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Draghi said EU rules needed to be clarified so that regulators can order technically solvent banks to strengthen their balance sheets without scaring off investors. He 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 recapitalisations” that would dilute shareholders without hurting junior bondholders and that also would give banks temporary access to public money.
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.
Draghi’s letter emphasised his view that public resources will be necessary to shore up the euro area banking system. At an October 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.”
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. 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 October 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.”
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.
Luxembourg Finance Minister Luc Frieden said on October 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.