book as of June 2012, according to the IMF.
While the domestic banks in Malta have limited foreign exposure and have so far sidestepped any fallout from the euro zone crisis, the central bank this week called for them to raise their provisioning to better cushion them from potential losses.
The vulnerability for Malta is the uncertainty caused by the Cypriot bailout, which for the first time forced large depositors and holders of senior bank debt to take losses - a 'bail-in' as the jargon has it.
"The key risk facing Malta is that its international offshore investors begin to relocate in light of the policy uncertainty created by the Cypriot bail-in," said Myles Bradshaw, portfolio manager at PIMCO.
"This would have significant negative economic effects that could in turn create a problem with domestic banks' asset quality. Together with the deep recession, this could force Malta to seek external assistance."
FOOL ME TWICE
Markets are betting that Slovenia, a country of 2 million perched on Italy's northeast border, will be the next euro zone country to succumb to a bailout.
In contrast to Cyprus, Slovenia's banking system is not large - around 1.4 times as big as the economy - and there are negligible foreign depositors.
But the Slovenian banks, most of them state-owned, are crippled with bad loans, which reached 14.4 percent of their loan books last year.
Like Cyprus, Slovenia does not have the money to recapitalize them.
The Paris-based Organisation for Economic Cooperation and Development heaped pressure on Slovenia this week when it said the level of bad loans at Nova Ljubljanska, Nova KBM
If Slovenia needs a bailout, investors will be watching to see if Europe stays true to its word that the Cypriot bailout was unique.
A Cyprus-style rescue involving losses on large depositors and banks' senior bonds would re-ignite contagion risk, particularly for countries with large banking sectors.
"Cyprus has sent a strong message to a lot of people," said Lee Robinson, founder of asset management firm Altana Wealth. "Non Europeans will be asking themselves whether they have exposure to any of these other countries where the financial sector looks dangerously large relative to GDP."
"Simply saying this won't happen again is not enough - it's the ‘Fool me once, shame on you. Fool me twice, shame on me'."
(Editing by Will Waterman)