October 20, 2013 5:21 pm

Brussels stands ground against Mario Draghi over bailout curbs

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Mario Draghi, President of the European Central Bank, ECB addresses a press conference©AFP

ECB president Mario Draghi

Brussels is standing its ground against Mario Draghi over the EU curbs on bank bailouts, despite the European Central Bank president warning that overzealous haircuts of bank bondholders could destroy confidence.

The strongly worded intervention from Mr Draghi, in a private letter leaked this weekend, came as he prepares to launch a deep review and stress test of banks on Wednesday, which is expected to expose capital shortfalls that eurozone states will need to cover.

Given the likely need for public backstops, Mr Draghi wrote in July to Joaquín Almunia, EU competition commissioner, raising concerns over revised state aid rules, which force losses on junior debt before any taxpayer support is approved. He said “improperly strict” interpretation “may well destroy the very confidence in the euro area banks that we all intend to restore”.

Nevertheless, the so-called bail-in rules came into force on August 1 and last week the commission reiterated its main principles, rejecting Mr Draghi’s request that “viable” banks are given easier access to state funds. Mr Almunia, however, repeated that all decisions would be taken on a case-by-case basis, without harm to financial stability.

Mr Draghi’s warning over the dangers of forcing junior bondholders, rather than taxpayers, to foot the bill for strengthening solvent European banks underscores the fraught discussions within the eurozone over the cost of repairing the financial system.

The stress test is intended to dispel doubt over Europe’s banks before the ECB takes charge of supervision from late 2014. But the euro area is torn over the public backstops that should be in place, with Germany insisting all junior and even senior bondholders pay before taxpayers.

Mr Draghi is worried that even penalising more lightly protected junior creditors could backfire.

Mr Draghi is supportive of bail-ins when a bank is failing. His specific concern is the forced conversion of junior debt into equity when banks meet their minimum capital requirements but are asked to strengthen their buffers following the stress test, according to his letter, first reported by Italy’s La Repubblica and seen by the Financial Times.

Mr Draghi said the move would “negatively impact” bank debt markets and could be considered “disproportionate” and in breach of contract. “By structurally impairing the subordinated debt market, it could lead to a flight of investors out of the European banking market, which would further hamper banks’ funding going forward,” he wrote.

State support should be allowed without such a conversion, he added, citing the risk of a “crowding-out effect” as banks race to raise capital after next year’s stress test and the potential for damaging deleveraging, as lenders shrink to meet the higher capital demands.

Mr Almunia has so far stood his ground. Even at banks reaching their regulatory minimum, “subordinated debt must be converted into equity before state aid is granted”, the commission said in informal guidance issued last week.

“A stress test revealing a capital shortfall is as such not relevant for state aid control,” it added. “State aid control would only become relevant when the private means to raise capital had been exhausted and a bank would need to resort to public resources to fill the gap. In these cases, the bank’s soundness becomes doubtful.”

In a nod to Mr Draghi’s concerns, the commission highlighted that under its rules exceptions can be made “when the implementation of writing down or conversion of subordinated creditors would lead to disproportionate results or would endanger financial stability”.

This, in particular, applies when the bank has already raised money and state support is minimal compared to its overall assets.

EU officials and the ECB are also in discussions over how mandatory conversion would apply to debt contracts issued under foreign law or cross-provisions that trigger default for other senior debt instruments.

Loss-expectations of junior bondholders have increased, particularly following the writedown of sub-debt in Spain’s bank bailout. However hitting junior debt still remains politically painful for national authorities, given the instruments were sometimes sold to retail investors unaware of the full risks.

Junior debt represents about 1.5 per cent of an average EU bank’s assets, compared to around 7 per cent for unsecured senior debt, according to Commission estimates.

Antoine Colombani, a spokesman for Mr Almunia, said: “The revised guidelines apply in all cases where the banks, their shareholders and their junior bond holders are not able to collect the necessary capital to cover either regulatory or precautionary requirements, and when they need to have recourse to public money. The revised guidelines also foresee exceptions, which would be applicable for financial stability reasons and on a case-by-case basis.”

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