1. Overview

In our previous credit crunch updates, we have provided an overview of the European Commission's response to State aid to the financial sector in the context of the current financial and economic crisis. Here, we discuss further developments since the end of 2008 in the provision of State aid to financial institutions in the context of the credit crunch. A fuller summary of the Commission's State aid decisions can be found here.

The beginning of the crisis saw rescue aid being granted to save individual financial institutions from insolvency (such as Northern Rock and West LB), followed by a second wave of such rescues after the collapse of Lehman Brothers in September 2008 (such as Bradford & Bingley and Hypo Real Estate). This aid was granted under the existing Rescue and Restructuring Guidelines under the exemption for aid for the development of certain economic activities (Article 87(3(c) of the EC Treaty).

Towards the end of 2008 the unprecedented scale of the liquidity crisis and the urgent need for State funds to safeguard the financial system from collapse became apparent. The Commission issued a framework "Banking Communication" on 13 October 2008 followed by a "Recapitalisation Communication" on 5 December 2008, which outlined acceptable conditions for Member States' financial rescue packages aimed at shoring up fundamentally sound institutions, such as recapitalisation and credit guarantee schemes. Such aid was granted under the exemption for aid to remedy a serious disturbance in the economy of a Member State (Article 87(3)(b) of the EC Treaty).

Since the end of 2008 the flow of State aid decisions in the wake of the credit crunch has far from abated and there have been a number of developments in this area.

2. Financial support and restructuring

A restructuring plan must be notified when a bank receives rescue aid, calls upon a guarantee granted under a guarantee scheme, has required emergency recapitalisation or where it has otherwise been agreed with the Commission as a condition of individual liquidity aid being granted. In most cases, the plan must be notified within 6 months of the aid being granted.

The Commission has stated that it is currently finalising guidelines on restructuring financial institutions (although this has been announced and postponed several times). It is understood the new guidelines will be based on the principles of the current Rescue and Restructuring Guidelines, amended to take into account the financial crisis, for example by placing substantially less emphasis on the need for a bank's 'own contribution' to the restructuring due to the difficulties of access to capital.

The Commission has recently launched investigations into a number of such restructuring schemes including those relating to Hypo Real Estate, Dexia and Fortis Bank. In addition, the restructuring plans of Northern Rock and BayernLB are still under investigation. The first decisions on these restructuring plans have also been made relating to Commerzbank and West LB.

It is apparent that particular concerns of the Commission relate to:

  1. ensuring the amount and duration of the aid is limited to the minimum necessary and that there is fair burden sharing with the bank in question, e.g. market value is paid for any assets nationalised; sufficiently high interest rates are being charged (Northern Rock, Dexia, West LB);
  2. ensuring there are sufficient safeguards to avoid distortions of competition, e.g. due to strong market power combined with the high amounts of aid involved (Commerzbank, Bayern LB, Northern Rock); and
  3. ensuring the plan will lead to long-term viability of the bank without the need for further aid (Dexia, Commerzbank, Hypo Real, WestLB, Northern Rock).

As outlined in our credit crunch update of 24 November 2008, as a condition of authorising the State aid, the Commission can demand behavioural conditions to ensure that the aid granted does not increase the bank's market power at the expense of competitors.

The Commission recently demanded stringent behavioural conditions when approving the restructuring plan of Commerzbank, including divestments of activities, assets and subsidiaries representing roughly 45% of its balance sheet (including the sale of Eurohypo, a real estate and public finance business), a general ban on acquisitions for three years and an undertaking it will not do business on more favourable price conditions than its competitors in markets/products where it has a market share above 5%. In this case, it seems the Commission had particular concerns over the potential for the State aid to distort competition because of the significant market power of Commerzbank (it is the second largest private German bank and one of Europe's largest banks) and the large amount of the aid provided (18 billion euros of capital).

However, Commerzbank was also said to be in favour of divesting the loss-making Eurohypo in order to keep its more profitable Eastern and Central European business and the Commission agreed to a flexible deadline for the sale (which must be within the next 5 years), Commissioner Kroes citing the need to be realistic and take into account the difficult market conditions facing any sale of financial assets.

Similar stringent divestment conditions were imposed on WestLB which was ordered to refocus on "less risky" activities and cease proprietary trading altogether and to reduce its balance sheet by half. In addition, Germany must change the ownership structure of the bank through a public tender procedure by the end of 2011.

These two decisions clearly show that the Commission is willing to closely scrutinise the banks' restructuring plans and take a firm line on preventing any potential distortions of competition.

3. 6 month reviews

Member States with recapitalisation and guarantee schemes are required to carry out a review of the scheme every 6 months in order to assess whether the scheme is still justified and whether any potential adjustments are necessary to deal with changes in the situation of the financial markets. Where there is a recapitalisation scheme in place, Member States must set out which banks have been capitalised and the terms of those recapitalisations, and undertake an assessment of the beneficiary banks' business model. The Member States must also consider the path towards exit from reliance on State capital. The results of this review must be submitted to the Commission. The first reports are expected to have been delivered in April 2009.

On the basis of such reports, the Commission could demand additional behavioural safeguards to be put in place. However, whilst one of the key elements of the financial rescue packages is that they are intended to be of only limited duration, the extent of the crisis means that following such reviews it is likely that certain aid packages will be prolonged beyond six months. This has been the case with the UK's Credit Guarantee Scheme, which is now authorised to run until 13 October 2009 (i.e. an extension of 6 months) and with the Finnish and Swedish guarantee schemes which have also been extended by 6 months. The scope of the Swedish guarantee scheme was also widened and the eligibility criteria relating to capital requirements were relaxed, which again suggests that in practice the Commission is adopting a flexible approach to these schemes in the context of the ongoing financial crisis.

4. Treatment of Impaired Assets

Recently, there have been several announcements of plans by Member States to 'clean-up' financial institutions' balance sheets and restore them to financial health by removing illiquid or 'toxic' assets, such as the "bad banks" announced by Germany and Ireland or the Asset Protection Scheme announced by the UK. In response to this, the Commission published a Communication on the "Treatment of Impaired Assets" on 25 February 2009 which outlines principles that must be followed in establishing asset relief measures, such as asset purchase, swap or guarantee schemes for impaired assets. The key principles outlined in the Impaired Assets Communication include:

(i) Full transparency and disclosure

Full transparency and disclosure of impairments must take place prior to government intervention by way of a full review of the bank's activities and balance sheet with a view to assessing the bank's capital adequacy and its prospects for future viability (a 'viability review').

(ii) Valuation of impaired assets and losses

It is understood that in many cases the assets concerned will have an extremely low or even nil current market value. Any difference between the price paid by the government in question to assume the risk of the impaired assets (i.e. the 'transfer price') and the current market price will constitute aid. The calculation of the transfer price should be based on the assets' 'real economic value' (meaning the underlying long-term economic value) rather than their current market value. The aid is more likely to be considered compatible where the transfer price is close to the assets' real economic value.

The Member States' valuation method must follow the principles set out in the Impaired Assets Communication and the valuation of the assets must be certified by independent experts and validated by the banking supervisory authority. The valuation and the valuation methodology used must then be approved by the Commission, which anticipates involving technical experts, for example from the European Central Bank, in order to do this.

(iii) Adequate remuneration for the State and adequate burden-sharing

There must be adequate remuneration for the State that takes into account the risks of future losses exceeding those that are projected when the real economic value of the assets is determined. This could be done, for example, by setting the transfer fee lower than the real economic value of the assets, as was the case with the Belgian government's plans to relieve Fortis Bank of certain impaired assets, which were approved by the Commission. For a guarantee scheme, this could be done by increasing the guarantee fee, whilst for an asset purchase scheme, it may be done by use of share warrants in the banks.

There must also be adequate burden-sharing with the banks of the costs involved, meaning that the government should not pay more for the assets than their real economic value. Where this is not possible initially, or where it is later found that the real economic value of the assets was overestimated, it is expected that the banks will contribute to the loss coverage at a later stage. This means that for an insurance scheme it is expected that the banks bear the first losses representing 10% of the total coverage and a minimum of 10% of the subsequent residual losses, whilst claw-back may be appropriate for an asset purchase scheme.

(iv) Limited duration

All schemes will only be authorised for a maximum period of 6 months and it should only be possible for banks to enrol in this six-month enrolment window except in exceptional and unforeseeable circumstances.

(v) Viability reviews and restructuring

Appropriate restructuring measures must also be taken for each beneficiary bank which will be assessed taking into account the total aid received by the bank concerned through recapitalisation, guarantees or asset relief. A viability review (a type of 'stress test') or restructuring plan for each beneficiary bank must be submitted within 3 months from the date it joins the scheme. 'In-depth' restructuring (implying large scale divestments or changes to the bank's business model) will be required where a bank has already received aid previously that either contributes to coverage or avoidance of losses or in aggregate exceeds 2% of the total bank's risk weighted assets.

The Commission is also now authorising individual asset relief measures for impaired assets on the basis of the Impaired Assets Communication. This was the case with the temporary back-up facility for illiquid assets created by the Netherlands for ING, which has been temporarily approved by the Commission for a period of 6 months. Final approval of this measure is subject to a detailed investigation by the Commission regarding the valuation of the assets and the remuneration to be provided to the Netherlands, because the Commission had doubts these were in line with the requirements of the Impaired Assets Communication. A restructuring plan for ING will also need to be notified.

5. Measures to help the real economy

On 17 December 2008, the Commission published its "Temporary Framework" for State aid to support access to finance in the economic crisis. The Temporary Framework outlines certain additional measures available which Member States can use to give relief to the "real economy", e.g. measures aimed at stimulating lending to homeowners and businesses, particularly SMEs. These include measures in the form of aid to be targeted at individual businesses specifically, such as:

  1. a lump sum of aid up to €500,000 per company;
  2. subsidised loans for the production of green products;
  3. risk capital for SMEs; and
  4. widening the scope of permissible State-funded export credit insurance.

However, certain measures can also be of benefit to the financial institutions themselves, such as:

  1. State guarantees for loans at a reduced premium; and
  2. aid in the form of subsidised interest rates on loans, to be calculated on the basis of the central bank overnight rate instead of the year inter-bank offered rate, plus a premium.

The Commission has been authorising such schemes relatively promptly under an accelerated procedure where the proposed schemes clearly comply with the conditions outlined in the Temporary Framework. As at 10 June 2009, there are 11 guarantee schemes (including one in the UK), 16 schemes for de minimis aid (including one in the UK), 3 schemes offering reduced interest loans to businesses investing in green products (including one in the UK), which are in particular targeted at providing aid to the automotive sector, and 8 schemes for subsidised interest rate loans (including one in the UK). In addition, 4 risk-capital schemes have been set up and Luxembourg and Denmark have established state-funded export credit insurance schemes under the Temporary Framework.

Crucially, once the schemes are approved, there is no need to notify individual grants made under the schemes. It is therefore possible for governments to quickly give out financial support to companies in financial difficulty – as is the case with the German government's loan to Opel, which is being made under an aid scheme authorised under the Temporary Framework. However, such schemes can only be open to companies which were not in financial difficulty before July 2008.