Brussels Threatens Financial Stability

The EU must distinguish between good and bad aid.

LORENZO COPPI AND GEERT VAN DER KLIS

European banks are facing the threat of forced restructuring as Brussels reappraises state aid given to financial institutions during the credit crisis. In a speech to the British Bankers Association earlier this year, European Competition Commissioner Neelie Kroes made it clear that she believes banks such as Lloyds and Royal Bank of Scotland will face "significant divestments." These institutions, along with other major banks around Europe, are expected to be at the center of the Commission's in-depth investigations starting next month.

The financial crisis led Brussels to green-light a series of government support measures for the financial sector, including capital injections and toxic-asset purchases. The urgency of the crisis meant that the approvals were rushed through without full analysis but subject to a six-month review. Recent rumblings from Brussels, however, indicate that as the first interim approvals expire in the next few weeks, and these transactions are revisited, the commission will apply state aid rules rigorously, potentially forcing significant asset sales. "In some cases, divestments may not be needed, but in many cases they will be essential," Ms. Kroes said in a speech last month to the International Bar Association. "Some banks may have been too big to fail, none are too big to restructure."

At the heart of the matter will be whether and how the commission will distinguish "good aid" from "bad aid." The former is given to structurally sound banks whose difficulties stem exclusively from turbulent market conditions. The latter is given to rescue unsound banks that overstretched themselves and would not survive even under normal market conditions.

This distinction is important because the punishment for "good aid" should be less exacting than that for "bad aid." To be considered "good aid," state support must be intended to remedy a serious disturbance in the economy. While nearly everybody—including the commission—agrees that the financial crisis constituted such a "serious disturbance," Brussels appears intent on applying the harsher "bad aid" rules to all banks under investigation.

This could lead to mandatory asset sales that would jeopardize financial stability and slow the return to fully functional financial markets. Banks could be forced to sell their most profitable assets, which would reduce their future viability. In a market with many more sellers than buyers it may be difficult to divest assets without depressing their prices to a level that could spark another financial crash.

To ensure the viability of the financial sector, while at the same time avoiding the risk that state aid would fuel moral hazard or distort competition, the commission should divide the aid that each bank received into two categories: a) aid that was proportionate to remedy the financial market failures (a "good aid" portion), and b) any additional support that simply preserved banks' viability in the face of losses which cannot be directly ascribed to those market failures (a "bad aid" portion).

While both types of aid are compatible with European Union law, banks that received only "good aid" ought to be considered structurally sound. Such banks were sufficiently solvent to have no need for government assistance in the absence of widespread market failures, and should not be unduly punished for a wider economic malaise by being required to restructure and divest assets. Behavioral measures, such as requiring the banks—including shareholders and bondholders—to bear part of the burden themselves and place limits on executive pay, would be sufficient punishment for "good aid."

Forced asset sales should only be considered for banks that received "bad aid." By applying a methodology similar to that used by regulators to stress-test bank balance sheets, the commission could differentiate between the two aid portions. The aid granted on account of the irrational, panic-driven loss in asset value and that granted on account of the widespread crisis of confidence in the financial system should be considered "good aid." Bank assets should be valued on the basis of fair-economic-value principles, and the difference between this fair economic value and the assets' market value at the time the aid was granted represents the loss in value due to the market failure (or the irrational panic) element of the crisis. In addition, one should calculate the increase in capital, above the regulatory level, that was necessary as the result of the crisis of confidence. The sum of these two elements constitutes the "good aid," as it redressed a market failure and a systemic confidence crisis. Any aid above that amount should be considered "bad aid," as it went to cover fair-market-value losses, which banks could have avoided by acting prudently.

Several national regulators and central banks, including the Bank of England, are aligning their positions against the threat that Brussels may make far-reaching interventions in the structure of the European banking sector. It is contrary to the principles of logic, sound administration and economic efficiency that aid given to counter exceptional market turmoil should be assessed as harshly as aid given to rescue a failing firm. By requiring restructuring measures and asset sales where they are not appropriate, the European Commission would punish banks that are fundamentally sound, undermine the current revival in financial stability and prevent the effective prudential supervision of the banks by their national regulators. We can only hope that the commission will recognize this in time.

Mr. Coppi is vice-president at CRA International and Mr. Van der Klis is a partner at Clifford Chance.