Policy authorities in Europe are rushing to guarantee the creditors of the banking system. Retail deposit holders are effectively safe everywhere, whatever the letter of the deposit insurance laws and regulations. Wholesale deposit holders are not far behind. The Irish government now has guaranteed all owners of majority Irish-owned Irish banks’ debt.
This moral-hazard-race-to-the-bottom, a textbook example of dysfunctional beggar-thy-neighbour policy competiton, must end, as it creates the most awful incentives for future reckless lending and investment. The EU should focus on a common set of rules limiting government guarantees to retail investors only.
Mandatory debt-to-equity conversions for all holders of preferred stock, subordinated debt and all other forms of unsecured debt should be part of any scheme to save the institution and its retail savers. Unless the bond holders and other non-retail creditors get a serious haircut/pay a hefty charge in these bank rescue operations, the authorities will have achieved the worst possible combination of ex-post grotesque unfairness and ex-ante bad incentives for future financial misbehaviour.
