UK: Bank Bailouts, State Aid And The Financial Crisis

Last Updated: 3 November 2009
Article by Elaine Gibson-Bolton and Michael Reiss

Initially published in Corporate Rescue and Insolvency, August 2009 edition

KEY POINTS

  • During the earlier part of the financial crisis the European Commission approved State aid for troubled banks (eg Northern Rock) under Article 87(3)(c) EC Treaty and the Rescue and Restructuring Guidelines.
  • Once the economic outlook worsened, the Commission came under pressure to approve structural aid more speedily, in some cases within 24 hours of notification, and to widen the scope of permissible State aid.
  • The Commission responded with new guidance on recapitalisation, credit guarantee and toxic asset schemes to rescue the European banking sector, as well as assistance for the real economy. It approved such aid under art 87(3)(b) EC Treaty, which is deployed only exceptionally in the case of a systemic economic crisis

INTRODUCTION

EU member states have dispensed generous portions of State aid to hungry banks during the current financial crisis. Their concern has been the wider economy these banks support as much as the banks themselves. In early April 2009, the European Commission estimated that it had approved crisis measures totalling €3,000bn or approximately 24 per cent of EU GDP (although not all of this would constitute State aid).

The Commission is the arbiter of what State aid is liable to distort competition and is incompatible with the common market. It can block illegal aid and order member states to recoup it where already given.

The Commission came under particular criticism from the French, German and other finance ministers during December 2008 for being an obstacle to member states' bank rescues. The Swedish finance minister warned his colleagues to 'call off these legions of State aid bureaucrats'.

What follows is a short guide to how the Commission has approached State aid during the crisis. We end with an interim appraisal of the Commission's efforts and an exploration of what lies next on the horizon.

IN THE BEGINNING: PLAYING BY THE ORDINARY RULES

State aid is aid granted by a member state, or through State resources, which may distort competition and affects trade between member states. For example, it could be a direct subsidy, a State-backed guarantee of a loan or a special tax exemption.

The Commission continued to apply the ordinary State aid rules during the earlier part of the financial crisis, which was effectively until the collapse of Lehman Brothers in September 2008. These included the core EC Treaty provision, art 87(3)(c), which allows 'aid to facilitate the development of certain economic activities or of certain economic areas, where such aid does not adversely affect trading conditions to an extent contrary to the common interest'. This is supplemented by the Community Guidelines on State aid for rescuing and restructuring firms in difficulty ('Guidelines'). These Guidelines have been applied on many occasions before with a reasonable degree of certainty since their introduction in 1994 by many member states to bail out firms in crisis, including national champions such as the UK's largest electricity generator, British Energy, in 2003.

The Guidelines note that rescue and restructuring aid are amongst the most distorting types of State aid, and that any aid given under the Guidelines must obey the 'one time, last time' principle: an institution must not be bailed out repeatedly. Only 'a firm in difficulty', as defined in the Guidelines, may benefit from such aid.

The Guidelines envisage two types of aid:

  • 'Rescue aid' is not meant to last longer than six months, and is to be given in the form of reversible liquidity support such as loan guarantees or loans at rates comparable to market rates for healthy businesses. It is designed to provide a breathing space for assembling a restructuring or liquidation plan. Recipients of such aid are generally not allowed to use it to finance structural measures, such as closing down a loss-making division.
  • Once this plan is formulated, any aid that follows is known as 'restructuring aid'. Such aid must be based on a detailed plan for restoring the business's long-term viability. The beneficiary is expected to make a significant contribution to the restructuring resources, for example through external financing or selling non-essential assets.

These Guidelines were used to approve support for banks heavily exposed to US sub-prime mortgage-backed assets, eg IKB in Germany, or those vulnerable to blockages in the wholesale money markets, eg Northern Rock (see case study).

THE COLLAPSE OF LEHMAN BROTHERS: TIME FOR SPECIAL MEASURES

The economic crisis worsened in September 2008 with the collapse of Lehman Brothers. Banks became even more reluctant to lend to one another, threatening banks that would not have been 'firms in difficulty' under normal market conditions. Applying the Guidelines became increasingly strained: 'structural' aid needed to be approved immediately without the usual timetable of 'rescue aid' first, followed by a restructuring plan. Ostensibly 'rescue aid' was approved for Bradford & Bingley in September 2008, yet the measures involved were structural: winding down the company and selling its retail deposit book to Abbey National.

On 13 October 2008 the Commission responded to these developments with its Communication, The application of State aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis (the 'Banking Communication'). The Banking Communication provides a framework for Commission approvals of State aid schemes and ad hoc rescue measures for banks.

The almost unprecedented basis for approvals under the Banking Communication is art 87(3)(b) EC Treaty: State aid 'to remedy a serious disturbance in the economy of a Member State'. This wording is construed very narrowly to include only serious and systemic economic difficulties such as those experienced at present in the world economy.

This Communication widens the scope of permissible State aid for banks by recognising the need for emergency structural interventions and rescue measures potentially lasting longer than six months. There are nevertheless restrictions on its scope. Article 87(3)(b) can only be invoked so long as the crisis lasts and member states must review and report to the Commission on any approved schemes. Aid is reserved for 'illiquid but fundamentally sound' banks; aid for those with inefficient and risky strategies are assessed under the usual Guidelines. Aid must also conform to the usual State aid principles of being well-targeted, proportionate and designed to minimise distortions of competition.

The Banking Communication lays down various general conditions for rescue schemes to be permissible including:

  • schemes can last a maximum of two years with six monthly reviews and any aid must be minimal with a significant contribution from the private sector and/or the beneficiary (eg at a later date through a 'better fortunes clause' providing for a greater contribution as and when the beneficiary's situation improves);
  • there must be restraints on a beneficiary's behaviour to prevent aggressive expansion on the basis of the State aid at the expense of competitors;
  • there must be follow-up adjustment measures for the sector and/or individual beneficiaries to solve the root causes of the crisis; and
  • there must be objective criteria for a bank to be able to participate in a scheme and there cannot be discrimination based on the bank's nationality. For example, an Irish scheme, under which the government would guarantee the retail deposits of six Irish banks, was modified after objections from the Commission to include all banks – whether Irish or not – that had a sufficiently large presence in the Irish economy.

CASE STUDY: NORTHERN ROCK ('NR')

  • NR's loan book was skewed in favour of mortgage-backed loans. Its financing strategy was heavily dependant on the wholesale money market and the mortgage securitisation market, both of which seized up during the latter half of 2007.
  • NR failed to secure private sector financing or a private sector takeover and therefore sought emergency Bank of England liquidity assistance in September 2007.
  • When news of this liquidity assistance leaked, a run on the bank ensued, which was stemmed by a government guarantee of existing retail deposits, later extended to future and other types of deposit.
  • The Bank of England later extended its liquidity assistance to NR at the Treasury's request.
  • On 5 December 2007 the Commission approved the government guarantees and extended Bank of England assistance as rescue aid under art 87(3)(c) EC Treaty; the initial Bank of England assistance was not deemed to be State aid, since it was granted independently of the government and was ordinary market assistance.
  • On 17 February 2008 NR was nationalised failing a satisfactory private sector takeover.
  • The UK submitted a restructuring plan to the Commission on 17 March 2008 including a gradual reduction in NR's mortgage book, increasing the proportion of the bank's retail deposit funding, repaying the Bank of England facilities, and curbing foreign expansion in the near future.
  • On 2 April 2008 the Commission opened an investigation into the restructuring plan.
  • On 30 March 2009 the UK notified substantial amendments to its restructuring plan: NR will be split into a small 'good bank' with the high quality assets, mortgage writing business and retail deposits, and a 'bad bank' with most of the past mortgage loans; the 'bad bank' would be wound down on a solvent basis with the government supporting losses on past mortgage loans.
  • On 7 May 2009 the Commission extended the scope of its NR investigation, which is currently outstanding.

VARIETIES OF STATE AID

The Banking Communication covers the following main types of State aid:

  • Guarantee schemes: government-backed guarantees of retail deposits, wholesale deposits and short and medium-term debt instruments can boost market confidence (such as the retail deposit guarantee scheme in Ireland) whether they are called upon or not;
  • Recapitalisation schemes: governments may inject public capital into banks (such as in France and the Netherlands) to prevent bank insolvencies, restart inter-bank lending, and encourage onward lending to the real economy;
  • Controlled liquidations: governments may contribute public funds to a controlled winding-up of an institution (such as Bradford & Bingley in the UK) as a direct step or as a result of the failure of a prior rescue plan;
  • Ad hoc interventions: governments may seek approval of State aid to a specific bank where that member state does not have an approved scheme (such as the recapitalisation of KBC in Belgium), or where the specific bank does not meet the requirements of an approved scheme.

RECAPITALISATION: MORE DETAILED GUIDANCE

The Banking Communication largely focused on guarantee schemes. Towards the end of 2008 the Commission faced demands from EU finance ministers for more detailed guidance on how it would treat recapitalisation schemes in particular. It responded with another Communication, The recapitalisation of financial institutions in the current financial crisis: limitation of aid to the minimum necessary and safeguards against undue distortions of competition dated 5 December 2008 (the 'Recapitalisation Communication').

According to the Recapitalisation Communication, a recapitalisation scheme must not distort competition by creating unfair advantages:

  • between banks in different member states;
  • between badly performing banks receiving aid and fundamentally sound banks within a member state; and
  • between publicly recapitalised banks and others when both are in pursuit of private capital.

For fundamentally sound banks, the Recapitalisation Communication endorses a set of recommendations from the European Central Bank for the remuneration of recapitalisation aid. The Recapitalisation Communication also requires recapitalisation measures to include incentives for the eventual exit of State capital, eg through stepped remuneration levels, or through linking dividend payments to obligations to redeem State capital. Six months after a recapitalisation scheme has been introduced, a member state is required to present a detailed report to the Commission on its implementation.

For riskier banks, which were facing difficulties even before the worsening of the financial crisis, recapitalisation must be at a higher level of remuneration (ie the recipient must pay more for this aid) and be accompanied by a restructuring or a liquidation plan. Before State capital is redeemed there must be a restrictive dividend policy, limits on executive remuneration, an increased level of the bank's solvency ratio and a timetable for State capital redemption.

CASE STUDY: UK FINANCIAL SUPPORT SCHEME

  • The UK scheme, as notified to the Commission on 11 October 2008, includes a mixture of measures:
  • Recapitalisation scheme: capital injection (up to £50bn per bank) in return for preference or ordinary shares;
  • Guarantee scheme: government guarantees of short and medium term debt (up to £250bn per bank) to assist bank funding; the debt must be issued within six months of the scheme's inception, although guarantees may last up to three years; and
  • Short-term liquidity measures: widening the collateral accepted for Bank of England assistance.
  • The measures do not discriminate against foreign banks with UK subsidiaries and the scheme is only open to fundamentally sound banks experiencing difficulties due to the economic crisis.
  • Banks benefiting from the recapitalisation scheme must abide by certain behavioural conditions, such as changes to their bonus schemes, the appointment of new independent directors, and commitments to lending to homeowners and small businesses.
  • Banks are prevented from using the recapitalisation or guarantees to fund aggressive expansion.
  • These measures were notified to the Commission on a Saturday, reviewed over the weekend and officially approved on the Monday. The government drew up the scheme in continuous contact with the Commission, which the Commission has repeatedly praised, even implying the status of the UK scheme as a form of prototype.
  • Amendments to the scheme were similarly approved with ease on 23 December 2008, including:
  • Obviating the need for fundamentally sound banks with State capital injections to provide restructuring plans; they could simply provide a report demonstrating that they remained fundamentally sound and how they planned to repay the State capital; and
  • The possibility of rolling over guarantees on certain instruments for an additional two years.
  • On 15 April 2009 the Commission approved an extension of the scheme by another six months until 13 October 2009.

GUIDANCE ON TOXIC ASSET SCHEMES

One response to the financial crisis that gained in popularity towards the end of 2008 was the idea of governments reducing banks' exposure to so-called toxic assets by purchasing these, setting up 'bad banks' to purchase such assets, or providing insurance, guarantees or swaps against them. It was not that such assets (eg mortgage-backed assets) were necessarily worthless; it was just that their market value was unclear due to market failure. Such schemes would reduce the level of risk on banks' balance sheets, therefore allowing them to increase their onward lending.

The Commission responded to this need on 25 February 2009 with its Communication on the Treatment of Impaired Assets in the Community Banking Sector. This Communication leaves the exact nature of an impaired asset scheme up to each member state, but lays down conditions in order to ensure a level playing field across Europe. For instance, banks must provide full disclosure of impaired assets before benefiting from any scheme and there must be adequate remuneration for the State. Approved schemes may only be open for six months and beneficiaries must commit to adequate restructuring.

NOT FORGETTING THE REAL ECONOMY

The special measures provided above were designed not just to help banks in a vacuum, but to restore banks' onward lending to the real economy suffering badly from the shortage of credit. However, on 17 December 2008 the Commission began to focus on direct State aid to businesses in the real economy by adopting its Temporary Community framework for State aid measures to support access to finance in the current financial and economic crisis (the 'Temporary Framework'). Before the Temporary Framework there were already a variety of permissible State aid options for the real economy, for instance in venture capital, regional development and environmental protection. However, the Temporary Framework permits additional types of State aid, again justified until the end of 2010 under the almost unprecedented Art 87(3)(b) EC Treaty.

The Temporary Framework's two main objectives are to unblock bank lending to companies and encourage companies to continue investing in the future. It permits measures such as a cash grant of €500,000 per company, higher State subsidies for loan guarantees, higher State-subsidised interest rates for loans, and higher State-subsidised interest rates for loans to manufacture green products that go beyond future EU environmental standards. The Commission set up a specialist Economic Crisis Team to deal with immediate queries on the Temporary Framework.

The Commission has approved schemes involving State-backed guarantees, €500,000 cash grants and reduced interest rate loans for green products in the UK.

HAS THE COMMISSION ANSWERED ITS CRITICS?

In conclusion, the Commission has had to tread a fine line between robust enforcement of State aid law and flexibility in the face of perhaps the worst economic crisis since the Great Depression. If the Commission had shut its ears to the critics and stuck rigidly to the ordinary State aid rules, then it is possible some member states would have simply disregarded these rules and pressed ahead with emergency rescue schemes regardless. The Commission could have censored such member states and even issued proceedings against them in the European Court of Justice. However, the authority of the Commission ultimately rests on legitimacy and this would have been sorely undermined.

On the other hand, if the Commission had substantially suspended the ordinary rules, then this could undermine the Commission's authority when the crisis has passed and undermine the important benefits of the single market achieved over many years. It could even encourage future reckless risk-taking by banks and member states in the likelihood that generous bailouts will be approved. It could also have led to a subsidy race by member states with capital fl owing chaotically across Europe in search of the most beneficial schemes.

To its credit, the Commission has modified the rules to a limited and helpful extent, whilst guarding against the worst excesses of national interest. It has provided detailed guidance on the sort of aid it will approve in order to assist member states in drawing up schemes that pre-empt the Commission's concerns. Furthermore, on a procedural level, the Commission has approved emergency State aid at unprecedented speed. In some cases it has given approvals within 24 hours of the aid being notified. Given how quickly financial markets move and crises worsen, speed is often as important as the substance of approval.

The next challenges for the Commission will be approving further banking aid schemes, permitting extensions of schemes where appropriate and scrutinising member states' reports on existing rescue schemes.

It will also have to enforce the new rules. The Commission has promised to focus its reviews on three key factors: the return of the banks to long-term viability, the private contribution to restructuring to keep aid to a minimum, and avoiding the distortion of competition. So far, at least, the Commission appears to be performing well.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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