Today, the European Commission published detailed guidance on how “Member States can recapitalize banks in the current financial crisis to ensure adequate levels of lending to the rest of the economy and stabilize financial markets whilst avoiding excessive distortions of competition, in line with EU state aid rules.” The guidance contemplates that “financially sound banks may need state capital to ensure an adequate level [of] loans to companies.” The new Guidance Communication, which was announced last week and refines the broader guidance adopted in October, “further addresses the necessity of appropriate safeguards to ensure that the public capital is used to sustain lending to the real economy and not to finance aggressive commercial conduct to the detriment of competitors who manage without state aid. Such safeguards also need to provide incentives for maintaining state intervention in the financial sector only as long as the crisis in the financial markets so requires. This approach ensures fair competition between Member States, fair competition between banks and a return to normal market functioning as soon as possible.”

The Communication, which is available here in its entirety, establishes

“principles for the pricing of state capital injections into fundamentally sound banks based on base rates set by central banks to which a risk premium is added that has to reflect the risk profile of each beneficiary bank, the type of capital used and the level of safeguards accompanying the recapitalization to avoid abuse of the public funding. Riskier banks will have to pay a higher rate of remuneration. The pricing mechanism needs to carry a sufficient incentive to keep the duration of state involvement to a minimum, for example through a remuneration rate that increases over time.”

The use of state capital for banks in distress can be accepted “only on the condition of a far-reaching restructuring restoring their long-term viability, including where appropriate a change in management and in corporate governance.” After six months, the Member State concerned will “report to the Commission on how the state capital has been used. The report must also include an exit strategy for fundamentally sound banks and a restructuring plan for distressed banks.”

The European Commission also approved today the French program to inject up to €21 billion of fresh capital into French banks, although the program initially will be limited to €10.5 billion injected into France’s six largest banks. The Commission noted that the French scheme complements its previously approved refinancing scheme. The Commission concluded “that the capital-injection scheme is an appropriate, necessary and proportionate means of stabilising financial markets, restoring confidence and enabling French banks to increase lending to the real economy,” noting in particular that the “remuneration, which will average about 8%, will reflect the degree of solvency of each beneficiary bank via a credit default swap (CDS) component, whereby remuneration is modulated according to the risk of default.” The Commission also noted that participating banks “must also undertake to adopt measures concerning the remuneration of senior management and market operators (including traders) and to observe ethical rules consistent with the general interest, including restrictions on the remuneration of senior executives” and “limit severance payments to senior executives and ban all severance payments where a senior executive or enterprise has failed or where a senior executive leaves voluntarily.”