EU prepares law to impose losses on bank bondholders

An Irish Times article reports that the European Commission is moving forward with a law that would see the bondholders of failing banks share in the losses.

Some would call this the return of capitalism.

The banks would call this the end of the world.  They fear that investors would not be interested in buying their debt.

Regular readers recall that the global financial regulators have created a moral hazard when it comes to requiring bank bondholders to take a loss.  After all, how can the global financial regulators impose a loss on a bondholder after they run a stress test and say that the bank is solvent?

Is the investor suppose to question the global financial regulators' ability to analyze the solvency of a bank?

If an investor is suppose to question the regulators' assessment, then why would anyone assume that any of the major banks are solvent today?  After all, each bank is loaded up with sovereign debt, toxic mortgage backed securities, commercial real estate loans, mortgages that cannot be repaid by individuals and exposure to other potentially insolvent banks.

The solution for the regulators is to require each bank to disclose on an on-going basis its current asset, liability and off-balance sheet exposure details.

With this information, investors could independently analyze the risk of the banks (there are no longer dependent on the regulators statement that the banks are solvent).  Based on this analysis, investors can decide how much, if any, exposure they want to the bonds of the banks.

With the ability to independently assess the risk of each bank, investors become responsible for all gains and losses on each bank's bonds.

The European Commission is set to propose a law within weeks that could let supervisors impose losses on the bondholders of a flagging bank, officials said, a move it has delayed until the end of the year for fear it will panic markets. 

The law is part of a European framework on winding up or salvaging troubled banks, seen as crucial to preventing another financial crisis, but which is sensitive because it has echoes of the Greek bailout package, in which holders of Greek government bonds share some of the losses. 

Banks are also worried that the new European law would break a finance industry taboo that bondholders are spared losses, making investors more reluctant to lend to banks and possibly compounding a credit freeze. 

From the banks perspective, it certainly is taboo.  If bondholders are not spared losses, then neither will the banks and the bankers.

If bondholders are not spared losses, the banks lose a significant amount of leverage in obtaining additional bailouts.

Banks have said that forcing bondholders, especially senior ones, to take a hit when a bank is in trouble should only be a last resort option. 

Earlier this year, the EU's executive began consulting with the industry about the change of rules. 

It said at the time: "This might include possible mechanisms to write down appropriate classes of the debt of a failing bank to ensure that its creditors bear losses. Any such proposals would not apply to existing bank debt." ....

One official, speaking on condition of anonymity, said the new rules would correct the imbalance between the treatment of bondholders and of shareholders, many of whom lost their investments in banks that failed during the crisis. 

"It is all very good saying that banks need more capital. But who will give it?" he said. The EU is prodding banks to raise extra capital to cope with a Greek default. "Why should bondholders be treated more favourably than equity investors?" ....

The new rules would allow a supervisor under the watch of the European Banking Authority to impose losses on bondholders of an endangered bank to keep it up and running.