* New regulation may repel staple investors
* Bond buyers say rules will push up debt costs for banks
By Sinead Cruise
LONDON, May 28 (Reuters) - Bond investors say they could stop funding Europe's fragile banks if rules designed to insulate them from shocks are put in place, making financial institutions even more vulnerable to the debt crisis and possibly more reliant on taxpayer money.
Global regulators want bondholders to give up a privileged position which gives them a priority over other investors if a bank runs into trouble, in favour or people who deposit their money in an account.
The European Union will unveil its draft version of the rules for big cross-border banks next month. They are designed to make sure taxpayers do not pay the bill for bailing out banks again, to prevent a run on banks and to make sure bank bonds are not seen as risk free.
But some investors say they will go too far at the expense of those who lend long-term money through unsecured bond markets, one of the most important sources of bank funding.
They say the cost of issuing the debt will rise, curtailing demand and leaving the sector dependent on a shrinking pool of funds that could send banks running back to governments or the European Central Bank to plug the gap.
"Why should I as a buyer of bonds wish to get into a senior bank bond today when I know that there's a very good chance that my bonds will become subordinated to other creditors?," said Stephen Snowden, fund manager at Kames Capital.
"The money raised from the markets will be more expensive. That means debt they lend to us will be too. Politicians have undoubtedly helped society by strengthening the banks but they have also crippled it by making it harder for them to lend."
Europe's market for unsecured debt seized up during the worst moments of the region's debt crisis, sending banks to the European Central Bank to take up a trillion euros of cheap long-term funding (LTRO) doled out in two exceptional lots.
Senior unsecured bondholders have lent just $122 billion to European banks this year, compared with $218 billion in the corresponding period in 2011, Thomson Reuters data shows.
The market opened up in the first few months of this year but seized up as concerns about Greece's future in the euro returned. The proposed rules will do little to help the market, investors say, and public support may once again be needed.
"This is all about policy response. This is about LTRO3, it is about keeping interest rates at very low levels for extended periods of time," said one equity capital markets banker.
The EU's draft law has been repeatedly postponed for fear it would unnerve investors, even though the measure would not likely come into effect for several years.
Banking lobby groups will point to this potential exodus of bond investors to try and persuade EU p olicymakers to review the plans and spend more time evaluating the consequences.
Regulators say big banks have benefited from unrealistically cheap funding because investors believed they would be rescued by governments if there was trouble.
Giving supervisors powers to impose losses on creditors is part of ending this "too big to fail" perception and regulators say many investors will still buy bank debt.
"I talk to a lot of investors about this and they say ...'we are not against it in principle... We may not mind buying a piece of debt that has a higher probability of bail-in but we can then price the risk attached to doing that'," said Andrew Bailey, the top banking regulator at the Bank of England.
But critics say bank bonds would become unattractive at a time when lenders need to stand on their own two feet and not rely on cheap ECB funds.
"Bail in will happen in some way, whether current bonds are subjected to new rules or there's a creation of an entire new debt asset class structured to lose some of its position when a bank's capital falls below a certain level," Edward Farley, principal at Prudential Financial's Pramerica said.
"But I can't figure out who would buy those instruments? If you went round the buy-side one by one, they'd say 'thanks, but no thanks'. Regulators are trying to find a species of credit investor that doesn't exist at the numbers they need."
Bondholders would only have to bear losses if writing down shareholder equity and regulatory buffers proved insufficient and there is some dispute among regulators over when the bail-in trigger would be pulled.
HSBC Chairman Douglas Flint said in a recent speech that proposals to create a minimum public threshold for bail-inable debt could potentially turbo-charge a bank failure.
"Any threshold should be a private number between the regulator and the institution as the market could start getting worried if a bank got near that limit," he said.
"Bail-ins will lead to significant changes in the debt market and potentially a lesser role for senior debt," he said.
Instead of making banks capable of coping in any crisis, many of the rules designed to galvanise balance sheets make future bank funding models even weaker, critics say.
"Banks are already worried about whether they can show that they are generating returns on equity that are sufficiently interesting for shareholders at the levels of reserved capital regulators are requiring of them. They cannot afford to lose bondholder demand too," David Butler, head of credit research at Rogge Global Partners.
"Different banks with different models will have their own problems but there are bound to be losers along the way, especially among those smaller banks who have taken on unsustainable debt loads and cannot roll those commitments over."
The ECB 1 trillion euros cheap cash injection should have inspired confidence among depositors and investors.
But under relentless pressure to become more efficient and boost returns for investors and improve capital ratios, banks like Royal Bank of Scotland and Spain's Banco Santander used the cash to buy out holders of their more costly subordinated debt, pushing senior bondholders closer to potential loss.
With a smaller capital cushion standing between more conservative bank bond buyers and shareholders on the frontline of market volatility, the costs of retaining bondholder support will likely soar to uneconomic levels for many lenders.
"The difference in the cost of going to the central bank and the cost of issuing senior unsecured is so large that many banks are now addicted to central bank funding," Legal & General Investment Management Credit Strategist Ben Bennett said.
"What is clear is that there is no way of moving from an old structure to a new structure in a smooth way, there will be casualties, differentiation, massive volatility - and that is not a very friendly environment for fixed income managers."
One of the ways in which banks are hoping to plug the likely funding gap is by issuing bonds secured on their prime mortgage book but with little fresh lending to replenish that collateral pool, covered bonds will only support needy banks for so long.
"If you screw over your senior bondholders and they effectively go on strike, then there's a huge problem for the banks again," Pramerica's Farley said.