By Jane Merriman

LONDON, Aug 27 (Reuters) - Plans to make hybrid bond
investors share the pain when banks run into trouble could
polarise the financial sector into big firms that can afford to
pay up for capital and smaller players that cannot.

Financial regulators want to ensure that taxpayers are not
the only ones on the hook when banks fail by proposing that
bonds that count towards a bank's capital should be written down
or converted to equity if it is close to collapse.

This form of contingent capital would mean bond investors as
well as shareholders would take a hit if a bank had to be
rescued.

But these plans from the Basel Committee on Banking
Supervision could reinforce a pattern emerging in the aftermath
of the crisis -- a two-tier banking market with international
banks that investors favour over smaller banks seen as riskier.

"It could polarise the market further in terms of issuer
access and could shut out some smaller institutions and give
larger firms a competitive advantage," said one debt capital
markets banker at a major international banking group.

During the crisis, some banks that had to be bailed out --
such as the UK's Northern Rock -- continued to pay coupons on
bonds that count towards capital known as Tier 2 because they
were legally required to do so.

Tier 2 bonds typically have mandatory coupons, if the bank
skipped a coupon it would trigger a technical default.

So bond investors not only benefited from a bank being
bailed out but also continued to receive coupon payments.
Shareholders, on the other hand, were wiped out and taxpayers
footed the bill.

The Basel Committee has proposed a solution to this that
requires banks' Tier 2 bonds to be written down in a crisis and
converted to equity.

POLARISED MARKET

"The latest proposals suggest that a bank's capital base
will be made up of expensive instruments because investors will
look at the downside and want to be paid well for the risk,"
said a credit analyst from a UK asset manager.

Bankers also think that the proposal will increase the costs
for the sector as a whole, with one official at a U.S. firm
saying that the additional spread investors will require could
be between 200 and 300 basis points.

Investors have mixed views on contingent capital. They would
have problems with more issues along the lines of bonds sold by
British bank Lloyds, which are designed to convert to equity in
the early stages of a bank running into difficulties.

"We don't think there is a large market for them, certainly
among institutional bond investors," said Roger Doig, credit
analyst at Schroders. Analysts say that such issues are
difficult for credit rating agencies to evaluate and many
institutional credit investors are not mandated to hold equity.

The Basel proposals have been unveiled as European banks
face substantial hybrid debt redemptions in the coming years
which they have to replace or shrink their balance sheets.

According to JP Morgan, nearly $29 billion is due in the
final three months of this year and a further $85 billion
matures in 2011.

Regulators are due next month to finalise what form
new-style capital should take and how much more capital banks
have to hold, with the new rules due to be implemented from the
end of 2012.

But Doig said he did not expect the latest Basel proposal on
contingent capital to change investor appetite for Tier 2 bonds.

"What it may change at the margin, is the number of banks
that can issue this sort of debt, as the proposed change in
"going concern" threshold from breach of regulatory capital
ratios to "non-viability" as determined by a regulator, slightly
raises the bar," he said.

The Basel proposal states that it could help even out
differences between big and small banks.

But market participants say a possible side-effect of the
proposals could work against regulatory efforts to tackle the
problem of banks that are deemed too big to fail.

Daniel Bell, director of product development at Bank of
America Merrill Lynch, said regulators would have to apply these
provisions across the board.

"If not, investors might not be willing to look at
non-systemically important banks because of concerns they will
simply be allowed to fail."

(Editing by Sitaraman Shankar)