* Debt cycle poses systemic risks - German govt advisor
* Consumption must be cut to ease debt burden -Krahnen
* Debt investors need to shoulder risk
* EU, UK aid for Ireland sidestepping 'second bank bailout'
By Dave Graham
BERLIN, Nov 23 Caps must be set on the amount of
debt lenders can hold if European governments are serious about
ending what threatens to become a cycle of country bailouts to
rescue ailing banks, a German government advisor said on
Jan Pieter Krahnen, a professor of finance at the University
of Frankfurt, said in an interview with Reuters that a "vicious
circle" of banks loading up on risky debt may already have taken
root due to "non-existent but much-needed rules" on asset
As euro zone markets continued to slide on Tuesday on
mounting fiscal and political uncertainties focused on Ireland's
banking sector and bailout plans, Krahnen said that, because of
their importance to the financial system, banks would continue
to take excessive risks as long as they knew they would be
bailed out if necessary.
Banks and regulators have locked horns over implementation
of the Basel III framework of reforms designed to ensure lenders
have enough capital to withstand future downturns. Banks in
Europe say too much red tape will prevent them from providing
financing to companies, killing off a nascent economic recovery.
Krahnen said a big reason for a jump in banking risk was
that prices had been distorted by cheap money from central
"When spreads on debt start to rise because default becomes
more likely, the only institution likely to be interested in
buying this type of debt are banks," he said.
"Why? Because banks are a safe haven for such debt since
theirs will most likely be redeemed."
This is because banks are part of "the systemic risk
scenario," said Krahnen, who sits on a panel chaired by former
European Central Bank chief economist Otmar Issing that advises
Chancellor Angela Merkel on financial reform.
"The governments are caught in this cycle and now they must
find a way out," he added. "I don't think our political systems
will be stable for long periods if we don't break the cycle.
"The only way to achieve that is to let investors know --
debt investors in particular -- that they will not be safe.
"However, this debt migration will always occur unless we
impose some limits on the debt banks acquire. They must be
restricted in how much they hold of other banks' liabilities."
By helping Dublin, euro zone states and Britain -- whose
banks have considerable exposure to Ireland -- were avoiding
having to carry out a "second domestic bank bailout", he said.
'CRAZY' BOND BUYING SCHEME
The need to make investors liable for their actions probably
helped explain Germany's insistence that private bondholders be
included in a revamped euro rescue shield due to replace an
existing mechanism in mid-2013, Krahnen said.
"The dilemma is that while they're coming up with a
protection scheme, banks are trying to be as profitable as
possible. An easy way to be profitable is to buy government
bonds and refinance with cheap government or ECB money.
"The issuers of these bonds can continue to issue, and the
banks buy it and make a profit and the whole bill is eventually
paid by 'the taxpayer'," he said. "It's a really crazy scheme."
In the end, everyone foots the bill, Krahnen said.
"If the hit is taken by the taxpayer, the bondholder, the
shareholder and the worker don't change their behaviour because
it's mentally booked on another account.
"But what we call the taxpayer is also the bondholder, the
shareholder or the worker. They're basically the same people."
Today's financial system is still choked by too much debt
and only by cutting consumption can the tide be turned, he said.
"We have been overplaying the debt game for many years, and
overplaying the debt game means over-consuming. At some point
the bill has to be paid," Krahnen added.
Other banking bailouts were likely elsewhere in Europe
because of the amount of risky debt lenders held, he added.
Spreads suggested markets expected Ireland and Greece's
existing bonds would receive haircuts, or valuation discounts,
They also suggested that Greece, which has already slashed
spending so as to receive European aid, would not be solvent
when the current rescue mechanism ends in mid-2013, he added.
"The real political dilemma is when the 'bail-in' policy
becomes effective," he said. "Too early and it will increase
market turmoil, too late and it will ruin government budgets."
(Editing by John Stonestreet)
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Keywords: EUROZONE GERMANY DEBT/
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