ANNEX 1

EUROSYSTEM GUIDANCE ON ASSET SUPPORT MEASURES FOR BANKS

The Eurosystem has identified seven guiding principles for bank asset support measures:

ANNEX 2

The different conceivable approaches to asset relief and experience with the use of bad-bank solutions in the United States, Sweden, France, Italy, Germany and Switzerland

I.   POSSIBLE APPROACHES

In principle, two broad approaches to managing assets subject to relief measures can be considered:

II.   EXPERIENCE WITH BAD BANKS

In the United States, the Resolution Trust Corporation (RTC) was created as a government-owned asset-management company in 1989. The RTC was charged with liquidating assets (primarily real estate-related assets, including mortgage loans) that had been assets of savings and loan associations (S&Ls) declared insolvent by the Office of Thrift Supervision, as a consequence of the Savings and Loan crisis (1989-1992). The RTC also took over the insurance functions of the former Federal Home Loan Bank Board. Between 1989 and mid-1995, the Resolution Trust Corporation closed or otherwise resolved 747 thrifts with total assets of USD 394 billion. In 1995, its duties were transferred to the Savings Association Insurance Fund of the Federal Deposit Insurance Corporation. Overall, the cost to the taxpayers was estimated at USD 124 billion in 1995 dollars.

The RTC operated via so-called ‘equity partnership programs’. All equity partnerships involved a private sector partner acquiring a partial interest in a pool of assets. By retaining an interest in asset portfolios, the RTC was able to participate in the extremely strong returns being realised by portfolio investors. Additionally, the equity partnerships enabled the RTC to benefit from the management and liquidation efforts of their private sector partners, and the structure helped assure an alignment of incentives superior to that which typically exists in a principal/contractor relationship. The various forms of equity partnerships are the following: Multiple Investment Fund (limited and selected partnership, unidentified portfolio of assets), N-series and S-series Mortgage Trusts (competitive bid for identified portfolio of assets), Land fund (to take profit from longer-term recovery and development of land), and JDC Partnership (selection of general partner on a ‘beauty-contest’ basis for claims which are unsecured or of questionable value).

In Sweden, two bank asset management corporations (AMCs), Securum and Retriva, were set up to manage the non-performing loans of financial institutions as part of the resolution policy for the financial crisis in 1992/1993. The assets of an ailing bank were split into ‘good’ and ‘bad’ assets, with the bad assets then transferred to one of the asset management corporations, mainly to Securum  (1). An important feature of the Swedish programme was to force banks to disclose expected loan losses in full and assign realistic values to real estate and other assets. For this, the Financial Supervisory Authority tightened its rules for the definition of probable loan losses as well as for the valuation of real estate. In order to obtain uniform valuation of the real estate holdings of banks applying for support, the Financial Supervisory Authority set up a Valuation Board with real estate experts. The low market values assigned to the assets in the due diligence process, effectively helped set a floor for asset values. As market participants did not expect prices to fall below this level, trading was maintained (2). In the long run, the two bank asset management corporations turned out to be successful in the sense that the budgetary cost of supporting the financial system was roughly balanced by the revenues received by the bank asset management corporations from the liquidation of their asset holdings.

In France, a public body enjoying an institutional unlimited state guarantee was created in the 1990s to take over and liquidate over time the bad assets of Credit Lyonnais. The bad bank financed the acquisition of the assets by means of a loan from Credit Lyonnais. The latter, therefore, could avoid recording losses on the assets and free capital for an equivalent amount of risk-weighted assets, as the loan to the bad bank could enjoy a 0 % risk weight in view of the state guarantee. The European Commission approved the bad bank as restructuring aid. A feature of the model was the neat separation between the good and the bad bank in order to prevent conflicts of interest and the clause ‘de retour à meilleure fortune’ on the good bank’s profit to the benefit of the State. After a few years, the bank was successfully privatised. However, transfer of the assets to the bad bank at book value sheltered the shareholders from responsibility for the losses and implied high cost for the State over time.

A couple of years later in Italy, Banco di Napoli was split into a bad bank and a good bank after the absorption of the losses by existing shareholders and a Treasury recapitalisation to the extent necessary to keep the bank afloat. Banco di Napoli financed the bad bank’s acquisition of the discounted but still impaired assets via a subsidised loan from the Central Bank counter-guaranteed by the Treasury. The cleaned bank was privatised 1 year later. In neither the case of Credit Lyonnais nor that of Banco di Napoli was there an immediate budgetary outlay for the Treasury for the acquisition of the bad assets, over and above the provision of capital to the banks.

A soft form of bad bank has been recently used by Germany in dealing with the bad assets of their Landesbanken. In the SachsenLB case, the beneficiary was sold as a going concern after the bad assets of around EUR 17,5 billion were channelled into a special purpose vehicle (SPV) with the purpose to hold the assets until maturity. The former owners, the Land of Saxony, gave a loss guarantee for around 17 % of the nominal value, which was considered as the absolute maximum of possible losses in a stress test (the base case was estimated only at 2 %). The new owner took over most of the refinancing and covered the remaining risk. The aid amount was at least considered to go up to the worst case estimate of around 4 %. In the WestLB case, a portfolio of assets of EUR 23 billion was channelled into an SPV and equipped with a government guarantee of EUR 5 billion so as to cover eventual losses and protect the balance sheet from adjustment of the value of the assets according to IFRS. This allowed WestLB to remove the market volatility of the assets from its balance sheet. A guarantee fee of 0,5 % was paid to the State. The risk shield is still in place and is considered to be State aid.

In Switzerland, the government has created a new fund to which UBS has transferred a portfolio of toxic assets that was valued by a third party prior to the transfer. To ensure financing of this fund, Switzerland first injected capital into UBS (in the form of notes convertible into UBS shares), which UBS immediately wrote off and transferred to the Fund. The remainder of the financing of the Fund was ensured by a loan from the Swiss National Bank.

In the late 1990s, the Czech banks’ lending conditions to corporations were very loose. The Czech banks were burned very severely by that and they had to be bailed out in the late 1990s by the government. Major rounds of cleaning up banks’ balance sheets were undertaken in order to establish a healthy banking industry.

In February 1991, the Czech government created a consolidation bank (Konsolidační banka, KOB), established in order to take on bad loans from the banking sector accumulated before 1991 — such as debts inherited from the centrally planned economy, especially those related to trading within the Soviet bloc. In September 2001, the special bank turned into an agency that also had to absorb bad loans connected to ‘new innovative’ loans (especially so-called privatisation loans, non-performing loans and fraudulent loans).

Starting in 1991, larger banks were freed from bad loans and as of 1994 emphasis shifted to smaller banks. In particular, the failure of Kreditní banka in August 1996, and a subsequent partial run on Agrobanka, caused some strain on the Czech banking system. The programmes concerned led only to a temporary increase of state ownership in banking in 1995, and again in 1998, due to the revocation of the license of Agrobanka. Overall, the government share in banking rose to 32 % at the end of 1995 from 29 % in 1994.

Moreover, to support the small banks, another programme — the Stabilisation Programme — was approved in 1997. This essentially consisted of replacing poor-quality assets with liquidity of up to 110 % of each participating bank’s capital through the purchase of poor-quality assets from the bank by a special company called Česká finanční, with subsequent repurchase of the residual amount of these assets within a 5 to 7-year horizon. Six banks joined the programme, but five of these were excluded after failing to comply with its criteria and subsequently went out of business. Thus, the Stabilisation Programme has not been successful and was halted.

By the end of 1998, 63 banking licences had been granted (60 of these before the end of 1994). As of end-September 2000, 41 banks and branches of foreign banks remained in business, 16 were under extraordinary regimes (8 in liquidation, 8 involved in bankruptcy proceedings), 4 had merged with other banks, and the licence of one foreign bank had been revoked because it had failed to start its operations. Out of the 42 remaining institutions (including CKA) 15 were domestically controlled banks and 27 foreign-controlled banks, including foreign subsidiaries and foreign branches.

In May 2000, the amended Act on Bankruptcy and Settlement and the Act on Public Auctions became effective, which aimed at accelerating bankruptcy proceedings and balancing creditors’ and debtors’ rights by allowing specialised firms or legal persons to act as trustees in bankruptcy proceedings and by offering the possibility to negotiate out-of-court settlements.

(1)  See Bergström, Englund and Thorell (2002) and Heikensten (1998a and b).

(2)  This is in sharp contrast to the Japanese policy setting too high values for ‘bad’ assets, thus freezing the real estate market for about a decade.

ANNEX 3

The definition of categories (baskets) of eligible assets and full disclosure concerning the impaired assets as well as the entire business activities of a bank

I.   THE DEFINITION OF CATEGORIES (BASKETS) OF ELIGIBLE ASSETS

The definition of baskets of impaired financial assets of banks should be a common denominator based on categories that are already used for:

Using a common denominator of existing reporting and valuation categories for defining asset baskets will:

Taking into account the above the Authority suggests the following baskets of financial assets as an entry point for determining the ‘economic value’ and the asset impairment relief:

Table 1

II.   FULL DISCLOSURE CONCERNING IMPAIRED ASSETS AND THE RELATED BUSINESS ACTIVITIES

On the basis of these asset baskets, the information provided on the impaired assets of a bank which should be covered by an asset-relief measure should be presented with a further degree of granularity as suggested in the comment column of Table 1.

On the basis of good practices observed by the Committee of European Banking Supervisors (1) (CEBS) for disclosures on activities affected by the market turmoil, information on the bank’s activities related to the impaired assets that would feed into the viability review referred to in section 5.1 could be structured as follows:

Table 2

(*1)  FVPL = Fair value through profit and loss = trading portfolio + fair value option); AFS = available for sale, HTM = Held to Maturity, L&R = loans and receivables.

(*2)  Cost means the carrying amount of the loans minus impairment.

(1)   Source: CEBS (Committee of European Banking Supervisors) report on banks’ transparency on activities and products affected by the recent market turmoil, 18 June 2008.

(*3)  In the SSG Report, each feature refers to an specific type of SPE, or to all of them as a whole, being SPE (Special Purpose Entities in general), LF (Leveraged Finance), CMB (Commercial Mortgage-Backed Securities), O (Other sub-prime and Alt-A Exposures), CDO (Collateralised Debt Obligations).

ANNEX 4

VALUATION AND PRICING PRINCIPLES AND PROCESSES

I.   Valuation methodology and procedure

For the purposes of the measures, assets should be classified along the lines of the illustrative tables 1 and 2 in Annex 3.

The determination of the real economic value within the meaning of this Chapter of the Authority’s State Aid Guidelines (see section 5.5) should be based on observable market inputs and realistic and prudent assumptions about future cash flows.

The valuation method to be applied to eligible assets should be agreed at the EEA level and could vary with the individual assets or baskets of assets concerned. Whenever possible, such valuation should be re-assessed with reference to the market at regular intervals over the life of the asset.

In the past, several valuation options have been applied more or less successfully. Simple reverse auction procedures proved useful in the case of categories of assets where market values are reasonably certain. However, this approach failed in valuing more complex assets in the United States. More sophisticated auction procedures are more adapted where there is less certainty about market values and a more exact method of price discovery of each asset would be needed. Unfortunately, their design is not straightforward. The alternative of model-based calculations for complex assets presents the drawback of being sensitive to the underlying assumptions (1).

The option of applying uniform valuation haircuts to all complex assets simplifies the process of valuation overall, although it results in less accurate pricing of individual assets. Central banks have substantial experience regarding possible criteria and parameters for collateral pledged for refinancing, which could serve as a useful reference.

Whatever the model chosen, the valuation process and particularly the assessment of the likelihood of future losses should be based on rigorous stress-testing against a scenario of protracted global recession.

The valuation must be based on internationally recognised standards and benchmarks. A common valuation methodology agreed at the EEA level and consistently implemented by EEA States could greatly contribute to mitigating concerns regarding threats to a level playing field resulting from potentially significant implications of discrepant valuation systems. When assessing the valuation methods put forward by EFTA States for asset-relief measures, the Authority may, in principle, consult valuation experts (2).

II.   The pricing of state support on the basis of valuation

The valuation of assets must be distinguished from the pricing of a support measure. A purchase or insurance on the basis of the established current market value or the ‘real economic value’, factoring in future cash flow projections on a hold-to-maturity basis, will in practice often exceed the present capacities of beneficiary banks for burden-sharing (3). The objective of the pricing must be based on a transfer value as close to the identified real economic value as possible. While implying an advantage as compared to the current market value and thus State aid, pricing on the basis of the ‘real economic value’ can be perceived as counterbalancing current market exaggerations fuelled by current crisis conditions which have led to the deterioration or even collapse of certain markets. The greater any deviation of the transfer value from the ‘real economic value’, and thus the amount of aid, the greater the need for remedial measures to ensure accurate pricing over time (for example, through better fortune clauses) and for more in-depth restructuring. The admissible deviation from the result of valuation should be more restricted for assets the value of which can be established on the basis of reliable market input than for those for which markets are illiquid. Non-compliance with these principles would represent a strong indicator for the necessity of far-reaching restructuring and compensatory measures or even an orderly winding-up.

In any event, any pricing of asset relief must include remuneration for the State that adequately takes account of the risks of future losses exceeding those that are projected in the determination of the ‘real economic value’ and any additional risk stemming from a transfer value above the real economic value.

Such remuneration may be provided by setting the transfer price of assets at below the ‘real economic value’ to a sufficient extent so as to provide for adequate compensation for the risk in the form of a commensurate upside, or by adapting the guarantee fee accordingly.

Identifying the necessary target return could be ‘inspired’ by the remuneration that would have been required for recapitalisation measures to the extent of the capital effect of the proposed asset relief. This should be in line with the Chapter of the Authority’s State Aid Guidelines on recapitalisation of banks, while taking into account the specific features of asset-relief measures and particularly the fact that they may involve higher exposure than capital injections (4).

The pricing system could also include warrants for shares in the banks equal in value to the assets (implying that a higher price paid will result in a higher potential equity stake). One model for such a pricing system could be an asset purchase scenario, in which such warrants will be returned to the bank once the assets are sold by the bad bank and if they have earned the necessary target return. If the assets do not yield such a return, the bank should pay the difference in cash to reach the target return. If the bank does not pay the cash, the State would sell the warrants to achieve the target return.

In an asset guarantee scenario, the guarantee fee could be paid in the form of shares with a fixed cumulative interest representing the target return. Where the guarantee needs to be drawn upon, the EFTA State could use the warrants to acquire shares corresponding to the amounts that had to be covered by the guarantee.

Any pricing system would have to ensure that the overall contribution of beneficiary banks reduces the extent of net state intervention to the minimum necessary.

(1)  In any case, an auction would only be possible for homogeneous classes of assets and where there exist a sufficiently large number of potential sellers. In addition a reserve price would need to be introduced to ensure the protection of the interest of the State and claw back mechanism in case the final losses would exceed the reserve price, so as to ensure a sufficient contribution by the beneficiary bank. In order to assess such mechanisms, comparative scenarios with alternatives guarantee/purchase schemes will have to be submitted, including stress tests, in order to guarantee their global financial equivalence.

(2)  The Authority will use the opinion of such valuation experts in a manner similar to other State aid proceedings, where it may have recourse to external expertise.

(3)  See section 5.2 of these guidelines.

(4)  In an asset guarantee scenario, it would also have to be taken into consideration that in contrast to recapitalisation measures, no liquidity is provided.

ANNEX 5

STATE AID PROCEDURE

EFTA States notifying asset-relief measures shall provide the Authority with comprehensive and detailed information on all the elements of relevance for the assessment of the public support measures under the State aid rules as set out in this Chapter of the State Aide Guidelines (1). This includes in particular the detailed description of the valuation methodology and its intended implementation involving independent third-party expertise (2). The Authority’s approval will be granted for a period of 6 months, and conditional on the commitment to present either a restructuring plan or a viability review for each beneficiary institution within 3 months from its accession to the asset-relief programme.

Where a bank is granted aid either as an individual measure or under an approved asset-relief scheme, the EFTA State shall provide the Authority, at the latest in the individual notification concerning the restructuring plan or viability review, with detailed information regarding the assets covered and its valuation at the time such individual aid is granted, as well as the certified and validated results of the disclosure of impairments concerning the assets covered by the relief measure (3). The full review of the bank’s activities and balance sheet should be provided as soon as possible to initiate discussions on the appropriate nature and extent of restructuring well in advance of the formal presentation of a restructuring plan with a view to accelerating this process and providing clarity and legal certainty as quickly as possible.

For banks that have already benefited from other forms of State aid, be it under approved guarantee, asset swaps or recapitalisation schemes or individual measures, any assistance granted under the asset-relief scheme is to be reported first under existing reporting obligations so that the Authority has a complete picture of multiple State aid measures benefitting an individual aid recipient and can better appreciate the effectiveness of the previous measures and the contribution that the EFTA State proposes to introduce in a global assessment.

The Authority will reassess the aid granted under temporary approval in light of the adequacy of the proposed restructuring and the remedial measures (4), and take a view on its compatibility for longer than 6 months through a new decision.

EFTA States shall also provide a report to the Authority every 6 months on the functioning of the asset-relief programmes and on the development of the banks’ restructuring plans. Where the EFTA State is already subject to a reporting requirement for other forms of aid to their banks, such a report shall be complemented with the necessary information concerning the asset-relief measures and the banks’ restructuring plans.

(1)  Pre-notification contact is encouraged.

(2)  See section 5.5 above and Annex 4.

(3)  A letter from the head of the supervisory authority certifying the detailed results shall be provided.

(4)  In order to facilitate the work of the EFTA States and the Authority, the Authority will be prepared to examine grouped notifications of similar restructuring/winding-up cases. The Authority may consider that there is no need to submit a plan for the pure winding up of an institution, or where the size of the institution is negligible.