By Tony Connelly, Europe Editor, Brussels

In Ireland we know only too well the cost of burdening the taxpayer with the fallout from a collapsing bank.

The sins of the financial sector placed a €64 billion weight on the shoulders of current and future generations.

Under Ireland’s presidency of the EU the issue of how to avoid a repeat of that in the future will dominate the remaining six weeks.

It’s called bailing in, as opposed to bailing out, and it’s all about how creditors – and not taxpayers – should absorb the losses from a bank collapse.

But there are significant divisions over how it should be done, and how much discretion member states should have.

The Cyprus debacle, where depositors and bondholders were all forced to take a hit and where controls were imposed to prevent a capital flight in the teeth of an EU-IMF rescue, provided a real world and brutal example of the painful issues involved.

The cack-handed way it was done was destabilising for the Cypriot banking sector but also for the eurozone as a whole.

At the time the concept of hitting depositors seemed an anathema and triggered bitter recriminations in both Cyprus, and in Russia where most of the country’s depositors hailed from.

Now it looks like the principle of hitting uninsured depositors has been conceded when it comes to future EU bank restructuring.

The hope is, however, that a clear set of rules would avoid such destabilisation in the first place, even if creditors taking a hit is still painful.

But a system that is poorly conceived could trigger bank runs, even against banks that might otherwise be viable.

Ultimately the question of how to deal with failing banks – known as “recovery and resolution” according to the jargon – will be a key pillar of the banking union that Europe is now embarked on.

At present 27 member states have different methods of winding down a stricken bank (some indeed barely have methods).

The only thing member states have in common is that bank deposits under €100,000 are guaranteed by the state (in Cyprus those deposits were dramatically subject to a new levy, and the levy was then just as suddenly withdrawn).

Under a European Commission proposal published in 2011 an effort has been made to ensure that there is, at least, a harmonised approach across Europe to winding down a bank.

It has now fallen to the Irish presidency to bring that proposal to a conclusion by the end of June.

Irish officials will try to win agreement among 27 member states over what kind of hierarchy or pecking order should be in place to clarify which creditors take the greater hit in the event of a bank collapsing.

They will also need to get agreement on how banks are wound down, namely, how the good parts of a bank can be recovered, and the toxic loans hived off into a bad bank.

Finally, agreement is needed on how each member state should build up a fund, made up by contributions from the financial sector, which will be able to cover losses and depositors where appropriate.

The aspiration is that once harmonised rules are in place at national level, a Europe-wide mechanism, or agency, will – in the longer term – manage and contain bank recovery and resolution instances (ie, the winding up of banks) into the future.

Since the ECB will, from the summer of 2014, have the power to supervise a majority of Europe’s banks, it logically follows, say the architects of the banking union, that a clear pathway should be in place to wind up any banks that Frankfurt deems as failing.

How will it work?

At the outset the commission’s proposal did not specify which creditors should suffer the most in the event of a bank collapse, leaving open the possibility that all depositors – insured and uninsured – might be vulnerable.

But since the Cyprus debacle the commission has since inserted the idea of a US-style “depositor preference” structure.

According to Irish presidency sources there is now “a growing view, but not a clear cut majority view” that uninsured depositors (eg, the kind that were eventually hit for a bank levy in Cyprus) would be the last in line to take a hit.

In other words, according to the pecking order envisaged, in the event of a bank collapse, shareholders would be the first to lose, unsecured and secured bondholders would be next, and finally uninsured depositors.

Uninsured depositors are those whose deposits are over €100,000 (anyone who has a deposit under €100,000 is, of course, protected by the state guarantee which prevails in all 27 member states).

Knowing they were last in line to take a hit might ensure more stability for that country’s banking sector.

However, according to reports, Denmark, the Netherlands and Finland would prefer not to give uninsured depositors preferential treatment, while Spain wants those depositors to be untouched altogether.

Officials insist that even if it came to it, uninsured deposit holders would not lose that much since by the time the other categories of creditors had taken a hit, most of the banks losses would have been covered.

The Irish presidency is keen to get overall agreement by the end of June and to convince the majority of member states of the benefits of leaving unsecured depositors last.

“I would like to enhance the position of depositors,” said the Minister for Finance Michael Noonan in Brussels on Monday.

“I would like the political agreement that the €100,000 deposit was sacrosanct into the future and this would be eventually written in stone as part of any bail in procedure.”

He added:  “Secondly we’d like to get agreement for a deposit preference above that level.”

Mr Noonan referred to the legal position in Ireland when Brian Lenihan was still alive.

At the time Mr Lenihan told the Dáil that depositors and senior bondholders were prone to the same level of vulnerability. Now the Irish presidency is pushing a solution where uninsured deposit holders are behind senior bondholders when taking a hit.

“We’d like to change that so that depositors over €100,000 would be on a lower legal line,” Mr Noonan said.

The Irish presidency has been examining some loopholes. Deposits over €100,000 which have been lodged by SMEs could, for example, be exempt from the bail-in, as could individuals who have uninsured deposits (a deposit over €100,000 held by an individual, as opposed to a corporation, is likely to be the person’s life savings).

But there are problems.

There is disagreement about how much banks should be asked to contribute to a resolution fund at national level.

One idea is that the fund should amount to 0.5% of all insured deposits, another is that it should be 0.5% of the bank’s liabilities.

Some countries argue that banks are already struggling to ensure they have enough capital buffers, and that asking them to put further funding aside would put an undue strain on their resources, especially when there are so few investors around willing to put their money into banks.

Some member states are pressing to have more discretion over how exactly banks should be wound up and how creditors should be handled.

The UK is resisting the idea of having a resolution fund in place beforehand.

The length of time it will take member states to get their banks to build up sufficient funds to deal with the fall out of a bank collapse is complicating the creation of a fully fledged Banking Union.

The European Commission wants the rules to be in place by 2018, but according to some officials it could be ten years before sufficient funds are in place.

As mentioned above, the ultimate destination is that a harmonised national system would be rolled into an EU-wide Single Resolution Mechanism (SRM) with its own fund.

Germany believes that would require a treaty change, while the Irish Government – and the European Commission – believe that EU law as it currently stands is sufficient.

Calls for treaty change have been seen as Germany trying to slow down the process of a banking union.

German finance minister Wolfgang Schauble has since softened his position, saying that a two-step approach could be adopted: the creation of a single bank supervisor via the ECB and a harmonised national approach to resolving failing banks first, followed by a long-term EU resolution agency or mechanism complete with treaty change.

The problem is that the Cyprus affair showed the dangers of allowing the current mish-mash of rules to continue in the long term.

Furthermore, Europe’s banking sector is still in poor shape.

Many observers believe that until the true nature of bank balance sheets are known, and the regime to deal with problem banks is fully clear and operational, then the financial sector and its deep-rooted problems will continue to act as a drag on economic growth.