Analysis: Forcing 'haircuts' on Irish bank senior debt could cause bank run

Political risk calculations hanging over Irish bond markets have been complicated by statements by key leaders of the Fine Gael party that senior debt-holders will also have to bear losses in a possible restructuring of the bank debt after the new government comes in.

Speculation has been growing that the next Irish Government will attempt to restructure some of the nationalized banks’ senior debt. So far only subordinated debt holders have had to undergo 'haircuts', or suffer losses, while senior debt-holders have been spared.

However, if the Fine Gael party emerges as a key partner in a coalition government, chances of which are high, the senior debt-holders will have to make sacrifices as the new government goes ahead with a bank debt restructuring.

The move has obviously caused jitters in the bond markets. However, there are analysts who think a move to make senior debt holders -- who hold a more protected form of debt -- will be counter-productive in many ways though it will be popular with taxpayers.

First, it could increase the chances of a bank run. When a bank runs into trouble, senior debt holders normally receive the same level of protection as depositors, says Ben May, European economist at Capital Economics. Accordingly, if senior bondholders faced haircuts, depositors might become worried that they could also lose money held in the affected banks.

Secondly, if investors feared that restructurings could happen again in the future, the whole banking system may find it more costly and difficult to issue senior debt, says May. In a worst case scenario, then,
imposing haircuts might lead taxpayers to have to pump more, not less, money into the banking sector.

The move will also likely damage European relations as the European Central Bank has already made it clear earlier that such a move could make it increasingly difficult for some banks elsewhere in the region to access capital markets. Given that Ireland’s banks remain heavily reliant on the ECB for funding, the Government may be reluctant to go against the ECB’s wishes, said May.

Forcing senior bond holders to shoulder the cost of recapitalizing the banks a reasonably unprecedented step, says May. He points out that the Icelandic Government is the only OECD government to have allowed a major bank to default on senior debt.

Ireland has already spent billions of dollars to recapitalize the banking system that bit the dust in the aftermath of the financial crisis.