The European Union is moving ahead with plans to shield taxpayers from having to bail out big banks in the future, but there are substantial obstacles to making bondholders share losses.
The EU's executive Commission on Thursday presented plans that could give national regulators the power to force the owners of bank bonds to accept so-called haircuts _ a reduction in the amount of money they are owed.
But the Commission stressed that any new bond rules would not affect existing debts _ an issue that is closely watched in Ireland, where the government's commitment to guarantee struggling banks' debts pushed the country to the brink of default.
The EU proposal forms part of a larger package designed to give regulators the tools to deal with banking crises and keep institutions from becoming too big to fail.
"Although our first objective is better prevention, banks will fail in the future and must be able to do so without bringing down the whole of the financial system," Internal Market Commissioner Michel Barnier said in a statement. "That is why we must put in place a system which ensures that Europe is well prepared to deal with bank failures in an orderly manner _ without taxpayers being called on again to pay the costs."
Any new rules for bondholders are unlikely to become law before 2013 and would then be phased in over time, EU officials said. They also have to be approved by EU governments and the European Parliament.
The plans, which are now open for discussion ahead of a legislative proposal in early summer, follow a similar initiative to make private creditors take losses when governments, rather than banks, are being bailed out. That decision triggered turmoil on government bond markets in the fall and has been blamed for worsening Dublin's troubles to the point where it had to seek a euro67.5 billion rescue loan.
Should the EU indeed manage to push through the new banking regulation, it could fundamentally transform the way banks fund their operations, as buying their debt would become much riskier.
During the financial crisis that followed the collapse of Lehman Brothers, private creditors were spared in all bailouts of European banks.
Bondholders usually lose money only when a bank declares insolvency, a move that European regulators skirted in fear of the consequences a failure might have on financial stability at a time when markets were already panicking. Instead, governments pumped billions of euros into struggling firms, shouldering taxpayers with massive burdens while bondholders walked away unharmed.
Although Commissioner Barnier has stressed many times that making taxpayers take on the cost of banks' risky bets in the future is unacceptable, EU officials said that they haven't yet decided on how best to substitute bailouts with so-called bail-ins.
"In this respect, the consultation is particularly open," an EU official said. "We're aware of the legal and practical challenges." The official didn't want to be quoted by name in line with department policy.
The Commission is considering either giving regulators the power to impose haircuts, or requiring banks to include clauses in a certain proportion of their bonds that would allow them to be converted into equity. In contrast to bondholders, shareholders took substantial losses in bank bailouts, as firms' market valuation sank and government stakes diluted the value of their shares.
"Being able to convert even a small fraction of bank bonds to equity can double or even treble the capital of a troubled bank overnight," said Sony Kapoor, director of Re-Define, a think tank that lobbies for banking reform. "The proposals may increase the cost of funding for financial institutions, but that may be no bad thing since banks have enjoyed implicitly subsidized borrowing costs that encouraged excessive leverage."
The Commission emphasized that a bail-in of private creditors would go hand in hand with a fundamental restructuring of a bank, including selling or winding down certain businesses.
The EU's executive also wants to give regulators the power to intervene early once they decide that a bank might become too big to fail, allowing them to change the management or ruling out certain business practices. It also hopes to improve coordination between national regulators when a bank that operates in several countries runs into trouble.
During the credit crunch, authorities struggled to come up with coherent measures when cross-border banks such as Fortis or Dexia threatened to collapse.
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