WASHINGTON (REUTERS) - A proposal to impose a tax on bank deposits in Cyprus sets an "incredibly dangerous precedent" and undermines confidence built up in recent months over Europe's handling of its debt crisis, the head of a global banking association said on Monday.

Mr Tim Adams, managing director of the Institute of International Finance (IIF), said a weekend announcement that Cyprus would impose a one-off tax on bank accounts as part of a €10-billion (S$16 billion) bailout by the European Union had reignited concerns over the euro zone crisis.

Mr Adams told Reuters the announcement broke with practices that depositors' savings were guaranteed. Cyprus will vote on the decision on Tuesday.

"Crossing the Rubicon of addressing insured deposits and undermining the explicit guarantee - you can call it a tax or whatever you want - but essentially the broken guarantee opens up lots of different possibilities for destabilizing effects in the short term, medium term and long term," he said in an interview.

"The next time there is a crisis in any one of these countries, depositors are going to ask themselves, why am I going to stick around to see if the same set of rules are applied or not? I do think it is an incredibly dangerous precedent, without question," he added.

The IIF is the world's largest international lobbying group for financial firms, with more than 450 members. It was the lead negotiator for private-sector creditors during Greece's private debt write-down last year. It is not involved in the Cyprus negotiations.

Under a deal struck in Brussels on Saturday, bank deposits in Cyprus with less than €100,000 faced a levy of 6.7 per cent, ripping up the protection savers thought they enjoyed on insured deposits up to that level.

That plan sparked protests in Cyprus, and euro zone ministers issued a statement late on Monday, urging that smaller savers - those with less than €100,000 - should be allowed to escape the bank deposits levy.

Cyprus now is looking at tilting more of the tax towards those with deposits greater than €100,000, but Mr Adams said investors would be watching closely how the situation was handled.

He warned that savers in other larger European countries could become nervous and start withdrawing their money.

"It is the medium term that is concerning. What happens if we're back at Spain, Portugal or Italy at some point six months from now, and the same set of issues arise?" he said.

"There is less confidence and greater probability of instability because of this," added Adams, who served as a US Treasury undersecretary for international affairs during President George W. Bush's administration.