Treatment of toxic assets – European Commission publishes guidance

On 25 February 2009, the European Commission published a Communication on the Treatment of Impaired Assets in the Community Banking Sector, particularly considering how impaired assets will be regarded under state aid rules.

The impaired asset guidance:

• outlines various methods to deal with impaired assets (e.g. bad bank scenarios);
• explains the budgetary and regulatory implications of asset relief measures;
• details the application of the state aid rules to asset relief measures;
• explains the criteria used to evaluate state aid given to banks as a result of asset relief measures;
• provides methodologies for valuing impaired assets,
• considers the necessary state payments for the asset relief; and
• sets out the procedural steps required for approval of asset relief measures.

This guidance follows three earlier communications on state aid resulting from the financial crisis issued by the European Commission. Two of these were directly aimed at financial institutions:

• Application of the state aid rules to measure taken in relation to financial institutions in the context of the global financial crisis – published October 2008
• The recapitalisation of financial institutions in the current financial crisis: limitation of aid to the minimum necessary and safeguards against undue distortions of competition – published December 2008 and one was aimed at the real economy:
• Temporary framework for state aid measures to support access to finance in the current financial and economic crisis – published January 2009 - (allowing slightly higher amounts of aid to escape the state aid rules, promoting green products, loosening state aid control on subsidised interest rates, relaxing controls on risk capital to small and medium size enterprises).

The European Commission has been vocal about its own importance in addressing the financial crisis by ensuring state aid control avoid “beggar thy neighbour” national responses. The Commission’s various guidance documents are only guidance or “soft law” and have not been tested in the European Courts. It is all too clear that there are no simple solutions to these challenges. The European Commission has been responding to the crisis by developing guidance in real time.

The European Commission’s impaired asset guidance is based on a number of principles:

• appropriate identification of the problem and options for solution: full ex ante transparency and disclosure of impairments and an upfront assessment of eligible banks;
• coordinated approach to the identification of assets eligible for asset relief measures through development of eligible categories of assets;
• coordinated approach to valuation of assets ex ante, based on common principles such as valuation on basis of real economic value (rather than market value), implemented by independent experts and certified by bank supervisors;
• validation by the European Commission of asset valuations;
• burden-sharing of the costs related to impaired assets between the State, shareholders and creditors;
• adequate remuneration for the State;
• coverage of the losses incurred from the valuation of the assets at real-economic-value by the bank benefiting from the scheme;
• aligning incentives for banks to participate in asset relief with public policy objectives, through an enrolment window limited to six months during which the banks would be able to come forward with impaired assets;
• management of assets subject to relief so as to avoid conflicts of interests;
• appropriate restructuring including measures to remedy competition distortion, following a case by case assessment and taking into account the total aid received through recapitalisation, guarantees or asset relief, with a view to the long-term viability and normal functioning of the European banking industry.

The procedural aspects of the impaired asset guidance contain stringent notification requirements. Member States will be required to provide a restructuring plan or a viability review for each beneficiary institution within three months of its accession to the asset relief programme as a condition of gaining approval.

In addition, Member States must report to the Commission every six months on the functioning of the asset-relief programmes and on the development of the banks’ restructuring plans. Furthermore, for banks that have already benefited from other forms of state aid, be it under approved guarantee, asset swaps or recapitalisation schemes or individual measures, any assistance granted under the asset-relief scheme is to be reported first under existing reporting obligations.

Please click here for the European Commission’s press release on this guidance.