By Will Caiger-Smith

NEW YORK, Oct 21 (IFR) - Large US investors are drafting proposals to guard against being left holding riskier debt in the event that big banks are broken up into smaller entities.

Amid political pressure to dismantle some of the country's largest financial institutions, industry group The Credit Roundtable is drafting new protective covenants for bank bonds.

The group, whose members collectively manage some US$3.8trn in assets and include Prudential and Vanguard, is expected to submit the proposals to regulators in the coming weeks.

"If banks break up tomorrow, there's not much protection for creditors in debt indentures," said David Knutson, the group's co-leader and head of Americas credit research at Schroders.

The desire for more protection comes amid perception that the largest US banks, despite post-crisis regulations that curbed their risk-taking abilities, are still "too big to fail".

The Federal Reserve and the Federal Deposit Insurance Corp said in April that five of the biggest US banks could not be unwound safely without being bailed out by taxpayers.

Public figures including Senator Elizabeth Warren and Minneapolis Fed president Neel Kashkari have championed the idea of breaking up large lenders to reduce that risk.

And last month Daniel Tarullo, the Federal Reserve's lead bank supervisor, said banks that struggle to cope with increased capital requirements should consider restructuring.

RISKY BUSINESS

Investors argue that bank break-ups could leave some investors holding the debt of entities with very different credit risks to the ones they bought initially.

"You could end up owning debt in a more levered or riskier entity," said Michael Collins, senior investment officer at Prudential Fixed Income.

The group's proposals would require banks to offer to buy back some debt if they make "material asset dispositions" that alter their business structure.

The new documents are intended to be used on debt issued to comply with Total Loss Absorbing Capacity rules, which allow bonds to be written down to recapitalize failing banks.

Only TLAC-eligible bonds in excess of the minimum requirement would be allowed to be bought back, according to the proposals.

Investors have piled into TLAC bonds over recent months, although the final version of the rules is yet to be released.

If they emerge as expected, senior bond documentation would have to be rewritten to remove provisions allowing creditors to demand accelerated payment in certain circumstances.

That offers investors an opportunity to insert protections to reflect the risk of large-scale bank restructurings, said Knutson.

"This is the first time in history that big banks are going to have to redo their indentures all at the same time," he said. "It's a chance to standardize them."

A senior FIG banker called the proposals a step in the right direction but cautioned that, although US banks might be receptive, regulators would have the final say.

The Credit Roundtable's proposals were initially submitted to the Federal Reserve and Federal Deposit Insurance Corporation over the summer.

Following feedback, they are being revised to specify that such bond buybacks would not be permitted if a bank is close to failing or in a resolution scenario.

(Reporting by Will Caiger-Smith; Editing by Shankar Ramakrishnan and Marc Carnegie)