Owners of long-term unsecured debt in a collapsing bank would be first in line to take losses under draft plans from the European Union to protect taxpayers’ money from future bailouts.
Short-term debt, with a less than one-year maturity, and derivatives should only be written down by regulators as a last resort if losses from longer-term debt aren’t “sufficient to restore the capital of the institution and enable it to operate as a going concern,” according to a draft European Commission proposal obtained by Bloomberg News.
“They are terrified of inadvertently killing off the interbank market,” Simon Gleeson, a financial services lawyer at Clifford Chance LLP in London, said in a telephone conversation. “This is a desperate attempt” to preserve it.
EU Financial Services Commissioner Michel Barnier had delayed proposing the law, which was originally scheduled to be released in September, because of market turbulence. The Bloomberg Europe Banks and Financial Services Index has fallen
34.7 percent in the past year on concerns lenders have been weakened by the European sovereign debt crisis.
The commission may further delay publication of the measures until the start of next year to avoid them being unveiled at a time when they could add to volatility on financial markets, an EU official said earlier this month.
“The commission has to be very careful indeed at this critical phase of the economic cycle about adding further burdens on the ability of financial institutions to fund their operations,” said Richard Reid, research director for the International Centre for Financial Regulation.
The EU plan would help “maintain the supply of liquidity and minimize the negative externalities on the interbank market and derivatives market” in the event of the failure of a bank, according to the draft proposals.
Under the proposals, unsecured senior bondholders of banks would take losses only after a lender’s capital and then the rest of its subordinated debt had already been wiped out.
By imposing losses on long-term senior unsecured debt ahead of short-term debt and derivatives, the proposals go against the normal principle in insolvency law that creditors in the same class should be treated equally, according to the EU draft.
Banks would have to pay into national funds to help cover the costs of bank failure, under the measures. These funds should have financing equivalent to the higher of 1.5 percent of deposits that are guaranteed by law or 0.3 percent of banks’ liabilities other than the “own funds of the institutions.”
The euro area’s bail-out fund, the European Financial Stability Facility, could be used to top up these funds in exceptional circumstances, the draft says.
Banks that continue as a “going concern” after losses are imposed on their creditors should be forced to replace their management and restructure, according to the draft rules.
Banks will have to hold minimum amounts of longer-term funding to prevent them from exploiting the commission’s plan to shield short-term debt from writedowns.
Lenders should be forced at all times to hold funding “with an original maturity of at least one year” equivalent to a minimum of 10 percent of their liabilities, according to the document.
The U.K.’s Independent Commission on Banking, led by John Vickers, had similar ideas for financial stability, Bob Penn, a lawyer at Allen & Overy LLP, said in a telephone interview in London.
“This is going in the same direction as Vickers,” Penn said. “Ten percent sounds like a similar measure to the primary loss-absorbing capacity in Vickers.”
The draft proposal exempts secured liabilities, as well as so-called repos and other liabilities secured by collateral, from the debt-writedown measures.
Bonuses aren’t protected under the plan and may be clawed back to shore up bank capital, according to the draft.
“That idea is new,” Gleeson said. “What it may do is accelerate the shift in bankers’ pay from bonus to salary.”
The proposals also include requirements for banks to draw up so-called living wills showing how they could be wound down if they fail.
Regulators would have the right to impose “changes to legal or operational structures” at banks to ensure their living wills could be executed, the draft says.
Lenders that fail to make living wills and agree on their content with national regulators may face fines of as much as 10 percent of their annual revenue, the draft says. Banks may also be punished for failing to alert regulators that they are close to collapse.
Separately, EU nations said last month that they will temporarily guarantee lenders’ bond issuance in order to open up the bank-lending market.
Temporarily protecting creditors from losses “would help banks continue their lending activities in 2012,” the European Banking Authority said on Oct. 26 “Banks may find it difficult to address their funding needs” next year without support, the EBA said.
A spokeswoman for the commission in Brussels declined to comment.