Small States Stress Distance from Cyprus

BRUSSELS�The risks posed by hosting a large financial industry became a flash point on Wednesday as the Cyprus bailout trained the spotlight on other small euro nations that depend on the sector for jobs and economic growth.

The issue has become a sore spot mainly for Luxembourg and Malta after the debate over Cyprus prompted European ministers and politicians to question the viability of housing a large financial center in a small country. Cyprus's bailout requires the country to shrink its large financial-services industry to the euro-zone average, setting an unwelcome precedent for nations whose economic models are based on financial services.

The decision to impose losses on Cypriot bank deposits as part of the bailout has also raised fears in some countries that the euro zone is turning itself into a less attractive environment for global finance.

Luxembourg, which is one of the euro zone's biggest financial centers despite its tiny size, fired back on Wednesday, saying it was concerned about recent "comparisons between the business model of international financial sectors in the euro area."

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Luxembourg Finance Minister Luc Frieden said there was nothing wrong with having a larger-than-average financial-services industry. "We want to expand it further, not to downsize it," Mr. Frieden said in an interview in an interview on Wednesday.

Mr. Frieden also rebuffed suggestions that the Cypriot bailout, which imposes steep losses on many uninsured bank deposits, should guide how the euro zone treats failing banks in the future. All deposits, regardless of size, should be protected in euro-zone bank overhauls, he said.

"The risks are too high with the Cypriot model," he said, adding that depositors must be able to have absolute trust in their banks.

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Luxembourg, a nation of 525,000 people sandwiched between Germany, France and Belgium, is a world financial center, packed with banks, investment funds and wealth-management firms catering to the very rich. The assets of its banking system are worth 22 times its annual economic output, by far the largest proportion in Europe and far higher than Cyprus, where bank assets are about seven times annual output.

The country, one of the euro zone's founding members, became a financial center thanks to low taxation and comparatively light regulation dating back decades. Luxembourg has weathered the financial crisis relatively well so far, but officials fear the country has much to lose if investors begin to see the currency area as a risky place to keep money. "Depositors and investors will go to Asia or elsewhere," Mr. Frieden said.

In an interview published on Wednesday, the central-bank governor of Malta, a small country with big ambitions to build a financial sector, also dismissed as "misleading" any comparison with Cyprus. The assets of Malta's major banks amount to "just below 300%" of gross domestic product, which by international standards was "within normal limits," Josef Bonnici told the Times of Malta. Overall bank assets are around eight times GDP, according to European Central Bank data.

Mr. Bonnici also highlighted the exceptional nature of Cypriot banks' losses on Greek government debt. "Maltese domestic banks have limited exposure to securities issued by the program countries," Mr. Bonnici said.

Meanwhile, Slovenia also defended its ability to fix the problem of nonperforming loans in its banking sector when its prime minister, Alenka Bratusek, told parliament on Wednesday that it won't need international aid. "We will continue restructuring and stabilizing the banking system," she said.

Luxembourg also took issue with comments by some officials that boiled down Cyprus's problems into a simple question of the size of its banking system, relative to its overall economy. What matters, rather, is the "quality and solidity" of the financial sector and its size in relation to the euro area as a whole, the government argued in a statement.

Still, some financial experts argue that governments need to pay close attention to the size of their financial sectors, because they could be dragged down by the inability to support failing banks.

"The lesson from Cyprus is that you have a very strong fragility of the sovereign when the banking system is very large," said Nicolas Veron, a senior fellow at Brussels-based think tank Bruegel.

Cyprus's bailout has sparked fresh warnings from policy makers about overreliance on financial sector revenues. In a speech in Moscow last week, European Commission President Jos� Manuel Barroso said the crisis in Cyprus was "the result of an unsustainable financial system" that was a multiple of the country's GDP and "certainly has to adapt."

"Markets are now focusing on potential weaknesses in euro-zone states whose banking sectors are very large relative to their economies," said Christian Schulz, an economist at Berenberg Bank in London.

Mr. Schulz said the political signals from the Cyprus bailout are a clear threat to Luxembourg's interests.

"Luxembourg will now have to explain why its financial system is so big," he said. "That in itself will raise concern with people who have large deposits there."

Still, Luxembourg's banking sector consists largely of subsidiaries and branches of foreign banks, so that significant support might be expected from mother banks and, ultimately, the governments of those mother banks, in the event of a crisis. Just 8% of Luxembourg's banking assets are held by domestic banks, compared with 71% for Cyprus, according to ECB data.

All three big international credit ratings firms still rate Luxembourg's government debt triple-A.

—Todd Buell and Leos Rousek contributed to this article

Write to Matthew Dalton at Matthew.Dalton@dowjones.com and Tom Fairless at tom.fairless@dowjones.com