Colm McCarthy explains what is happening in plain language (Sunday Independent – prescis)

The Irish resort to external official bailout was not due to budgetary indiscipline but rather to an extraordinary bank credit bubble undetected by either domestic supervisors or the European Central Bank. This has exposed a fundamental flaw in the design of the eurozone, namely the absence of centralised bank supervision.

The emergence of a fully integrated European money market, free of exchange rate risk, in a world awash with cheap credit, exposed weaknesses in bank supervision in many countries. Under the eurozone as designed, the detection of problems in the banks, and their rectification once detected, was left to the member states. This has turned out to have been a disaster for Ireland, since the Central Bank and Financial Regulator failed to spot the bubble, failed to do anything about it and then compounded these errors by misleading the Government as to the scale of the problem once the bubble burst. The result was the ill-advised blanket guarantee of bank liabilities which led directly to the loss of the State’s access to credit.

In the euro area, each member state must supervise its own banks (which the Irish certainly failed to do) but must then, it would appear, ensure, at the cost of each country’s taxpayers, that bank creditors are made good without apparent limit. The result of this doctrine, pursued doggedly thus far by the European Central Bank, is that European financial institutions which lent to non-sovereign entities in Ireland will now be made whole by Irish taxpayers, creating an enormous international fiscal transfer. It is entirely likely that the No-Bondholder-Left-Behind policy so beloved of the ECB will involve transfers out of the Irish Exchequer and into other European countries exceeding comfortably the accumulated discretionary transfers into Ireland since the country joined the EU back in 1973.

The latest episode in the AIB saga played out in the High Court and it is clear that substantial further capital injections may be needed. But I hope it is sobering for the ECB to reflect that this is the same AIB which, in the summer, passed a stress test that was more stringent than the ECB’s much-vaunted test across the European banking system, which several banks failed. Let’s be clear about this. There is to be a further round of stress tests in the New Year. If these tests are done properly this time, lots more banks will fail. The reason is that asset quality was not assessed harshly enough last time round and the ECB has lost further credibility with the markets.

The Irish bank stress tests have been less indulgent of the banks than the ECB version, the Irish banks have experienced severe outflows of deposit resources and have had to resort to liquidity support from the ECB. This is the next serious design flaw in the euro system, the ambiguous remit of the European Central Bank as lender of last resort to distressed banks.

RESOLVING BANKING CRISES

The textbook procedure in resolving a banking crisis is to quantify the losses rigorously and then get the pain distributed as quickly as possible. If banks have made disastrous loans on a large scale, then bank shareholders need to get hit, followed by bank bondholders, followed by unguaranteed depositors if there be any such.

In Europe, the political leadership, particularly the German chancellor, appears happy to contemplate default on sovereign bonds yet to be issued while protecting bank bondholders to a degree which may force some countries into defaulting on sovereign bonds already issued. Why should those who lent to governments be put at risk to protect those who lent to incompetently managed banks?

BANK BOND HOLDERS MUST HAVE INVESTMENTS DEVALUED

Should the sovereign bond crisis spread to Portugal and Spain in the New Year, these issues can no longer be ducked, and it will be time to bite the bullet and make bank bondholders accept haircuts, as they have had to do in similar situations before.