An alternative to bailing out all bank creditors – a form of bailing them in – needs to be looked at, writes JOHN McHALE

IN A week of dizzying revelations one dividing line in the debate has crystallised – should the creditors of failing banks be bailed out or should they be bailed in?

The bailout option – the Government’s chosen course – has taxpayers provide necessary funds to ensure all bank creditors are paid back. The other option – supported with nuances by opposition parties – has creditors share in bank losses using new resolution tools for failing institutions. While it is easy to caricature either option, it is critical to examine each on merit.

It is important to be clear about what is not being debated. No credible person is advocating reneging on explicit guarantees to creditors; at issue instead is what to do when existing guarantees expire. Nor are there serious arguments for imposing losses on ordinary depositors or on secured creditors such as the European Central Bank (ECB) on their liquidity support to Irish banks.

Two main rationales have been offered for giving loss protection to all creditors. The first is the risk of contagion to future bank and sovereign borrowing. It is feared international bond investors will not buy future issues of Irish bonds because of losses incurred in the past. This presumes curiously backward-looking or grudge-holding investors.

It also takes the questionable position the creditors will feel seriously aggrieved if they do not receive a State bailout on what were investments in private companies.

More than most, professional investors are inclined to let bygones be bygones as they search for the next buck. What matters to them is future creditworthiness.

Prof Patrick Honohan put it well on IrishEconomy.ie back in May – four months before he became governor of the Central Bank: “Mature reflection by the financial markets would recognise that a country honouring its debts and guarantees to the letter – and not beyond – was more creditworthy than one which handed over money lightly to unguaranteed risk investors.”

As always in financial crises, investors will claim they had an implicit guarantee that the Government would protect them. Their cries should be treated with scepticism.

Yet the Government seems convinced it must affirm this guarantee with a bailout in order to protect its access to financial markets. If a guarantee is essential to securing funding in the future, then it should be explicit and prospective.

The current strategy of doing whatever is necessary to maintain a 100-per-cent credible implicit guarantee to bail out private creditors is unnecessarily costly.

The second rationale for a bailout is that imposing losses will impair the balance sheets of other institutions and individuals. This fear is partly driven by a false analogy with Lehman Brothers.

Lehmans was densely entwined in the US and global financial systems. Its failure led to widespread fears that other institutions would not be able to meet their obligations. The result was a generalised liquidity crisis.

Ireland became enmeshed in the resulting freeze-up of the financial system and responded with the blanket guarantee of bank liabilities. With hindsight it is now obvious that Anglo should not have been included. However, one has to sympathise with the Government given the extreme uncertainty and speed of events.

The situation is quite different now. Although the authorities have been less than forthcoming about the identity of creditors, we are dealing now with more run-of- the-mill cases of bank impairment.

The Government might sympathise with investors who seriously underestimated the risks they were taking when investing in bank debt. However, unless the Government plans to protect all investors in financial products, then taxpayers should not feel obliged to bail out these particular investors.

How would the bail-in alternative work? A critical element is that the Government puts in place an American or UK-style special resolution regime (SRR) for failing banks. This regime should be ready to go when the existing guarantee expires and would affect unguaranteed bondholders whose bonds have yet to mature.

The SRR would provide options for a bank to seamlessly continue in operation under new ownership (eg, AIB or Bank of Ireland) or for a gradual winding down (eg, Anglo or Irish Nationwide).

If a bank cannot meet specified capital adequacy requirements on its own, it should be resolved in a manner that is least costly to the taxpayer, while also ensuring that all creditors do at least as well as under a normal bankruptcy procedure. One option would be for bondholders to become owners of a now well-capitalised bank through a debt-equity swap.

The regime should also allow for the clear protection for depositors and secured creditors such as the ECB. In a wind-down scenario, unprotected creditors should bear losses before any burden is placed on the taxpayer.

The Government holds the genuine belief that there is no alternative to a bailout of bank creditors – however distasteful.

Many independent economists believe that a bail-in approach is feasible and would save billions for the taxpayer. With much capital yet to be committed, it is not too late to achieve a fairer and more effective sharing of the burden of bank losses.

John McHale is a professor at the JE Cairnes School of Business and Economics at NUIG