European Central Bank president Mario Draghi challenged rules that would bar banks from accessing public aid unless they forced losses on junior bondholders, a central building block of European Union protocols for handling struggling banks.

In a letter to EU Competition Commissioner Joaquin Almunia, Draghi said EU rules need to be clarified so regulators can order technically solvent banks to strengthen their balance sheets without scaring off investors. Draghi said public capital needs to be available ― without wiping out subordinated debt holders or forcing them to convert to equity ― if a bank’s holdings are above regulatory minimums and also below what supervisors deem necessary in a particular case.

“An improperly strict interpretation of the state-aid rules may well destroy the very confidence in the euro-area banks which we all intend to restore,” Draghi said in a July 30 letter to Almunia obtained by Bloomberg News. The ECB president called for the possibility of “precautionary recapitalizations” that would dilute shareholders without hurting junior bondholders and that also would give banks temporary access to public money.

Draghi’s comments come as EU officials squabble over what backstops should be put in place should the ECB decide that individual banks need more capital after a series of assessments next year. The danger under the state-aid rules addressed by Draghi’s letter is that subordinated bond holders could dash to dump their investments if a bank is deemed to require cash, risking another round of market turmoil.

The ECB on Oct. 23 will announce how it will handle comprehensive assessments of euro-area banks, which are needed as it prepares to take over the currency bloc’s financial supervision next year. The Frankfurt-based central bank has said its reviews need to be tougher than previous rounds of European stress tests in order to reassure investors that euro-region banks aren’t on the brink of another crisis.

“From a bondholder perspective, it’s important the creditor hierarchy is respected and creditors don’t take losses before equity is wiped out,” said Steve Hussey, a credit analyst at AllianceBernstein Ltd. in London, which manages about $430 billion.

“Draghi doesn’t want to see systemic risk when the results of the asset-quality review are published,” Hussey said. “A hardline government demanding bondholders take losses in a bank that’s still a going concern might end up shooting itself in the foot. What Draghi is saying is not to make things so black and white, to look at each situation and be flexible.’

New EU state-aid rules that took effect in August require shareholders and junior debt holders to share in the burden of absorbing bank losses before public assistance steps in. The rules are linked to several proposed EU laws and to guidelines on when lenders could have direct access to the euro area’s 500 billion euro ($683 billion) firewall fund. (Bloomberg)