MEASURING AND ASSESSING FISCAL DEVELOPMENTS IN AN ENVIRONMENT OF UNCERTAINTY

1.1. ACCOUNTING FOR BANK RESCUES

This section summarises how government measures in support of the financial sector impact on the government accounts (in particular the government deficit and gross debt) compiled according to ESA, (19_{) which are relevant for the}

SGP. While the accounting implications of government measures in support of economic activity in general (like tax cuts or increases in spending) are trivial, specific measures in support of the financial sector, often involving the purchase of financial assets or other complex transactions, raise a number of complex issues.

1.1.1. Complex rescues raise a number of accounting issues

Since the adoption of the first government measures in support of the financial sector in the context of the financial turmoil (e.g., the bail outs of Northern Rock in the UK, in September 2007; (20_{) of Roskilde Bank in Denmark, in}

August 2008; and of the Landesbanken and IKB in Germany), there have been intense discussions among Eurostat, other Commission departments, the ECB and the national authorities in charge of compiling government finance statistics. The aim of these discussions has been of ensuring that the ESA accounting principles and rules are duly respected and that similar transactions in different countries are recorded in a comparable manner. At this stage, it is useful to remind that, according to ESA, transactions are recorded according to their economic substance, rather than on the basis of formal considerations.

The discussion has allowed to organise the measures in support of the financial sector along the following clusters – for accounting purposes:

(19_{) ESA (or ESA95) stands for European System of National}

and Regional Accounts. ESA is the EU version of the UN’s System of National Accounts (SNA1993). The ESA rules are in Council Regulation (EC) N° 2223/96 (OJ L 310, 30.11.1996, p. 1), as last amended by Regulation (EC) N° 1392/2007 of the European Parliament and of the Council (OJ L 324, 10.12.2007, p. 1).

(20_{) For a detailed analysis of the Northern Rock bailout and}

some accounting implications, see Kellaway and Shanks (2008).

(i) purchases of equity in banks; (ii) granting of loans; (iii) purchase of financial assets (e.g., asset removal schemes for impaired securities); (iv) guarantees to banks’ liabilities; (v) asset protection schemes; (vi) exchange of asset schemes and (vii) deposit insurance. Most of these measures have been carried out by governments. However, in some cases, governments (on their own or in cooperation with the private sector) have created new entities for the purpose of bailing out banks or otherwise supporting the financial sector. In these cases, a crucial and often complex issue concerns (viii) the sectoral classification – in the general government sector or in the corporate sector – of these new entities.

(i) Purchase of equity in banks or other financial institutions. This includes the purchase of new (or existing) shares in quoted and unquoted banks. The equity bought by the government can be ordinary shares or some sort of preferred shares. The purchase of equity may, or may not, give to the government a controlling stake. It also includes cases of forced transactions, whereby the government expropriated equity and paid (or pledged to pay) an appropriate indemnity to the former shareholders.

Most cases of purchase of equity are recorded in the ESA accounts without any direct impact on the government deficit – in accounting jargon, these transactions are said to be ‘booked below the line’ – since the government acquired a financial asset of the same value of cash paid out. However, there is a need to book a deficit-increasing transaction where the government has paid for the shares more than their market price or fair value, or if the expected rate of return of the investment is deemed to be insufficient. In those cases, the impact on the deficit corresponds to the difference between the price paid and the market price or fair value of the equity. (21₎

(21_{) In most cases, the shares acquired by government are not}

quoted in stock exchanges. Even when the equity is quoted in the stock exchange, the government decision of buying shares and the price it is ready to pay may significantly distort market prices. Therefore the identification of the amount that has to be recorded as deficit-increasing is not trivial. Where there is a need to identify an expected rate of

In the vast majority of cases, the purchase of equity adds to the government gross debt – though the government net debt may remain unchanged, at least at inception – since, presumably, the government had to issue debt to finance the purchase. However, one has also observed cases where the government managed to finance the purchase of equity without issuing new debt, by reducing its stock of other financial assets, like deposits in the central bank or commercial banks, or of securities held by government-owned reserve funds.

(ii) Granting a loan is also a financial transaction that has no direct and immediate impact on the government deficit. However, there will be a need to record a deficit-increasing transaction in the future, if for any reason – like insolvency of the debtor – the government has to fully or partially cancel the debt at a later stage.

Typically, granting of loans implies an increase in government gross debt, unless the State managed to finance the loan without issuing debt.

(iii) The asset removal schemes, i.e., the purchase by government of impaired financial assets – the so-called ‘toxic assets’ – previously in the banks’ balance sheet, is also neutral for the government deficit provided that the price paid by the government is estimated to be a fair value. Similarly to the purchase of banks’ equity, one needs to book a deficit-increasing capital transfer in case the price paid was in excess of the fair value.

The identification of the market price or fair value for impaired assets in a context of financial turmoil is a thorny issue. Not only there is no liquid market for those assets, but some of them may be particularly difficulty to value given their structured nature. The EU statisticians have agreed a number of pragmatic rules to help them checking whether any transaction needs to be fully or partially booked as deficit-increasing. (22_{) In}

return and to judge whether this rate of return is sufficient, EU statisticians usually refer state aid-related documents. (22_{) The criteria that statisticians apply in order to check}

whether a given transaction took place at fair value refer notably to (i) the existence of an adequately operating market with smoothly evolving prices for identical or similar assets; (ii) some mechanism undertaken to

practice, statisticians consider that the price paid corresponds to fair value, unless there is evidence suggesting otherwise.

The disposal of these assets by the government at maturity, if not earlier, will lead to holding gains or losses. Those gains and losses are usually recorded in the revaluation account and have no direct impact on the government deficit. However, given the specific situation of uncertainty in a financial turmoil and the difficulty of identifying market prices and fair values, statisticians may have to impute holding losses to the government deficit whenever their size and nature suggests that the initial transaction had been carried out at a price in excess of fair value.

(iv) Several governments have granted guarantees to banks’ liabilities (bonds or loans). A guarantee is a contingent liability that has no direct impact on the deficit and debt. In case the debtor honours its liability, the guarantee is never booked in the government finance statistics. However, in the rare cases the guarantee is called and the liability has to be taken over by the government because the debtor defaults, there will be an increase in both government deficit and debt at the time of the debt take over.

Governments usually collect some fees when they grant guarantees. These fees are recorded as sales of services and reduce the government deficit. The recording of those fees as government revenue has some counter-intuitive implications for the ESA accounts. Since fees are recorded as sales, they reduce nominal government consumption, as the latter is measured as salaries plus purchases of goods and services plus depreciation less sales. Moreover, since real consumption is not affected by these transactions, the government consumption deflator falls. (23₎

determine a market value, such as an auction; (iii) the carrying value of the asset in the business accounts of the seller provided that those accounts have been compiled on suitable business accounting principles at a point in time reasonably close to the time of transaction; or (iv) independent valuations.

(23_{) To avoid this unfortunate consequence on nominal}

consumption and consumption deflator, one could alternatively record the fees as insurance premia or as financial derivatives. However, these accounting options

Part II Evolving budgetary surveillance

(v) The accounting implications of asset protection schemes are quite similar to the guarantees granted to third parties’ liabilities. Typically an asset protection scheme will work as follows: against a fee paid to the government, the government and banks agree in sharing the holding gains and the holding losses to be recorded in the future in relation to a set of assets which remains in the banks’ balance sheet.

At inception, there is no impact on the government debt and deficit (other than the fees). In case the asset loses value and the government has to indemnify the banks subsequently, one needs to record a deficit and debt increase.

(vi) To contribute to the liquidity of interbank markets, some countries have established exchange of assets schemes. The aim of these scheme is to increase the stock of government bonds in the banks’ hands that they can use as collateral in interbank lending. An example is the special liquidity scheme (SLS), which was then replaced by a permanent discount window facility (DWF), in the UK. These schemes start with the government issuing bonds which are lent to the central bank. (24_{) The central bank then}

temporarily exchanges these bonds with commercial paper in the banks’ balance sheet. Before maturity, the bonds are exchanged again against commercial paper – which goes back to commercial banks – and the government bonds return to the central bank and then to the government. As a result, the government will not have to reimburse these bonds or to pay interest on them.

This kind of schemes has no direct impact on the government deficit, other than the fees paid to the government. Potentially, there is some deficit- increasing effect, if a commercial bank defaults, collateral in the central bank’s hands proves to be insufficient and the central bank has to be indemnified by the Treasury.

( )

would oblige statisticians to heroically estimate the probability of defaults and of guarantees being called. (24_{) Note that bonds are lent to the central bank, not sold; the}

government receives no cash, other than a fee.

When publishing the deficit and debt data reported by Member States (see Eurostat News Release 56/2009 of 22 April 2009), Eurostat indicated that the treasury bills provided by the UK Treasury to the Bank of England for use in the SLS amounted to 12.8% of GDP.

The impact on the government gross debt of these schemes has been among the most heated discussions among statisticians. On the one hand, the scheme works in such a manner that the government does not have to reimburse or to pay any interest on these bonds. In essence, the scheme can be seen as a way of designing a government guarantee for interbank lending. This would suggest that, effectively, the scheme does not create government debt. On the other hand, the government has issued paper which was lent to the central bank, exchanged against commercial paper, used as collateral and potentially sold several times among commercial banks. Therefore it would be inappropriate that those bonds where not recorded anywhere in the ESA framework. At the time of writing this report, nothing has been recorded in the government debt in relation to this scheme, but the issue is still under discussion. (25₎

(vii) The deposit guarantee or insurance schemes

do not necessarily imply any recording in government accounts. In most EU countries the deposit insurance schemes have been classified in the financial corporate sector as insurance companies and not in government. (26_{) In}

particular there was no deficit or debt impact when the EU decided an increase in the ceiling for deposit protection. 27

In case a deposit entity becomes insolvent, the impact on government accounts depends very much on how the deposit protection scheme is organised; this differs from country to country. The indemnities are either directly borne by the State (thus increasing the government deficit and

(25_{) As per the usual procedures whenever there is a doubt}

concerning the correct interpretation of ESA or its application to a concrete transaction, Eurostat has consulted the CMFB (committee on monetary, financial and balance-of-payment statistics; this is a consultative body that gathers senior statisticians from the national statistical offices and central banks of the whole EU). The CMFB opinion of 18 March 2009 on the recording in ESA accounts of the UK’s special liquidity scheme, and a background document are available at the CMFB website at http://www.cmfb.org.

(26_{) In Sweden and the UK, the respective deposit guarantee}

schemes have been classified in central government. (27_{) On 7 October 2008, EU Finance ministers committed to}

raise the minimum level of deposit guarantees to EUR 50 000; this will increase to EUR 100 000 by end 2010 in compliance with Directive 2009/14/EC of the European Parliament and of the Council on deposit- guarantee schemes (OJ L 68, 13.3.2009, p.3).

debt); defrayed through the sale of assets accumulated by the deposit insurance scheme over the years; distributed among other commercial banks; or a combination of these.

(viii) Most support to the financial sector has been directly provided by the governments. However, there are a number of cases in relation to which one needs to consider the classification in government or in other sectors of the entities providing support.

Notably, in most cases, financial defeasance agencies (i.e. government-established entities created on purpose and specialised in purchasing and disposing of financial assets in a financial crisis, often called ‘bad banks’) are classified in the government sector. This is the case even when those entities have the legal status of public enterprises or special purpose vehicles, and even when those entities are partially owned by the private sector. What matters to decide the classification of those entities is who controls the agency’s activities and bears most of the risks associated to its activity. (28_{) The accounting of}

transactions of ‘bad banks’ that are classified in government is similar to the accounting of transactions carried out directly by the State. An interesting case of an entity created on purpose to provide support to banks is SFEF in France. (29₎

This is an entity – legally speaking, it is a company – created and owned by the French State and some private banks. It borrows with a State guarantee and lends to banks against high-quality collateral. The French statistical authority (INSEE) decided that, in spite of the legal nature and ownership of SFEF, the latter should be classified in the government, given its limited autonomy and the fact that its activities’ risks are borne by the State.

(28_{) In its opinion concerning statistical accounting}

consequences for government of the financial turmoil of 18 March 2009 (available at the CMFB website at http://www.cmfb.org, together with a background document), the CMFB considered that ‘bad banks’ are classified in the general government sector ‘if the government pre-determines the body's activity and assumes all or a majority of the risks associated with the body's activities.’

(29_{) Société de financement de l’économie française.}

Another noteworthy example of an entity active in the context of the financial crisis and whose classification has been discussed by statisticians is AFS in Denmark. (30₎

It should also be noted that, to ensure the principle of economic substance, a transaction in support of the financial sector carried out by a public corporation (e.g., a government-owned bank that is classified in the corporate sector) for public policy purposes under government instructions rather than for commercial reasons will be recorded in the government accounts. (31₎

1.1.2. Conclusion

The vast majority of government measures in support of banks add to the government gross debt, though they are neutral – at least in the short-term – for the government deficit. This is because the government acquires financial assets of the same value of the cash disbursed. In case the government ‘overpays’ for financial assets, the estimated ‘overpayment’ is deficit-increasing. See Table II.1.1 for a summary of the most likely impacts in government deficit and gross debt of measures in support of banks.

In many cases, the support to banks consists in shifting risks to the government, either through the accumulation of assets with uncertain or volatile value or of contingent liabilities. Therefore, the cost for public finances of bank rescues will depend significantly on how these assets and contingent liabilities will be managed and will evolve in coming years.

Given the ESA rules on the valuation of assets, liabilities and respective transactions at market price or fair value, the availability of data on these concepts is crucial to ensure the quality of statistics. However, during a financial turmoil, those concepts may not be directly observable and

(30_{) Afviklingsselskabet til sikring af finansiel stabilitet A/S.}

For the time being, AFS has been classified as financial corporations, and not in government (see Eurostat News Release 56/2009 of 22 April 2009).

(31_{) Technically, the transactions carried out by a unit but}

booked in the accounts of another unit are said to be rearranged or rerouted. This issue is also considered in the above-referred to CMFB opinion concerning statistical accounting consequences for government of the financial turmoil.

Part II Evolving budgetary surveillance

Table II.1.1: Accounting for bank rescues: a summary

Impact on government deficit Impact on government gross debt

Purchase of shares Most likely: neutral Most likely: increase

and

Asset removal schemes But: deficit increases if payment above fair value

But: neutral if transaction financed by a reduction in financial assets (e.g. deposits)

Most likely: neutral Most likely: increase

But: deficit increases in the future if debtor defaults But: neutral if transaction financed by a reduction in financial

assets Most likely: neutral

But: deficit increases in the future if counterpart defaults and collateral insufficient

Most likely: neutral Most likely: neutral

But: deficit increases in the future if guarantee is called But: debt increases in the future if guarantee is called