By John O'Donnell
BRUSSELS (Reuters) - The weight of debt on Europe's banks means it is only a matter of time before euro zone governments impose losses on senior bank bondholders, analysts believe, although policymakers remain nervous about taking such a radical step.
Throughout a five-year banking crisis in Europe, euro zone governments have typically stepped in to rescue troubled banks, shielding senior bondholders from losses to keep markets and investors calm. But the costs are rising.
With the debt of fragile euro zone banks topping 5 trillion euros ($6.1 trillion), according to ECB statistics, and weaker governments in no position to support them further, officials, analysts and investors believe it is inevitable that bondholders will eventually have to shoulder losses on their investments.
Many say that extending losses that are typically limited to subordinated or junior debt and imposing them on senior bondholders would scare off investors, compounding banks' problems. Only Iceland and Denmark have taken that step so far.
"Treating bank bondholders in Europe as sacrosanct has certainly been a problem," said Eric Stein, a fund manager with Eaton Vance Investment Managers, a U.S. investment fund that buys European government debt.
"They are closing in on the senior bondholders. Bailing in senior bondholders now would be suicide. But how long do you wait? It is only a matter of time before they are going to have to bear some of the burden of this adjustment."
For now, the European Commission has explicitly ruled out such a move in the case of Spain, which is expected to receive approval for up to 100 billion euros of aid for its banks as soon as this week.
A draft agreement with Madrid, obtained by Reuters last week, limits such "burden sharing" to bank shareholders and owners of hybrid capital instruments.
But some countries believe this should be amended, arguing that debt restructuring requires firmer steps to protect taxpayers. Finland, among others, has pressed that line.
"It's still open," said one EU official familiar with the talks, who asked not to be named. "If this is the price of agreement, then it will happen.
"Investing in bonds is risky. So why should you have protection for certain categories? For the private sector, it is natural that you have restructuring," the official said.
Making the owners of junior or subordinated debt issued by euro zone banks take a "haircut" provides only limited relief.
Banks in the euro zone have $199 billion of such junior or subordinated debt outstanding - a fraction of the $1.8 trillion of senior debt they issued, according to data from Thomson Reuters. Of that senior debt, roughly $850 billion is unsecured.
Debt that is secured against assets such as a home mortgages or credit-card receipts could not be easily cut in value as investors have legal recourse to collateral. Pursuing unsecured bondholders is the most likely option.
The picture is similar in Spain, where the country's banks have issued roughly $70 billion of unsecured senior debt, more than twice that of the $27 billion of subordinated debt. Spanish banks' total senior debt amounts to $428 billion.
The European Central Bank, on whom many of the bloc's banks depend for funding, will influence the final decision.
Its president, Mario Draghi, appeared to take a softer stance at a meeting of euro zone finance ministers last week than his predecessor, according to two euro zone officials.
"Draghi suggested that the option of the senior bondholders being squeezed could be acceptable in the case of some banks. His suggestion concerned non-viable banks. But the finance ministers did not want this," one of the officials said.
"As I understand it, in Spain, there will be no burning of senior bondholders."
Jean-Claude Trichet, the former ECB chief, vehemently opposed any such move, forcing Ireland to seek an international bailout to honor its guarantee to prop up the nation's banks. Dublin now hopes this deal can be revised.
Trichet also opposed making private investors take losses on Greek government debt, which was eventually agreed on a voluntary basis and as a "unique case" this year. Analysts do not expect another such sovereign "haircut", leaving few alternatives but to tackle bank debt directly.
Jens Sondergaard, European economist with Nomura, said that while restructuring bank debt might be the best solution, it remained politically contentious.
"When people look at the debt level of all those banks and look at the debts of the sovereigns, then there is a perception that something has to give," he said.
"Restructuring of bank debt would be the best way forward but I'm not sure policymakers are willing take that risk."
The sensitivity of the debate can also be seen in discussion about a draft EU law to make it easier to impose losses, including on bondholders, when a bank is failing, as part of a framework to close down troubled lenders.
This is an important part of forging a banking union or common response in Europe, or at least in the euro zone, to the financial crisis.
If agreed by member countries, the law on winding up stricken lenders would introduce an insolvency regime for banks in the European Union from 2014 and later give regulators power to impose losses on bondholders, or "bail them in".
The proposals, put forward in June by Michel Barnier, the European commissioner for financial regulation, would not have included "bail-in" provisions without the ECB's blessing.
At a meeting of EU finance ministers in Brussels last week, Spanish Economy Minister Luis de Guindos warned that the draft rules should be handled carefully to avoid aggravating market turmoil.
Others argue that it is time for Europe to break the taboo that banks cannot be closed and that bondholders should be shielded from the consequences.
"The European Union has a lot to learn from the United States," said Nicolas Veron, who works at the Peterson Institute for International Economics, a Washington-based think-tank, as well as with Brussels think-tank Bruegel.
"In the U.S., the FDIC (Federal Deposit Insurance Corporation) wipes out almost all the subordinated debt and imposes heavy losses on the unsecured senior bondholders."
Should Europe choose not to follow, it could come at a heavy cost.
"For the euro zone to be safeguarded from unraveling, sovereign default will not be the way to reduce debt. Other forms of debt liquidation will have to be found," said Veron. "I suspect that a lot of this will be through the banks."
(Additional reporting by Jan Strupczewski in Brussels and Alex Chambers in London)