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

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.

The ECB will on Oct. 23 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.

Public Assistance

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 ($684 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.

“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.”

More Capital

Draghi flagged the possibility that supervisors could decide a bank needs more capital even it if 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. European 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.”

National Regulators

The European Commission has been in talks with the ECB, the European Banking Authority and national regulators, Antoine Colombani, a spokesman for Almunia, said in an Oct. 19 e-mailed statement.

“The revised guidelines also foresee exceptions, which would be applicable for financial-stability reasons and on a case-by-case basis,” Colombani said. He said the rules don’t require senior bondholder losses and seek to limit use of taxpayer funds by asking a bank, its capital holders and junior creditors to “contribute to a maximum extent.”

Draghi’s July letter warned that the EU’s efforts to strengthen its banks could have the opposite effect without clearer access to public funds. Banks deemed healthy enough to survive should try to raise capital from financial markets, and they also should have avenues to tap public funds if they can’t raise private capital quickly, he said.

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.

Last Resort

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.

“The Netherlands and Germany are on the same line. Only under exceptional situations and under strict conditions,” should countries be able to ask the European Stability Mechanism for direct bank aid, Dutch Finance Minister Jeroen Dijsselbloem told lawmakers in The Hague last week. He said the ECB’s balance-sheet reviews and stress tests would probably take most of 2014 to be completed.

‘Two Kinds’

Luxembourg Finance Minister Luc Frieden said on Oct. 15 that the EU needs a resolution mechanism that is “as broad as possible” so the EU doesn’t harm its banking sector.

“We have to watch out not to create two kinds of securities, two kinds of banks,” Frieden told reporters in Luxembourg. He called for more discussion of how to step in when a bank requires restructuring.

“The question is about what happens when a bank resolution is needed, whether national or European, and we’re pleading for a more European solution,” Frieden said.

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.

Martin Kotthaus, Schaeuble’s spokesman, declined to comment, as did a spokesperson for Dijsselbloem.

To contact the reporters on this story: Rebecca Christie in Brussels at rchristie4@bloomberg.net; Jana Randow in Frankfurt at jrandow@bloomberg.net