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Review of Rescue and Restructuring aid Guidelines - UK response to Consultation

Executive summary

1. Rescue and Restructuring aid is the most distortive form of aid and the State aid framework has an important role in regulating its use. The UK strongly supports the strict enforcement of the State aid framework in order to protect and strengthen the single market in the EU and prevent wasteful subsidy races between Member States.

2. The temporary frameworks did usefully provide Member States with the flexibility to respond effectively to the severe economic dislocation caused by the financial crisis. However, with the worst of the financial crisis having passed, we believe it is important that the EU returns to the strict enforcement of Rescue and Restructuring guidelines under article 107(3)(c).

3. The provision of State aid must continue to be restricted to those instances as assessed under article 107(3), that is, where Member States can demonstrate that the provision of aid is necessary in order to achieve well-defined policy objectives of common interest over and above the negative effects on trade and competition. In the majority of instances, bankruptcy proceedings or resolution (for the financial sector) should be the normal course of action for a firm facing insolvency.

4. Where aid is provided however, three key principles should continue to be at the heart of the permanent EU State aid framework for both the real economy and the financial sector:

Ensuring that aid is restricted to the absolute minimum necessary by extracting the maximum possible own contribution towards a rescue consistent with long term viability;

Ensuring that distortions to competition are remedied through compensatory measures; and

Ensuring that the aid recipient undertakes sufficient restructuring measures to return to standalone viability.

5. The crisis has demonstrated nonetheless that the general Rescue and Restructuring guidelines are not appropriate to deal with the unique economic characteristics and forms of intervention in the financial sector. As demonstrated in the last two years, banks are uniquely susceptible to sudden losses of confidence and unlike in other sectors the failure of a bank can have significant negative externalities for its competitors and for the entire real economy. Given its unique economic characteristics, the UK believes that the best way to control State aid in the financial sector is through separate rescue and restructuring rules specific to this sector.

6. The banking sector State aid framework must maintain procedural flexibility to provide Member States with the option of pursuing a range of interventions at the rescue stage. Unlike in the real economy, interventions in the financial sector need to take place in a short period of time, and it is difficult to specify ex ante what type of State intervention will be necessary. However, the State aid principles set out

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above should continue to be strictly enforced, and should specify detailed rules on how private sector burden sharing must be imposed to ensure aid is restricted to a minimum.

7. To this effect, the banking State aid framework should reflect the resolution tools that are due to be introduced across the EU as a result of the European Commission‟s Crisis Management Framework Legislation. In particular, the State aid framework should be prescriptive on the private sector burden sharing that needs to take place prior to the provision of aid. In this manner, the State aid rules have an important role in incentivising Member States to make full use of these resolution tools. By setting clear and detailed rules upfront prior to any bank resolution the State aid framework can provide predictability to the different stakeholders involved in bank resolutions, including the relevant Government authorities. This predictability is extremely beneficial both to preserving financial stability (e.g. by facilitating a quick sale of an undertaking back into the private sector over a weekend), and for the purpose of addressing moral hazard (e.g. making it clear what burden sharing will be necessary).

8. In the event that any aid is provided to a bank, the UK believes that the recipient should be subject to strict restructuring measures to compensate for the resulting distortions to competition and to ensure that the bank returns to long term viability. Where certain private sector burden sharing options have not been executed through the resolution toolkit, yet aid has still been provided, the UK believes that the restructuring requirements should be more severe to remedy resulting distortions to competition. The UK response to the consultation document provides our thoughts on the various restructuring options that should be considered by the Commission in its State aid approval process.

9. By setting such clear ex ante expectations on private sector burden sharing in the State aid framework, the UK believes that the State aid and the Crisis Management Frameworks can work in tandem to address moral hazard and reduce the implicit guarantee that currently benefits European banks.

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SECTION A: APPLICATION OF THE RESCUE AND RESTRUCTURING GUIDELINES, IN

PARTICULAR IN THE LIGHT OF THE CRISIS

Summary

1. We consider that Rescue and Restructuring aid is the most distortive form of aid and the Commission should pay close attention to all applications. However, each case must be considered individually and we accept that there are companies whose closure would have a very serious economic and social effect. Companies that are rescued by Government support should be subjected to the rigours of the restructuring process ensuring a return to long term viability free from Government support rather than be constantly propped up through other forms of aid.

2. We note that the current questionnaire is based on Member States‟ experiences of giving R&R aid during the financial crisis. The UK gave such aid only twice during the crisis to Modec (NN19/2009) and LDV (NN41/2009). Our comments are therefore of a more general nature.

A1 Objective of the aid

3. We agree that that the Commission should be able to take other policy objectives into account when considering Rescue and Restructuring (R&R) aid .This does not mean that other objectives should trump consideration of competition. The normal balancing of positive and negative effects of aid should still be taken into account.

4. The Guidelines should certainly continue to allow social and regional policy considerations to be taken into account. However, this should be balanced by the ability of areas meeting the criteria of Article 107(3)(a) to be able to offer higher intervention rates and thus attract business to compensate for company closure. It should be borne in mind that the loss of a significant employer in even a relatively prosperous area, could have substantial economic and social consequences. The potential closure and loss of jobs may paradoxically be worse in an area which cannot benefit from assisted area status to attract replacement jobs.

5. Other wider policy considerations such as the effect on the Community Research and Development targets may also need to be taken into account. In considering this, weight would need to be given to whether or not similar research was already been carried out, how easy it would be for other market players to continue the research and whether or not the research had already benefitted from state and Community funding which would in effect be wasted. However as stated above this should not weaken the competition analysis.

A2 Eligibility Criteria – link with national bankruptcy laws

6. There are various types of UK insolvency of which, administration and a company voluntary arrangement with creditors are aimed at rescuing a company as a going concern.

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7. Administration can help an insolvent company that has a saleable business. The initial stage of administration involves a period of statutory moratorium, during which creditors cannot take action against the firm and administrators can attempt to restructure the business or create a way to more efficiently sell the company‟s assets. Administrators have a legal obligation to try to promote and sell the firm or any parts that are worth saving, as a going concern. Failing this, the administrator must establish the best realisation of the firm's assets to ensure they are worth more to creditors than if the company was in liquidation. If this is not possible, the administrator should make sure any assets that can be recovered go towards paying the most secured, preferential creditors.

8. The creditors‟ voluntary arrangement is available for those who have an insolvent business which can‟t pay its debts as and when they fall due, but which, if given some breathing space, would be able to make regular monthly payments into a fund which could be distributed to creditors annually. Most arrangements of this sort stay in place for 60 months and may also include lump sum payments at various stages, for instance if it is envisaged to sell property.

9. In practice, a company must be able to contribute at least £1,000 a month. For a business with a significant turnover, this should be easily manageable. It is often combined with severe cost cutting, which enables the business to re-structure itself and emerge leaner. On occasions it follows an administration, which may have first been used to protect the assets of the company from plunder from creditors taking enforcement action. In this way the CVA is a great protection against the action of creditors.

10. A creditors‟ voluntary arrangement is not to be undertaken lightly as to fail it would mean that all unpaid debts would still remain due. It is worth bearing in mind that business fortunes can change over time, and a commitment that is entered into this month may not hold up 12 months later.

11. For employer‟s using these insolvency rescue procedures to restructure there is further assistance under the Transfer of Undertakings (Protection of Employment) Regulations 2006 (which implements Directive 2001/23/EC Acquired Rights Directive) they have a measure of protection as the National Insurance Fund (UK insolvency guarantee institution) bears a certain proportion of the employee liabilities to encourage transfer to a viable entity and, more generally, as a system to support employees of an insolvent entity.

12. We see no reason to give rescue and restructuring aid before a company is actually insolvent. Insolvency proceedings are a clear and understood milestone. It should also be borne in mind that companies can experience a period of difficulty which may be severe and trade through. Intervening too soon may actually prevent a non assisted recovery. The Oxera1 report on the counterfactual scenarios for restructuring

1 “Should aid be granted to companies in difficulty?” A study on counterfactual scenarios in restructuring aid Oxera December 2009 http://ec.europa.eu/competition/state_aid/studies_reports/restructuring_aid_study.pdf

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aid suggests that 77% of non aided companies in crisis actually survive three years after the onset of crisis. This suggests that not all companies in difficulty fail.

A3 Form of Aid – rescue aid

13. We consider that there is still a need for a clear distinction between the two forms of aid. It is possible that a company can actually work its way out of difficulty if given a period to consolidate. As rescue aid is given at a rate which is close to market, this period should give minimum distortion to the market. Restructuring aid on the other hand is distortive.

14. We see no need to extend the current six month period for rescue aid. This is long enough for consolidation. We are also not convinced of the need to offer anything other than liquid and reversible support at market levels and consider that the reference rate plus 100 basis points is a suitable proxy for the market rate. The company needs an incentive to either quickly pay off the loan or to engage in real restructuring plans. A grant would not provide such an incentive.

15. We would however welcome clarity on how far we can interpret urgent structural action (para 16 of the Guidelines). There may need to be an injection of cash to cover activities which the company started to alleviate its condition – for example laying off staff – and which cannot just be suspended until the restructuring phase. Whilst we appreciate that this is for Member States to argue and that it will depend very much on the facts of the case some guidance is needed around how flexible the idea of urgent can be.

A4 Restructuring – return to viability

16. It is essential that the company demonstrate that it can return to viability without further support, otherwise we are simply keeping a company afloat which cannot compete in the market. This is highly distortive and is a poor use of tax payer money. If a company cannot return to viability it suggests that there is a problem with the business model or the management or that the good or service they provide is unwanted. In either case there seems to be no good reason to keep the company in the market.

A5 - Restructuring Aid – own contribution / burden sharing

17. Companies should continue to contribute to their restructuring costs. There must be some share of the burden as this binds the company in, reduces the distortive effect of the aid and forces them to take the measure seriously. The burden of this second chance should not fall entirely to the tax payer. We agree that the levels set out in the current Guidelines remain suitable as long as there is the possibility for Member States to argue for a reduction in cases of genuine difficulty. However these should be the exception.

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18. We consider that shareholders should be the first resort for finance. They should make capital available to pay interest on loans or guarantees provided by the state. The company cannot take action to protect shareholders at the expense of the tax payer – thus funds cannot be set aside to guarantee payment of dividends or the coupon payment on subordinated debt.

A6 Restructuring aid – measures to limit distortions of competition (compensatory measures.)

19. The concept of compensatory measures to alleviate distortions of competition is sound and the Commission‟s current practice as set out in paragraphs 39 and 40 of the Guidelines is sensible. However, the compensatory measures should be looked at as just one part of a wider package involving the counterfactual of aid and burden sharing. It is also important to have clarity on which distortions and where exactly they lie. This would lead to meaningful compensatory measures.

The counterfactual of aid

20. The current guidelines assume that the counterfactual would be exit and thus the ability of competitors to have access to assets or market share. The Oxera report suggests that this is not be true with a high percentage of companies surviving in some form, at least in the short term. There needs to be an analysis of the steps a company might have taken in order to survive – or stave off bankruptcy for as long as possible. This is likely to include sale of subsidiaries, withdrawal from secondary markets and production reduction. These are exactly the sort of compensatory measures normally proposed. If this is what would have happened anyway, it suggests that the compensatory measures for aided survival need to be looked at closely.

21. The aim should be to avoid simply replicating what would have happened in any case. The counterfactual analysis should aim to trace what exactly the company would have had to do to ensure survival rather than assuming exit. For example to what extent would the company have reduced output and to what extent would it have lost market share to more efficient companies as it recovered from distress – assuming that there is another company to take its place. This could set a baseline for ensuring minimum distortion.

Burden Sharing

22. If a company is making a significant on-going contribution to its own restructuring, involving its shareholders and creditors, this should go towards mitigating any competition distortions which might occur and thus should influence the scale of compensatory measures.

A7 Uses of Other Instruments to help firms in difficulty

23. During the financial crisis the UK Authorities set strict criteria for those companies we would help. Apart from the banks very few companies were actually offered rescue or restructuring aid. As noted above, we did give rescue aid to Modec (NN19/2009) and to LDV (NN41/2009) – in neither case was this followed by

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restructuring aid. Modec were able to repay the loans offered and the rescue aid for LDV was given to allow time for a buyer to be put in place. In the event a buyer was not found and LDV were allowed to go into insolvency and exit the market.

24. It is possible that some of the companies assisted under the Temporary Framework were at the time in difficulty – even if they had not been on 1st July 2008. However, as the majority of aid given under the Temporary Framework was under the Small Amounts of Compatible Aid provision, the chance of real distortion was minimal. As the Commission will be aware, the UK is concerned that the Temporary Framework could be used as a means of avoiding the rigours of the Rescue and Restructuring aid rules and press for it to end on the appointed date. In effect it was possible for the loans and guarantees provisions of the Framework to be used as rescue aid for more than two years.

25. The UK did not use any other means to keep companies in difficulty afloat. We consider that Rescue and Restructuring aid is the only form of aid which should be offered to companies in difficulty. This should continue to be the exception rather than the rule. In most cases a state bale out will not be justified and would be better to allow troubled firms to exit the market through the normal exercise of bankruptcy and insolvency law.

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SECTION B: RESCUE AND RESTRUCTURING OF FINANCIAL INSTITUTIONS

Summary

The state aid framework needs to reflect:

(i) The urgency of resolving a failed financial institution in order to avoid

contagion effects; and (ii) The higher probability that rescue and restructuring aid of a financial

institution will be economically justified on the balance of welfare effects in comparison to a rescue of a firm from any other sector.2

The best way to achieve this whilst maintaining the principles of State aid control will be to put in place a separate set of rescue and restructuring guidelines for the financial sector building on the experiences of the temporary “financial crisis” framework. This response provides detailed views on how such guidelines should be designed. The guidelines should be:

Flexible on the timing and nature of the intervention – the full range of resolution

options needs to be available for all banks at all times. The guidelines should enable the Commission to make fast decisions on State aid cases involving financial institutions. This is necessary to allow national authorities to act quickly and decisively to resolve troubled banks where necessary, thereby avoiding economically damaging financial instability.

Prescriptive on burden sharing and depth of restructuring – thereby making it clear to Member States and the industry in advance what private sector burden sharing measures are expected to have been exhausted prior to aid being approved.

Joined up with linked policy areas – State aid rules are a key element of the European crisis management framework and a key factor in the ability of EU Member States to credibly address moral hazard and too big to fail perceptions. It is essential that the Commission and Member States‟ resolution tool kits are coherent across the piece and provide clear and credible messages to banks and their creditors on how they will be treated in a resolution situation and reinforces the principle that State aid is very much a last resort option. It is also essential that the European Union delivers on its commitment made in the summit of G20 Leaders to implement the Basel 3 agreement in full and on time. With a significant transition period, Basel 3 introduces a single definition of capital which will strongly underpin the single market and end national variations, an agreed minimum level of capital, new liquidity requirements, and a transparent backstop for leverage which will

2 This can be demonstrated through comparing and contrasting the rationales for rescues of financial institutions during the crisis with rescues of real economy firms using the Commission‟s own framework – Common principles for an economic assessment of the compatibility of state aid under article 87.3.

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become binding over time. Full and rigorous implementation of Basel 3 should make the need for official sector support for the banking sector in the future less likely and so is a critical part of the overall reform package.

B1 – Specifics of the financial sector

Should financial institutions in difficulty be treated differently from companies in other

sectors when it comes to rescue and restructuring aid?

1. Yes - it is necessary for financial institutions to be treated differently to other sectors

when it comes to rescue and restructuring aid.

If so, could you specify why

2. The economic rationale for rescue and restructuring aid of a financial institution

tends to be stronger than that for rescue and restructuring of firms in other sectors

for three reasons: 3

Banks are uniquely susceptible to sudden collapses in confidence which can have

serious consequences for a bank‟s solvency;

The disorderly failure of one bank can have significant negative externalities for

its competitors in contrast to the failure of a company in the real economy; and

The disorderly failure of a bank can have significant negative consequences for

the real economy and bring an extremely high social cost.

3. Impact of collapse in confidence: In comparison to other types of firm, financial

institutions rely uniquely heavily on confidence, and are accordingly uniquely

vulnerable to panic. The financial system is also structurally vulnerable to contagion.

Due to the nature of the market‟s supply of funding (to a large extent dependant on

deposits that can be immediately redeemed) and demand for lending (which tends

to be for longer periods – e.g. for mortgage finance) banks borrow short and lend

long – a process known as maturity transformation. Banks lend out the majority of

customer deposits on a longer-term basis reflecting the belief that most depositors

will choose to leave their money in the bank on any given day. In addition, financial

institutions have a higher level of balance sheet gearing in comparison non-financial

institutions. It is not common for non-financial firms to have liabilities in excess of

their equity capital (and rare for them to have liabilities in excess of twice their

3 For more lengthy discussion on these issues see, for example - Bailing out the banks: Reconciling stability and competition, CEPR, 2010. Or Competition Policy, Bailouts and the Economic Crisis, Bruce Lyons, CCP Working Paper 09-4, 2009. Or The financial crisis and competition policy: Some Economics, John Vickers, GCP Online, December 2008. In addition, the analysis made in section is consistent with the OFT‟s assessment of the competition dynamics of retail banking in Office of Fair Trading Review of barriers to entry, expansion and exit in retail banking November 2010.

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equity capital), whereas financial firms routinely have liabilities equivalent to 20

times equity capital.

4. The maturity transformation and credit formation roles that financial institutions

perform are critical to the performance of the real economy, but the nature of these

functions involve them taking on significant amounts of risk. The industry‟s nature –

and societal functions – leaves the institutions within it particularly vulnerable to a

sudden collapse in confidence. In the absence of full insurance, bank lenders (e.g.

depositors) have a lot to lose in the event of a bank failure, and therefore tend to

withdraw their cash at any sign of worries – even unfounded rumours – about a

bank‟s insolvency. When a number of lenders withdraw their money from a bank,

this can lead to a self-fulfilling „run‟ which can threaten the survival of even

technically solvent financial institutions.

5. Governments around the world have responded to these inherent features of the

financial sector by putting in place a wide range of regulatory measures – e.g.

central bank lender of last resort facilities (which allow solvent banks to survive a

short term liquidity crisis) and deposit insurance (which protects retail depositors

and deters bank runs). However, as the financial crisis of the last three years has

demonstrated, this regulatory architecture is not comprehensive and vulnerabilities

remain.

6. The banking sector‟s vulnerability to crises of confidence, combined with the two

features outlined below, leads us to believe that the economic rationale for rescue

and restructuring of systemic financial institutions is likely to be significantly stronger

at the present time in comparison to the rescue and restructuring of firms in other

sectors.

7. Impact of bank failure on competitors – Firstly, unlike in other industries the

disorderly failure of a bank can carry a large negative externality for its competitors.

A disorderly bank failure damages confidence in the entire industry and this can

further undermine the general health of firms in the sector. This effect can occur as

a result of banks‟ customers and investors observing the collapse and thereby losing

confidence in their banking partners – possibly because of shared characteristics

with the failed firm – and withdrawing their deposits from these institutions.

8. There are also direct contagion effects that flow from the interconnectivity of the

banking sector which are not normally found in other sectors. The exposures that

banks necessarily have to one another mean that competitors can suffer losses in the

event of a disorderly failure. The interbank market helps banks efficiently manage

liquidity, helping them to reconcile the short term maturity of their liabilities

(customer deposits) and the longer-term liabilities of their assets (mortgages, and

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other longer-dated loans), and facilitate their customers‟ transactions. However, this

approach to liquidity management creates a systemic risk through the

interconnection of reciprocal liabilities across the system. A disorderly failure of one

of the connected banks will cause losses to its counterparties and can also lead to

cautious decisions from each individual bank to close off exposure to other market

participants. This in turn can lead to a general liquidity crisis as the inter-bank

lending market stops functioning as a means of reconciling different maturity

profiles.

9. For these reasons the banking sector reacts very differently to a failure of a major

firm from, for example, the manufacturing industry. The potential positive effect for

competitors of gaining additional market share by picking up the disenfranchised

customers of a failed bank tend to be outweighed by these negative contagion

effects.

10. Impact of disorderly bank failure on real economy – There can be extremely high

social costs to disorderly bank failure that tend to be much larger than the social

costs associated with failure of other types of firm. Banks play a crucial role in

facilitating the economic activity of agents across the economy through the

following functions:

Providing a payment system – facilitating efficient transfers of financial value,

and low transaction costs;

Transforming assets to match the short-term maturity profile of the supply of

funding (from depositors) with the longer-term maturity profile of demand for

credit (e.g. from mortgages borrowers); and

Providing the link between the ultimate savers and the ultimate borrowers – it is

more efficient socially for banks to specialise in evaluating potential borrowers,

monitoring their activities and ensuring repayment than for individual small

savers to do so.

11. A disorderly failure of a bank has the potential to undermine each of these functions

and in doing so have a significant negative impact on the real economy. In particular

the final two functions are key to ensuring that credit flows to worthy enterprises in

an economy and that good businesses are given the opportunity to grow. The

example of the failure of Lehman Brothers provides evidence of the negative impacts

on confidence, lending to the real economy, and ultimately growth that can be

generated by disorderly financial institution failures. Following a disorderly failure –

or during a time where there is fear about a looming disorderly failure – banks

become risk-averse in order to protect their capital position. All types of firm across

the economy will find it more difficult to finance investment in such conditions, or

even to finance day-to-day activity. Given this credit channel effect, academic

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commentary generally accepts that – given the inadequate resolution tools that

were available in most cases – it has been necessary to rescue systemically important

firms during the financial crisis.

12. In sum, the combination of these impacts are unique to a banking failure and differ

significantly from the impacts related to the failure of manufacturing firm where

there is generally no similar contagion effect. In a manufacturing industry context

the negative externalities from firm failure on its competitors and the wider market

are not as large as there are considerably fewer interdependencies, and the impact

on availability of finance to the firm‟s competitors will be positive. In addition, there

are likely to be fewer negative externalities for market output and employment as

the firm‟s competitors expand or new entrants emerge to occupy the space in the

market that the failed firm has vacated. In contrast, where a bank failure brings

wider market instability, its competitors are often disinclined – or unable, in view of

barriers to entry and expansion – to expand their balance sheets to capitalise on the

vacated space in the market, as they in turn are seeking to delever and derisk their

balance sheets. The state aid framework therefore needs to reflect (i) the urgency of

resolving a failed institution in order to avoid contagion effects and (ii) the higher

probability that rescue and restructuring aid of a financial institution will be

economically justified on the balance of welfare effects in comparison to a rescue of

a firm from any other sector.4

If so, could you specify to what extent? In your view, would a specific new framework

for the rescue and restructuring of financial institutions be needed due to their

distinctive features or should there only be one set of rescue and restructuring

guidelines, possibly with a few specific rules to take account of certain particularities of

the financial sector?

13. The UK believes that the distinctive features of the financial sector outlined above

require fully separate rescue and restructuring guidelines for financial institutions.

The need for flexibility in the rescue phase and for prescriptive burden sharing and

compensatory measures frameworks means that State aid rules applied to the

banking sector should not be mere “tweaks” to the general rescue and restructuring

rules.

14. This will be the best way to credibly enforce the state aid principles and maintain

control of state aid in the financial sector over the long term. Detailed ex ante

guidelines specifically designed for financial institutions should be sufficiently flexible

at the rescue phase to reflect the need in extremis for authorities to have all

resolution options available in a crisis to avoid the large negative externalities

4 This can be demonstrated through comparing and contrasting the rationales for rescues of financial institutions during the crisis with rescues of real economy firms using the Commission‟s own framework – Common principles for an economic assessment of the compatibility of state aid under article 87.3.

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associated with disorderly bank failure. These bespoke guidelines could also help

national authorities overcome commitment problems by setting out a consistent

framework for tough burden sharing and restructuring rules.5 Spelling out these

tough rules up front in more detail could usefully reinforce the role of State aid in

reducing moral hazard in the industry, strengthening market disciplines and

ultimately reducing the number of institutions requiring State aid. It is crucial that

the State aid regime for financial institutions reflects and complements the future

EU crisis management framework currently being developed by DG MARKT, and

policy development on the idea of „bail in‟ as an alternative and / or complement to

public recapitalisation. We also note that such a shift is endorsed by other

prominent figures in the EU.6

15. It is important to note that it is not always possible to predict when a financial crisis

will occur, nor which Government measures will be required. The permanent State

aid guidelines for the rescue and restructuring of financial institutions therefore

need to be designed to deal effectively with a widespread crisis situation under

107(3)(c). The case of Northern Rock showed the difficulty on relying on a general

framework for rescue and restructuring that did not adequately address the

particular characteristics of the financial sector. Overly restrictive rules on the aid

that is permissible at the rescue phase (restriction to liquidity aid), and the

assumption on the need for a six month period prior to restructuring were not

appropriate and hindered authorities‟ handling of the case. A fully separate

framework is needed for state aid control that will apply to banks whether in a

situation of isolated instability or wider market instability. This will allow cases

arising from potentially nascent financial crises to be handled effectively without

having to wait for a formal Commission decision to switch to a crisis framework on

the basis of a judgement whether that bank‟s distress represents an isolated case or

the precursor to wider financial instability (see B3 for further discussion).

If yes, what should be the precise scope of that specific framework (e.g. narrow deposit

taking institutions only, or also including other financial institutions like conglomerates,

insurers, hedge funds)?

16. The UK suggests that the scope should be limited to deposit taking institutions and

other systemically important financial institutions.7

5 By commitment problems we are referring to authorities‟ commitment to take a tough approach with financial institutions and their private sector stakeholders. In the absence of a supra-national framework that binds all authorities to a tough approach the implementation of burden sharing may be perceived as risky by authorities as it may drive investors to other „softer‟ jurisdictions. 6 For example see - The role of state aid control in improving bank resolution in Europe, Bruegel Policy Contribution, May 2010. 7 Other systemically important financial institutions would be likely to include entities such as investment banks, and clearing houses. We recognise that the international debate on the definition of systemic

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B2 – Procedural approach to rescue aid

Do the specificities of the financial sector call for a different procedural approach as to

the rescue of financial institutions in difficulty as compared to companies in other

sectors?

17. Yes, there should be a specific procedural approach to rescue banks in difficulty. In

order to avoid the large negative externalities associated with uncertainty over a

troubled financial institution‟s solvency, a Government rescue intervention needs to

be swift and decisive at the rescue phase. The rules must therefore facilitate quick

decision making at the rescue phase in order to provide legal certainty to the public

bodies and private stakeholders whose efficient co-operation is required to resolve a

failing financial institution. This requires flexibility to approve at the rescue phase a

potentially very wide range of interventions, for example regarding capital support

and immediate structural measures such as the rapid sale of a deposit book in a

“good bank / bad bank” operation or the transfer of the viable banking business to

a bridge bank until such time as the business can be sold. It will also require the

continued application of liquidity support to ensure that a „bad bank‟ can be wound

down in a controlled manner. This should not mean that state aid principles should

not be applied rigorously to cases involving financial institutions, as discussed in

more detail below.

Have your authorities put in place a resolution scheme or other specific proceedings for

such purposes or do they plan to do so?

18. Yes – the UK has introduced a Special Resolution Regime for UK incorporated

deposit takers in March 2009. The introduction of this regime was in recognition

that general insolvency law is inadequate for dealing with failing banks when speed

and flexibility are of the essence to maintain financial stability. Putting in place a

special resolution regime for the banking sector is essential to help ensure the

continuity of key banking functions such as the operation of the payment system

and of banks‟ credit intermediation functions.

19. The EU Crisis Management Framework is likely to introduce an obligation for all

Member States to introduce resolution tools specific to financial institutions. The

European Commission is also consulting on the introduction of new tools that

would go further than the UK‟s current regime, notably in relation to a potential

debt write-down tool or bail-in tool. It should be a top priority for the design of the

permanent Rescue and Restructuring regime for financial institutions that state aid

guidelines are fully consistent with and act to complement the use of these new

resolution tools. We expand on this point below at section B5 on burden sharing.

importance continues – as this debate matures State aid guidelines can reflect this by specifying the scope of the guidelines more precisely.

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If so, could you describe the main characteristics of this scheme? How are State aid rules

integrated in the scheme?

20. Alongside this response we have attached a slide-pack that the Bank of England

presented to DG COMP in June 2010 describing the SRR and outlining the State aid

issues that arise during different types of resolution.

21. It is particularly important that State aid rules are designed to facilitate best practice

bank resolution by retaining the ability to provide clear decisions at speed. Potential

private sector purchasers of parts of insolvent institutions require legal certainty on

the status of the transaction, and will be deterred from completing a sale if there is

any lingering legal uncertainty regarding potential future restructuring obligations.

Where closure of a bank and the rapid payout of depositors is inappropriate the

swift transfer of assets and liabilities to a sound purchaser is usually a much better

solution than, say, a full nationalisation. State aid guidelines should be designed to

facilitate such solutions and provide as much upfront legal certainty to purchasers as

possible. Delays to approval and ongoing legal uncertainties have the potential to

result in the failure of private sector options thereby leading to the eventual need for

larger amounts of state aid, and increasing the costs to taxpayers.

22. State aid guidelines for the financial sector should also make it clear that bridge

banks should not be classified as „new companies‟, and should therefore not be

captured by any rules banning „aid to new companies‟. These institutions exist only

as a temporary resolution mechanism and exist only to allow time for a permanent

private sector solution to be achieved if possible. When a bridge bank, or part of a

bridge bank, which has been the recipient of aid is sold back into the private sector

the aid follows the entity and may therefore require compensatory measures – for

example if recapitalisation was needed. However, the aid in these instances should

be seen as compatible aid and the Commission‟s approach should seek to facilitate

these transactions through providing quick legal certainty on the State aid status of

the entity. Similarly, bridge banks may not be considered as a “firm in difficulty”

which would be eligible to receive rescue aid on a strict interpretation of the general

Rescue and Restructuring guidelines; however, they clearly should be accepted as an

eligible aid recipient in the context of a resolution framework in the bank-specific

guidelines. Whenever timing allows (i.e. when it is not necessary to agree the sale of

a bridge bank extremely quickly to preserve financial stability), the sale of a bridge

bank which has been the recipient of aid should happen through an open

competitive sale process. In any event the sale process should at all times be non-

discriminatory and transparent, with an appropriate level of competitive tension.

When this process is observed and the assets go to the highest bidder, the sale price

is considered to be the market price and aid to the buyer can be excluded.8 To the

8 As per the Bank Restructuring Communication, paragraph 19.

16

extent that any aid remains in the transferred aided undertaking, compensatory

measures should be swiftly agreed so that there can be legal certainty on the State

aid status of the transferred entity.

23. We have also attached The UK Special Resolution Regime for failing banks in an

international context (published by the Bank in July 2009) that provides additional

background information on the SRR.

B3 – Form of rescue aid

Footnote 3 to paragraph 25a) of the current Rescue and Restructuring Guidelines opens

the possibility for rescue aid going beyond liquidity support in the form of loan

guarantees or loans in the financial sector, but expressly excludes structural financial

measures related to the financial institution's own funds, in order to ensure that the aid

remains temporary and does not go beyond preserving the status quo. The crisis rules

allow for recapitalisation and impaired asset measures already in the rescue phase,

against appropriate remuneration Do you think that other structural measures (such as

capital injections) should already be allowed at the rescue stage in the post-crisis

regime? Which ones and why?

24. Yes, other structural measures should already be allowed at the rescue phase.

Distressed financial institutions sometimes require capital or impaired asset relief to

restore market confidence in their long term viability. Rescue and restructuring

guidelines for financial institutions should allow for sufficient recapitalisation at the

rescue phase to restore the market‟s confidence that the recipient can survive and

continue to function on an ongoing basis. A full range of bank resolution options

needs to be available for all banks at all times to protect against damaging financial

instability.

25. It would be a mistake to rely on transitioning to a more flexible „crisis regime‟ under

article 107(3)(b) in a financial crisis, and retaining restrictive rules during normal

market functioning (e.g. excluding capital relief at point of rescue). The onset of a

financial crisis can happen quickly, and therefore rules governing the rescue and

restructuring of financial institutions under article 107(3)(c) need to, in extremis,

facilitate swift and comprehensive rescue packages for systemically important firms

where this is necessary to protect financial stability. The experience of the financial

crisis shows that the transition period for moving to a crisis regime can be lengthy

given the difficulty in deciding ex ante whether the failure of one bank is an isolated

event or the first of many others. Given the speed with which financial crises can

start and spread - the guidelines governing 107(3)(c) therefore need to be designed

to deal with the effective rescue of failing banks.

17

What measures would you suggest should be introduced to avoid emergency rescue aid

resulting in irreversible support even when this is not warranted?

26. Unfortunately there is no effective way to half-rescue a distressed bank.9 Due to the

nature of the banking sector – reliant as it is on market sentiment on the overall

health of the network of institutions across it – reversible interventions to prop up

ailing banks are likely to be ineffective. Distressed banks require high quality capital

to absorb losses and where that capital is not available in the market Government

support will be necessary if an intervention is required to avoid financial instability.

By definition under the new Basel 3 agreement, Core Tier 1 capital must be

perpetual. State aid rules should be geared towards ensuring that, if such support is

provided, it will be sufficient to be effective at averting financial instability.

27. However, burden sharing rules should set expectations on the sources of private

sector burden sharing that should be achieved prior to State aid injection, or prior to

final approval of the State aid and the associated restructuring plan. Where

insufficient burden sharing has been achieved, or if aid has been injected

unnecessarily generously, tough restructuring guidelines should make it clear ex ante

that this will result in harsher restructuring remedies. This approach will set the right

incentives for firms and authorities to pursue private means of capital raising earlier

in order to avert capital problems. Further detail on how this might work is outlined

in answer B5.

28. It is also possible in a good bank / bad bank resolution (see Dunfermline Building

Society for example) to minimise the distortive effect of aid by matching transferring

deposits with cash paid under the Deposit Guarantee Scheme (DGS). The UK

Government considers that where DGS funds are used to manage the resolution (i.e.

liquidation or wind down) of a firm this should not be treated as distorting aid.

However, where DGS resources are used to provide funding or capital to an entity

that will remain in, or will return to, going concern status then the State aid through

this post-funded industry insurance scheme may be distorting and may therefore

require restructuring and behavioural remedies.

B4 – Maintaining rules of the Bank Restructuring Communication

29. The UK broadly agrees with the key objectives of bank restructuring as identified by

the Commission‟s Bank Restructuring Communication. Firstly, as discussed in further

detail in section B5, it is important to ensure that aid is restricted to the absolute 9 However, if a bank is not a systemic institution it should be possible to close it down. If insured depositors are paid out quickly financial instability should be avoided.

18

minimum necessary by ensuring sufficient private sector burden sharing towards a

rescue. Such private sector burden sharing in a rescue situation is essential to

tackling the problems of moral hazard and the implicit guarantee in the sector.

Secondly, where aid is provided to a bank, the UK agrees with the main types of

competition distortions caused by aid to the financial sector as identified in the

Commission‟s Restructuring Communication. As discussed in section B6,

compensatory measures should therefore have the objective of remedying these

distortions. Thirdly, restructuring plans must seek to return the bank to standalone

viability. This objective must be borne in mind when considering the types of

measures which would satisfy either of the first two objectives, and is discussed

further within sections B5 and B6.

Are there any special rules introduced by the Bank Restructuring Communication during

the crisis which should be maintained in the post-crisis restructuring regime for banks?

Why? Please submit evidence.

30. One time last time – The special rule allowing the possibility of the provision of

further tranches of aid during the restructuring period should be retained. The

general Rescue and Restructuring guidelines sets out that any firm in receipt of

rescue or restructuring aid should not be entitled to a second rescue or restructuring

package within 10 years of the first except in exceptional circumstances.10 This is

designed to ensure inefficient firms exit the market and to avoid excessive distortions

of competition. The UK supports that objective, and recognises that it is appropriate

for non-financial sector entities. However, it does not reflect the possibility that

additional support for a financial institution may be necessary if market sentiment

does not improve after the first intervention and the social cost of failure remains

unacceptably high. As demonstrated in the recent crisis, a number of banks

including the Royal Bank of Scotland, Lloyds Banking Group, BNP Paribas, Dexia, IKB,

Hypo Real Estate, KBC, West LB, Irish banks, Fortis / ABN Amro and ING required

more than one intervention within the space of a year to restore their viability as the

crisis gradually deepened over 2008 to 2009. The framework should therefore

recognise that it may be necessary to intervene on multiple occasions to prevent the

disorderly failure of a large bank. The moral hazard and distortion of competition

caused by a repeat intervention can be dealt with by even more intrusive

restructuring and / or orderly liquidation requirements.

31. The risk of a second intervention can however be minimised through the use of a

rigorous, comprehensive and transparent stress test as the basis for designing the

first intervention. The State aid guidelines must therefore require national authorities

10 Community guidelines on state aid for rescuing and restructuring firms in difficulty, EU, 2004. Section 3.3.

19

to undertake thorough stress tests of those banks in distress, and provide

transparency to the market as to the severity of these tests, to determine the

necessary amount of aid required to restore the bank to viability and restore market

confidence.11

32. Restructuring period – The recognition that stabilising and restructuring a distressed

financial institution can take up to five years should also be retained. The financial

crisis has demonstrated that restructuring weaker banks that have had to resort to

State aid is an extremely challenging process. Firstly, successfully executing such

restructuring is heavily dependent on market conditions. Restructuring plans require

a significant disposal of assets and/or businesses and whether a bank can dispose of

these (and at a price that is not heavily capital depletive) is dependent on market

conditions at the time. In a situation of financial instability (that might be expected

around the rescue of a systemically important financial institution “SIFI”) a sale will

be particularly difficult due to the unavailability of buyers as other market

participants seek to hoard their resources, and avoid taking on additional risk. These

factors are beyond the control of the aided entity and may take a number of years

to return to normal. Resorting to a fire sale would undermine a bank‟s capital

position and send a negative signal to the market which could serve to exacerbate

its weak position. Secondly, some of the business disposals required under the State

aid rules can be extremely complex to execute. This is particularly the case with

respect to retail business divestments as this may require the bank to identify the

branches, customers and assets from scratch to be divested in accordance with the

State aid requirements e.g. LBG case.

33. Sound versus unsound – The distinction between sound and unsound financial

institutions based on a threshold amount of recapitalisation has now been dropped

and that is positive. This distinction was used during the crisis in a way that distorted

competition and, in some cases, supported aided mergers. A number of financial

institutions did not require recapitalisation State aid in order to maintain stability

and perform their core functions in the economy (e.g. HSBC, Deutsche Bank,

Santander, Barclays) – any other bank that was required to take any recapitalisation

State aid (in particular where multiple tranches were needed) should not have been

considered to have been sound and should have been subject to detailed

restructuring requirements. On an ongoing basis we would expect that all financial

institutions that require recapitalisation to be obliged to submit a restructuring plan.

In time the rules should require that a bank requiring any type of State aid

(including only liquidity support) should submit a restructuring plan. Long term

reliance on public sources of liquidity support will be distortive and risks creating

11 State aid guidelines might helpfully set out that stress tests should use the EBA macroeconomic stress scenario as the minimum degree of severity. The stress tests should be designed to test resilience over at least a three year stress period.

20

zombie banks that are addicted to State aid. However, we realise that the

transitional phase away from Government liquidity support will need careful

management to avoid financial instability. DG COMP may have a role to monitor the

withdrawal plans of member States and to impose restructuring plans where

necessary if unviable institutions are being allowed to artificially survive in the market

due to continued State aid.

34. The specific rules on burden sharing for financial institutions should be retained, but

should form a starting point for more specific and binding rules in future. See

section B5 for detailed comments.

B5 – Burden-sharing

With regard to the sharing of costs for bank restructurings ("burden-sharing"), the Bank

Restructuring Communication introduced bank-specific rules relating to the contribution

of capital holders, compared to the current Rescue and Restructuring Guidelines. Did

you encounter any problems in designing and implementing burden sharing

arrangements in particular cases of financial restructuring?

35. In general the UK Government considers that the role of DG COMP in enforcing the

burden sharing rules within the Bank Restructuring Communication was a positive

influence on the design of authorities‟ interventions in the latter stage of the crisis.

In this later stage, holding a consistent line on the need for burden sharing to be

pursued where sources were available, and acknowledging successful burden

sharing measures in restructuring outcomes the Commission improved outcomes for

taxpayers and reduced distortions to competition. In particular we note the role that

the Commission‟s explicit rules on blocking coupon payments on hybrid debt helped

facilitate liability management exercises that enabled some burden sharing with

subordinated creditors.

36. However, the Restructuring Communication was limited in how far it specified

which sources of burden sharing were expected to be utilised, and to what extent.

This reflected the lack of appropriate tools that the authorities had available to

extract contributions from banks‟ shareholders and creditors during the crisis period,

and a lack of consistency in these tools across Member States. With the introduction

of a common crisis management framework across all Member States there is now

an opportunity (and indeed necessity) to be more specific and to set higher and

clearer expectations in State aid guidelines.

21

For the post-crisis regime, how should "burden-sharing" be designed in order to ensure a

proper participation of shareholders and creditors in the costs of restructuring and to

limit the costs to taxpayers?

37. There are a range of initiatives at national, European and international level aiming

to minimise the risk and costs to the public purse posed by financial institutions and

in particular SIFIs. In general these initiatives have the effect of increasing the loss

absorbency of bank capital, and various categories of bank debt. Of particular

relevance to the State aid guidelines are the Basel 3 proposals to increase the quality

and quantity of bank capital, introduce new liquidity requirements and, over time, a

binding leverage ratio (all of which should reduce the likelihood of State aid). There

are also important proposals to strengthen the European crisis management

framework and ensure that all Member States have a common and credible

minimum set of tools and powers to resolve failing banks. All systemic institutions

will have recovery and resolution plans which are critical to ensuring appropriate

planning for a crisis but also enable a crisis response by firms and authorities,

including with respect to restructuring. In particular, the Crisis Management

Framework includes proposals to establish bail-in tools that would introduce ex-ante

rules for shareholders and creditors to share at least part of the burden of

resolution.

38. The UK Government supports EU and international efforts to explore bail-in options,

and recognises that there are good arguments for bail-in in principle as a means of

exerting market discipline in the financial sector. These efforts should extend to

evaluating the potential role of State aid rules setting a framework within which the

co-ordinated use of bail in tools could be managed. Bail-in tools could be greatly

enforced if embedded in State aid rules, potentially helping to increase the ability of

authorities to resolve complex institutions without the need for State aid. However,

EU policy development will need to rigorously evaluate the costs and benefits of the

various bail-in proposals being developed prior to implementation. This will require

policy makers to improve understanding of the risks associated with bail in (e.g.

impacts on cost of capital, and operability during a financial stability crisis) as well as

the potential benefits (e.g. reduced fiscal costs of financial crises, more efficient

credit allocation due to imposition of market discipline).

39. The UK believes considerably more attention should be given to the distortions of

competition caused by the implicit guarantee to systemically important financial

institutions (SIFIs), which is made explicit through the provision of aid. To the extent

that the standards for burden sharing are not met, and available policy tools are not

used to extract contributions from the private sector, compensatory measures must

decisively address the competition distortion caused by the aid directly provided, and

by the aid provided through the implicit guarantee. There are two key types of

22

competitive distortion caused by the implicit guarantee. First, it reduces the funding

costs of beneficiary institutions, giving them a competitive advantage in relation to

banks that do not benefit from the implicit guarantee or benefit to a lesser extent.

Second, it encourages excessive risk-taking supported by the implicit guarantee as a

fall-back.12

40. Evidence from the Bank of England clearly supports the contention that some

institutions benefit from an implicit funding subsidy from taxpayers, which

encourages them to make greater use of debt finance and to engage in riskier

activities to fully benefit from the subsidy. This implicit guarantee originates from

the expectation that government will support a category of institution in case of

failure in view of the large economic costs that such a failure entails.13 The existence

of this expectation distorts the prices that debt financiers offer to banks to fund

their activity. Funding prices do not reflect the inherent risks of the activity a

systemic financial firm‟s business model entails, but rather the firm expectation that

banks‟ debt investors will always be protected in the event of such a firm‟s failure

due to the likelihood of Government rescue. This moral hazard leads to an inefficient

allocation of credit as debt funders provide inefficiently cheap funding to finance

systemic firms‟ risky activity.

41. It may be debated whether the implicit guarantee is in itself a transfer of State

resources that would on its own engage Article 107 TFEU. However, when a

Member State fails to take action to mitigate the systemic risks associated with the

implicit guarantee, and has to provide State aid, the distortive effect of the aid is

magnified as it serves to sustain the market presence and risky behaviour of the

bank that was until then supported by the implicit guarantee. In addition, failure to

deal with this issue is contrary to the principles of burden sharing and maximisation

of the beneficiary‟s own contribution. In this scenario, State aid creates moral

hazard and prolongs and multiplies the distortive effect of the implicit guarantee,

and the likelihood of having to resort to State aid. As such, compensatory measures

12 The UK also considers that the impact of the implicit guarantee and of State aid on dynamic

competition and barriers to entry and expansion should be carefully considered when compensatory

measures are being proposed. The lack of appropriate tools to deal with the failure of SIFIs, besides

creating moral hazard, weakens competition by not allowing inefficient incumbents to exit the market,

which in turn reduces the incentives (and indeed the ability) of more efficient firms to compete vigorously

(See Office of Fair Trading Review of barriers to entry, expansion and exit in retail banking November

2010). And State aid itself harms potential new competitors, as well as unaided firms already in the

market, by increasing the hurdles to gain access to a market which is naturally characterised by high

barriers to entry. As such, compensatory measures that aim at lowering barriers to entry and/or favour the

entry of new firms are to be encouraged.

13 For more details see http://www.bankofengland.co.uk/publications/fsr/2010/fsrfull1012.pdf in particular section 5.2.

23

have to be designed in a way that addresses the cumulative effect of the aid coupled

with that of the implicit guarantee.

42. Annex A sets out a detailed UK Government view on how burden sharing rules

should work in State aid guidelines. This aims to strike the balance between

ingraining high expectations that will lead to the maximum use of available tools to

impose losses on shareholders and creditors whilst avoiding financial instability by

imposing unrealistic obligations.

B6 – Compensatory measures

What kind of distortions should, in your view, be targeted by compensatory measures

for financial institutions?

43. The UK broadly agrees with the main types of competition distortions caused by aid

to the financial sector identified in the Commission‟s Restructuring Communication.

Compensatory measures should have the objective of remedying these distortions.

Despite the fact that rescuing banks may have a positive externality on competitors

(see response to question B1 above), rescue aid to banks can be assumed to be

distortive. Even if the short-term effect of the aid is to give some benefit to

competitors (directly e.g. if they are also creditors of the aid recipient, or indirectly

e.g. by lowering funding costs for the entire industry), the effect of the aid in the

medium and long term will be to weaken competition by not allowing inefficient

incumbents to exit the market, which in turn reduces the incentives (and indeed the

ability) of more efficient firms to compete vigorously.14 In addition, large banks are

also active in non-banking sectors, where they compete with firms that do not

benefit indirectly from aid to banks. As such, aid can have distortive effects in other

markets, for example by lowering the cost of funding of banks active in non-banking

sectors.

44. Furthermore, the assessment of distortions of competition in the field of State aid

control is not limited to the harmful effects of the aid to competitors. The impact on

the overall level of competition, on the level playing field between Member States,

and on consumer welfare, is also taken into account.15 So even if the static net effect

of the aid on competitors is positive, the overall distortive effect on the competition

process and on the level playing field is likely to be negative. In other words,

considering the impact of the distortions only from the optic of competitors neglects

the distortive effect of the aid on other parameters of competition.

14

See Office of Fair Trading Review of barriers to entry, expansion and exit in retail banking November 2010. 15 See European Commission staff paper Common principles for an economic assessment of the compatibility of State aid under Article 87.3, paragraph 51.

24

45. We also believe that more emphasis should be placed in the guidelines on the

second objective to eliminate moral hazard through the introduction of burden

sharing requirements that oblige authorities and institutions to use available policy

tools to ensure appropriate burden sharing with the private sector (see B5).

However, compensatory measures should also bear in mind the third objective of

returning a bank to viability.

Drawing from your experience with compensatory/competition measures during the

financial crisis, what kind of compensatory measures are in your opinion most adequate

to address competition concerns?

Retail and commercial banking business divestments

46. The UK believes that measures to address competition distortions in retail and

commercial banking should have as its core objective the improvement of conditions

of competition in the market rather than being an indiscriminate transfer of assets

from the aided bank to any of its other competitors or potential competitors. Where

business divestments are mandated to address distortions of competition they

should be implemented through open, transparent, objective and non-

discriminatory competitive sale process to facilitate cross-border trade. To the extent

possible, compensatory measures should focus on favouring entry and/or expansion

of small incumbents. Indeed, we have been told that the prospect of state aid sell-

offs is an important factor in some of the prospective entrants considering coming

into retail banking market.16 We are supportive of the measures requiring that the

buyer or buyers of the divestments do not already hold market shares beyond

certain levels in market segments where there are high barriers to entry. Acquiring a

divested business enables prospective entrants to overcome the problem of

consumer inertia and quickly achieve a reasonable degree of scale (in particular

through an established branch network), required to cover large fixed and sunk

costs such as IT systems.

47. As a general principle, it is right that compensatory measures in retail and

commercial banking markets are focused on those markets where real competition

concerns exist in view of the market position of the aided firm. However, given the

relatively weak evidence on the correlation between market structure and level of

competition in retail and commercial banking markets, it is important that the

assessment of competition in a particular market is not over-reliant on structural

characteristics such as market shares or “head-counting”. A market share of 20% in

a market with high barriers to entry and low levels of customer switching allows

greater levels of market power than a similar market share in a more competitive

16 See Office of Fair Trading Review of barriers to entry, expansion and exit in retail banking November 2010.

25

market. As such we would encourage the Commission to make use of rigorous

economic tools as used in assessment of competition in mergers and acquisitions

cases, to better understand where the competition concerns lie with respect to

those markets that an aided firm operates.

48. Furthermore, it is also important that retail business divestment packages are

sensibly designed to maximise the likelihood of achieving a positive outcome for

competition. Important elements for this are:

Any retail divestment must be equipped with the necessary infrastructure to

allow it to operate as an efficient challenger either on a standalone basis or as a

business integrated with a small incumbent. This infrastructure includes the

requisite staff, IT systems, and service level agreements with the aided bank to

continue to provide certain services whilst the divestment business builds its own

capacity.

The retail divestment must also be „commercially coherent.‟ By this we mean that

the business should mirror the retail asset quality of the State aided bank after

the disposal of its non-core assets and as it returns to viability. The divestment

should also contain the necessary mix of business lines and services to meet its

clients‟ needs and it should have a diverse geographic distribution to enable it to

grow sustainably. Furthermore, the divested banking business should be

adequately retail-depositor funded to avoid the need of the buyer to rely too

heavily on the wholesale market with concomitant risks of financial instability.

Besides being commercially coherent, the divested business has to be sufficiently

large so that it is an “effective challenger” in the target markets on a standalone

basis, increasing its attractiveness for an entirely new entrant.

The sale of large divested assets should not serve to increase the market power

of established banks. In the UK, in order to ensure that the retail businesses to be

divested by LBG and RBS would have a material positive impact on competition,

it was agreed that these assets could only be purchased by firms that were

below a certain market share threshold. This will ensure that the divestments will

not end up serving to reinforce the market position of larger incumbent banks,

and will instead improve the conditions of competition in the UK retail banking

market.

Balance sheet reductions

49. The UK believes that there is a role for balance sheet size restrictions and / or

reductions on banks that have received state aid. In many instances it is the

aggressive expansion of the balance sheet that led some banks into crisis, and in

26

some instances, for already systemic firms the existence of an implicit guarantee in

itself served to incentivise over-expansion. These restrictions should however be with

a view to ensuring a return to viability and private sector burden sharing. The latter

objective is discussed in B5. Care must also be taken to ensure that deleveraging

does not impair wider economic objectives, such as the supply of credit to the

economy during a recessionary period or a period recovering from recession.

50. Post-crisis, some reduction in the balance sheet is inevitable as recovering banks

deleverage and dispose of the most heavily impaired assets. Nonetheless, for the

purpose of restoring viability the State aid rules should also require the further

disposal of non-core assets on the balance sheet that represent the greatest

potential financial stability risk (high RWAs and balance sheet volatility) to the bank

and entail a heavy reliance on short term funding in order to reduce the risk of

further aid being required in the future.

51. In certain circumstances, restructuring may also entail requiring a bank to desist

from certain non-critical financial activities altogether. In assessing what constitutes

the critical activities of the bank, we believe that the Recovery and Resolution Plans

that form part of the Crisis Management Framework provide an opportunity to

identify those economic functions that the bank and the Member State consider as

critical to the functioning of the financial system and wider economy. However, this

requirement needs to be tempered by an appreciation of the negative impact that

such restrictions may have in reducing overall market capacity where competitors are

unable to increase the supply of „non critical‟ functions.

52. In those financial activities where the bank is required to divest of assets or an entire

business due to the risk contained, the bank should be prohibited from re-starting

those activities again (where it has divested of the business activity entirely), or

restricted from re-scaling the size of the business beyond a certain level (where it has

divested of assets) at least until any State aid has been repaid in full.

53. As suggested in the temporary framework, a suitable timeframe to realise the

balance sheet reduction is 5 years.

Behavioural remedies

54. Aided banks should not be allowed to purse overly aggressive commercial strategies

with the benefit of an effective government guarantee. They should not be in a

position to offer better deals on the back of State aid.

55. With this objective in mind – and particularly where structural remedies such as

business divestments may not be available – it may be appropriate to use

behavioural measures to minimise the competition distortions caused by the aid.

27

Behavioural measures may include access remedies, where access to infrastructure

and networks is granted to facilitate market entry and deal with a key obstacle

preventing banking markets to operate efficiently (barriers to entry).

56. However, some behavioural remedies such as market share caps and restrictions on

price leadership must be treated with caution in view of the risk that these may

reduce rather than increase competition in the market to the detriment of

consumers if certain market conditions are present. Therefore, when designing

behavioural remedies consideration should be given to the likely effect of such

remedies, taking into account characteristics of the particular relevant market such

as willingness of customers to switch, market concentration and barriers to entry

and expansion.

What kind of problems did you encounter when proposing/implementing compensatory

measures? From your experience, were the compensatory measures in particular cases

adequate to address the competition problems? Why? Why not? Please submit

evidence.

57. The lack of metrics and benchmarks in the temporary State aid guidelines made it

difficult to understand the Commission‟s requirements with respect to a

restructuring plan. The Commission‟s views on these issues seemed to change at

different stages of the process and even within discussion of particular cases.

Furthermore, it remains unclear whether there was consistent treatment across

cases, with some banks which received aid (including as part of aided mergers)

required to undertake no compensatory restructuring. As discussed in this paper, the

permanent State aid guidelines should introduce clearer and tougher ex-ante rules

and expectations as to burden sharing prior to receipt of aid, and as to subsequent

compensatory measures where aid is provided.

58. There is a risk that compensatory measures required of banks provided with aid may

encourage a retrenchment to national markets. This is particularly the case where

compensatory measures seek to extract business divestments that are deemed non-

core due to the fact that they are located in foreign jurisdictions. It is not necessarily

the case that such businesses can be deemed non-core, and it is important for the

guidelines to appreciate the risk that compensatory measures could result in

retrenchment to national markets.

28

B7 – Monitoring

With regard to the monitoring phase, which elements of good practice from the

restructuring of banks during the financial crisis should be exported to general

restructuring rules? What was your experience, if any, with the establishment of a

monitoring trustee?

59. The Commission should look to ensure that a Monitoring Trustee has been

appointed prior to the release of the State aid decision letter, or as close to that time

thereafter. This is because many banks under State aid obligations will seek to

implement and execute the requirements swiftly and it is important to ensure that a

Monitoring Trustee is already in place to monitor developments.

29

Annex A – UK views on the design of burden sharing rules

1. The role of private sector burden sharing to effective State aid control in the banking

sector is critical. The more that the burdens associated with dealing with troubled

banks can be pushed onto banks‟ private sector stakeholders, the less need for State

aid, and the fewer the distortions to competition that will be generated. State aid

rules should therefore seek to incentivise, and where appropriate mandate, all

available burden sharing. This should be done in such a way that allows reduction in

the amount of State aid, and where possible eliminates the need for it altogether. In

doing this State aid rules will have a positive impact on the vital task of reducing

moral hazard in the financial sector.

2. Regulators‟ tools for imposing burdens on the private sector will improve as reform

of the industry progresses. State aid rules should encourage and support this shift by

embedding in the guidelines minimum requirements upon the private sector.

3. This section provides thoughts on the design for the first set of burden sharing rules

and reflects an indicative understanding of what tools will be made available to

authorities across Europe as a result of the upcoming EU crisis management

Legislation. Two key challenges are:

Ensuring consistency of approach with the EU Crisis Management Framework;

and

Judging how – and to what extent – the rules should specify the sequencing of a

bank resolution. This needs to balance the need for fast interventions to

maintain financial stability, with imposing rules that oblige authorities to take

advantage of available sources of private sector burden sharing in order to allow

any State aid interventions to be minimised.

4. The discussion below summarises preliminary thoughts on how a set of burden

sharing rules could be designed, suggesting how different sources of private sector

loss absorbency might be treated in the rules. The proposed approach assumes

that:

The new EU crisis management tools will allow efficient resolution of non

systemic financial institutions. The only firms that would ever need structural

(capital support, or long term liquidity support) State aid would be SIFIs.

Authorities will implement a single rescue intervention that will seek to

comprehensively restore market confidence. A rescue package – including

burden sharing measures and (to the minimum extent necessary) State aid –

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would be required to transparently restore long term viability, including restoring

sufficient strength to withstand a three year stress period.17

Actions that the Commission should consider mandating prior to or at the point of Aid

injection

5. This section captures measures that should be taken to minimise the amount of aid

provided and maximise burden sharing, and which can be quickly implemented

without creating excessive financial instability.

6. The regulatory architecture is designed to ensure that authorities use these private

sector sources of capital recovery early on in a financial institution‟s potential failure,

in order to reduce the risk that a Government rescue may be needed. State aid rules

should recognise this and specify that a bank in distress must implement each of

these measures to the maximum available extent prior to the receipt of State aid.

The contributions that these measures will make to the recovery of the institution

should clearly be taken into account into the sizing of any State aid package,

ensuring that this private sector contribution to filling a capital shortfall offsets the

amount of State resources injected. This approach will help to minimise the amount

of State aid in line with State aid law.

Suspension of equity dividend payments / suspension of coupons on debt instruments

Contribution to burden sharing

7. As a condition to secure Commission approval for State aid received in the course of

the financial crisis, a number of recipient financial institutions were required to

suspend equity dividend payments/coupons on debt instruments for a certain

period, usually two years.

8. The contribution to the bank‟s capital position from suspending coupons on debt

instruments is readily quantifiable given that these are calculated by a yield on the

size of the investment. The contribution to the bank‟s capital position from

suspending equity dividend payments will obviously depend on the size of the

distributable profits, which in turn would depend on how early into a period of

distress that a bank chose to suspend equity dividend payments. It is clear

nonetheless that profitable banks have sought to reduce their dividend payout ratios

as a result of the recent financial crisis in order to preserve their capital buffers. The

Bank of England estimates that the dividend payout ratio of those banks paying

dividends fell from 67% in H1 2009 to 49% by H1 2010.18

17 Using a robust stress test methodology. 18 Bank of England Financial Stability Report, Dec 2010.

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Triggering

9. National regulators are required to implement the Basel III rules in their entirety by

the end of 2018. Basel III requires that banks meet a regulatory CT1 ratio minimum

of 4.5%. In addition to this they will be required to meet a countercyclical buffer

within a range of 0-2.5% of common equity. Furthermore, by 1 January 2019,

banks will be required to build a capital conservation buffer of 2.5% to be met by

common equity.

10. Though the purpose of the conservation buffer is to allow banks to absorb losses

during periods of financial and economic stress, the closer their regulatory capital

ratios approach the minimum requirement, the greater the restraints on earnings

distributions that the national regulatory can impose. Such restrictions would

include the payment of equity dividends and of coupons on debt instruments.

11. The Commission‟s Consultation Document on the Crisis Management Framework

similarly envisages the powers of early intervention allowing supervisors to restrict or

prohibit distributions by credit institutions, including payments to hybrid instrument

holders, in circumstances where there may be a likely breach of the CRD (Capital

Requirements Directive).

Remuneration constraints

Contribution to burden sharing

12. As a condition of State aid approval for the aid that they have received, the UK

banks RBS and LBG were required to commit to being at the forefront of domestic

and international agreements on remuneration best practice. Using historical

precedent, a bank would be able to quantify the scale of savings that could be made

through a graduated reduction in the scale of discretionary bonuses.

Triggering

13. As with the suspension of equity dividend payments and coupons on debt

instruments, under Basel III, national regulators would also be able to require

restrictions on remuneration.

Conversion of market-trigger contingent capital

14. A number of banks have already issued forms of contingent capital that would

trigger on the basis of certain market events such as a fall in a bank‟s capital ratios

below a certain level. Contingent capital instruments are constructed with the

explicit purpose of providing a bank with capital support in times of stress. As such

the conversion of such instruments into equity contributes towards the burden

sharing principle by enhancing a bank‟s capital position through private means.

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15. It is likely that the conversion of such instruments will happen prior to the point at

which authorities would deem the institution as non-viable and/or consider that

Government support is necessary, given that they have been designed with the

purpose of providing private capital before the point of failure. As such, the State

aid guidelines must stipulate that all contingent capital must be converted in the

event that the authorities exercise a wider write-down or conversion of sub-debt

instruments as discussed below and certainly prior to the provision of any State aid.

Conversion / write down of sub debt

16. The European Commission published its Consultation Document on 11 January

which contained a consultation on the possibility of providing national authorities

with a tool to write down certain liabilities of a credit institution in circumstances of

a failing institution.19 The proposed design of a debt write down tool begins with

the assumption that such a tool would allow authorities to write off all equity and

either write off all sub-debt or convert it into an equity claim. This formulation is

indicative of the agreed view internationally that authorities should impose losses on

subordinated debt holders in the event of bank failure.20 If a debt write down tool is

introduced in the way proposed State aid guidelines should consider introducing the

obligation that sub-debt be duly written down or converted to equity prior to, or at

the point of, any Government support being provided. Such an approach would

potentially have a significant impact on minimising the amount of State aid needed

in a SIFI rescue, and could concurrently have a significant positive impact in

addressing moral hazard.21

17. The Commission is also consulting on two options to extend the write down tool by

either requiring banks to issue a certain amount of „bail-in able‟ debt‟ or extend the

tools to senior debt through a „comprehensive approach‟. If the former approach is

chosen the UK believes there is merit in investigating whether State aid Guidelines

should mandate that all „bail-in able‟ debt is written off prior to the provision of any

Government capital support. The extension of the tool to senior debt is discussed in

further detail below under the Senior Debt section.

18. EU policy development will need to rigorously evaluate the costs and benefits of the

various bail-in proposals being developed prior to implementation. This will require

policy makers to improve understanding of the risks associated with bail in (e.g.

19 Technical details of a possible EU framework for bank recovery and resolution, EU Commission, January 2011. 20 On January 13, 2010, the Basel Committee issued final minimum requirements for regulatory capital instruments to ensure loss absorbency at the point of bank non-viability. This requires that all non-equity capital should be written off or convertible into equity at the point of „non-viability‟. 21 RBS‟s balance sheet at the end of 2007 contained £37bn in subordinated liabilities. If this was converted into equity this could have significantly reduced the fiscal costs of RBS‟s failure.

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impacts on cost of capital, and operability during a financial stability crisis) as well as

the potential benefits (e.g. reduced fiscal costs of financial crises, more efficient

credit allocation due to imposition of market discipline).

Actions the Commission could consider imposing on financial institutions prior to

approval of a restructuring plan

19. This section captures measures that can in principle be required from or imposed on

aided banks, but that may take a significant amount of time and / or may in

themselves generate risks to financial stability. To the extent possible these measures

should be used in the same way as mandatory actions, in order to eliminate or

minimise any aid element of Government intervention. It should be made clear that

where these measures are available but are not implemented this will result in an

intensified distortion to competition, and that this will result in the need for more

significant restructuring.

Asset sales and business divestments

20. As a condition of State aid approval in the last crisis many banks were required to

significantly reduce the size of their balance sheet (by c.40% or more) through asset

disposals and business divestments. A balance sheet reduction requirement achieved

through either or both of these measures, can help meet the three objectives of a

bank restructuring plan namely remedying distortions to competition, ensuring a

return to standalone viability, and ensuring private sector burden sharing. The

relationship between asset reduction and business divestment, and the first two

objectives of competition and viability have been discussed under the restructuring

section of this response paper.

21. Under certain circumstances enforced asset reduction may contribute towards

burden sharing. Under the Commission‟s Crisis Management Framework that is

currently being consulted upon, any systemically important financial institution will

be required to develop a Recovery and Resolution plan. One option that must be

considered in the Recovery plan is that of disposing of liquid assets to ease a

funding / liquidity or capital stress. As such, national authorities and the State aid

guidelines should require that a bank in distress must execute the disposal of liquid

assets contained in its recovery plan prior to the receipt of aid.

22. After aid has been provided, national authorities and the European Commission

would have to exercise their judgement as to the appropriate level of asset reduction

that the bank must seek to execute with a view not only to burden sharing but

remedying competition distortions and ensuring return to viability. Asset reduction

for the purposes of restoring viability would most likely entail the disposal of low

quality assets, predominantly non-core to the bank‟s future. However, it is also

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possible that there will be assets on the balance sheet that are not critical to the

future of the bank, and its performance of critical functions, and have not suffered

heavy impairments. Where it is possible for the bank to achieve a price above book

value, though they may lose the future income streams associated with these assets,

the bank would benefit from a capital uplift. Such an uplift could serve to reduce

the need for State aid, and help speed up the repayment of State aid that had been

provided. This objective needs to be balanced however against the risk of

undermining the Group‟s profitability and thus long term viability. Similarly, forcing

further asset reductions for the sake of further punishment, regardless of any

resultant capital deterioration would be counter-productive. As such, the State aid

guidelines should require that from a burden sharing perspective a bank should seek

to execute further asset disposals that would realise capital uplift subject to not

undermining long term viability after the receipt of aid.22

23. Similarly, a bank‟s Recovery Plan should also list businesses that it would seek to

divest if it were to extract itself from a period of stress. As in the case of disposal of

assets, a sale of a business above book value would provide the bank with capital

uplift and also serve to reduce the funding burden on the bank. However, it is

unlikely that a bank would be able to execute such a divestment in a short period.

Rather a divestment process is likely to take a number of months. Given that the

onset of financial instability can often be sudden, it would be impractical to require

a bank to execute certain business divestments prior to the receipt of aid. However,

divestments of businesses can be a valuable contribution towards the burden

sharing objective. Where it is clear that a business divestment will generate a

significant capital uplift, and where the divestment is consistent with (or will

enhance) the distressed institution‟s return to long term viability, authorities should

mandate the divestment on management prior to or at the point of the agreement

of any State aid rescue package. The anticipated capital benefits should be factored

into the sizing of any rescue package - minimising or ideally helping to eliminate any

direct Government support.23 Where this is not possible, then this will need to be

taken into account in the design of the restructuring plan, with any additional

distortion generated through the provision of excessive aid addressed.24

Write downs / Bail-in of senior debt

24. The same burden sharing principles discussed earlier in relation to the bail in of sub-

debt would apply to the write down/bail-in of senior debt. That section also

22 This „further‟ tranche of asset disposals is over and above the deleveraging (through disposals and run off) necessary for a return to viability. 23 As set out above, any Government intervention to rescue a bank should be designed to ensure the institution passes a robust stress test based upon the impact of a severe negative macroeconomic outturn over a [three] year period. 24 Aid might be judged to be excessive if the size of any public support failed to take account of anticipated capital uplifts that would be achieved upon the disposal of such operating businesses.

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mentioned the European Commission Consultation Document‟s proposals on

extending the powers for national authorities to write down sub-debt to powers to

write-down senior debt. The discussion below provides some initial thinking about

how such a tool might be used if it were introduced, and how it might be treated in

State aid guidelines.25

25. One option would be to require banks to issue a certain amount of bail-in-able debt

that could be written down or converted into equity at the discretion of national

authorities. There may be instances where a bail in of sub-debt would be insufficient

to return an institution to solvency and where an extension of write-downs or equity

conversion to senior debt may be thought desirable. In the „comprehensive

approach‟ to the design of a debt write-down tool, resolution authorities would be

given the ability - at the point where a firm meets the trigger conditions for entry

into resolution - to write down or convert senior debt as necessary to return the

institution to solvency. Under the alternative „targeted approach‟ where banks will

be made to issue a stock amount of bail-in-able debt, the resolution authority

similarly must exercise its discretion to write down or convert that portion of

contractual bail-in-able debt that is necessary to restore solvency.

26. If either approach were implemented then State aid rules would need to reflect this

and could help provide a framework within which such tools could be used. In the

case of a failing financial institution where sub-debt write-down or conversion to

equity (and the implementation of other burden sharing measures discussed above)

is not sufficient to restore solvency, then national authorities might then consider

the write down of senior debt. This decision will need to take into consideration the

financial stability implications of taking this approach, and the risk that bail-in of

senior creditors actually itself might spread contagion effects through the financial

system. To the extent that the bail in of senior creditors is used to extract a

contribution to the costs of bank failure, but State support is still required to avoid

an unmanaged SIFI failure, the burden sharing achieved will reduce the competition

distorting effect of aid. State aid guidelines should recognise this by making it

explicit that any restructuring remedies would be significantly and materially reduced

in the event of senior debt bail in.

25 The UK supports further exploration of bail in options. However, EU policy development will need to

rigorously evaluate the costs and benefits of the various bail-in proposals being developed prior to

implementation. This will require policy makers to improve understanding of the risks associated with bail

in (e.g. impacts on cost of capital, and operability during a financial stability crisis) as well as the potential

benefits (e.g. reduced fiscal costs of financial crises, more efficient credit allocation due to imposition of

market discipline).

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Conclusion

27. The State aid principle that the amount and intensity of the aid must be limited to

the strict minimum justifies the Commission imposing strict guidelines specifying

what contributions to the costs of financial institution failure must be absorbed by

the private sector.26 This section has provided some initial thinking on how these

rules might be drawn in such a way that ensures authorities use the tools available

to minimise the need for aid. Ensuring that all State aid cases are scrutinised against

this common understanding of burden sharing requirements has the potential to

have a significant positive impact in reducing the implicit subsidy of SIFIs, and

reducing the fiscal costs associated with the failure of systemic financial institutions.

28. In putting forwards these preliminary thoughts the UK Government would like to

highlight the following questions for further analysis as policy development on the

future guidelines progresses:

Which elements of burden sharing deliver sufficiently clear capital benefits for

these to factor into the sizing of any potential State aid rescue of a systemic

firm? How will the guidelines ingrain a common approach to this element of

resolution design?

Is it right for the guidelines to specify a stress testing basis to ensure the

appropriate sizing of any State rescues of systemic firms? Does this mean that

the comprehensive resolution of SIFIs would be slowed down whilst a stress test

was undertaken? What are the implications of this?

26 As articulated, for example, at para 25 of the Banking Communication.