While the attention of bond investors has been focused on Ireland’s efforts to bail out its ailing banks, Germany has been quietly forging ahead with plans that could have far wider consequences for the industry.

The Bundesrat, the German parliament’s upper house, is expected on Friday to pass radical bank restructuring laws that will include one of the first examples of a so-called “bail-in”, a scheme to ensure that creditors take losses when a bank is failing, rather than the state.

The new rules would mean bondholders, even those ranked at the top of a bank’s capital structure, could be forced to swap some of their investment for equity and potentially suffer big losses to help rescue a bank before taxpayers are called upon.

The controversial idea has become increasingly popular among European policymakers doubtful about the ability of cross-border mechanisms to deal swiftly with ailing banks. They expect countries to remain largely responsible for their own rescues.

Banks fear the proposals could push up funding costs. But some regulators and central bankers hope it will lead to more market discipline when it comes to pricing risk. As one financial lawyer puts it: “Part of the game of being a central banker is to try to convince people that there is moral hazard. You need to be able to say credibly ‘I can fix this bank and you’ll be stuffed. So please price and assess credit accordingly’.”

Germany’s new law, which includes setting up a rescue fund by levying an annual charge on banks, envisages several stages of bank intervention.

The first level of restructuring would be instituted by a bank itself. It would involve the bank being reorganised under the supervision of an administrator, similar to what happens under the US Chapter 11 bankruptcy procedure. New capital could be injected and its providers would outrank existing debtholders.

More radical action could involve debt-to-equity swaps and special resolution powers. This would allow Germany’s financial regulator, BaFin, to move assets to a new ”good bank” that can then be sold, leaving bondholders’ claims with the “bad bank”.

When that is wound up, bondholders would receive whatever is left.

“It remains to be seen how much the first restructuring mechanism will be used,” says Dennis Heuer, a partner at White & Case in Frankfurt. “Probably troubled banks that qualify go straight to the higher level of intervention that will allow debt-to-equity swaps and the like.”

But, as support for bail-ins has been gaining among regulators, so investor unease has been mounting. Bankers in the debt capital markets are also privately voicing concerns about the impact that the threat of bail-ins would have on the funding ability and costs of banks based in countries with these powers.

“If you leave it to regulators and management to decide on a bail-in, then they’re always going to do it too early,” says Hugh Savill, acting director of investment affairs at the Association of British Insurers. “From a manager’s point of view it is cheap equity, and from a regulator’s, they’ll do anything to prevent failure.”

In essence, bail-ins are a back-to-front form of the carrot-and-stick talks with bondholders that are typical for any distressed company.

Usually a company negotiates with its investors. Ireland, for example, in its efforts to recapitalise Anglo Irish Bank, has been negotiating to try to force losses on the bank’s junior bondholders, who are fighting the plans. Under bail-ins, those losses would be imposed immediately by the regulator.

In Germany, this would be done through creditor groups, who need to approve any bail-in measures. If necessary, a court could impose a solution so long as it leaves creditors no worse off than they would be without a restructuring.

“The big stick is the banking act and authorities’ power to involuntarily transfer assets and liabilities. The carrot is that if creditors agree to a voluntary restructuring, the transfer won’t happen,” says Kai Schaffelhuber, a partner in Allen & Overy’s German practice.

The biggest attraction of a bail-in is that it could, in theory, be triggered over a weekend, leaving a bank ready to open the following Monday, albeit with liquidity provided by a central bank.

The Association for the Financial Markets in Europe, an industry group which has supported the idea of the bail-in, has published details of an example based on Lehman Brothers [see graphic] that would have left the US bank with capital far in excess of its peers’.

This would have involved wiping out shareholders and converting subordinated bonds and preferred shares into new equity.

Senior bondholders, the largest group, would have seen only up to 15 per cent of their holdings converted.

Those wary of bail-ins question whether any system could work so cleanly given the speed of banking collapses and the dependence of banks on the financial markets’ confidence in them to operate.

“It’s almost certainly impossible to fully analyse even a medium-sized bank over a weekend,” says Simon Gleeson, partner at Clifford Chance.

“That leaves you with two options. Either the government undertakes to compensate if it gets it wrong and short-changes a group of creditors, or it decides it cannot do anything until it has completed its analysis,” he says. “And, in the aftermath of Lehman, we all know what time delays do to the markets.”

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