The State Aid Temporary Framework for COVID-19, the Banking Communication, and Burden-Sharing

 Dionysios Pelekis                www.linkedin.com/in/dionysios-pelekis

 

In November 2020, the Commission approved an aid scheme designed to support the liquidity of the Italian banking sector. This measure authorised Italy’s Ministry of Economy and Finance to grant a State guarantee on the liabilities of banks based in Italy, and on loans granted discretionarily by the Bank of Italy to Italian banks. The scheme was explicitly linked to the adverse economic effects of the Covid-19 pandemic.

Specifically, the scheme provided for guarantees totalling EUR 19 billion, which cover new senior liabilities and emergency liquidity assistance provided by the Bank of Italy. The law introducing the scheme explained that the guarantees must be confined to solvent institutions, be proportionate to the consequences of the serious disturbance in the economy, and not be used to offset losses incurred or likely to be incurred by the receiving institutions. The guarantees must also comply with the relevant provisions of the Bank Recovery and Resolution Directive (BRRD), and the Single Resolution Mechanism Regulation (SRMR). Italy also made a number of commitments relating to the guarantees, seen in paragraph 16 of the Decision. As mentioned above, the scheme was approved by the Commission.

That is not in and of itself odd or worth discussing – the State aid prohibition is neither absolute nor unconditional. Aid measures are approved, if deemed to be compatible with the internal market all the time. Especially in the context of the economic disturbance caused by the Covid-19 pandemic it may therefore appear normal for the Commission to approve such an aid measure. In fact, the Temporary Framework for State Aid Measures to Support the Economy in the Current Covid-19 Outbreak explicitly states in paragraph 7 that if banks need extraordinary public financial support in the form of, inter alia, liquidity, and the relevant conditions of the BRRD and the SRMR are met, measures providing such liquidity would be allowed. The same paragraph however creates the issue at stake: it exempts such measures, to the extent that they are caused by Covid-19, from the requirement of burden-sharing under the Banking Communication.

Burden-sharing is an integral part of the State aid framework for banks, in effect saying that for State aid to be allowed, first, losses must be absorbed by equity, contributions by hybrid capital holders and subordinated debt holders. The bank’s subordinate debt must also be converted into equity. Burden-sharing addresses and aims to reduce ‘moral hazard’. Given that the Banking Communication came in the aftermath of the Great Recession, this makes sense – nobody wants bankers going wild in the expectation that they will be bailed out. Thus, this obligation ensures that they bail-in before receiving aid.

An exception exists for this obligation, namely when burden-sharing would endanger financial stability or lead to disproportionate results, although it has very rarely been used. In the Communication, it is provided that an exception from this obligation could also apply where the aid amount to be received is small in comparison to the bank’s risk weighted assets and, where the capital shortfall has been reduced significantly in particular through capital raising measures. The Covid Framework makes no mention to any of those exceptions – rather it provides for an almost general exception from the burden-sharing regime, as long as the need for extraordinary financial support is due to Covid-19.

The application of the Temporary Framework in the Italian Banks Decision can demonstrate this. Before looking at the reasoning of the Decision, it is important to outline the compatibility regime. The measure in question was authorised under Article 107(3)(b) TFEU, which provides for a derogation to remedy a serious disturbance in the economy of a Member State – thus it clearly applies to aid introduced to make up for the damage caused by Covid-19. However, for aid granted under Article 107(3), beyond the requirements of the specific subparagraph invoked, the aid also needs to be appropriate, necessary, and proportional to the objective of the subparagraph invoked. Additionally, due to the wide margin of discretion afforded to the Commission by Article 107(3), it is obliged to perform a balancing exercise, weighing the negative and positive effects of the aid, and thus evaluate the impact of the aid in economic and social terms. Finally, any and all allowed aid needs to not contravene any other provisions of EU law.

Here, the Commission discusses those compatibility criteria, and finds that they are satisfied, in recitals 23-35 of the Decision. Specifically, the scheme is appropriate to remedy a serious disturbance, especially since the measures to combat the pandemic have eroded the creditworthiness of borrowers. The scheme is also deemed to satisfy the necessity criterion, as it does not encourage banks to obtain more liquidity than they need, and therefore they cannot use said liquidity to finance their lending activities. The scheme is also deemed to be proportional, as it is accompanied by conditional and situational restructuring plans, and by behavioural safeguards. Additionally, the scheme was found to be compliant with the BRRD and the SRMR, meaning that the banks cannot be deemed as failing or being likely to fail.

However, the Commission did not explain how or why the exception from burden-sharing applied to the scheme at hand. Of course, the Temporary Framework provides for an exception, but its application is not linked at all to any of those provided for in the text of the Banking Communication. This would suggest that the Temporary Framework provides for a new exception from the burden-sharing requirement, which is not accompanied by any analysis or justification. For example, it would have been possible, in the context of the pandemic, to claim that, since (at least some of) the financial difficulties faced by banks came about through no fault of their own, a burden-sharing requirement would have been disproportionate and could have endangered financial stability. Such an explanation would seem to be in line with the text of the Temporary Framework, which states that the exception only applies to the extent that a measure addresses problems linked to Covid-19. However, such an approach is not evident in neither the Temporary Framework, nor the Decision at hand, applying it. Thus, we cannot assume that this is reasoning behind the burden-sharing exception.

As a result, the only conclusion we are left with, given the absence of the burden-sharing requirement and its exceptions from the Commission’s reasoning, is that the Temporary Framework has indeed created a new exception from the burden-sharing requirement under the Banking Communication. This is particularly odd if we consider that the Temporary Framework is not overall too friendly towards banks, excluding them for the most part from its scope of application, with the exception of indirect advantages. The fact therefore that it seems in practice to have created an automatic and very wide exception from a cornerstone of the State aid regime applicable to banks seems perplexing. The unanswered question here therefore is what would happen to some bad gambles made by banks that failed not necessarily because but certainly during the pandemic? Would such losses be covered by taxpayers? Based on the skin-deep analysis of the Commission in the case at hand, and the lack of justifications, the answer would seem to be yes.

Thus, in effect, the Temporary Framework provides for a new exemption from the burden-sharing obligation, which does not seem to take into account the underlying logic of the exemptions codified in the Banking Communication, thus potentially undermining the protection the latter provided against the aforementioned ‘moral hazard’.

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