Rescue Packages and Policy Responses

Chapter 5
Rescue Packages and Policy Responses

Introduction

The GFC triggered an unprecedented response by governments all over the world. Not surprisingly, the countries most affected by the crisis, the United States and the member states of the European Union (EU), responded vigorously in their attempts to stabilize their financial systems and mitigate the effects of systemic risk. There remained a number of challenges for governments and policymakers to overcome in order to deal with the crisis effectively. First, there was the challenge of properly understanding and assessing the level of risk confronting the world’s financial markets. This would, in turn, require analysis of the underlying sources and triggers of the GFC.1

Second, regulatory authorities came to the realization that both conventional and non-traditional methods were required to provide an effective policy response to deal with the consequences of the GFC on the real economy. With economic activity declining at an alarming rate and the rate of unemployment rising in many industrialized countries, central banks adopted expansionary monetary policy by aggressively reducing their key interest rates. However, when interest rates had been reduced to near zero levels, other non-standard policy responses were implemented to further stimulate economic growth.

Third, governments all around the world realized that if they were to provide an effective response to the global crisis, international coordination and cooperation would be required. Without proper coordination and cooperation any proposed regulatory reform or policy response would enjoy limited success.

Finally, there was a need for regulatory authorities and governments to acknowledge the weaknesses and structural vulnerabilities that existed within their own regulatory and supervisory frameworks. The financial crisis had exposed significant gaps that existed between market practices and regulatory frameworks. The gaps were especially apparent with OTC derivatives markets and the shadow banking system, which operated in parallel with the more highly regulated mainstream banking system.

Some countries adopted a more proactive policy response, whilst other domestic regulatory authorities reacted to the crisis in a more measured and reactionary manner. Sometimes governments and regulatory authorities responded with international coordination and cooperation, often with either the United States or the European Union leading the way with policy responses and strategic direction. On other occasions regulatory authorities from each country would adopt unilateral actions designed to prevent any further fallout from the crisis.

The Emergency Economic Stabilization Act 2008 authorized the US Treasury to purchase billions of dollars of toxic mortgage-backed securities from US mortgage originators and investment banks.2 The main aim of the program was to ensure that the toxic assets would be effectively flushed out of the US financial system. TARP was designed to provide a safe harbour and protect the American economy, taxpayers and business from the financial fallout from toxic sub-prime mortgages and structured financial products.

The TARP Act provided the legal mandate for Treasury to make funding commitments to purchase troubled assets from any financial institution on terms and conditions directed by the Treasury Secretary.3 TARP also enacted a key recommendation of the Treasury Department discussion paper on financial markets reform,4 which recommended the creation of an Office of Financial Stability and Oversight.5

One of the main functions of the Office of Financial Stability will be to provide for proper oversight of the TARP funds to be expended by the Treasury Secretary for the purchase of toxic assets. Included as part of its oversight functions, the Office of Financial Stability will also be responsible for the appointment of financial agents, designing asset classes to be purchased under TARP and providing plans for the use of special purpose vehicles to purchase troubled assets.6 The Financial Stability Office will also be responsible for reporting any suspected fraud, misrepresentation or malfeasance to the Special Inspector General for TARP or the Attorney General of the United States.7

The TARP Act authorizes TARP funds to be used to purchase “troubled assets” from any “financial institution.” The term “troubled assets” is broadly defined to include any assets:

residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages that were issued or originated on or before 14 March 2008, the purpose of which the Secretary of the Treasury determines promotes financial market stability.8

Troubled assets can also include:

any other financial instrument that the Secretary [of the Treasury] after consultation with the Chairman of the Board of Governors of the Federal Reserve System determines the purchase of which is necessary to promote financial market stability.9

The term “financial institution” is also broadly defined to include:

any institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company, established and regulated under the laws of the United States.10

Mindful of the fact that taxpayer funds were being used to purchase toxic assets held by financial institutions, the TARP Act provided additional assistance to US homeowners. Under TARP, when acquiring residential mortgages, mortgage-backed securities and other assets secured by residential real estate, the Treasury Secretary needs to implement a plan which seeks to maximize the level of assistance that will be provided to homeowners.11 Assistance is to be provided in the form of encouraging mortgage providers to minimize foreclosures on family homes, and for the Secretary to use loan guarantees and other credit enhancements to facilitate loan modifications.

In addition, the Treasury Secretary should also where possible allow tenants who are residing in homes and who are not in default on their rent to continue to live in their home.12 Further assistance will also be provided to home borrowers “to reasonable requests for loss mitigation measures, including term extensions, rate reductions, principal write downs.”13

The assistance measures are designed to minimize foreclosures so that owners can remain in their homes. In the event of foreclosure, homeowners can receive additional support through other governmental agencies.14 Foreclosures have been a considerable problem in the United States because most home borrowers have non-recourse loans. This is a peculiar feature of US mortgages which typically have fixed rates of interest, are secured by way of collateral against the residence, and allow the borrower to walk away from any future loan obligations in the event of foreclosure.

Non-recourse loans expose mortgage originators to risk of loss in the event of loan default by the borrower. This is because the borrower with a non-recourse loan can walk away if the mortgage debt exceeds the aggregate value of the collateralized home. The lender has no recourse to make the borrower pay the shortfall. When this occurs, the loan is effectively “under water,” because the total value of the loan exceeds the value of the mortgaged asset. This situation is typically known as “negative equity,” as the remaining equity in the home falls below zero.

In the event of significant house price declines, the risk of loss following foreclosure will have effectively passed from the borrower to the lender. A direct consequence of the current crisis has been the millions of homes which have been foreclosed in the United States. This has led to the supply of available houses for sale to increase dramatically, which, in turn, has caused significant price declines, and exposed holders of mortgage securities to billion dollar losses.

The homeowner assistance afforded under TARP would have a second important aim, namely to minimize the rate of foreclosure in the United States. If successful, the homeowner assistance would place an effective floor on any further decline in prices for residential homes. By reducing the available stock of homes for sale, the expectation would be that there would be a more orderly sale of foreclosed homes, which would stabilize house prices and reduce loan losses.

In addition to providing homeowner assistance, the TARP Act also implemented reforms for the executive remuneration and corporate governance of financial institutions involved in the sale of troubled assets.15 When the US Treasury purchases equity or takes on the liability obligations of a financial institution which holds troubled assets, the Treasury Secretary shall “require that the financial institution meet appropriate standards of executive compensation and corporate governance.”16 The relevant standard that is required to be applied under the TARP Act continues for the entire duration that the Treasury holds investment in the financial institution, and includes the following criteria:

limits on compensation that exclude incentives for senior executive officers17 of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution; provision for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains or other criteria; prohibition on the financial institution making any golden parachute payment to its senior executive officer during the period that US Treasury holds an equity or debt position in the financial institution.18

The provisions relating to executive compensation serve an important public aim and are designed to ensure that senior executive officers do not receive disproportionate remuneration at the expense of the American taxpayer. Reconciling the use of public funds to shore up the stability of the US financial sector and not allowing Wall Street investment bankers to be enriched would always prove to be a difficult task. Both the Bush and Obama administrations had strong public support to prevent senior executives at failed financial institutions deriving significant personal returns at the expense of American taxpayers.

Under TARP, the Treasury Secretary is entitled to a graduated system of authorized payments to purchase troubled assets from American financial institutions. Section 115 provides that the Treasury Secretary can purchase troubled assets in three distinct tranches:

$US250 billion at any one time;19 $US350 billion at any one time provided the President of the US submits to the Congress written certification that the Treasury Secretary needs to exercise the authority under this provision;20 $US700 billion outstanding at any one time provided the President of the US provides Congress with a written report detailing the plan of the Treasury Secretary to exercise the authority under this section.21

Hence, TARP became known as the $US700 billion bail out fund, designed to be used to purchase toxic mortgage assets from financial institutions located in the US. The overall aim of the bailout package was to promote financial stability in the US financial sector as well as the overall US economy. However, the US government came under increasing pressure to provide assistance to main street businesses, unemployed workers and families who had become victims of the GFC.

US Automotive Industry

With this in mind, President Obama announced that he would provide assistance to the US automotive industry and, in particular, to Chrysler LLC in the United States and Chrysler Canada Inc.22 Both the US and Canadian governments would contribute $US10.5 billion in funding, including short-term and medium-term capital and debtor-in-possession financing to assist with the court-supervised restructuring of Chrysler LLC.

Out of the total $US10.5 billion in term funding, the United States would contribute $US8.08 billion, whilst the Canadian governments (including the Government of Canada and the Government of Ontario) would provide $US2.42 billion.23 The investment by both countries would see the United States government obtain 8% equity in the restructured Chrysler entity and the Canadian government would receive 2% in Chrysler. The funding arrangement for Chrysler was conditional on the US government receiving the authority to appoint four independent directors to the Chrysler board, with the Government of Ontario having the authority to appoint one independent director.

In addition to the financial assistance provided by both governments, the US government would also be active in arranging for another international car company, namely FIAT, to partner an arrangement to restructure Chrysler and save thousands of jobs. Under the arrangement Fiat would contribute a free licence permitting all of its intellectual property to be utilized with Chrysler in exchange for 20% of the equity in the restructured Chrysler entity. Fiat would also have the right to appoint three additional directors to the reconstituted Chrysler board. Fiat would also obtain an additional 15% in the equity of Chrysler in three installments of 5% each in exchange for satisfying key performance indicators, including: the introduction of a new vehicle to be produced at the Chrysler plant in the US; the provision of a distribution network for Chrysler in numerous foreign jurisdictions; and the manufacture of state-of-the-art, next-generation engines at a US Chrysler factory.24

As was reported by the Obama Administration press statement, the new Chrysler entity would also establish an independent trust that would provide health care benefits for Chrysler’s retired workers.25 To pay for these benefits, the trust would be funded by issuing notes of up to $US4.6 billion payable over approximately 13 years with a 9% rate of interest. In return, the trust would receive 55% equity in the new Chrysler and would have the right to appoint one independent director to the new restructured board.26

US Monetary Policy

US monetary policy became a key instrument for the US Federal Reserve to use to respond to the GFC. However, some had argued that monetary policy had become a blunt policy instrument that would be incapable of providing an effective and measured policy response to the unfolding crisis. Even the Chairman of the US Federal Reserve, Ben Bernanke, commented that the crisis was “so complex that its lessons are many, and they are not always straightforward […]. As with regulatory policy, we must discern the lessons of the crisis for monetary policy. However, the nature of those lessons is controversial. Some observers have assigned monetary policy a central role in the crisis.”27

Despite these uncertainties, monetary policy became the main regulatory policy relied upon by authorities throughout the crisis. From as early as August 2007, the Federal Reserve had noted that financial market conditions had deteriorated, credit conditions from short-term money markets had tightened and increased uncertainty existed about global economic growth.28

The first reduction in the US federal funds rate occurred in September 2007, when the Federal Open Market Committee (FOMC) decided to lower its target for the federal funds rate by 50 basis points to 4.75%. According to the FOMC, economic growth had been moderate over the first half of 2007, but the tighter credit conditions that existed, particularly in short-term money markets, had the “potential to intensify the housing correction, and to restrain economic growth more generally.”29

The federal funds rate was again reduced in October 2007, this time by 25 basis points to 4.5%. According to the Committee, although economic growth was solid in the third quarter of 2007, and strains had eased in financial markets, “the pace of economic expansion [would] likely slow in the near term.”30 In December 2007 the FOMC lowered its federal funds rate by another 25 basis points to 4.25%. The reduction in the key federal funds rate was recommended on the basis of continuing slowdown in economic growth and further intensification of the housing correction. Further strains in financial markets had also occurred, with evidence of tighter credit conditions being played out in short-term money markets.

In January 2008, the US economic outlook weakened further, with appreciable downside risks to overall economic activity. Although short-term money market conditions had improved slightly, the broader financial market outlook had deteriorated. Given the ongoing weakness, the Federal Reserve lowered its target federal funds rate by 75 basis points to 3.5%.31 This was a significant reduction by the Federal Reserve. The size of the cut in the key federal fund rate indicated that the US economy had slowed dramatically and was headed for a considerable slowdown.

The concern for a sizeable downturn in the US economy was further reflected by the Federal Reserve, which again lowered the federal fund rate by another 50 basis points to 3% in the month of January 2008. According to the FOMC:

[f]inancial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening of labor markets.32

Unfortunately, the reductions in the key federal fund rate proved to be insufficient on their own to stabilize US financial markets. The markets remained under stress and liquidity pressures continued to build in funding markets. In order to improve liquidity in financial markets, the Federal Reserve with other central banks, including the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan and the Swiss National Bank, announced measures to provide term funding of up to $US200 billion to financial intermediaries.33

Lending through the Fed’s balance sheet is a non-conventional monetary policy response. It was designed to provide additional liquidity to US financial markets, which had been experiencing tighter credit conditions. The Fed’s term lending strategy was aimed at overcoming the liquidity crisis in the US banking sector and fostering a more orderly functioning of financial markets. Under the additional lending package announced by the FOMC, the Fed would lend up to $US200 billion of Treasury securities to primary dealers in financial markets for a term of up to 28 days. Further, the Fed would also provide pledges for other securities, including federal agency debt, federal agency residential mortgage-backed securities and non-agency AAA/Aaa-rated private residential mortgage-backed securities.34

In addition to increasing domestic lending through the Fed’s balance sheet, the FOMC authorized further increases in its existing temporary swap lines with other central banks, including the European Central Bank (ECB) and the Swiss National Bank. These arrangements would provide additional funding to both the ECB and the Swiss National Bank, which are designed to increase liquidity in European financial markets.35 The Federal Reserve then announced further aggressive cuts to the federal funds rate in March 2008. By the beginning of April the Fed would lower its key interest rate by another 75 basis points to 2.25%.36

The Fed was now committed to utilizing its full array of policy options to respond to the crisis in US financial markets along with the emerging downturn in the US economy. The Fed’s policy response would now include a combination of both conventional and non-traditional methods to deal with the crisis. The Fed’s conventional response would be to continue to aggressively cut its federal funds rate to the point that the key rate would be reduced to a range between 0% and 0.25%. The Fed would also deploy non-standard measures, including quantitative easing, in the form of lending from the Fed’s balance sheet.

Following the collapse of Lehman Brothers and the continuing liquidity shortages in credit and money markets, the Fed implemented a quantitative easing program designed to stabilize US financial markets. In March 2009, the Fed announced that it would purchase an additional $US750 billion in toxic mortgage-backed securities, which would bring the total purchases of these toxic assets to $US1.25 trillion. The Fed would also purchase up to $US300 billion in longer-term Treasury securities, and up to $US200 billion of agency debt by the end of 2009.37

By September 2009, the US Federal Reserve received indications that economic activity had slightly improved following the severe downturn experienced in late 2007 and throughout 2008 and early 2009. There were signs that household consumption appeared to be stabilizing and activity in the housing sector had improved from its low base earlier in the year.38 Although the policy responses by the Federal Reserve appeared to have their anticipated effect in providing much-needed liquidity, job growth remained sluggish and the unemployment rate would continue to climb, to be almost 10% by 2010.39

The Federal Reserve acknowledged the weakness in the recovery of the US economy, as well as the continued high levels of unemployment. The situation was about to take a dramatic turn for the worse when, at the time the economic recovery was appearing to take hold and financial markets had been emerging from their crisis, uncertainty and volatility began to intensify in European currency and financial markets.

In response to the unfolding crisis in confidence in the Euro, along with the US dollar, the Fed announced that it would recommence its swap lending facilities with other central banks around the world. The Fed re-established its temporary US dollar swap facilities with the Bank of Canada, the Bank of England, the ECB and the Swiss National Bank.40 The Fed’s temporary swap lines that were coordinated with other central banks were designed to provide much-needed liquidity in US and international financial markets. By improving liquidity the Fed hoped its actions would help prevent the spread of systemic and contagion risk to international financial markets.41

Despite these proactive policy responses, the pace of recovery in economic activity, growth and employment remained subdued. With ongoing market volatility evident in European financial markets and the euro, there was heightened concern that the recovery in the international economy would be adversely affected. With the volatile market conditions persisting, the US Federal Reserve decided to keep its federal funds rate between the range of 0% and 0.25%, and engage in a new round of quantitative easing.

In November 2010, the Fed announced that it would purchase a further $US600 billion of longer-term Treasury securities by the first half of 2011.42 This would equate to approximately $US75 billion per month. The additional asset purchases undertaken by the Fed were designed to inject additional liquidity into the US financial system. By improving liquidity credit and lending, markets would begin to stabilize, which, in turn, would encourage lending to businesses and individuals.

The policy responses provided by the Federal Reserve through its expansionary monetary policy agenda had provided much-needed stability to US financial markets. By utilizing both conventional and non-traditional methods, the Fed had been proactive in its policy response and determination to alleviate stress in financial markets and to stimulate economic activity. The expansionary policy response by the Fed had been supported by financial markets and promoted by the US government. The level of support for expansionary monetary policy was to be contrasted with US fiscal policy, which continues to be controversial and subject to much scrutiny and ongoing debate.

US Fiscal Policy

The severe economic recession that followed on from the GFC led to a significant deterioration in the United States’ fiscal position. The US, like other countries, had suffered a considerable decline in its collection of tax revenues as a result of higher levels of unemployment and declining profitability from the corporate sector. In many ways the US budgetary position had responded appropriately, given the economic recession the country had been experiencing. When an economy experiences a slowdown, tax collections fall and welfare payments rise. The budget goes into deficit and becomes “automatically” expansionary. The expansionary nature of a fiscal deficit is designed to stimulate economic activity by increasing consumer demand for goods and services.

However, there is also a downside with a fiscal deficit, particularly if it is large and ongoing. In 2010, and 2011, the fiscal position of the United States government deteriorated significantly. According to the Congressional Budget Office (CBO), unless the US government takes active steps to reduce the federal fiscal deficit, the deficit will increase considerably. According to the CBO the federal debt in the United States at the end of 2010 would stand at 62% of GDP,43 a significant rise from 2007, when the federal debt stood at 36% of GDP.44

The rise of the federal fiscal deficit in the United States represents a considerable challenge in US government policy. According to CBO, the rise in the deficit was directly attributable to the GFC. This is because the GFC led to a deep and protracted global recession. The fiscal deficit was also larger due to the expansionary policy responses adopted by Treasury and the US government to deal with the crisis.45 The size of the current fiscal deficit in the US is also important for another reason. It is the first time since World War II that the US sovereign debt has exceeded 50%. Moreover, CBO has projected the federal debt to rise considerably in the United States over the following two decades. Under current US law the federal debt is expected to rise to be approximately 80% of GDP by 2035.

However, if the proposed changes to US tax laws (including indexation) and Medicare payments are made, then the US federal debt is expected to be nearly 90% of GDP by 2020, 110% by 2025 and a mammoth 180% by 2035.46 The CBO estimates that if there is no change in tax revenue collections or government expenditure, by 2035 the rise in the fiscal deficit and associated government debt would “pose a clear threat of a fiscal crisis during the next two decades.”47

Policymakers in the United States now face the daunting challenge of dealing with the high levels of unemployment caused by the Great Recession and the GFC, and the unintended consequence of a potential new crisis flowing from a ballooning fiscal deficit. The CBO has warned that the federal budget deficit in the United States has the potential of creating further uncertainty for financial markets and investors, leading to further destabilization of the US economy. This has happened in other countries that have experienced fiscal crises; these have often made recessions much worse than otherwise would have been the case.48

The potential for a new crisis to emerge, this time from an uncontrollable fiscal deficit in the United States, will inevitably limit the effectiveness of budgetary policy as a policy response to the GFC. With limitations on an effective expansionary fiscal policy, the US government is restricted on what actions it can take to deal with a crisis. However, a more disturbing consequence that could emerge from the fiscal deficit might be if the US government were to prematurely respond to lowering the deficit; the fragile recovery in the United States might stall as fiscal stimulus measures were wound back.

Expectations of large and increasing deficits in the future could inhibit current household and business spending – for example, by reducing confidence in the longer-term prospects for the economy or by increasing uncertainty about future tax burdens and government spending – and thus restrain recovery. Concerns about the government’s long-run fiscal position may also constrain the flexibility of fiscal policy to respond to current economic conditions.49

According to both Bernanke and the CBO, unrestrained fiscal spending and/or declining tax revenues have resulted in an ever-increasing fiscal deficit that is unsustainable.50 Both acknowledge the need for proper rules, along with careful consideration of the options that are available to return the federal budget to a position of fiscal sustainability.51

Moreover, any attempt to make fiscal adjustments designed to improve the underlying structural components of the fiscal deficit will mean that international consequences have to be taken into account. This is because if the United States were to act too aggressively in its pursuit of deficit reduction it may thwart any recovery in the international economy. The opposite is also true, namely, if the United States were to do nothing to address the issue of fiscal sustainability in the longer term, a new crisis could emerge which would undermine financial stability and long-run economic growth in both the United States and the international economy.52

The European Union

The EU Commission issued a communication entitled “The application of State aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis,” commonly called the “Banking Communication.”53 The EU issued the communication on 13 October 2008 following the collapse of Lehman Brothers in the United States. The Banking Communication was designed to bring stability to European financial markets, as well as the banking sector. By releasing the communication, the Commission implicitly recognized the importance of providing an effective policy response to the emerging crisis, which had “intensified markedly and now impacted heavily on the EU banking sector.”54

According to the Commission the problems confronting financial markets in the United States had led to an erosion of investor confidence in the EU banking sector.55 Investor uncertainty concerning the credit risk and financial viability of financial institutions, which included banks, building societies and credit unions, led to a crisis unfolding in interbank lending, which in turn led to liquidity shortages as lending and credit dried up in financial markets.

The Commission had also been acutely aware that interconnected financial markets increased the risk that a failure of a major financial institution would have systemic ramifications for European banks and financial markets.56 The Commission felt it necessary to provide a determination regarding the use of state aid for member states to adopt and follow so that the measures “do not generate unnecessary distortions of competitions between financial institutions operating in the market or negative spillover effects on other Member States.”57

Hence, the central purpose of the Banking Communication was to provide guidance for the development of depositor guarantee schemes for financial institutions, including banks, in each member state of the EU. To avoid any significant distortion of competition, the eligibility criteria for the depositor guarantee were to be objective, transparent, well targeted, proportionate to the challenge faced, and designed to minimize negative spillover.58

Under the Banking Communication, member states could provide retail deposit guarantees for their banks and financial institutions.59 The retail deposit guarantees would give depositors additional security for customer deposits with EU banks. According to the Commission, the retail deposit guarantee would represent a “legitimate component of the public policy response.”60

The Banking Communication also allowed member states to provide wholesale guarantees for their banks and financial institutions, provided these guarantees were targeted, practical and necessary to overcome the adverse effects of the financial crisis.61 Provision for a wholesale guarantee was justified on the basis that the interbank lending market had dried up and there had been a systemic erosion of confidence among financial institutions. However, such guarantees were not to be extended to cover subordinate debt or any other associated liability, as this would provide protection to shareholders and other risk capital investors.62

In late 2008, EU member states began implementing guarantee schemes for their respective banks and financial institutions. The EU allowed its member states to increase its retail depositor guarantee from €20,000 to €50,000 initially and then up to €100,000.63 The increase in the retail deposit guarantee by the EU would reduce the risk of bank runs, since the EU would guarantee retail deposits of up to €100,000. The guarantee and would also be extended to cover the European Economic Area (EEA) member states, Norway, Iceland and Liechtenstein.64

Some member states such as Ireland went further then the EU mandate, providing an unlimited guarantee for retail depositors in Irish banks. The unlimited guarantee was designed to promote stability in Ireland’s banks and financial institutions and to overcome the risk of runs. During 2008 and 2009 there had been a significant decline in investor confidence in Irish banks and a mounting uncertainty that had been driven largely by Ireland’s mounting fiscal deficit and sovereign debt.

During 2010 funding and access in the interbank markets in Europe improved as a result of the wholesale guarantees provided by the member states. The improvement in wholesale funding in Europe’s financial, bond and money markets led to discussion that the wholesale guarantee should be gradually wound back.

On 2 December 2009, the European Competition and Finance Council (ECOFIN) concluded that a strategy should be designed and implemented for a gradual phasing out of the wholesale guarantee. The conclusion arrived at by ECOFIN was endorsed by the European Council on 11 December 2009. The European Parliament further resolved on 9 March 2010 that member states should not provide support or assistance indefinitely in the form of wholesale guarantees to its banks and financial institutions.65 The EU Competition Working Group concluded:

As a consequence of the general improvement in market conditions, the risks for financial stability at large have subsided, and the distortions of competition between those banks that issue guaranteed bonds but are not currently under restructuring obligations and those that issue strictly under market conditions has become greater.66

The proposed gradual phasing out of the wholesale guarantee by member states was also consistent with the overall improvement in market conditions. Market data collected by the EU Competition Working Group in 2010 demonstrated that the use of government guarantees by banks in the member states had declined since the peak of 2009. The improved market conditions in bond, credit and interbank lending markets led to a decline in the reliance of financial institutions on wholesale guarantees issued by the member states, since there had been improvements in both the pricing and availability of bonds.

Governments commit themselves to provide capital when needed in appropriate volume while favouring by all available means the raising of private capital. Financial institutions should be obliged to accept additional restrictions, notably to preclude possible abuse of such arrangements at the expense of non beneficiaries, and legitimate interest of competitors must be protected, in particular through the State aid rules.67

The Recapitalization Communication served to provide a number of common objectives, including: restoring financial stability, ensuring lending to the real economy is maintained and ensuring that any systemic risk is effectively dealt with in the event of a major bank insolvency.68 The Communication provided guidelines for the recapitalization of banks which may require additional capital if they encounter difficulties with sourcing funding requirements from bond markets and from interbank lending.

According to the Communication, member states are not allowed to provide an unfair competitive advantage to any banks to which a state may provide assistance relative to other competitor banks from other member states.69 Hence, member states would not be permitted to use state aid under the guise of recapitalization to achieve an unfair advantage, nor would they be permitted to use recapitalization to distort competition in the banking sector.70

The Communication recognizes that in any recapitalization of banks, a balance needs to be struck between potential competition concerns and the objectives of restoring financial stability with European Banks.71 Hence, the Communication provides that in the event that a member state is required to provide state aid to a bank or a financial institution, it needs to properly assess any state intervention. Accordingly, the intervention should be both proportionate and temporary and “should be designed in a way that provides incentives for banks to redeem the State as soon as market circumstances permit, in order for a competitive and efficient European banking sector to emerge from the crisis.”72

The EU Treatment of Impaired Assets Communication

In February 2009, the EU Commission issued a further communication on the treatment of impaired assets in the community banking sector.73 The Communication was designed to provide specific guidance on the application of state aid rules for impaired assets relief. The new Communication would provide guidance on the following issues:

1. Transparency and disclosure requirements.

2. Burden-sharing between all relevant stakeholders, including the state, shareholders and creditors.

3. Aligning incentives for beneficiaries with public policy objectives.

4. Principles for designing asset relief measures in terms of eligibility, valuation and management of impaired assets.

5. The relationship between asset relief, other government support measures and the restructuring of banks.74

The EU considered that impaired assets which belonged to financial institutions were a key problem in the banking industry. Considerable uncertainty had been generated because of the valuations attached to impaired assets, including confusion over the precise location of impaired assets within European banks. The uncertainty, in turn, had continued to undermine confidence in the banking sector and had weakened government efforts to promote stability within European financial markets.75

Although European banks had recorded significant write-downs of their impaired asset holdings, the problem of toxic assets was still generating considerable uncertainty for investors in European financial markets. According to the IMF and data complied by the EU, there had been a total of over $US1 trillion in write-downs involving toxic assets by banks. Of this, over 70% of the write-downs related to US-based banks and approximately 30% or $US300 billion involved asset write-downs by European banks.76 The IMF estimated that total write-downs for toxic assets worldwide would be in excess of $US2.2 trillion.77 The estimate by the IMF was based on total worldwide holdings of mortgage-backed securities and securitized structural financial products.

The EU acknowledged that the type and size of any response by member states to purchasing toxic assets from their respective banks and financial institutions would necessarily involve budgetary considerations. The likely asset relief program would invariably involve billions of dollars and require governments and taxpayers in member states to effectively foot the bill and finance the purchase of impaired assets.

The EU Communication on impaired assets provides a set of guidelines for member states to follow when providing state aid involving the purchase of toxic assets from European banks. According to the EU communication, any asset relief buy-back program should be subject to full and independent transparency and disclose the amount of impaired assets that would be purchased by the member state as part of the impaired asset buy-back.78 The application of state aid should also follow a full review of the bank’s trading activities and balance sheet. The purpose of the review is to assess the bank’s capital adequacy and working capital capabilities, and to provide an indication of whether the bank is a going concern.79

The EU communications on banking, recapitalization and impaired assets provided a coordinated response to the global crisis confronting European financial markets and financial institutions. Member states made use of the guidance and permissions contained in the communications to seek approval from the Commission on the provision of state aid to distressed financial institutions and banks. It was not uncommon through 2008, 2009 and 2010 for member states to intervene and provide state assistance to financial institutions, banks and bank depositor schemes in order to promote stability and confidence to investors and other market participants.80 The EU Commission has also given member states formal approval to provide assistance to specific financial institutions that have been experiencing financial and liquidity constraints. In some instances the EU Commission was required to provide approval for government intervention with the liquidation process of distressed financial institutions.81

EU Monetary Policy

On 10 January 2008 the ECB carried out term auctions for a total of $US30 billion with terms of maturity of 28 days.82 This was followed by further terms auctions of US dollar denominated bonds in July 2008, when up to $US50 billion of term auctions took place, with maturities of 28 days and 84 days.83 The term auction facilities were further supplemented by coordinated reciprocal swap currency arrangements between the US Federal Reserve, the Bank of England, the Swiss National Bank and the Bank of Canada.84

In response to the collapse of Lehman Brothers and to the heightened risk confronting European financial markets, the ECB undertook further measures designed to boost liquidity in short-term money markets. On 29 September 2008, the Federal Open Market Committee of the Federal Reserve of the United States and the ECB decided to double their temporary reciprocal currency swap arrangements from $US120 billion to $US240 billion.

In addition to this arrangement, central banks from other countries, including the Bank of Canada, the Bank of England, the Bank of Japan, the National Bank of Denmark, the Swiss National Bank, the Reserve Bank of Australia and the National Bank of Norway, also entered into reciprocal currency swap arrangements with the US Federal Reserve.85 The coordinated measures by the ECB and other international central banks were designed to improve liquidity and funding to financial institutions, which were beginning to face serious financial difficulties and access to European and US financial markets.86

Despite the policy responses and measures undertaken by the ECB, the Central Bank reported that in December 2008 significant risks and vulnerabilities remained in European financial markets. The ECB in a press release stated:

Following the bankruptcy of Lehman Brothers, the persistent liquidity stresses eventually gave way to deeper concerns about the creditworthiness of even the largest financial institutions and the adequacy of capital buffers.87

According to the ECB, the situation confronting European financial markets was to improve by the end of 2009. In a press release issued in December 2009, the ECB reported that the extraordinary actions undertaken by European authorities including the policy response measures adopted by other central banks and governments had been successful in restoring confidence to fragile financial markets.88

The policy responses had not only improved underlying investor confidence in European financial markets but, importantly, also reduced the risk of contagion spreading further to cause damage to the real economy. Expansionary macroeconomic policies in the form of lowering key interest rates, as well as quantitative easing measures designed to boost liquidity in short-term money markets, also proved successful in promoting economic activity and stimulating economic growth.

The EU Sovereign Debt Crisis

Although the policy measures adopted by European authorities helped to stabilize financial markets, new concerns were soon to arise in the form of sovereign debt crisis for a number of European nations. The first signs to emerge from the new crisis were in May 2010, when the ECB reported:

Outside the financial system, the progressive intensification of market concerns about sovereign credit risk among the industrialized economies in the early months of 2010 opened up a number of hazardous contagion channels and adverse feed back loops between financial systems and public finances, in particular the euro area.89

The ongoing sovereign debt crisis was to take a turn for the worse when investors began to lose confidence in Greece’s ability to repay its sovereign debt. In 2008 Greece’s public debt was among the highest in the world and stood at approximately 110% of GDP.90 As the GFC took hold to undermine investor confidence in debt-laden firms and financial institutions, investors began to turn their attention to the state of the public finances.

To compensate for the heightened level of risk associated with Greece’s sovereign debt, investors demanded higher yields on Greece’s government bonds. As the US Congressional Budget Office reported, by 2010 Greece was paying over 4% more in interest on 10-year government bonds compared with Germany.91

Greece’s plight was to worsen during 2010, as investors continued to push up yields on Greece’s 10-year bonds. Yields on Greece’s credit default swaps also continued to widen as investors demanded higher returns from the elevated risk of default. Credit default swaps on Greek government bonds continued to rise to an all-time high, signalling the loss of confidence by investors and bondholders in Greece’s ability to combat its fiscal crisis.