Here’s Why Mario Draghi Wants to Relax a Banking Regulation

European Union

Mario Draghi, the chief of the European Central Bank, has called into question rules that force banks to make junior bondholders take losses before applying for public aid, Bloomberg reports. With all eyes on the central bank before it announces a plan for a comprehensive review of European banks later this week, Draghi has voiced his opinion that a rule governing the region’s banks should be relaxed.

The rule says that if a bank wishes to apply for aid from any public group — including the ECB or the Firewall Fund that is being established to provide a public source of credit for struggling banks in the region — junior bondholders must first be made to lake losses on their effective loans to the bank. The rule is designed to dissuade banks from applying for public funding by imposing a sort of penalty for doing so. The penalty isn’t just that the bondholders lose money but that the reputation of the bank would also suffer greatly.

In the face of the ECB’s check on the status of the region’s banks — which will almost certainly include an asset quality review and several stress tests — Draghi has questioned whether the rule is too harsh on banks that are still solvent but would benefit from the use of the central bank’s resources. Under new guidelines, it is entirely possible that banks that are still far from going belly-up would need to raise additional capital in order to comply with the results of the central bank’s review, a prospect that would leave banks strapped for cash unless the funds were made available through some public means.

Draghi believes that by repealing the rule, access to the public funds would be expanded, and a more flexible, case-by-case approach could be implemented. Thus, if a bank required additional money but private capital was scarce, an institution could make use of the Firewall Fund on a temporary basis until it was able to obtain the capital through private sources. Draghi has also claimed that confidence in the euro region’s banks would tank should junior bondholders be forced to take losses, making the rule detrimental to the very problem that the ECB is trying to solve.

Still, there are many in the region — including the Dutch and German finance ministers — who have expressed opposition to the central bank’s plans. They question whether it is in the best interest of the eurozone to have the bank both conduct the review and be the institution behind the financing of banks that are not up to standards. In addition, critics have said that the central bank is undermining national initiatives to regulate and support financial institutions, which they argue should be the primary vehicle of maintaining stability in the region’s banks.

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