- Measures to Strengthen the European Banking System
- November 7, 2011
- Law Firm: Skadden Arps Slate Meagher Flom LLP - New York Office
On October 26, 2011, European leaders at the Euro Summit agreed to a number of measures aimed at relieving the stress in Europe’s financial system. These measures include:
the development of a voluntary bond exchange with private investors at a discount of 50 percent on the nominal amount of outstanding Greek sovereign debt;
an agreement to leverage the European Financial Stability Facility (EFSF) rescue fund by four to five times through credit enhancement and possible SPV structures (which assertedly could increase the rescue fund’s firepower to around €1 trillion); and
a plan to recapitalize European banks and improve their access to medium-term funding markets.
On each of these measures, however, only very general parameters were established, with details to be developed and agreed over coming weeks and months. This memorandum summarizes the Euro Summit’s agreement on bank capitalization and term funding plans and offers a number of our preliminary observations.
Strengthened Capitalization to Achieve “Temporary Buffer”
The European Council (comprising the EU heads of state or government) agreed that European banks must attain a capital ratio of 9 percent — composed of “highest quality” capital and after accounting for market valuations of sovereign debt exposures as of September 30, 2011. This required level of capital is characterized as a “temporary buffer” and must be achieved by June 30, 2012. To this end, the European Banking Authority (EBA) will require that banks submit capital raising plans to their national supervisors by the end of 2011. These plans will have to be agreed with national regulatory authorities and discussed with the EBA. Under the auspices of the EBA, the national supervisors must ensure that these plans do not lead to “excessive deleveraging” and maintain credit flow to the real economy.
The European Council envisages that banks will first seek capital from private sources, including through the restructuring and conversion of debt to equity. Banks would be restricted in their distribution of dividends and payment of bonuses until they attained the capital target. If the capital target cannot be achieved through private sources by the end of June 2012, national governments should provide support, and, if this support is not available at a national level, requisite amounts would be funded through loans from the EFSF to national governments which would then invest the loan proceeds as capital into the affected banks.
The EBA has indicated that it will interpret the 9 percent capital target to be based on Core Tier 1 capital, largely as was used in the 2011 EU-wide stress test, except that the EBA will also permit certain newly issued private convertible instruments to be counted as Core Tier 1 capital for this purpose based on “strict and standardized” criteria to be defined by the EBA. The EBA said it is working on a common European term sheet to define permitted private convertible instruments that will count towards Core Tier 1 capital for this purpose.
It remains to be seen what types of instruments will be issued in the European bank recapitalization plan and what types of conditions would attach to any governmental or EFSF support. It is possible that such support would be based on the design of some EU national governmental recapitalization schemes developed during 2008-09, which in some cases involved convertible preference share structures that effectively carried governmental veto rights on various corporate governance matters, including on the distribution of dividends, share buybacks and senior management employment and remuneration. It is also possible that any governmental capital instruments could borrow features adopted in the U.S. Troubled Asset Relief Program (TARP), which over time tracked certain features of the U.K. Bank Recapitalisation Fund pursuant to which HM Treasury initially subscribed for preference shares and underwrote private offerings of ordinary shares by certain U.K. banks. Originally intended as a government-funded program to acquire troubled assets from U.S. banks, the TARP evolved to become direct government capital investments in qualifying U.S. financial institutions and involved direct government investment in a standardized, non convertible, preferred instrument with a stated 5 percent dividend — coupled with warrants to acquire common stock. The dividend on the preferred instrument increased to 9 percent after a period to encourage replacement of the government preferred with private capital. Although the terms of the TARP significantly limited dividends and compensation for executives, the U.S. government generally avoided an active role in the governance and management affairs of the participating banks.
Direct Support for Term Funding of Banks
The European Council’s statement on term funding for banks describes a requirement to provide direct guarantees of bank liabilities, in part to limit deleveraging actions by the banks, avoid a credit crunch and safeguard the flow of credit to the real economy. Noting that current market conditions would impede a discretionary guarantee program at the national level, the statement calls for a “truly coordinated approach at the EU-level” on entry criteria, pricing and conditions. The European leaders called on the EBA to jointly explore options with the EU Commission, ECB and European Investment Bank for achieving this objective.
The plan to provide direct government support to term funding builds on support provided at a national level in 2008 and also could end up resembling the U.S. Temporary Liquidity Guarantee Program. Under the U.S. program, the Federal Deposit Insurance Corporation (a quasi-independent arm of the U.S. government) guaranteed newly issued senior unsecured debt securities issued by participating financial institutions. The guarantee extended for up to three years and participating institutions were required to pay assessments to the FDIC. Participation in the program was widespread among U.S. banks, and the program is generally regarded as having helped calm the market for term funding of U.S. banks.
The Euro Summit banking measures are aimed at the challenges and political pressures facing Europe. We provide below some preliminary observations based in part on our experience with the governmental and market responses to the U.S. banking crisis in 2008-09.
The details will make all the difference. Key details on the capital strengthening and term funding plans remain to be explained, including the amount, form, terms and conditions that will be applicable to governmental support, whether the government equity investments will be in the form of common, preferred or hybrid equity (including contingent convertibles), whether warrants or other governmental upside participation will be attached to any form of support, what other conditions relating to business and employee compensation plans will be imposed on recipients, and how the EU Commission will address EU state aid and competition law issues raised by the different forms of support that may be developed by individual EU member states. These details will determine the ramifications for the banking system stakeholders and the ultimate success of the banking package measures.
Goal to avoid deleveraging is vague and difficult to police. Given the stated objective of achieving the 9 percent Core Tier 1 ratio target by mid-2012, banks will have incentives to preserve capital to the greatest extent possible and create capital through deleveraging and other actions that could frustrate the flow of credit to businesses and consumers in the Eurozone. European leaders were clearly cognizant of that risk, but it is unclear how national supervisory authorities and the EBA will be able to enforce a limit on deleveraging actions by the banks.
Willingness of private sources to invest in banks is unclear. It remains to be seen whether private investors will be willing to invest in undercapitalized banks without governmental support, and if so, on what terms. In the U.S., the catalyst for attracting private investors back into the banking industry was the willingness of the Federal Deposit Insurance Corporation to share losses in respect of troubled bank assets through receivership transactions. Such a mechanism does not currently exist on a European-wide basis.
Known deadline for capital raising increases leverage of private investors. The European plan does not provide incentives for private investors to rush to participate in recapitalization transactions. Unless there is significant competition for a particular investment, investors may defer action as they could expect to have maximum leverage to demand preferential terms by the end of the capitalization deadline in mid-2012.
Recapitalization plan will create winners and losers. A key attribute of the U.S. approach to bank recapitalizations was that the U.S. Treasury’s upfront investments in all major banks avoided differentiating banks that were in need of governmental support from those that were not. We believe this feature had the effect of strengthening the perception of restored stability in the U.S. banking system as a whole. In the European approach, by contrast, the market may be able to choose winners and losers. This creates the potential for continued uncertainty regarding which banks ultimately will become the subject of governmental support.
Term funding plan has potential to provide relief to bank credit markets. Based on the U.S. experience, a well-crafted term funding plan can provide real relief to the bank credit markets, but the effectiveness of the plan and the level of participation across the European banking industry will depend on the terms and conditions that will be attached to governmental guarantees of term funding.
The next few months will be critical for the European banking system. Some banks will be able to earn their way to a 9 percent Core Tier 1 ratio by the end of June 2012. Other banks will need to explore all other options to increase their capital ratios, including steps to delever balance sheets and/or raise new forms of Core Tier 1 capital. This could lead to increased M&A activity, including branch and noncore subsidiary dispositions and asset and portfolio sales, as well as significant efforts to raise additional equity from various private actors, including private equity funds, sovereign wealth funds, hedge funds and other institutional investors as well as the public markets. If these measures fail, government capital aid will need to be obtained, the terms and conditions of which are not yet clear. In addition, banks will need to navigate the new term funding guarantee scheme, which could potentially be used by a wide array of banks if guarantee terms are sufficiently attractive.