Investors other than ordinary shareholders would take a loss before banks are bailed out by taxpayers or fail under a new proposal from the Basel Committee of global banking regulators.
The proposal, unveiled on Thursday, is part of wide-ranging measures regulators have been planning to reshape the financial system and avoid a repeat of the credit crisis that forced governments to inject hundreds of billions of dollars to shore up ailing lenders.
Under the proposal all capital instruments other than common stocks would could be written-off or converted if a bank is about to be rescued by the state or about to fail, effectively hitting capital providers -- such as holders of bonds and preferred shares -- before ordinary citizens.
The proposed new clause triggering the write-offs would be activated at the request of the regulator based in the relevant jurisdiction.
The Basel Committee "believes that a public sector injection of capital needed to avoid the failure of a bank should not protect investors in regulatory capital instruments from absorbing the loss that they would have incurred had the public sector not chosen to rescue the bank," it said in its proposal.
The plan stems from the realization that when governments stepped in to shore up lenders during the credit crisis, they bailed out both the bank and the capital providers.
"As a precondition for being treated as regulatory capital, an instrument must be capable of bearing a loss if the issuing bank is unable to support itself in the private market," said Nout Wellink, chairman of the Basel Committee and head of the Dutch central bank.
Banks ranging from Britain's Royal Bank of Scotland and Lloyds to ABN AMRO and Fortis in the Netherlands to Switzerland's UBS took government cash or were partly nationalized at the peak of the crisis.
The Basel Committee proposal goes a step further in trying to address the too-big-to fail problem, which is still under discussion in international regulatory circles.
The proposal, which would require changes in contractual law, is open for consultation until Oct 1.
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