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Bank Writedown Rule Changes May Spur Risk Taking, EU Warns

Banks may be given incentives to take irresponsible risks if governments press ahead with plans to change the European Union’s blueprint for handling stricken lenders, EU officials warned.

Proposals to amend draft EU rules for imposing creditor losses may imperil “the level playing field across the varying banking models and could promote more risk taking and moral hazard,” according to a European Commission working paper dated Oct. 7 and obtained by Bloomberg News.

The commission’s concerns center on how banks should calculate whether they meet minimum targets set by regulators for issuing subordinated debt and other unsecured liabilities that could be written down in an emergency, according to the document.

The bank resolution proposals, put forward last year by Michel Barnier, the EU’s financial services chief, seek to take taxpayers off the hook for rescues by imposing losses on unsecured creditors, a process known as bail-ins, and by requiring nations to build up bank-financed funds that can be tapped in crises.

Under Barnier’s blueprint, lenders would face binding targets for the proportion of bail-in-able securities they should have on their balance sheets, measured as a fraction of the lender’s total liabilities, excluding capital.

Unintended Incentives

Moves by governments and the European Parliament to exclude some types of liabilities from the denominator of the calculations may create unintended incentives, the commission said in the document.

Such a step would give banks a smaller target for the proportion of liabilities that can be bailed in, according to the document.

Lenders may also take advantage of exemptions to try to game the system and minimize the liabilities that they have to issue, the commission warned.

The commission cites concerns over a proposal by governments to exclude derivatives from the calculation of banks’ total liabilities, so favoring “bigger trading banks” that deal more in these securities, the commission said.

A move by the European Parliament to exempt covered bonds from the calculation may unintentionally spur banks to issue more of these instruments, the commission warned in the document.

Workable Solution

“The whole issue is still under discussion,” Sharon Bowles, chairwoman of the Parliament’s economic and monetary affairs committee, said in an e-mail. “I think all parties want the same: something that works, something that reflects political sense on order of subordination and something that fits with international standards,” she said.

One area of ongoing work is the treatment of derivatives in a bail-in situation, Bowles said.

“We still don’t know how over-the-counter and illiquid ones could be bailed in, which would then create a perverse incentive away from traded derivatives,” she said. A general exclusion from the calculation of writedown-eligible liabilities could balance that out, she said.

EU leaders have said that the plans are an essential building block for further steps by the 17-nation euro area to set up a centralized bank resolution system.

Barnier’s proposals require approval by national governments and by EU Parliament lawmakers before they can take effect. Finance ministers reached a common negotiation position on the measures in June, allowing talks to start with legislators on the final version of the plans.

While national regulators would have discretion on how high to set the target for each bank, the threshold would be measured as a percentage of the lender’s total liabilities, excluding capital.

Chantal Hughes, a spokeswoman for Barnier, didn’t have an immediate comment.

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