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* Euro zone ministers to discuss retroactive direct help for banks
* Germany, Netherlands, Finland see direct funding only in future
* Ireland, others say idea should be used retroactively
By Jan Strupczewski
BRUSSELS, Jan 21 (Reuters) - The euro zone bailout fund should be allowed to buy stakes in banks in the region that are still viable but need an injection of government money, Irish Finance Minister Michael Noonan said.
Euro zone finance ministers will discuss at a meeting in Brussels on Monday evening which financial institutions should be eligible for direct recapitalisation with euro zone funds, but no decisions will be taken.
Such recapitalisation is meant to break the vicious circle between highly indebted governments that borrow more to recapitalise banks that need support because they own bonds issued by those states but which are liable to lose value.
Ireland invested 64 billion euros - 40 percent of its GDP - in its banking sector to prevent its collapse, forcing it to seek a euro zone bailout.
Greece will have borrowed 48 billion from the euro zone to recapitalise its banks, while Portugal borrowed 12 billion euros and Spain got almost 40 billion euros.
Euro zone leaders agreed on June 29 last year that the bank-state loop must be broken and that the 500 billion euro permanent ESM bailout fund should be able to buy bank equity to ease the debt burden on already struggling sovereigns.
But there is no agreement on which banks are eligible.
Germany, Finland and the Netherlands believe the ESM should be allowed to take stakes only in banks that get into trouble in future, once the European Central Bank becomes their supervisor in 2014. That would dramatically reduce the chances of the ESM investing in any banks at all.
The three countries believe that any problems that have arisen before the ECB takes over should be dealt with by national governments as "legacy" assets.
Other countries, including those that borrowed heavily to support their banking systems - like Greece, Ireland, Portugal or Spain - believe the ESM should be allowed to act retroactively. They take the view that the point of direct recapitalisation is to ease the current debt burden on the sovereign.
"We will be arguing what we understood the situation to be on June 29, that banks that were still functioning, lending, trading banks would be eligible, even though insolvent banks might not be," Noonan told reporters before the meeting.
"My political input will be that these policy instruments... should be applied retroactively to banks that are still trading, like the Bank of Ireland, AIB and Permanent TSB," Noonan said.
He said there was about 7 billion euros in preference shares and contingent capital in the institutions and that he would "not be adverse to selling the preference shares and contingent capital at par" to the ESM.
Even after the ECB takes over bank supervision in 2014, the option of direct bank recapitalisation might be phased in gradually, Noonan said.
"If a bank in country X goes bust four weeks after the new rules are put in place, no one would expect that the European authorities should carry the whole responsibility," he said.
"There would be some residual responsibility with the sovereign country that allowed things to develop to that point. But as time goes by, obviously the input by the sovereign would diminish to virtually zero, and...whatever support is in place for insolvent banks would carry the totality of the burden."
The ESM recapitalisation option was mainly agreed to help Spain, where the banking sector had been hit by the collapse of the property market and the government was struggling to regain market confidence amid a recession and record high unemployment.
But since Spanish borrowing costs tumbled thanks to an ECB promise to buy unlimited amounts of Spanish bonds, the issue lost much of its urgency, officials said.
Further removing the need to hurry, euro zone leaders gave ministers until June 2013 to sort out the operational details of direct recapitalisation.
Because investment in equity is seen more risky than in sovereign debt, direct recapitalisation would tie up more of the ESM's resources than lending to governments.
The ESM would also get sucked into the problems of managing those institutions, such as addressing how the different banks it owns compete with one another.
The prevailing view is that the ESM should only step in to recapitalise a financial institution as a last resort, when the bank has failed to raise the money from private investors and the government is not fiscally strong enough to help either.