EUROPE´S UNDERCOOKED BOND BAIL-IN PLANS / THE WALL STREET JOURNAL ( RECOMMENDED READING )

HEARD ON THE STREET

JANUARY 7, 2011, 9:01 A.M. ET.

Europe's Undercooked Bond Bail-In Plans

By RICHARD BARLEY

The European Commission is determined to put an end to the untouchable nature of senior bank bonds. Its latest consultation paper suggests unsecured creditors other than depositors could suffer losses if banks face trouble, even if they are preserved as going concerns.


The aim is sensible: bank rescues have cost 13% of European Union GDP, led to the emergency bailout of Ireland and will mean higher taxes in many countries. But the Commission is no further forward on solving the thorny problem of how this will be achieved.


The Commission has said its proposals won't affect existing debt, and hasn't given a time frame for debt to become burden-sharing. It proposes two approaches to writedowns, each with their own pitfalls. Under the first, any and all senior unsecured bonds might be subject to writedowns after equity and subordinated debt is wiped out, if needed to restore solvency—but regulators could decide which specific classes are affected, in part as a consideration of how losses might affect systemically important creditors. That risks creating unequal treatment of equal-ranking creditors, a big problem. It also suggests short-term debt might be excluded, risking banks becoming more reliant on volatile funding.


Under the second approach, a certain proportion of debt would contain clauses to allow it to be written down at a trigger point. This raises long-standing questions about who would buy this debt and where the trigger would be set. It could also leave some senior creditors essentially in a risk-free position even in the face of catastrophic losses if a bank cannot be allowed to fail.


European banks may end up at a disadvantage, given their greater reliance on bonds for funding than their U.S. and Asian competitors. For the euro zone, wholesale funding comes in at close to 20% of GDP, UBS notes.


That complicates the equation for bank recapitalization: If wholesale funding costs rise sharply due to new regulations, banks will face squeezed margins until their asset books reprice, a much longer process. Alternatively, banks may need to shrink their balance sheets, reducing the flow of credit to the economy and crimping growth.


The Commission plans to develop legislation by summer. Its challenge will be to avoid creating such regulatory uncertainty that it causes further turmoil in a market already shuddering at the resurgence of European sovereign-debt strains. Good luck with that.


Copyright 2010 Dow Jones & Company, Inc. All Rights Reserved