Bank Restructuring Aid Economic and Policy Analysis

1. Bank Restructuring AidEconomic and Policy Analysis Dr. Lorenzo Coppi Presentation to the Dutch Association of Competition LawyersAmsterdam, 7 October 2009

2. Outline • The financial crisis and the European Commission’s response: the Restructuring Communication • The inadequacy of the standard Rescue and Restructuring framework for assessing Art 87(3)(b) aid • An alternative framework: the Balancing Test • Rationale and benefit of the aid • Proportionality principle and distinction between structurally sound and unsound banks • Distortions of competitions • The implications for compensatory measures • Conclusions

3. The financial crisis European TED Spread

4. The Commission’s response to the financial crisis • Initial Commission’s response within the standard framework of Rescue and Restructuring Aid • Northern Rock (UK), Bradford & Bingley (UK) • Sachsen LB (DE), IKB (DE), WestLB (DE), Bayern LB (DE), Roskilde (DK) • After late September 2008 aid approved under the hardly ever used framework of a serious disturbance to the economy under Art. 87(3)(b) • Emergency measure, fairly flexible approach • Various types of aid allowed: loan guarantees, recapitalization, purchase of distressed assets • Guidance by the Commission • October 2008: the Banking Communication set out the main principles • December 2008: the Recapitalisation Communication better specified the rules • February 2009: the Impaired Assets Communication listed a series of requirements for the Member States’ asset purchase schemes • July 2009: the Restructuring Communication discusses restructuring of “structurally unsound” banks

5. The Restructuring Communication • The Restructuring Communication lays out the Commission’s approach to evaluating aid given during the financial crisis • It distinguishes between “structurally sound” and “unsound” banks and it requires a Restructuring Plan for structurally unsound banks • banks deemed “unsound” if state guarantees triggered, or • if they received aid for more than 2% of their capital • As part of the Restructuring Plan, the Commission requires substantial compensatory measures, often including significant asset sales • Key question: how should the Restructuring Communication be applied in practice? • To maintain consistency with the general State aid framework enunciated in the Commission’s Common Principles paper • To achieve the goal of the aid and remedy a serious disturbance in the economy … • … While minimising distortions of competition and helping prevent a similar crisis in the future

6. The inadequacy of the R&R aid framework • Aid given under Art. 87(3)(b) is inherently different from the standard R&R aid under Art. 87(3)(c), and should be analysed differently • R&R aid helps keep in business firms that have been unable to survive under normal market circumstances • Aid given to remedy a “significant disturbance in the economy” is primarily seeking to return a market affected by a series of market failures to its efficient state • The problem is systemic, not specific to any individual firm (though some may be faring worse than others) • Aid under Art. 87(3)(b) should be evaluated using the Balancing Test • Weigh the costs of the aid in terms of market distortions against the benefits in terms of financial stability • Three-step test identified in the Commission’s Common Principle paper • Is the aid aimed at well-defined objective of common interest? • Is the aid well designed to deliver the objective of common interest? • Are distortions of competition and trade limited?

7. Step 1 of the Balancing TestThe goal of the aid: remedying a serious disturbance • Avoid a collapse of the financial system • Banks are particularly vulnerable as they face several types of risk (solvency risk; liquidity risk; contagion risk) • The failure of one bank at the centre of the payments system can bring about a domino effect on others • Bank crises are extremely costly for the economy • Return a market affected by a series of market failures to its efficient state • Various market failures at the root of the crisis (mispricing of risk, unrealistic expectations, asset price bubbles, and moral hazard followed by panic) • “Lemons problem” caused by asymmetric information • Resulted in the seizure of various securities and interbank markets and in market prices not reflecting the fair economic value of assets

8. Step 2 of the Balancing TestApplying the proportionality principle • Instead of distinguishing between “good banks” and “bad banks”, the Commission should distinguish between “good aid” and “bad aid” • Separate the State funding into • Non-aid (using the Market Economy Investor Principle) • Aid proportionate to remedying the market failures that led to the financial crisis • Additional aid necessary to avoid a systemic crisis • Aid proportionate to remedying market failures is “good aid” • Banks that received only proportionate aid should be considered “structurally sound” • Additional aid may result in distortions of competition and needs to be assessed more rigorously • This covers losses which would have materialised even in the absence of market failures • Banks that received also additional aid are not “structurally sound”

9. Separating proportionate aid from additional aidA structurally sound bank Before the crisis Assets Liabilities €100 €17 capital €83 other liabilities A. ‘Fair economic value’ (FEV) losses (€10) B. ‘Market failure’ losses (€20) C. Change in minimum capital due to crisis of confidence €5 (from €5 to €10) • Aid Granted = €30 • Proportional Aid = B + C = €25 • Additional Aid = Aid Granted – Proportional Aid = €30 – €25 = €5 Bank has €17 in capital, it can repay the Additional Aid Structurally Sound Surplus capital (€17 - €5) > FEV losses (€10) Structurally Sound

10. Separating proportionate aid from additional aidA structurally unsound bank Before the crisis Assets Liabilities €100 €10 capital €90 other liabilities A. ‘Fair economic value’ (FEV) losses (€10) B. ‘Market failure’ losses (€20) C. Change in minimum capital due to crisis of confidence €5 (from €5 to €10) • Aid Granted = €30 • Proportional Aid = B + C = €25 • Additional Aid = Aid Granted – Proportional Aid = €30 – €25 = €5 Bank has €10 in capital, it cannot repay the Additional Aid Structurally Unsound Surplus capital (€10 - €5) < FEV losses (€10) Structurally Unsound

11. Step 3 of the Balancing TestDistortions of competition are limited • “Moral hazard” is the most significant potential distortion • Overly risky behaviour would be fostered if banks expected that they will always be saved without being punished • Proportionate aid does not result in moral hazard, as it only applies to widespread market failures • Additional aid may result in moral hazard if no burden sharing and no behavioural measures are taken • Proportionate Aid returns the market to an efficient economic situation: distortions of competition in the product markets are not possible • Additional Aid may result in some distortions of competition in the product markets, but those are likely to be limited • Most large banks received aid, so level playing field largely maintained • Aid does not necessarily confer an advantage • In financial markets, the loss of a competitor may cause more harm than good • The way banking markets work does not allow competitors to win significant share quickly

12. Implications for compensatory measures • No compensatory measures should be considered for Proportionate Aid • Proportionate aid does not result in appreciable moral hazard or distortions of competition in the relevant product markets • Compensatory measures should be considered only for the Additional Aid • Need to be commensurate to the level of Additional Aid not to Total Aid • Need to consider the degree of “fault” of the financial institutions • Even for AdditionalAid, compensatory measures need to be considered carefully • Moral hazard best tackled by behavioural remedies (and some burden-sharing) • Only distortions of competition in the product markets may justify asset sales • Distortions of competition in the relevant product markets are unlikely to be significant • Significant asset sales run the risk of endangering financial stability and slowing the return to fully-functional financial market

13. Conclusions • The Commission’s communications note the exceptional nature of the financial crisis and associated market failures • But the Commission at times appears to slip back to the familiar, yet inadequate, R&R approach • Rather than distinguishing between “good banks” and “bad banks” the Commission should distinguish between “good aid” and “bad aid” • No compensatory measures are required for Proportionate (“good”) Aid • The Commission should impose behavioural remedies commensurate to the level of Additional (“bad”) Aid • Asset sales are largely unnecessary, relatively ineffective, and potentially dangerous

14. Dr. Lorenzo Coppi CRA International 99 Bishopsgate London EC2M 3XD Tel: 020 7959 1429 lcoppi@crai.com