From Saviour to Guarantor

The actions of the EU Member States during the first stage of the crisis (2008) were aimed at guaranteeing market stability. The States intervened to support the banking system in random order and with different instruments according to the requirements. In some instances they acquired a share of the banks’ capital, underwrote special financial instruments, or directly purchased the securities ‘most at risk’ (the so-called toxic or illiquid assets). However, in each case their action caused an increase in the public debt.¹ The European Union intervened at a later stage, only to redefine the regulatory framework with respect to State aid to banks (which was done very promptly) and to the discipline of financial oversight (which is a more complex activity still ongoing).²

In the EU, State guarantees for the stability of the banking system qualify as State aid on the basis of long-standing practice¹ and case law,² if they provide their beneficiaries with an economically appraisable advantage that they would not have been able to obtain otherwise. The advantage obtained by the beneficiary lies in the assumption of risk by the State, which must be compensated for appropriately.³

The Member States guarantee the safeguarding of the euro and the stability of the banking system through a ‘new’ type of contract which we will call a defaultable guarantee contract. A defaultable guarantee contract is quite peculiar with respect to a standard one. In fact, in a standard guarantee, the borrower is subject to default risk but the guarantor is default-free (so that its risk does not depend on the risk of the borrower). In contrast, in a defaultable guarantee contract, (i) both obligors are exposed to counterparty default risk and the risk of the guarantor could be higher than that of the borrower, and (ii) there may be a form of dependence between the default risks of the guarantor and those of the borrower. For example, it is clear that the pattern of default risk which characterises the European Stability Mechanism (ESM) scheme of public aid to Member States is ‘circular’, because the States are at the same time guarantors and shareholders of the fund, as well as potentially assisted parties (partly ‘self-assisted’). There is also a correlation effect in the case of a government guarantee covering bank debt, as ‘the link between the condition of sovereign borrowers and that of their domestic banking systems has been a key feature of the global financial crisis’.¹

The ESM finds the resources on the market to provide aid to European States in difficulty. Further, it has adopted enforcement guidelines to govern its intervention procedures. Similar to the EFSF, the Member States of the ESM which request financial assistance are required to comply with the restrictions imposed by the programme according to the ESM’s Treaty and its specific agreements: the memorandum of understanding (MoU) and the specific financial assistance facility agreement (FFA).

In the previous chapters we described the main features of State guarantees in favour of the ESM, and their relevance. We will now address the effects that the current system produces at both operative and systemic levels.

In the case of a government guarantee to cover bank debt, if the bank’s reference obligation — for example, a bank bond — experiences a default event before the maturity date of the contract, the State (guarantor) makes a default payment to the bondholders to cover the loss. The bank (borrower) pays the guarantor a periodic fee for the insurance. After the default of the reference entity, the fee payments stop. The guarantee fee is usually calculated on the basis of a rule defined by the law, or on a contractual basis, and expressed in the form of an annualised percentage of the notional value of the bank’s reference obligation. In particular, the European Commission has set out the pricing formula for the minimum remuneration level of these State guarantees.

The category of ‘risk’ has taken a fundamental role in the present life of the international economic and financial system and in the search, presently under way, of new balances that may ensure a sustainable market finance. This is relevant for our study too, because the extent to which State guarantees may be useful to support the economy depends on the nature and the characteristics of the underlying risk of such public contingent claims. In the following pages we present a few considerations in chronological order on the instruments and techniques that have characterised the ‘path’ followed by risk from the private to the public sector.¹

One function that was originally supporting the market and later of acting as guarantor was carried out by the ECB, promptly converted from the ‘crutch’ of banks into the ‘lifeline’ of States. In fact, the guarantee system described above may only work if the risk borne by Member States is further transferred to other players. In the case of guarantees in favour of the States, the risk is transferred to the ESM fund — a subject of international law created with a specific Treaty — and the guarantor of last resort is (above all) the ECB, where the securities issued by the ESM fund may be lodged as collateral.

The European Union finds itself in a sort of a ‘middle age’ where the States have not transferred the necessary competences to allow EU institutions to operate in economic and fiscal policies; these competences only exist for monetary and budgeting policies.