It comes with the territory. Since the global financial crisis began in 2007, a succession of island nations – first Iceland, then Ireland, now Cyprus – have got into dreadful trouble thanks to overblown banking systems that their national governments have been unable to handle.

The dynamics of each market have been different. Iceland overstretched itself, lent too much abroad and lost it in the first flush of the global crisis. Irish banks were similarly overleveraged but quickly came unstuck as the domestic property market collapsed.

The Cypriot crisis has been a far slower-burning affair. It has been clear for months that the partial default of Greek government bonds, held in large volume by the Cypriot banks, combined with a shaky domestic property market and troubled commercial lending to Greece, Russia and other former eastern bloc economies, would cause havoc for the sector.

When Pimco, the investment group, conducted a stress test of the sector, it concluded that the latent losses on the banks’ books meant the sector needed €7bn-10bn of new capital, close to 60 per cent of GDP – a controversially high estimate that led to the report never being published officially.

Many economies have lost control of their banks over the past five years, but for islands like Iceland, Ireland and Cyprus, it has been impossible to bear without outside aid because of the size of the banks relative to the domestic economy.

According to information compiled by Open Europe, a think-tank, using European Central Bank data, lenders in Ireland and Cyprus last year had assets equivalent to seven and a half times their GDP. When its banks collapsed, Iceland’s lenders boasted an eight times multiple.

The undoing of the Cypriot banks has in part been an accident of history – the island’s ties to Greece, Russia and Ukraine have backfired in the form of high loan defaults – and in part the result of aggressively low tax rates, which saw money flood into the island, and into the banks.

The resultant surfeit of funding enjoyed by Cyprus’s banks – the inverse of the financing squeeze felt in many other markets – gave them more to invest than they knew what to do with.

Fierce competition in the mid-2000s between the island’s “big two” – Bank of Cyprus and aspiring rival Laiki (Popular) Bank – became pernicious, according to analysts in Nicosia.

“Laiki adopted a very aggressive lending policy, trying to overtake Bank of Cyprus and become the biggest lender,” says Lambros Papadopoulos, an independent analyst.

Former managers at Laiki, controlled by Greece’s Marfin Investment Group, have been accused of making insufficiently secured loans to other companies in the group. MIG officials deny the allegations.

Whatever the truth, Laiki was in even worse shape than its rival until the Cyprus government came up with a €1.8bn bailout last year and appointed new managers.

Bank of Cyprus has its own problems as it tries to restructure its Russian subsidiary Uniastrum, where non-performing loans are more than 25 per cent higher than the average for the country.

The first obvious blow for the banks came last year when the Greek government bond writedowns left the two lenders holding €3.8bn of almost worthless paper. Next to hit will be losses from a once-booming real estate sector that accounts for about 40 per cent of each bank’s loan book. Pimco modelled for a halving of property prices over the next three years and overall estimated it would cost up to €4bn to recapitalise each bank, according to a person familiar with the study.

Amid the efforts to find the necessary funds to rescue Cyprus and its lenders, there has been almost universal criticism of the plan to “bail in” depositors’ money, including individuals’ savings of less than €100,000 which are theoretically covered by a deposit insurance scheme.

But bankers concede that some hit to deposits was an inevitable consequence of the unusual dominance of deposits in the banks’ funding structure. While lenders in most parts of the world rely on large volumes of bond funding, some of which typically takes a “haircut” in a crisis, Cypriot banks have negligible outstanding bonds (barely 3 per cent of deposits).

No one can predict to what extent the terms of Cyprus’s rescue will prompt deposits to flee from the island. If they do, lending will have to shrink, too.

The goal of the international authorities will be to cut back the Cypriot banking system to the 350 per cent European average as a share of gross domestic product within five years.

The first step – already arranged – will be for the Cypriot banks to shed their operations in Greece. Other overseas assets would follow during the IMF programme period. The real challenge, though, will be to reassess and reduce the book of non-performing loans at the two large Cypriot banks – a crucial factor in finalising how much money Cyprus really needs.

Additional reporting by Robin Harding in Washington

Copyright The Financial Times Limited 2018. All rights reserved.