* Loans for banks' rights issues should be penalised -survey
* Greek central bank says nothing to stop such loans
* Germany says loans need to be "deducted" from capital
* Expert says practice creates "banks as big as you like"
By Stephen Grey
LONDON, Aug 2 (Reuters) - European banks should face penalties if they loan cash for share issues by other banks, national regulators from across Europe told Reuters. This comes after a Greek bank was found to have raised money from offshore companies financed by other institutions.
A survey of central banks and other authorities found that in most euro zone countries such transactions, if discovered, carry a hefty price: banks providing loans for the purpose of investing in another bank's share capital should deduct an equivalent amount from their own capital.
The findings come after a Reuters report exposed how a major bank in Greece raised share capital via special offshore companies funded by other Greek banks. Some academic experts described the scheme as tantamount to raising "virtual capital" through a Ponzi scheme.
The Bank of Greece, which regulates the country's banks, said that nothing prevented unconnected banks funding each other's equity, raising concerns the technique might be widespread.
"European Union law does not prohibit granting loans to an entity (person or organisation) in order to participate in a share capital increase of another credit institution," the Bank of Greece said in a statement.
Since 2008, Greek banks struggling with the financial crisis have raised more than 13 billion euros ($15.8 billion) of new capital. The Bank of Greece did not respond to an emailed query from Reuters when asked how much of this money was raised through indirect loans from other Greek banks.
In July Reuters reported that at least one fifth of a capital-raising last year by Piraeus Bank, Greece's fourth-largest lender, involved shares bought by offshore "special purpose vehicles" with money borrowed from other banks.
Those funds included 65 million euros borrowed by the family of Piraeus's chairman, Michael Sallas, to finance an undeclared stake of over 6 percent in the bank he heads.
Several banking officials in Athens said it was common for senior bankers in Greece to finance shareholdings in their own institutions with loans from other banks.
Sallas declined to answer questions on the issue. Piraeus is suing Reuters for an earlier story about the bank renting properties owned by companies run by Sallas and his family, and wants 50 million euros in damages.
According to the European Banking Authority (EBA) and other banking experts, loans to finance shares in other banks should normally result in the lending banks taking a deduction from their own capital equivalent to the value of the loans.
Otherwise, said Hans-Peter Burghof, professor of banking and finance at the University of Hohenheim, Germany, "You can produce as much equity as you like and make banks as big as you like."
A survey by Reuters of euro zone banking supervisors and central banks found that a majority agreed with Burghof's view, though Spain, Luxembourg and Slovakia supported Greece's position.
Asked about loans to a special purpose vehicle for the "sole purpose" of buying shares in another bank's share issue, Germany's Bundesbank said this amounted to an "indirect holding of capital instruments" of another financial institution. A spokesman said "such transactions will have to be deducted from the investing bank's capital" under EU rules.
Austria's financial market authority said it took the same view and "requires the deduction of holdings" from the lender's capital.
The Bank of France took a similarly tough line. A spokeswoman confirmed that under French rules such lending should be declared.
"If it is an undeclared carried equity stake, then there is a presentation of false accounts and an offence has been committed. It's a crime." If declared, it should be deducted from the balance sheet, she said.
The Netherlands agreed, as did Finland. A spokesman for the Finnish regulator said: "If this kind of business is done greatly across the local banking sector it will create one potential system risk of course."
Commenting on the survey, Simon Gleeson, UK-based regulatory partner at law firm Clifford Chance, said there was undoubtedly some "imaginary capital" in the European banking system. He said authorities may have little incentive to dig too deeply into the issue in countries where banking stability was a pressing concern.
British, and other major regulators, he said, tried correctly to apply a "substance over form" approach, attempting to consider the intention and effect of a loan scheme.
"If you have money going into a vehicle that has been set up for the sole purpose of buying these capital instruments, then it's an issue, and capital should be deducted by the lender," Gleeson said.
A few regulators in the euro zone did not agree. A Bank of Spain spokesman said: "Generally speaking, the law does not limit who you can give loans to." Deductions applied only if the banks involved were linked, he said.
Luxembourg's financial regulator said that "under European law the transaction mentioned (a loan to invest in capital raising) is not illegal and no deductions required".
A spokesman for the National Bank of Slovakia said: "Yes, such loans are permitted, but there is no consequence on the field of capital deduction."
Italy, Belgium, and Cyprus did not respond to questions from Reuters on the issue, nor did Britain's Financial Services Authority.
Gleeson said: "This is one of the areas where a single regulator would be the only practical way of ensuring consistency between countries."
Yannis Varoufakis, professor of economics at the University of Athens, was blunter about the way Greece allows banks to raise capital via loans from each other while the country relies on huge bailouts from the "troika" of the IMF, ECB and European Commission.
"These are loans from one bankrupt bank to another bankrupt bank," he said. "It is scandalous the troika stays silent about this form of corruption while handing over billions of taxpayers' money to these banks."
Reacting to revelations about Piraeus Bank, the European Commission said last week that Greek banks would face due-diligence audits and possible management shake-ups in return for the share of bailout cash.
"The recapitalisation process will entail a significant revamp of corporate governance structures and management practices in banks where malpractice has occurred," a spokesman said. [ID: nL4E8IN520] The IMF and ECB declined to comment.