Euro bailout fund may use subsidiaries to recapitalise banks

An employee counts Euro notes at the Bank of Taiwan head office in Taipei May 10, 2010.

BRUSSELS (Reuters) - The ESM euro zone bailout fund could set up subsidiaries to directly recapitalise banks to limit the negative impact that buying bank equity would have on its credit rating and lending capacity, a euro zone official said.

The Eurogroup of euro zone finance ministers meets on Monday to discuss which banks should be eligible for direct recapitalisation from the European Stability Mechanism (ESM).

"Setting up subsidiaries is one of the options that has been discussed and will be discussed, although it is not on the agenda for this Monday," said the official, who has knowledge of the discussions.

Government leaders decided last year that the ESM could buy stakes in banks that hit trouble because the value of the government bonds on their books fell dramatically in the euro zone crisis.

Recapitalising banks via subsidiaries would help break the circle of ever more indebted governments borrowing to recapitalise banks, which need recapitalisation because they buy bonds of the government.

"The option of subsidiaries would allow the ESM to fulfil several goals at the same time -- break the negative loop between sovereigns and banks, limit the impact of recapitalisation on its lending capacity, keep as high a credit rating as possible and not ask for more money from euro zone governments," the official said.

Investing in equity is more risky than lending to governments so the ESM, which has a 500 billion euro lending capacity, would have to make provisions for the extra risk -- thus limiting its firepower over a normal loan.

The official said that according to some calculations, one euro invested in bank equity reduced the ESM's lending power by 3 euros.

ESM subsidiaries for bank recapitalisation would be set up using money raised on the market by the ESM via bonds, the official said.

Recapitalisation via a subsidiary would mean that every euro invested in a bank would reduce the ESM's firepower by only 1.5 euros, the official said.

The ESM can borrow on the market thanks to 80 billion euros of paid-in capital and 620 billion of callable capital. This arrangement also ensures the fund has the highest credit rating.

The official said ,however, that to safeguard the rating and lending capacity, the governors of the ESM -- euro zone finance ministers -- were also discussing a limit on the total amount that the fund could spend on recapitalisation in general.

Germany favours a top limit of 80 billion euros.

A further safeguard would be that the country of the bank would also have to participate in the recapitalisation to some extent, "to retain some skin in the game" and create incentives for the authorities to monitor the bank. (Additional reporting by Michelle Martin in Berlin; Editing by David Cowell)