Denmark could teach Ireland a lesson

 
Allister Heath
SO Ireland’s banks need another €24bn if they are to become strong enough to withstand another shock. It is a fiscal catastrophe of immense proportions to which the European establishment doesn’t seem to have much of an answer, at least not right now. But if you want to see how to really deal with troubled banks, don’t waste your time getting to grips with the Irish fiasco – go to Denmark, which has emerged as a (relative) oasis of common sense in a world that has largely taken leave of its senses.

The authorities there have done the sensible thing: rather than assuming that a bank’s bondholders are sacred and should always be bailed out, for fear of frightening the horses, they imposed a 41 per cent haircut on the unsecured senior bonds of Amagerbanken, a regional lender. That bank had made stupid investments and failed in February. Rightly, it wasn’t just the shareholders who paid the price – it was also the bondholders, who lost a large chunk of their investments. As a result, Moody’s cut its credit ratings on a range of Denmark-based lenders, which means much of the sector will have to pay higher interest rates to borrow – but such is life. It is right that an increased rate of default be priced in: it is not the state’s role to endlessly bail out the financial system. The Danish authorities have emerged as key proponents of this more rational approach and have even written to the European authorities, urging them to be harsher on senior bondholders.

Debt write-offs must be conducted in a calm and controlled manner. We can’t go overnight from a position where all financial debt is guaranteed by the state to one where none is. But as a first step smaller, non-systemic countries such as Portugal, as well as smaller financial institutions everywhere, shouldn’t be bailed out at all.

As a second step, special bankruptcy and resolution schemes must be introduced for the largest institutions. These would allow a controlled wind-down of bust banks: they could be dismantled without endangering the economy. Traditional bankruptcy regimes are fine for most firms but not for systemically important ones such as giant universal banks; utilities (including nuclear power plants) and large airports which are already governed by special rules. Speaking earlier this week, Bob Diamond, Barclays’ boss, said that his own firm’s living will –?and hence ability to be wound down in an orderly fashion in the event of failure –?is nearing completion. This is excellent news: most commentators don’t realise just how far down that road many big banks have already moved, in Europe as well as the US.

But there is one big danger facing the financial system, and that is the regulatory requirement for banks and insurance firms to own sovereign debt. Fortunately, the UK government remains solvent, unlike Portugal. But the fact that UK banks and building societies bought £29.6bn worth of gilts between November and February, equivalent to 84 per cent of net gilt issuance, is unhealthy. Banks are quietly delivering the QE2 stimulus sought by some. That may be fine in the case of the UK, where the risk of default is low – but the fact that European financial companies have been encouraged or forced to hold vast amounts of dodgy local sovereign debt could destroy other European economies. Bail-outs must end – but so should stupid regulations that pretend that nations can never go bust. allister.heath@cityam.com

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