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Allow Bad Cyprus Banks to Fail, Restructure: Banking Expert

Cash-strapped banks in Cyprus should be allowed to fail, Adam Lerrick of the American Enterprise Institute told CNBC on Thursday.

Lerrick, a banking expert who was in Cyprus to speak at a conference, told "Squawk Box" he would recommend an orderly restructuring of the troubled banks.

"The banks would be closed for two days," he said. "What would come out is when they reopen … The small depositors would be fully protected. The large depositors would be the owners of a bank."

"The banks [there] would be solvent," he continued. "The banks could be highly capitalized and they would then have access to the ECB for refinancing to provide any liquidity."

The European Central Bank has set a Monday deadline for Cyprus to agree to a bailout plan, threatening to cut off funding to its banks.

(Read More: ECB to Cyprus: You Have Four Days to Strike a Deal)

Cyprus has faced the prospect of bankruptcy since Tuesday when its parliament voted unanimously against a levy on bank deposits to raise $7.51 billion demanded by the European Union under a $12 billion rescue plan.

(Read More: Blackmailed' by EU: EX-Cypriot Central Banker)

Cypriots line up at the ATM to withdraw their savings in the midst of the banking crisis in Nicosia, Cyprus.
Michelle Caruso-Cabrera | CNBC
Cypriots line up at the ATM to withdraw their savings in the midst of the banking crisis in Nicosia, Cyprus.

With the banks in Cyprus closed through the end of the week, people there are lining up at cash machines to try to get money. CNBC's Chief International Correspondent Michelle Caruso-Cabrera is on the ground in in Nicosia, the capital of Cyprus, and described the frustration of the people on the long lines.

"They are desperate and very angry and they are frightened and they can't believe they're living through this situation. The reason they're living through this situation is something has to be decided and very, very soon about what they're going to do in order to raise capital to bail out two bad banks that they have here."

As for reaction in the financial markets, Lerrick, a former investment banker, said, "The market doesn't care. Cyprus is a tiny economy. Its banks are not highly connected with the rest of the international financial system. There is no risk of contagion here."

Meanwhile, the Dutch finance minister and new head of the Eurogroup of finance ministers, Jeroen Dijsselbloem, told CNBC that he was confident an agreement could be found over Cyprus, but Russia might not be the source of the solution.

(Read More: Russia Aid Not Likely for Cyprus: Eurogroup Chief)

Cyprus is in talks with Russia—whose businesses and citizens make up an estimated 20 percent of all depositors there—about extending an existing $3.3 billion loan and getting $6.5 billion in new aid, but Dijsselbloem was not optimistic that Cyprus would get the aid.

Dijsselbloem insisted that Cyprus would have to contribute to the bailout for it to work.

By CNBC's Matthew J. Belvedere; Follow him on Twitter @Matt_SquawkCNBC