RPT-European Union told to handle fragile banks with care
* Officials warn ministers of risks in banking
* Commission delays contested proposal on failed banks
* Lending to business critical to spur flagging economy
COPENHAGEN, March 30 (Reuters) - European Union finance ministers were warned of the continued fragility of the region's banks on Friday as the bloc's executive postponed a contested proposal critics warn could make nervous banks even more reluctant to lend.
Lending to business is essential to spur economic growth as the euro zone slides towards recession but Europe's banks, shaken by the financial crisis, are more reluctant than ever to give credit to small companies and others considered high risk.
In a report prepared for the EU finance ministers' meeting in Copenhagen, EU officials warn of possible problems in banking. They flag the risk that banks would be unwilling to write down bad loans, something that in turn would prevent them from giving new credit.
"Developments since the beginning of this year have surprised on the upside, but risks to the macroeconomic outlook remain tilted to the downside," officials write.
"If an aggravation of the sovereign debt crisis were to result ultimately in a credit crunch and a collapse in domestic demand, this would probably entail a deep and prolonged recession."
It is fears like these that prompted the European Commission, which writes the first draft of laws to regulate finance, to delay the announcement of a proposed framework for winding up troubled lenders.
The EU's executive wants to include rules that would allow the imposition of losses on a failed bank's bond holders, who were largely spared during the financial crisis while shareholders and governments bore the brunt of the cost.
NO MORE BAILOUTS
Critics say the so-called bail-in rules, by laying the foundation for bondholder losses, would scare off the buyers of such debt, pushing up the cost of borrowing for banks and making them more reluctant to lend.
Michel Barnier, the European commissioner responsible for drafting this and other regulation, has been postponing its publication for fear of unsettling investors, already rattled by billions of euros of losses in a Greek debt restructuring.
On Friday, he announced that the proposal would require at least another month's preparation before being presented to countries for them to amend or approve.
His officials will use this time to canvas the views of central banks, who are concerned about the new rules, as well as countries.
They want to gauge the level of political support for pushing losses on the bondholders not only of failed banks that are being wound up but also one that is in danger of failing, in a bid to prop it up. They will also ask what type of debt should be covered by the rules.
"Bailout ... it's taxpayers who pay," Barnier told journalists. "Bail-in, it's shareholders and creditors who end up paying. It must be a possible option. We don't want tax payers to end up bailing out the banks."
"It is a very sensitive issue and that is why we are taking a further four weeks, starting today, to discuss with key stakeholders how to calibrate the proposals on bail in," Barnier said.
The new rules for failed banks, seen by many experts as one of the central regulatory reforms needed to strengthen the financial system, will only apply from 2013 at the earliest. This is roughly six years after the start of the banking crisis in Europe.
The delay has upset European regulators, who have informed ministers that it aggravates uncertainty for investors, said one official familiar with the matter.
Critics point to the risks that could further drag out discussions with EU countries, whose blessing is needed for the proposal to become EU law.
"If the banks cannot raise longer-term money, then they will have to shrink the amount of credit to the economy, which - in plain terms - means calling in loans to SMEs and individuals," said Graham Bishop, an expert in EU financial policy. "That would throttle economic growth."
Barnier has unveiled a raft of regulatory rule changes from curbing banker bonuses to regulating hedge funds since taking his post more than two years ago. Many have run into stiff opposition.
The commissioner may have to abandon part of a proposal for an EU law to change the way credit rating agencies work.
In the face of opposition from some countries, the suggestion that debt issuers such as corporates rotate the ratings agencies they use to rank creditworthiness may be dropped from a draft EU law, diplomats and officials said.