By Luke Baker
BRUSSELS (Reuters) - In September last year, at a below-the-radar meeting in Helsinki, three euro zone finance ministers came up with a two-word phrase that sounded harmless at the time but has since troubled European leaders a great deal.
Banks' "legacy assets" sound innocent enough but in the context of Europe's debt crisis, and particularly for Ireland and Spain, the question of how to deal with existing bad debts is a time bomb that has not been defused.
In the months since the term entered the EU's lexicon, efforts have been made to parse it or play it down.
But those that came up with it -- the finance ministers of Finland, Germany and the Netherlands -- appear determined to keep it alive, and until June 2013, the deadline leaders have set themselves to resolve it, the issue will fuel uncertainty.
At its heart, it comes down to the difference between a euro zone country getting direct banking assistance from the region's 500 billion euro rescue fund, known as the ESM, or a country largely being left to fend for itself, with the market volatility and high borrowing costs that go with it.
In that respect, "legacy assets" are a critical link in the chain that binds governments to their banks -- the "vicious circle" that has dragged several states down with their lenders which policymakers are desperate to break.
From the Finnish, Dutch and German point of view, any banking problems that have already come to light, or emerge before the European Central Bank takes over as the euro zone's single banking supervisor in mid-2014, are "legacy".
As Finnish Prime Minister Jyrki Katainen said earlier this month, "a line has to be drawn somewhere" so that European taxpayers aren't left footing the bill for badly run banks.
Katainen says existing banking problems in Ireland, Spain or elsewhere should remain chiefly the responsibility of their governments, and only in the future, after mid-2014, would the ESM, and ultimately European taxpayers, provide any backstop.
"Direct capitalization through the ESM has been decided to be used only once the European supervision is up and running," he said on January 16. "This is the rule that we have decided."
The problem is that is not the way Italy, Spain, Ireland and others have interpreted the rule since it was drawn up at a summit of euro zone leaders in Brussels last June.
At that time, Italian Prime Minister Mario Monti praised the deal, which said the ESM could "have the possibility to recapitalize banks directly", as a breakthrough that would change the debate after nearly three years of debt turmoil.
Markets rallied and yields on the debt of periphery euro zone countries fell sharply on expectations direct recapitalization would soon cut the link between indebted banks and their sovereigns. Maybe that was premature.
In meetings of euro zone finance ministers since then, discussions have taken place about precisely what steps would need to be taken before a country can receive funds from the ESM and how to resolve the "legacy assets" issue.
While the process will only be finalized in the months ahead, it is expected there will be specific rules stating that banks have an obligation to raise their own capital first. If that is insufficient, then the national government would step in, and as a very last resort, the ESM could, under strict conditions, provide capital directly, euro zone officials say.
That is a far more convoluted process than first envisaged, but one that even Ireland's finance minister, one of the strongest advocates for direct recapitalization, including for "legacy assets", has acknowledged is likely.
"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," Michael Noonan said after the last Eurogroup meeting on January 21.
NO RECAP EVER?
Part of the aim of Finland, Germany and the Netherlands is to make accessing the ESM so onerous that few countries will do it. If it is too straightforward, a string of states will apply and the scarce resources of the fund will be used up.
The ESM is based on paid-in capital, which will eventually total 80 billion euros. To bail out a bank, the fund would either have to dip into that, which would get depleted quickly, or borrow on the market to buy bank shares, which is inherently more risky than lending to a government.
Since the ESM is based on paid-in capital, and any direct recapitalization of banks would require the transfer of capital, the fund, which will only have 80 billion euros in it at the moment rising, would be depleted very rapidly.
"We don't want this to be so attractive that everyone lines up to recapitalize their banks," said a finance official from one of three northern European countries.
It is not just a case of keeping "legacy assets" separate and making it difficult to tap the ESM after mid-2014, there is even a push by some officials to make sure that the direct recapitalization of banks either never happens or at least does not for several years.
Those officials argue that there needs to be a fully functioning system for winding up bad banks in place before any recapitalization can happen. Only once all resolution measures, such as the 'bailing-in' of bank bondholders, have been enforced would the ESM be in line to provide help.
New legislation on bank resolution will be proposed in June and is expected to reiterate that bondholders would only be in the firing line from 2018. If that is the case, then some officials say direct recapitalization shouldn't happen until after that date either.
"It may even be the case that no euro zone bank is ever directly recapitalized from the ESM," said the official from the northern euro zone country. "Ideally, that's what will happen. But we will have to see."
(Additional reporting by Jan Strupzcewski, editing by Mike Peacock)