State Aid to Banks in the Financial Crisis: The Past and the Future

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1 66 Journal of European Competition Law & Practice, 2010, Vol. 1, No. 1 Economist s Note State Aid to Banks in the Financial Crisis: The Past and the Future Emily Adler, James Kavanagh, and Alexander Ugryumov* Introduction The years 2008 and 2009 provided an unprecedented and difficult environment for European Commission (EC) state aid policy. Starting in 2008, banks and other financial institutions experienced an extreme combination of write-downs on their assets, dried-up liquidity in wholesale funding markets, and loss of consumer confidence. In response, national governments took various measures to support their banking sectors, including the provision of direct state aid to banks. The main objective of this has been to avoid the considerable knock-on effects for the rest of the economy in the event of the failure of one or more systemically important banks. The measures taken are widely understood to have played an important role in avoiding meltdown of the financial markets, in restoring confidence in both the financial markets and in the economy more widely, and in supporting the flow of credit to the real economy. Now is a good time to reflect on whether state aid policy in the financial services sector has reflected sound economics. While the detailed rights and wrongs of the European approach to date have been discussed elsewhere by lawyers and academics, this Economist s Note focuses on two points where economics might add particular insight. Lessons from the past: the unavoidable economic trade-offs that have been faced to date, in terms of helping banks while minimising distortions to competition in banking going forward. Lessons for the future: the trade-offs that could be encountered in the next five years, as a wide-ranging set of aid measures are unwound. It is suggested that a difficult choice may be faced between unwinding aid according to national priorities and unwinding aid to minimise distortions of competition. * Senior Consultants at Oxera. We wish to thank Oxera colleagues Dr Gunnar Niels and Fod Barnes for their comments, and to recognise the valuable contribution of the Oxera Economics Council meeting in Key points Uniquely in Europe, state aid policy has been used in the financial crisis to control the flow of public funds to the banking sector. During the financial crisis, state aid decisions had to prioritise saving financial institutions over distortions to competition. But post-crisis,- saving institutions is not the same as saving the financial system. The more stable the financial system becomes, the easier it is for state aid control to take a tough approach to aided banks. Looking forward, as aid is unwound there is a policy choice to be made whether to prioritise competition in the single market (by coordinating withdrawal of aid) or to prioritise competition within national markets (by removing state support as and when local conditions permit). This economist s note discusses economic tradeoffs that state aid policy has confronted to date, and trade-offs that will arise as public support is withdrawn from the banking sector. First, we give a little background on the approach to date. Background The extent of state aid In the period from October 2008 to mid-july 2009, the European Commission approved a large number of guarantee and recapitalisation schemes. The total volume of the approved guarantee measures covered loans amounting to E2.9 trillion, and the total amount of funds committed to the recapitalisation measures September 2009 to our perspective on state aid. The views expressed are, however, those of the authors. James.Kavanagh@oxera.com # The Author Published by Oxford University Press. All rights reserved. For Permissions, please journals.permissions@oxfordjournals.org

2 Emily Adler et al.. State Aid to Banks in the Financial Crisis ECONOMIST S NOTE 67 Figure 1. State aid across Member States (total effective aid in % of GDP and Em). Source: European Commission, DG Competition s review of guarantee and recapitalisation schemes in the financial sector in the current crisis, 7 August amounted to E313 billion. Over and above these guarantee and recapitalisation measures, a number of Member States notified asset relief measures and direct lending. 1 The scale of state aid measures per Member State varies. Figure 1 shows the scale of measures as a share of GDP and Em. Measures consist of capital injections, guarantees, impaired asset relief and liquidity support. Economic rationale for aid to banks The main economic rationale for granting state aid to financial institutions in crisis has been to avoid the collapse of banks causing serious problems for the wider economy. At the same time any such support in the European Union (EU) needs to be provided in the context of state aid policy. As recognised by the Commission, in the crisis environment Member States could be tempted to pursue unilateral national interests. Member States introduced a range of measures to support their financial services sectors. From an economic perspective, depending on the types of measures and the context in which they are implemented, the impact of state aid on competition is expected to be 1 European Commission, DG Competition s review of guarantee and recapitalisation schemes in the financial sector in the current crisis, [7 August 2009]. Available at, legislation/review_of_schemes_en.pdf. (last accessed 9 October 2009). different; hence, the response from state aid policy is also expected to be different. First, governments supported the overall financial system. This support included, for example, provision of exceptional liquidity facilities by the European Central Bank with the goal of preventing shortages of liquidity. Although such measures clearly benefited the sector (as, in general, cheaper capital means higher profits, and some institutions avoided failure), they do not generally conflict with state aid policy as they are not exclusive to any player and hence do not distort the level playing field between banks. Second, governments recapitalised viable banks that, due to closed capital markets and adverse selection, could not raise capital at a reasonable price. To achieve this governments provided Tier-1 capital, 2 and temporarily or permanently acquired banks assets. From the state aid perspective, such interventions are justified as they seek to remedy market failures, which in this case relate to inefficiently functioning capital markets. The main consideration is whether in such cases aided banks benefit relative to non-aided banks due to the potentially lower price of state capital; hence, the price of the 2 Tier-1 capital is the highest form of capital of a bank and is regarded as broadly equivalent to equity. This means it must be capable of absorbing losses so that the bank can continue trading even if it makes losses up to the value of that capital.

3 68 ECONOMIST S NOTE Journal of European Competition Law & Practice, 2010, Vol. 1, No. 1 state support is key to minimising competition distortions. Third, governments aided some fundamentally nonviable banks that is, banks that could not cover losses over the business cycle that were at risk of failing. From the state aid perspective, supporting such banks could have a significant impact on market structure and competition and has less justification on the grounds of remedying market failures in banking. While saving all significant institutions may have been synonymous with saving the financial system during the crisis, this is no longer true after the crisis. Hence aid to non-viable banks may need to be used to efficiently restructure the banks and be accompanied by measures aimed at limiting distortions to competition, or ultimately to liquidate the bank in an orderly fashion. The Commission appears to have tried to capture the distinction between these cases within the banking sector, as well as the difference between crisis aid to banks and normal state aid issues, in the series of crisis-specific Communications introduced to assess state aid granted to financial institutions. 3 European Commission policy In its banking Communications, the Commission recognised that the severity of the crisis justified the granting of aid under article 87(3)(b) of the EC Treaty, which allows aid to remedy a serious disturbance in the economy of a Member State. It also set out a framework for the provision of public guarantees, recapitalisation measures, and impaired asset relief, whether granted by States to individual banks or as part of a wider national scheme. Although issued specifically in response to the crisis and only for aid granted to financial institutions, the Communications are based on the same three general principles set out in the 2004 Community Guidelines on State aid for rescuing and restructuring firms in difficulty (the R&R guidelines ). 4 Those principles require the following. Restoration of long-term viability the aid should lead to the restoration of viability of the beneficiary in the longer term without State aid. 3 European Commission, 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 ), 25 October 2008; European Commission, The recapitalisation of financial institutions in the current financial crisis: limitation of aid to the minimum necessary and safeguards against undue distortions of competition (the Recapitalisation Communication ); 15 January 2009; European Commission, Communication from the Commission on the treatment of impaired assets in the Community banking sector (the Impaired Assets Communication ), 26 March 2009; European Commission, The return to Avoidance of undue distortions to competition the aid should be accompanied, to the extent possible, by measures to minimise distortions to competition. Ensuring appropriate burden sharing the aid should be limited to the minimum required and accompanied by adequate burden-sharing. While the Commission is applying the general framework and tools designed for dealing with aid granted to failing firms, it recognises that the problems faced by banks in current circumstances are substantially different. For one, the traditional R&R guidelines addressed the problem of how to deal with a single failing firm, while the new crisis-specific Communications are attempting to deal with problems in an entire sector. Furthermore, the problems faced by particular banks in the current crisis are not necessarily of their own making; a loss of general market confidence can make it impossible for a bank to raise money, for example, regardless of whether it is healthy or not. The Commission recognises that in current circumstances healthy banks can be affected as well as non-healthy banks, 5 and therefore establishes that healthy banks (termed fundamentally sound ) do not need to undergo as extensive restructuring, or pay as much, in terms of fees to the state or the interest rate on loans, for the aid received. Lessons from the crisis: Economic trade-offs In implementing state aid policy according to the objectives outlined above, it is almost inevitable that conflicts will arise between the objectives themselves and also between recipient institutions which, as noted above, may have been either fundamentally sound or not. This section provides a few observations on conflicts which have arisen in case practice thus far. The Commission has occasionally tried to downplay the importance of conflicts that exist between the Commission s various objectives. In a recent speech, Commissioner Neelie Kroes stated that there is no trade-off between competition policy and financial stability. 6 In published communications, however, the Commission has appeared to place the restoration of viability and the assessment of restructuring measures in the financial sector in the current crisis under the State aid rules (the Restructuring Communication ), 19 August European Commission, Community Guidelines on State aid for rescuing and restructuring firms in difficulty, 1 October European Commission, Banking Communication, 25 October 2008, para 2. 6 Neelie Kroes European Commissioner for Competition Policy, Opening address at 13th Annual Competition Conference of the International Bar Association, 11 September 2009.

4 Emily Adler et al.. State Aid to Banks in the Financial Crisis ECONOMIST S NOTE 69 financial system stability ahead of minimising distortions to competition: Financial stability remains the overriding objective of aid to the financial sector in a systemic crisis, but safeguarding systemic stability in the short-term should not result in longer-term damage to the level playing field and competitive markets. 7 And in the treatment of individual banks: Measures limiting distortions of competition should not compromise the prospects of the bank s return to viability. 8 Despite the similarity between the Commission s crisisspecific guidelines and the traditional R&R Guidelines, therefore, the nature of the trade-offs between the various objectives is different in the case of banks. Rival banks can benefit Abankthatfails,regardlessofwhetheritwassoundor not, has the potential to create serious disruptions in the economy and create difficulties for other banks, including direct competitors of the failed bank. This can be either directly because the other bank is a creditor of the failed bank or indirectly because that bank s customers are adversely impacted via the impact of the failure of the wider economy. Thus, in the case of the failure of a significant bank, it would be less straightforward to argue that its competitors would have benefited from the removal from the market of their rival, as would be the case for traditional failing firms. This argument could imply that banks may be better off with their systemically important rivals staying in the market, regardless of whether these rivals are efficient or not. If this were true then, for as long as the winding up of these banks cannot be accomplished without serious negative impacts, there would seem to be little role for restricting state aid to banks on the basis of short-run competitive distortions. The benefit of saving the economy and the banking system would outweigh the risk of distorting the market in the supply of banking services. Yet a number of recent Commission decisions include substantial remedies designed to minimise distortions to competition. It seems the Commission s logic is that even if there is an argument for placing less emphasis on distortions to competition in the short run, in the long run a number of competitive distortions would arise, which must take some priority over other objectives. 7 European Commission, Restructuring Communication, 19 August 2009, para Ibid, para 32. Lending commitments The trade-off between short-run stability and long-run healthy competition is not the only tension. Some aided banks face lending commitments imposed by Member States, which would tend to preserve or expand their market share, when from a state aid perspective the aided banks ought to restrict growth or even shrink in size. What should a bank do where the requirements of the Commission are in conflict with the commitments made to its national government as part of the conditions for receiving the aid in the first place? For example, certain banks have a commitment to lend to SMEs (small and medium-sized enterprises) in their domestic markets, markets where they already have a high and static market share, with little evidence of entry. Here any state aid remedies which restrict the growth of the aided bank are in conflict with the commitment of the bank to the Member State. It may be that in reality state aid cannot reconcile these conflicts, and must effectively prioritise financial system stability first, followed by individual bank viability, followed by minimising distortions to competition. The final prioritisation will be seen in the Commission s forthcoming decisions. Looking to the future, priorities will tend to change as risks to system stability diminish and aid is unwound. This is the subject of the next section. Lessons for the future: The next five years As the crisis fades, attention will turn to the future of public interventions in the banking sector. From the European Commission s perspective, it is still (at the time of writing), a little early to have a discussion about unwinding state aid measures: The issue will be given further attention in due course, in order to initiate in a timely manner the discussion on the phasing-out of schemes when the crisis starts to abate. 9 While this debate may be slow-starting, it is not too early to consider the economics of how the unwinding process will play out. Unwinding support will involve a wide range of governments, banks, regulators, and markets, and uniquely in Europe state aid policy. The timing, pace, and sequence of the exit strategy is not pre-determined, and is highly challenging given the potential conflicts between safeguarding short-run 9 DG Competition, DG Competition s review of guarantee and recapitalisation schemes in the financial sector in the current crisis, 7 August 2009.

5 70 ECONOMIST S NOTE Journal of European Competition Law & Practice, 2010, Vol. 1, No. 1 financial stability and restoring market principles. Exit strategy merits further debate and scrutiny. Timing The decisions being made now with regard to state aid approval have direct consequences for exit strategy, and set market expectations going forward. For example, the Commission s Restructuring Communication has set a timeframe of a maximum five years for restructuring to be completed. 10 Within this timeframe all aided banks should be back to long-term viability, with state aid either redeemed or remunerated at market terms. Government guarantee schemes also have time limits attached, typically shorter than five years. These deadlines start to coordinate the timing of exit, insofar as the time constraints will bind. Similarly, where state aid decisions in have set a timetable for the repayment of aid, or step-ups in the rate of remuneration for state aid, this also helps set the pattern and expectations for exit. Coordination across Europe in terms of when aided banks face step-ups would tend to lead to a concentration of private capital-raising in a relatively short space of time and push banks prices to their customers upwards to ensure they can pay market rates for their capital, which could distort capital markets and squeeze lending capacity to the real economy. Coordination could also have a circular effect: banks will seek to raise large amounts of private capital to refinance state ownership, which may lead to capital rationing and a higher cost of capital overall (since state capital is meant to be oriented to market rates). For example, Baudouin Prot, Chief Executive of BNP Paribas, told the Financial Times on 22 September 2009 that the incentives for his bank have a tipping point in mid-2010: The French [government] capital is not cheap. There is no real incentive to repay before June But after that window it becomes more expensive. We certainly want to start repaying earlier than [that]. 11 Coordinated disengagement The process of unwinding and disengagement may need to be tailored to the individual circumstances of different Member States. Unwinding of short-term liquidity and confidence-building measures, such as some guarantee schemes, might occur first, while the disposal of equity and impaired assets are likely to take much 10 European Commission, Restructuring Communication, 19 August 2009, para Financial Times, BNP to start paying back state funds early, 22 September longer. The optimal strategy to avoid market disruption, return assets to the private sector and maximise recovery rates will tend to vary across Europe, and inevitably some EU countries will reach a point of stability and confidence in the financial sector before others. The IMF Executive Board noted in September 2009 that: The process of disengagement should be tailored to individual country circumstances and should not begin until certain preconditions have been met. 12 Likewise, an IMF staff paper says: For a credible disengagement strategy, a phased approach is likely to be required that will avoid market disruptions and maximize asset recovery rates. 13 As previously set out in Figure 1, individual country circumstances are diverse, in terms of the amount of GDP committed to the recapitalisations and the nature of aid measures, but also in terms of growth prospects post-crisis and the size of government deficits. This all suggests a tailored approach, where macroeconomic conditions, including the overall state of the financial system, at a country level are carefully analysed and taken into account. Yet from the state aid perspective a tailored disengagement may be sub-optimal it raises the prospect that some EU banks could lose their state guarantees, state capital, and asset protection schemes before others. There may also be a political factor whereby governments may find it strategically attractive to seek to use state capital to influence banks behaviour (e.g. lending into the real economy). This seems to go to the heart of state aid control, which is to ensure a level playing field and the avoidance of beggar-thy-neighbour interventions whereby state protection in one country can lead to problems for non-protected banks in other countries. Tailored disengagement will therefore need to be carefully managed to avoid further cross-border distortions within the single market pursued unilaterally, tailored disengagement could harm collective interests. At the same time, pressure to disengage unilaterally will come from non-aided banks, who will not want to see their domestic competitors endlessly propped up. A gradual process The two problems identified a crunch point where all support is withdrawn simultaneously (via time limits 12 International Monetary Fund, IMF Executive Board Discusses the Management of Crisis-Related Interventions in the Financial System, 15 September International Monetary Fund, Crisis-Related Measures in the Financial System and Sovereign Balance Sheet Risks, 31 July 2009.

6 Emily Adler et al.. State Aid to Banks in the Financial Crisis ECONOMIST S NOTE 71 which bind or step-up clauses), and a beggar-thyneighbour problem where support is withdrawn in some EU countries but not others are difficult to reconcile. Either disengagement can happen according to individual circumstances at different points in time or it can happen more symmetrically. Staggered removal of guarantees and other measures would create crosscountry distortions whereas simultaneous removal could expose vulnerabilities in financial stability and delay the process of disengagement (with the result that distortions within national markets are prolonged). From an economic perspective, state support should be withdrawn gradually with a degree of international coordination, and, as market conditions improve and step-up clauses kick in, the value of a state protection ought to fall such that even if disengagement is partly asymmetric then the distortion to competition would remain very limited. This disengagement process should naturally recognise that, post-crisis, saving individual banks may not be the same as saving the system. Hence part of the solution may be to force non-viable banks to liquidate, according to local market conditions. The timing will also be contingent on policy initiatives which are designed to make it easier to wind up financial institutions without contagion impacts. The decisions on the extent to which state aid policy will permit tailored solutions according to local market conditions cannot be postponed for very long, which makes the debate on how state aid measures are phased out a key priority for doi: /jeclap/lpp006 Advance Access Publication 27 November 2009