Europe seeks united front to back troubled banks

By John O'Donnell and Michelle Martin

BRUSSELS (Reuters) - European finance ministers will pledge on Friday to stand by banks that are exposed as being dangerously weak by health checks next year, but questions remain over countries unable to prop up them up alone.

Ministers will make their joint statement to reassure investors following a meeting in Brussels, taking Europe one step closer to coming clean on the banking problems that have dogged it for more than half a decade.

It sets the scene for bank health tests next year - first by the European Central Bank and then by regulators across the wider European Union - that are likely to reveal losses on loans and pose the question as to who pays for the clean-up.

According to a draft obtained by Reuters, EU ministers will underline their readiness to move quickly to tackle problems that are uncovered in those checks.

The ministers will say that any bank under the ECB's watch will have "national backstops" in place in time for the tests.

While countries agree in principle on the need to support banks, it remains unclear whether the euro zone's rescue fund - the European Stability Mechanism - will be able to provide direct assistance to such banks, as originally promised, rather than by lending to their governments.

"France continues to believe that we ... must not exclude direct recapitalisation by the European Stability Mechanism as a last resort," France's Finance Minister Pierre Moscovici told reporters as he arrived at the first day of the meeting.

Speaking just yards away, however, Wolfgang Schaeuble, Germany's finance minister, poured cold water on that idea.

"The German legal position rules it out now," he said. "That's well known. I don't know if everyone has registered that."

The discussions in Brussels are part of wider negotiations on setting up a so-called banking union, Europe's most ambitious reform since the start of the euro currency.

It would see the ECB police lenders and should ultimately form a united front across the euro zone to back weakling banks or close them down.

But the path to banking union is strewn with obstacles and time is running out for the ministers to strike agreement by their self-imposed deadline of the end of the year. One of the most sensitive questions is how to deal with banks so badly wounded that they need to be closed.

"We won't put a knife to our throats," said Moscovici. "It's unlikely we will reach agreement tomorrow."

BANKING UNION

The first pillar of banking union will see the ECB take on the supervision of big banks towards the end of next year.

In tandem with this step, it will conduct a review of their balance sheets, laying the foundation for the wider tests across the European Union.

But before this can take place, the question of who pays for the costs of closing or salvaging weak banks must be answered.

In their statement, ministers will say that if the tests show that a bank is short of capital, its shareholders and other investors will be asked to raise it.

Very few countries have special funds for that purpose, so the ministers have to make sure that at least legislation is in place for them to inject capital.

"In the eventuality that the (tests) reveal a capital shortfall, the established pecking order - first private sources, then national and euro area/EU instruments - will apply," the draft statement said.

Ministers will make clear that government help will only be possible if private funds are not available.

In other words, state help will come at a heavy cost by imposing losses on shareholders and junior bondholders, changing a bank's management and capping salaries and bonuses.

In time, possibly as soon as 2015, senior bondholders and even depositors with more than 100,000 euros in a failing bank, will be forced to take losses.

If a euro zone government cannot raise the capital itself, it could ask the euro zone bailout fund, the ESM, for a loan, as Spain did to recapitalise its banks in 2012.

If borrowing from the ESM would overburden a government, however, the ESM could recapitalise a bank directly from November 2014, the statement said. Germany's objections cast uncertainty over this.

(Additional reporting by Robin Emmott, Martin Santa and Jan Strupczewski; Editing by Alison Williams)