NOTE NUMBER 9

PUBLIC POLICY FOR THE PRIVATE SECTOR

Banks in Crisis OCTOBER 2009

David Scott When Governments Take Temporary Ownership

David Scott (dscott@ The current financial crisis evolved quickly. In most of the developed worldbank.org) is program countries affected, governments initially improvised solutions that manager in the Financial and Private Sector Devel- eventually led to substantial investments in systemically important opment Vice Presidency of banks. Not all their actions are worth emulating, especially those that the World Bank Group. undermine normal governance arrangements and the ability of all This is the ninth in a shareholders to hold the banks’ board and management accountable. series of policy briefs on the crisis—assessing the Lessons from earlier crises show that governments acting as temporary policy responses, shedding owners can minimize costs to taxpayers by following sound commercial light on financial reforms practices and good corporate governance principles. Quickly developing currently under debate, and providing insights and making public the exit strategy is also important. for emerging-market policy Among the policy measures that governments have Notable recent examples include the acquisi- makers. adopted in the financial crisis are public investments tion of Bear Stearns by JPMorgan Chase with in debt, equity, and hybrid instruments resulting in the support of a liquidity line from the Federal their partial or full ownership of financial institu- Deposit Insurance Corporation (FDIC), and the tions. Government investments have recapitalized seizure of Washington Mutual by the FDIC and distressed banks that failed to meet legal minimum its subsequent sale to JPMorgan Chase. capital requirements and increased capital in banks In other cases, such as larger banks that could FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY that met legal requirements but were nonetheless not be readily sold or complex groups in which thought to require more. the legal basis for the intervention was not clear, In distressed banks, governments generally governments have taken an ownership position, had a legal basis for intervening in ownership and sometimes to the extent of outright nationaliza- governance. Such interventions can potentially tion. In the United Kingdom, for example, the result in the revocation of the banking license government has recapitalized RBS and Lloyds and liquidation. More commonly, however, by acquiring stakes of 70 percent and 65 per- shareholders’ rights were overridden, and the cent, respectively, and has nationalized Northern bank (or most of its assets and liabilities) was sold Rock and Bradford & Bingley by acquiring 100 to another bank, sometimes with government percent stakes. financial assistance. This is standard practice Governments have also made capital available

THE WORLD BANK GROUP for resolving failed banks in the United States. to banks that did not contravene capital rules, BANKS IN CRISIS WHEN GOVERNMENTS TAKE TEMPORARY OWNERSHIP

through programs that generally are voluntary holder decisions, again often without owning and open to large, systemically important banks common shares. The most common interven- (as in the United Kingdom) or to all banks (as in tions are limits on executive compensation the United States). In several countries govern- (France, Germany, Ireland, Italy, Sweden, the ments’ interventions were initially ad hoc, then United Kingdom, the United States) and restric- formalized under more standardized, industry- tions on dividend payments (France, Germany, wide arrangements (such as the U.S. Troubled Greece, Italy, the United Kingdom, the United Asset Relief Program). States). While a stated objective of most invest- A range of financial instruments have been ments is to maintain bank lending, few invest- 2 used. Recapitalizations of deeply distressed ments involve requirements to maintain specific banks have typically involved common shares, lending volumes. usually resulting in significant or full direct gov- ernment ownership. Investments in other banks Objectives of temporary ownership have usually involved preferred shares and, in The objectives of government investment and some cases, subordinated debt. Recapitalization temporary ownership need to be agreed on and through preferred shares and subordinated debt articulated from the outset. The primary objec- more readily allows banks to redeem or retire tive tends to be to remove any concerns about the the new capital, either from future earnings or liquidity and capital adequacy of a systemically by raising new capital from the private sector. important bank, so as to maintain confidence in In some cases these instruments have involved the bank and in the financial system generally and high dividend or interest rates or step-up clauses to ensure that the bank can meet its obligations, (specifying a higher cost of redemption after a including to the payments system. A secondary certain period) intended to provide an incentive objective may be to restore the bank’s capabil- for early repayment of support (as in Austria, ity to provide new credit to the economy. This Ireland, and the United Kingdom). Governments objective may increase in importance with the in some cases also obtained warrants to acquire size of the share of troubled banks in the system, additional shares. These provide upside poten- reflecting social and political concerns about the tial for taxpayers but also allow the government potential broader economic impact of a systemic to inject additional capital and to take a larger contraction in bank lending. equity position should it become necessary. In the While these objectives may conflict, particu- current crisis, market analysts have placed par- larly in the near term, both require quickly ticular emphasis on banks’ Tier 1 capital ratios, restoring the bank to financial health. While and many of the instruments have been declared governments are involuntary investors, becom- to qualify as Tier 1 capital.1 ing an owner for reasons other than return on How governments have intervened in gover- investment, they need to act as any professional nance as a consequence of their investment varies investor would, with the aim of maximizing the considerably. Four different means for structur- value of their investment whether or not it can ing the ownership function have been used. Some be fully recouped. governments have used existing arrangements To help ensure a consistent and comprehen- for state ownership (Austria, Belgium), while sive approach to temporary government owner- others have located the ownership function in ship, governments need to develop and publicly a new bank recapitalization entity (the United communicate a credible ownership policy. This Kingdom and prospectively the United States) or, policy would articulate the government’s objec- less commonly, in the finance ministry (Ireland) tives in temporary ownership, define the gen- or the deposit insurance entity (prospectively in eral terms and conditions that will apply to its Canada). investment, and describe how it will exercise its In some cases governments have acquired ownership as well as what its intentions are for board representation even though they own no divestment.2 common shares (Belgium, Ireland). Governments To help minimize the long-run costs for tax- also have directly preempted board and share- payers and facilitate eventual divestment, the ownership policy needs to be based on a set of assets, strengthen controls and risk management, guiding principles associated with sound com- improve efficiency and shed noncore operations, mercial practices, good corporate governance, and reduce indebtedness.4 Debt restructuring and competitive neutrality. Sound commercial involving debt-to-equity conversions might also practices and good corporate governance need to be required or encouraged by the government be applied to decisions on the amount, structure, as part of this process. and terms and conditions of the investment and As a general principle, banks that meet legal its subsequent handling. Governments would in minimum capital requirements should not be effect seek to mimic the practices of a private forced to apply for government capital support. 3 sector owner. Their investment and subsequent Instead, consistent with Pillar 2 of the Basel II actions would be oriented toward returning the capital accord, supervisory procedures can be bank to profitability, probably after financial and applied to ensure that management and the operational restructuring over a short period, board achieve capital levels exceeding the legal and maximizing value. minimum given the bank’s risk profile and other Similarly, the availability and amount of the relevant characteristics. In a period of widespread investment, its terms and conditions, and the crisis and extreme uncertainty, however, preemp- subsequent involvement of government in gov- tive recapitalization of such banks, especially sys- ernance need to be consistent with the principle temically important banks, may be required to of competitive neutrality. That means ensuring maintain or restore confidence in the financial equal treatment by the supervisory authorities system. and other arms of government for banks in which the government has a temporary ownership stake. How much, what form, and what structure? Special forbearance from prudential rules for The investment needs to be large enough to such banks, for example, is best avoided. In the restore the bank to financial health. The goal is euro area an action plan adopted at a summit not only to meet regulatory capital requirements. in October 2008 specifies that banks benefiting It is also to ensure that the bank can return to from government capital support “should be profitability after funding the cost of financial obliged to accept additional restrictions, notably and operational restructuring and absorbing the to preclude possible abuse of such arrangements losses associated with this restructuring.5 at the expense of non beneficiaries.”3 To achieve this goal, there needs to be rea- sonable certainty that the bank will be able to Terms and conditions of the investment generate an adequate (market) rate of return Governments need to approach the investment after the investment and required restructuring. decision, and structure the terms and conditions A common error, arising from failure to obtain of the investment, in a manner consistent with the adequate information and undertake sufficient objectives set out in the previous section. analysis, is to underestimate the size of the invest- ment required, leading to a need for additional Whom to support? recapitalization later. Insufficient recapitaliza- For a distressed bank that appears to be solvent, tion can undermine management and board the management and board ideally should be incentives, delay a return to normal operations, required to make formal application for gov- and impede divestment. Managers operating with ernment recapitalization. The application pro- insufficient capital have incentives to take inor- cess would provide the information needed dinate risks (to “bet the bank”) and to delay the for analysis to support decisions on the capital recognition of losses, such as those that might situation of the bank and on the size, structure, be inherent in necessary restructuring. terms and conditions, and other features of the Structuring the terms and conditions of the new investment. As part of the application, the investment so that bank managers and owners do management and board would need to present not request more new capital than needed is also plans for financial and operational restructur- important. This requires a dynamic process for ing, such as how they intend to handle problem assessing the bank’s application—one that holds BANKS IN CRISIS WHEN GOVERNMENTS TAKE TEMPORARY OWNERSHIP

management and the board to a high standard What resulting ownership interest? in information and supporting analysis and that So that existing shareholders bear the cost of uses outside expertise in assessing and challeng- past mistakes, their ownership interest in the ing management’s plans. bank should be diluted, perhaps substantially. To achieve the goal of restoring the bank The government should acquire an ownership to profitability, the investment would best take interest commensurate with the amount of its the form of common stock (ordinary shares). investment. The information and analysis under- Convertible preferred stock (preference shares, taken in the application process would be the or what the U.S. government calls “contingent main basis for determining what proportion of 4 common capital”) is also an option. The key ownership should accrue to the government as distinction between the two options is whether a consequence of its investment. The decision the government will have the ownership rights would also be the subject of extensive negotia- inherent in common stock or whether it will tions between the government and the bank’s be a passive investor by investing in nonvoting board and management. These negotiations preferred stock.6 For recapitalization of deeply might also involve other parties, such as unse- distressed banks, an investment in common stock cured creditors whose debt might be subject to is the better option. In such cases taxpayer funds debt-to-equity conversions and who thus might will be at substantial risk, and the government also acquire an ownership interest in the bank. cannot be a passive investor. The use of preferred stock and subordinated Governance arrangements debt is best reserved for banks with good pros- In principle, when a government becomes an pects for a near-term private sector solution to owner of common shares, it gains the same rights the capital deficiency. The intent would be to and obligations as other shareholders, exercised buy time for a private sector solution to mate- mainly through voting at the annual general rialize, and to create incentives for the board meeting of shareholders. During the current cri- and management to find such a solution. If no sis, however, even some governments that have private sector solution should materialize, gov- not acquired common stock have made board ernments generally have the option to convert representation a condition of investment and preferred stock or subordinated debt to common have directly intervened in matters that under shares or to exercise warrants and acquire com- normal circumstances are the purview of the mon shares. This has been the approach taken, board and common shareholders (such as execu- for example, in the United States, Germany, tive remuneration). While these extraordinary Switzerland, Belgium (except in the national- interventions in governance may be explained ization of Fortis), and Ireland (except in the by the emergency nature of the investments and nationalization of Anglo Irish Bank). the public outcry over perceived abuses in execu- At the same time, however, seeking to cre- tive compensation, they undermine the ability ate an incentive for a private sector solution by of government and other shareholders to hold using preferred stock with a high cumulative the board and management accountable. This dividend requirement, or subordinated debt at section therefore offers guidance on address- above-market interest rates, runs counter to the ing governance issues without resorting to such fundamental objective of restoring the earnings extraordinary interventions.7 capacity of the bank and is best avoided. In the United Kingdom, for example, the government Separating ownership and regulation originally recapitalized RBS and Lloyds with pre- To separate the handling of temporary owner- ferred stock with a 12 percent dividend yield. ship from the policy and regulatory functions of There was no way for the banks to deploy such government, a specialized ownership unit can be funds profitably, and because they could not established. This unit would be responsible for meet the dividend requirement, the government implementing the ownership policy, exercising had to convert the preferred stock to common ownership and governance responsibilities, and shares. carrying out the exit strategy. The unit could be, for example, the government entity responsible the private sector who can help recruit board for the ownership function in all state-owned enti- members. When there are other owners as well, ties or a special team or separate body subject to the ownership unit could appoint less than half executive or legislative oversight. Whatever form the committee. To find board candidates with the unit takes, it needs to be adequately staffed appropriate skills and experience, the committee and led by a person with at least as much influ- could use private recruitment firms. The owner- ence and authority as the bank’s chairperson and ship unit needs to follow the recommendations chief executive officer.8 of the committee at the shareholders’ meeting The ownership unit needs the expertise to apply when the board members are elected. 5 good corporate governance practices, ensure that The board’s mission would be twofold: to operations follow commercial principles, and max- ensure that the bank is restructured and managed imize the value of the investment. If these skills are with the objective of restoring profitability and not readily found in government, the ownership financial strength, and to facilitate the govern- unit can rely on outside advisers with backgrounds ment’s divestment on favorable terms. This mis- in such areas as finance and investment banking, sion would require the board members, especially corporate governance, corporate restructuring, the chairperson, to maintain a continual dialogue corporate and bankruptcy law, and information with the ownership unit. The chairperson would technology. Contracting for such expertise will be responsible for ensuring that the ownership require access to funding. But the cost is likely to unit is adequately informed about the bank’s per- be small relative to the size of the investment and formance, its strategy for achieving restructuring would be recouped by the higher value ultimately and other goals, and other issues of importance to realized on the investment. the owner. At the same time, the board members To ensure public accountability for its actions need to act in the interest of all shareholders. In and performance, the ownership unit needs to countries with long-standing deficiencies in bank operate transparently. The unit should publicly governance arrangements, the government could disclose its intentions, its decisions and actions, leverage its temporary investment to upgrade the the basis for these, and its performance in dis- board’s governance policies and procedures.10 charging its responsibilities. The ownership unit and other government officials need to refrain from interfering in deci- Handling the board sions on the bank’s day-to-day operations and The temptation to put government officials on avoid making decisions that are appropriately the bank’s board should be resisted. The board the responsibility of the board and for which the needs to be composed of individuals with the board should be held accountable. Nor should collective knowledge, skills, and experience the ownership unit seek to influence individual (such as in banking, finance, corporate law, and credit decisions. To achieve a government objec- accounting and auditing) to effectively oversee tive of providing new credit to the economy, management. Government officials may lack the quantitative credit targets should be avoided. qualifications or the time to function effectively Instead, the focus should be on promoting rapid as board members. Moreover, putting govern- restructuring, establishing a rate-of-return target ment officials on the board could undermine that cannot be met by investing solely in govern- its balanced functioning if they are perceived as ment paper, and engaging in a dialogue with having extraordinary authority relative to other the chairperson to ensure that the board and board members.9 management take into account the views of the A professional board needs to be formed government (as shareholder) in this respect. through a transparent process organized by the Just as the ownership unit needs to operate ownership unit. For example, the unit could transparently, it also needs to promote a high create an investors’ committee responsible for level of transparency in the operations and per- selecting appropriate board members. When the formance of the bank. Transparency will support government is sole owner, half the members of eventual divestment by better enabling potential the committee could be individuals active in new investors to evaluate the bank’s prospects. BANKS IN CRISIS WHEN GOVERNMENTS TAKE TEMPORARY OWNERSHIP

Exiting the investment temporary ownership of financial institutions as To avoid market distortions and reduce uncer- a last resort. As the preceding discussion makes tainty, the government needs to divest as soon as clear, this would entail clarifying up front the this can be done on good terms. All developed objectives of temporary government ownership country governments that have taken owner- and the conditions under which it might be appro- ship stakes in banks during the current crisis priate, making preparations to have the informa- have emphasized the temporary nature of their tion and analytical capacity necessary to structure investments, and most have expressed an intent any possible government investment, determining to divest promptly. how to organize and staff the temporary owner- 6 To prepare the way for prompt divestment, ship function, and having the capacity to quickly the ownership unit needs to start developing identify and appoint new qualified board mem- alternative exit strategies as soon as the invest- bers. Governments can formulate in advance a ment is made. The criteria for divestment are statement of objectives and principles to guide any commercially sensitive issues, but general guide- future investment and subsequent governance or lines need to be publicly disclosed to give the ownership as well as a plan to communicate this market and other potential investors an idea information to the public. They can also identify about when the unit will start to consider a sale. and prepare for the legal requirements involved Such criteria would concern both the bank and in the entire process, from initial intervention to the overall banking system. For the bank, the eventual divestment. criteria would focus mainly on the achievement of enough progress in restructuring so that the probable impact on the ultimate balance sheet structure and future earnings becomes clear. For Notes the banking system, the criteria would include This policy brief is based on the author’s experience in measures indicating that the system has stabi- organizing support to the government of the Republic lized (such as conditions in the interbank market, of Korea during the Asian fi nancial crisis as well as spreads, and bank equity market valuations) and subsequent work on the corporate governance and is returning to normal operations (such as rate performance of state-owned fi nancial institutions. Arne of credit expansion). Berggren, an independent consultant to the World The ownership unit should be responsible Bank and a former offi cial of the Swedish Ministry for executing the divestment. The unit would of Finance and the Swedish Bank Support Authority, therefore need to keep itself informed about the provided substantial inputs, drawing on his experience bank’s performance and market developments in the response to the Swedish banking crisis of the and continually evaluate the proper time and early 1990s. Valuable comments were provided by Laura method for exit. One or more investment bank- Ard, Alex Berg, Katia D’Hulster, Heinz Rudolph, and ing firms with international and local experience Constantinos Stephanou. could help in developing the divestment strategy. 1. Whether these instruments qualify as Tier 1 capital A process for selecting such an investment bank under the Basel II capital accord is open to question. should be initiated at an early stage. The standard setters may take a relaxed attitude toward The government’s stake can be divested these discrepancies, however, since the source of the through sale to strategic or portfolio investors, capital is the government, which might reasonably through public sale or flotation, or through a be relied on to convert such instruments to common combination of these. In deciding on the method equity if necessary. of divestment, the impact on the future gover- 2. A good example is the United Kingdom’s Shareholder nance of the bank needs to be taken into con- Relationship Framework Document (UK Financial Invest- sideration. ments Ltd. 2009). 3. Declaration of a Concerted European Action Plan Conclusion of the Euro Area Countries, fi nal version, October 12, Authorities in economies not immediately affected 2008 (http://ec.europa.eu/economy_fi nance/publica by the crisis can prepare now for the possibility of tions/publication13260_en.pdf). 4. The application and information gathering process, Rock, this decision was later reversed. In future the or postinvestment analysis, may reveal that the bank is directors of this nationalized bank will be chosen by insolvent. In such cases, if the bank cannot be closed the specialized ownership unit, UK Financial Invest- or resolved through other established means, the bank ments Ltd. should be nationalized as a last resort, with the govern- 10. For these purposes reference can be made to OECD ment taking full or nearly full ownership. guidelines on corporate governance, including the 5. Restructuring can give rise to losses in a number of corporate governance of state-owned enterprises (see ways. The most common is the write-down of the book OECD 2004, 2005). value of assets. Losses can also be incurred in restructur- 7 ing certain liabilities, and there can be costs associated References with exiting certain business lines and reducing the OECD (Organisation for Economic Co-operation and number of staff. Development). 2004. Principles of Corporate Gover- 6. In practice, as noted, the conditions imposed by nance. Paris. some governments represent the de facto exercise of ———. 2005. Guidelines on Corporate Governance of State- ownership rights even when the government holds no Owned Enterprises. Paris. common shares. But doing so undermines established Scott, D. H. 2007. “Strengthening the Governance and corporate governance arrangements and, as is argued, Performance of State-Owned Financial Institutions.” is best avoided. Policy Research Working Paper 4321, World Bank, 7. This section is consistent, for example, with the Washington, DC. OECD Guidelines on Corporate Governance of State-Owned UK Financial Investments Ltd. 2009. Shareholder Relation- Enterprises (2005). ship Framework Document. http://www.ukfi .gov.uk/ 8. UK Financial Investments Ltd., set up by the U.K. gov- publications/. ernment and subject to a framework document governing its relationship with the Treasury, is one such example. 9. Although the U.K. government initially placed government officials on the board of Northern crisisresponse

The views published here are those of the authors and should not be attributed to the World Bank Group. Nor do any of the conclusions represent official policy of the World Bank Group or of its Executive Directors or the countries they represent.

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