the current financial crisis and state aid · 12/9/2008 · abel m mateus seminar on the current...

The current Financial Crisis andState aid

Abel Moreira MateusVisiting ProfessorUniversity College of London andBritish Institute of International and Comparative Law

1UCL, Jevons Institute, 12/9/2008

Abel M Mateus Seminar on The Current Financial Crisis, UCL, Jevons Institute, 9/12/2008.

Outline

A. Assessing State aid1.Why intervene: a market failure2. But the worst is still to come3. The Commission approach4. Lessons from past financial crisis

B. The menu of instruments4. We need an economic approach5. Scoring the menu of measures6. Sequencing and conditionality

C. Strengthening the EU approach7.Preventing regulatory failure8.The Commission Guidance9. Why we need a “leadership” position from the Commission10. Fighting the economic crisis (stag-deflation)

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Why intervene? Why state aid in a financialcrisis?

Externalities and systemic risk:the failure of a large bank may create a systemic risk of generalizedbank failures due to cross balance sheet relationships, that are notinternalized in the failure of the particular bankThe failure of an important deposit institution may create bank-runsthat lead to liquidity squeezes and precipitate bank failures

Externalities between financial and real sectorIncreasing risk of failure of banks leads them to curtail lending to firmsand households precipitating a downturn in the economyLoss of deposits and other household assets leads to decrease inmoney supply and cuts aggregate demand (specter of deflation)

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And the upcoming economic crisis?Cross-border externalities: bank failures in one country may lead to bankfailures in other countries, especially in a currency union or a financiallyintegrated areaCross-border externalities also occur due to the interaction of thefinancial and real sector across all countries in the EU

Information asymmetries and collapsing markets: banks may not have good information about the liquidity andsolvency of their domestic or commercial clients. Besides, in a mark-to-market world the values of all assets may decrease simultaneously,it may be difficult to distinguish between a relative price and overalladjustmentCapital markets suffer from the same asymmetries in information –difficulty in distinguishing good and bad investments (large correlationin risk)

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Plus: we need to buy time for correcting regulation failures


Recommendations of ECOFIN

Ecofin, October 7th, 20085


Basic requirements for state aid control

Timely and speedy intervention and approvalBut, no blanket solution. Each institution may require a tailor-madeinterventionNeed to assess different alternatives on the specific and systemic risk

Thus

Requires very good Guidelines to give guidance to States and regulatorson different alternatives and best practicesEstablish “de minimis” criteriaDefine measures and conditions that “most likely would be rejected” (redlines)Define a clear and efficient system for monitoring evolution after the aid

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Article 871. Save as otherwise provided in this Treaty, any aid granted by aMember State or through State resources in any form whatsoever whichdistorts or threatens to distort competition by favouring certainundertakings or the production of certain goods shall, in so far as itaffects trade between Member States, be incompatible with the commonmarket.2. The following shall be compatible with the common market:(a) aid having a social character, granted to individual consumers,provided that such aid is granted without discrimination related to theorigin of the products concerned;(b) aid to make good the damage caused by natural disasters orexceptional occurrences;(c) aid granted to the economy of certain areas of the Federal Republic ofGermany affected by the division of Germany, in so far as such aid isrequired in order to compensate for the economic disadvantages causedby that division.

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3. The following may be considered to be compatible with the commonmarket:(a) aid to promote the economic development of areas where thestandard of living is abnormally low or where there is seriousunderemployment;(b) aid to promote the execution of an important project of commonEuropean interest or to remedy a serious disturbance in the economy ofa Member State;(c) aid to facilitate the development of certain economic activities or ofcertain economic areas, where such aid does not adversely affect tradingconditions to an extent contrary to the common interest;(d) aid to promote culture and heritage conservation where such aid doesnot affect trading conditions and competition in the Community to anextent that is contrary to the common interest;(e) such other categories of aid as may be specified by decision of theCouncil acting by a qualified majority on a proposal from theCommission.

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Abel M Mateus Seminar on The Current Financial Crisis, UCL, Jevons Institute, 9/12/2008. 9

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Two contrasting cases of resolutions: Sweden

Facts:large shock (bank losses between 13 and 37% of lending)Fiscal costs: 2.1% of GDP; GDP cost: app. 3.5%Crisis solved in 2-3 years, with asset resolution up to 5 years

Main instruments: bank nationalization (2 major banks), bank guaranteesand bank recapitalizationSet-up agency for “toxic assets” (Securum) that got all bad assets frombanks intervened

Totally owned by State, but independent and staffed by specializedprofessionalsStarted by recuperation of assets – most cases declare ownerbankrupt – became largest real estate owner, but did not disposeimmediately assets Third phase: (i) firms owned run efficiently, (ii) repackaging formaximizing value, (iii) maximizing sales value by IPOs, corporatetransactions and selling individual properties.

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It all depends on policies! Japan: the lost decade

Facts:Large shock (nonperforming loans: 25% of GDP in 1995 (Caprio), 18% ofGDP in 1998; bad loans still 35% of total loans in 2002 )Fiscal cost: 22% of GDP; GDP cost: app. 22.5%Crisis lasted for more than a decade

Instruments: Obushi Plan (1995) provided 12% of GDP in public funds fordepositor protection, buying bad loans, recapitalization

7 banks nationalized, 61 institutions closed, and 28 merged.Problems:

Too strict conditions on use of state aid in the first 5 yearsBanks concealed bad debts (with regulators inaction) and keptlending to insolvent clients: the zombie syndrome

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Main lesson: transparency of bank real situation is fundamental,and decisive action “in cleaning up”, with immediate impact on the real economywill shorten crisis


Main lessons

Debt restructuring is absolutely necessary to prevent a viciouscycleDebt relief and rehabilitation of viable but debt-ridden firms and theliquidation of nonviable firms are crucially important to wipe out thepayment uncertainty from the economy and restore market confidence. Ifzombie firms stick around in the market, uncertainty and businessshrinkage will linger on. Capital injections into banks are just a beginning.Stringent asset evaluation and sufficient write-offsStringent and conservative evaluation of the toxic assets should be thepremise behind bank-capital injections and debt restructuring. Financialregulators should establish task forces for asset evaluation and pushfinancial institutions to recalculate their asset values conservativelyenough so that the market can rely on their numbers. Evaluate toxicderivative securities by “reverse engineering”.

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Main lessons (2)

Purchase of bad assets by public asset management companiesTo stop the vicious cycle of debt deflation, the governments strugglingwith the financial crisis should establish asset management companies,public entities that purchase and hold the bad assets. The purchase andfreezing of toxic assets is necessary to stop debt deflation. The publicentities should then restructure the bad assets and sell them off graduallyafter the market stabilizes.Suspension of mark-to-market accounting has a long-term sideeffectIf bankers hide bad assets, zombie firms will persist and the paymentuncertainty will remain, setting the stage for very low long-term economicgrowth.

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First phase of crisis:Banks took excessive risk from households (and firms)Investment banks securitized and leveraged riskFall in housing prices, coupled with drop in liquidity and complexderivatives led to investment banks collapse and large losses incommercial banks

We are now in second phaseFall in housing prices: 10 to 30% of households with negative equityin some developed countriesCapital markets: largest drop since GD (50% since 2007)Unemployment climbs fast to record levels (in the US and EU mayreach 10% by 2009-10)Record level of corporate failuresWhich will have a further negative impact on banks balance sheets

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Entering a third phaseBank losses accumulate with household and enterprise failuresMonetary policy impotent (liquidity trap) with record low interest ratesFiscal stimulus starting to operate, but concerns of a large public debthang-up

So …

Need for an expansionary demand policyCombination of monetary and fiscal policy to fight stag-deflationFurther bank state aidStrengthening bank regulation

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Effects-based approach to evaluate state aid

Criteria for evaluation: total welfare (efficiency plus consumer surplus) with equity considerations

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The economic approach (effects-based) to state aid

A benefit-cost analysis, based on the NPV of stream of benefits andcostsDirect benefits: avoiding contraction of credit to economy (use creditmultiplier)Indirect benefits: contain systemic risk and overall risk of recession(compute impact on financial risk)Costs:

To taxpayersShort-term: interest costs of public debt, and cost of guaranteesMedium-term: potential costs due to asset valuations and bankruptcy ofinstitutionAdministrative costs of implementing measures

To depositors and investors (option cost of inaction)

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Need to establish templates for quick evaluationIt will shorten time of analysis and “focus the discussion”


Typeofaid Impactonfinancialins3tu3on

Impactoneconomy

Distor3ononbehavioragents

Distor3oncompe33on

Costtaxpayers Administra3vecostsandcomplexity

Dura3on

Generaldepositguarantees High(insuranceoflargeshareofdebtincommercialbanks,butnotothers)

Highonsecuringthebankingsystem

Createsmoralhazardoncommercialbanks(1)

Generalmeasure:nodistor3on

Mediumtolow.Equaltoprobabilityofabankfailure3mesthepoten3allossesofbank(2)

Low Long

Stateguaranteetobondsorothercreditsissuedbybanks

Medium:mainimpactisincreasingliquidity

Maybeimportanttoresumebanklendingtotheeconomy

Createsmoralhazardonbanksbecausetheycantakeaddi3onalrisk

Generalmeasure:nodistor3on

Low.Equaltoprobabilityofdefaultonthosecredits3mespoten3allossesofbanks

Low Dura3onofcrisisandrecoveryofeachins3tu3on

A menu of state aid interventions


Statetakesminoritystakeinbankcapital

Avoidsbankfailure Dependsonshareofbankassetsontotalmarketassets(problemof“toobigtofail”)

Createsmoralhazardbybankmanagementandinvitestakingonexcessrisk(3)

High,sinceit“savestheoffender”thattookexcessrisk

Small,sincepreferredsharesmayberequiredtoearnaminimumreturn,andprobabilitylossdependsonprobabilityofbankfailure

Low,esp.ifgovernmentdoesnotinterveneinadministra3on

Dura3onofcrisisandrecoveryinins3tu3on

Statetakesmajoritystakeinbankcapital

Avoidsbankfailure Dependsonshareofbankassetsontotalmarketassets(problemof“toobigtofail”

Createsmoralhazardbybankmanagementandinvitestakingonexcessrisk(3)

High,sinceit“savestheoffender”thattookexcessrisk

Medium,sincepreferredsharesmayberequiredtoearnaminimumreturn.Probabilitylossdependsonprobabilityofbankfailure

Medium Dura3onofcrisisandrecoveryinins3tu3on

Na3onaliza3onbank Avoidsbankfailure Dependsonshareofbankassetsontotalmarketassets(problemof“toobigtofail”)

Createsmoralhazardbybankmanagementandinvitestakingonexcessrisk

It“savestheoffender”thattookexcessrisk.Dependsontermsofcompensa3on.

High,sinceStatehastocoverallpresentbanklosses.Onlyrecoveredloansinfuturewilllowerthatcost

High.Governmenthastodesignatenewadministra3on

Dura3onofcrisisandrecoveryinins3tu3on


Mergingofbanksorassetsacquisi3on

Avoidsbankfailure Avoidsbankruns.Dependsonbankshareoftotalmarket

Nomajorproblem Poten3allyhigh Nocostifsimplemerger.ButStatemayhavetosweetenthedealorgetpartofbadassets

Low Immediatesolu3on

Bankliquida3on Allowanorderlyunwindofopera3ons

Avoidbankrunsandassetdeteriora3on.Canhaveahighimpactonriskofotherbankfailure

Noproblem Nomajorproblem Statemayhavetopaydepositorsandcreditorsforlosses

Low(liquida3ngcommiXeenominated)

Lowtomediumdependingon3meneededtoliquidate


Buyingtoxicassetsfrombanksthru“reverseauc3ons”

Avoidsbankfailureifbuyingpricebygovernmentabovemark‐to‐market

High.Reducesbadassetsonbankassetsandcreates“room”fornewlending

Createsmoralhazardbybankmanagementandinvitestakingonexcessrisk

Poten3allysomedistor3on,rulesofaccessshouldnotbediscriminatory

Veryhigh.Equalsamountofassets3mespartnotrecovered

Veryhigh.Governmenthastoadministerassetsandrecoverloans

Long.Un3lcreditsarerecovered

Directaidtohouseholds(mortgagereform)

Limitedatbeginning.Builds‐upaslargershareofbankassetsis“cleanedfromthebooks”

Limitedatbeginning,andincreasing.Increasesliquiditytohouseholdsandgivesanincen3vetoincreasedemand

Reduceddistor3on,sinceonlyhouseholdsintroubleare“saved”

Low,sincethereisnodiscrimina3onbetweenins3tu3ons

Veryhigh.Tohaveanimpactonfinancialsystemhastobecarriedoutinlargeamounts

Verydifficultandcomplextoadminister.Needstotargeteachhouseholdinbankruptcy

Long


DirectaidtoSMEs(directloans) Limitedatbeginning.Builds‐upaslargershareofbankassetsis“cleanedfromthebooks”

Limitedatbeginning,andincreasing.Increasesliquiditytofirmsandgivesanincen3vetoresumeproduc3on

Reduceddistor3on,sinceonlysmallfirmsintroubleare“saved”


Hightomedium.ItisequaltoprobabilityofSMEsfailing3mesaverageloss

Difficultandcomplextoadminister.Needstodefineclearcriteriaforaccess

Long

DirectaidtoSMEs(loanguarantees)



Reduceddistor3on,sinceonlyfirmsintroubleare“saved”


Medium.ItisequaltoprobabilityofSMEsfailing3mesaverageloss


Long

DirectaidtoSMEs(reducingloancharges)



Reduceddistor3on,sinceonlyhouseholdsintroubleare“saved”

Low,ifthereisnodiscrimina3onbetweenfirms

Medium.ItisequaltoprobabilityofSMEsfailing3mesaverageloss


Long


Directaidtolargefirms(directloans) Limitedatbeginning.Builds‐upaslargershareofbankassetsis“cleanedfromthebooks”


Createsmoralhazardbymanagementoffirms,thatmaybecomplacenttorestructuringneeded

Highlydistor3onary Veryhigh.Itisequaltoprobabilityofbankrupcy3mesaverageloss

Verydifficultandcomplextoadminister.Needstodefinecriteriaforaccess.Needstoanalyzeandmonitorrestructuringplan

Long

Directaidtolargefirms(loanguarantees)




Highlydistor3onary Medium.Itisequaltoprobabilityofbankrupcy3mesaverageloss


Long

Directaidtolargefirms(reducingloancharges)




Highlydistor3onary Medium.Itisequaltoprobabilityofbankrupcy3mesaverageloss


Long


Scoring different measures on CBA

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Conditionality

Guarantees to deposits: only a temporary “all deposits guarantee”. Aftercrisis it should be subject to a maximum by depositor and bank, to limitmoral hazard. Assumes large depositors have enough information on riskof the bank.Require that funds to back-up guarantees be financed by contributionfrom banks, which decreases cost to taxpayers.Government have to require that shareholders do not profit from therecapitalization, by preconditioning write-down of capital, and avoidingpayment of dividends and large bonus to management while bankbenefits from aidNationalization and liquidation should be only a last resort measure

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Preventing regulation failure

Subject all measures in a country to a periodic review of capabilities ofnational bank supervision (jointly with IMF?)Subject to an assessment of bank regulation

Improve regulatory prudential rules, in cooperation with other for a(Basel Committee, FFS), and subject each country to an annualreview of measures implemented

Subject to monitoring of bank restructuring and system recovery

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Commission guidance

Priority of guarantees to bank depositsIf guarantees extended to other liabilities (like subordinated debt)restrictions have to be imposedRecapitalization of banks are also appropriate, but

Only to sound institutionsShould be done at market pricesMust be preferred shares with adequate remuneration, orWith claw-back mechanisms or better fortune clauses

Liquidation as a second-step, if guarantee did not workLiquidity provision by the CB is not considered state aid if open to allinstitutionsLiquidity provision to individual institutions not state aid if the bank issound and CB charges penalty rateNon-discrimination should apply to all schemes

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Lessons learned

Systemic solutions to “shore-up” the financial system, based onguarantees, are always preferable, and should be a precondition for anyspecific intervention (e.g. deposits guarantees)Minority stakes in bank recapitalization are the least costly intervention totaxpayers, if appropriate measures avoiding the leaking of the aid areimposed (need to write-off losses to capital)State officials are not good bank managers and Governments may betempted to use banks for “other purposes” than commercial orientedoperations (profit at minimum risk). Thus they should avoid be involved inbank management and privatize as soon as possibleRecapitalization does not solve the problem of jump starting themonetary and credit marketsBuying toxic assets from banks requires “reverse repos” and the set-upof a specialized agency for collecting the bad debts, which may take along time

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Direct intervention at household level may be required in a prolongedrecession, to decrease the rate of foreclosure, but it is administrativelymore complex (is seen as more equitable, than saving directly the banks)

UK: state pays interest for up to 2 years to unemployedPT: state plus bank fund to allow substitution from homeowner totenant

Direct intervention at SMEs level may also be required in a prolongedrecession (is also seen as more equitable, may be important foremployment support)

Fund for guarantees to loans or mutual guarantees systemAnother problem:

What cost should be borne by the minority shareholders?In Sweden they were compensatedProhibition of dividends should be to all? Problem of pension funds

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Fundamental role of the Commission

To avoid cross-border effectsEven in a Union of separate national supervision systems (the Frenchproposal of a Community bailout opposed by Germany did not makesense)

Commission needs to take “hard line” on state aidNational governments have a commitment problem: they are not ableto commit to clear rules and a fixed budget ex-ante (Kornai problem ofsoft budget constraint)

Problem of agent to ask for a renegotiation of conditionsRegulatory, administrative and political capture at national level

Dynamic commitment problems create intertemporal inefficienciesBut at the same time promote a more aggressive and transparentapproach by MS to solve crisis (remember the Japanese case)

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Need for new guidance from Commission

We are in broad agreement with Commission Guidance on the bankcrisis. It has sound principles. However, needs to be revisedMore comprehensive,

Should address all the instruments and measures referred abovePrioritize and establish rules for its use in a more rigorous way

Consider measures for jump-starting the credit markets (so far there isstill a paralysis)Need to extend measures to households and firms in distressRecognize the need for complementary measures (state aid is not all…)

Fight deflation (reflate the economy)Deleverage orderly financial institutionsFiscal stimulus to stimulate demand

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Bank lending

Lending is still falling – and sharply

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

90 92 94 96 98 00 02 04 06 08 10

-40

-20

0

20

40

60

80

100

Corporate Lending Growth

Lending Survey (Advanced 6qtrs, RHS)

Does the European?Eurozone Corporate Loan Growth in Percent

Source: IMF WEO, October 2008, p. 130.

US Lending Survey Leads Loan GrowthUS Corporate Loan Growth in Percent

Source: Citi, EcoWin, Federal Reserve Senior Loan Officers’ survey.

-10%

-5%

0%

5%

10%

15%

20%

02 04 06 08 10

-40

-20

0

20

40

60

80

100

Corporate Lending Growth

Lending Survey (Advanced 6qrts, RHS)


Main problems and what lays ahead

To jump start the economy CBs and SPCs may need to start buying toxicassets (Spanish proposal)

Using reverse repo auctionsCommission reluctant to acceptSetting-up a collection agency (bad bank) for recuperating credits

Moral hazard has not been squarely addressed: how to punish managementand stockholders for taking excess risk (moral hazard)

Question of dividendsRemuneration of management

Presently, no direct aid to the real economy is contemplated, althoughCommission has recognized the plight of SMEs (and households indistress?):Fed and Freddy Mac already using some unorthodox measures (buying toxicassets directly from banks, money creation)Nationalizations and remuneration to stockholders has also to be clarified

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the current financial crisis and state aid · 12/9/2008 · abel m mateus seminar on the current...

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