Recapitalisation Of Financial Institutions

On December 5th 2008, European Commission published a guidance for Member States on recapitalisation of financial institutions (for example banks) in the current financial crisis. The Commission already released a document regarding this issue (October 13th 2008, with the title: “The application of State aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis”): the latter is complemented by the former that gives a deeper guidance on the modalities of how Member States can act in the process of recapitalization of financial institutions, stressing in particular the willingness to avoid excessive distortions of competition.

The first document was released when the crisis outbreak was clear (in US, important institutions like Lehman Brothers went bankruptcy, others, like AIG needed a dramatic help from the state), and in Europe the situation was very difficult too: big banks, like the Dutch ING, asked for state aid. The second document, here analysed, recognizes that the current financial crisis is affecting the real economy, so an adequate response is needed not only for the sake of financial institutions, but for the whole economic system. On November 20th 2008, the Governing Council of the European Central Bank published some recommendations on how to set the pricing of state recapitalization and the Commission followed these while drafting this guidance.

In the document, the Commission recognize that recapitalisation of financial institutions is a key measure to address the crisis, and it can have several objectives:

  • give confidence and stabilizing the financial system
  • ensure the flow of lending to the real economy, limiting the spill-over effects
  • help in the short term institutions facing insolvency, in order to recover and gain long term viability or procede in the liquidation process.

In the Treaty establishing the European Community (TEC) consolidated version, Article 87 Paragraph 3 (b) states that aids granted in order “to remedy a serious disturbance in the economy of a Member State” may be considered compatible with the common market. This is for sure the case of the current crisis.

However, the Commission is concerned about possible distortions of competition due to state aid: these distortions can happen at three different levels. The higher level is among Member States: if aids are uncoordinated and unilaterally decided (example of this can be the different levels of deposit guarantees decided during October 2008), differences in states decisions can introduce distortions in the market; another negative outcome could be a subsidy race among Member States. Thus, in order to have effective measures, these need to follow a coordinated approach. The second level is among financial institutions, and this is probably the aspect more related with competition in usual sense: if no differentiation is present in the conditions at which the injection of capital is made, financial institutions that have an higher risk profile, due to their business model, will have an advantage compared to other institutions that are fundamentally sound that need help just for the exceptional conditions determined by the crisis. Finally, the third level regards the distinction between institutions that will get state aid and those seeking capital on the usual market: the latter should not be penalized giving the former too favourable conditions in respect with market-based operations.

The Commissioner for Competition Neelie Kroes said that the objectives of preserving the flow of credit to the real economy and of stabilizing financials markets are not in contrast with the idea of avoiding competition distortions and maintaining a level playing field in the financial market. She stated that “these objectives can not only be reconciled but are mutually reinforcing”. In the communication, it is said that a balance has to be reached between competition concerns and the other objectives.

An important point stressed at various points in the Communication is the fact that the interventions of states should be as much as possible limited in time and in amounts of capital provided so that aids has to be designed with these objectives in mind. Embedded in the aid, there should be incentives for state capital redemption, for example the Commission suggests a restrictive dividend policy, in order to stimulate private capital raising to substitute the state capital, and/or a remuneration that increase over time. Another idea proposed in the document is to stay close to a market-oriented pricing of capital injection. This possibility will achieve two positive effects at the same time: limiting the competition distortions and giving an incentive to redeem the state as soon as possible. This idea cannot be always applied, especially for distressed institutions who can only afford a lower remuneration, at least in the short term, or for the case when normal market conditions are not reflected.

As already mentioned before, a distinction is made by the Commission between fundamentally sound (and so well-performing) and distressed (and so less-performing) financial institutions. This distinction is important because, in order to not give competitive advantages to distressed institutions, is necessary to assess in some way the risk profile of each possible beneficiary of recapitalization plans. The Commission recognize that this assessment could be complicated, since conditions in crisis period do not fully reflect the reality; for this reason, it proposes the use of pre-crisis indicators together with actual indicators (CDS spreads and ratings are cited).

For the first category, the fundamentally sound financials institutions, the Commission present a detailed and exhaustive guidance regarding entry level price, incentives for state capital redemption and how to prevent undue distortions in competition. About this last issue, it is pointed out the importance of having safeguards in order to avoid abuses in recapitalisation schemes. For example, aggressive commercial conduct of recipients of these aids has to be prohibited, merger&acquisition should be assessed with special care, and the prohibition of advertising state recapitalization for marketing purpose should be enforced.

Regarding the second category, the distressed financials institutions, the guidance says that requirements should be stricter than the previous case: remuneration should be higher due to the higher risk connected to them. Another condition necessary is that state aid has to be subjected to the presence of a plan for a regular liquidation or a restructuring plan, in order to restore the long term viability of the recipient of the help.

As final remarks, the Commission affirm that it is ready to accept different pricing mechanism others that those set out in the guidance; however it is necessary that the level of return for the state would be comparable with that proposed by Commission.

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