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By Huw Jones
LONDON, Oct 18 (Reuters) - Pre-arranged "bail ins" of banks offer a promising solution to the problem of how to shore up troubled lenders, but they must be legally watertight and accepted by markets, regulators and former central bankers said on Monday.
Under a bail-in, a bank's bondholders would accept a speedy, discounted conversion of their bonds into equity to bolster an ailing bank's capital base.
The proposal is one of several on the agenda for global regulators meeting in South Korea this week to find ways of ensuring taxpayers don't pick up the tab the next time a "too big to fail" lender threatens to go under and destabilise the financial system.
The package is being put together by the Financial Stability Board (FSB), a body tasked by the world's leading economies to implement a string of financial reform pledges, and will also contain options such as contingent capital and capital surcharges on the world's 30 or so very big banks.
"The most promising avenue to good resolution is bail-in but this needs considerable further development before it can serve as a reliable emergency plan that the authorities have in the drawer to be used at a moment's notice," Thomas Huertas, a senior official at Britain's Financial Services Authority said.
Huertas' comments were read out on his behalf at a
conference on regulation held by the London School of Economics.
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Huertas, who is a member of the Basel Committee of global banking regulators and central bankers also meeting in South Korea this week, said bail-in arrangements must be airtight and capable of very rapid execution.
Some regulators and fund managers are sceptical there would be enough investor appetite for such debt, with similar concerns raised about "contingent capital".
Charles Goodhart, a former member of the Bank of England's monetary policy committee, said a bail-in would trigger a shock in the markets that might hamper the ability of other banks to raise capital.
"The experience of this last crisis, whenever the authorities have actually looked hard on the effects of putting a loss on the debt holders, they have actually shuddered and gone into the opposite direction and guaranteed all debt," Goodhart said.
"Why would the future, if you are going to penalise debt holders, be so different?"
Huertas warned that, if bail-ins could not be made to work, the alternative was making banks simpler or forcing them to hold more capital -- a step the industry fiercely opposes.
Wilson Ervin of Credit Suisse said bail-ins were one of the more credible ways of ensuring taxpayers won't have to rescue banks in future.
"It gives access to huge amounts of capital," Ervin said.
The European Union's executive European Commission will on Tuesday present a policy paper for a framework to deal with a crisis at the cross-border banks that dominate the bloc's banking sector.
Bail-in mechanisms could form part of an eventual framework.
"I strongly believe this policy of bail-in has to be part of our resolution framework," said David Wright, who has just stepped down as deputy head of the Commission's internal market unit.
Without a bail-in to allow supervisors to move quickly "you are driven to the U.S. system which is to drive everybody into ...bankruptcy," Wright said.
There is a huge education effort to be made to convince the market how it would work, and investment funds should voice their concerns or propose alternatives, Wright added.
The Group of 20 (G20) leading developed and emerging market economies are due to endorse the FSB's package on "too big to fail" in South Korea next month, but so far there is disagreement over elements such as capital surcharges.
"Any surcharge would be useless, unfair and probabaly counterproductive," said Christian Lajoie of French bank BNP Paribas, echoing his country's opposition to surcharges.
Lajoie said an EU law was needed to give supervisors powers to restructure an ailing bank by converting debt into equity.
EU Internal Market Commissioner Michel Barnier is expected to propose a draft law next year on tackling failing cross-border banks.