Banking reform at the edge of the precipice – the latest news – Report 1

The latest news from the US

On 14 October, Henry Paulson announced that $250 billion of TARP funds would be invested in the capital of US banks and other financial institutions. This switch in priorities (from the initial emphasis on the purchase of mortgage backed securities) followed international consensus on the response to last week’s market collapse (apparently based on the UK proposals). The impaired asset purchase plan has not, however, been abandoned and reverse auctions are still planned. The TARP legislation gives broad powers to the US Treasury which are now to be used for the bank capitalisation plan.

Nine large US institutions have already signed up to the plan ( Citigroup, Goldman Sachs, State Street, Bank of New York Mellon, JP Morgan, Wells Fargo, Merrill Lynch, Morgan Stanley and Bank of America). The program will also be available to a broad array of small and medium sized banks and thrifts. The investment will involve preferred shares with warrants to subscribe for ordinary equity. This is different to the UK approach below and is intended to avoid an immediate dilution of existing shareholders.

Participating institutions will be subject to the TARP standards which restrict executive compensation and golden parachutes and there are expectations in relation to support for ‘struggling homeowners’.

The UK Bank Recapitalisation Fund

On 8 October 2008 the government announced its financial support package in the context of a commitment from the UK’s top 8 banks (Abbey National, HBOS, Royal Bank of Scotland, Barclays, Lloyds TSB, HSBC, Nationwide Building Society, Standard Chartered Bank) to increase their regulatory capital. Initial reports emphasised that for banks taking up funding from the state (from the Bank Recapitalisation Fund), investment was likely to be in the form of preferred shares which would not dilute existing shareholders equity.

It is now clear that the majority of the funding commitment to RBS and Lloyds/ HBOS is by way of subscription for ordinary shares; this may reflect the restrictions in GENPRU 2.2.29R which means that no more than 50% of tier one capital can be ‘non-core’ tier one (such as perpetual non-cumulative preference shares). The size of the ordinary share subscription is such that unless there is substantial take up by existing shareholders, RBS is likely to be state controlled with the government holding up to 60% of the voting rights. The government stake in Lloyds/ HBOS could reach about 45%. Each subscription will be structured as a placing and open offer underwritten by the Treasury; existing shareholders will be able to subscribe but there will be no opportunity to sell their rights as occurs on a rights issue. The transaction has to be conditional upon the bank’s existing shareholders passing a “white wash” resolution as required by the City Code on Takeovers and Mergers; this resolution is necessary so that the Treasury can acquire a controlling stake in excess of 30% without having to make a mandatory offer to buy all the shares of existing shareholders.

The government is also taking preference shares (presumably within the GENPRU limits) which will be non-cumulative and non-redeemable; they will carry a punitive 12% coupon. Once the banks can meet solvency ratios without the preference shares, they will wish to repay these as soon as possible.

HSBC rejected use of state investment; Barclays hopes to be able to raise capital from the market without relying on the bank reconstruction fund.

The planned fund raising will increase the tier one and core tier one ratios of the UK banks. FSA has explained that it has required the banks to stress test their solvency/capital position against a scenario of a major economic collapse; the improved ratios are intended to cover this unlikely possibility. It is assumed that the scenarios include provision for FSCS levies and the increasing exposure to compensation payments and FSCS borrowings (see below). Further details of the FSA’s longer term policy are awaited and may well depend on reforms at international and EU levels.

The recapitalisation fund is also open to other UK banks and to UK building societies but little has been published about the precise terms available. Capital for building societies would be in the form of permanent interest bearing shares (known as PIBS) which are a deferred share under the Building Societies (Deferred Shares) Order 1991 (as provided for in GENPRU 2.2.111R).

The 2008 Credit Guarantee Scheme

Those institutions which have committed to meet what government now considers to be an appropriate capital ratio are eligible for the 2008 Credit Guarantee Scheme. This includes the 8 banks mentioned above. The scheme is intended to improve inter-bank lending, particularly in the context of refinancing maturing wholesale funding. £250 billion of guaranteed debt is anticipated; the guarantee will be given directly by HM Treasury (and not by a state owned SPV as originally announced).
The scheme covers new Certificates of Deposit, Commercial Paper and senior unsecured bonds and notes; these may be stand-alone or issued off programmes, but only plain vanilla, non-complex instruments are eligible. Instruments may be for a term of up to 3 years and may be denominated in sterling, euros or dollars. Issuers must apply for the guarantee; it does not cover eligible instruments automatically. There is a fee to be paid by issuers for the guarantee; for sterling instruments the current fee is a per annum rate of 50 basis points plus 100% of the institution’s median 5 year CDS spread during the 12 months to 7 October 2008.

Materials can be found at the following links:

HM Treasury statement

Debt Management Office Announcement

Bank of England press release

Treasury statement on financial support to the banking industry

FSA statement

Implications of State Participation in the Banking Sector

The Government announced that it had obtained commitments from the banks supported by the recapitalisation scheme to:

• maintain the availability and active marketing of competitively-priced lending to home owners and to small businesses at 2007 levels for the next three years;
• support schemes to help people struggling with mortgage payments to stay in their homes, and to support the expansion of financial capability initiatives;
• controls on the remuneration of senior executives - both for 2008 (when the Government expects no cash bonuses to be paid to board members) and for remuneration policy going forward (where incentive schemes will be reviewed and linked to long term value creation, taking account of risk; and restricting the potential for rewards for failure);
• a right for the Government to agree with boards the appointment of new independent non-executive directors; and
• a dividend policy.

There is considerable speculation about the precise terms of these commitments (the full terms of which are set out in individual agreements with each bank which have not ben made public). It seems that dividends on ordinary shares cannot be paid until the preferred shares have been repaid (a restriction which the banks are reported to want to renegotiate) and that the specific commitments on remuneration relate to board members.

There are many implications of state public inspection which are yet to be appreciated or worked through. For example, the relationship between financial institutions and their directors, and the state bodies with their different roles as: regulator; economic shareholder protecting the tax payer investment; and government responding to consumer concerns on mortgage availability, the housing market and the credit crunch. There is clearly considerable scope for conflict and confusion here. The government has recognised this and announced that it will create a new arms length body to manage the government’s shareholdings in recapitalised institutions; this will act solely in the interests of the tax payer.

The European initiatives including the latest news on EU state aid rules for bank rescues and the clearance of the revised Irish guarantee scheme

Following the eurozone meeting in Paris at the weekend (attended by Gordon Brown), European governments have announced a variety of further measures including bank recapitalisation schemes and guarantees for bank deposits and debt. There is no single pan-European scheme but there is clearly much greater co-ordination than in previous weeks and many of the schemes seem to follow the UK model.

We pointed out the urgent need for state aid guidance in our previous Law-Now. The Commission has now issued a communication with further guidance on the application of the EU state aid rules. These are important because schemes and guarantees in breach of these rules are unenforceable.

When announcing the new state aid guidance, Commissioner Neelie Kroes referred favourably to the Danish scheme and to undertakings she had from the Irish minister in relation to the concerns about discrimination and a lack of limits and controls on the Irish guarantee scheme. Formal clearance of the revised Irish scheme was given last Sunday (12th October). Full details of the revised Irish scheme have now been published (yesterday evening); as previously announced it has been extended to include Irish subsidiaries of UK and Benelux banks (including subsidiaries of HBOS and Royal Bank of Scotland). (The scheme is not yet effective as it has to be approved by the Irish parliament and institutions will then need to enter into the guarantee agreement).

The EU publishes updated tables of national bank rescue measures and deposit guarantee schemes across the EU – the latest on 14 October.

To read the table please click here. To read the communication, please click here.

The Commission's Communication specifically covers guarantees (both guarantees of retail deposits and those covering more wholesale types of deposits), recapitalisations and other forms of liquidity assistance.

The Commission recognises that the level of seriousness of the current crisis means that, in state aid terminology, the conditions are in place for "a serious disturbance in the economy of a Member State". This is a general principle rarely involved which may be used only in really exceptional circumstances where the entire functioning of financial markets is jeopardised.

The main principles of the Commission's guidance are that any aid, be it a guarantee, recapitalisation or other liquidity measure, must be strictly limited to what is necessary in material scope and in time. This means that the measures must be:

• well targeted;
• proportionate to the challenge faced and not going beyond it;
• designed in such a way as to minimise negative spill-over effects;
• non-discriminatory– schemes should generally be open to all qualifying banks;
• subject to six monthly reviews;
• generally available for up to 2 years, or in certain circumstances, for the duration of the crisis; and
• restructuring plans must be submitted for intuitions which are given specific rescue and restructuring aid.