Every country has detailed procedures to govern private sector bankruptcy. These allow the residual assets of the insolvent company to be divided equitably between creditors. The insolvent party can begin again, reputation damaged but at least able to move forward with the slate wiped clean.

But there are two big gaps in coverage: these procedures don't work well for banks or nations which have become insolvent. Europe over the last few years illustrates how these two lacunae become entwined.

Why do banks present special problems? The central issue is that any whiff of failure leads to a bank run, with depositors trying the get their money out before the bank's doors close. A run on one bank sets off runs on other banks which might be intrinsically solvent but unable to liquidate enough assets to meet the sudden withdrawals. This contagion risks bringing down the entire banking system, and with it the payments system and credit provision, the life-blood of commerce.

Speed is of the essence in bank resolution. But how to sort out the conflicting claims? Until the 2008 financial crisis, there was a near-universal understanding that small and medium-sized depositors would get back all their money, guaranteed by the government. The bank's shareholders would take the main hit, with bigger depositors and bond-holders suffering a haircut (trimming the value of their asset) if there was still a shortfall.

When the Irish banking system imploded in 2008, this understanding changed: not only were depositors paid out by the government, but bond-holders were also. Many of these bond-holders were European banks. Rather than have them take a life-threatening hit, the EU offered Ireland a deal: a concessional loan to enable the Irish to repay the bond-holders.

This was only the start of the re-writing of the rules.

Greek banks are de facto insolvent, but are being held up by the EU rescue package and support from the European Central Bank. As with Ireland, not only are depositors safe (at least so far), but so too are bond-holders. Again, the generosity of the EU was in part a reflection of the huge losses French and German banks would take if Greek banks failed.

Cyprus represents a further variation on the break-down of old understandings. This time, at least in the initial format of the rescue, depositors (even small depositors) will take a haircut. There weren't enough bond-holders to absorb the size of the losses, but why not give the large depositors (who are rarely guaranteed in full, anywhere) a more substantial haircut, paying the small depositors in full? Again, international considerations seem to have been in play: many of these larger depositors are Russian. Big losses to depositors would put an end to Cyprus' role as a favoured tax-haven for rich Russians.

In each case, the knock-on effects of the need to keep the banks afloat has shifted the problem over to the government. The problem has been kicked down the road through EU/IMF rescue packages, but it is inevitable that there is more pain for creditors ahead.

In a normal domestic bankruptcy there would be some kind of stand-still which limits the creditors' ability to take legal action while an equitable arrangement is sorted out in the meantime. The Greek rescue allowed those whose bonds were maturing to get out at full value even though Greece's insolvency was apparent at the time. An equitable arrangement for remaining creditors still has to be worked out. If private creditors take a further haircut, why not the official creditors? If the ECB takes a haircut, why not the IMF? This is a slippery slope. At some stage, Greece and perhaps others among this group will have to be given an orderly restructuring that restores debt sustainability. But there is no internationally agreed process of sovereign debt restructure.

It's not as if sovereign defaults are rare, with Iceland and Argentina just a couple of recent examples. After the Asian crisis, Anne Krueger, then Deputy Managing Director at the IMF, made a valiant but ultimately futile effort to put in place agreed procedures covering just a few aspects of sovereign debt restructuring. 

The US gave no support, showing its usual disdain for multilateral rule-making. Many creditors thought they would do better with ad hoc arrangements, especially if the ad hocery forced bigger contributions from governments. Even among the potential defaulters there was no agreement on how generous the arrangements should be or on seemingly sensible matters such as collective action clauses. Resolution has been achieved in the past through the Paris Club, or through ad hoc efforts such as the Brady bonds for Latin America in the 1980s, or the negotiated rescheduling achieved by Uruguay in 2003.

This ad hocery, however, saps confidence which in turn undermines growth. We see the outcome in the case of Europe: successive market panics, with self-serving drama-queen creditors ready to warn of widespread contagion, thus putting more pressure on governments to offer more generous taxpayer support. With the Cyprus depositors' haircut, banking runs will now become more common. Recent US court cases relating the 2001 Argentinian rescheduling have undermined existing ground-rules. In short, there is a disconnect between the growth of global capital integration and the rules needed to make it work well.

Photo by Flickr user danielmoyle.