Pros of debt haircuts
Save taxpayer money. Taxpayer funds can be replaced dollar for dollar by reductions in the amount of debt outstanding. A dollar of debt reduction increases the bank’s capital by a dollar, meaning the government needs to infuse that much less to achieve an acceptable capital ratio for the restructured bank. As noted, the volume of bank debt often exceeds the needed capital infusion and therefore could eliminate the need for taxpayer funds.
Give debtholders an incentive to monitor banks carefully in the future. Taking losses now, or seeing other investors do so, should make debt investors much more careful. They did not make a sufficient distinction in the past between banks that represented higher and lower risks, since they believed it was highly likely that the government would rescue any of the largest banks. This substantially reduced the signaling benefits that active investors can provide to the management and regulators of a large bank. Ideally, profit‐motivated investors would react to mistaken or risky management strategies by pushing down the market value of the debt and raising the interest rate on any new debt.
Encourage less debt leverage in the future. Reducing or eliminating the effect of perceived implicit federal guarantees should increase the interest rates charged by debt investors, especially for riskier banks. This should produce at least a marginal move towards less debt in the capital structure and more common stock, making the banks less risky.
It is fair that debtholders bear a cost they agreed to take. The debt contracts and insolvency laws clearly indicated that the debtholders could lose their money. Nor was there any explicit government guarantee. Some would argue that it is therefore only fair that the investors carry out their side of the bargain and take losses if the value of the bank falls far enough to wipe out the common and preferred stockholders.
Gain greater public support for the financial rescues. Many in the public, and in Congress, believe that the bank rescues have taken money out of the pockets of the taxpayer and handed it to “Wall Street.” Having investors share in the losses, while reducing the cost to taxpayers, would presumably broaden support for the efforts.
Cons of debt haircuts
Opponents of debt haircuts in the current crisis generally acknowledge the validity of most or all of the previous arguments and often strongly support finding a way to implement debt haircuts in future crises. However, they believe that several critical factors mean that such haircuts would do massive harm to a fragile financial system in the current environment.
Risk of a “run” on the other banks by creditors. If debt investors take losses on a nationalization, they and their peers will factor a substantially increased risk into their valuations of bank bonds. There would be a dual adjustment. Bonds would be riskier because the implicit federal guarantee has vanished and