* 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 Tuesday.
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 holdings.
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. [ID:nLDE6AI0XL]
Krahnen said a big reason for a jump in banking risk was that prices had been distorted by cheap money from central banks.
"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, Krahnen said.
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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