(Adds German bank association reaction)
BERLIN, April 10 (Reuters) - Germany has given its banks long-awaited legal certainty on the tax treatment of "CoCo" bonds that can be converted into shares to bolster their capital, the finance ministry said on Thursday.
The ministry said banks will be allowed to deduct interest payments on these contingent convertible bonds from their taxes, paving the way for German banks to issue the securities.
The securities are designed to act as reserve capital when a bank runs into trouble. They can be converted into shares, temporarily written down, have coupon payments suspended, or get wiped out entirely if a bank's capital falls below a set level.
"The finance ministry, together with the federal states, today created legal certainty on the treatment of instruments of banks' additional core capital, so-called CoCo-bonds," the ministry said in an email to Reuters. "On the basis of existing tax law, banks in Germany can use these instruments with comparable conditions to their European competitors."
CoCos have proven popular with banks and investors, who receive a high rate of interest to compensate for the risks involved in holding them.
German banking association BDB has described the long-awaited approval as an urgent matter for banks seeking to bolster their balance sheets, saying the delay threatened to put the country's financial sector at a competitive disadvantage.
Banks in Britain, France, Switzerland, Denmark and Belgium have all issued them, after those countries laid the regulatory groundwork ahead of Germany. Bank BBVA was the first Spanish bank to issue this form of capital last year after Madrid cleared the way.
In Germany, Deutsche Bank alone plans to issue at least 5 billion euros ($7 billion) of the securities before the end of next year, paving the way for other banks.
Germany's Aareal Bank has said it will seek to repay the 300 million euros in state aid from the financial crisis by issuing them later in the year.
"CoCos are a type of reinsurance for banks and regulators in case of a catastrophe, such as if a trading loss in the billions causes the capital ratio to plunge overnight," Marcus Schulte, regional head of bank debt issuance at Credit Suisse, said.
"That's not going to actually happen very often. Normally, a bank would already address its capital ratios starting at 7 percent and possibly raise new capital or introduce other measures."
The German banking association BDB said German banks would now be allowed to raise capital as a security buffer ahead of crises. "Now the tax framework for German banks is structured the same as in other European countries," the association said.
Investor demand has been high, allowing banks to raise cheap capital to fortify balance sheets and improve their leverage ratios. Banks have been keen to raise new capital because of a balance sheet check by the European Central Bank, which will supervise Europe's big banks from the end of this year.
"It's going to get interesting when these conditions change. That will sort the wheat from the chaff." Schulte said. "Then for banks with weaker capital or credit profiles, it's going to possibly get tougher, or at least more expensive, to issue CoCos."
Under the bank safety framework known as Basel III, banks can raise 1.5 percentage points of their 6 percent Tier 1 capital ratio using the securities.
"CoCos are not a magic wand to solve all capital problems, rather, one instrument among many. We expect European banks to issue CoCos to optimise their capital structure," Marc Hellingrath, head of financials and fixed income fund manager at Union Investment, said.
Bankers and investors expect German banks to use the same structure as French, Danish and other banks, where if bank regulatory capital falls below a certain threshold, bondholders lose their investment. But investors still have the potential to recover those losses should the bank return to health.
According to recent research by JPMorgan, Deutsche Bank's requirement is almost 13 billion euros while Commerzbank may need to raise almost 2.5 billion euros in this form of capital. (Additional reporting by Thomas Atkins in Frankfurt; Writing by Annika Breidthardt; Editing by Catherine Evans and Jane Merriman)