* Bank lobby head calls Hypo law 'unforgivable mistake'
* Says bank borrowing costs could rise up to 1.5 bln eur/year
* Downbeat on prospects for cap on bailout fund contributions (Adds Cernko quotes and background)
VIENNA, June 17 Austria's decision to wipe out holders of subordinated debt in nationalised lender Hypo Alpe Adria despite guarantees from its home province could increase banks' borrowing costs by up to 1.5 billion euros ($2 billion) a year, the bank industry warned.
Willibald Cernko, head of the Austrian Bankers Association and chief executive of UniCredit Bank Austria, cited that figure to reporters based on central bank estimates from 2010 on the impact of removing implicit state backing for banks.
Cernko launched a blistering attack on the Hypo draft law unveiled last week, saying the government had made "an unforgivable mistake" by unilaterally eliminating a public debt guarantee on the bank Austria nationalised in 2009.
"This is not just breaking confidence. It may also cause substantial collateral damage," he said on Tuesday. "I can only urge the people in charge to reconsider whether it is responsible to place the highest asset of trust in jeopardy."
The law may take force in August should parliament approve it as expected next month.
Cernko criticised the Financial Market Authority and central bank for waving through a step that he said jolts insurers, pension funds and other investors who thought they held safe Hypo debt because no regulators had warned against buying it.
"It is simply not right for supervisors to say now that investors should have known the state guarantees were no good, he added. "I find this line of argument very dangerous."
Austria broke new ground for debt markets by deciding to annul 890 million euros of subordinated Hypo Alpe Adria debt guaranteed by Carinthia.
The move aims to ensure that investors - not just taxpayers who have pumped more than 5 billion euros into Hypo so far - share wind-down costs for the stricken lender, officials said.
The debt holders are set to lose all their money, although there remains a small chance that some of it may be left over once Hypo is finally wound down years from now.
Getting junior bondholders to share the pain in bank bailouts is not new in Europe, but imposing losses on holders of debt with a state guarantee has credit rating agencies worried about the reliability of Austrian state backing.
Cernko held out scant hope of a breakthrough in talks with the government on freeing Austrian banks from paying both a domestic levy on assets as well as contributing to a new European fund for winding down ailing banks.
"The optimism is limited," he said, detecting differences among the two government coalition partners.
The levy on big banks raises 640 million euros a year for the state budget, to the chagrin of bankers who want the money earmarked for a bank-sector support fund, as in Germany.
Social Democrat Chancellor Werner Faymann has said he would keep that levy despite a parallel programme to set up a fund to enable winding down ailing euro zone banks.
Austrian banks face a 380 million annual hit to fund the European bank wind-down fund and joint deposit insurance.
($1 = 0.7345 Euros) (Reporting by Michael Shields and Angelika Gruber; editing by Mark Potter and Tom Pfeiffer)