SUGGESTIONS FOR THE RESOLUTION OF EU BANK RECAPITALISATION
The European Union (EU) has been in existence in one form or another from its original concept for 50 years. The purpose of bringing together European countries has always been to prevent the endless wars that have plagued the continent for thousands of years.
It was perceived as impossible to create a federal union such as the USA at the beginning and therefore starting with trade cooperation initially and evolve from there was the best way forward. That is what has been happening up to the current time and nearly all European countries have decided that it is in their best interests to be part of the EU.
Most would agree that the original concept has achieved its purpose and would like the EU to continue to exist even if the exact format is difficult to predict at this time. All would probably agree that continuing with the trade cooperation and allowing this to evolve further is important.
It wasn’t until the financial crisis occurred that people started to look more closely at what is happening in the EU and where it was heading. We won’t go into the reasons for the crisis here since it has been discussed by everyone in depth by now. However, the consequences of it are substantially overvalued assets held by banks and massive deficits in the EU sovereign budgets and in most developed countries around the world.
Formulating an economic growth plan would help enormously to ensure that any bank recapitalisation will succeed. It is vital that business leaders have a clear idea of the plans that the EU has for Europe and how they will be implemented and activated. One of the main reasons for the slow pace of investment is the lack of direction by the EU commission and the larger countries in the union which encourages senior management to divert and concentrate their expansion plans elsewhere, usually in the emerging markets.
In these countries, the economic development plans are constantly updated and usually set out a clear path for government and the rate of growth they wish to achieve. A close working relationship with business creates the environment of cooperation combining infrastructure improvement and capital investment by companies to accomplish the ambitions they have set themselves.
In many cases those businesses are not local but they are willing to invest in conjunction with governments because they can see the market potential. The creation of new businesses employs people in that country and usually the profits are reinvested there because of the growth prospects.
Everyone has a good commercial reason to participate and encourage the plans to be realised. The results have been phenomenally successful in many of these countries to the extent that they are now the driving force for the majority of the economic expansion we see around the world.
The quicker these countries grow the more people are brought into the economic experience and start to contribute to the tax revenue base allowing the social and cultural heritage to become something for all the people to be proud of and feel they are really participating.
In the developed world everything is the other way around. There is a rich cultural heritage and everyone is involved one way or another in the economy of their country. However, there is a lack of economic growth mainly, in my view, because of a lack of direction and investment by business to expand into new areas that will supply the EU and the emerging markets. Admittedly, the financial crisis was the main cause of the current recession but the lack of growth has been a problem for many developed countries for some time now. If that problem is corrected and an EU economic plan is put forward together with the recapitalisation plan in this proposal, it is my belief that it would be a big stimulus to drive forward growth.
A SHORT HISTORY OF THE BANKING CRISIS
Most banks hold property as collateral against the loans they have made. There are no accurate figures that reveal the shortfall in the value of this collateral; the estimates are so large that governments have to be involved with the solution to return the banks back to financial health.
Fortunately, interest rates are at a record low which makes the problem less urgent because in many cases the borrowers can just afford to make the repayments on the loans. If they cannot, the repayment period and the interest rates are adjusted to meet what they can afford. Therefore you have performing loans but with collateral that is below the value of the loan. In normal times, the banks would take the loss and charge it against the profit and loss account when the borrowers could not make the interest due and repayments. The level of adjustments compared to the actual loss is unknown and if interest rates rise, write downs would have to occur.
The reason the banks cannot do this now is that the write down in value they would have to accept would completely wipe out all capital they hold, technically making them insolvent. In that situation they would not be able to operate as banks and funding for anything would disappear closing down the EU economy; that is why, at the moment, making the banks value their assets at market value has been relaxed.
This has left the situation in abeyance with the politicians hoping that a gradual increase in capital and growth will solve the problem soon. In the meantime, bank funding is difficult to obtain restricting the vital working capital finance that businesses need to grow. The European economies have little chance of recovering while this impasse is left unresolved.
In the USA, the Treasury Department in 2009 insisted that all the major banks valued their assets properly and either they recapitalised themselves via the stock market or the government via one of their agencies providing the capital to put them on a secure footing. Most of the banks have now repaid that capital injection taken via government agencies by raising capital in the markets when conditions improved or from profits.
The Federal Reserve (The Central Bank) now has a regular assessment procedure to check on the viability of all banks to withstand a deep recession which has recently shown that Goldman Sachs and Morgan Stanley were just above the minimum required in capital reserves, surprising many people in the financial community. This is mainly because they are both big market makers in equities and bonds that require a substantial trading book to function properly which requires more capital than it used prior to the crisis. In a deep recession this clearly has a big impact on capital reserves when prices fall quickly.
All the large privately owned American banks are now well capitalised and pass the Federal Reserve’s assessment procedure. We have here a good example of how you recapitalise banks but it does mean allowing the budget deficit and the Federal Reserve’s balance sheet to increase which the American government decided was necessary to give growth a chance to recover, which has happened although not at the pace they would like. That is mainly because Europe, its largest trading partner, is still in recession.
The individual European countries within the euro zone have agreed in a treaty to limit budget deficits to 3% of GDP and therefore they are not allowed to increase their budget deficits substantially to recapitalise their banks. They cannot independently increase the balance sheet of their own central banks like the Federal Reserve because the European Central Bank (ECB) has taken over that function. So, in effect, they have both hands tied behind their backs unable to copy the American example.
Because of these restrictions imposed on Euro zone countries, the ECB has provided banks with a Long Term Refinancing Operation (LTRO); the latest issue in February 2012 was for 3 years which has stabilised bank liquidity.
ECB rules specifically forbid budget deficit funding; the EU has only recently established the European Stability Mechanism (ESM) to fulfil that role which imposes very strict structural reforms and conditions. While this was being set up, the ECB announced it would purchase government debt if the markets reacted against the interests of any Euro zone country subject to a prior application to the ESM. The president of the ECB made clear that the it would do ‘whatever it takes’ to stabilise bond markets which instantaneously settled markets although this program, referred to as Outright Monetary Transactions (OMT), has not been utilised by any country.
Cyprus is the only country to officially apply to the ESM so far. The two previous bail-outs for Ireland and Portugal were funded by the European Financial Stability Facility (EFSF), which is in the process of being merged with the ESM.
Those EU countries outside the euro zone do have the capacity to act similarly to the Americans but they are very susceptible to the influence of the markets forcing them to be cautious. Even though these countries are outside the Euro zone, the markets feel they are heavily influenced by those inside it and tend to be grouped together; this means that until a resolution of the Euro zone problem itself is implemented, all European countries will have difficulties growing their economies.
To summarise where we are now, the real difference between the USA and Europe is the willingness of the Americans to use fiscal and monetary policies to grow their economy. The Europeans have been forced to reduce government spending and not use monetary methods mainly because of the rules set out in the EU treaty as explained above.
If you would like to learn more about the decision process, there is a very good easy to understand press release in a ‘frequently asked questions’ format in the link below;
WHERE WE ARE NOW
The EU has prepared a plan to recapitalise the banks which is going through the European Parliament process right now before it can become official.
The following is taken from the European Parliament press release for EU bank capital. If you wish to read the whole press release the link below will take you there.
I have selected the relevant sections for this discussion which are copied below:-
The EU Capital Requirements Regulation (CRR) and Directive (CRD) aim to stabilise and strengthen the banking system by making banks set aside more and higher quality capital as a cushion against crises. The new rules should also foster a convergence of supervisory practices across the EU. Banks that are better able to withstand future crises should be more capable of financing investment and growth.
The new legislation consists of two instruments governing capital requirements for investment firms and credit institutions, including banks.
The Capital Requirements Regulation, a new instrument added during the current revision of the existing Capital Requirements Directive, lays down prudential requirements for capital, liquidity and the credit risk for investment firms and credit institutions in EU member states.
As a regulation, the CRR applies directly in every member state. It can therefore impose a single set of rules across the EU, thus leaving no scope for arbitrary interpretation and ensuring certainty as to the law for all EU single market players.
The directive, by contrast, will have to be incorporated into the national laws of the member states. The rules on bankers’ remuneration and bonuses, prudential supervision, corporate governance and capital buffers will remain the responsibility of the member states’ national competent authorities.
The CRR and the CRD will increase the capital requirements for all banks. The liquidity conditions have been set out as follows:-
The latest financial crisis revealed that banks were holding insufficient liquid assets. The CRR will require them to constitute “liquidity buffers” to enable them to remain stable in times of stress.
The 30-day “liquidity coverage requirement” (LCR) buffer must suffice to cover part of the difference between a bank’s financial inflows and outflows in times of stress. It is to be phased in at 60% of this difference starting in 2015, rising to 100% in 2018. However, the European Commission may be able to delay the introduction of the 100% requirement, if justified by international developments.
For the medium term (over one year), the CRR would also introduce a “net stable funding requirement” (NSFR).
Although member states may impose their own national liquidity requirements, the CRR will require that banks hold liquid assets equal to at least 25% of outflows.
The market is of the view that this liquidity coverage requirement (LCR) will cause most banks to decrease their assets to meet them consequently reducing the amount they lend out because there is little demand for the amount of equity the banks will have to issue to meet the new capital regulations.
The other big problem is the ECB; when the comprehensive balance sheet assessment of all 150-odd banks is transferred under its direct supervisory authority, a deadline now planned around mid-2014, will insist that the banks value their assets at market value placing further demand on capital for banks.
Clearly, this is going to make expansion of the economies of Europe difficult to achieve and extend the period of low growth for some considerable time. In effect, it will counteract the ambitions of others to stimulate growth unless another approach is adopted.
This proposal presents an alternative to that scenario and allows banks to access fully paid up capital without having to rely on capital markets as well as stimulating growth in the process.
The one thing that is clear about re-financing the banks is that there is no appetite for using tax payers’ funds to make the investment; even if it was within the 3% deficit limit. If it can be done without increasing government budgets then politically it should be acceptable and carry with it support from people and businesses.
This proposal fulfils those requirements and also establishes a new innovative approach to project finance utilising the equity collateral issued by the banks when the recapitalisation is completed. A new organisation is created to manage this activity, the European Project Finance Initiative (EPFI), or it could be handled directly by the European Investment Bank (EIB). It is proposed that the EPFI becomes a division of the EIB if it is decided that it should be created.
Bonds are issued by the EIB in equal value to the equity issued by the banks and exchanged. In effect, the banks are recapitalised to the amount deemed necessary by the Capital Requirements Regulation (CRR) and the ECB, by receiving the bonds in exchange for the equity they issue which is held by the EPFI. The equity would be convertible preferred stock so as not to disrupt the current capital structure of the banks. The interest rate on the bonds and the preferred stock would be the same.
EPFI issues 5 year guarantees for an annual fee using the new preferred stock created by the banks as collateral to finance projects of all kinds. EPFI is allocated a minority equity stake in all the commercial projects for which it issues a guarantee, this stake increases a little every year the guarantee is live prior to refinancing when the project is cash generative to encourage creating a sound business as soon as possible. For infrastructure projects a different arrangement would be agreed (see below in Detailed Explanation for more on this).
The profits from the sale of equity gradually redeem the bonds exchanged. The banks use the bonds to repo them with the ECB and utilise the funds to lend to businesses and the EPFI guaranteed projects stimulating the economies of all countries throughout Europe providing the growth incentive desperately needed. It would be a condition that the banks must only lend the repo’ed funds to EU businesses when the recapitalisation is activated.
In effect, the recapitalisation is paid for by repurchasing the bonds from the banks when profits are made by the EPFI together with the sale of the collateral they issue when it is deemed appropriate and the market conditions are right. This should mean the bonds are redeemed before they are due to be repaid by the EIB. The EPFI then has the option to sell the rest of the bank collateral and use the cash to support the guarantees or maintain ownership.
The proposal combines recapitalising the banks with an economic growth plan and is paid for by profits generated over the medium term and if necessary, the sale of the preferred stock issued by the banks to make up any shortfall. It does not increase government budgets and generates tax revenue from the very beginning helping to alleviate budget deficits further.
THE DETAILED EXPLANATION
Firstly, this section will explain the creation of the EPFI, the convertible preferred stock to be issued by the banks and the bonds to be issued by the EIB. That is followed by using the bonds to be repo’ed by the banks to provide the finance for commercial and infrastructure projects. This section is headed ‘The Recapitalisation’.
Secondly, the easiest way to explain how the EPFI process would work in practice is to follow a project from the time it is fully costed and ready to go through the financing stage to completion and refinancing. That description will set out each stage of the procedure and explain the purpose of formulating the initiative in that way. This section is headed ‘The Establishment of the EPFI and Operating Procedure’.
The recapitalisation of the banks is achieved by exchanging bonds for convertible preferred stock which is used as collateral to issue guarantees. The amount of stock to be issued by the banks is determined by the CRR and the ECB and the exchange is made on a Euro for Euro basis. The coupon on the bonds will be the same as that for the preferred stock.
This does not upset the bank equity market or drain more funding from the market for government sponsored bonds. It injects precious capital into banks and allows them to be fully receptive to business funding demand helping to revitalise capital investment in Europe.
The centre of this proposal is the creation of a new organisation called the European Project Finance Initiative (EPFI), which would be a division of the EIB. It would be the driving force behind the whole programme selecting the projects, arranging for the issue of the guarantees and negotiating the sale of the equity that it has acquired as part of the risk for the guarantees for the commercial projects. For infrastructure projects the arrangement would be different, see the next section The Establishment of the EPFI and Operating Procedure for more on this.
It is proposed that the EPFI is purely a division of the EIB. The EIB has all the procedures for issuing bonds and funding projects already in place and has been managing these functions for many years. There has been discussion about using the facilities of the EIB to stimulate growth by funding more infrastructures in recent communications within the European parliament and the Commission so it is not an unusual suggestion for this proposal.
By exchanging bonds for bank capital stock, the EIB would be enhancing its own capital base since this would be a one for one swap and most banking capital requirements allow far greater leverage. Therefore, there would not be any need to ask for extra funding from government or EU budgets.
Establishing the amount of capital the banks would need to raise is something the CRD and the ECB have been analysing for some time. It should be straightforward to conclude how much each bank will be required to issue, especially now asset prices have levelled out and banks are beginning to off load to professional investors. It is assumed the amounts are quite large for some banks and hence it would be sensible to leave the current equity share capital intact to protect the pension funds who are big investors in banks.
It is suggested that convertible irredeemable preferred stock is the best class of capital to issue since it is equity and does not dilute the current shareholders. Making it convertible into equity, say in five years’ time, would allow the banks to recover and buy back the stock and issue another more suitable form of capital to meet the Basel 3 rules which will have become official by then. The coupon on the preferred stock would be the same as the bonds that the EIB will issue in exchange to make it effectively interest free to the EIB.
It is proposed that the EIB bonds are redeemable in 15 years with the option to repurchase the bonds as funds are made available from fees and the sale of project company equity. This would give plenty of time for the equity the EPFI acquires for the commercial risks it takes issuing the guarantees to be sold on and repay the bonds. This would start the winding down of the EPFI unless other collateral was pledged, see below on this.
It would be best to establish a sinking fund to manage the redemption of the bonds because judging the right time to redeem them would need careful thought. Since redeeming the bonds removes the repo facility for the banks, which provides the funding for the projects by the banks. In the event the EPFI project equity does not redeem the bonds completely before they are due for repayment, the preferred stock could be used to make up the difference. Since the preferred stock is convertible into the equity of the bank, it should increase the value of the stock after the recapitalisation and the expansion of their balance sheets over time. This maybe a very profitable investment for the EIB enabling a substantial increase in the equity of the bank.
Often when these solutions to the big financial problems are implemented, they can have the desired effect more quickly than anticipated. If that was the case in this instance, it would be possible to agree a reverse exchange whereby the banks give back the bonds and the EIB returns the preferred stock. This could also happen if the sale of equity did not completely redeem the bonds by the repayment date.
It would be preferable if the EIB bonds and the convertible preferred stock were quoted and marketable in case they do need to be sold on if alternative arrangements were made while the plan was still in force.
When the banks receive the bonds, they will be able to repo them with the ECB when the funding for the EPFI guarantees is required. The purpose is to provide the funds to lend to the projects which are also guaranteed by the EPFI. The banks will have no risk on these loans and will only have to apply the lowest capital rating for this lending. It is intended that all lending instigated and guaranteed by the EPFI is backed 100% by collateral at all times. It may be feasible to allow the banks to repo the EPFI guaranteed loans as well further increasing the amounts for lending.
The banks will have the capacity to lend well in excess of the EIB bonds they hold since the capital increase by the issue of the preferred stock will allow further lending to the EU market helping to improve access to working capital by businesses. In the event that banks were unable to manage the lending the EIB could issue its own bonds to fund the projects which it has been doing very successfully for many years. Although this proposal is meant to provide banks with a secure guaranteed lending opportunity to increase their asset base, it is an option available if lending capacity is unavailable within the banking system for whatever reason.
Once the EPFI is established and has been operating successfully for a few years, it would be possible to extend the opportunity to participate to fund managers who could be seeking extra yield for their own funds. As stock lending is becoming less profitable and more onerous to manage, this could have great appeal to fund managers and would be more lucrative. It is predicted that the low interest environment we find ourselves in could last for some time and a secure means of increasing yield on investments would be hard to find. The EPFI has the capability to be expanded substantially to fund projects around the world increasing the influence of the EU to many other economies. It would be advisable to include this facility in the charter when the EPFI is set up.
The EPFI would be considered very safe and have the capacity for many fund managers to participate which would be very attractive to pension funds who are struggling to find safe extra income for their pensioners.
The Establishment of the EPFI and Operating Procedure
The first concentration of effort prior to the creation the EPFI would be engaging the staff to manage the organisation. The funding to run the EPFI would come from a fee charged for each project when the guarantees are issued. The EIB is perfectly capable of funding the EPFI while it is being established until it can support itself from the guarantee fees earned at which time it would be able to repay the EIB.
The centre of operations would be the EPFI guarantee committee. This would authorise work to be done for the due diligence and the issue of the guarantees for the projects. It is likely a lot of the staff will come from the professional consultants that advise project companies and from organisations familiar with processing and funding projects. It is expected that this team of people will become very specialised and experienced in encouraging the development of projects that will be of particular benefit to the EU and making sure that they progress to completion without the long delays many encounter currently.
Over time, the EPFI will become a highly specialised and experienced project promoter, processor and funder providing an important service to industry and government. It will become very streamlined being able to advise and support all kinds of businesses whether it is developing the latest technology or filling the funding gap that prevails at the moment for capital expenditure and investment for companies of all sizes. The depth of experience and knowledge that the EPFI will encompass amongst its staff and the close associations it will develop with the professional and scientific communities will bring forward many new and exciting concepts helping to progress the economies of the EU.
Other activities to arrange are the creation of the web site and setting out the criteria for qualifying for the project financing. It is anticipated that the initial approach to the EPFI should be through the web site to ensure that the criteria are met and the business activity is within the framework of the initiative before the staff start the process of assessing each project.
It is intended that the criteria are comprehensive in order that all projects submitted have a clear understanding of the conditions and rules prior to applying for funding. It is important that all project advisors are made aware of the decision making path to prevent the substantial expenditure on preparation that all projects incur being wasted because of non-conformity. It is likely the number of applications will be substantial and therefore streamlining the original applications will be vital if the processing is to progress promptly.
Once the EPFI has agreed that a project meets all the criteria, the due diligence process begins. The staff of the EPFI will prepare the project for the guarantee committee to give the go ahead for the final processing to be undertaken. In effect, this gives permission for the staff to undertake the checks, assessments and obtain the confirmations required for the projects’ viability. If it has not already been done, the funding will be arranged with a bank or the bank syndication begins for the larger projects. It is most likely that applications will be made by professional consultants, financial intermediaries and the banks all of whom are fully aware of the procedure for funding projects. This should speed up the process since a lot of the work that is required to be done will have been prearranged prior to applications being made.
If the project is commercial (in this sense not reliant ultimately on government funding in total), the EPFI will arrange for the equity in the project company that it requires as part of the risk for issuing the guarantee. For all projects the equity percentage is suggested to be 20% which increases by 5% per annum over the 5 year life of the guarantee until the project company refinances the loan or the guarantee expires. The purpose of this is to encourage the project company to refinance and it is expected that the current bank lender/s would take over the loan when the company is cash generative and able to meet the repayment terms. They may also request that some new equity finance is raised to replace the security of the guarantee (the EPFI could help with this funding). An alternative would be that the project bank loan is repackaged as a bond and placed in the market. Whichever method is chosen, the EPFI would then have the option to sell the equity holding or retain it as collateral for more guarantees.
It is not anticipated that all infrastructure projects would be able to offer an equity stake since the funding would be repaid from government budgets over a long period. Although it would be possible to establish some form of bonus payment for taking the risk of completing the project on time and on budget. If a contingency amount is included as is normal for most projects that could be the basis of an extra payment when the refinancing takes place on completion, if it is not used.
While the infrastructure project is under construction, the EPFI would be receiving the annual 3% fee which may be the only income received if it is to be handed over to a government organisation on completion. If the project generates income, such as tolls, it would be feasible for the EPFI to be allocated an equity stake or receive extra income when the project is refinanced; it would also have the option to sell that equity stake if it was allotted. Whichever way the project is originally structured, on completion, the project would be refinanced and placed in the market as a long term bond attracting the finest rates since it would be a highly rated investment.
The final phase is the funding and payment of the fee to the EPFI. Assuming all the checks, schedules and planning have been confirmed and approved; the agreements can be prepared ready for signature and signed. The EPFI issues the guarantee directly to the bank, the loan is activated and the first annual guarantee fee of 3% is paid by the project company.
The Objective of this Paper
This proposal is designed to stimulate discussion concerning EU bank recapitalisation and is not meant to be definitive in the suggestions put forward. The concept has been devised to alleviate the problem of raising the finance for the banks to re-engage with their usual role of funding companies that cannot issue bonds to fund their growth plans.
It is also suggesting that the banks are not capable of being the sole provider of funding for unquoted companies and there is a serious need for other organisations to be actively involved whether they are government controlled or privately motivated. It is imperative that these organisations have the ability to arrange funding independently of the banks but work closely with them where necessary and provide specific professional expertise to make sure that projects can succeed.
It is the lack of alternatives that has destabilised the corporate funding processes in the EU and elsewhere; this paper is suggesting that access to finance by companies is expanded substantially in conjunction with an economic growth plan. Your comments will be posted on the forum.