ECB Shows Signs of Bailout Flexibility

Ten days after becoming Irish finance minister last March, Michael Noonan spoke with Jean-Claude Trichet, then the chief at the European Central Bank, and told him what his Fine Gael party had been telling voters for weeks: the new government intended to force losses on holders of senior Irish bank debt.

Mario Draghi
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Mario Draghi

Mr. Noonan reasoned that private bond investors had made bad bets on Ireland’s most free-spending financial institutions, particularly the collapsed Anglo Irish Bank. Now that Irish taxpayers were left with the tab, those same investors should share the bailout’s burden.

Mr. Trichet was unmoved.

“He refused to allow any writedowns,” Mr. Noonan recalled during an Irish parliamentary hearing last month. “I had subsequent conversations with him... at which I repeated the request and he refused, for good and sufficient reason from his perspective, but not from mine.”

Nearly 16 months later, with Mario Draghi in the seat once occupied by Mr. Trichet, the ECB appears to be changing its tune. During a closed-door debate last week on a bailout of Spain’s banks, Mr. Draghi proposed exactly what Mr. Trichet had forbidden: forcing senior bondholders in failed Spanish banks to accept writedowns.

EU officials involved in the deliberations cautioned that the suggestion was rejected by euro zone finance ministers at the meeting and insisted that Mr. Draghi’s idea was part of a free-flowing debate rather than a firm policy proposal. “This was just an open discussion without operational results,” said one person involved in the talks.

The ECB declined to comment on Mr. Draghi’s intervention, which was first reported by the Wall Street Journal. “The ECB provides advice when requested,” it said. “The ECB’s advice aims to ensure that treatment of senior bondholders is in line with EU rules.”

Still, for an institution that has long resisted any leeway in paying private investors what they are owed—Mr. Trichet fiercely resisted Greece’s sovereign bond default last year, for example—Mr. Draghi’s change of heartis significant.

“Draghi is moving in the right direction, towards a proper resolution mechanism where everybody gets hit,” said Lucrezia Reichlin, a former ECB director of research. “This is very different from past policy and it is going to create market tensions if not managed properly.”

Since the crisis sent markets reeling two years ago, the ECB has insisted any sign euro zone leaders could renege on commitments to private investors would spread panic—a claim partially borne out in Greece, where public threats to default on sovereign debt spurred sell-offs in Irish and Portuguese bond markets. Once the default became a reality, Spain and Italybegan to teeter.

But under Mr. Draghi, the ECB has begun to relax some hard lines. Two weeks ago, in closed-door meetings on the sidelines of an EU summit, Jörg Asmussen, ECB executive board member, strongly supported a plan that could eventually shift some Irish bank debt off Dublin’s sovereign books—something the ECB had resisted for months.

Mr. Asmussen signaled the new pragmatic line as far back as April, when in a speech he argued the ECB’s hard-line 2011 positions were necessary during the hothouse market conditions at the time—clearly intimating Frankfurt was now willing to be more flexible.

The practical implications of the ECB’s shift may be minimal for now. Even if ministers were to accept the change for Spain, most Spanish banks will not be wound down—and those considered targets for closure are small with few senior bondholders left.

In addition, the European Commission has already proposed allowing collapsed banks to “bail in” senior bondholders by 2018; adopting Mr. Draghi’s new line would merely speed up the inevitable.

But if Mr. Draghi is willing to change course on a policy the ECB once held so firmly, analysts now wonder what other sacrosanct stands may become flexible in bailouts to come.

And for Ireland? In September, when Mr. Noonan made one final appeal to Mr. Trichet, there were 10.6 billion euros ($13.02 billion) still owed to senior bank debt holders; now there are just 160 million euros.

“At the very least, this is a significant evolution of the ECB’s position. And it is to be welcomed,” said Brian Lucey, a former Central Bank of Ireland economist. “Unfortunately, it’s too late for Ireland.”