The Financial Services Agency will consider effectively nationalizing banks that have received public funds if a bank's earnings fall substantially short of its preset target, FSA sources said Wednesday.

The effective nationalization could take place by converting preferred shares -- purchased from banks in exchange for public fund injections -- into common stock.

Under recently mapped-out guidelines, the FSA will consider conversion if a bank's operating and net profits "fall short by more than 30 percent" of levels estimated by the bank when it took public funds in exchange for issuing preferred shares "for a certain duration," the sources said.

If the government converts its preferred shares into common stock, it would become a major shareholder and be able to exert more influence on a bank's decision-making; it could demand that the bank implement restructuring or replace top managers.

Preferred shares carry no voting rights but provide higher dividends than common shares.

The guidelines also recommend considering a conversion if a bank cannot raise funds from the market or in the event that depositors wage a run on a bank, the sources said.

The FSA is expected to announce the guidelines by Monday.

Between 1998 and 2002, the government funneled nearly 10 trillion yen into badly hobbled major and regional banks, mostly through purchases of preferred shares but also via subordinated loans and bonds.

The new guidelines, have a loophole, however; the FSA would refrain from converting preferred shares if a bank fell under the 30 percent threshold due to aggressive bad-loan disposals, the sources said.

In the event that the capital adequacy ratio at a bank operating internationally falls below 4 percent, the FSA would convert the preferred shares into common shares, the sources said.

The Bank for International Settlements requires banks operating internationally to have capital equal to at least 8 percent of their outstanding loans.

If the capital adequacy ratio at a bank operating domestically drops below 2 percent, the FSA would convert the preferred shares into common shares.

The new guidelines also recommend converting preferred shares into common stock in the event that a recipient of public funds cannot pay dividends on the preferred shares for a certain length of time.

The business daily Nihon Keizai Shimbun reported Wednesday that the FSA would conduct such a conversion in the event a bank cannot pay dividends on the preferred shares for two straight years.