Treatment of Toxic Assets in the European Community Banking Sector - briefing

26 February 2009
by eub2 -- last modified 26 February 2009

The European Commission has provided guidance on the treatment of asset relief measures by EU Member States. Impaired assets correspond to categories of assets on which banks are likely to incur losses (e.g. US sub-prime mortgage backed securities). The Commission considers that a common European approach is presently needed to deal with the treatment of impaired assets, to make sure that foreseeable losses are disclosed and properly handled and banks can use their capital to resume their normal function of lending to the economy instead of fearing they would need this capital to cushion against possible losses. The Commission's Communication outlines various methods to deal with impaired assets, notably through asset purchase (including bad bank scenarios) or asset insurance schemes. It explains the budgetary and regulatory implications of asset relief measures and presents details concerning the application of the State aid rules to such measures. In particular, the guidance provides methodologies concerning the valuation of the impaired assets, the necessary remuneration of the State for the asset relief and the procedural steps that will be followed as well as the criteria that will be used to evaluate the State aid given to the banks as a result.

What is being done by the Commission with respect to alleviating banks of their impaired assets?

Following the call of the Ecofin Council, the Commission has prepared a guidance document for the treatment of impaired assets, in consultation with the ECB. The document addresses budgetary and regulatory implications of the possible introduction of asset relief measures and contains guidelines for the application of the State aid rules of the Treaty to such measures. The objectives of our coordinated approach are to (i) accelerate bank recovery and promote a return to normal market conditions; (ii) reduce the risk of fragmenting the internal market; (iii) minimise the economic and budgetary cost of State intervention; and (iv) minimise the inherent competition distortions between aided and non-aided banks, between Member States, and between aided institutions with different degree of problems, and to tackle moral hazard.

The guidance of the application of the State aid rules is based on a number of principles:

• full transparency and disclosure of impairments, which has to be done prior to government intervention;
• coordinated approach to the identification of assets eligible for asset relief measures through development of eligible categories of assets ("baskets");
• coordinated approach to valuation of assets ex-ante, based on common principles such as valuation based on real economic value (rather than market value), implemented by independent experts and certified by bank supervisors;
• validation by the Commission of the valuation of the assets, in the framework of the State aid procedures on the basis of uniform assessment criteria;
• adequate burden-sharing of the costs related to impaired asset between the shareholders, the creditors and the State;
• adequate remuneration for the State, at least equivalent to the remuneration of State capital;
• coverage of the losses incurred from the valuation of the assets at real-economic-value by the bank benefiting from the scheme;
• aligning incentives for banks to participate in asset relief with public policy objectives, through an enrolment window limited to six months during which the banks would be able to come forward with impaired assets;
• management of assets subject to relief so as to avoid conflicts of interests;
• appropriate restructuring including measures to remedy competition distortion, following a case by case assessment and taking into account the total aid received through recapitalisation, guarantees or asset relief, with a view to the long-term viability and normal functioning of the European banking industry.

What are impaired assets? How do you define them? How big an amount are we talking about?

Impaired assets correspond to categories of assets on which banks are likely to incur losses (e.g. US sub-prime mortgage backed securities). The Commission has not itself made an estimate of the overall amount. All banks that will want to benefit from asset relief programmes will have to fully disclose the amount of losses, and then we will get more clarity about the size of the problem in the EU.

What are the valuation methodologies used?

The Communication provides guidance on principles to be followed when valuating different pre-defined categories of assets. It also prescribes a process to be followed: valuation based on these principles needs to be certified by an independent third party expert and validated by the national supervisory authority. In addition, the Commission will on its side verify valuation methods used by Member States in the course of State aid procedure, and will have recourse to the panels of experts for that, to order to ensure consistency and a level playing field in the EU.

What will happen to the impaired assets once the government has acquired them?

An exact design of asset relief measure is a choice of Member States, and there are many models available: you can purchase bad assets and put them into a centralised "bad bank", you can guarantee bad assets while leaving them on the balance sheet of banks, you can do an asset swap, or you can nationalise the banks and take direct control of those assets. Whatever the model chosen by a Member State in view of its particular circumstances, in particular the size of the impaired asset problem and budgetary means, the same principles to management of such assets apply: management, staff and clients associated with bad and good assets should be separated in order to avoid conflict of interest and manage bad assets with a view of getting the most out of them over time.

What is the process to be followed by the Commission?

A Member State notifies to the Commission valuation methodology to be used for its banks, and the Commission verifies this methodology ex ante, and after having ensured that all the requirements of the State aid rules are complied with, approves an asset relief measure for 6 months; ii) Banks have 6 months to put assets into an asset relief measure, and need to send to the Commission the results of the valuation of these assets (certified by an independent third party expert and validated by the national supervisor), and of their viability review by the supervisors, which the Commission verifies; iii) A restructuring plan is notified to the Commission 3 months after the bank has acceded to an asset relief programme, on the basis of previous dialogue with the Commission as to the scope of the needed restructuring, using the criteria provided in the communication; iv) Commission assesses the restructuring plan, and either approves the aid or has doubts and opens a detailed investigation, in which case final decision comes later.

What is real economic value – and why will you pay that value for the assets and not market value? How much aid will be allowed?

In very simple terms: there is no market for many of these assets, yet some retain a potential to deliver revenue and profits over the long-term. So the market value in this exceptional case may simply be zero. At the other end you have the book value of these assets which much higher than the current market value. In order for an asset relief measure to deliver a relief to a bank, the assets need to be transferred at a value higher than the current market value. That transfer value should be the real economic value, based on the underlying cash flow of a given asset over time. The difference between the current market value and the transfer value based on real economic value is the amount of State aid we allow. The difference between the book value and the transfer value is the loss that the banks need to bear now in order to share the cost of the asset relief measures with the taxpayers.

What about burden sharing between the State, the shareholders and the creditors?

Burden-sharing is a key feature behind allowing asset relief measures, needed to translate into practical consequences the principles of transparency and disclosure, limit moral hazard, ensure that banks take partial consequences of past risk taking, and limit competition distortion between Member States and banks due to very different budgetary capacities of different Member States. The core principle is that the banks should bear now the losses associated with the impaired assets, which are the difference between the assets book value and their real economic value (based on underlying cash flow and broader time horizon). You can depart from this principle only for a bank who would become insolvent after such write downs and who is so important to financial stability that putting it into administration now would not be advisable. In such duly justified cases, a higher transfer value is allowed, implying higher aid, against larger restructuring or even winding down of the beneficiary later.

Does the Commission prescribe the choice of model for impaired assets programme?

No. Whether an asset purchase, swap, guarantee or hybrid model, this is the choice of the Member State. But at the European level we will apply to same principles to all measures.

Are asset relief programmes going to be available to all banks?

Asset relief measures are open to banks that need them – whether fundamentally sound or not. Participation should be on the basis of clearly defined and objective criteria. However, the follow-up required, including the extent of necessary restructuring of the beneficiary, will depend on the individual situation of each bank.

Which assets can benefit from asset relief schemes? Can banks present anything they want?

No. Only assets existing on the balance sheet of the banks by the end of 2008 can be eligible, and assets that at present are not impaired cannot enter any asset relief programmes. This is not an open-ended insurance against future consequences of recession.

The Communication identifies common categories of assets that are eligible for asset relief programmes in all Member States, in order to ensure level playing field and avoid situations when cross-border banks shop around between different schemes. Additionally, if banking sector in a Member State is hit by a specific problem (e.g. has not been exposed much to US sub prime assets but has experience a domestic real estate bubble) of an order that jeopardises its financial stability, Member States can extend asset eligibility to such well-defined categories upon justification and without any quantitative restriction. And finally, given the diversity of situations in Member States, 10 to 20% of assets of a given bank not belonging to the above two categories would be covered by a relief measure.

What kind of follow up will be required from banks that benefit from impaired assets measures?

The Commission approval for asset relief measures will be granted for a period of six months, and conditional on the commitment to present details of the valuation of the impaired assets, as well as viability assessment and restructuring plan for each beneficiary institution within 3 months from its accession to the asset relief programme. Depending on individual situation of each beneficiary, appropriate restructuring may include measures to remedy competition distortion, taking into account i.e. the total aid received through recapitalisation, guarantees or asset relief, with a view ensuring that the banks can return to long-term viability and perform their normal lending functions without State support.

Source: European Commission