Both the Irish bank liability guarantee (instituted in September 2008 and likely to be renewed) and the asset purchase scheme (likely in place soon via NAMA) have been controversial, and their strengths and weaknesses have been widely debated. Less attention has been paid to the powerful interactions between these two schemes. If both schemes go ahead, perhaps these powerful interactions could serve to improve overall cost-efficiency and policy effectiveness.
I want to make an argument which does not lean too heavily on particular parameter values but instead relies on basic ideas from applied economic theory. Suppose for simplicity that the economy (and therefore taxpayers) would be badly hit by removing the bank guarantee, and the banks would suffer devastating bank runs. Hence both parties (taxpayers and bank management) benefit substantially from having the guarantee in place. The payoff matrix is one-sided with both parties benefitting from instituting the guarantee:
Taxpayers Bank Managers
Liability guarantee + +
No Liability guarantee – –
Obviously the two parties will agree to institute the bank liability guarantee. The bank managers may succeed in bargaining for underpricing the liability insurance, particularly if there are only a few dominant banks in the economy so that each dominant bank has bargaining power against the taxpayers. The banks’ off-equilibrium threat not to participate in the programme unless the insurance is under-priced is not credible, but the bargaining solution in terms of insurance price is not determinate.
Next, the taxpayers propose an asset purchase scheme to the banks. The ordering of the two steps is important (first the guarantee, then the asset purchase proposal). Since the liability guarantee is in place, the banks can bargain very hard over the terms of the asset purchase. The banks hold a potentially enormous put option on their net value, with the put option issued by the taxpayer via the liability guarantee. This gives the banks the power to bargain hard over the asset purchase scheme pricing, and credibly threaten to drop out of the asset purchase scheme if it is priced fairly (since much of the fair value of the scheme accrues to the taxpayers via their put option liability). The banks can bargain hard, by threatening to waste taxpayer funds (in the form of the written put option). Getting them to participate requires excessive valuation, not fair valuation.
An obvious improvement in the two schemes is to tie them together. Banks should be eligible to participate in the renewed liability guarantee only if they accept the asset purchase programme with fair-valued (not over-valued) pricing. This could save billions in the pricing of the asset purchase scheme, and ensure ready acceptance by the banks. In the cut-and-thrust politics of current NAMA debate, this note may seem academic, but I argue that the point is valid and might even be helpful.
 I have been reading a lot of Ken Rogoff recently. See, e.g., This Time Is Different by Carmen Reinhart and Kenneth Rogoff, Princeton University Press.