King & Wood Mallesons partner Ian Paterson said the final report of David Murray's Financial System Inquiry is likely to include recommendations on the matter.
"A more advanced resolution regime would keep a failing bank going while imposing the costs of failure on creditors of the bank without contribution from government or the public at large," he said.
"This might be done by turning the creditors into shareholders (a 'bail-in'). It is time to debate whether these ideas are worthwhile," said Mr Paterson.
So far Australia has addressed the problem of “too big to fail” institutions by subjecting banks to greater oversight and higher capital requirements, said Mr Paterson.
He warned, however, that like “heavier and heavier armour on a battleship, this improves safety but may compromise efficiency”.
“Nor can it ever eliminate the risk of failure – even the best built battleship may berth at Pearl Harbour,” said Mr Paterson.
He also argued against the approach of structurally separating a banking entity to protect certain business lines from the risks in other business lines conducted by the bank.
“It cannot ensure immunity from risk and in some situations it may increase it,” Mr Paterson argued.
“For instance where it results in a loss of the reduction in credit risk that might have been obtained through netting of obligations, had the business all remained in the one legal entity.”
Mr Paterson said in the current legal regime a number of creditors “enjoy a preferred position over general creditors if an Australian bank fails”.
He explained that holders of covered bonds have their specific security, while holders of derivatives under a close-out netting contract can net their positions and the collateral by exercising rights of close out, and to “interfere with that would raise profound systemic issues”.
He argued, however, that the “scheme as a whole lacks clarity of concept and certainty of application”.
“It hardly seems appropriate for a resolution to bail-in creditors on whom the law has conferred a preferred position in the event of liquidation, at least until after the lower ranking creditors have been bailed-in,” he said.
Mr Paterson argued that any 'bail-in' banking resolution regime must be “fair, clear and coherent”.
“That is likely to require some serious policy choices, including re-examining how classes of creditors of a bank are defined and treated in a liquidation as well as in the resolution regime."
