Taxpayers shouldn't be the only ones paying the price for government bailouts, international regulators said Thursday.

The Basel Committee on Banking Supervision said investors should also help in absorbing losses in the event of future public sector assistance due to excessive risk taking.

"During the recent financial crisis a number of distressed banks were rescued by the public sector injecting funds in the form of common equity and other forms of Tier 1 capital," the committee wrote. "This had the effect of supporting not only depositors but also the investors in regulatory capital instruments."

The Basel committee issued a consultative paper arguing that all regulatory capital instruments should be capable of absorbing losses - either written off or converted to common shares - in the event a bank is unable to find support in the private market.

The proposal is part of an effort by international regulators to avoid what occurred during the latest financial crisis, when Tier 2 capital instruments, primarily subordinated debt, did not absorb losses.

"In order for instruments to be treated as regulatory capital, the committee considers it a precondition that such instruments are capable of bearing a loss," the committee wrote.
Still, some analysts viewed the committee's proposal as evidence of a continued dispute among regulators over how to define capital.

"The consultative paper goes beyond talk of contingent capital to address both Tier 1 and Tier 2 capital, mandating that all instruments have demonstrable loss-absorption capacity," said Karen Shaw Petrou, managing partner of Federal Financial Analytics Inc. "This is in conflict with other proposals to permit certain intangible capital — e.g., deferred tax assets — to count, making clear that the overall issue of what's capital remains a significant point of contention."

As part of its proposal, the committee said any capital injection by the public sector should not prevent investors from absorbing a loss they would have taken had a bailout not taken place.

"The numerous public sector injections of capital during the crisis and other forms of public sector support have had the indirect consequence of ensuring that in many instances capital instruments issued by banks that have been bailed out have not taken any losses at all," the committee wrote.

Instead, the committee is recommending that a deterrent mechanism be imposed on all such securities to ensure a loss is taken in the event the bank reaches the point of "non-viability."
Doing so would reduce moral hazard and lower excessive risk-taking by discouraging investors from purchasing securities with the assumption they would be able to avoid losses should the bank collapse, the committee said. It would also make the private sector the first source of new common equity to revive a bank on the verge of collapse, the committee said.

A comment period has been issued on the committee's proposal until Oct. 1.

The Basel committee, which represents central banks and regulators from 27 nations, has been working to draft rules on the new capital and liquidity standards. The committee is anticipated to present a final package of reforms to the Group of 20 leaders when they meet in Seoul in November.

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