Capital injections, state guarantees and loans granted to banks can be free of State aid if they are priced at market rates which reflect the risk borne by the state.
Introduction
If banks can obtain capital, loans and guarantees from the state at market rates why don’t they go directly to the market? No one has yet given a satisfactory answer to this question. During the past decade at least three theories have been advanced by speakers at various conferences to explain this conundrum.
The first is that the Commission has simply accommodated the interventionist instincts of Member States to prevent the collapse of the European economy. I think the Commission has indeed acted effectively and with flexibility but on the whole it has enforced State aid rules rigorously. The three cases which are reviewed in this article attest to that.
The second theory is that governments do not really intend to stick to the commitments they make and that they will use every trick in the book to confer covert advantages to banks after the Commission gives its approval. Perhaps there is an element of truth in this theory but there is no firm evidence to support that this is a wide practice.
The third theory is more serious and if true it should lead to rethink of the rules on State aid to banks. It goes as follows. In periods of market turbulence and increased uncertainty, the normal market indicators such as credit ratings lose their significance. Market operators become excessively risk averse. Indeed we have seen wild swings in market sentiment from overly optimistic to overly pessimistic. The only way to induce investors to overcome their heightened risk aversion is for the government to invest a big enough chunk of money that can absorb a large proportion of possible losses. So, according to this theory, even if the state co-invests on equal terms with private investors, in fact, without a commitment by the state no private investment can be forthcoming.
If this theory is true the unavoidable consequence must be that state investments must carry a premium. In other words, the state should earn a higher return than the prevailing market rate for the same presumed risk and same amount. This is easy to say but immensely more difficult to quantify and apply in practice. But perhaps the Commission should consider it and put to rest the suspicion that richer Member States have an advantage over poorer Member States with fewer disposable resources.
I. Capital injection in a bank
In decision SA.49094, the Commission assessed several measures for the strengthening of the capital base and restructuring of Norddeutsche Landesbank or NordLB.[1] The measures were assessed individually and each was found to be market conform.
NordLB is majority state owned and it is the fourth largest Landesbank bank in Germany. In 2011 and 2012, NordLB received State aid amounting EUR 0.5 billion and EUR 0.9 billion, respectively. Nonetheless, the bank continued to suffer losses, mostly from non-performing loans to shipping companies.
The measures that are the subject of decision SA.49094 were intended to streamline the bank and return it to viability.
Sale of assets
NordLB proposed to sell two assets to the Land of Lower Saxony. The German authorities valued the two assets using a discounted cash-flow method [DCF]. The Commission’s external experts used the same method but with more conservative parameters.
The external experts estimated a sales price for the assets between EUR [100-150] million and EUR [150-200] million.
The Commission considered that the proposed sales price of EUR 150 million was “well within this range” and that NordLB would not derive any advantage.
Asset guarantees
The Commission noted that all three asset guarantee contracts confer to a Trustee the task of ensuring that the Land of Lower Saxony would pursue its own economic interest.
Because the non-performing loans in those assets have no comparable market rate, the Commission’s external experts estimated their value according to the present value of the expected cash flows.
Direct capital injection
NordLB’s business plan aimed for significant cost reductions, some asset decrease and some revenue increase.
The Commission considered all three aims to be realistic. The Commission also examined the funding cost of the various actions foreseen in the business plan and concluded that the costs were credible as they were equivalent to the credit spreads expected for senior preferred bond and that they were comparable to observable CDS spreads for NordLB.
The relevant benchmark for the cost of equity [CoE] was ranging between [8% and 10%] and calculated on the basis of the CAPM. The derived IRR was [9% – 14%].
Although, those values were far above the risk-free rate of 0% and the country risk premium of 0% for Germany, the Commission recalculated the IRR and arrived at a value of 8.9%, which was close to the middle of the range of 8% to 10%.
Coverage of extra health-care cost
The relevant public authorities required NordLB to increase its provisions for the health care of its staff. The possible extra costs were covered by a state guarantee.
An actuary estimated the possible extra costs as normal business practice based on long-term trends. The one-off guarantee fee was found to be more than the expected costs.
II. State guarantees for the securitisation of non-performing loans
Some EU banks still have a large number of non-performing loans [NPLs]. This makes them vulnerable to any downturn in the market and reduces their leeway to grant new loans. One way to reduce the proportion of these NPLs in their assets is to raise new capital. Another way to deal with them is simply to get rid of them. The problem is that the market is reluctant to buy portfolios of loans of shaky quality. For this reason, some governments have granted State aid to banks to help them bridge the gap between the book value and the price at which the loans are sold. Some other governments have guaranteed the value of bonds issued for the purpose of raising fresh capital. Yet some other governments have guaranteed the value of packages of NPLs sold to investors.
In decision SA.53519, the European Commission assessed such a state guarantee for the securitisation of NPLs disposed by Greek banks and concluded that it was free of State aid because the guarantee premium corresponded to the market fee that would be charged by a private market operator.[2]
The measure was voluntary and open to any bank. The guarantee covered only the senior tranche of the “securitisation structures”. The junior tranche would bear fully any gains or losses. A participating bank would have to appoint an independent “servicer” to work out the underlying NPLs in the securitisation structures. Part of the fee to be paid to the servicer would be linked to achievement of performance targets.
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Pricing of the state guarantee
The premium charged for the guarantee was equal to the market price of the risk borne by the state. The risk was calculated by taking as a base the price of the credit default swaps for Greece and then adjusting it upwards to reflect the specific quality of each securitisation structure.
Notice on Guarantees
The Commission assessed the Greek measure according to the principles laid down in its 2008 Notice on Guarantees. First, the Commission noted that a guarantee scheme is free of State aid when:
“(a) The scheme is closed to borrowers in financial difficulties;
(b) The guarantee amount can be measured when it is granted;
(c) The guarantee cannot cover more than 80% of the outstanding financial obligation;
(d) The remuneration is based on a realistic assessment of the risk and the premiums paid so that the scheme can be considered self-financing;
(e) The level of premiums has to be reviewed at least every 12 months in view of the self-financing nature of the scheme;
(f) The premiums charged have to cover the normal risks associated with granting the guarantee, the administrative costs and a yearly remuneration on the necessary capital.” [paragraph 46 of the decision]
Then the Commission pointed out that it “(47) cannot exclude that the Scheme is open to borrowers in financial difficulty or might be used in specific circumstances to provide guarantees covering more than 80% of the outstanding financial obligation. The Commission therefore considers it likely that these conditions will not be fulfilled in all instances of the Scheme’s usage.”
Since it could not rely on the principles in the Guarantee Notice, it went on to consider whether the fee charged for the guarantee in this case corresponded to the premium that a market operator would have charged.
Excessive risk?
In paragraphs 52-56, the Commission assessed the risk assumed by the Greek state. It found that:
First, the NPLs’ management was transferred to an independent servicer whose fee would partly be linked to performance. This would increase the likely recovery and reduce the risk of miscalculation of the actual value of the NPLs.
Second, the senior tranche would have a fully preferred status. No money would be paid to the junior tranche before the senior tranche would be repaid in full.
Third, the exposure of the Greek government was confined to the senior tranche of the securitisation structure.
Fourth, the credit rating of the senior tranche and the size of the loss-absorbing tranches would be established by an independent expert.
Fifth, the scheme was design in such a way so that the guarantee would be effective only when at least 50% of the junior tranches would be sold to private investors. That meant that the state guarantee on the senior tranche would “in effect guarantee less than the transfer value of the underlying assets.”
Market price?
The Commission also found, in paragraphs 59-78, that the remuneration of the state for its guarantee reflected all the elements that a private market operator would take into account and corresponded to the amount of risk borne by the state. In fact the fee was estimated conservatively because it included an extra margin.
Again the Commission assessed positively the fact that the junior tranche would be paid after the senior tranche and that the guarantee would become operational only after the majority of the junior tranche was sold.
III. Remuneration for funds deposited at a state treasury
The Italian postal service, Poste Italiane [PI] is authorised to operate savings accounts. Italian law requires PI to deposit the accumulated funds from the millions of accounts it manages into a single account at the Italian Treasury. The Commission investigated this arrangement and concluded in decision 2009/179 of July 2008 that it involved incompatible State aid because the rate of interest obtained by PI was higher than what a prudent private borrower would have paid. It was also higher than the rate of interest PI paid to its own savers.
The Commission reached that conclusion after it considered the amount, stability and average duration of deposited funds and the financial risk borne by the state.
However, in September 2013, the General Court found, in an appeal lodged by PI, that the Commission erred in law and annulled the decision of the Commission [case T-525/08, Poste Italiane v Commission].
As a result, the Commission re-opened the case and concluded afresh in decision 2019/1968 that the remuneration received by PI was free of State aid.[3]
The Commission explained as follows the reasoning of the General Court:
“(31) The existence of a positive difference between the [Treasury’s] rate and the rate granted to the prudent private borrower was not sufficient to demonstrate an advantage for PI. […] (33) The General Court noted that even if the rate granted to the prudent private borrower was not at the level of the market rate, PI would benefit from an advantage only if the [Treasury’s] rate was higher than the return PI could have reasonably achieved in the absence of the Obligation. (34) The General Court determined that the Commission could not conclude that the measure benefitted PI without actively demonstrating that, in the absence of the Obligation, PI could not have gotten a higher return by investing the deposits from the postal current accounts as compared to the Treasury’s rate.”
It is difficult to understand the reasoning of the Court. In essence the Court criticised the Commission for not proving that in the counterfactual situation it would have been impossible for PI to earn more. But was a hypothetical counterfactual relevant given the fact that PI was obliged by law to deposit savers’ funds at the Italian Treasury? And, more importantly, given that PI was a “captive” customer of the Treasury why would the Treasury, acting as a rational market operator, pay anything more than the cost borne by PI for managing those funds?
In order to assist it in its re-assessment, the Commission requested an analysis of yields of various alternative investment strategies by an independent expert. Although the Commission did not completely agree with the findings of the independent expert, it decided that “(121) the expected rate under the [agreement between the Treasury and PI] is lower than the expected return of alternative investment strategies, in a stationary rate scenario, at similar risk levels, in the absence of the Obligation. As a result, the rate under the [agreement] did not entail an immediate advantage for PI.”
As pointed out above, it is unclear why alternative investment strategies are relevant at all, given that PI was legally obliged to deposit funds at the Treasury.
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[1] The full text of the Commission decision can be accessed at:
https://ec.europa.eu/competition/state_aid/cases1/20203/283125_2123117_150_5.pdf.
[2] The full text of the Commission decision can be accessed at:
https://ec.europa.eu/competition/state_aid/cases1/201945/282211_2106701_128_2.pdf.
[3] The full text of the Commission decision can be accessed at:
