Euro bailout fund conditions complicate efforts to separate bad banks and sovereigns

LUXEMBOURG Fri Jun 21, 2013 7:46am IST

Latvia's lats and euro banknotes and coins are seen in this illustration picture in Riga March 9, 2013. REUTERS/Ints Kalnins

Latvia's lats and euro banknotes and coins are seen in this illustration picture in Riga March 9, 2013.

Credit: Reuters/Ints Kalnins

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LUXEMBOURG (Reuters) - Euro zone finance ministers on Thursday agreed on how its bailout fund can invest in troubled banks, but imposed so many conditions that they may not completely succeed in their goal of separating problem banks from their indebted home countries.

The 500 billion-euro bailout fund was originally set up to help struggling governments and was later expanded to include banks in an effort to restore confidence in the financial markets, ravaged by three years of debt and financial crisis.

Policymakers hoped the move would galvanise interbank lending and borrowing, so the wheels of the euro zone economy would start moving again after a lengthy recession.

The decision to allow the bailout fund to buy bank shares was made at the height of the crisis in June 2012 - the Spanish banking sector needed tens of billions of euros and Madrid's borrowing costs were climbing fast, raising the prospect of it being cut out of the markets.

The European Central Bank has pacified markets since then with a commitment to buy unlimited amounts of government bonds to support the euro if necessary.

That calm has opened the way for Germany and others to put the brakes on sweeping banking sector reforms, which German Finance Minister Wolfgang Schaeuble feared would end up leaving Germany too much on the hook for others' problems.

The deal on Thursday goes some distance to separate problem banks from their governments, but not as far as envisaged nine months or a year ago, when leaders called for a clear "breaking" of the negative loop between banks and sovereigns.

A government in financial crisis would sell its bonds to the banks in its country. The banks would then hold sizeable amounts of their government's debt, creating a negative feedback loop between a shaky government and vulnerable banks.

"This instrument will help preserve the stability of the euro area and remove the risk of contagion of the financial sector to the sovereign, thus weakening the vicious circle between banks and sovereigns," the chairman of euro zone finance ministers, Jeroen Dijsselbloem, told a news conference.

Germany's Schaeuble put it more bluntly.

"We must avoid that there are false expectations in connection with the direct bank recapitalisation. Those who expect that any bank that needs capital can go to the (bailout fund), that's nonsense," he told reporters after the meeting.

The bailout fund will be able to spend a maximum of 60 billion euros on buying shares in banks, so as to preserve its firepower for its main purpose of the less risky lending to governments, but the limit may be raised if necessary.

GOVERNMENTS, CREDITORS WILL CONTRIBUTE

The ministers also agreed that the country of the bank in trouble would always have to contribute to the rescue.

A government would first have to recapitalise the bank to make sure it meets the mininum common equity Tier 1 ratio of 4.5 percent, before the bailout fund could become a shareholder.

If a bank already meets the minimum ratio, the government would have to provide 20 percent of the necessary capital injection alongside the bailout fund's 80 percent during the first two years after the law comes into force in autumn 2014.

After the two years, the government contribution to the necessary capital increase would fall to 10 percent.

Further eroding the confidence-boosting effect of the package is the assumption that before the bailout fund invests in a bank, its shareholders, bondholders and possibility even large depositors might be required to contribute.

"An appropriate level of bail-in will be applied before the bank is recapitalised by the (bailout fund), in line with EU state aid rules and applying principles of the forthcoming bank recovery and resolution directive," Dijsselbloem said.

EU state aid law foresees losses only for shareholders and junior bondholders, but in the still-not-finalised directive senior bondholders and large depositors could also take a hit.

The discussions on Thursday are separate, but closely linked to talks on Friday, when the euro zone ministers will be joined by colleagues from other European Union countries, on the directive to rescue or close down a failing bank.

Guidelines for the bailout fund will only be finalised in a legal form once the European Parliament votes through the directive.

The ministers also decided that the bailout fund will be able to become a shareholder in a bank that got into trouble before autumn 2014 - what EU policymakers call retroactivity.

The decision which banks may qualify for such retroactive help will be made on a case by case basis, Dijsselbloem said.

Ireland is interested in the bailout fund buying stakes in its banks, as might be Greece, Cyprus and Portugal. Spain has said it would not seek such an option so as not to send a signal to the markets that the sovereign cannot cope on its own.

Germany's Schaeuble signalled Dublin could be considered.

"We have told our Irish friends that an eventual retroactive use is not ruled out, based on a decision on a case by case basis," he said.

(Additional reporting by John O'Donnell, Robin Emmott and Martin Santa; Writing by Jan Strupczewski, Editing by Mike Peacock and Lisa Shumaker)

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