Cyprus Bailout Puts New Pressure on Europe’s Banks

12:14 p.m. | Updated

LONDON - Just as pressure was easing on Europe’s financial sector, the situation in Cyprus has once again created chaos.

After a proposed levy on retail deposits in Cyprus, shares in many of Europe’s largest financial institutions tumbled on Monday. Shares of Barclays fell 4.9 percent, while shares in Deutsche Bank were down 3.3 percent.

Shares in American banks were also largely down, though not by as much. The most affected were the stocks of Citigroup and Morgan Stanley, which were down 2 percent and 2.9 percent, respectively.

Investors are worried that other banks, especially those in highly indebtedcountries like Italy and Spain, could face further troubles.

In a rare move, Cyprus is trying to raise around 5.8 billion euros ($7.5 billion) from a one-time bank charge on local deposits. Unlike in other European countries, local banks only have a small amount of outstanding bonds, which have their own set of legal complications. So the Cypriot government was unable to require the banks’ creditors to take major losses to finance the bailout.

“Authorities have taken a calculated risk. If the problem escalates, the entire euro zone banking system could implode,” said Cormac Leech, a banking analyst at Liberum Capital, in London. The deposit levy “shows that it’s O.K. to break the rules. Politicians are betting that they won’t have to do this again.”

In other struggling countries, bondholders would likely be the first to feel the pain.

Analysts warned that investors in Southern European banks, which already have received bailouts from local governments, could fac! e more losses if additional funds were required to support them. Bondholders in Northern European banks could also take a hit if governments require them to bear the brunt of any future write-downs.

Fearing similar moves to those in Cyprus, local depositors in countries like Spain and Italy may look to shift their money to banks in stronger European economies. Such moves would reduce those institutions’ much-needed retail deposits at a time when banks across the Continent are being required to raise their capital reserves in case of future financial shocks.

“The Cyprus bailout highlights the continued weak links in the system,” Huw van Steenis, a banking analyst at Morgan Stanley, told investors in a research note on Monday. “The pressure on many European banks, particularly the mid-cap peripherals, is intense.”

The resurgent fears bout European banks come after significant efforts taken by authorities to calm investor anxieties.

Last year, Mario Draghi, president of the European Central Bank, said he would do whatever it took to preserve the euro, including the purchase of European government bonds to help bring down local borrowing costs. The central bank also unveiled more than $1.5 trillion of short-term loans to the Continent’s banks in late 2011 and early 2012 after many firms were unable to raise money in the capital markets as banks feared that competitors would not be able to repay the loans.

In response, European banks have continued to sh! ed assets! , increase capital reserves and cut costs in an attempt to improve profitability. The efforts to strengthen Europe’s financial sector had been paying off. Many of the largest banks had raised billions of dollars from new bond issuances, while the local equity markets also had reopened to capital-raising efforts and initial public offerings.

Royal Bank of Scotland, which is 81 percent owned by the British government after receiving a bailout during the financial crisis, said last month that it planned to sell a stake in its American unit Citizens, as part of plans to raise new funds. A number of European I.P.O.’s, including from LEG Immobilien, a German real estate company owned by the Goldman Sachs investment fund Whitehall, also had raised investor hopes that the worst of the debt crisis was over.

But the proposed levy on retail deposits in Cyprus has rekindled uncertainty over the financial services sector. “This is certainly new territory,” said Pete Hahn, a banking professor at Cass Business School in London. “What is confronting Cyprus is a unique situation, but the idea could be applied in other places in Europe.”

Analysts say bank bondholders could be particularly hard hit if other European countries take unilateral steps to repay bailout funds, or take over local firms that have run into trouble.

Last month, the Netherlands wiped out holders of subordinated bonds in the Dutch bank SNS Reaal after the local government nationalized the firm, which had faced major capital losses because of defaulting real estate investments. The Irish government also recently announced that it would liquidate the former Anglo ! Irish Ban! k in a deal that required the firm’s bondholders to take major losses.

For banks in Southern European countries, the proposed levy in Cyprus could also prompt consumers to move their money to more secure firms in countries like Germany or France.

Analysts said the move was more likely as the policy in Cyprus represented a major about-face for the local government, which had repeatedly told citizens that it would not impose the one-time tax. With other European countries on shaky ground, many questioned whether it was just a matter of time before other governments imposed comparable levies in a bid to repay bailouts from the European Union.

“One can’t help thinking that this move has crossed a sacred line,” Deutsche Bank analysts said on Monday. “Depositors in any bank domiciled in a country relant on the largess of the E.U. should in theory now think very carefully about alternative places to store money, whatever the size of their holdings.”