Banks must be allowed to fail, ECB's Lautenschlaeger says

FRANKFURT, March 15 (Reuters) - Banks must be allowed to fail once again as expectation that failing lenders would be bailed out is creating unsustainable and risky businesses, European Central Bank board member Sabine Lautenschlaeger said on Thursday.

Governments spent billions rescuing banks during the financial crisi, fearing the destabilization of the entire banking system. A raft of new regulations were subsequently introduced to avoid such contagion, including in the euro zone.

"Banks must be able to fail," Lautenschlaeger said in a lecture at the Florence School of Banking and Finance.

"Banks got used to an implicit and costless government guarantee, which kicked in when things went wrong," she said. "At the end of the day, banks and their investors had little incentive to act in a sustainable and forward-looking manner."

Supervising the euro zone's biggest lenders only for the past three years, the ECB is still learning to manage bank failures, having dealt with only four, ranging from Spain's relatively big Banco Popular to Latvia's tiny ABLV.

Lautenschlaeger, who also sits on the ECB's supervisory board, argued that taxpayers should not be forced to pay for bank failures and instead owners and creditors should bear the losses.

"The bail-in establishes what you might call a hierarchy of loss-bearers," Lautenschlaeger said. "First (Other OTC: FSTC - news) in line are shareholders, followed by holders of subordinated debt, followed by other creditors."

"The question is, of course: how much can be bailed in? And the answer is: everything! Well, in theory."

Bail in is notoriously difficult in some parts of Europe, particularly Italy, where subordinated products are often sold to household investors, who are not aware that they are first in line in case of a default.

"For such people, a bail-in is not just a financial loss; it is a personal tragedy," Lautenschlaeger added. "We must avoid such tragedies."

"But we must do so in a way which is in line with the basic idea of bail-in. And this is as much a question of consumer protection as of financial education," she said. (Reporting by Balazs Koranyi; Editing by Toby Chopra)