Small European banks are warning that tough EU rules aimed at staving off future taxpayer rescues of their bigger cousins could wreak havoc with their capital costs and force them to cut back lending.

The European Parliament is determined to avoid a repeat of the financial crisis when bondholders generally avoided losses, even as governments pumped in taxpayer funds to stabilise failing banks.

So some MEPs are seeking to rewrite bank safety rules to require any debt instrument that counts toward regulatory capital requirements to have a contractual “bail-in”, or a clause that specifies a writedown or conversion to equity in times of stress. Anything that does not meet the requirement would cease to count, with 10 per cent phasing out each year, starting in January 2013.

The combination will hit smaller banks, UK building societies and London subsidiaries of non-EU banks particularly hard, because they rely far more heavily on this kind of debt, known as “hybrid Tier one” or “Tier two” capital, than bigger institutions.

One bank chief executive estimated that 30 per cent of his capital would have to be renegotiated or replaced and another put the figure at 22 per cent and said his cost of capital could double or triple because so much existing debt was issued when investors were willing to accept lower returns.

“Politicians keep beating the drum about increased lending to [small and medium sized businesses], yet they show little understanding of the invidious position of many smaller banks who may have to improve their capital bases on very short notice,” says John Ahern, partner at the Jones Day law firm. “A large number of banks’ access to the capital market is limited.”

The proposal is aimed at insuring that EU banks comply with the global “Basel III” reforms requiring bail-in.

“Banks should not be able to count funding as Tier two capital if the regulator does not have the tools to convert it into equity,” said Vicky Ford, the MEP who is sponsoring the requirement as an amendment to the EU capital rules. “This is a key principle. If smaller banks need a grandfathering period or there are specific circumstances or instruments that give concern, then we should talk about practicalities and timing.”

But critics note the US has achieved the same result with a law that gives regulators the blanket power to bail in all capital, no matter what individual contracts say.

The European Commission has said it also intends to move this way – after a year of delays, the commission brought out a crisis resolution package that would include this kind of statutory bail-in – but Ms Ford and other MEPs say they are reluctant to give up the contractual requirement until it is clear that the crisis package will pass.

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