From Fragmentation to Financial Integration in Europe

Chapter 13. Bank Recapitalization

Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Thierry Tressel

This chapter draws on the February 2013 IMF Staff Discussion Note, “A Banking Union for the Euro Area” (Goyal and others, 2013), and on the accompanying technical background note on bank recapitalization. The contribution of the various authors of those notes is gratefully acknowledged.


A Potential Turning Point in the Euro Area Crisis

On June 29, 2012, euro area leaders correctly identified the vicious circle linking banks and sovereigns as a core problem with the monetary union and called for the establishment of an effective single supervisory mechanism (SSM) and common backstop for bank capital. On June 20, 2013, the Eurogroup reached agreement on the main features and way forward for the European Stability Mechanism (ESM) direct recapitalization instrument. This is an important step forward with many positive elements.

However, finalization of the operational framework has been linked to adoption of the Bank Recovery and Resolution Directive (BRRD) and the Deposit Guarantee Schemes (DGS) Directive, which may create uncertainty in the recapitalization instrument’s start date. Mobilizing this recapitalization tool in a timely manner is critical to developing a path out of the current crisis. In this regard, it is of critical importance that ESM direct recapitalization of banks, including migration to ESM of existing public support to banks, is not subjected to overly burdensome preconditions, even if the ESM recapitalization would require unanimity in the ESM Board of Governors and approval by national parliaments in some jurisdictions (e.g., Germany). ESM investment decisions should take a long-term perspective, cognizant that gross upfront crisis outlays tend to dwarf ultimate costs net of recoveries/capital gains and, in many instances, generate positive financial returns.

Direct Recapitalization

The ESM’s timely and effective direct recapitalization of domestically systemic banks in the euro area could play a key role not only in breaking the vicious circle linking banks and sovereigns but also in repairing monetary transmission and preparing for banking union, and it could therefore help complete the economic and monetary union. As a patient, deep-pocket investor, the ESM can maximize the financial stability benefits of, and long-run returns on, its investment.

The ESM would need to stand ready to take material losses in a downside scenario, but it would be unlikely to actually incur those losses, because the investment would also improve the funding environment for banks and minimize the risk of an adverse scenario occurring.

This chapter is structured as follows. The next section provides general principles for the design of a solution to delink sovereigns from weak banks, relying on the ESM. This is followed by a discussion of implementation issues and, finally, concluding remarks.

Designing an Effective Solution


The ESM Board of Governors would appear to be authorized to develop a direct bank recapitalization instrument that is effective in breaking the sovereign-bank vicious circle. Creating such an instrument is consistent with the ESM’s purpose:

to mobilize funding and provide stability support under strict conditionality, appropriate to the financial assistance instrument chosen, to the benefit of ESM members which are experiencing, or are threatened by, severe financing problems, if indispensable to safeguard the financial stability of the euro area as a whole and of its member states.1

Member states ultimately decide on the scope of action that is allowed under the current ESM Treaty; in this regard, it appears that the current ESM Treaty may leave sufficient flexibility to accommodate related financial operations, such as ESM participation in or ownership of an asset management company (AMC).

The Eurogroup Agreement on the ESM Direct Recapitalization Framework

The June 20, 2013, agreement on the main features of the ESM direct recapitalization framework is an important and positive step forward (see Box 12.1 for a description). It includes conditions for access, time of entry, burden sharing, valuation, conditionality, and governance. Importantly, there is no a priori exclusion of legacy assets, and there could be retroactive application of the instrument on a case-by-case basis and by mutual agreement. Valuation would be based on the real economic value of the assets based on market data and on realistic and prudent assumptions of future cash flows and stress tests. Conditionality would be either institution-specific or more general and would be attached to the Memorandum of Understanding (MoU).

Nevertheless, several issues appear to remain:

  • Timing. The timing of the final agreement on the ESM direct recapitalization is still uncertain, since it is linked to the legislative processes of the BRRD and the DSG Directive.

  • Conditionality and burden sharing. State aid conditionality would be a prerequisite for ESM direct recapitalization, which could raise issues about the use of bail-ins under the European Commission rules published on July 10, 2013. The role of bail-ins in ensuring burden sharing with the private sector has been usefully clarified in the BRRD, but the revised state aid rules introducing the early enactment of the bail-in provisions for junior debt could create uncertainty, while the move to give the European Commission an ex ante veto right on restructuring plans could introduce delays. If its early activation is required for ESM direct recapitalization, the new regime should be applied consistently across countries and with due regard to any adverse consequences for financial stability, especially in the event of the resolution of large systemic institutions.

  • Size and access. Although it is difficult to prejudge the eventual needs, the limit for ESM resources available for direct recapitalization has been set at €60 billion (subject to review by the ESM Board). When needed, ESM direct recapitalization should be available on a timely basis, so that the ESM can be seen as an effective and credible common backstop.

What an Effective Instrument Requires

Interrelated goals. The mobilization of the ESM direct recapitalization instrument should ensure that systemic banks have adequate capital; it should also sever the link to the sovereign so banks are no longer a source of contingent fiscal liabilities.

Confidence effect. Achieving these goals will enhance market confidence in the credit standing of both the sovereign and the banks, including by reducing the extent to which exposure to the sovereign impairs market confidence in the banks. Nonetheless, the ESM recapitalization tool is not a panacea. Failing non-systemic banks should be resolved at least cost to national deposit insurance funds and taxpayers. Equally, systemic banks benefiting from ESM support will need effective supervision and sustained reform before they can be fully returned to private ownership, with state aid rules mandating formal restructuring plans. The sovereign itself will also need an adjustment program.

The European Stability Mechanism’s Ownership of Banks

Source of strength. In a business where confidence is important, capital support for banks by the ESM would reassure creditors that, in the event of a negative surprise, potential future capital needs could be met. This virtuous dynamic is codified in U.S. banking statutes as the “source of strength” doctrine, asserting that the financial strength of a bank is inextricably wedded to the financial strength of its owner, thus justifying supervision of banks’ holding companies. Confidence derived from ESM capital support, in turn, would feed into lower funding costs, restore profitability, and build capital over time. This much-needed stimulation to lending and growth in the periphery would help facilitate needed fiscal adjustment, while also helping return capital from the periphery to the core. Positive effects would be further amplified where ESM equity investments would have a significant immediate impact on sovereign credit standing. For all these reasons, a large equity participation in a bank by the ESM is quite distinct from a share transaction in the market, as it changes prospects for banks and for the economy by weakening the link between sovereigns and banks.

The ESM as a patient, deep-pocket investor. Although the Treaty establishing the ESM appropriately provides for the possibility of losses, it is clear that such losses should not be expected in its financial operations, including bank recapitalization—the expectation is that the ESM as bank investor must be careful to take balanced risk positions. Taken to the extreme, however, if the ESM were to restrict its investments to sanitized banks valued at depressed market prices—terms no more beneficial than those available from the private sector—it would likely fail to achieve the policy goals of the instrument. Therefore, a balanced approach is needed, one that prudently internalizes the benefits of ESM capital support by looking ahead over a time horizon sufficiently long to realize the benefits. As initial outlays rise to a threshold where banking stability and sovereign debt sustainability can improve decisively, so too does the likelihood of durable economic recovery underpinning a positive return on investment.

Risk sharing. As a patient, deep-pocket investor, the ESM provides assurance to creditors that, in the event of a negative surprise, potential future capital needs could be met. In other words, while the ESM would not take on expected losses, it would shoulder the risk of unexpected losses going forward. This approach is in line with efficient risk sharing, wherein the patient investor bears the residual risk. In this regard, it should be noted that, conditional upon the ESM standing ready to take material losses in a downside scenario, it would be unlikely to actually incur those losses, because the investment would minimize the risk of the adverse scenario occurring.

Broad Issues in Applying the Instrument

Which countries should be eligible? In view of moral hazard considerations and the need to husband finite ESM resources, the direct bank recapitalization instrument should only be applied where there is a paucity of private capital—including capital from burden sharing with creditors, as appropriate—and where use of national taxpayer capital would threaten sovereign market access or significantly undermine the terms on which the sovereign has such access.

What types of institutions should qualify? At this time, the instrument appears to be limited to domestically systemic banks. In principle, however, the AMCs and resolution corporations used to restructure such banks by warehousing certain segregated assets should also be eligible. When such vehicles remain under national ownership, the sovereign is exposed to residual uncertainty regarding the value of their assets, potentially leaving intact the most important part of the bank-sovereign link.

What extent of capital shortfall should be covered? ESM bank capital holdings should eventually be marketable. Given the mandate of the ESM as discussed above, capital that a patient, forward-looking investor could not expect to recover over time could not be furnished. Thus, capital needed to bring a systemic bank out of insolvency would in the first instance need to be provided by shareholders and creditors, and then by the national government, with any remaining shortfall covered by the ESM. In principle, however, there would be significant advantages to breaking the vicious circle if all the capital needed to ensure that a systemic bank was adequately capitalized were ultimately provided by a central fiscal authority, especially if the scenario were to play out in a small jurisdiction.

How should bank equity be valued? Current depressed market valuations of bank equity would not be appropriate, since they reflect downside risks stemming from bank-sovereign links. An historical-cost approach to valuing bank equity could be considered where the analysis underlying bank recapitalization has been conducted in coordination with relevant European authorities. Even here, however, stress tests designed to calibrate prudent equity buffers for a downside scenario do not provide balanced valuations of bank equity. This is so because they deliberately take a conservative view on economic variables and potential credit losses and factor in net income over a time horizon of, at most, a few years. Instead, the assessment should be based on internalizing the benefits of the investment (e.g., for funding costs), factoring in reasonable baseline projections rather than a stress scenario and using, for instance, a real long-term economic value approach that takes into account underlying profitability under stable macroeconomic conditions.

Should banks first have a balance sheet restructuring? A flexible approach is needed, recognizing that distressed asset workouts are a core function of banking. In most cases, where banks are best suited to manage in-house their own distressed assets, such assets should be retained on balance sheet at valuations that make prudent allowance for lifetime credit losses in a baseline scenario. Nonetheless, a separate legal vehicle may offer advantages in resolving certain asset classes, such as larger, more idiosyncratic loans with valuation uncertainty, while enabling banks to focus on improving their performance in their ongoing core businesses. Ideally, if a vehicle is used, it should also fall under ESM ownership; otherwise, effectiveness in breaking bank-sovereign links is diminished. Indeed, the ESM may choose to segregate the assets of banks under its control into separate but affiliated entities that would nonetheless be captured by a consolidated supervision of the banking group as a whole.

What types of risk-sharing arrangements are appropriate? To minimize contingent fiscal liabilities, a clean break would usually be best, with the sovereign providing no downside risk protection and correspondingly receiving no claim on a future upside, except if it retains a minority equity stake. Nevertheless, simple option structures can help facilitate transactions where there are large valuation uncertainties.

Implementation Issues

Direct Recapitalization by the ESM

Elements. The ability of the ESM to support bank restructuring hinges on several elements:

  • Mandate. The ESM can directly recapitalize banks, based on diagnostics performed by (or under the leadership of) the SSM led by the European Central Bank (ECB). As noted in the euro area summit statement of June 29, 2012, this would require a “regular decision,” albeit one that requires unanimity in the ESM Board of Governors and, in some jurisdictions, approval from national parliaments.2

  • Transparency, governance, and accountability. The strategic approach of the ESM would need to be communicated clearly to ensure investor understanding and acceptance, enhance confidence, and secure broad public buy-in. Elements that would help in this respect include a transparent investment strategy and governance mechanism and an incentive structure in which the public sector shares any upside.

  • Principles for access. The modalities for ESM investment should provide incentives for banks to seek private sources of capital first, in particular by diluting existing shareholders. National authorities would then be expected to cover at least any negative equity that might remain subject to the need to ensure sustainable public debt dynamics, as noted above, and an exit from the crisis.

  • Role of bail-in. Holders of capital instruments (such as subordinated debt and preferred shares), in both going and gone concerns, should be subject to burden sharing to reduce the fiscal costs of bank resolution. For banks undergoing resolution, losses could be imposed on remaining creditors in line with the seniority of claims, including senior unsecured bond holders, if the systemic consequences could be contained. Insured depositors, which in most of Europe rank pari passu with senior creditors, would need to be protected and given preference to avoid contagion.

  • Operations. The ESM would need to build capacity to manage its equity stakes in banks, including, as warranted, the exercise of ownership rights. Alternatively, a special vehicle could be established with a mandate to manage the ESM’s investments at arm’s length, as the U.K. Financial Institution does. In any event, the management of the ESM’s investment should be at an arms-length from the political process and follow strictly commercial principles. The ESM could forgo annual dividend income on its holdings, however, as this would help reduce the funding costs of these banks and increase their prospects for returning to profitability. At the same time, the beneficiary economies must not implement policies that could harm the profitability or viability of the recipient banks (e.g., through onerous taxes or ex post resolution levies).

  • Design of instruments. Capital instruments utilized for ESM recapitalization should allow for transparency and flexibility. Recapitalizations should be effected through the acquisition of ordinary shares—resulting in dilution of existing shareholders. For banks that have already been nationalized by member states, debt-equity swaps should be considered, with the member states transferring the equity stakes in banks to the ESM with a corresponding reduction in their debt.

  • No first-loss guarantees. ESM investments should not benefit from loss protection provided by the sovereign. Such approaches would preserve sovereign-bank links, undermining the purpose of ESM direct recapitalization. But there should be safeguards for the ESM (e.g., built into the sales contract) against domestic policies that could directly harm the viability or profitability of the recipient banks (e.g., onerous taxes ex post or stiff resolution levies).

  • Exit strategy. There should be incentives for an early ESM exit and private investor entry. The timing would be built around the European Union-approved restructuring plans. Mandatory sunset clauses should be avoided, as they could affect negotiating power ahead of the deadline.

  • Adequate resources. Direct equity injections into banks could absorb significant amounts of ESM capital. It would be important to ensure that the ESM has adequate capital not only to allay any investor concerns about ESM credit quality, and thereby limit any rating implications, but also to play its potential role as a common backstop for bank recapitalization.

Supporting a Work-out of Impaired Assets

Clean up. Resolving impaired assets in the euro area banking system is a necessary supplement to the roll-out of the banking union. While banks are in the business of collecting on delinquent loans, and thus must have the expertise, unresolved nonperforming assets can deepen the severity and duration of a systemic crisis, as they tie up bank managerial and financial resources and inhibit a recovery in lending. This is particularly the case with non-marketable assets and when secondary markets become illiquid. A clear segregation between impaired and performing assets would remove doubts about the quality of banks’ balance sheets and thus contribute to restoring confidence in the euro area banking sector.

Legacy assets. This term has been very controversial, reflecting concerns that creditor countries could be expected to put capital into nonviable banks. This is not what is being suggested above. Rather, losses on impaired “legacy” assets should be recognized through upfront provisioning and proper (long-term/post-crisis) valuation. It is not recommended that all impaired assets be segregated from a bank prior to ESM direct recapitalization and placed into recovery vehicles ultimately backed by the national taxpayer; such an approach would greatly reduce the effectiveness of the tool in addressing bank-sovereign links. Rather, bank health should be restored with shareholders, including the sovereign, bearing the expected loss of past excesses by being subjected to an independent valuation exercise consistent with the shared commitment to restore full viability after the restructuring period.

Box 13.1The Irish and Spanish Asset Management Companies (AMCs)

Ireland. The National Asset Management Agency was set up in December 2009 to help Irish banks divest of bad loans (Irish commercial property) and in turn receive government-backed securities as collateral against European Central Bank (ECB) funding. The agency aimed to achieve this task by acquiring bad loans from the five participating banks, working pro-actively on a business plan for acquiring and disposing of bad loans, protecting and enhancing to the maximum amount possible the value of these assets. The agency had acquired assets at an average discount of over 50 percent. The process lasted for over a year and required detailed asset-by-asset valuation. The European Commission communication, however, allows for an alternative where valuation of assets appears particularly complex, including the creation of a “good bank” whereby the state purchases the good assets rather than the bad ones. Nationalization combined with the creation of a “good bank” was used in Latvia for the resolving of Parex bank in 2008–10.

Spain. Legislation enacted in Spain in August 2012 established the AMC for assets arising from bank restructuring (SAREB), empowering the Fund for the Orderly Restructuring of the Banking Sector to instruct distressed banks to transfer problematic assets to it. In mid-December 2012, SAREB increased its capital to allow its main private participants (banks) to become shareholders.

Asset management companies (AMCs). AMCs have been used in the past in systemic crises and as a part of a wider package of measures to facilitate (1) resolution of insolvent and nonviable financial institutions; (2) restructuring of distressed but viable financial institutions; and (3) privatization of government-owned and government-intervened banks. Examples of (1) include the U.S. Resolution Trust Corporation and the Thai Financial Sector Restructuring Agency. Examples of (2) include the U.S. Maiden Lane LLCs established by the Federal Reserve to resolve Bear Sterns and AIG and Sweden’s Securum. Combinations of (1) and (2) include the Korea Asset Management Institution and the Malaysian Danaharta. An example of (3) is the French Consortium de Realization. The Indonesian Bank Restructuring Agency combined all three elements. Centralized AMCs, often with broad mandates, were also widely used during the 1990s transition in central and eastern Europe, for example in the Czech Republic, Georgia, Hungary, Kazakhstan, Lithuania, Macedonia, Slovakia and Ukraine. In the current crisis, a number of AMCs have been established in the European Union, including in Belgium, Denmark, Ireland, Spain, and the United Kingdom; there have also been discussions concerning possible AMCs in Cyprus and Slovenia (Box 13.1).

Advantages and disadvantages. Centralized AMCs can remove balance sheet uncertainty by acquiring assets of unknown (or difficult to quantify) value; allow the consolidation of scarce workout skills and resources in one agency and the application of uniform workout procedures; help securitization by generating a larger pool of assets; provide greater leverage over debtors if AMCs are granted special powers of loan recovery; prevent fire sales or destabilizing spillover effects as banks deleverage; and allow the “cleaned up” banks to focus on their core business.

Such considerations need to be balanced against potential disadvantages. These include the loss of banks’ specialized information about their borrowers; the AMCs’ limited ability (relative to the bank) to provide additional financing to support restructuring of nonperforming loans; and the risk of a deterioration in asset values following transfer to an AMC if the assets are not actively managed. It may also be difficult to insulate public agencies such as centralized AMCs from political interference. Finally, centralized AMCs may raise concerns about asset warehousing and can extend their own lifespans by open-ended transfer arrangements that, ultimately, can also undermine credit discipline in banks.

Lessons. The experience with AMCs has been mixed and has helped identify common prerequisites and design features that can contribute to an AMC’s success:

  • Prerequisites. An insolvency framework that supports rehabilitation of viable firms, liquidation of nonviable firms, and out-of-court debt recovery and realization of collateral; a neutral tax framework; and robust financial regulation, supervision, and a bank resolution framework.

  • Design features. Strong leadership and operational independence; accountability, transparency and strong governance; adequate funding; strong legal basis; appropriately structured incentives (including forms that enable AMC owners to benefit from future increases in the value of bank assets); and a commercial orientation.

Transfer price. Assets for transfer to the AMC need to be properly priced (Box 13.2). The general rule is that assets should be purchased at a price as close to a fair market value as possible based upon expected recovery, cash flow projections, and appraisal of collateral. But pricing nonperforming and illiquid or complex assets can be difficult, time consuming, and subjective, especially in the midst of a financial crisis—one reason why in the United States the Troubled Asset Relief Program was ultimately not used to purchase mortgage-related assets. The U.S. Treasury decided to conduct a second round of capital injections into financial institutions instead, stating that the original plan of purchasing troubled assets would take time to implement and would not be sufficient given the severity of the problem. When a large number of assets is involved, the transfer can take place at an initial price with the explicit agreement that the final price of the transaction be established after the value of the assets has been estimated or the assets have been sold. Some form of profit-sharing arrangement may be utilized to make transactions more palatable for banks, but these should not remove the full update for the government sponsoring the centralized AMC. The Malaysian Danaharta, for example, purchased impaired loans at an average discount of 55 percent, while banks that sold assets retained the right to receive 80 percent of any recoveries in excess of the acquisition costs that the AMC was able to realize.

Box 13.2Key Considerations for Asset Management Companies (AMCs)

The transfer price at which impaired assets are removed from restructured banks’ balance sheets is a key parameter with broad implications.

  • The lower the transfer price, the larger the losses imposed on restructured banks: to the extent that the banks remain viable, this increases the need for capital injections. Transfer prices have a direct impact on whether or not there is “negative capital” to be filled in.

  • Low transfer prices also limit the size and therefore the capital/funding requirements of the AMC, limiting the extent of fiscal costs to be incurred over time and perhaps even providing some potential upside as bad assets are liquidated and spur the interest of private-equity investors.

  • There is therefore a trade-off between crystallizing large capital needs and setting up a large AMC that would also need to be capitalized and funded.

  • The European Commission typically applies the principle that transfers should take place at the “real (long-term) economic value,” which for impaired assets would typically be closer to the market value than to the historical value.

Long-term funding of asset run-off vehicles is critical to ensure that recovery values are not impaired by fire-sales.

  • If the AMC has a banking license, it could in principle access Eurosystem refinancing directly. However, the bad assets are unlikely to be eligible for collateral under European Central Bank (ECB) operations, and emergency liquidity assistance is not an appropriate vehicle for long-term refinancing purposes. Even if the AMC is capitalized with government bonds, the ECB may challenge the eligibility of the entity itself as a monetary policy counterparty, or it may challenge the appropriateness of Eurosystem refinancing on the basis of the monetary financing prohibition.

  • There are precedents for central bank funding of AMCs, most involving the protection of central banks’ balance sheets against potential losses. However, even if the ECB were to provide funding, the risks on its balance sheet should be protected by a fiscal guarantee, for instance, from the ESM (which may require amendments to the ESM Treaty).

  • A non-bank AMC can be funded by issuance of government guaranteed bonds that can be placed directly in the market or with the restructured banks as payment for the assets that are transferred. It is critical that such securities be eligible for Eurosystem refinancing (e.g., as per the Spanish MoU).

Private investors should be invited in AMCs, albeit with proper risk sharing arrangements, to maximize recovery values.

Competition policies. EU competition policies complicate asset pricing in the European context.3 The European Commission requires a clear ex ante identification of the magnitude of a bank’s asset-related problems and a viability review, with assets valued at market prices whenever possible. Since the current market value can be quite distant from the book value, the European Commission’s approach allows for a transfer value reflecting a “long-term economic value” of the assets, on the basis of underlying cash flows and broader time horizons. In the experience of setting up Ireland’s national asset management agency in late 2009, lack of a universally accepted methodology for this valuation led to a protracted process whereby bank book values were repeatedly discounted, prolonging uncertainty and delaying normalization of bank funding. In the case of Spain, this process was more rapid, with transfer prices set conservatively, based on haircuts in line with the adverse stress test scenario.

AMC funding. Funding of AMCs is another key design feature. The AMC must have sufficient funds to perform its intended functions, with the operating budget separate from funding for asset takeover. In past crises, funding came from either the proceeds of government bond issues or the AMC’s own bond issuance backed by the government, with losses absorbed by the budget since private investor participation is unlikely to materialize in the early stages. For instance, in Ireland, banks received government-guaranteed securities in return for assets transferred to the Irish national asset management agency. A key advantage of using a company without a banking license (an AMC) instead of a “bad bank” is that AMCs do not need to meet regulatory capital and liquidity requirements, thereby reducing their overall costs.

Sovereign–bank loops. In the current euro area context, funding by governments reinforces the sovereign–bank links and complicates AMC design. To the extent that AMC debt funding bears on public debt, there is an incentive to minimize the size of these vehicles and therefore the scope of the assets that are segregated. This raises a question about possible alternative sources of equity and liquidity for the AMC, and specifically of the potential roles of the ECB and ESM in these areas. In particular, to limit further contingent fiscal liabilities and harness efficiencies, consideration could be given to allowing the ESM to set up and own AMCs.

Potential Role of the European Central Bank

Direct support. The ECB is subject to a number of legal protections to safeguard its balance sheet, but it could have a role in funding AMCs. The European System of Central Banks Statute limits its credit operations counterparties to “credit institutions and other market participants, with lending based on adequate collateral.” Hence, the statute may provide a leeway to fund non-banks. That said, funding the acquisition of bad assets or the resolution of bad banks remains a fiscal responsibility. Therefore, were the ECB to provide such funding, the risks to its balance sheet should be protected by a guarantee from euro area member states such as could potentially be extended by the ESM (Box 13.3).

Indirect support. An alternative route would be for the ECB to support AMC operations indirectly, subject to the prohibition of monetary financing. In particular, the ECB could accept government-guaranteed AMC bonds issued to banks in exchange for their assets as collateral for Eurosystem financing operations and for a range of safeguards, such as an observer status in the AMC governing committee(s) and special access to the AMC internal information. Bond characteristics will be important in determining acceptance by the ECB as repo collateral, including interest rate, maturity, and marketability.

Box 13.3Central Bank Funding of Asset Management Companies (AMCs)

There are precedents for central bank funding of AMCs, most involving protection against potential losses:

  • In the United States, the “bad bank” of Continental Illinois was owned by the former shareholders of the bank and funded with liabilities to the Federal Reserve, fully guaranteed by the Federal Deposit Insurance Corporation (FDIC), which owned the good bank.

  • A number of central banks in Central and Eastern European transition economies were engaged in funding AMCs or bad banks; the losses incurred were covered by the national budget or, over time, by seigniorage.

  • The Swiss National Bank (SNB) supported in 2008 the transfer of illiquid securities and other troubled assets of UBS to a special purpose vehicle—the Swiss Stabilization Fund—controlled and mainly funded by the SNB. Assets were transferred to the fund at market prices and thus, on average, with a discount to notional value. Asset transfer from UBS was financed by a 90 percent loan from SNB, backed by a security interest in all the fund’s assets, and a 10 percent financing contribution from UBS. The management of assets was outsourced to UBS, which was given an option to repurchase the fund. Protection was provided to the SNB in the form of loan overcollateralization and warrants for UBS shares, to cover any losses on liquidation of assets. The broad recovery of secondary market asset valuations in 2010 allowed the fund to dispose of assets with sales mostly above their intrinsic values.

Central banks accept collateral of a high credit quality that is liquefiable in secondary markets, which helps manage the risks associated with implementing monetary policy. They also typically accept government and quasi-government securities as collateral, subject to not being a direct party to monetary financing of the fiscal deficit.

Conversely, central banks would not typically accept nonmarketable securities (for example, special-purpose government bonds that may not be on-sold in the market). Open market purchases of bonds and the general acceptance of a class of securities as collateral from all counterparties are the acceptable ways central banks acquire government securities.4 Hence, the mechanism through which the central bank acquires government securities is important in determining their acceptability by the central bank. A side deal in which the central bank agrees to purchase or accept a particular class of nonmarketable securities that have been directly issued to just a few banks would not generally be an acceptable practice.

Box 13.4Eurogroup Agreement on the European Stability Mechanism (ESM) Direct Recapitalization Instrument: Main Features*

Objective: ESM direct recapitalization of banks will aim at preserving financial stability of the euro area as a whole and of its member states by delinking the sovereign from the financial sector.

Timing: The instrument will be ready as soon as the Bank Recovery and Resolution Directive (BRRD) and the Deposit Guarantee Schemes Directive are finalized with the European Parliament; it would be ready by mid-2014 for the Single Supervisory Mechanism Balance Sheet Assessment and European Banking Authority stress test.

Conditions for access: Four criteria must be met for accessing the new instrument, which are consistent with the objective of weakening the sovereign–bank links where they create risks to the sovereign’s balance sheet:

  • The sovereign is unable to recapitalize banks without endangering fiscal sustainability or high risk of losing market access in absence of ESM financing.

  • There is a high risk to the financial stability of the euro area as a whole or of its member states.

  • The bank is or will be in breach of prudential capital requirements but it must be viable, and private capital is not available.

  • The institution is systemic for the euro area or for the member state.

Limit: An ex ante limit of €60 billion is set but the limit can be reviewed by the Board of the ESM.

ESM financial structure/instrument: Direct recapitalization of banks will be performed by a fully owned subsidiary of the ESM, against the acquisition of common equity shares. The ECB/supervisor will determine the appropriate capital requirement.

Valuation: Valuation of assets under the guidance of the ESM is based on the real economic value of the assets, based on market data, and realistic and prudent assumptions of future cash flows and stress tests, with the support of experts and in collaboration with the ECB and the European Commission. There is no exclusion of “legacy assets.”

Burden sharing: Recapitalization is subject to a clear pecking order, relying first on private capital, including a write-down of shareholders and of creditors in line with state aid rules and with the BRRD. A scheme determining the respective contributions of the ESM and of the sovereign may remain to be further clarified:

  • First part: The sovereign will recapitalize first up to the Basel III Common Equity Tier 1 capital minimum of 4.5 percent of risk-weighted assets.

  • Second part: Above that threshold, the sovereign will contribute 20 percent in the first two years of entry into force of the instrument, and 10 percent afterwards.

  • The contribution of the sovereign cannot be less than the second part.

  • The contribution of the sovereign can be suspended by mutual agreement if the fiscal condition of the sovereign does not allow such contribution, including given implications for market access

Legacy: There could be retroactive application of the instrument, on a case-by-case basis and by mutual agreement.

Conditionality: State aid conditionality will be a prerequisite for ESM direct recapitalization. Additional institution-specific conditionality can be established by the ESM, in liaison with the ECB and the European Commission. More general conditionality can also be attached to the memorandum of understanding.

Governance: Decisions regarding conditionality and the exercise of ownership rights will be made by the governing bodies of the ESM, and the degree of intrusiveness will be addressed on a case by case basis, in line with the European Commission Merger Regulation. The ESM will have access to all relevant information.

Review: The instrument guidelines will be reviewed after two years of the instrument’s entry into force, including the burden sharing scheme.

* Based on the Eurogroup document, “ESM direct bank recapitalization instrument—Main features of the operational framework and way forward,” Luxembourg, June 20, 2013. Available online at

Potential Role of the European Stability Mechanism

Broadened mandate. Consideration could be given to broadening the ESM mandate, allowing it to own or lend support to AMCs. The main argument supporting this would be that the risk of losses on impaired assets for creditor member states (via the ESM) is likely to be much lower because of the retention of the long-term value of assets transferred to the AMC. In such circumstances, the transfer of conservatively valued assets from the banks’ balance sheets to an ESMowned AMC would be beneficial for all banking union participants (although, as noted, it would also increase the capitalization needs of banks).

Governance and accountability. There may be potential conflicts of interest between the various capacities in which the ESM is envisaged to operate. For example, the ESM could end up acting both as a (co-)owner of banks following an equity injection and as a purchaser through an AMC. Safeguards could entail: (1) clear and transparent evaluation criteria on asset prices, guided by the ECB’s diagnostics; (2) clear rules on the interaction with the ECB in its capacity as single supervisor, as well as with resolution authorities; and (3) if needed, a potential revision of ESM governance and decision-making arrangements (which would require modifying the ESM Treaty).


Effectiveness. Banks benefiting from ESM participation will need time to reorder their operations and restructure their distressed loans. With moral hazard addressed through appropriate burden sharing, conditionality, and supervision, the ESM can act as the quintessential patient investor, taking a forward-looking approach to its equity holdings and internalizing the benefits of its ownership for the medium- to long-term outlook. Such an approach to ESM direct bank recapitalization would maximize effectiveness in breaking the vicious circle that links banks and sovereigns. By safeguarding the financial stability of the euro area as a whole, this approach would serve the common interest.

Urgency. With a large international body of experience showing that delays almost always ramp up the costs of crisis resolution, time is of the essence (see, for example, Laeven and Valencia, 2012). Some euro area member states continue to face severe stresses in both sovereign and bank funding markets, with broad ramifications for the currency union. Others may be poised at a decision point between durably restored market access and potentially prolonged dependence on official financing. In no case would a delay in applying the ESM direct bank recapitalization instrument improve the ultimate outcomes. The sooner the ESM can move, the sooner current market dislocations in both the periphery and the core can be resolved, for the benefit of all.

Specifically, it is of the utmost importance to have the ESM backstop in place ahead of the SSM balance sheet assessment to motivate national authorities and to address capital shortfalls where fiscal space is insufficient. If needed, the flexibility in the framework should be used to the fullest to prevent a flare-up of negative sovereign–bank loops and of procyclical effects in the context of the balance sheet assessment exercise. The ESM could also provide a line of credit to the SRM before a more long-term fiscal backstop is in place.


Article 3 of the Treaty Establishing the European Stability Mechanism, available at:

The June 29, 2012, statement of euro area leaders can be found at:

Guidance to member states is provided by, among other sources, the European Commission (2009).

In the case of the ECB, various “opinions” discuss this matter. See, for example, CON/2010/2 in which the ECB indicated that “the prohibition of monetary financing prohibits the direct purchase of public sector debt, but such purchases in the secondary market are allowed, in principle, as long as such secondary market purchases are not used to circumvent the objective of Article 123 of the Treaty.” Also see recital 7 of Council Regulation (EC) 3603/93.

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