State intervention in the UK banking sector – round two

As expected, on Monday 19 January the Government announced a range of further measures and schemes to support the banking sector and to boost lending in the economy. (To read our Law Now on the bank recapitalisation scheme of last October please click here and to read our Law Now on the Banking Bill please click here.) Details are still awaited and parts of the proposals are subject to state aid approval from the European Commission. Briefly the measures are as follows:

State insurance for the banks’ “toxic assets”

The Government announced a new asset protection scheme under which the state will provide credit risk insurance to banks and building societies for certain assets (see below). This is directed to the banks’ existing portfolios.

This is an alternative to a transfer of “toxic assets” to a Government-backed “bad bank” or spin-off vehicle. It is hoped that this cap on potential losses will provide certainty for the banks and their investors, and avoid the need for more extensive state ownership through direct investment by the Government or outright nationalisation.

State Guarantee Scheme for new asset-backed securities

A new guarantee scheme for asset-backed securities – the Government is basing the scheme on the recommendations in Sir James Crosby’s Report on Mortgage Finance. The state will guarantee asset-backed securities including corporate and consumer debt, as well as mortgages (see below). These securities, if fully guaranteed, could have a credit rating equivalent to gilts, and it is hoped that this will make them sufficiently attractive to kick-start investment in new issues of asset-backed securities.

Extension of the existing state guarantee scheme for banks’ commercial paper and long-term liquidity

The existing Government Credit Guarantee Scheme (CGS) for the guarantee of commercial paper issues by banks and building societies will be extended (the drawdown window will end on 31 December 2009 rather than 9 April 2009). The Bank of England will extend its new Discount Window Facility to provide on-demand long-term liquidity after the Special Liquidity Scheme closes on 30 January 2009.

Quantitative Measures

Also announced is a new Bank of England asset purchase facility with a new fund of £50 billion, financed by Treasury bills, used to purchase high quality private sector assets in the secondary market (including paper issued under the CGS, corporate bonds, commercial paper, syndicated loans and some new asset-backed securities). This is partly designed to give the Monetary Policy Committee a tool to reduce borrowing costs (given the limited scope for using interest rate policy as interest rates approach 0%) and partly to boost liquidity in the relevant markets for these instruments. This is not a measure to support any specific individual companies or banks - companies will not apply to have their debt purchased by the Bank of England.

Boosting RBS’s Core Tier 1 Capital

An increase in the State’s ordinary shareholding in the Royal Bank of Scotland from 60% to 70% - achieved by the conversation of the preference shares issued in October last year. RBS announced potential record losses for 2008, together with further write-downs. To view HMT’s statement on this aspect of the measures, please click here.

In addition:

• A reversal of Northern Rock’s previous strategy of running down its mortgage book.
• A brief statement by FSA on bank capital requirements (see below).

Credit Insurance for banks and building societies – the asset protection scheme

HMT will provide protection against future credit losses on portfolios of defined assets. This insurance will be available to eligible institutions – initially UK incorporated banks and building societies (including UK subsidiaries of foreign institutions) with more than £25 billion of eligible assets (and may also be available to affiliated entities). It may be made available to other institutions later at the discretion of HMT.

The scheme, as opposed to the Guarantee Scheme detailed below, is targeted at those assets that are already on the banks’ books, whose future performance is uncertain. This will include:

• portfolios of certain commercial and residential property loans;
• structured credit assets including asset-backed securities;
• certain other corporate and leveraged loans; and
• related hedges.

Applicants will have to make full disclosure about eligible assets, which will be subject to investigation by HMT’s advisers.

Assets in the scheme will remain on the institution’s balance sheet but restrictions will apply to their management and disclosure standards will apply.

The proposals are designed to ensure eligible institutions retain an appropriate share of the risk of future credit losses. As a result, on any given portfolio eligible institutions will not be protected against a “first loss” amount and will also be responsible for a proportion (expected to approximately 10%) of any further losses; they will pay a fee for the protection in the form of alternative capital instruments (other than ordinary shares) that they will issue to HMT. It seems that the pricing will be designed as an incentive to the institution to meet the commitments it will be required to give to HMT to “support lending to creditworthy borrowers in a communal manner” and in relation to its remuneration policy and certain other matters. Compliance with these commitments will be independently audited. Banks will be able to cancel the protection subject to paying a termination fee.

There is little hard information available about the scheme and the government and its advisors may still be working on the mechanics of Monday’s proposals. It seems that protection may be offered for a term of between 5 and 10 years but there is no detail about:

• pricing mechanics or rates
• the extent of the loss coverage - it appears that the insurance will be at a portfolio level and may provide protection against remote or catastrophe-type losses
• how assets will be valued to distinguish insured future losses from losses already incurred
• restrictions on assets during the insurance period
• the scale and capacity of the scheme
• the basis on which coverage will be offered and the priority as between banks and assets (unless the scheme has unlimited capacity for all eligible assets)
• the time it will take to put protection in place for the first wave of banks (with eligible assets exceeding £25 billion) and then for other institutions

Some of these issues may not be entirely within the government’s control as the scheme requires state aid approval from the European Commission. The details of the proposed scheme will therefore have to be submitted for review by the Commission and will have to satisfy the criteria for approval and the Commission’s temporary framework for state aid measures to support access to finance in the current financial and economic crisis. (To view the Commission guidance on its approval of state aid measures under this framework, please click here).

It is anticipated that the UK government will not implement the schemes until the European Commission indicates that it finds them acceptable. One key issue may be the pricing of the insurance; the announcement refers to a price structure ‘ having regard to international practice’ but it is impossible to judge the extent of the ‘aid’ that may be involved. The Commission's guidance sets out various parameters for guarantees it will find acceptable

Further details will not be published before the last week of February. Meanwhile, it is extremely difficult for the market, individual banks and those scrutinising the proposal to evaluate the impact it will have.

Securitisation - Guarantee Scheme for asset-backed securities

In order to reinvigorate the market for asset-backed securities, the Government will provide a full or partial guarantee for those triple-A-rated securities issued by eligible parties wishing to make use of the guarantee. UK banks and building societies will be eligible to participate but the scheme conditions have not yet been published. They will be published by the DMO in time for the scheme to commence in April 2009. The scheme will require best practice on underwriting, disclosure, reporting and valuation and only transparent structures and high quality assets will be eligible.

In common with other measures announced by the government, the scheme requires state aid approval. Again, the extent of the ‘aid’ involved is unclear. However, the DMO has confirmed the guarantees will be awarded under auction conditions. The use of an auction process mean the proposals are more likely to be approved by the European Commission, provided that the criteria for participation in the auction are objective and do not exclude or discriminate in favour of British banks.

The scheme is based on the recommendation put forward by Sir James Crosby in his report on Mortgage Finance. The report noted that without intervention “mortgage lenders will have to live with little or no access to asset-backed funding through 2008 to 2010, together with having to cope with in excess of £160 billion of redemptions of existing [mortgage-backed securities] over the same period.” Sir James’ recommendations were focused solely on the UK mortgage-backed securities market. However, the scheme now proposed is wider as it will also include securities backed by corporate and consumer debt. Sir James identified a remote risk of default in the UK triple-A rated mortgage-backed securities, as opposed to their US counterparts, which, if true, reduces the potential exposure under the guarantees.

The scheme will create an alternative to the gilt market for bonds with a government-level credit rating, with the security of the debt being on a similar, if not equal, footing to the traditional Government investment vehicle. Interestingly, in making his proposals Sir James noted that his proposed guarantee scheme might have an effect on the market for Government gilts.

Regulatory approach to bank capital

The FSA also issued a statement on bank capital in which it confirmed its support for changes, in the longer term, to introduce, so called, ‘counter-cyclical’ measures. The debate in this area has focused on the potentially undesirable pro-cyclical effects of current rules which may encourage banks to lend in the good times but then, when the recession arrives and loan losses increase, the rules require the banks to restrict lending (unless they raise fresh capital). Attention has focused on the policy, introduced in 2000 by the Bank of Spain – known as the statistical provisioning - to address concerns that Spanish banks, when making loans in the benign environment of low-interest rates and a growing economy, were underestimating the losses they would eventually incur when the economy went into recession.

“Dynamic provisioning” which is now being considered in the context of Basel reform would mean that banks build a reserve in the good times to absorb losses in the bad. The current emphasis is on a general bad debt provision for debts which, although not identified as such individually, are already impaired. The changes may involve a reserve for expected losses on debts over the cycle. This would have various implications; most fundamentally it would change the accounting basis for bank income; reported income under this system would be lower in the good years and higher in the bad years - when compared to reporting under the current regime.

The FSA announcement addresses one narrow point of clarification in response to confusion about the FSA’s current requirements on regulatory capital for banks. It explains that the minimum core tier 1 capital ratio remains at 4%; the higher ratios, referred to at the time of the recapitalisation plan last October, took account of the additional capital required to meet potential future losses based on more rigorous stress testing for the economic downturn. The difference represents an additional cushion of capital, which is held at the start of the downturn; FSA confirms that this is expected to reduce as future losses are absorbed during the course of the recession; in theory, this additional cushion should ensure the 4% minimum capital is never breached but the cushion itself may be used up during the downturn. This means that a bank does not have to plan on the basis that it will have to maintain the increased capital levels throughout the downturn.

FSA has also announced some changes to their rules which are intended ‘to significantly reduce the requirement for additional capital resulting from the procyclical effect’.

This announcement comes at a time of intense debate about the financial regulation of banks, both in the UK and internationally. In a speech on 8 December 2008, the FSA’s Thomas Huertas was critical of the internal capital models which banks were permitted to use under Basel II. The FSA is currently conducting consultations on some aspects on financial regulation. For example:

Stress Testing – FSA CP08/24. The FSA is proposing more robust stress and scenario testing for a firm to determine its capital requirements.

Liquidity Requirements – FSA CP08/22. This is the FSA consultation on the implementation of international liquidity requirements, which were agreed in light of the economic downturn.