The Cyprus banking crisis underscores the crucial need for Europe to put standardized rules in place for the protection of insured depositors.

By Sheila Bair

FORTUNE -- In Greek mythology, Cyprus was the birthplace of Aphrodite, the Goddess of Love, and surrogate mother of Adonis, the God of Desire, who was an avid hunter. A typical overbearing mother, Aphrodite warned Adonis never to hunt an animal that showed no fear. A a typical know-it-all son, Adonis ignored his mother's warning. He pursued an enormous (and fearless) boar. But the hunter quickly became the hunted, and he was brutally killed by the wild animal.

Up until Monday morning of this week, bank depositors in the troubled Eurozone were looking as fearless as the boar. They were keeping faith in their national deposit insurance schemes, even in southern European countries with significant fiscal problems. Though last summer, there had been a spate of "bank trots" in Spain, Greece, and Italy, for the most part depositors seemed to trust the legal commitments their sovereigns had given them to protect their savings. They stayed put.

In fact, the surprising confidence bank depositors exhibited in national deposit insurance schemes slowed momentum to create a central deposit guarantee system (DGS) in the Eurozone to provide consistent coverage with the collective backing of all Eurozone countries. Progress on creating a single resolution mechanism for handling failing banks also slowed down.

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But then government officials in Cyprus, a tiny country with big banking problems, decided to hunt the boar, going after depositors below the 100,000 Euro deposit limit with a 6.75% "assessment" to help bailout their troubled banking industry. This was apparently done to reduce haircuts on large depositors who exceeded the limit, many of whom are reported to be rich Russians who use Cyprus banks to avoid paying taxes.

The boar charged. Street protests ensued and markets dropped, amid widespread speculation that this proposal would shake confidence in deposit insurance systems throughout southern Europe and beyond, precipitating massive bank runs. Unlike Adonis, the Cyprus parliament had the wisdom to retreat quickly and rejected the plan.

Those involved in concocting this fiasco included the IMF and European finance ministers. What in the world were they thinking? If there has been one constant throughout the financial crisis and its aftermath, it is that imposing losses on insured depositors was off-limits. Unfortunately, the Armani suits and dresses around the Cyprus bailout negotiating table lost all perspective when it came to protecting the backbone of any banking system--household depositors.

Elites in the financial media sniveled that it shouldn't be a big deal that some of the little folk had to pay. Some actually hinted that it might be a good thing. Maybe those schoolteachers and policemen would learn a thing or two by taking losses on their bank accounts and start exercising a little market discipline in deciding where to deposit their money. Instead of relying on deposit insurance schemes, they should be going home at night and downloading and analyzing banks financial reports. (Curiously, they didn't seem too bothered by the bailout of institutional bondholders who presumably are a little better equipped to evaluate bank balance sheets.)

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Appeased, the boar has retreated. The markets have calmed down a bit, pending Cyprus' next move, and protesting depositors have returned to their homes. But this never should have happened. It only underscores the crucial need for Europe to put standardized rules in place for the protection of insured depositors and the allocation of losses for their troubled banks.

A claims priority is not hard to construct. Here's how we do it in the US: equity gets wiped out first, followed by junior debt, senior debt, and deposits above the insurance limits. Insured depositors always get paid with losses covered out of reserves built from insurance premiums paid by the industry. We don't protect bondholders for two very good reasons: 1) there is no insurance program for them and they shouldn't get a free ride and 2) they are mostly sophisticated institutions that should be exercising market discipline and analyzing a bank's health before deciding to buy its debt. Whether this priority makes sense for Europe is something Europe can decide for itself. The important thing is to decide. The ad hoc way Europeans are making decisions is creating unfairness and uncertainty in the way bank creditors are treated and impeding their banking system's recovery.

And for heaven's sake, would Europe please create a strong, centralized deposit insurance authority to stand up for household depositors the next time some blockhead decides they might be an easy, economically vulnerable target when putting a bailout package together? There is a reason that the U.S. hasn't suffered a bank run since the Great Depression and it is called the Federal Deposit Insurance Corporation. Europe needs an FDIC, and they need it badly.