##down of the real economy. but such a rescue can place a huge burden on government finances – and no country knows that better than ireland, where support for the financial sector was a major factor why the debt ratio soared from 25 % of gdp in 2007 to 108 % in 2011. conversely, weak government finances can destabilise banks – directly through their exposure to sovereign bonds, and, indirectly, through worsening macroeconomic conditions. that is what we are also witnessing at this very moment. thus, breaking the link between banks and sovereigns is vital for making the euro area more stable. a banking union can very well be a major step in that direction – but by harnessing the disciplinary forces of the market, not by doing away with them. core elements of a banking union therefore have to be : first, a comprehensive bail - in of bank creditors, and second, an appropriate risk - weighting of sovereign bonds. in order to minimise the risk that bank rescues pose to government finances, creditors have to be the first in line when it comes to bearing banks ’ losses. implicit guarantees have to be removed as taxpayers ’ money can only be the last resort. by the same token, sovereign bonds need to be risk - weighted appropriately when it comes to the adequacy of capital buffers. riskier bonds have to become more expensive in terms of the amount of equity that they tie down, as is already the case for non - sovereign bonds. this serves two purposes : on the one hand, surcharges of this kind should translate into lower demand and, hence, into larger spreads, which gives a disciplining signal to the respective sovereign. and, on the other hand, banks would become more resilient in the event of market turmoil. bis central bankers ’ speeches adequate risk - weighting of sovereign bonds helps to prevent fiscal difficulties from translating directly into financial instability. if fiscal autonomy remains with national member states, which is still the status quo in the eu treaties, this is crucial. banks have to internalise the fiscal position of sovereigns in a similar manner as they take into account the risk of corporate bonds or loans. otherwise, the envisaged recapitalisation of banks via european funds could turn out to be a backdoor for mutualising sovereign solvency risks. i therefore believe that these two regulatory reforms – a comprehensive bail - in of creditors as well as an adequate risk - weighting of sovereign bonds – need to complement the envis

last few years have been challenging, many signs point to a silver lining. there has been significant progress in reforms with the results to show for it : on - track deficit reduction, falling unit labour costs, a positive current account and last but not least a return to positive growth. to sum it up : i am very much confident with regard to the irish case. and i am more and more convinced that we are witnessing a resurgence that is instructive for the euro area as a whole. the problems experienced by ireland are by no means confined to the “ green island ”, but are typical of what went wrong in the run - up to the crisis. thus, the reforms undertaken in ireland hold valuable lessons for the wider monetary union. but what exactly did go wrong at the onset of emu? bis central bankers ’ speeches 2. the origins of the crisis for many euro - area member states, the introduction of the euro ushered in a new era of abundant capital. in the case of ireland, for instance, capital inflows amounted to about two trillion euro between 1999 and 2008. in principle, this is exactly what standard economic reasoning predicts : capital was flowing from capital - rich to capital - poor economies, where returns should be higher. such flows complemented limited domestic saving in capital - poor countries and reduced their cost of capital, boosting investment and growth. as we all know, it did not always work that way. overblown financial sectors channeled the capital flows into unproductive investments. ireland is certainly a case in point as light - touch regulation and tax incentives encouraged the financial sector to balloon. overinvestment in real estate as well as in public and private consumption failed to boost productivity. unit labour costs soared, competitiveness declined, and rigid labour and product markets meant that this process gained additional momentum. when the financial crisis broke out in 2007, the vulnerabilities became apparent in ireland. growth imploded, deficits – which were often already too high before the crisis – exploded, and cracks in the irish banking system started to show. as an aside, you may recall that these cracks extended right into germany, where irish subsidiaries or special investment vehicles got their german parent companies into trouble. not surprisingly, investor sentiment began to shift, and also interest rates in your country started to rise sharply, triggering a major crisis that is still far from being resolved. how could it all go so wrong? key to understanding the crisis is the euro area