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The world won't end if banks get burned Add to ...

The world did not end in February when Danish regulators forced haircuts on senior bondholders of a small bank that had burnt through its capital and could not repay creditors. Nor should it as a result of the Irish government’s plans, revealed last week, to mete out similar treatment to bond investors in two defunct banks.

Having threatened for some time to “burn” senior creditors in Anglo Irish and Irish Nationwide (as well as push losses on to junior bondholders in other banks), the new Fine Gael-led government floated the idea of haircutting €3.6-billion of their senior unsecured debt. While controversial -- restructurings of such bonds are rare -- this did not dishonour the past guarantees that Ireland had extended to bank creditors because the bonds in question lay outside them.

What a pity, then, that Dublin has made the prospect of such a restructuring more remote by emphasizing that it would proceed only with the European Central Bank’s consent. If forthcoming at all, this will surely be long delayed.

It should not be. European policymakers have elevated to the status of a founding myth the idea that because Lehman Brothers nearly brought down the financial system, every bank is systemically significant and cannot be allowed to fail. This not only led to the egregious mistake of Irish taxpayers bailing out German, French and British investors in private Irish banks; it also continues to pile pressure on European bank regulators to fudge stress tests.

The Danish experience, where haircuts were forced on Amagerbanken without systemic mishap, should have shaken this faith. Some argue that this has no relevance for Ireland because Amagerbanken was tiny and Denmark is outside the euro zone. However, that in itself presupposes that markets can draw distinctions between institutions.

In one sense, contagion is inevitable. Bank funding costs rose pre-emptively when Dublin revealed its intention, and might stay higher were haircuts imposed. But this is not an argument for inertia. Bank funding costs previously enjoyed a subsidy that risks bankrupting states -- as Irish taxpayers know too well. Having banks pay the true cost of their risk is a benefit to society, not a harm.

Sometimes, in a crisis, guarantees are the only option; but they should be a last resort, given reluctantly and removed as soon as practicable. It is brave of the Irish to lead the way in the euro zone in letting the market do its work. But someone has to be first.

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