Bondholders and governments will always have to contribute to shoring up a failing euro zone bank even when the bloc's bailout fund ESM offers direct aid, according to an EU document obtained by Reuters.
Seeking to limit the burden on euro zone taxpayers, "private capital resources will be explored as a first solution, including sufficient contributions from existing shareholders and creditors of the beneficiary institution(s)," the document said.
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It was prepared for euro zone finance ministers to discuss next week in Luxembourg.
While already agreed, the ESM rules will be finalized only when EU institutions, including the European Parliament, agree on two pieces of legislation on guaranteeing bank deposits and closing down bankrupt banks.
The document did not specify the size of the losses that would be imposed on a bank's bondholders, saying only that their level would have to be appropriate.
"An appropriate level of writedown or conversion of debt will have to take place, in line with European Union rules," it said.
The document said the European Stability Mechanism fund could become a shareholder of a euro zone bank only if the bank's capital was in danger of or already had sunk below the level required by the European Central Bank.
Aid could be offered only if the bank was important enough for its failure to endanger the financial stability of the euro zone as a whole.
Before the ESM would spend any money, however, the bank would have to try to raise the necessary funds from private investors and through writing down its debt or converting it into equity. The government of the country where the bank was based would also have to step in.
The ESM, which has a war chest of 500 billion euros ($667 billion), will not spend more than 50-70 billion on buying stakes in euro zone banks because such investment would deplete its resources more quickly than loans to sovereigns, which are regarded as less risky.
If a bank and the government of its home country cannot handle recapitalization on their own, the European Central Bank, together with the European Commission and external experts under the guidance of the ESM, would evaluate the bank's assets and determine how much it could absorb in losses.
This evaluation would be based on "a sufficiently prudent scenario of a stress test."
Once existing shareholders of a bank and its creditors are tapped for funds, the ESM will check whether the bank has the minimum legal common equity Tier 1 ratio of 4.5 percent. If not, the government would have to inject the required cash.
If the bank already meets the minimum, the government would provide between 10 and 20 percent of the money needed to bring the bank's capital to the level required by the ECB as the euro zone bank supervisor.
"This burden sharing between the ESM and the requesting Member is specifically constructed in a way to cater for the existence of legacy assets, through the first part of the scheme, as well as for the need to ensure that incentives are always properly aligned through the second part," it said.
If, however, a government is so strapped for cash that it cannot come up with the money, the ESM can suspend such a contribution.
The ESM investment will carry conditions, including the possibility of limiting the remuneration and bonuses of the bank's management.
When it becomes a shareholder of a bank, usually through a specially created subsidiary, the ESM will "exert an appropriate influence, commensurate to its exposure, both through its role as a shareholder and through the conditions imposed within the recapitalization operation."
The ESM would tackle issues such as the degree of involvement in deciding strategy and business models, monitoring business performance, appointing senior management and board members and exercising voting rights, aiming "to ensure a return to market functioning".
The recapitalization rules are to be reviewed at least every two years.
($1 = 0.7496 euros)
(Reporting by Matthias Sobolewski, additional reporting by Annika Breidthardt, writing by Jan Strupczewski; Editing by Ruth Pitchford)