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34. ‘Just in case’: the direct bank recapitalisation tool

The euro area established a direct channel to banks – a major advance for the monetary union – when the ESM’s toolbox was expanded to include a direct recapitalisation instrument (DRI). First conceived in 2012, the DRI was seen as a way to prevent further crisis escalation in the event of a heavily indebted country having to take on more loans to save a systemically important bank.
At the time, there were few public avenues for stabilising a failing bank and little consensus on when and whether troubled financial firms should be propped up or shut down. Now the EU has clear rules for those contingencies, and the banking union features a Single Resolution Board, backed by its own resolution fund, with the power to dismantle a systemic bank safely.
When Europe’s crisis-fighting strategy was a work in progress, the development of the DRI served as reassurance for the banking system, especially between 2012 and 2014.
‘At the time, it was really important to dispel or reduce the fears that Europe was unable to manage the crisis. For that, the instrument was useful. The probability of this instrument being used is now close to zero,’ said Sutt, the ESM’s head of banking from 2013 to 2016.
Had it been available at the time, direct recapitalisation could have suited Ireland, whose state bank guarantee led to a substantial spike in government debt, damaging the overall economy. The Irish experience, which came as exposure to US subprime debt was forcing governments in Germany, France, the UK, and elsewhere to prop up their banks, exploded market fears about linked bank-sovereign finances.
Nonetheless, it took more than two years – from a summit pledge in June 2012 until the last details were ironed out in December 2014 – for the euro area to declare the tool ready for ESM deployment. During that time, negotiations were shaped by the success of indirect ESM lending to stabilise Spain’s banks and a broader shift in the European regulatory backdrop.
In the original 2012 commitment, euro area leaders had tied use of the DRI to a series of conditions, including compliance with the EU’s state aid rules. By autumn 2012, those conditions took on more emphasis: at a 25 September meeting in Helsinki, the finance ministers of Germany, the Netherlands, and Finland stressed that the ESM would step in only ‘as a last resort’ and at a member state’s request.
The first line of defence, the three ministers said in a statement[1], would be bank shareholders and creditors and the budget of the member state concerned. ESM intervention, in other words, wouldn’t take place overnight.
In their view, intervention was warranted for problems on a euro area scale, not to rectify the failures of national bank supervision. The statement clearly showed how difficult this kind of assistance was for some countries to accept.
‘There was a great deal of discussion on the direct recapitalisation of banks. These proposals clashed with the reluctance of many to share risks,’ said de Guindos, the Spanish finance minister through much of the crisis and now the vice president of the ECB.
A key condition regarding the use of the DRI is that the bank concerned should be systemically important, rendering its rescue indispensable to safeguard the financial stability of the euro area. The European Commission would also have to judge that an ESM-backed recapitalisation and restructuring would restore the bank to viability.
Political agreement on the operational framework for direct ESM banking intervention was reached at a Eurogroup meeting in June 2014[2]. ‘It was hugely controversial among [the ESM] Members,’ Sutt said. ‘The conservative view was that this was too risky. From the southern part of Europe, the idea was “this is exactly what we need.”’
Finance ministers said the ESM could use up to €60 billion of its total capacity on the DRI. The actual drain on ESM resources, however, would be greater because the provision of direct financial assistance to distressed banks carries higher risks than lending to a cash-strapped government. Use of the tool would reduce the ESM’s lending capacity, possibly by as much as €180 billion off the ESM’s overall lending ceiling of €500 billion. However, by preventing further crisis escalation, the benefits were thought to outweigh this potential drain.
A government applying for a direct recapitalisation programme would have to show that it would be saddled with excessive debt if it borrowed from the ESM in order to pass the funds on to the troubled bank, as Spain had done. The purpose of the direct ESM injection is to bypass the government and avoid increasing its sovereign debt. While the Spanish example was a success story, it might have been trickier for a country whose debts were larger relative to the size of its economy.
The creation of the direct bank intervention tool marked the ESM’s biggest departure yet from the IMF’s crisis-lending model. With this new step, the euro area rescue fund took on duties similar to those performed by the European Bank for Reconstruction and Development or the World Bank’s International Finance Corporation.
‘Historically, we only lend money to sovereigns, as the IMF does. On the other hand, as a crisis-fighting institution it could make sense to go into the private sector like multilateral development banks.’ ESM Managing Director Regling said.
Following the political go-ahead from the Eurogroup, it fell to the ESM to draw up the operations manual for direct recapitalisations. Regling brought in David Vegara, a former deputy finance minister in Spain and
IMF veteran, as a senior advisor in September 2012. In December, Vegara moved to the Management Board and, alongside Frankel, became a deputy managing director, in recognition of the scope of his experience.
Vegara was tasked with overseeing the building up of an ESM team capable of managing large-scale bank holdings across Europe. At that time, it was clear that banking issues would be an increasingly central issue for the ESM and there was a clear need for Vegara’s particular expertise.
‘It’s a huge amount of work. You’re looking at taking on the management and oversight of a bank or even several banks,’ Vegara said.
Thanks to Vegara’s technical and management skills, the ESM was able to build its banking department from scratch and make sure it could be fully operational when needed. But, when the DRI became ready to use in December 2014, it also became clear that the tool would be unlikely to be deployed. Vegara moved back to his old role as special advisor before departing from the ESM in February 2015, his assignment complete.
The ESM’s General Counsel, David Eatough, said: ‘The idea is that you take the sovereign out of the credit equation, and rather than the sovereign owning the money and then lending it, you buy shares in the banks and directly recapitalise the banks. It would have been a massive change from anything the institution had done before.’
To wield the new instrument, the ESM needed staff expertise to assess whether a bank is viable or needs to be split and resolved, taking into account conditions in the relevant national banking market. ESM experts would have to master a given bank’s valuation metrics and the due diligence required.
Besides recruiting public and private banking professionals, the ESM put together a project group drawn from across the organisation. It spent six months developing a clear understanding of how to assess, structure, and execute a transaction while maintaining the safeguards to underpin the ESM’s high credit rating.
One of the additions was Mike Hesketh, hired from the European Bank for Reconstruction and Development and one of the ESM’s principal banking experts. ‘The concept of direct recapitalisation, putting a large equity investment into the viable part of a bankrupt systemic bank, was challenging,’ Hesketh said. ‘My role was to help develop the processes and internal procedures for how to assess risk, and how we could best structure it to mitigate that risk.’
The point wasn’t to create a full-time bank-intervention department. The ESM decided that, in a crisis, it would supplement the core banking team with staff on secondment from other international financial institutions, and that it would hire consultants for detailed due diligence work.
It was also decided to create a subsidiary body within the ESM to carry out the bank recapitalisation. This format won out over using a special purpose vehicle under Luxembourg law, which had been considered earlier but did not pass legal muster.
Planning was also essential for the financial risks associated with bank shareholdings, given the potential for tremendous year-to-year volatility. For a conservatively managed institution such as the ESM, the prospect of losses or share markdowns would be a dramatic change.
‘What we could insist upon was that the costs we would incur, to arrange the funding and certain other costs, could be passed back to the beneficiary Member State,’ Hesketh said. ‘At least we wouldn’t be incurring operational costs. But we would take the pure equity risk of the investment.’
Dealing with that risk would impose further limitations on the potential use of the tool. ESM Treaty rules could lead it to a call on Members to provide more capital if losses on equity holdings were to reach a certain limit – a controversial proposition.
As it issues bonds on the public markets, the ESM’s need to provide regular transparency on its financial position also ruled out the use of deferred-loss accounting methods, which are common with nationally managed bank recapitalisation funds.
‘Let’s assume that we make a loss on the equity holdings and that directly affects the ESM’s equity,’ Hesketh said. ‘Then we’re actually obliged to make a call to the shareholders. And, as Klaus memorably said: “That would be a painful call to make.”’
The new tool could not be deployed until the Single Supervisory Mechanism for euro area banks was up and running. Its debut took place on 4 November 2014[3]. Shortly afterwards, in December 2014, the ESM declared the new instrument operational. By this time, however, the crisis had subsided and European bank regulation was moving on[4].
New rules for resolving troubled banks – the bank recovery and resolution directive – took effect at the start of 2015, although it would be another year before its creditor-loss hierarchy would be phased in. But the creditor-loss protocols kicked in immediately for any bank seeking ESM direct recapitalisation, giving member states another consideration to ponder.
In parallel, the euro area had equipped the ECB to become the common banking supervisor for systemic banks. The central bank had also in October 2014 conducted a comprehensive assessment of bank balance sheets, revealing total capital needs of only €24.6 billion across 25 out of the 130 largest banks[5]. The review revealed that the euro area’s most important banks were in much better shape than at the start of the crisis, and less likely to fall back on the newly minted ESM tool.
‘The results of the recent asset quality review and stress tests confirm that the use of the new instrument seems unlikely,’ Regling said on 8 December 2014, when the ESM unveiled the direct recapitalisation tool[6].
While the tool has remained on the shelf, the financial sector expertise gained along the way has served the ESM well. Not only is the knowledge essential for ongoing programme monitoring, in the future there will be close coordination between the rescue fund and the Single Resolution Board because in 2018 the euro area agreed to make the ESM its backstop for the Single Resolution Fund and to phase out the direct recapitalisation tool once that arrangement is in place.

Focus

Carlo and Hugo

The ESM’s banking team staged two trial runs of the bank recapitalisation tool, to test it out in practice. The drills were called Project Carlo and Project Hugo, named after the streets around the ESM’s headquarters that honour the Luxembourgish economist Carlo Hemmer and the Luxembourgish- American inventor and science fiction publisher Hugo Gernsback.
‘It was really a demanding exercise because we were under enormous pressure, as if it were really happening and not just a test,’ said Sutt, former ESM head of banking.
Activating the instrument would involve the entire banking team, supported by most of the rest of the ESM. For the first dry run, Project Carlo in March 2014, the ESM also worked with a financial advisory and asset management company, to prepare the exercise and a 600-page handbook on the tool.
The practical tests revealed that the tool had unexpected drawbacks. One of the principle takeaways was that the tool would not be the rapidly deployable emergency instrument that had been intended. Distressed banks would need to have their national government lodge a formal request with euro area finance ministers, the ESM’s directors and governors, the relevant directorates-general of the European Commission, and the ECB. In some cases, Members would need to follow their national parliamentary procedures. The ESM also would have to conduct a full analysis of the bank to assess the likelihood of recovering its investment.
Project Carlo, the first test exercise, was based on a real bank in one of the programme countries, but with the data changed for the purposes of a purely hypothetical exercise. Under the simulation, the bank’s home country requested the instrument’s aid to recapitalise one of its big banks. The ESM team had two and a half days to analyse the bank’s financial situation, come up with a workable investment structure, and perform due diligence: stress tests, entry equity valuations, exit routes, and potential exit valuations. To make things even more interesting, the exercise facilitators changed some of the external events halfway through, in keeping with how the crisis had played out in real life.
Instead of granting the requested amount of aid for the troubled bank, the ESM team found it needed to split the bank and provide a large amount of funding, most likely in the form of a regular loan to the country. This led to ‘a very small equity investment for direct recapitalisation and a very high probability that the country was going to have to request a full economic adjustment programme,’ said Hesketh of the ESM banking department. Since the direct recapitalisation instrument was designed to help a country in lieu of a standard programme, the realisation that it would work only alongside a full programme was a surprise.
‘We all know it would not have been just one bank that needed to be resolved, but probably would result from an overall situation that would have affected the state itself,’ said Jansen, former ESM general counsel.
Project Hugo followed in September 2014. It too featured a simulated bank based on real programme country data and a straightforward request for direct aid, but this time with the Commission taking part and other simulated external actors, such as the media. The ECB was invited, but it was too busy conducting its real-life comprehensive banking review to take part.
Bringing in these outside actors highlighted how direct bank investments would dramatically change the ESM’s negotiating role, over and above the political difficulties of getting a direct recapitalisation programme in place. The acquisition of a stake in a private company would compel the ESM to protect its investment and negotiate for higher returns on behalf of its shareholders. This might mean navigating trade-offs between what is best for the bank and what regulators might request as part of their efforts to limit taxpayer liability. One example might be whether or not to sell subsidiaries, which might have long-term value to the institution but could also generate upfront cash.
Project Hugo led to the same conclusion as its predecessor: even though the request was for one specific bank, there would be too much contagion for the country to avoid a full macroeconomic programme. The bulk of the programme would probably entail an indirect recapitalisation facility. Direct aid would be a smaller component, at a higher cost.
‘The conditions that we would impose for direct recap are very burdensome on the Member,’ Hesketh said. ‘Essentially, they lose control of a systemically important bank in their country. We make a small equity investment but we’re probably taking 70% to 80% of the shares.’
In that scenario, a Member would probably opt not to pursue a direct aid investment. Instead it could aim for a larger indirect facility and maintain control of its banks.

34. ‘Just in case’: the direct bank recapitalisation tool

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[1] Finland, Ministry of Finance (2012), ‘Joint statement of the ministers of finance of Germany, the Netherlands and Finland’, Press release, 25 September 2012. https://vm.fi/en/article/-/asset_publisher/joint-statement-of-the-ministers-of-finance-of-germany-the-netherlands-and-finland
[2] Statement by the president of the Eurogroup, 10 June 2014. https://www.consilium.europa.eu/media/28065/143163.pdf
[3] ECB (2014), ‘ECB assumes responsibility for euro area banking supervision’, 4 November 2014, Press release. https://www.ecb.europa.eu/press/pr/date/2014/html/pr141104.en.html
[4] ESM (2014), ‘ESM direct bank recapitalisation instrument adopted’, Press release, 8 December 2014. https://www.esm.europa.eu/press-releases/esm-direct-bank-recapitalisation-instrument-adopted
[6] ESM (2014), ‘ESM direct bank recapitalisation instrument adopted’, Press release, 8 December 2014. https://www.esm.europa.eu/press-releases/esm-direct-bank-recapitalisation-instrument-adopted

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