Strengthening the legal framework to manage an international financial failure does not make failures more likely.

The International Monetary Fund raised blood pressure, never mind eyebrows, with a suggestion in its December 2011 report on Greece that the government should consider retroactively writing collective action clauses (CACs) into its Greek law sovereign bonds issues. These would enable debt restructuring with the support of a majority of bondholders, without having to battle holdout investors through the courts.

CACs have been included in sovereign issuance by many emerging markets since a $1bn bond launched by Mexico in March 2003. In keeping with the ongoing global role reversal, they have not been included in the paperwork for developed market sovereign bonds, on the basis that the threat of restructuring was irrelevant.

The Mexico bond issue was a success, with investors not noticeably demanding a higher premium because they could be more easily subjected to a haircut. By contrast, analysts are already fretting that the IMF’s suggestion for Greece could be adopted by other eurozone sovereigns as well.

Unlike Mexico in 2003, Europe is overleveraged, and not just at the sovereign level. The painfully slow response to the unfolding sovereign crisis is partly driven by the fear that banks are not strong enough to survive potential haircuts. So be it. If we must choose between failed banks and failed states, the choice is obvious. Governments need a rule book that allows a rapid return to solvency, not years of paralysis.

And banks need to be allowed to fail without destroying people’s life savings. The UK has already unveiled proposals to resolve this dilemma at a national level. But one of the much-touted benefits of the euro was the development of large, cross-border banking groups. Philipp Hildebrand of the Swiss National Bank, and The Banker’s central bank governor of the year for Europe, warns that the absence of clear international agreements on orderly cross-border resolution is the hole that undermines the rest of the post-crisis regulatory regime.

That hole also opens the door to a triumph of nationalism over global financial stability during a crisis. International policy-makers should do everything they can to avoid massive financial failures. But they must also know what to do when such failures become unavoidable. This does not make failure more likely. On the contrary, the knowledge that there is a rule book on how to fail should deter investors from lending indiscriminately to governments or banks in the first place. 


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