Philip Lane

The IMF Banking Union has quite a bit to say about how the ESM should go about the recapitalisation of banks, including in relation to legacy problems. The main quotes are below (including the lengthy section C):

Meanwhile, to delink weak sovereigns from future residual banking sector risks, it will be important to undertake as soon as possible direct recapitalization of frail domestically systemic banks by the European Stability Mechanism (ESM). Failing, non-systemic banks should be wound down at least cost, and frail, domestically systemic banks should be resuscitated by shareholders, creditors, the sovereign, and the ESM.
ESM and crisis resolution. To be clear, the core purpose of ESM recapitalization of domestically systemic banks undergoing restructuring must be to remove the residual risk from the balance sheet of a sovereign whose finances are already strained. Unviable, non-systemic banks should be wound down at least cost; and systemic banks should be resuscitated by shareholders, creditors, the sovereign, and the ESM as the quintessential patient, deep-pocket investor. By delinking the sovereign from future unexpected losses on bank balance sheets, ESM direct recapitalization would remove future tail risks from the sovereign balance sheet; by ensuring that the banks have an owner of unquestioned financial strength, it would improve bank funding conditions. Thus, the ESM would attack the sovereign-bank link from both sides. In all cases, ESM involvement should be conditional upon a determination of systemic risk, which could be as basic as a finding that the bank is too large for the sovereign alone to wind up, given the state of public finances. A robust mechanism for the systemic risk determination will be critical (Box 4).

C. ESM direct recapitalization

44. Purpose. Mobilizing the ESM direct bank recapitalization tool in a forceful and timely manner is critical to developing a path out of the current crisis, and would complement other measures such as the ECB’s Outright Monetary Transactions. Recapitalization of frail, domestically- systemic banks in the euro area, including some migration to the ESM of existing public support to such banks, can help break the vicious circle between banks and sovereigns, reduce financial fragmentation, repair monetary transmission, prepare for banking union and, thus, help complete the economic and monetary union. To be sure, failing non-systemic banks should be resolved at least cost to national resolution funds and taxpayers. Equally, systemic banks benefiting from ESM support will need effective supervision and reform to be returned to full viability and private ownership, with state aid rules mandating formal restructuring plans. In some cases, the sovereign itself may need an adjustment program, providing an enabling environment for asset price recovery.

45. Approach. The mobilization of the ESM direct recapitalization tool should ensure frail, domestically systemic banks have adequate capital, access to funding at reasonable cost, and positive profits—in short, a viable business model. To this end, asset valuations are critical, as are the roles of shareholders, creditors, and the domestic sovereign in bearing costs.

 In principle, there would be significant advantages to breaking the vicious bank-sovereign circle if all capital needed to ensure a systemic bank was adequately capitalized was ultimately provided by a central fiscal authority. This would especially be the case if the scenario were to play out in a small jurisdiction, and even more so if it also had to internalize spillovers to others (that might result, e.g., if external creditors did not share in losses, for fear of triggering wider problems). More generally, pooling risk would provide protection ex ante to all, as any country could in theory find itself in a similar position in the future.

 In practice, although the Treaty establishing the ESM provides for the possibility of losses, such losses are not expected in its financial operations, including bank recapitalization. As a bank investor, the expectation is that the ESM must be careful to take balanced risk positions. It likely could not provide capital that a patient investor would not expect to recover over time. Thus, capital needed to bring a systemic bank out of insolvency (i.e., to bring it from negative to nonnegative equity) 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. Fortunately, there are unlikely to be large, insolvent banks currently in most economies.

 A balanced approach would prudently internalize the benefits of ESM capital support by looking ahead over a time horizon sufficiently long to realize the benefits. As a patient, deep-pocket investor, the ESM should take a long-term perspective in its investment decisions, cognizant that gross upfront crisis outlays tend to dwarf ultimate costs net of recoveries/capital gains and, in many instances, generate positive financial returns.

 Asset valuation. The implications for asset valuation, which determine the size of recapitalization needs as well as the investors’ up/downside risk, are twofold. First, asset values should be neither too high (which would imply mutualization through the back door)

could be given to allowing the ESM to set up and own AMCs. Possible roles for the ECB in supporting AMC operations could also be considered (although concerns regarding the prohibition on monetary financing may also be raised). ECB funding, if possible under its statute, would help smooth over time the warehousing and disposal of hard-to-value and hard-to-sell assets. An alternative would be for the ECB to support AMC operations indirectly by accepting ESM- guaranteed AMC bonds issued to banks in Eurosystem refinancing operations.

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nor too low (in which case, the private sector could simply buy the assets, and there would be limited benefit to having an official investor). Second, because the ESM is a patient investor willing to give the banks the necessary time to restructure, assets should be priced at values that give due consideration of the positive effect of recapitalization on asset values. This includes not just the direct positive effect of recapitalization (including more favorable funding costs) and recovery, but also the removal of tail-risk events (see next bullet).

 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 can 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, the ESM would be unlikely to actually incur those losses, because the investment would minimize the risk of the adverse scenario occurring.
 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 EU-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 to not only allay any investor concerns about ESM credit quality, and thereby limit any rating implications, but also play its potential role of a common backstop for bank recapitalization.

46. Legacy assets. This term has been very controversial, reflecting concerns that creditor countries could be expected to put capital into unviable 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 the 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.

47. Further support. To further support balance sheet clean up, certain classes of legacy assets could be transferred to asset run-off vehicles such as asset management companies (AMCs) under ESM ownership. Expected losses would remain with the sovereign, given the terms of the foregoing recapitalization. But to limit further contingent fiscal liabilities and harness efficiencies, consideration

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Agreement on burden sharing and ESM direct recapitalization must also not be delayed, lest the costs of the crisis keep mounting.