The Current Financial Crisis and State Aid in the EU

The Current Financial Crisis and State Aid in the EU

THE CURRENT FINANCIAL CRISIS AND STATE AID IN THE EU

ABEL M MATEUS*

A. INTRODUCTION

We are in the middle of the worst financial and economic crisis since the GreatDepression. We argue that an aggressive and timely state aid and intervention isrequired. The European Commission has acted on the measures notified by theMember States in a fast and adequate manner, and has issued a generallyappropriate guidance, according to a cost–benefit analysis. But this was theresponse to the first wave of the crisis. We argue that bank guarantees andrecapitalisation may not be enough to re-launch economic activity and someeconomies may require the “cleaning-up” of bad debts, which needs a revisionof the guidelines.

All the major developed economies are expected to have a negative GDPgrowth rate in 2009, with a slow recovery in the second half of 2010. The UShas already been in recession since the end of 2007, and unemployment ratesmay well reach close to 10% in the US and 12% in the euro area before the crisisis over. Equity prices have already registered the largest drop since the GreatDepression, falling by 50% between the peak last year and current levels. Thecrisis, triggered by the burst of the real estate bubble in mid-2007,1 reached aserious stage in September 2008, when the financial systems of the US andEurope seemed on the brink of collapse. After this first wave, the decrease inhousing and stock prices and the accumulation of losses in the financial sectorled to a sharp fall in lending and a decrease in investment and consumerdemand. The deterioration of the real economy will further deteriorate thebalance sheets of banks and continue to feed into a vicious circle that will have tobe reversed by appropriate monetary, fiscal and structural policies.

April 2009 European Competition Journal 1

1 There have been similar financial crisis in the last 50 years, namely the S&L crisis of the 1980s,the Nordic crisis of the early 1990s and the Japanese crisis of the 1990s. In all of them real estatebubbles played a major role. For a compilation of crisis and their characteristics see C Reinhartand K Rogoff. “This Time is Different: a Panoramic View of Eight Centuries of Financial Crisis”,mimeo, Harvard University (April 2008), available at http://www.economics.harvard.edu/faculty/rogoff/Recent_Papers_Rogoff (accessed December 2008). See also C Reihart andK Rogoff, “The Aftermath of Financial Crisis” (December 2008), at the same website.

* Visiting Professor at University College of London and British Institute of International andCompetition Law.

In this paper I will address, within the context of the EU, the need for stateaid to the financial sector and the rest of the economy. I will look at the rationalefor state intervention and state aid, and the way that the European Commissionhas responded to the measures taken by Member States. Overall, theCommission has responded quickly and with the right approach. Then I willanalyse the menu of measures currently being used using an economics-basedapproach. The ranking of the measures shows that most of the governments inthe EU have responded with the right measures. However, with the experienceof past crisis, I consider that the menu has to be expanded, and the second waveand further cycles of the crisis may warrant the expansion of the measures usedso far. The last section takes this issue further and considers whether more boldand unorthodox measures may be required if the crisis continues to deepen inorder to jump-start the economy. This requires a revision and expansion of theguidelines issued by the Commission2 and a more coordinated approach withother institutions, mainly the ECB and regulatory bodies.3

B. WHY STATE AID? THE COMMISSION INTERVENTION

State intervention and aid to the financial sector in a crisis situation are essentialto avoid the collapse of the system. First, there are externalities and systemic riskinvolved: the failure of a large bank may create a systemic risk of generalisedbank failures due to cross-balance-sheet relationships that are not internalised inthe failure of the particular bank. Also, the failure of an important depositinstitution may create bank runs, which will lead to liquidity squeezes andprecipitate bank failures. Secondly, there are externalities between the financialand real sectors: the increasing risk of failure of banks leads them to curtaillending to firms and households, precipitating a downturn in the economy; andthe loss of deposits and other household and firm assets leads to a decrease in themoney supply and cuts aggregate demand (the spectre of deflation). The secondbroad type of market failure occurs due to information asymmetries andcollapsing markets: (i) banks may not have good information about the liquidityand solvency of their household or firms clients. Besides, in a mark-to-marketworld the values of all assets may decrease in synchronization, and it may bedifficult to distinguish between a relative price and overall adjustment; and (ii)

2 The Current Financial Crisis and State Aid in the EU ECJ VOL. 5 NO. 1

2 Communication from the Commission—Temporary Community Framework for State aidmeasures to support access to finance in the current financial and economic crisis, (2009/C19/01), [2009] OJ C16/1. See also Communication from the Commission—The application ofState aid rules to measures taken in relation to financial institutions in the context of the currentglobal financial crisis, (2008/C 270/02), [2008] OJ C270/8.

3 At the time of writing, Treasury Secretary Geithner has announced some of the measures that arebeing here proposed, like planning to buy bad assets from banks. See “Geithner Proposes NewBank Rescue Plan”, New York Times, 10 February 2009.

capital markets suffer from the same asymmetries in information—it is difficult todistinguish good and bad investments, accentuated by the large correlation inrisk.

There are also cross-border externalities: (i) bank failures in one country maylead to bank failures in other countries, especially in a currency union or afinancially integrated area; and (ii) there are also externalities arising from theinteraction of the financial and real sectors across all countries in the EU.

In view of the severity of the crisis, the Ecofin Council of 7 October 2008established the following principles for the Commission intervention:

1. intervention should be timely and the support should in principle betemporary;

2. Member States should be watchful with regard to the interests oftaxpayers;

3. existing shareholders should bear the due consequences of theintervention;

4. Member States should be in a position to bring about a change inmanagement;

5. the management should not retain undue benefits—governments shouldhave, inter alia, the power to intervene in remuneration;

6. legitimate interest of competitors must be protected, in particular throughthe state aid rules; and

7. negative spill-over effects should be avoided.

The scale of the collapse of the financial system, with ominous consequences tothe real economy,4 required a timely and speedy intervention and approvalsystems. However, there was no blanket solution, since markets and agents werein different situations. There were economies with high and low leveragedhouseholds; the leveraging levels by firms also diverged significantly; and thequality of bank supervision was also quite diverse. Besides, each institution indifficulty requires a tailor-made intervention, ranging from a minority stakerecapitalisation up to liquidation. Moreover, the menu of measures that can betaken is quite large, so each country has to assess the best policy at the time withregard to its impact in reducing the specific and systemic risk. Consequently, theonly way to orchestrate rescues in the financial system, which also requires themaximum secrecy in order to avoid bank runs, is to elaborate an excellent set ofguidelines to give clear guidance to states and regulators on different alternativesand best practices. Similarly to other areas of state aid, the system has to:(i) establish de minimis criteria; (ii) define measures and conditions that “most likely


4 Policymakers need to avoid the mistakes of the Great Depression, where bank failures led to adecrease in money supply of about one third. This, coupled with a contractionary fiscal policy, ledto unemployment rates of about 30%.

would be rejected” (red lines); and (iii) define a clear and efficient system formonitoring evolution after the aid.

As of 3 December 2008, the Commission was notified by all major EUcountries on measures involving state aid of the following types: depositguarantees (DG), guarantees for bank lending (BG), bank recapitalisationschemes (BR), set-up companies to dispose of bad assets (CD) and funds to buybad assets from banks (BA). The following countries have introduced generalmeasures to shore-up the financial sector: Austria (BG), Denmark (DG, BG, CD),Finland (BG, BR), France (BG, BR), Germany (DG, BG, BR), Greece (BG, BR),Hungary (BG, BR), Ireland (DG, BG), Italy (BG, BR), Latvia (BG), Netherlands(BG), Poland (BG), Portugal (DG, BG, BR), Slovenia (DG, BG), Spain (BR, CD),Sweden (BG) and United Kingdom (DG, BG, BR). There were also 22 bankrescues notified,5 and one bank liquidation by Denmark. The majority of theinterventions have been on issuing state guarantees to bank liabilities and to setup funds for recapitalisation. Only Denmark and Spain have set up a separatecompany and fund, respectively, to buy and dispose of bad bank assets. But, sofar, the Commission appears to be reluctant to accept this type of intervention.6

There are some common benchmarks developed by this new case law:

1. eligibility and non-discrimination: subsidiaries of foreign banks, systemicbranches;

2. 6 months as the normal duration of schemes with review clauses, thoughthis term seems too short in view of the normal 2- to 3-year duration offinancial crises;

3. limitations on the issuance windows for guarantees, limitations in thematurity of the debts (3 years); and

4. minimum remuneration of capital injected by the state.

In 6 months the Commission will review the measures already approved andMember States will have to notify the Commission of their restructuring plansfor beneficiary entities. There will also be an assessment of the adequacy of themeasures and of their distortive effects.

Comparing two of the recent financial crisis—the Swedish crisis of the early1990s,7 which was dealt with quickly and with a relatively small fiscal andeconomic cost, and the Japanese crisis of the 1990s,8 which led to a decade of


5 Belgium, Germany and Netherlands, with four cases each, Luxembourg, UK and Sweden, withtwo cases each; and France, Finland, Portugal and Latvia, all with one case.

6 Similar measures were taken by the US during the Great Depression and the S&L crisis. TheReconstruction Finance Corporation was created to recapitalise banks, manage the portfolio ofshares and supervise the banks that had undergone state intervention from a commercialshareholder perspective. The Resolution Trust Corporation was set up to buy bad assets.

7 For a comprehensive view of the crisis and policies adopted see P Englund, “The Swedish BankingCrisis: Roots and Consequences” (1999) 15(3) Oxford Review of Economic Policy 80.

8 See, eg, T Hoshi and A Kashyap, “The Japanese Banking Crisis: Where Did It Come From andWhere It Will End?”, NBER Working Paper 7250 (July 1999).

low growth and a financial cost ten times larger—we can learn a number oflessons. The most important one is that banks need to be transparent andevaluate their situation realistically, with the regulators doing their proper job.Denying the problem and waiting for the economy to improve leads to aprolonged crisis. Secondly, debt restructuring is absolutely necessary to prevent avicious cycle: debt relief and rehabilitation of viable but debt-ridden firms andthe liquidation of nonviable firms are crucially important to wipe out thepayment uncertainty from the economy and restore market confidence. TheJapanese case shows that if zombie firms stick around in the market, uncertaintyand business shrinkage will linger on. Capital injections into banks are just abeginning. Thirdly, stringent asset evaluation and sufficient write-offs of the toxicassets should be the premise behind bank-capital injections and debt restruc-turing, with close supervision by the regulators. Fourthly, purchase of bad assetsby public asset management companies will unwind the leveraging: if bad assetsare disposed of by distress selling in the market, stringent asset evaluation willresult in a vicious cycle of debt deflation. To stop the vicious cycle of debtdeflation, the governments should establish asset management companies—public entities that purchase and hold the bad assets. The public entities shouldthen restructure the bad assets and sell them off gradually after the marketstabilises. Finally, suspension of mark-to-market accounting has a long-term sideeffect: if bankers hide bad assets, zombie firms will persist and the paymentuncertainty will remain, setting the stage for very low long-term economicgrowth, so it should not be pursued after the phase of acute crisis.

C. AN ECONOMIC-BASED APPROACH TO THE MENU OF MEASURES

I have demonstrated the need of financial aid to stop a market failure. In order tostudy the most appropriate measures for state aid, their impact on reducing thesystemic risk and improving the solvability and liquidity of the financial systemneeds to be established, with an ultimate view of reducing the losses of(consumer) welfare in the economy. Next, how the incentive changes the behaviorof banks and agents, which in this case have real problems of moral hazard andadverse selection, should be studied. Finally, distortions to competition and tradeshould be reduced to a minimum.

For each specific case, a cost–benefit analysis could be undertaken with thehelp of some simple financial models, based on the net present value of streamof benefits and costs. Direct benefits arise from avoiding contraction of credit tothe economy (use can be made of the credit multiplier or financial acceleratorestimated by the European Central Bank). Indirect benefits arise from containingsystemic risk and the overall risk of recession, after computing the impact onfinancial risk. On the costs side, there are obvious immediate and delayed costs


to taxpayers: over the short term, there are the interest costs of public debt andthe cost of guarantees; over the medium term, there are potential costs due toasset valuations and bankruptcy of the institution. There are also administrativecosts related with the implementation of the measures that may be important insome cases (consulting, management, etc). Finally, there may be also direct coststo depositors and investors, mainly an option cost of inaction. Financialspecialists use similar models for evaluating mergers and acquisitions or buyoutsin 2 or 3 days; we hope that similar methodologies will be used by state aidspecialists.

This is the methodology for specific cases. We used a scoring method forevaluating the menu of measures mostly used and proposed to attack differentaspects of the financial crisis. We can group the menu of measures the followingway:

. General measures addressed to all banks:. Guarantees:. Bank deposits (main share of bank liabilities). Guarantees for other bank liabilities. General measures, but with a specific bank incidence:. Bank recapitalisation:. It can take a minority or majority stake. Buying “toxic assets” from banks. Need to set-up a fund, company and system for buying the assets. Direct bank intervention. Nationalisation. Liquidation. General intervention in the real sector. Households holding mortgages under foreclosure. Small to medium enterprises (SMEs) with bad debts and may be bankrupt. Large firms holding bad debts and may be bankrupt

Fig 1 shows the scoring (from 1 = worst to 5 = best) on the following aspects:

1. benefit to the particular institution;2. reduction in systemic risk and other systemic impacts on the financial

sector and real economy;3. distortions on behavior of the agents;4. competition distortions;5. costs to taxpayers;6. administrative costs and complexity of implementation; and7. duration of the aid/intervention.

The measure with the highest score has the best cost–benefit ratio, the lowest theworst. The best measures are the general deposit guarantee and minority stake,


which coincides with a large number of the measures approved by theCommission. However, next comes general aid to SMEs and to households indistress, then guarantees to other liabilities issued by banks, where the benefitsare restricted to a liquidity effect, despite it being used by a large number ofcountries. At almost the same level comes the buying of assets by the state. Lastcome the most drastic solutions, like majority stakes and nationalization, and themeasure with the least cost–benefit ratio—liquidation of institutions.

However, there is still some significant variation in the scoring according tothe specifics of the measure. For example, a minority stake may cost taxpayerssubstantially if there is no previous write-off of the capital and it covers themarginal losses of the bank. There are a number of important aspects thatminority stakeholders should take into consideration when designing aprogramme.

First, no other state aid should be given without a depositor guarantee, sincethis the measure with the highest score of benefits relative to costs. All modernfinancial systems have this type of insurance. However, a blank guarantee to alldeposits should be only temporary. Normally, it is subject to an upper limit perdepositor and per bank, to limit moral hazard, assuming that large depositorsshould have enough information about the risk of the bank. The fund for this


Fig 1 Scoring Policy Measures for Financial Crisis on Cost–Benefit Analysis.Source: author’s estimates.

guarantee should also have the contribution of all the banks that benefit fromthe insurance, thus decreasing costs to taxpayers.

Secondly, in recapitalisations of banks the government should require thatshareholders do not profit directly or indirectly from the infusion of capital tocover the bank losses.9 There should be previous write-offs of the capital andreserves, including all the provisions. Payment of dividends should be limited oreven prohibited during state intervention and, as the guidance states, either thereshould be remuneration of the state capital invested or there should beclaw-back clauses to lower risk to taxpayers. The same holds for bonuses tomanagement. A problem arises with minority shareholders, especially pensionfunds, which in certain cases, such as in Sweden, had special treatment.

Thirdly, nationalisation of banks should be a measure taken only as lastresort. State officials are not necessarily good bank managers, and governmentsmay be tempted to use banks for purposes other than commercially orientedoperations (profit at minimum risk). Thus they should stop their involvement inthe management of the bank and privatise it as soon as possible.

The financial crisis is a case of massive regulatory failure, and the capabilityof recovering taxpayers money, as well as economic recovery, depends cruciallyon good regulation. Thus, a daring but necessary conditionality for all these stateaid measures would be the periodic review of capabilities of national banksupervision, carried out by an independent body jointly with InternationalMonetary Fund (IMF) and Bank for International Settlements experts.10

The ultimate impact of all state aid depends on the established rules forfinancial institutions regulations. The G-20 has already established a set of areasthat need further strengthening.

Finally, the effectiveness and cost to taxpayers of state aid to each individualinstitution, certainly subject to moral hazard, depends on restructuring andsystem recovery measures, so the Commission should follow its implementationclosely.

D. THE WAY AHEAD AND CONCLUSIONS

With regulatory systems that are national it makes little sense to have EU-wideinterventions in the financial system, like the recent German and French episodeshowed.11 However, as the French presidency showed, EU-wide measures are


9 This is in fact mandated by the Ecofin statement, above.10 It is worrisome that, despite the large systemic risk in the eurozone, a way to improve the quality

of bank supervisors has yet to materialise. Lacking an EU-wide regulator that is long overdue, theminimum is to carry out peer reviews, like in other fields, as among competition authorities.

11 The French proposal was to set up a large fund to support banks in the eurozone. But who wouldfinance the fund? The German government reacted by saying that German taxpayers were notwilling to bail out banks from other countries, given the fact that German households have some

very important due to their reinforcing and spillover effects. Besides thisleadership at the political level and fiscal and monetary coordination, there isalso an important role that the Commission can play on state aid.

There are three theoretically strong justifications for the Commission to takea hard-line position on state aid. First, to avoid “subsidy races”. Secondly,because national governments have a commitment problem: they are not able tocommit to clear rules and a fixed budget ex ante (this is the Kornai problem ofsoft budget constraint). There is also the problem of economic agents askingnational states for a renegotiation of conditions and the difficulty in settingconditions. At the same time, regulatory, administrative and political capture areall recognised to be easier at national level. The third problem is the difficulty ofnational governments to respect dynamic commitments which may createintertemporal inefficiencies.

Notwithstanding, the Commission needs to promote a more aggressive andtransparent approach by Member States to solve the crisis and revise itsapproach, as we now argue, taking the hard lessons of the Japanese case and thetendency for complacency of some national regulators and the less transparencyin the European markets in relation to the US.12

The Commission Guidance has already established a number of solidprinciples for state aid in the context of a financial crisis. As discussed above,priority is given to guarantees to bank deposits. In case guarantees are extendedto other bank liabilities, like subordinated debt, restrictions have to be imposedin order not to let shareholders take a free ride.13 The Guidance also establishesthat recapitalisation of banks is appropriate, but only for sound institutions,which means institutions with no major solvability risk and that should be able torecover when normal market circumstances prevail.14 It should be done atmarket prices, and there are two modalities accepted: preferred stocks withadequate remuneration, or with claw-back mechanisms or better fortune clauses.This is right for shoring-up the bank. However, the Guidance stops short ofrecognising the most important impact, which is to enable the bank to supplyfurther lending. If the recapitalisation is going to have any impact on the assetside of the bank, in order to clean up the balance sheet it needs to be used tocompensate losses. Two conditions were established above: that there is properaccounting and recognition of the debts, which requires collaboration of the


of the lowest leverage in the EU and the German economy does not have a negative externalassets position that is threatening some smaller countries. In fact, the Stability and Growth Pactwas built on the assumption that no big country would bail out small countries’ economies.

12 In fact, for quite a number of financial instruments that measure bank or corporate risk, themarkets in Europe are substantially underdeveloped.

13 The economic model of a bank is based on the idea that shareholders and managers are theagents which act in the name of the principal, which are depositors. So, when a bank takes anabnormal amount of risk those primarily responsible are the shareholders and managers.

14 Once more, this is an analysis that financial analysts are able to carry out.

auditors and regulators, and that there are previous write-offs of the capital. TheJapanese case is extremely telling on this point.

The Commission Guidance also recognises that liquidation should be takenas a second alternative if the guarantee does not work. I would go further andsay that liquidation should be used pure and simply as a last resort. There wereenormous costs to the bankruptcy of Lehman in the US, and despite the moralhazard that all these measures generate, I still think that liquidation of a majorbank should be an in extremis situation due to the systemic risk that it ultimatelycreates.

The Guidance also specifies that liquidity provision by a central bank is notconsidered state aid if open to all institutions and, when provided as aid to anindividual institution, is not state aid if the bank is sound and normal penaltycharges are applied.

Most of these measures, and especially the way they are moulded, are forliquidity support. However, according to most of the market news, Europeanbanks now have plenty of liquidity, still mainly provided by the central bank,whilst the economic situation continues to deteriorate rapidly. Households arecutting consumption and increasing savings, due to large losses in wealth and anexpected drop in income, whilst unemployment rises at an alarming rate. Andcorporations are cutting investment and production. So we have a vicious circleof dropping demand for loans and banks cutting lending. Figs 2 and 3 show thefall in actual corporate lending in the US and the deceleration in the eurozone,and the rapidly deteriorating expectations.

Not all economies have the same level of household and firms leverage, butthe second phase of the financial crisis is about to hit in full force, affectingmainly the highly indebted countries. And, as referred to above, this requires achange in the approach to the problem.

Certainly, that fiscal stimulus is an important policy in this situation, and somefiscal measures can also help resolve the financial crisis when they help the realsector to stimulate demand.15 Structural measures to increase productivity arealso of tremendous importance at the time of the economic crisis.

Direct intervention at the household level may be required in a prolongedrecession, to decrease the rate of foreclosure, although generalised schemes aredifficult to administer. These measures are very important for equity purposes,since they usually help the poorest taxpayers, or taxpayers who have suffered asudden loss of income.16 For example, in the UK the government introduced a


15 Governments should also think hard about the large implicit subsidy that they are givinghomeowners who some economists have argued are also at the root of the crisis in mortgagelending.

16 There are economists that have advocated these types of measures because they have animmediate impact on the real economy, they help the most illiquid of the households and thushave a larger multiplier effect.


Fig 2 US Corporate Loan Growth (in %).Source: Citi, EcoWin, Federal Reserve Senior Loan Officers’ survey.

Fig 3 Eurozone Corporate Loan Growth (in %).Source: IMF WEO, October 2008, 130.

measure for the state to pay interest in arrears, for up to 2 years, for householdsin which the main breadwinner has became unemployed or has suffered a largedrop in income. In Portugal, the government is proposing to set up a state fundin conjunction with major banks to allow homeowners who are to be foreclosedto stay in their property as tenants.

Direct intervention to help SMEs, through fiscal measures, debt rescheduling,reduction in interest costs or guarantees, is also very important, since they are thebackbone of the European economy—especially in a prolonged recession. Theyalso have a significant impact on employment support.

These direct measures to the economic agents are seen as an importantcounterweight, in equity and political terms, to the other measures for saving thebankers. A less costly alternative is to establish funds for guarantees to loans orsetting up risk clubs.

The most important measure that needs to be introduced in the highleveraged economies is the cleaning and restructuring of bank balance sheets. Tojump-start the economy, central banks17 and state institutions, using speciallycreated vehicles, may need to start buying toxic assets (as the Spanish proposalenvisaged). These schemes should use reverse repo auctions so as to betransparent and competition friendly. Government may need to set up acollection agency (bad bank)18 for holding and freezing these toxic assets whilethe markets remain depressed and then quickly unwind the portfolio. TheSwedish government followed this path with the Securum Bank, a “bad bank”created to resolve the problem of toxic assets.

I conclude by reiterating that we need to use all our expertise and lessonsfrom past crises, and all the instruments—fiscal, monetary, state aid andregulatory policies—in a coordinated and harmonic way in order to fight theonce-in-a-generation crisis that has now reached global proportions.


17 The Federal Bank is already using unorthodox measures by extending the securities used forcollaterising its operations and even conducting open-market operations and buying toxic assetsdirectly from banks. This is purely money creation that may help fight deflation.

18 This would allow a specialisation of managers and personnel, dividing those who are good atlending and those who are good at collecting bad debts.


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loan

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ially

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Dir

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)

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ium

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ualt

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loan

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ited

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iste

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cess

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g

An

nex

con

tin

ued


Typ

eof

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cton

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cial

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yD

istor

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ents

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tort

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rsA

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ativ

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plex

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Dur

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n

Dir

ecta

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(dir

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imite

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uild

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bank

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aned

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ited

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ates

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plac

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stru

ctur

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ed

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hly

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nary

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tis

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tyof

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ytim

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elo

ss

Ver

ydi

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ltan

dco

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adm

inis

ter.

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ecr

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g

Dir

ecta

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(loan

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ited

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cent

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ates

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stru

ctur

ing

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ed

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hly

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nary

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ium

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ualt

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ility

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adm

inis

ter.

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ecr

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cess

.Nee

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yse

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mon

itor

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urin

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g

Dir

ecta

idto

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ucin

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anch

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ited

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ited

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ing,

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easi

ng.

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ease

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ates

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ctur

ing

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ed

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ortio

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ium

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seq

ualt

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ility

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loss

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inis

ter.

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ruct

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Lon

g

An

nex

con

tin

ued


An

nex

foot

not

es

a Thi

sis

the

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aran

tee

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ually

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ough

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rmat

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b The

fund

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tee

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edby

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ribu

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hich

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ayer

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c Gov

ernm

ent

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ere

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d

The Current Financial Crisis and State Aid in the EU

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Transcript of The Current Financial Crisis and State Aid in the EU