Australian banks could face hefty losses on their $4 billion of loans to Ireland, as part of the restructuring of the country’s failed banking system.

On the weekend, Ireland finally capitulated to pressure and officially requested emergency financial assistance from the European Union and the International Monetary Fund.

In exchange for providing this assistance, the EU and IMF will insist on Ireland implementing tough austerity measures, such as cutting the minimum wage and reducing the size of the public sector.

But the EU and IMF will also pressure Dublin to shrink the size of the oversized Irish banking system. As a result, Irish banks are likely to speed up their current plans to off-load their foreign operations, and reduce the size of their balance sheets, even if this means that they have to dump assets at a steep discount.

But bankers and investors in Irish bank bonds are terrified that the EU and the IMF will go further, and force the Irish government to wind back its open-ended commitment to guarantee the senior debts of the Irish banks.

These fears were fanned by comments by Dutch finance minister Jan Kees de Jager overnight, when he warned that the restructuring of the Irish banking sector was likely to result in pain for the banks’ shareholders, as well as holders of subordinated bonds in Irish banks.

At the same time, financiers are keenly aware that there is growing disquiet in Germany at the seeming never-ending nature of the bailouts, and the ever-escalating costs of rescuing debt-laden eurozone countries. The eurozone sovereign debt crisis has already claimed Greece and Ireland, but it is now threatening to engulf Portugal and even Spain.

In the German media there is increasing sympathy for the view that bankers should be forced to bear the cost of bailing out weaker debt-laden eurozone countries, because their reckless lending decisions were responsible for creating the problem.

Some economists argue that debt restructurings for some of the weaker eurozone countries are inevitable because these countries have built up such massive debt burdens they’ll never be able to repay. They argue that providing countries such as Ireland and Greece with emergency bailout funding is only delaying the unavoidable end-game when banks and bond holders will be forced to take a “haircut” on some of their loans to these countries.

And this could mean lenders to Ireland, including Australian banks, facing hefty losses on their Irish loans.

According to figures from the Bank for International Settlements, Australian banks had a combined exposure of $US3.72 billion to Irish borrowers at the end of June this year.

This is a relatively minor exposure compared with some of the country’s biggest lenders. For instance, BIS figures show that French banks had a total exposure of $US43.6 billion; German banks  had exposures totaling $US138.6 billion; UK banks with total loans of $US131.6 billion; and US banks had $US57.2 billion in total loans.

Nonetheless, it would represent an unwelcome development for the Australian banks, which are reporting surging profits as a result of steep declines in their domestic problem loans.

The collapse of the Irish banking sector provides a stark lesson in the dangers of government guarantees of private-sector debts.

Irish banks enjoyed spectacular growth and surging profits during the boom years, as they fuelled the country’s massive property bubble. The country borrowed heavily from abroad, amassing a foreign debt that stands at 10 times the size of the economy.

But the collapse of the Irish property bubble left the banks saddled with heavy losses on their residential and commercial property loans.

When the Irish banks faced intense funding pressures during the global financial crisis, the Irish government made the questionable decision to fully guarantee the senior debts of the country’s banks.

But the decision to bail out the vainglorious Irish banks overwhelmed the country’s finances. Last month, the Irish government estimated the cost of bailing out the banks now stood at an astronomic €45 billion ($US60 billion). The Irish budget deficit swelled to 32% of GDP this year, or more than 10 times the official eurozone limit, as a result of the bank bailout costs.

At present, the EU and the IMF are working out a plan for salvaging the country’s banking system. It’s likely that Ireland will be given a loan of about €85 billion, of which €35 billion will be earmarked for the banks, with the rest going to the Irish government.

The big question for bankers is whether this will be enough to prevent them having to take some losses on their Irish loans.

*This story first appeared on Business Spectator.