REFILE-UPDATE 1-ECB's Draghi backs public backstop for soured Italian bank loans

(Adds “non-performing loan” after NPL acronym in para 5)

* Would avoid fire sales “in exceptional circumstances”

* State guarantees are among options - euro zone sources

FRANKFURT, July 21 (Reuters) - A state-funded backstop would be “very useful” in helping Italian banks sell down some of their bad loans that have hampered their ability to lend, European Central Bank President Mario Draghi said on Thursday.

Italian banks have come under pressure from financial markets and the ECB to unload high levels of soured credit and Rome is in talks with the European Commission to allow state aid to its most troubled lenders, hoping to shield savers from losses resulting from selling those loans.

Though Draghi does not have a direct say in the talks, his support for a public backstop is meaningful because the ECB is the euro zone’s banking watchdog and needs healthy banks to transmit its monetary policy measures.

“A public backstop would be very useful but certainly should be agreed with the Commission according to existing rules,” Draghi said at a news conference after the ECB held interest rates and its asset purchase programme unchanged.

He argued that creating a functioning market for non-performing loans was key to addressing the problem and a public backstop on some of these loans would be help “when, at times of exceptional circumstances, the NPL (non-performing loan) market is not well functioning and we will want to avoid fire sales”.

The main factor holding back Italian banks from selling their 360 billion euros worth of NPLs is a wide gap between the price at which they are prepared to sell - typically around half of the original value for loans backed by property - and what investors are prepared to pay, which is around 20 percent for such credit.

Euro zone officials with knowledge of the matter told Reuters that one scenario to address the issue involved Italian bank loans at risk of non-payment being hived off into a separate vehicle, which would then repackage and sell them onto investors in a securitisation.


One of the sources said this could entail a state guarantee and possibly a commitment by banks to absorb any losses if the loans ultimately go unpaid, a formula meant to encourage investors to buy.

“The aim is not to clean the balance sheets over time,” said a source with knowledge of the matter who spoke on condition of anonymity in describing the scheme.

“The aim is to clean it now. You need to find investors for that and so you need protection.”

The Italian government is negotiating with the European Commission to secure a form of immediate state support to its weakest lenders, including Monte dei Paschi di Siena, that may be exposed as weak in pan-European health checks of the banking sector due to be published on July 29.

Italy wants to inject fresh funds but European rules usually require the imposition of losses on creditors -- chiefly holders of subordinated debt -- first. The Commission is charged with ensuring that state aid does not distort competition.

Italy wanted to exempt investors from a bailout, fearing that losses would undermine faith in the heavily indebted country and cause protests against the government ahead of a crucial autumn referendum on constitutional reform.

But Germany flatly rejected a push by Italy to protect all investors, big and small, from any fallout.

“For long-term investors to come back in a meaningful way there needs to be more clarity as to what policy response we will get,” Michael Metcalfe, head of global macro strategy at State Street Global Markets, said.

A spokeswoman for European Union competition commissioner Margrethe Vestager, who is leading negotiations with Italy, said there was “constructive contact with the Italian authorities”.

“There are a number of solutions that can be put in place in full compliance with the EU rules addressing liquidity and capital shortages in banks without adverse effects on retail investors,” Vestager said. (Editing by Mark Heinrich)