Draghi Challenges EU Bank-Aid Rules Over Forced Losses

European Central Bank President Mario Draghi challenged rules that would bar banks from accessing public aid unless they forced losses on junior bondholders, a central building block of European Union protocols for handling struggling banks.

In a letter to EU Competition Commissioner Joaquin Almunia, Draghi said EU rules need to be clarified so regulators can order technically solvent banks to strengthen their balance sheets without scaring off investors. Draghi said public capital needs to be available -- without wiping out subordinated debt holders or forcing them to convert to equity -- if a bank’s holdings are above regulatory minimums and also below what supervisors deem necessary in a particular case.

“An improperly strict interpretation of the state-aid rules may well destroy the very confidence in the euro-area banks which we all intend to restore,” Draghi said in a July 30 letter to Almunia obtained by Bloomberg News. The ECB president called for the possibility of “precautionary recapitalizations” that would dilute shareholders without hurting junior bondholders and that also would give banks temporary access to public money.

Bond Holders

Draghi’s comments come as EU officials squabble over what backstops should be put in place should the ECB decide that individual banks need more capital after a series of assessments next year. The danger under the state-aid rules addressed by Draghi’s letter is that subordinated bond holders could dash to dump their investments if a bank is deemed to require cash, risking another round of market turmoil.

The ECB on Oct. 23 will announce how it will handle comprehensive assessments of euro-area banks, which are needed as it prepares to take over the currency bloc’s financial supervision next year. The Frankfurt-based central bank has said its reviews need to be tougher than previous rounds of European stress tests in order to reassure investors that euro-region banks aren’t on the brink of another crisis.

“From a bondholder perspective, it’s important the creditor hierarchy is respected and creditors don’t take losses before equity is wiped out,” said Steve Hussey, a credit analyst at AllianceBernstein Ltd. in London, which manages about $430 billion.

‘Systemic Risk’

“Draghi doesn’t want to see systemic risk when the results of the asset-quality review are published,” Hussey said. “A hardline government demanding bondholders take losses in a bank that’s still a going concern might end up shooting itself in the foot. What Draghi is saying is not to make things so black and white, to look at each situation and be flexible.’

New EU state-aid rules that took effect in August require shareholders and junior debt holders to share in the burden of absorbing bank losses before public assistance steps in. The rules are linked to several proposed EU laws and to guidelines on when lenders could have direct access to the euro area’s 500 billion-euro ($683 billion) firewall fund.

Draghi’s letter emphasized his view that public resources will be necessary to shore up the euro-area banking system. At an Oct. 2 press conference, he said it ‘‘astonishes” him that investors have doubts about whether enough backstops will be available. In the July 30 letter, he stressed the importance of putting mechanisms in place.

‘Credible’ Backstops

“It is essential that member states commit credible public backstops to ensure that resources are available in case private sources of capital are insufficient in the face of capital shortfalls,” Draghi said in the letter. “The absence of a public commitment would undermine the credibility of the exercise from the outset.”

In his Sept. 3 reply to Draghi, Almunia said the ECB’s assessment timetable will allow banks that foresee potential shortfalls to raise capital in advance.

“Banks that could expect to find themselves in this position have an extended period of time to generate additional capital from now on,” he wrote. “Such banks have a responsibility to start the capital raising as soon as possible,” he said, for example by cutting dividends and selling “non-core assets.”

Under EU rules, regulators may deviate from imposing creditor losses in “exceptional circumstances,” subject to a case-by-case review, “as we have been doing already in our case practice to date,” Almunia wrote. “I therefore consider that your concerns can be tackled through the provisions already foreseen by our Banking Communication.”

Slovenian Banks

The bank-aid rules are being applied by the commission on two of Slovenia’s smallest banks, Probanka d.d. and Factor Banka d.d., which the government plans to liquidate.

Dutch Finance Minister Jeroen Dijsselbloem, who chairs meetings of his euro-area counterparts, said today that he “very much” supports Almunia’s state-aid position, adding that he also received Draghi’s letter.

“The letter refers to banks that do comply with capital requirements and yet fail the stress tests. It would seem to me that these banks are quite healthy and should be able to get private funds in the capital markets in order to supplement their capital needs,” Dijsselbloem told reporters in Ljubljana.

Private Capital

Draghi flagged the possibility that supervisors could decide a bank needs more capital even if it isn’t on the brink of failure, and therefore might need to tap government backstops if the lender couldn’t raise money quickly enough on private markets. The commission documents explaining the new state-aid rules take a stricter approach, saying a bank that can’t raise private capital may not in fact be healthy.

“In cases where the capital ratio of the bank remains above the EU regulatory minimum, the bank should normally be able to restore the capital position on its own,” the EU said in Oct. 15 guidelines posted on its website. “If there are no other possibilities, including any other supervisory action such as early intervention measures or other remedial actions to overcome the shortfall defined by the supervisory authority, then subordinated debt must be converted into equity before state aid is granted.”

Requiring junior bondholders to take losses, “as seems to be implied by the revised state-aid guidelines, could negatively impact the subordinated debt market, which would in the future be wary of a ‘non-resolution’ probability of conversion,” Draghi said.

‘No Indications’

Almunia replied that discussions with market participants and “monitoring of issuance of junior debt since the adoption of the new rules” on state aid turned up “no indications that the new rules are creating any difficulty for this market,” he wrote. “It seems that markets have already priced this in based on the experience in program countries.”

Since June 2012, when EU leaders handed euro-area oversight to the ECB as a way to break the bank-sovereign links that had exacerbated the debt crisis, EU officials have sought to portray public assistance as a last resort. Creditor nations like Germany and the Netherlands have sought to make it harder for banks to gain access to public money, particularly from cross-border backstops.

German Finance Minister Wolfgang Schaeuble has resisted efforts to put EU-wide backstops in place, instead calling for banks to rely on private investors and national resources. During Oct. 14-15 talks in Luxembourg, a rift emerged among finance ministers between proponents of enhanced backstops and those who believe existing options will suffice.

An ECB spokesman confirmed Draghi’s letter, saying the central-bank president sought to address how the EU would handle cases where bank reviews found that a lender is solvent and also in need of additional capital.

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