Law 'must mind depositors, not bondholders'
THE law should be changed to guarantee bank deposits without guaranteeing a bank's senior bondholders, Prof John McHale told the Kenmare Conference yesterday.
Irish law currently ranks money held on deposit equally to bonds -- a rule that forced the Government to guarantee both bank deposits and most lending to banks two years ago.
Depositors are ranked higher than all bond holders in the United States and many other countries, which makes it much cheaper and easier to bail out banks in those countries. Changes to the law could be imposed retrospectively, Prof McHale added.
"The classic reason for protecting depositors is not that it would be unfair to make them bear losses, but rather it is to minimise the risk of a bank run," he said. "This does not apply to longer-maturity bondholders. The primary reason for protecting depositors is not fairness but financial stability."
Prof McHale said the blanket guarantee given by Finance Minister Brian Lenihan to bank depositors and creditors was an "overreaction". Despite this, the Galway academic said the Government should guarantee new lending by banks to ensure that money is lent to businesses and individuals.
Mr Lenihan and his advisers failed to understand that the banking crisis was a solvency crisis rather than a liquidity crisis, he added.
The guarantee would have worked if there had been a temporary liquidity crisis, but was too generous in the event of a solvency crisis because it prevented the Government from sharing the cost of the crisis with creditors. Guarantees stop banks from taking responsibility for their actions but should not be removed for the time being, he added.
The reason for this is that an unofficial or implicit guarantee will exist regardless of whether there is an official or explicit guarantee. For this reason the State is better off if it retains the guarantee and charges banks rather than operating an unofficial guarantee and earning no income.
"I think that on balance it is wise to keep the explicit guarantee in place for as long as necessary," he said.
"An explicit guarantee at least has the advantage that the Government can charge for the insurance it provides."
Prof McHale added that he also believed the Government was right to avoid nationalising the two main banks.
He said the effort required to create the National Asset Management Agency was so great that regulators and civil servants had been unable to complete other vital work, such as drawing up legislation to govern bank failures. In the absence of such legislation, often called a special resolution regime, the Government should now consider adopting a version of the legislation passed in Britain to manage any future bank collapses.
Prof McHale warned that regulation of the banks may soon be too tough at a time when banks are reluctant to lend anyway.
"During the boom phase [the banks] clearly embraced risk recklessly, but now may have swung to the opposite of extreme risk aversion," he said.
"Is the Financial Regulator piling on [pressure] just when the propensity of bankers to show insufficient caution is least likely to be a problem?" he added.
The regulator should instead consider new measures that punish banks for losses caused by the banks' reluctance to crystallise losses, but the regulator should not punish banks for any losses linked to lending, he added.