Following announcements by various European governments of plans to address the continuing financial crisis by relieving banks of the toxic debts on their balance sheets, on 25 February 2009 the European Commission issued a communication on the application of the state aid rules to the treatment of impaired assets in the EU banking sector.
The guarantee or purchase of impaired assets on bank balance sheets by EU member states will typically constitute state aid as it will amount to financial assistance or a subsidy to the bank in question. Such aid must be notified to and cleared by the Commission to be lawful.
In assessing such state aid, the Commission is supportive of measures which aim to clear impaired assets from banks' balance sheets. To minimise the inevitable distortions on competition, the Commission emphasises the need for a common and co-ordinated Community approach to ensure consistency between member states in the measures they adopt. The Commission states that member state co-operation before measures are adopted will limit the need for intervention by the Commission after state aid notifications have been made.
To assist co-operation, the Commission sets out its own common guidance on the basic features that relief measures should contain to minimise adverse effects on competition and the single market. These features include:
Applications for aid should be subject to full prior disclosure of impairments by eligible institutions on the assets which will be covered by the relief measures.
Banks ought to bear the losses associated with impaired assets to the maximum extent. Clawback provisions should be used where it is not possible to achieve full burden sharing beforehand.
A common approach to categories of assets and to the valuation of those assets should be developed. This will help minimise the likelihood of cross-border arbitrage between different relief measures.
A limited enrolment window of six months should be applied, which should limit incentives for banks to delay necessary disclosures in the hope of higher levels of relief at a later date.
Beneficiary banks should be subject to behavioural safeguards to ensure that the capital effects of providing relief are used for providing credit to meet demand.
If the evaluation by the member state indicates a situation of technical insolvency, the bank should be wound up, put into administration, restructured or nationalised.
On 18 March the long awaited Turner Review was published. In the Review the FSA's chairman, Adair Turner, presented his much anticipated recommendations on the changes in regulation and supervisory approach needed to create a more robust banking system for the future.
Accompanying the Review was a lengthy FSA discussion paper (DP09/2) which set out in more detail Lord Turner's proposals for the banking system.
About half way through the discussion paper there is a discussion of passporting and branching. The FSA begins by stating that while, for the most part, branching arrangements do not create problems, the current situation is "intrinsically unsatisfactory".
The FSA's stated reason for this is that in principle the current arrangements allow banks from jurisdictions "in which the supervisors may lack the skills, resources or motivation to take an adequate group-wide approach" to establish branches which may be large and systemically important in the host country and which also take extensive deposits. The FSA argues that the host state supervisor may have no way of identifying emerging firm wide problems and, even where they are able to identify problems, they may not be able to ensure that the problems are addressed at a sufficiently early stage.
In the Review the FSA notes that proposed changes to the Capital Requirements Directive seek to improve the situation. However, the FSA wants to go further and puts forward three options:
The implementation of a system of peer review in the EU to ensure that home states exercise effective supervisory regimes and/or that financial support is sufficient to compensate host state customers in the event of failure.
Host state supervisors given further powers over branches.
The passporting regime to continue in its present form only if it were underpinned by an EU-wide framework, such as an EU-wide pre-funded deposit guarantee scheme.
To move forward with these proposals the FSA requires broad support from both within the UK and around the EU. Indeed, the proposals may seem to be running counter to the concept of the European Single Market. However, the issues raised by the failure of the UK operations of the Icelandic banks in particular cannot be ignored.
Chapter 6 of the Turner Review discusses the scope of regulation, including a brief discussion of unregulated activities within regulated groups.
Almost invariably regulated firms and large, cross-border financial institutions are part of a group. Sometimes the ultimate parent company in the group will be unregulated with its business being to hold shares in, and control, its investments in the companies that comprise the group. Many of the companies within the group may be regulated so that ultimately there is an unregulated entity exercising control over a regulated entity.
While the ultimate parent company has a pivotal role within the group the FSA has very limited direct powers over it, unless it is itself carrying on a regulated activity.
The FSA states in the Turner Review that it has a number of concerns regarding the current position and these include:
Regulators having little or no ability to prevent or control the activities of an unregulated holding company that increases the complexity of the group and the risks it poses to regulated subsidiaries.
For multi-jurisdictional groups, mismatches can occur between the global outlook of the holding company's board and senior management and the local focus of the regulated entities in the jurisdiction in which the ultimate holding company is incorporated.
In the Turner Review the FSA advocates legislative change in the UK and elsewhere to ensure that unregulated parent holding companies for financial services groups are subject to direct regulatory supervision so that they comply with prudential regulatory requirements.
The Turner Review also sets out another angle to group supervision. This concerns unregulated entities that exist elsewhere within a financial services group. The key for the FSA is to ensure that regulators who supervise regulated entities within a financial services group have sufficient information on unregulated entities (obtained through supervisory reporting or the provision of management information) so that they have a clear understanding of both the:
Solo and group level implications of any relationship between regulated and unregulated entities.
Aggregate exposures of the group to unregulated activities.
The UK Government has published two sets of draft legislation which seek to help companies struggling as a result of the current financial crisis.
The test for UK companies to form a group for group relief purposes is that, broadly, 75% of ordinary share capital must be under common ownership. Ordinary shares are any shares that are not fixed-rate preference shares.
As a result of the financial crisis, it is becoming increasingly common for subsidiaries of banking groups to issue non-cumulative preference shares (shares that do not carry a right to a dividend if paying one would risk breaching the bank's capital requirements). Such shares are popular since they increase the banking group's Tier 1 capital (www.practicallaw.com/9-107-7391).
Concerns have been raised that these shares may not be fixed-rate preference shares and consequently may "de-group" part of the banking group. The new legislation will change the types of preference share that are excluded when considering whether companies form a group to make it clear that non-cumulative preference shares are not ordinary share capital.
Although these changes seek to help banking groups, they apply to all corporate groups and introduce new concepts that will need to be considered by all companies that have issued or are thinking of issuing, fixed-rate preference shares. The changes apply to all accounting periods beginning on or after 1 January 2008 subject to an opt out for pre-18 December 2008 shares.
The second legislative change will allow a company which computes its profits and losses for tax purposes in a currency other than sterling, to carry back or forward losses and to convert those losses into sterling at the same exchange rate as the profits they are being used to offset are converted.
Although there are some technical concerns with the draft legislation (particularly the new preference shares rules), it is welcome that the UK Government is trying to address tax issues which have come to prominence as a result of the credit crunch.