THE GOVERNMENT has hired economist Dr Peter Bacon to assess the possibility of creating a “bad bank” or risk insurance scheme to take so-called toxic debts off the banks’ balance sheets in a bid to free up new lending.

Dr Bacon was appointed “special adviser” at the National Treasury Management Agency this week for three months to enhance the agency’s team as it continues its work on recapitalisation. He will report to Minister for Finance Brian Lenihan.

It is understood Dr Bacon will focus solely on assessing a possible risk insurance scheme or bad bank for the Irish banking sector.

Dr Bacon declined to comment. A spokesman for the Department of Finance was unable to comment on the nature of his work.

While combined risk insurance-bad bank schemes are being developed in the US and EU, such schemes are likely to be tailored for the Irish market as international schemes are designed to remove hard-to-value credit market investments, while the Irish bad debts relate to assets affected by the property crash.

Announcing the €7 billion recapitalisation of AIB and Bank of Ireland last week, Mr Lenihan said he was “prepared to discuss schemes for assessing and eliminating risk” for the banks but that it would have to involve “careful protection for the taxpayer”.

The Government said in its recapitalisation statement last week it would investigate further “proposals for the management and reduction of risks”.

Analysts have argued that without an insurance scheme or bad bank, uncertainty about future loan losses would remain, forcing banks to hoard capital and making them reluctant to lend.

Under a bad bank scheme, governments would, in return for a charge on the banks, have to fund the purchase of bad debts upfront.

The idea may force banks to recognise additional losses, creating higher demands for capital and leading to greater government ownership. An insurance scheme allows states to take losses over a longer period, mitigating the risk.