European Competition Law Annual 1999: Selected Issues in the Field of State Aid 9781472559104, 9781841132242

Citation preview

LIST OF PARTICIPANTS

Giuliano Amato (Presidente del Consiglio, Rome, Italy) Colin Bamford (Chief Executive, Financial Law Panel Limited, London, UK) Jacques Bourgeois (Partner, Akin, Gump, Strauss, Hauer & Feld, Brussels, Belgium Pierre Buigues (Head of Unit, DG-III of the European Commission, Brussels, Belgium) Alec Burnside (Partner, Linklaters & Paines Brussels, Belgium) Gerardo Carnerolli (President, European Court of Auditor, Luxembourg) Marc Dassesse (Professor, Institute for European Studies, Free University of Brussels, and Partner McKenna & Cuneo) Claus-Dieter Ehlermann (Professor, Dr., Member of the WTO Panel, Geneva Switzerland and Professor of the Robert Schumann Centre, Florence, Italy) Jonathan Faull (Formerly, Deputy Director General, State Aid Control, DGIV of the European Commission, Brussels, Belgium; now, Press Secretary to the President of the European Commission) John Fingleton (Professor, Department of Economics, Trinity College Dublin, Ireland) Mauro Grande (Head of Prudential Supervision Division, European Central Bank, Frankfurt, Germany) Jordi Gual (Professor, IESE, University of Navarra, Barcelona, Spain) A.J.E. Havermans (Member of the Board of Netherlands Court of Auditors, The Hague, Netherlands) Walter Hellerstein (Professor, School of Law, University of Georgia, Athens GA, USA) Gary Horlick (Partner, O'Melveny & Myers LLP, Washington D.C., USA) Anne Houtman (Head of Unit, State Aid Policy, DG-IV of the European Commission, Brussels, Belgium) Charles Ilako (Pricewaterhouse Coopers Consultants, London, UK) Christian Koenig (Director, Centre for European Integration Studies, University of Bonn, Germany)

viii

List of Participants

Patrick Low (Director, Office of Director-General WTO, Geneva, Switzerland) Patrick A. Messerlin (Professor, Institut d'Etudes Politiques de Paris, France) Fiorella Padoa-Schioppa Kostoris (Professor, ISAE, Rome, Italy) Alfonso Papa Malatesta (Professor, Cerardi Luiss University, Rome, Italy) Agar Petersen (Former Deputy Director General, State Aid Control, DG-IV, of the European Commission, Brussels, Belgium) Patrick Rey (Professor, Institut d'Economie Industrielle, Universite des Sciences Sociales de Toulouse, France) Gian MicheleRoberti (Partner, Studio Legale Tizzano, Brussels, Belgium) Wulf-Henning Roth (Professor, Dr., Institut fur Internationales Privatrecht und Rechtvergleichung, Bonn, Germany) Mario Sarcinelli (President, Former President, Banca Nazionale del Lavoro, Rome, Italy) Matthew Schaefer (Professor, College of Law, University of Nebraska, USA) Ian Host Schmidt (Director, Economic Evaluation Unit, DG II/E of the European Commission, Brussels, Belgium) Uwe H. Schneider (Professor, Dr., Centre for German and International Law of Financial Services, Guttenberg Universitat Mainz, Germany) Peter Schuetterle (Cr., Secretary General, Energy Charter, Brussels, Belgium) Michael Schutte (Cr., Partner, Bruckhaus, Westrick, Heller Lober, Brussels, Belgium) Paul Seabright (Professor, University of Cambridge, UK) Romano Subiotto (Dr., Partner, Cleary, Gottlieb, Steen & Hamilton, Brussels, Belgium) Tihamer Toth (Dr., Counsellor, Office for Economic Competition of Hungary, Budapest, Hungary) Antoine Winckler (Partner, Cleary, Gottlieb, Steen & Hamilton, Brussels, Belgium) Giuseppe Zadra (Dr., Director General, Associazione Bancaria Italiana)

LIST OF

SPONSORS

Akin, Gump, Strauss, Hauer & Feld (LLP), Brussels Office, Belgium Cleary, Gottlieb, Steen & Hamilton, Brussels Office, Belgium Howrey Simon Arnold & White, Washington DC Office, USA Martinez Lage & Asociados, Madrid, Spain, Skadden, Arps, Slate, Meagher & Flom (LLP), Brussels Office, Belgium White & Case (LLP), Brussels Office, Belgium Wilmer, Cutler & Pickering ,Brussels Office, Belgium Bruckhaus, Westrick, Stegemann, Brussels Office, Belgium Linklaters & Alliance, Brussels Office, Belgium O'Melveny & Myers, Washington DC Office, USA Studio Legale Tizzano, Rome Office, Italy

TABLE OF CASES Judgments of the European Court of Justice and the Court of First Instance Air France v Commission [1996] ECR 11-2109 Andrea Francovich et alv Italy [1991] ECR 1-5357 Asteris et al v Hellenic Republic and the EEC ECR [1988] 5515 Automec v Commission [1992] ECR 11-2223 Banco Exterior de Espana [1994] ECR 1-877 Banco Exterior de Espana v Ayuntamiento de Valencia ECR [1994] 877 Belgium v Commission (Meura) [1986] ECR 2263 Belgium v Commission (Tubemeuse) [1990] ECR 1-959 Boch No 2 [1986] ECR 2321 Boussac [1990] ECR 1-361 Bremer Vulkan [1996] ECR 1-5151 Bretagne Angleterre Irlande v Commission [1999] ECR 11-0123 British Airways and Others v Commission [1998] ECR 11-2405 Case T-149/98 Societe Generale v Commission (pending) OJ (1998) C 358/20 Case T-32/96 Societe Generale v Commission (pending) OJ (1996) C133/31 Case T-62/97 Societe Generale v Commission (pending) OJ (1997) C166/14 Cassis de Dijon, ECR [1979] 649 Cityflyer Express v Commission [1998] ECR 11-757 Commission v Chambre syndicale nationale des entreprises de transport defond et valeurs (Systraval) and Brink's France SARL [1998] ECR 1-1719 Commission v Federal Republic of Germany [1989] ECR 175 Commission v Federal Republic of Germany [1990] ECR 1-3437 Commission v Federal Republic of Germany [1973] ECR 813 Commission v Greece [1993] ECR 1-3131 Delacre v Commission [1990] ECR 1-395 Deufilv Commission [1987] ECR 901 Draehmpaehl [1997] ECR 1-2195 DTIvBAe and Rover [1991] 1CMLR 165 Ecotrade Sri and Altiforni e Fernicre di Servola Spa [1998] ECR 1-7907 ENI-Lanerossi [1991] ECR 1-1433 Executif Regional Walloon and Glaverbelv Commission [1988] ECR 1573 Federal Republic of Germany v Commission [1984] ECR 1492 Federal Republic of Germany v Commission [1987] ECR 4013 Federal Republic of Germany v Commission [1985] ECR 1814 Federation Francaise des Societes d'Assurances e.a. v Commission [1997] ECR 11-229 (CFI) Federation Francaise des Societes d'Assurances e.a. v Commission [1998] ECR I1305 (ECJ)

xii

Table of Cases

Federation nationale du commerce exterieur des produits alimentaires and Syndicat national des negociants et transformateurs de saumon v France [1991] ECR 1-5505 Federation Nationale du Commerce Exterieur des Produits Alimentaires and Syndicat National des Negociants et Transformateurs de Saumon v French Republic [1991] ECR 1-5505 FFSA v Commission [1997] ECR 229. France v Commission (Boussac) [1990] ECR 1-307 France v Commission [1988] ECR 4067 France, Italy and UKv Commission [1982] ECR 2545 French Republic v Commission [1998] ECR 1-1375 Greece v Commission [1988] ECR 2869 Heineken Brouwerijen v Inspecteurs der Vennootschafpsbelasting [1984] ECR 20 Het Vlaamse Gewest v Commission [1998] ECR 11-717 Hillegom v Hillenius, judgment of 11 December 1985 Italgrani [1995] ECR 11-1329 Italy v Commission [1991] ECR 1-4437 Italy v Commission [1974] ECR 709 Italy v Commission (Alfa Romeo I), [1991] ECR 1-1603 Italy v Commission (ENIILanerossi I), [1991] ECR 1-1433 Kirsammer Hack [1993] ECR 1-6185 Ladbroke v Commission [1994] ECR 1015 Leeuwarder Papierwarenfabriek [1985] ECR 809 Lemmens [1998] ECR 1-3711 Lener Ignace SA v. Beauvois et al 2 CMLR [1994] 419 Lorenz [1973] ECR 1471 Namur-Les assurances du credit SAIOffice national du ducroire and the State of Belgium [1994] ECR 1-3829 Philip Morris v Commission [1980] ECR 2671 SFEI ECR [1996] 1-3547 Sloman Neptune [1993] ECR 1-887 Spain v Commission (Hytasa) [1994] ECR 1-4103 Steinike and Weinling [1997] ECR 595 Steinlike en Weinlig ECR [1977] ECR 595 Sytraval [1998] ECR 1-1719 TWD Textilwerke Deggendorf GmbH\ Germany [1994] ECR 1-833 Viscido [1998] ECR 1-2629 Walt Wilhelm and others v Bundeskartellamt [1969] ECR 1 Zuchner v Bayrische Vereinsbank [1981] ECR 2021

Decisions and Opinions of the European Commission Addinol Mineralol GmbH iGV, OJ (1998) C186/7 Air France (1994) OJ C152/6

Table of Cases

xiii

Air France OJ (1994) L254/73 Banco di Napoli OJ (1999) LI 16/36 Banco di Sicilia and Sicilcassa, OJ (1998) C297/3 Credit Fonder de France OJ (1996) C275/2 Credit Lyonnais OJ (1996) C 390/7 Credit Lyonnais, OJ (1995) L308/92 Credit Lyonnais, OJ (1998) L221/28 £F/MOJ(1993)C349/2 04ATOJ(1998)L78/1 Head Tyrolia Mares OJ (1997) L25/26 HIBEG OJ (1998) L316/25 HIBEGlKrupplBremer Vulkan (1993) OJ L185/44 Hilaturasy Tejidos Andaluces OJ (1992) L171/54 //yforaOJ(1994)L386/l Ilva OJ (1993) C 213/6 Imepiel OJ (1987) LI72/76 Intelhorce OJ (1987)L176/57 Lemwerde OJ (1997) L306/18 Magefesa OJ (1991) L5/18 Magneti MarellilCEAC OJ (1991) L222/38 NAVEWA-ANSEAU, (1982) OJ LI67/ 39. Olympic Airways OJ (1994) L273/22 Procter & Gamble/VP Schickedanz OJ (1994) L354/32 SKET Walzwerkstechnik GmbH, OJ (1998) Cl 18/5 Societe de Banque Occidentale (SBDO) OJ (1999) L103/19 Societe Marseillaise de Credit OJ (1997) C49/2 Societe Marseillaise de Credit OJ (1999) L198/1 Special Financing Schemes in France OJ (1979) LI 38/30. SST-GmbH OJ (1994) LI 14/21 Steel Aidin Germany (Case 54/89 ex NN 27/89, No 140/89) OJ (1991) L158/71. Triptis Porzellan GmbH OJ (1999) L52/48 Westdeutsche Landesbank-Girozentrale {WestLB) OJ (1998) C140/9

North American Cases Bacchus Imports Ltd. v Dias, 468 U.S. 263 (1984) Boston Stock Exchange v State Tax Commission 429 U.S. 318 (1977) Building & Constr. Trust Council v Massachusetts Water Resources Bd., 507 US 218(1993) Colorado Central KK v Lea, 5 Colo. 192 (1879)). Cooky v Board of Wardens, 53 US (12 How.) 299 (1851). Cumberland Farms, Inc. v Mahany 943 F. Supp. 83 (D. Me. 1996), rev'don other grounds, 116 F.3d 943 (1st Cir. 1997) Denver v Bach, 58 P. 1089, 1090 (1899)

xiv

Table of Cases

Freeman v Hewit, 329 U.S. 249 (1946) General Motors Corp. v Tracy, 519 U.S. 278 (1997) Halliburton Oil Well Cementing Co. v Reify, 373 U.S. 64 (1963) Hughes v Alexandria Scrap Corp., 426 US 794, 806-810 (1976) Hughes v Oklahoma, 441 U.S. 322, 325 (1979) Hunt v Washington State Apple Advertising Commission, 432 U.S. 333, 350 (1977) Maready v City of Wins ton-Salem, 467 S.E.2d 615, 626 (1996) McLeodvJ.E. Dilworth Co., 322 U.S. 327, 330 (1944) McNichols v City & County of Denver, 280 P.2d 1096 (1955) Miller Bros Co. v Maryland, 347 U.S. 340, 344 (1954)) Mitchell v North Carolina Indus. Dev. Fin. Autk, 159 S.E.2d 745, 761 (N.C. 1968) New Energy Co. v Limbach 486 U.S. 269 (1988) Northwestern States Portland Cement Co. v Minnesota, 358 US 450, 457-458 (1959) Oregon Waste Systems, Inc. v Department of Environmental Quality, 511 U.S. 93, 106 n.9 (1994) Pike v Bruce Church, Inc., 397 U.S. 137, 142 (1977) Re Interrogatory Propounded by Governor Roy Romer on House Bill 9IS-1005, 814 P.2d 875 (Colo. 1991) Reeves v Stake, 447 US 429,436-40 (1979) Seminole Tribe v Florida, 517 US 44 (1996) South Carolina v Dole, 483 US 203, 207-08 (1987) South Central Bell Telephone Co. v Alabama, 119 S. Ct. 1180 (1999) South Central Timber Development, Inc. v Wunnicke, 467 US 82 (1984) Tosto v Pennsylvania Nursing Home Loan Agency, 331 A.2d 198 (Penn. 1975) Tosto v Pennsylvania Nursing Home Loan Agency, 331 A.2d 198 (Penn. 1975) US v Lopez 514 US 549 (1995) Welton v Missouri, 91 U.S. (1 Otto) 275 (1876) West Lynn Creamery, Inc. v Healy 512 U.S. 186 (1994) Westinghouse Electric Corp. v Tully 466 U.S. 388 (1984) White v Mass. Council of Construction Employers, Inc., 460 US 204, 206-11 (1983) Wisconsin Dept. of Indus, v Gould, 475 US 282 (1986) ZenithlKremer Waste Systems, Inc. v Western Lake Superior Sanitary District, 572 N.W.2d 300 (Minn. 1997), cert, denied, 118 S. Ct. 1857 (1998)

TABLE OF TREATIES AND LEGISLATION

I. Articles of the European Treaties Consolidated Treaties {Amsterdam)

EC Treaty Article

Article 2 Article 3 Article 5 Article 6 Article 10 Article 12 Article 28 Article 36 Article 39 Article 81 Article 82 Article 83 Article 86 Article 87 Article 88 Article 89 Article 90 Article 96 Article 97 Article 101 Article 107 Article 188(c)(3) Article 226 Article 229 Article 234 Article 242 Article 295 Article 311

[ex 2] [ex 3] [ex 3b] [ex 3(c)] [ex 5] [ex 6] [ex 30] [ex 42] [ex 48] [ex 85] [ex 86] [ex 87] [ex 90] [ex 92] [ex 93] [ex 94] [ex 95] [ex 101] [ex 102] [ex 104] [ex 106] [ex 136a] [ex 169] [ex 173] [ex 177] [ex 185] [ex 222] [ex 239]

xvi

Table of Treaties and Legislation

II. Legislation Recent Legislation 2000: Commission Notice on the application of Articles 87 and 88 of the EC Treaty to state aid in the form of guarantees, OJ (2000) C71, of 4.03.2000 Directives 1976: Second Council Directive 77/9I/EEC, on co-ordination of safeguards which, for the protection of the interests of members and others, are required by Member States of companies within the meaning of the second paragraph of Article 58 of the Treaty, in respect of the formation of public limited liability companies and the maintenance and alteration of their capital, with a view to making such safeguards equivalent, OJ (1976)L26/1 1977: Directive 77/780/EEC, First Banking Directive 1989: Council Directive 89/299/EEC, OJ (1989) L124/16 on the own-funds of credit institutions 1989: Council Directive 89/646/EEC, Second Banking Directive, OJ (1989) L386/1 1989: Council Directive 89/647 on a solvency ratio for credit institutions, OJ (1989) L386/14 1993: Council Directive 93/6/EEC, OJ (1993) L141/1, amended by Directive 98/31/EC, OJ (1998) L204/13., on the capital adequacy of investment forms and credit institutions 1993: Council Directive 93/22/EEC, OJ (1993) L141/27 on investment services in the security field 1994: Directive 94/19 of the European Parliament and of the Council of May 30, 1994 on deposit-guarantee schemes, OJ (1994) L135/55 1997: Directive 97/9/EC of the European Parliament and the Council, OJ (1997) L84/22 on investor compensation schemes Regulations 1998: Enabling Regulation, OJ (1998) LI42, No 994/98 on the application of Articles 87 and 88 [ex 92 and 93] of the Treaty to certain categories of horizontal aid 1998: Group Exemption Regulation, Regulation No 994/98, OJ (1998) L142, of May 14 1998. 1999: Commission Regulation (EC) No. 618/1999 of 23 March 1999 on provisional countervailing duty on stainless steel wire from India 1999: Procedural Regulation Regulation, No 659/99, OJ (1999) L83,l of March 27 1999

Table of Treaties and Legislation

xvii

Frameworks and Guidelines 1994: Community Guidelines on state aid for rescuing and restructuring of firms in difficulty, OJ (1994) C368/12 1996: Community Guidelines on state aid for small and medium-sized enterprises, OJ (1996) C213/4 1998: Community Framework for state aid for research and development, OJ (1996) C45/5. Framework on training aid , OJ (1998) C343/10 1998: Guidelines for national regional aids, OJ (1998) C74, of the 10.3.1998 1998: Multi-Sectoral Framework on regional aid for large investment projects, OJ (1998) C107/7, of the 7.4.1998 Notices and Communications 1992: Commission Notice on co-operation between national courts and the Commission in the state aid field, OJ (1995) C 312/8 1993: Commission Communication concerning the application of Articles 92 and 93 of the EC Treaty and Article 5 of Commission Directive 80/723/EEC to public undertakings in the manufacturing sector, OJ (1993) C307/3. 1996: Commission Notice on the de minimis rule for state aid, OJ (1996) C68/9. 1997: Commission Notice on the definition of the relevant market for the purposes of community competition law OJ (1997) C372, of the 9.12.1997 1998: Commission Notice on the application of state aid rules in the field of direct business taxation, OJ (1998) C384, of 10.12.1998.

TABLE OF ABBREVIATIONS

AA AEA AGF ATA CFI CHIPS DSU EBF EC ECB ECB ECSB EFTA EIB ECJ EMU ESA ESCB FDI FLP FPO GATS GATT IGPAC ITA LTCM MA MAI NAIRU NASDA NCB NGA NMA OECD OFT R&D SAIs

Antitrust Authorities Association Europeenne des Avocats/European Association of Lawyers Les Assurances Generales de France Anti-Trust Authorities Court of First Instance Clearing House Interbank Payments System Understanding on Rules and Procedures Governing the Settlement of Disputes European Banking Federation European Commission European Central Bank The European Central Bank European System of the Central Banks European Free Trade Area European Investment Bank European Court of Justice Economic and Monetary Union EFTA Surveillance Authority European System of Central Banks Foreign Direct Investment Financial Law Panel Fraud Prevention Office General Agreement on Trade in Services General Agreement on Tariffs and Trade Report of the Intergovernmental Policy Advisory Committee Internal Trade Agreement Long-Term Capital Management Monitoring Authority Multilateral Agreement on Investment Non-accelerating Inflation Rate of Unemployment National Association of State Development Agencies National Central Bank National Governors Association Nederlandse Mededingingsautoriteit Organisation of Economic Cooperation and Development Office of Fair Trading Research and Development Supreme Audit Institutions

XX

SAIs SCM SLIM SME SOA TGV WestLB WfA

Table of Abbreviations

Supreme Audit Institutions Agreement on Subsidies and Countervailing Measures European Simplification Procedure Small and Medium-sized Enterprises Statement of Assurance High Speed Train Westdeutsche Landesbank Wohnungsbauforderungsanstalt

INTRODUCTION

This volume contains the writings and edited transcripts of discussions at the Fourth Annual EU Competition Law and Policy Workshop, held at the Robert Schuman Centre of the European University Institute, in Florence, in June 1999. Readers of the European Competition Law Annuals will remember that the first EU Competition Law and Policy Workshop (1996), discussed the problems of implementing competition policy in a federal context. The second (1997) analysed the objectives of competition law and policy. The third (1998) debated the issue of how to ensure effective competition in the rapidly evolving market of communications. In 1999, the Workshop focused on an aspect of EU competition policy that is generally less explored and understood, the control of state aids. The overall subject of EU state aid control is so broad and complex that the Workshop could only examine certain, clearly delimited, aspects of it in any depth. In choice issues for debate, the organisers sought to give priority to those areas that were most contentious and in need of new policy inputs at the time of the event. The participants within the Workshop—a group of 35 top-level policy-makers, academics and business representatives, drawn mostly from the EU and its Member States, but also including representatives from the US and from 'candidate countries', such as Hungary—were asked to concentrate on three particular issues: a) the justifications for state aids; b) specific problems arising in the control of state aids in the banking sector, and c) the prospects for a more decentralised from of control of state aids within the EU. The control of state aids is a unique feature of EU competition policy. No similar control system exists in any of the Member States or in any federal state outside the EU. This model has, nonetheless, an increasing influence beyond the borders of the Community: its rules have been 'exported' to the European Economic Area, and, more recently, to the Central and Eastern European countries (CEECs) which are candidates for EU membership. EU state aid rules and oversight practice have also influenced the evolution of the subsidy discipline imposed at the level of the GATT and the WTO. Compared with other sectors of EU competition law, academic interest in state aid control has historically been rather limited. The paucity of literature on this subject can be explained by the small number of players in the field. Antitrust rules are directed at individual companies, and enforcement operates

xxii

Introduction

in a decentralised way as companies confront each other in private law suits. Instead, EU state aid rules are directed at the Member States, and the control of state aids is centralised and implemented by the European Commission alone. The control procedures privilege central governments, while other economic and political actors have traditionally played a limited role. While antitrust is clearly dominated by economic and legal concepts and rules, state aid control is considered to be strongly influenced by political considerations. More recently, however, the interest of regulatory, business and academic circles in the state aid control system has notably increased. This phenomenon is, to a certain extent, contextual: ie, related to the completion of the Single Market Programme and the launch of the EMU. Intensified competition in an increasingly integrated market can only enhance the distorting effects of state aids. It is, therefore, not incidental that the need for a strict state aid policy is, today, repeatedly stated in the declarations of the Industry Council and the European Parliament. Yet, if state aid control is no longer the Cinderella of EU competition policy, or a poor relative of antitrust, this is also due to the Commission's efforts to improve the control system. In particular, during the reign of Karel van Miert as Commissioner for Competition, EU state aid regulation and the Commission's control activities were visibly consolidated and expanded. The reader will be pleased to find Karel van Miert's engaging account of the main developments in EU state aid policy during his seven years of office within this volume. A good part of the Commission's reform initiatives in the field of state aids was directed at streamlining and increasing the transparency of its own control activities. Recently, two further important steps have been taken in this direction. In March 1999, the Commission's proposal for a Procedural Regulation on state aids obtained the approval of the Industry Council (Council Regulation No 659/1999, OJ (1999) L83, of 27.03.1999). After four decades of functioning, EU state aid control was endowed with a basic procedural act similar to Regulation 17/62 in the area of antitrust. Shortly afterwards, the Industry Council approved a Regulation enabling the Commission to adopt group exemptions for certain categories of horizontal aid. Under the system of group exemptions, a technique that was borrowed from antitrust law, less significant cases of state aid will no longer be required to be notified to the Commission and authorised by it. This should alleviate the Commission's workload and allow it to concentrate on the most significant state aid cases. A first group of group exemptions, concerning SMEs, training and de minimis aid, is expected to enter into force during the second half of the year 2000. State aid control is the area of EU competition policy where the different economic and political interests at stake are notoriously difficult to reconcile. The new Procedural Regulation codifies the existent centralised control practices, and, as such, it is a disappointment to those hoping for more involvement of third parties: ie, the competitors of the aid beneficiaries in state aid cases. In balance, however, the Procedural Regulation also brings some improvements to the control system. It establishes deadlines within which the Commission must

Introduction

xxiii

finalise its preliminary and formal investigations into notified state aid. The Commission's control powers are strengthened by the introduction of three injunctions (on information, suspension of aid and provisional recovery), which can be used against the Member States during the investigation of state aids which were not notified. Finally, the Member States are obliged to take all necessary measures to obtain the immediate reimbursement of illegal aid when recovery ordered by the Commission is blocked though proceedings before national courts. The Commission's reform efforts were also directed towards the updating and refining of EU state aid regulation, and, in some cases, rendering state aid regulation more consistent with related EU policy objectives. For example, the updated Commission Guidelines on national regional aid (OJ (1998) C74, of 10.3.1998) seek to reduce regional aid expenditures in the better-off Member States and, thus, to ensure more consistency between EU state aid and cohesion policies. The new rules, applicable to regional aid in general, were supplemented with a Multi-sectoral Framework (OJ C107 (1998), of 17.04.1998), allowing case-by-case scrutiny of regional aid to large investment projects. The close scrutiny investment aid is a 'first' since the establishment of the EU state aid control system. In relation to the application of the Code of Conduct for Business Taxation, the Commission clarified the rules on harmful tax measures qualifying as state aid (Commission Notice on the application of state aid rules in thefieldof direct business taxation, OJ (1998) C384, of 10.12.1998). At the time of writing, the compatibility of about thirty-five taxation measures with EUfiscalaid rules was under investigation in different Member States. The adoption of specific policy guidelines on fiscal aid was, more than anything else, a signal of the Commission's intention to begin a more scrupulous form of control of a state aid form which had previously been somewhat overlooked. This coincides with a more general trend, observed over the last years, to expand the scope of EU state aid control into sectors of the market that had only recently been opened up to competition, such as the liberalised public sectors. On the implementation side, a number of negative decisions taken in important and controversial state aid cases over the last years have revealed a Commission with more clout to resist political pressures from the Member States. Several contributions to this volume refer to the most important of such cases, which were equally mentioned in discussions during the first two sessions of the Workshop. In a similar way, the Commission proved, on occasion, to be considerably more determined to compel recalcitrant Member States to agree with some of the state aid policy guidelines it proposed. For example, in 1990, the Commission adopted a decision (OJ (1990) L188 of 20.7.1990) requiring Germany to comply with its special rules on state aid to motor vehicle companies. Germany had initially opposed the adoption of the Framework. Thereafter, the Commission opened several investigation procedures into motor vehicle aid schemes that had already been approved in Germany. The Commission's intensified activities in the field of state aids revived the debate on the objectives, coverage and implementation of EU state aid policy.

xxiv

Introduction

Against this background, the 1999 EU Competition Law and Policy Workshop was intended to further the debate on some of the aspects of the EU state aid policy that had been insufficiently explored in the past, such as the justification for state aids and the prospects for a more decentralised control of state aids. In addition, the Workshop debated the most urgent and controversial policy challenges of the time, which were related to state aids in the banking sector.

Session I: The Justification for State Aids The first session of the Workshop explored the controversial issues that arise in EU state aid policy in relation to the justifications for, and effects of, state aids. Discussions and conclusions in the 1997 edition of the Workshop emphasised the fundamental importance of clarifying the objectives of antitrust policy. It was then underlined that, in all major jurisdictions, antitrust policy objectives were being narrowed down to an explicit concentration on notions of economic efficiency and consumer benefit. In other words, non-economic political considerations had receded into the background as a legitimate element of antitrust policy. Just as in antitrust, the issue of the justification for state aid is fundamental within EU state aid control. From the point of view of economic efficiency, state aids are justified only if used to correct certain failures in the functioning of the market. In reality, however, state aids are seldom exclusively motivated by legitimate market failure concerns. They will often be based on equity and other political considerations, or mix efficiency and equity objectives. The provisions on state aid in the EC Treaty are mainly efficiency-oriented, but include equity and fairness considerations. Article 87(3)(a) [ex 92(3)(a)], for example, justifies state aids promoting the Community goal of economic and social cohesion, thus legitimising both direct national and indirect EU aid (via the Structural Funds) given for regional policy objectives. It follows that answering the question of whether state aid is justified under EU state aid rules, often requires a laborious search for the appropriate balance between the different objectives and requirements of the EC Treaty. The analysis of whether state aids are justified poses numerous difficulties. For example, the issue of the economic justification for state aid is not solved by simply identifying the market failure to be addressed through public intervention. The scale and form of the intervention must, as far as is possible, be appropriate and proportional to the nature and significance of the problem. Yet, assessing the importance and magnitude of market failures in itself poses a number of analytical problems. Economists generally list the following types of market failure as relevant to the analysis of state aids: (i) public goods; (ii) merit goods; (iii) increasing return of scale; (iv) externalities; (v) imperfect or asymmetric information; (vi) institutional rigidities; (vii) imperfect factor mobility; (viii) frictional problems

Introduction

xxv

of adjustment to changes in markets, and (ix), subsidisation of foreign competitors. The determinants of the magnitude of each kind of economic problems cannot be easily specified. Externalities, for example, are, by definition, not the subject of market transactions, and thus cannot be easily measured or valued. Even where the determinants of magnitude are easily identified, another m'ajor constraint would be the availability of data necessary for the concrete measurement of the problem. It would be unrealistic to expect the Commission, given its heavy workload and limited human resources, to perform such scrupulous measurements in the case of each of the numerous state aid cases notified. As a result, nobody should be surprised if the disbursement of aid in the Member States bears little relation to the reasonable estimates of the magnitude of the market failures being targeted. Yet, as one of participants at the Workshop remarked, the existent control practice could, nevertheless, be improved in at least two accessible ways: first, by asking the Member States to provide more information on the market failures targeted by aid in their notifications; and secondly, by encouraging the greater involvement of third parties within state aid investigation procedures. In this sense, the Commission's recent proposals for improving the transparency of aid expenditures in the Member States—ie, the introduction of State Aid Registers and Scoreboards—may have the effect of encouraging more complaints from interested third parties, for example, against state aid that was not notified. The identification of a specific market failure does not necessarily imply that state aid is the most adequate instrument to address it. For example, in the case of environmental protection, subsidies could be substituted by regulatory instruments, taxation or tradable emission licenses. In the case of regional policy, less distorting and more efficient alternatives to aid, at both national and EU level, could be thefinancingof infrastructure or human capital formation. Another regulatory solution for reducing regional unemployment, proposed by one of the participants at the Workshop, could be the extension of the Community's principle of mutual recognition to labour contracts and social security systems. In the European context, state aid traditionally was, and to a large extent remains, the form of public intervention that is often preferred by governments. The EU itself uses more than one third of the Structural Funds budget to aid production investment projects in the European regions assisted under Objectives 1 and 2. It is obvious that politicians prefer to give aid because it produces more immediate and visible effects, whereas alternative forms of public intervention give results only in the medium to long-term. On the other hand, as one of the Commission officials present at the Workshop explained, in some cases it is EU state aid regulation that either does not welcome alternative forms of intervention, or is insufficiently elaborated for their assessment. An example, in this sense, is the regime applicable to state aid for SMEs. EU rules essentially limit intervention to investment infixedcapital and discourage aid to working capital or for share acquisitions. Yet, investment aid only addresses the effects

xxvi

Introduction

of the market failures that affect SMEs and does not deal directly with the problem at its source. SMEs are mostly affected by market failures in the phase of their start-up and development, when they need working and risk capital. In summary, consensus as to the best way to target a specific market failure is quite often difficult to reach. The ideal, however, would be to deal with the problem at the source rather than try to minimise its undesirable effects. The criteria for determining whether state aid is justified are further obscured in the case of state aids with compound objectives. Regional aid is the typical example of public intervention that mixes efficiency and equity objectives. When state aids are motivated by equity consideration, they are not only often inefficient—ie, they might be better replaced by other forms of public intervention—but also often produce negative externalities. Such negative externalities may hurt competition in other Member States. Yet, in the case of state aid proposed for the achievement of regional policy objectives, EU rules allow for a sacrifice of efficiency in favour of cohesion. This sacrifice is justified only if the aid indeed serves the cohesion objective: ie, it contributes to raising income or solving the unemployment problem in the region targeted by the assistance. But, the determination of whether regional aid is justified on cohesion grounds requires complex macro-economic evaluations that are different from the micro-economic assessments usually performed in state aid cases. The debate on the economic justifications for state aids logically brought the role of economic analysis in EU state aid control into the discussion of the participants at the Workshop. The general feeling amongst the participants was that economists are not particularly well-equipped to help the Commission to discipline state aids through general guidelines, although their assistance in improving analytical tools for dealing with individual cases can be valuable. One of the main obstacles to a proper economic evaluation of the justification for, and effects of, state aid is the ex ante nature of the EU control system. According to this model, state aids must be assessed upon their notification for approval, at a time prior to their concrete implementation when there is still a good deal of uncertainty about their true ex post effects. By contrast, ex post monitoring of state aids within the EU system, generally entails little more than a routine legal procedure. The main problem with ex ante control is that, within economics—as one of the participants put it—'once the assumption of perfectly functioning markets is abandoned, in many instances [...] theory cannot tell ex ante what would be the effects and consequences of a given state aid measure. The outcomes would depend on a variety of specific circumstances and pre-existing conditions. For the same reason, it would be impossible to establish a comprehensive prior set of rules to predict the welfare output of various kinds of state aids given in different circumstances. Economic analysis can, instead, be useful when it comes to judging the design of rules. Moreover, it is indispensable in the analysis of individual interventions where the circumstances can be specified'. Commission decisions in state aid cases are, therefore, sometimes criticised for their arbitrariness or manifest error in the economic assessment of the

Introduction

xxvii

justification for, and effects of, aid. In a simple example, the Commission sometimes fails to identify cross-border negative externalities before diagnosing distortion of competition, which is the prerequisite for the application of EU state aid rules. In particular, the distortion is sometimes presumed if a large volume of intra-community trade in the sector in which the aid beneficiary operates was identified. Such errors of assessment are often due to the already lack of information available during the ex ante scrutiny of state aid. At the same time, the Commission could still call upon the economists to aid them to improve the analytical 'tool-kit' that is used in the assessment of individual state aid measures. For instance, one of the basic analytical tools developed in the field of antitrust, market definition, has rarely been used in the control of state aids. The scope for using market definition, as well as the appropriate method of denning markets in state aid cases, is explored by one of the contributors to this volume. It is suggested that state aids could be loosely divided into two categories. Some might be allowed automatically, provided certain conditions are fulfilled (R&D, SMEs and de minimis aid), others will require consideration on a case-by-case basis, or, through the application of a 'rule of reason' approach similar to that applied in antitrust law (regional aid and rescue and restructuring aid). For state aids in the last category, a modified version of market definition—based upon developments within the antitrust field, yet taking into account the specific characteristics of aid—could play a useful role in assessing the effects of aid. In particular, the method of measuring substitutability would take into account the fact that substitutability in the state aid field works in exactly the opposite direction to substitutability within antitrust. In addition, state aids can have effects in complementary markets that do not arise in the same way in the antitrust field. One of the important messages to emerge from the discussions of the Workshop, was that the tightening of EU state aid rules and the more rigorous scrutiny of individual state aid cases might be not be sufficient to reduce state aid expenditures across the EU. The latest state aid Survey (The Eighth Survey) confirmed the downward trend in aid expenditure observable within the Community since 1993. Overall aid expenditures across the EU decreased from 40,341 million Euro in 1994 to 28,400 million Euro in 1998. Even so, aid levels remain far too high, particularly in some of the better-off Member States. Moreover, it is still unclear whether the general downward trend reflects more liberal economic thinking and a more cautious attitude towards the spending of taxpayers' money within the Member States, or whether it is merely contextual: ie, related to the tighter budgetary discipline required by EMU. Some of the Workshop participants unveiled the work that is underway for the supplementing of the micro-economic control of state aids currently exercised by the Commission, with a macro-economic approach to the reduction of state aid expenditures in the Member States. Aggregate macro-economic targets for the reduction of state aid expenditures could be useful on at least two accounts. First, a goodly share of the state aid measures which successfully pass scrutiny under EU state aid rules are nevertheless inefficient: economic

xxviii

Introduction

evaluations of state aid expenditures in several Member States have, by contrast, shown that there is little correlation between levels of aid given and the even simplest measures of efficiency applied in most cases. Secondly, however, a reduction in certain categories of state aid expenditure would help Member States to remain within the budgetary discipline criteria imposed by the Stability Pact. According to estimates presented to the Workshop, a 0.42% of GDP cut in state aid expenditures in the Member States could save about 24 million Euro at EU level without jeopardising efficiency objectives. It is suggested that such cuts should primarily affect sector-specific and regional aid expenditures. It is nevertheless unlikely that the Member States will reach a political agreement on specific aggregate targets for reduction. It may, instead, be more feasible to seek a simpler and moreflexibleagreement, or standstill system, whereby those Member States with aid expenditures higher than the EU average would be required to roll back. This system could be complemented by recommendations on specific reduction targets for Member State, similar to those already made by the Commission in its 1999 Broad Economic Policy Guidelines (COM(1999)143 final). Another mechanism, suggested during the Workshop, would be the introduction of 'concentration benchmarks' focusing on the degree of disbursement of different aid expenditures among beneficiaries. The Workshop also revealed that the debate over the coverage, application and implications of international anti-subsidy rules in the context of the WTO subsidy discipline are somewhat distinct from those arising in the European context. WTO anti-subsidy rules focus on the protection of the interests of producers and the securing of access to foreign markets, even though this is not always a consistent way of evaluating the justification for subsidies in an international trade context. In addition, WTO subsidy rules contain a prohibition on certain types of specific subsidies. The fact that there is little economic justification to assuming that specific subsidies are more damaging from a welfare point of view than certain general measures notwithstanding. An approach to the application of anti-subsidy rules, which is more in line with the 'rule of reason' rationality, would nonetheless be difficult to establish within the international context in which the WTO operates. In other words, there is little motivation for certain countries to subscribe to a more welfare-oriented supranational discipline so long as global welfare can only be increased at the expense of some countries losing part of their own national welfare. To sum up the discussions in this session in a few points, the participants agreed that: a) economists are not particularly well-equipped to help the Commission draw general policy guidelines on the justifications for, and effects of, various state aid measures; but b) economic theory can help to improve the analytical tools used by the Commission in the screening of individual state aid cases; and c) work is underway for the introduction of aggregate macro-economic targets

Introduction

xxix

for the reduction of state aid expenditures across the EU, which are designed to complement the micro-economic control exercised by the Commission under EU state aid regulation.

Session II: Some Problems Arising in the Control of State Aids in the Banking Sector The second session of the Workshop was devoted to the problems arising in the control of state aids in the banking sector. The last years have seen the emergence of major state aid problems in this sector; problems that were practically unknown during the first thirty-five years of the EC. The Workshop discussed three of the most complex and challenging policy issues, namely: (i) rescue and restructuring aid to banks; (ii) the institutional guarantees enjoyed by certain publicly-owned banks, such as the German Landesbanken; and (iii), the validity and enforceability of non-notified—and, therefore, not approved—loan guarantees given to banks by the Member States in order to facilitate the granting of loans to companies. The most visible control issues arising in the banking sector are, of course, those related to cases of rescue and restructuring aid to banks, such as the famous case of Credit Lyonnais, which is estimated to have cost the French taxpayer 150 billion FF. The justification for rescue and restructuring aid to troubled companies is, generally-speaking, one of the most controversial issues in EU state aid policy. This kind of state aid is used to re-establish a player on the market who might otherwise have disappeared. Given that the market provides alternative solu-, tions for enterprises in difficulty—closure, sale of assets to investors who believe that the previous activity can be continued profitably after some restructuring—one could argue that there is no justification for this type of public intervention, even of the equity type. This argument holds true to an even greater degree in the case of troubled companies where the unemployment caused by closure would not affect a particularly underdeveloped region or less advantaged members of society. The Workshop participants discussed whether these considerations also apply in the case of a distinct service sector such as banking. In other words, the issue is one of whether the characteristics of the banking sector justify its special treatment under the EU state aid regime, and the application of rules different from those that govern manufacturing or other service sectors. In particular, can the social consequences of the closure of big banks be considered as circumstances that mitigate in favour of public intervention? Should certain banks be allowed to benefit from implicit state guarantees by virtue of the rationale that they are 'too big to fail'? Does this so-called danger of systemic crisis in the banking sector justify the special treatment of the state aid used to prevent it?

xxx

Introduction

Some of the participants at the Workshop argued that one of the main peculiarities of banking, which is high exposure to the risk of failure, could generally be considered to be a justification for state aid in this sector. Alternatively, high exposure to risk in this sector could be considered to be a form of market failure that lends itself to correction through public intervention. Another argument for allowing public intervention in cases of banking failure related to the expected increase in concentration within the banking sector following the completion of the Single Market Programme and the launch of the EMU. In other words, national regulatory and supervisory agencies may still be insufficiently prepared to cope with such concentration trends and the possible risks that they entail. Credit Lyonnais is an exemplary case, where not only the bank, but also supervisory agencies and private credit-rating agencies failed: the bank continued to have a high rating throughout the entire course of its difficulties Other participants at the Workshop considered such arguments to be insufficient to justify the special treatment of state aid to banks. Those who took this view maintained that existing EU state aid rules and control practices were sufficient to deal with the problems of rescue and restructuring aid cases within the banking sector. For example, Commission and ECJ decisions in banking cases during the last decades have shown that the market economy investor principle can be applied without particular difficulties in the assessment of cases where national supervisory or regulatory bodies intervene to support banks. In addition, public intervention in cases of 'systemic crisis' can be dealt with under Article 87(3)(b) [ex 92(3)(b)] EC. The Commission should, however, bear in mind the need for the development of 'special', or speedier, procedures for the assessment of state aid proposed in cases of systemic crisis, where the main issue is the need for urgent intervention. As one of the participants phrased it, rules on state aid to banks in cases of systemic crisis should be 'soft' enough to deal with cases of emergency, yet sufficiently 'hard' to combat moral hazard effects, or the phenomenon of reliance upon public intervention. The debates also revealed that the Commission is generally ill-prepared to evaluate whether state aid can contribute to restoring the long-term economic viability of the aid beneficiaries, which is one of the conditions for the approval of aid to finance a restructuring plan. This holds also true when it comes to the assessment of the feasibility of complex restructuring plans in banking. Another further issue raised is the frequent failure of the Commission to establish whether the proposed amount of state aid is 'proportional to the nature and form of the problem addressed'. The principle of proportionality in EU state aid policy seeks to ensure that aid approved by means of exemption, since its objectives are justified, should nevertheless be limited in terms of amount to what is strictly necessary for achieving its proposed objective. This is a mode of ensuring that the distorting effects of approved state aid are limited to the 'unavoidable minimum'. A thorough application of the principle of proportionality in cases of aid to companies in difficulty would require, in a first step, the determination of the extent to which the restructuring plan could befinancedby the beneficiary through own-resources, via the sale or placement

Introduction

xxxi

of non-core assets in financial trust. The state should, instead, only be allowed to finance that part of the cost of a restructuring operation that cannot be financed by the beneficiary. The problem that arises in relation to the application of such rules in the banking sector is that the 'non-core assets' of banks are even more difficult to identify and value than in other sectors. The second subject of debate in this session was the issue of whether the institutional guarantees enjoyed by certain German public-owned banks, namely the regional public banks (Landesbanken) and the local public savings banks (Sparkassen), fall under the scope of EU state aid rules. The German Landesbanken and Sparkassen enjoy certain advantages because of two form of guarantee, 'Anstaltslast' and 'Gewahrtragerhaftung', which are foreseen by German laws and which are constituted as public law institutions. Such institutional guarantees first allow the banks to obtain a better rating from credit-rating agencies. In turn, this better rating allows the Landesbanken to save considerably on the cost of refinancing. The legal nature and effects of the German institutional guarantees is the subject of vivid controversy. The German government, as well as a part of the German legal community, takes the view that 'Anstaltslast' and 'Gewahrtragerhaftung' are an integral part of the institutional rules that govern Landesbanken and Sparkassen under German public law. As a consequence, they are protected under Article 295 [ex 222] of the EC Treaty, which excludes Community interference with rules governing the system of property in the Member States. It is useful to recall that the German Government even sought (unsuccessfully) to protect the privileges of the German public banks through a Protocol to be added to the Treaty of Amsterdam. An additional argument invoked in the defence of the German institutional guarantees is that Landesbanken and Sparkassen perform services of general interest, and are, therefore, excluded under Article 86 [ex 90] EC from the application of EU competition rules. The contrary view, however, is that Anstaltslast' and 'Gewahrtragerhaftung' act as statutory guarantees, and fall under the scope of EU state aid rules because they financially advantage German public banks over their competitors in other Member States. Article 295 of the EC Treaty does not protect the German institutional guarantees granted under national law from the application of EU state aid rules. THis provision only requires Community neutrality with respect to the form of ownership in the Member States, which is not the issue at stake. Institutional guarantees are similarly only protected under Article 86 EC Treaty to the degree that German publicly-owned banks provide services that are of general economic interest according to EU law. While it is true that these publicly-owned banks provide certain services on behalf of the state—the Sparkassen, for example, disburse loans to SMEs—the financial advantage conferred upon the banks by the institutional guarantees may nevertheless exceed the value of the service provided. Both positions are argued in detail by contributors to this volume. During discussions at the Workshop, the majority of the participants felt that, beyond

xxxii

Introduction

the extent to which they fall under Article 86, the German institutional guarantees to publicly-owned banks are difficult to justify. This conclusion coincides with the position taken by the Commission in the aftermath of the Workshop. In March 2000, the Commission overcame its initial reluctance to approach this politically sensitive subject and expressed its doubts about the compatibility of German institutional guarantees for the Landesbanken with EU state aid rules. The Commission considers that the German institutional guarantees to such banks qualify as state aid because they are unlimited in time and amount, and no remuneration is paid for them. Moreover, in the Commission's view, the triple-A rating from credit-rating institutions for the Landesbanken is due only to the guarantees. The practical consequence of this rating is to lower the cost of fund-raising on the capital market. Accordingly, the Commission engaged in discussions with the German government in search for solutions ensuring compliance with EU competition rules, which would also allow the public character of the Landesbanken to be maintained. Institutional guarantees granted the Sparkassen may, by contrast, be considered by the Commission to be compatible with EU state aid rule's. To begin with, the activities of the German local savings banks do not necessarily affect trade between the Member States. In addition, the Sparkassen promote SMEs. As long as the financial advantage derived from the institutional guarantees is proportional to the value of this service, there would be few reasons to consider the guarantees to be incompatible with EU state aid regulation. A third subject of debate in this session was the validity and enforceability of non-notified—and, therefore, not approved—state guarantees to banks when given to facilitate loans to companies which otherwise would not have been granted the loan at all, or would have normally been granted the loan on more onerous terms than those obtained because of the guarantee. State guarantees to banks for loans to companies are frequently used in the Member States as a form of public intervention to support companies in difficulty. The advantage of state guarantees over direct subsidies is that they avoid immediate commitments from the public budget. In the case of state guarantees for bank loans to companies, the state becomes a lender of last resort, who is only obliged to pay the guarantee if the borrower is not able to pay its debt. The triangular relationship that arises between the state, the lending bank and the borrowing company in the case of state guarantees raises several problems in the control of state aids. While it is now generally accepted that a state guarantee may contain an element of aid to the borrower, many commentators contest the conclusion that state guarantees may contain aid to the lending banks themselves. Just as in many other domains of EU state aid regulation, the criteria that determine whether a state guarantees can be considered to contain an element of aid to the borrower were refined gradually. The Commission originally took the view that all state guarantees could be presumed to contain an element of

Introduction

xxxiii

aid to the borrower. In its 1989 policy guidelines, the Commission requested that all individual state guarantees and guarantee schemes be notified for approval. This extreme per se approach was relaxed over time. The recently adopted Commission Notice on the application of Articles 87 and 88 of the EC Treaty to state aid in the form of guarantees (OJ (2000) C71, of 4.03.2000) clarify the presumption under which State guarantees can be assumed to be aidfree. This should be the case when: (i) the borrower isfinanciallysound; and (ii), able to obtain a loan without the guarantee; (iii) the guarantee is for a fixed amount and does not exceed 80% of the outstanding obligation; and (iv) the borrower pays a market price for the guarantee to the state. The question of whether state guarantees might also include an element of aid to the lending bank is subject to a greater degree of dispute. Some commentators argue that banks do not derive any financial benefit from the guarantee and loan operation. In other words, all the additional benefit of the issuance of a loan at a more advantageous interest rate goes to the borrower, while the bank does not derive any benefit from having undertaken a risk that otherwise would not have been undertaken. It is difficult, however, to deny that, for example, if it is granted after the conclusion of a loan agreement between the bank and the borrower, a state guarantee may yet increase the security of the loan. In addition, when a loan is guaranteed by the state, banks in certain Member States are not obliged to furnish a security ratio from their own funds to cover the risk of the loan, as would be the case when normal loan agreements are concluded. The most controversial legal issue within the triangular relationship created by a state guarantee to a bank, however, is undoubtedly the legal status of 'unlawful' guarantees that were not notified to the Commission for approval under EU state aid rules, and so could not be approved by it. The potential effect of unlawful aid on the validity of the underlying guarantee is clearly of importance to the banks. The invalidity or non-enforceability of state guarantees affects the value of the assets of a bank and, in the case of commercial banks, even impact upon the question of whether such assets are available for capital adequacy purposes.. The legal issues related to the validity of a guarantee containing unlawful aid may arise both in Commission proceedings and in legal proceedings before national courts. What is the legal status of state guarantees pending a Commission decision on the legality of aid contained in the guarantee? Can the bank claim the payment of a state guarantee that was not notified pending a Commission investigations into the legality of the aid contained in it? Alternatively, is the guarantee to be considered void and unenforceable? Furthermore, what are the legal effects of an interim Commission injunction suspending the underlying guarantee pending Commission investigation into the legality of aid contained by it? Finally, if a state guarantee is ultimately declared to contain illegal aid to the borrower, what should the legal consequences be with respect to the validity of the guarantee vis-a-vis the lending bank, that is considered by some commentators to be simply a 'third party' in such cases?

xxxiv

Introduction

These issues provoked a particularly vivid and controversial discussions amongst the participants to the Workshop. Some argued that while a Commission decision on the legality of an aid element contained in nonnotified guarantees is pending, the guarantee should be considered to be unenforceable (or 'temporarily void') under national law. One of the main legal arguments that supports this view is the fact that Article 87(3) [ex 92(3)] of the EC Treaty, which obliges the Member States to notify aid for approval, is endowed with direct effect and a scope similar to the Article 81(2) [ex 85(3)] prohibition in antitrust law. Other participants took an opposite view: pending a Commission decision on the aid contained in the underlying guarantee, it should be considered enforceable before national courts. Yet, if this latter approach were to be taken, practical difficulties would arise in its application. More concretely, national courts in several Member States would probably not adjudicate on an agreement whose compatibility with EU rules is still to be decided, unless this possibility were clearly foreseen in EU state aid regulation. One of the Workshop participants suggested that this problem could be tackled by a Council Regulation specifying, for example, that state guarantees are not void or unenforceable merely because they are given in connection with unlawful aid. The same Regulation might also specify that such treatment should only apply to guarantees registered in a public register. While the participants could not reach a consensus on these issues, all agreed that the continued state of legal uncertainty is unhealthy, and that the clarification of the situation should be one of the Commission's priorities. In its recent policy guidelines on the application of EU state aid rules to state guarantees, the Commission nonetheless failed to take a firm position on the possible impact of the unlawful or incompatible nature of such aid on the validity of the underlying guarantee. With respect to underlying guarantees for unlawful aid, the Commission guidelines merely state that 'national courts may have to examine whether national law prevents the guarantee contracts from being honoured and, in that assessment, the Commission considers that they should take account of the breach of Community law'.

Session III: The Prospects for a More Decentralised Approach to the Control of State Aids The task assigned to Panel III of the Workshop was to examine the prospects for decentralisation in thefieldof state aid control. State aid control within in the EU is exercised exclusively at the 'centre', by the Commission. The Commission's monopoly over state aid control results directly from the EC Treaty (Article 88 [ex 84]), and not simply from a Council Regulation, such as Regulation No 17/62, which established the Commission's monopoly power to exempt agreements which restrict competition and fall under Article 81(1) [ex 85(1)].

Introduction

xxxv

While the Commission has never been able fully to exercise its monopoly to grant exemptions according to Article 81(3), it has been able to implement its decision-making responsibilities under Article 88 comprehensively. Its state aid control activities are, of course, much criticised. Such criticism, however, is directed at the substance and content of decisions, rather than the manner in which they are taken. In the area of state aids, the Commission has not been forced to develop an instrument as ambiguous as the famous 'comfort letters' that relate to agreements to be evaluated under Article 81. Alternatively, up until very recently, the Commission has, grosso modo, been able to acquit itself correctly with regard to its decision making competence in the field of state aids. However, state aid control functions have come under growing pressure since the beginning of the 1990s. Their scope has increased considerably. One cause for this is the increase in the number of Member States, while another, much more important, reason is the extension of state aid control over activities which were not hitherto considered to contain state aid and, therefore, were felt to be beyond the reach of Article 87. The application of the market economy investor principle to undertakings owned or controlled by the state marked the beginning of this development. The introduction of competition in sectors traditionally reserved for state monopolies has reinforced the trend and continues to make the issue of state aid control even more sensitive in the eyes both of newcomers and incumbents within these markets. In recent years, the Commission and its DG for Competition have, therefore, devoted much effort great efforts to the rationalisation of state aid control. The introduction of a de minimis threshold and proposed block exemption regulations for the state aids field are the most conspicuous signs of these attempts. Both instruments are, of course, well known, having been used successful within the antitrust field since the early 1960s. Another technique borrowed from the area of antitrust is that of the mobilisation of national judges. The Commission Notice on co-operation between national courts and the Commission in the state aid field (OJ (1995) C312, of 23.11.1995) is an effort to foster a concomitant mobilisation in the field of state aid. Block exemption regulations will increase the number of provisions of Community law that are directly applicable and will enhance the importance of Article 88(3), the direct effect of was recognised by the ECJ as early as 1973 (Case 77/72 Capolongo [1973] ECR 611). The decentralised application of antitrust rules is not limited to national judges. EU (and national) antitrust law is also applied by the administrative authorities of the Member States. The Commission and its DG for Competition have encouraged such application. This development culminated in the Commission's White Paper on the modernisation of EC antitrust policy, published in May 1999. In view of the apparent parallelism between the implementation of Articles 81 and 82, on the one hand, and Articles 87 and 88, on the other, it is tempting to explore the question of whether the concept of decentralisation can also be

xxxvi

Introduction

pushed further in the field of state aid control, through the entrusting of certain 'watchdog' functions to national administrative authorities. Could administrative decentralisation be an instrument to enhance the efficiency of state aid control, as proved to be the case in thefieldof antitrust? Might decentralisation serve to relieve the Commission of a portion of its current responsibilities, so allowing it to concentrate its scarce resources on major state aid cases? Might it facilitate the Commission's endeavours to detect and evaluate state aids? In other words, is the delegation of state aid control functions to national administrative authorities conceivable? Alternatively, is such a control function a 'natural monopoly', that is best exercised by the Commission? Further, could national administrative authorities usefully be assigned the task of assisting the Commission in its enforcement activities? Which national authorities are suited to the assumption of such responsibilities? Given the lack of relevant experience within any existing Member State, it appeared to us to be appropriate, in the first instance, to pose these questions to the representatives of the institutions that are responsible for the task of auditing public finances, national regulators and national competition authorities. In addition, however, it seemed logical, in the light of the obligation to establish national state aid control mechanisms imposed upon CEECs by the Europe Agreements, to examine developments in a country such as Hungary. Finally, the temptation to explore the US context proved to be too strong to overcome: its internal market—which is, in many ways, the paradigm of an internal market-seems to function in the total absence of state aid control. Cab the US teach us any lessons? The Workshop produced a strong consensus on one fundamental point: the decision-making monopoly of the Commission with respect to the compatibility of state aids under the EC Treaty should not be shared with any national administrative authority. Control is, indeed, a natural monopoly. In stark contrast to the realm of antitrust, administrative decentralisation should play no part in the field of state aid control. However, it is nevertheless desirable to increase transparency both at Member State and at EU level. Increased transparency at national level would facilitate and reinforce the control activities of the Commission, in particular, through the 'unveiling' of aid granted in the absence of prior notification under Article 88(3). Greater transparency and clarity at EU level—for example, with respect to the definition of what is state aid—would facilitate the role of all of those national administrative authorities that have the potential to assist the Commission in its task of identifying and controlling state aid, which has been granted, but which has not been notified. The discussions of the Workshop mostly centred upon fact that the organisation of an efficient state aid control system within Member States is an impossibility. The reasons for this are well known: in parliamentary democracies, politicians are tempted to grant state aids. Giving subsidies appears to be a more popular exercise than saving the money of taxpayers. Even if politicians were to overcome their natural tendency not to engage in any measure of auto-

Introduction

xxxvii

discipline and binding rules were to be established to restrict their freedom of action, these rules would be likely to be enforced in an overly lax manner. With particular regard to subsidies designed to attract investment, participants also highlighted the, so-called, 'prisoner's dilemma', which sees competing authorities, at state, regional or local level, bound into a subsidies spiral due to a lack of reliable information on and mutual trust in the efficient enforcement of the internal law of their competitors—provided, of course, that such laws exist at all. The prisoner's dilemma accordingly indicates that neither budgetary constraints nor internal law are likely to give rise to a stringent state aid discipline. Efficient state aid control can only be expected from a set of rules—mirroring EC Treaty provisions and the WTO rules relating to subsidies—which bind national legislators and which are enforced by mechanisms situated at a higher level than the participating entities, such as, the Commission or the ECJ within the EU, or the dispute settlement bodies within the WTO. Recent US experience in relation to the constitutional provisions of certain individual states is particularly revealing in this regard. Even though they expressly prohibit the granting of subsidies, such provisions have been 'distinguished', or interpreted in a somewhat 'soft' manner by state constitutional courts, in order to avoid the situation whereby individual states are required to engage in what might be characterised as 'unilateral disarmament'. At US federal level, there are no rules—either of a constitutional or of a statutory nature—which deal with state aids explicitly. Although, according to one of the panellists from the US, such rules would be desirable, it is highly unlikely that they will ever be adopted. The sole existing discipline is derived from the 'dormant' commerce clause prohibition. This prohibition is, however, limited to discriminatory taxation. In addition, its exact limits are not very clear. Mistrust amongst Member States also bedevils the situation within the EU. Two particular contributions to the Workshop illustrate this finding. The first, concerns the marked differences that are apparent between the enforcement of antitrust rules and the application of state aid control provisions: as one panellist remarked, Member States stand 'shoulder by shoulder' in the area of antitrust, but are suspicious and confrontational with regard to state aids. The second, highlights the negative reactions to the Dutch Audit Court's report on aid schemes involving Fokker, NedCar, DAF and Fokker/DASA: the highly critical stance of the Dutch Government in this case, and its fears that the competitive position of the Netherlands would be damaged in relation to other Member States, appears to be understandable in view of the lack of similar transparency in other parts of the EU. Any attempt to organise state aid control at national level would encounter major difficulties. In stark contrast to the area of antitrust, the subjects of oversight are not undertakings, but the state in the character of all of its different components (central, regional and local) and all of its different institutions (legislative and governmental). Both aspects of control raise fundamental constitutional questions. In order to make the control effective—for example, with

xxxviii

Introduction

respect to the national parliament—the legal rules to be enforced would need to be enshrined, at least in part, within the national constitution. It would nonetheless be inappropriate to entrust the oversight of such rules to the judiciary (in the form of a national constitutional court), since the granting of state aid is, normally, a highly political and largely discretionary decision. As a consequence, the Workshop barely touched upon constitutional courts and concentrated, instead, upon finance ministers, audit courts, competition authorities, sector specific regulatory agencies and newer forms of control bodies. Participants agreed that an authority charged with decision-making powers in the field of state aid control would need to be independent from the legislature and from the government. It is clear that absolute independence, in terms of establishing the budget of such authorities and appointing senior staff—is almost impossible to achieve, These limits notwithstanding, however, audit courts and institutions with equivalent functions might very well possess the necessary independence, but their tasks nonetheless differ widely and they very often lack decision-making powers. They might, however, be able to assist the Commission by identifying state aids that have not been notified, and by overseeing the implementation of decisions taken by the Commission with respect to a particular state aid. By the same token, the attribution of such a responsibility should not be perceived as a threat to the independence of audit authorities, and it is perhaps regrettable that they themselves seem to have been given this impression by the, possibly inappropriate wording, of the recent Commission proposal to establish a link between itself and the national audit courts—made in order to facilitate the control of the implementation of earlier Commission decisions—and to oblige Member States to grant their audit courts the necessary information gathering and reporting powers. It is even more regrettable that this proposal was not accepted by the Council. This refusal clearly demonstrates the differences in attitudes towards and perception of antitrust and state aid control: the Commission and national antitrust authorities are viewed as 'network' of enforcement agencies. This network idea is (still) entirely absent in thefieldof state aid control. It would have been interesting to compare the experiences and views of audit courts with those of national competition authorities. To date, national competition authorities play no part in the enforcement of state aid control and, unfortunately enough, were not represented at the Workshop. Remarkably enough, however, none of the participants within the Workshop proposed that they should be charged with state aid control functions. National competition authorities, of course, do take binding decisions, but these concern the behaviour of and are addressed to undertakings. In contrast to audit courts, they do not supervise the activities of the state. In addition, not all of them are independent from the government. Even if this were to be the case, their independence might be more fragile than that of audit courts, the independence of which is often guaranteed by the national constitution. On the other hand, national competition authorities are practised in the art of evaluating complex eco-

Introduction

xxxix

nomic facts. According to the Commission's suggestions in the White Paper on the modernisation of EC antitrust policy, they will, in the future, also apply Article 81(3) exemption provisions, which may require them to take considerations other than pure competition concerns—such as the environment—into account in their investigations. Antitrust control activities are, therefore, relatively close to state aid control functions. In contrast to the notion of entrusting oversight functions to national competition authorities, the concept of the pursuit of state aid control through sector specific regulatory agencies—more precisely, those charged with banking supervision—found some support. It would, however, be dangerous to generalise this support and interpret it as a plea for the involvement of sector specific regulatory agencies across the board. The suggestion that banking supervisory bodies should be charged with the task of exercising some aspects of state aid control came from only one participants and was justified by the special character of the banking sector: ie, the systemic risks generated by the difficulties incurred by a single bank. In addition, it was stated that such authorities should only exercise control in relation to certain sums below a minimum threshold, to be determined by the Commission in relation to concrete experience, and should not be involved in situations in which cross-border activities are involved. Even in this limited form, however, the suggestion was received with considerable scepticism: not only is there a considerable of regulatory capture, but there is also a risk that supervisory bodies may be tempted to approve state aid in an effort to cover up the mistakes that they have themselves made in the course of their supervisory activities. In view of this overall hostility towards the decentralisation of decisionmaking powers in thefieldof state aid, the limited mention of the prospects for the establishment of a new authority, which would be endowed with a horizontal responsibility for the control of state aid in each Member State, was hardly surprising. Instead, 'co-chairman' Giuliano Amato tackled the issue of decentralisation with reference to his experiences as a member of the Italian Government, in particular, the lessons he learned as the Minister of Finance. It would thus seem that a member of the government can exercise a considerable influence upon the behaviour of colleagues by simply drawing their attention to the existing state aid discipline and, most notably, the obligation to notify new state aid projects to the Commission. A considerable deterrent effect can be established by simply making potential grantors of aid conscious of their procedural obligations.. The assumption that ministers of finance can play a decisive role in the monitoring of state aids also explains the organisation of state aid control within the CEECs. The national authority that is responsible for the monitoring of state aid is often the ministry of finance. Other CEECs have entrusted this responsibility to their national competition authority. However, these differences in institutional approach do not seem to have a major impact on overall substantive results. State aid control within the CEECs is still considered to be somewhat unsatisfactory. The most obvious reason for this is, of course, the

xl

Introduction

difficulty inherent to the identification, evaluation, reduction and elimination of state aid within countries in which large sectors of the economy are still directly owned or controlled by the state, and are often not competitive. Experience within the EU shows that the fight against subsidies not only requires considerable technical skills, but also determination and political courage. However, other factors were also mentioned, such as insufficient pressure from Brussels. In addition, the establishment of an internal state aid monitoring system is likely to be hampered by the absence of any equivalent regime in the existing Member States that could serve as an example to be followed. Finally, all CEECs aspire to a rapid accession to the EU, which will soon make the maintenance of their own system of state aid monitoring superfluous. The experiences of the CEECs under the Europe Agreements are, thus, not a positive source of inspiration for reflections about decentralisation of state aid control within the EU. Once again, the fundamental opposition to any form of decentralisation of decision-making powers in state aid matters, determined that the Workshop made no mention of the more detailed questions that would necessarily arise within any decentralisation scenario. Such questions primarily concern the rules to be monitored: should these be the existing EC state aid provisions or national rules? Would national rules need to be uniform? Could they, instead, perhaps be approximated, but continue to vary? Profound mistrust between Member States and the 'prisoner's dilemma' would plead for uniformity, the subsidiarity principle for the acceptance of diversity. In addition, questions arise about the definition of categories of cases to be assigned to decentralised decision making, which is an issue that has already been well aired in relation to the sharing of responsibilities between the Commission and national competition authorities in the antitrustfield.Though briefly touched upon by some of the papers prepared for the Workshop, none of these issues were subject to in-depth discussion. The absence of such debate is, nonetheless, regrettable since the de minimis rule will determine that the Commission will no longer examine various categories of state aid. The competitive distortions that such state aids cause in the case of SMEs, however, may be appreciable enough to warrant monitoring at Member State level. In the absence of national schemes to control aid, economic operators will be required to live with these distortions of competition. The pressure for national level control of state aid would probably be stronger were the business community to feel that there be a real need for such control. In this respect, the overall picture seems to be contradictory. At EU level, sensitivity towards the distorting effects of state aids has clearly grown, in particular, during the last decade. US participants, however, indicated that companies—most notably, those operating on a nation-wide basis—seem to be relatively comfortable with the different subsidy schemes that operate in different parts of the country. In any case, they noted a conspicuous lack of plaintiffs: firms seem to prefer shopping around for subsidies abovefightingagainst them in court. At world level, this trend has been mirrored by a sparing use of

Introduction

xli

GATT and WTO dispute settlement mechanisms with respect to subsidies. Governments alone are entitled to make use of these mechanisms. Governments nonetheless seem to fear it by virtue of a 'glass house' sentiment: they might be as vulnerable, or even more so, as the countries they complain about. However, even the WTO dispute settlement system, which has very recently seen a notable increase in subsidy complaints and decisions, might still lead to a degree of centralisation of state aid control, in particular, should the EU and US engage in subsidy wars that are subsequently brought to Geneva. Summarising Panel III discussions in three points, panellists felt: (i) that decision-making in the area of state aid control should not be decentralised to Member States authorities; (ii) that such authorities could, nonetheless, perform a very useful role in assisting the Commission by increasing transparency at the national level, both by identifying and encouraging the notification of state aids, and through the monitoring of the correct implementation of Commission decisions; and (iii) that Member States and their authorities would find it easier to comply with their Community law obligations if the EU institutions, in particular the Commission and the Court of Justice, were to clarify further key notions within the EC state aid discipline, most notably, the question of what 'state aid' is. The most serious contribution to the reduction of state aids may, however, come from a source other than legal control mechanisms. Economists in particular, highlighted the fact that the best allies in the fight against subsidies are the people who pay for subsidies, ie, the taxpayers. A major objective of the Commission should, therefore, be to inform the general public about the waste of money resulting from unjustified or excessive subsidies. Claus Dieter Ehlermann and Isabela Marilena Atanasiu Florence, Summer 2000

Opening Statement

REFLECTIONS ON SEVEN YEARS AS COMMISSIONER RESPONSIBLE FOR STATE AID Karel Van Miert' I very much welcome the opportunity, which Claus Ehlermann has kindly offered to me, to look back over the developments in the state aid field that occurred during the time I was the member of the Commission responsible for competition policy. This was a challenging time for Europe and the Commission as a whole, but it was also very particularly so for competition policy. Moreover, within the field of competition policy, I think that state aid policy has begun to take its rightful place and to be recognised for its significance. It is now recognised, I believe, that state aid control is a serious and important discipline, which has no need to be considered as antitrust policy's poor relation. It has an increasingly well developed set of procedural and substantive rules, of case law and of accompanying economic theory, and an increasing degree of attention is paid to it in academic circles. I welcome this. This policy forum is a further step in this direction, and I am delighted about the list of dis. tinguished names who have made the journey to Florence—perhaps not such a hardship in early June, but a significant commitment of time by busy people nonetheless—to join the discussion. This academic recognition is already an achievement, and one that we value highly. What else have we achieved in the last 7 years? One thing we have largely achieved, I believe and hope, is the acceptance right across the Community of the need for a fair and strict state aid policy. It is accepted that the critical project of the European Union, the creation of a single market for goods, services, capital and labour, can be seriously undermined if public authorities are not restrained from selective intervention in favour of enterprises. Such intervention can be as damaging to competition and to the benefits it brings as any cartel, restrictive practice or dominant position. There are several reasons for this increased acceptance of what, for some, has long been evident. One reason is that even Member States with whom the Commission has traditionally fought the hardest state aid battles have discovered that there are enterprises within their territories which are affected by state aid that is granted elsewhere. A striking example of this arose when the granting of aid to Forges de Clabecq, a steel plant in the Walloon region of Belgium, was mooted. The strongest insistence on a tough line came from a state-owned

Former Member of the European Commission responsible for Competition.

Panel Discussion

enterprise in a country better known for granting aid than for resisting it. The Commission took a negative decision.1 My own political background may also have something to do with it. Indeed, I am sometimes asked how a socialist politician can take control of a policy area that has so often been seen as the preserve of economic liberals. But, I have never hidden my personal commitment to the upholding of the values of fairness and equity within the economy, as well as within in politics in general. And increasingly people are realising that it is just such basic issues which are at stake in applying the state aid provisions of the Treaties. Above all, however, the Commission as a whole may take the credit, because by consistently applying the state aid rules in a defensible and fair-minded way it has persuaded Member States that there is a common interest in having, and living by, a common set of rules. It has also persuaded them that the Commission, as a body, is an institution capable of enforcing the rules. Indeed, it is, in my view, the only body which can take on this role as arbiter between the conflicting interests of the different Member State governments. In carrying out this role it must, of course, be under the control of the Court: but, the detailed analysis of cases—of their economic effects and of their compliance with common rules—can only be carried out within an organisation such as the Commission, which has both the independence and the depth of resources necessary for this purpose. This, among other factors, has resulted in a steady fall in state aid across the Community during my time in office: We cannot afford to be complacent, and there are worrying signs of an increase in some particularly distortive types of aid, but, overall, the trend is in the right direction. The Commission's view continues to be that levels of state aid remain far too high within the Community, and we have initiated a discussion with Member States on achieving a reduction, but this should not distract attention from the fact that our figures show that aid levels are falling rather than rising. Reaching this position of a broad acceptance of the need for state aid policy and of the Commission's ability to implement it, has not been a simple task. In the rest of this paper, I would like to describe some of the challenges that we have faced, and how we have, nonetheless, reinforced discipline in the state aid area. When I became competition Commissioner in 1993, much of Europe was descending into recession. Inevitably, this increased the pressure on the Member States to grant state aid to enterprises and sectors which were particularly affected. This is a normal and entirely understandable part of the democratic process: indeed, it explains why state aid control at a supra-national level is desirable. But it is precisely in such circumstances that state aid can be most distortive, because it can delay the necessary restructuring decisions, and can reward the less efficient at the cost of the more efficient. It decreases overall 1

Decision of 18 December 1996. Official Journal of the European Communities OJ (1996) L106 of 24 April 1997.

I - Justification for State Aids

welfare by skewing decisions about the allocation of resources. The challenge of state aid policy is to ensure that aid is granted with the objective of accompanying and rewarding the necessary restructuring, and of cushioning the social and regional effects of recession, instead of resisting the necessary change. One sector, which presented particular difficulties in 1993, was the steel sector. New capacity reductions were essential: the Commission and the Member States were in favour of the imposition of a solution at Community level, and, indeed, Community funds were made available to meet closure costs. Yet, such a solution could only be reached in the context of a rigorous and disciplined control of state aid. Some of the hardest steel cases at that time came from the country where our symposium is taking place. The Commission was required to take unprecedented action against Italy, in July 1993, under Article 88 of the ECSC Treaty, in order to maintain the level of state aid discipline on which a Community solution could be based. And, indeed, further steel cases, from many Member States, have been a regular part of my work during the time I have been Competition Commissioner. In 1996, the Commission adopted a new code for aid to the steel industry,2 ensuring that a disciplined approach was put in place prior to the expiry of the ECSC Treaty in 2002.1 am convinced that, as a result of these measures—and while fully recognising the difficulties which capacity reductions have caused for the regions and communities in which they operate—the Community steel industry is better placed to confront world competition. It is also costing less to the taxpayers. The steel sector is, of course, one which has been an important part of Community business for many years. Few meetings of the Council of Industry Ministers go by without a steel point being placed on the agenda. It is a sign of progress that these discussions are now made up of reports3 monitoring the implementation of agreed restructuring plans, rather than of the need to initiate new ones or to envisage further aid packages. One point that has particularly characterised my years as Competition Commissioner, however, has been the rise in the importance of other sectors in state aid terms. For example, there is a huge challenge ahead with regard to the treatment of the state aid which Member States propose to grant to meet socalled 'stranded costs' in the context of the liberalisation of the electricity sector. Recently, the Commission has also had to look at questions of state aid in the sectors of the media, healthcare and even sport. State aid has also been alleged in the sales of land for large retail developments. But perhaps the most striking example of a new state aid challenge is the one this seminar will address following my intervention, namely, the banking sector. We can be sure that there are many arguments still to be had in this sector, 2

OJ(1996)L338/42. See, for example, the 11th Report on Monitoring Steel Aid Cases under Article 95 ECSC, published by the European Commission under reference SEC(1999) 458 final, adopted 30.3.1999. 3

Panel Discussion

notably in respect of banks benefiting from implicit or explicit state guarantees. I hope and expect that this forum will shed light on this difficult issue, which is difficult, both in technical and political terms. But, some of the arguments are now behind us, and some essential points have been established, which will enable my successor to tackle the challenges ahead. 4 The first major case was that of Banesto in 1994. Although the Commission's decision in this case was that no aid was involved, it allowed us to establish that the state aid rules could apply to state intervention in the sector—even if the main objective of that intervention was to avoid a banking crisis or a generalised loss of confidence in the banking system. Such factors could be taken into account in deciding whether an intervention was compatible with the common market and could therefore be authorised, but could, in no way, prevent us detract from considering the possibility that such an intervention might constitute state aid. Against this background, the Commission was confronted with the looming crisis within Credit Lyonnais in 1995. This case, which lasted for a full three years and whose implementation is still continuing, was a major test of the Commission's resolve. When the case returned for Commission consideration in 1998, we had to face the issue of whether, in the absence of clear commitments to the restructuring we regarded as being necessary, the Commission was prepared to allow the bank to be liquidated—for liquidation would undoubtedly have been a consequence of the recovery of the aid in question. The negotiations showed that, in the eyes of the French authorities, the liquidation of Credit Lyonnais was unthinkable: it was 'too big to fail'. They clearly also believed that the Commission would, in the last resort, take the same view, and that they did not, therefore, need to accede to the reductions in the Credit Lyonnais' balance sheet which the Commission was seeking. In other words, they did not believe that the Commission's ultimate sanction of refusing to authorise the aid could truly be put into effect. The Commission was convinced that this view was mistaken, and that a negative decision, or refusal to authorise, was an outcome that could be contemplated. In our view, few, if any, enterprises are too big to fail. The challenge was to prove this to be so, in a situation where mere assertion had been shown not to be enough. Nor was it enough to demonstrate that liquidation was a credible option, even if an expensive one. The only option was to proceed down the road, not just of threatening a negative decision, but of actually taking one. A 4

On 8.7.1999, the Commission took a significant new decision that capital injected into Westdeutsche Landesbank Girozentrale (WestLB) by the Land of North RhineWestphalia between 1992 and 1998 was provided on favourable terms. The Housing Promotion Institute Wohnungsbauforderungsanstalt (WfA), which was the property of the Land, was transferred to WestLB by the Land authorities against payment of only 0.6%; this was not the behaviour of a provider of capital operating under market conditions. The state aid element involved amounted to DM 808 million and was incompatible with the rules of the European Union. The German authorities were instructed to recover this money from WestLB at once.

1 - Justification for State Aids

decision was thus prepared and circulated, under conditions of great secrecy, inside the Commission. Somehow, however, France caught wind of this. They reluctantly returned with greater concessions within a matter of days, allowing the Commission to take a positive decision.5 But, the Commission also used the opportunity of its decision to set out why it regarded any argument that any enterprise was 'too big to fail' with a great deal of suspicion. What the episode showed was that it is not enough, in handling state aid cases and in imposing a state aid discipline, to have the right arguments. The Commission has to be sure of its ground and to be prepared to act—sometimes in the face of considerable pressure—to show that it is serious in its pursuit of its objectives. The Credit Lyonnais case was the largest, certainly in total volume of aid, dealt with under the guidelines on state aid for rescuing and restructuring companies in difficulty. The Commission adopted these guidelines in July 1994,6 in order to tackle the serious distortion of competition which aid to rescue ailing companies can provoke. Such aid is, potentially, the most distortive type of aid because it penalises, rather than rewards, successful companies, and allows unsuccessful ones to escape the consequences of poor management decisions. The essential principles of these guidelines—that aid can be granted only in the context of a coherent restructuring plan, which must assure a return to viability and, if necessary, must contribute to the required capacity reductions in the sector—have stood the test of time. Nonetheless, given the continuing concern about the level of this type of aid, the Commission undertook to tighten the rules in 1996. The work of revising the guidelines has been continuing since 1997. I hope to achieve the outcome of this work with the adoption of new guidelines before the end of my term in office.7 The level of concern about ad hoc restructuring aids is understandable. The granting of such aid is very unevenly distributed around the Community: it is essentially limited to four large Member States, and is often given in very large amounts to relatively few beneficiaries in a few specific sectors—in addition to banks, the airline and electronic sectors come particularly to mind, given cases like Iberia, Alitalia, Bull and SGS-Thomson. Inevitably, other Member States and competitors of beneficiaries, regard the aid givers as 'buying their way out of trouble'. I can well understand the frustration of those enterprises which compete unaided, which run their enterprises well, controlling costs and attracting customers, and who then find that their less successful competitors are saved from the consequences of their inability to cope. This is why we often insist, if an aid to restructure a failing company is ever authorised, that the beneficiary reduces its presence on the market or markets in question. In manufacturing, this can often be expressed in terms of capacity 5

Commission Decision 98/490/EC of 20 May 1998 concerning aid granted by France to 6the Credit Lyonnais group, OJ (1998) L221. OJ(1994)C368. 7 The Commission adopted new guidelines on 8 July 1999.

Panel Discussion

reduction. In other sectors, its application is less easily quantified: in Credit Lyonnais case, the reduction was set in terms of balance sheet total and of divestment of certain operating subsidiaries.8 As already noted, the beginning of my period as competition Commissioner was marked by a deep recession. Inevitably, this brought with it serious unemployment problems, problems which are still with us today in many parts of the Community. Just as Member States are tempted to react to sectoral crises with state aid for enterprises in the sector which may, in fact, do no more than prolong the problem, the Commission has been confronted with schemes trying to promote employment in those sectors where jobs are most at risk. The two most notable cases have been the 'Plan Borotra' in the textile sector in France, and the 'Maribel' schemes in Belgium. Of course, the Commission is favourable to initiatives designed to create employment. Many of the most effective of such measures do not even fall under the state aid rules—for example, a reduction in social charges for all enterprises. But a scheme which selectively singles out certain enterprises and sectors for such reductions, on the basis that these are the jobs at risk in the short term, is both seriously distortive of competition and also a very ineffective way to maintain employment in the longer term. It has a similar effect to rescue and restructuring aid in that it negates the effect of the free play of competition forces on resource allocation in the economy. To make this position clear, the Commission adopted a communication on sectoral employment measures in 1996.9 The tough message that we delivered there is often not a welcome one, but it needs to be made clear in the long term interest of our common European economy. Competition, of course, is not only seriously distorted by aid to failing companies and declining sectors. Aid to promote new investments, especially in sectors which, while not in decline, have surplus capacity can also be distortive. A particular instance of this in recent years has been the car sector. The Commission has introduced new rules to ensure that aid for new investment in this sector is limited and justified by the possibility that the investment would otherwise be made outside the Community.

8 In the newly adopted guidelines, we have made clear that such reductions can be required even where the market in question does not suffer from overcapacity. This clarifies a point which has, in the past, been the source of some confusion. The reduction is needed not just because there is a need for the beneficiary of the aid to make a contribution—one going beyond its 'share' of the total overcapacity in the sector—to the sector's necessary restructuring. It is also to act as a compensation to competitors for the fact that the beneficiary remains in existence despite commercial failure, and has a 'second chance' to succeed—perhaps at their expense—and to guard against any possibility that the aid leaves the beneficiary in a position to compete in an aggressive or predatory way. These latter considerations apply equally in markets where there is no overcapacity, and it is, therefore, appropriate for the Commission to reserve the right to exact reductions even when no overcapacity is shown to exist. 9 OJ(1997)C1.

1 - Justification for State Aids

The particular case where the Commission most needed, on behalf of the entire sector, to maintain this tough line was the 1996 case of Volkswagen's investment policy within the former GDR.10 The fact that the region badly needed new investment could not be allowed to override the serious risk of distortion in this very sensitive sector. In practice, the aid was repaid—but, the investment still went ahead as planned. This reinforces my conviction that the Commission's decision was correct, since aid should only be granted where it is necessary to achieve the objective envisaged. In general, the Commission has been very understanding of the special problems of the new German Lander. The special treatment accorded to the Treuhand regime, and the enormous amounts of aid authorised in certain key projects, notably in the chemical industry,1' are examples of this. In the area of rescue and restructuring aid, the Commission has authorised aid cases that would never be approved in other parts of the Community. Yet, the Volkswagen case illustrated that there must be limits to this. The Volkswagen case also clearly illustrated the difficulties associated with aid control in Member States where considerable authority—and budgetary power—is vested in regional governments. The aid was granted by the regional authority, while the Commission's only interlocutor, at an official and legal level, was the national Government. This situation is repeated in a number of Member States with a clear federal structure—Spain and Belgium are the obvious examples. In keeping with the principle of subsidiarity, the Commission would not wish to suggest that power devolved to regional authorities is a bad thing—far from it. But, it does need to be clear that the definition of state aid includes aid granted at regional level and that the means must be in place for the Commission to control it. In the right circumstances and with the appropriate controls, state aid, including aidfinancedby Community funds, can be a powerful tool for regional development. But, this effect is entirely nullified if rich regions can outbid poor ones for a mobile project. Equally, if we do allow very high aid intensities, this will encourage potential investors to instigate an aid auction among regions to collect the maximum amount possible. At worst, high levels of regional investment aid can encourage companies to relocate simply in order to benefit from generous grants. In the last two years, therefore, the Commission has taken some major steps to tighten the regional aid rules. It has reduced allowable aid levels to all regions.12 It has reduced the geographical coverage of the regional aid map, so that regional aid is better concentrated on areas which really need it. And, it has

10 11

OJ (1996) L308, of 29.11.1996 See, for example, the decision in OJ (1995) C203, of 8.8.1995, authorising DM 9.5 billion of aid in favour of BSL Olefinverbund. 12 OJ (1998) C74, of 10.3.1998.

10

Panel Discussion

adopted new rules on the largest regional aid projects, so that these will be scrutinised individually by the Commission.13 There is also often a regional angle to the issue of aid granted through fiscal instruments, given the level of fiscal autonomy now enjoyed by many regional authorities in the Community. The Commission is exercising increasing control in this area, following the communication adopted in 1998,14 and against the background of the Code of Conduct on business taxation.15 This is another area where I think the outgoing Commission can be satisfied with its work: our increased vigilance towards less transparent forms of aid, such as aid granted through national and regional taxation systems, determines that we are uncovering means by which competition is distorted other than the traditional mechanisms of grants, loans and capital injections. Another theme that marred the last years of my period in office, has been the concentration on larger and more important cases and the need to reduce the resources devoted to less troublesome cases. In 1996, following a key discussion held under the Irish Presidency of the Industry Council, the Commission launched a modernisation initiative to ensure that the system of state aid control was equipped with the appropriate instruments to deal with its workload. This initiative can be compared in its importance with the modernisation initiative in Article 81 and 82 [ex 85 and 86] cases which was launched in 1999.15 To go down this route in the state aid field meant breaking the great taboo of using Article 89 [ex 94]. This is the Treaty Article which allows the Council, on the Commission's initiative, to exempt categories of state aid from the notification requirement and to set out rules for the application of the state aid chapter of the Treaty.17 The article had, traditionally, not been used—successive Commissioners feared that too much debate within the Council would be taken out of their hands and that Member States might use the opportunity to rein back the level of state aid control. The few attempts that had been made to use the Article had not been encouraging. The time seemed right, however, for another attempt. It should be noted that the very fact that this could be envisaged reflected the greater confidence of the Commission that Member States were generally supportive of the need for state control.

13 14 15

C2/1.

Multisectoral framework, OJ (1998) C107, of 7.4.1998. OJ(1998)C384/3. Conclusions of the ECOFIN Council meeting on 1 December 1997, OJ (1998)

16 White Paper on Modernisation of the Rules Implementing Articles 81 and 82 [ex 85 and 86] of the EC Treaty, Commission programme No. 99/027, adopted 28.04.1999. 17 Art. 89 reads as follows: 'The Council, acting by a qualified majority on a proposal from the Commission and after consulting the European Parliament, may make any appropriate regulations for the application of Articles 87 and 88 and may, in particular, determine the conditions in which Article 88(3) shall apply and the categories of aid exempted from this procedure'.

- Justification for State Aids

11

The first result of this was what has become known as the enabling regulation,18 adopted by the Council in May 1998. This allows the Commission to exempt whole categories of aid from the notification obligation. The Commission had gone a small way down that road, in 1992, under my predecessor, with the de minimis rule, under which the Commission could avoid being burdened with minor cases and schemes of no interest in Community terms. The new enabling regulation goes much further and should, once the implementing regulations are in force, free up many resources for tackling the serious cases which cause most concern. Paradoxically, this apparent lightening of the control regime is, in fact, a means to endure tougher control. The Council has also adopted another Commission proposal, made in the same modernising spirit, for a regulation clearly setting out the procedural rights and obligations of the Commission, Member States and other interested parties in state aid proceedings.19 One aim of the proposal was simply to codify the existing regime, which had been established through jurisprudence and practice—something which led to an initial criticism of the proposal as lacking in ambition. In practice, however, the regulation goes beyond codification in a number of important ways which will increase the rigour of the state aid discipline. It will do this, not just for the Member States, but also for the Commission: it introduces time limits within which the Commission must act on notified aid, and, in the case of illegal aid, may act under the newly introduced 'statute of limitations'. The Commission has, thus, accepted new constraints upon itself—a fact which, I hope, will enable it more readily to impose constraints upon others. But, perhaps most importantly, the new procedural regulation enshrines the principle which is the cornerstone of state aid control: the 'standstill' provision under which aid measures may not be put into effect unless they have been notified to and authorised by the Commission. At present, some 20% of aid cases treated by the Commission have been put into effect in violation of this principle. Not only does the regulation underline the illegal nature of such practices, it also reinforces the strength of the principle by making clear the powers available to the Commission where Member States nonetheless put unlawful aid into effect. As well as ordering the suspension of the measure, the Commission can also, if necessary, order the recovery of aid already granted—even ahead of any assessment of the measure's compatibility with the state aid rules. The regulation also places a clear obligation on the Commission to seek the recovery of aid, which has been granted without authorisation, and which is found to be incompatible with the common market. The only exception provided for, is the case where such recovery would contravene a principle of 18 Council Regulation (EC) No 994/98 of 7 May 1998 on the application of Arts. 87 and 88 [ex 92 and 93] of the EC Treaty to certain categories of horizontal aid, OJ (1998) L142, of 14.5.1998. 19 Council Regulation (EC) No 659/99 of 22 March 1999 laying down detailed rules for the application of Art. 88 EC [ex 93], OJ (1999) L83, of 27.3.1999.

12

Panel Discussion

Community law, the most obvious example of this being, the fact that a legitimate expectation created by the Commission itself would so be frustrated. The difficulty of enforcing recovery decisions remains a problem, there being too many cases, some of very long standing, where the Member State concerned has not yet achieved effective recovery of the aid. The Commission has stressed that it is ready to go, if necessary repeatedly, to court to see its decisions enforced, and the regulation has reinforced the obligation placed on Member States to do everything possible to give immediate effect to the Commission's decision. A further consequence of the procedural regulation is that the clearer rules it entails not only make it easier for national authorities and the Commission to know and respect their roles, but also better-define how third parties can intervene and how national courts can enforce Community law. It is with great pleasure that I have noted that the present seminar is devoting a working group to this issue. Although the nature of the state aid assessment process, relying fundamentally on the relationship between Commission and Member State, precludes the involvement of third parties to the same extent seen in antitrust proceedings, there is certainly scope for third parties to invoke, and for national courts to enforce, respect for the standstill principle I referred to earlier. Although this is not a new theme—the Commission issued its communication on co-operation with national courts in 199520—I am hopeful of greater results in future.21 One area, which I have not touched on directly but which has equally been an area where the Commission has reinforced discipline, is that of the Member States' relationship with enterprises under their ownership. It was a subject with which I dealt, indeed, had to deal, very early on in my period of office when the Court annulled an earlier Commission communication that had sought to increase the amount of information that was available to the Commission for the monitoring of this relationship. The Commission adopted an amendment to the Transparency Directive in 1993, and prepared a further draft amendment in 1999, to require separate accounting where undertakings benefit from special rights, or carry out services of general economic interest, and also operate in competition with other companies. I am convinced of the need for the Commission to concentrate ever more closely on this issue. As more and more services are opened up to competition, it will become that much more important to ensure that the position of incumbent, formerly monopolistic, operators is not unduly favoured through state aid or cross-subsidy. It will only be possible to avoid this if the Commission has reliable information at its disposal. This paper began with a mention of Italian steel cases. Appropriately enough, therefore, I will also end with an Italian case. Perhaps the toughest issue concerning the treatment of public sector enterprises, was the discussion 20

OJ (1995) C312, of 23.11.1995. See, also, the study commissioned by D G I V a n d available on the internet at europa.eu.int/comm/dg04/aid/en/app_by_member_states. 21

1 - Justification for State A ids

13

with the Italian authorities in 1993 concerning Article 2362 of the Italian Civil Code. Cited in its dry numerical form it sounds innocuous enough, but it was the subject of a major negotiation with the Italian authorities. Under the article, any shareholder owning 100% of an enterprise was entirely responsible for the enterprise's debts. Although the text was ostensibly a general provision of company law, its main effect was clearly in the public sector. The Commission took the view that the honouring of the debts of bankrupt public enterprises under the terms of the provision constituted a state aid. Discussions on the measure were difficult, but ended in an important agreement that I was able to conclude with the then Foreign Minister, Professor Andreatta. This not only established that the measure was indeed a state aid, but also set out a framework for the restructuring of the Italian public sector. It is perhaps a prime example of how disciplined action, apparently against a Member State, can lead to a beneficial result for the economy of the state in question. This brings me back to my opening theme. State aid discipline is important because it benefits the whole Community. It is not a zero-sum game in which Member States win if they grant aid and lose if they are prevented from doing so. This is now increasingly understood. While much work remains for my successor, and for the officials of the Commission who will serve under him, this wider understanding is an important asset.

PANEL ONE JUSTIFICATIONS FOR STATE AIDS

PANEL DISCUSSION

PARTICIPANTS

Pierre Buigues Alec Burnside Marc Dassesse Clifford R. Dammers Claus-Dieter Ehlermann Jonathan Faull John Fingleton Jordi Gual A.J.E. Havermans Gary Horlick Anne Hqutman Christian Koenig Patrick Low

Patrick Messerlin Fiorella Padoa Schioppa Kostoris Asger Petersen Patrick Rey Paul Seabright Mario Sarcinelli Matthew Schaefer Ian Horst Schmidt Michael Schiitte Peter Schutterle Karel Van Miert Antoine Winckler

1 - Justification for State Aids

17

Panel One: Justification for State Aids • EHLERMANN—I would like to greet all of you gathered here today, particularly those I have not had a chance to greet personally. Greetings are also extended in the name of Giuliano Amato, who, unfortunately, is not with us today since he is detained at the European Council in Cologne. I would also like to thank Commissioner Van Miert, dubbed as 'The Star Commissioner' by Brussels' journalists, for his opening statement and open up the floor for questions to him. • SCHUTTERLE—I share many of the points of view that Mr Van Miert has put forward and would just like to ask him whether he feels that the EU's 'own aid'—via the Structural Funds—which is not, strictly-speaking, state aid, should also be controlled as strictly as national aid. • VAN MIERT—Yes, we have tried to make the system a more coherent one. Now, of course, Community aid through the Structural Funds may be granted in some regions where national or regional aid is not allowed—a contradictory situation. Yet, despite efforts by myself and others, the Council of Ministers has failed to settle upon a coherent system. The Commission controls national -and regional- state aid and can take the decisions. Member States, however, control the Structural Funds so that—as happened in Bavaria—state aid can be granted within regions on the basis of Objective 5b of the Structural Funds, by means of compensating the relevant state or region. The Berlin agreement of a few months ago shows that governments tend to decide upon these issues through 'horse-trading'. This leads to unfortunate results—last week, for instance, I had a very tough discussion with the Swedish government since they had received compensation in Berlin, which they said had been given to them by the European Council. 'By what right', they asked me, 'can you, a Commission technocrat, refuse us to allow regions to benefit from regional aid?' I answered, 'Yes, this is our responsibility and there is no reason for us to allow you to do it'. This, however, is a very complex and difficult situation. There was no objective justification for the granting of aid which was the mere outcome of political horse-trading—but the system is like that. Clearly, the Commission and the Court of Auditors must oversee what is happening. At EU level, everyone knows that the Court of Auditors has been extremely active, and we are certain they will continue to be so. Yet, it is still unfortunate that we have failed to reach the degree of coherence desired by the Commission. • HORLICK—How would DGIV react to a situation in which a Member State was competing with a non-Member State: a subsidies race if you will?

18

Panel Discussion

• VAN MIERT—We have already had some cases of this and there will undoubtedly be more. However, we cannot simply allow everything to happen in the EU, solely because subsidies might be given elsewhere. It still remains to be seen, for example, whether BMW was really looking for an alternative site or not, and aid to Rover was apparently proposed because Rover might have otherwise transferred to a Hungarian site. These situations must be sorted out. We will certainly have increasingly difficult cases of this kind between investment in the EU and in the candidate countries. Obviously, on the basis of the Europe Agreements, we will then talk to the authorities concerned to make sure that they maintain a minimum of discipline and attempt to cut back on practices such as the Polish 'Economic Zones', where no taxes are paid—clearlyflyingin the face of what would be required of an EU Member State. Elements of state aid discipline are gradually being developed in the candidate countries. However, we can only encourage this through discussions with the relevant authorities, and cannot simply enforce our own rules. • DAMMERS—Did your Directorate interface or co-operate with the group that is investigating unfair tax competition? • VAN MIERT—The main discussion was about the measures that may be considered to be 'general' measures that then fall under the competence of the Member States and thus trigger the questions of whether we should harmonise or not, and, if so, to what extent. Mario Monte is in charge and is trying to sketch out measures within a Code of Conduct. Where a measure is not a general one—though this is a very difficult thing to sort out—we consider it to be state aid. Borderline cases, like Maribel, which was about social aid and covered a lot of, but not all, sectors, are common. Here, we said it was about state aid since it was not a general regime. But again, it is not so easy to sort these things out. I feel the tax group helped us by clarifying various issues. However, I am not sure that all governments will be happy to see real results, since this will allow the Commission to act. I have already indicated that there is great political turbulence in relation to the 30 to 35 cases that we are now investigating. The Belgian government is clearly not happy to be told that its co-ordination centres are being considered as a state aid measure rather than as afiscalincentive. I very much believe, however, that we must tackle this issue in this manner since it is all about unfair competition. If governments wish to reduce taxes, fair enough, but they must take general measures and not simply target single sectors and companies. • KOENIG—How can we tackle the situation—visible now—whereby governments attempt to evade state aid control by means of a general tax-exemption construction that is not directed at specific enterprises?

/ - Justification for State Aids

19

• VAN MIERT—In this regard, we are very happy that the Commission is not alone, and that the Primarolo Group at the Council as well as the governments of the Member States are keen to discuss these issues. We have concluded that, where general measures are designed to give unilateral advantage to a sector or given companies, they are, in fact, state aid. As I have already stated, the distinction is not easy—for example, tax breaks might be given for very good reasons such as environmental protection and be targeted at specific policy issues. Nonetheless, whilst it cannot give a solution in 100% of cases, the current approach is suited to tackling such problems and will undoubtedly be aided by the desire of national governments to expose 'what is going on next door'—a trend which has become apparent in the last years. • EHLERMANN—Thank you, Mr Van Miert for a very lively introduction. We know turn to the presentation of the papers within the Panel on justifications for state aid. • PADOA-SCHIOPPA KOSTORIS—My contribution seeks to highlight alternative instruments which might be used to pursue the same objectives as EU aid (via the Structural Funds) and national aid. As such, it may not, in fact, entail a justification for state aid. Perhaps the most important economic policy goal in Europe now is the creation of employment. At federal level, however, the EU does not appear to possess many instruments with which it might combat this market failure. Normally, the public budget would be used. However, the EU federal budget is small, at approximately 1.2% of European GDP. Equally, the supply-side fiscaltightening that is implicit in both the Maastricht Treaty and in the Stability and Growth Pact mitigates against large scale public spending. Finally, we may raise doubts about effectiveness of national (state aid) and EU public spending (Structural and Cohesion Funds) to combat unemployment. The EU centrally promotes two main instruments that the Member States or the EU may make use of: first, exemptions from and derogations to Article 87 [ex 92] EC Treaty granted by the European Commission or Council and, second, the direct use of the federal European budget for the Structural and Cohesion Funds. The latter instrument should be consistent with the former, although this is not always the case. Structural Funds are sometimes supplied to regions that are not authorised to receive national aid. More often, however, the objectives of Structural and Cohesion Funds are the same as those justifying derogations from Article 87(1). Government intervention is allowed: (i) where 'initial' conditions are not competitive (damages caused by natural disasters, exceptional occurrence)s; (ii) where the benefits accruing are social rather than private (important projects, common European interests, cultural heritage conservation, general education and training); or (iii), where market failures are present (insufficient regional development, abnormally low standard of living, serious underemployment).

20

Panel Discussion

Some experts are sceptical and others are very critical about the effectiveness of these European forms of budgetary intervention. All agree that they should never be open-ended. In some cases, 'the economic analysis of state aid suggests that their effect on market integration is negative, that they delay inevitable structural adjustments or trap Member States in a negative-sum game which benefits firms but not the rest of the society' (quoted from a 1999 manuscript by Steve Martin and Paolo Valbonesi). In any event, the economic principles underlying the exemptions from Article 87(1) and the use of Structural and Cohesion Funds are theoretically complex, difficult to translate into operational terms, and, partly for these reasons, political hot potatoes , since—harmonisation efforts notwithstanding—they create many tensions between the Member States. Y. Chassard, for example, describes the failure of the first attempts at harmonising state aid policies across the EC. More recently, efforts to reach an agreement onfiscalharmonisation had a similar fate. This is how I interpret the Commission's statement in its 1996 Report on the development of tax systems in the EU: in order to develop the taxation conditions for an optimal single market, the Commission will clarify the scope and improve the consistent application of Community competition rules, including the state aid rules, but it must, at the same time, pay due regard to the principles of subsidiarity and proportionality, so that it will not seek the harmonisation of taxation systems. Clearly, derogations from the general rules of competition in the case of government intervention are still necessary, since growth and full employment secure social and political stability and suitable living conditions. They are, nevertheless, undesirable to the extent that they are cumbersome, logically incoherent and even more difficult to manage from a political viewpoint. A much cleaner way to promote equity goals without affecting competition within the EU would be to favour employment and growth in a very different manner: when market failures and absence of competition are observed, the EU, rather than allowing or promoting government interventions, should promote regulatory reforms that reinforce the competitive conditions demanded by the objectives of the single market. One such reform would be the extension of the principle of mutual recognition to labour contracts and social security systems. Article 28 [ex 30] EC states that 'quantitative restrictions on imports and all measures having equivalent effect shall be prohibited between Member States'. Thus far, this provision was applied only for capital and commodity markets, yet should be applied in relation to services and the labour markets too. In Cassis-de-Dijon, the European Court of Justice developed the famous principle of mutual recognition in relationto the circulation of goods: any product imported from another Member State must, in principle, be admitted to the territory of the importing Member State if it has been lawfully produced, ie, if it conforms with the rules and processes of manufacture that are traditionally accepted in the exporting country. It suffices that the objectives or effects of the relevant rules and regulations in other Member States are equivalent (not iden-

1 - Justification for State A ids

21

tical) to those of the importing country, the underlying idea being that all Member States care for their citizens and can never be assumed to produce unsafe or unhealthy products merely because technical specifications differ amongst countries. Accordingly, in the last twenty years, Germany and Italy have been unable to prohibit imports of Cassis-de-Dijon from France solely because German or Italian alcohol standards differ from the French ones. However, French enterprises still cannot produce Cassis-de-Dijon in the Rhein valley or in 'Chiantishire', the Val di Chianti, under the same contractual conditions that apply in the Cote d'Or. Were one of the French enterprises to open a subsidiary in the Rhein valley, or in 'Chiantishire', it could not continue to pay the same salary to its workers once they had moved to Germany or Italy: they would not be able to maintain their existing compulsory pension schemes (although workers who move for less than one year may continue to make contributions in their country of origin) and might not even be allowed to retain their supplementary pension schemes. Equally, the French enterprise might not hire Italian or German workers under French contractual conditions, whilst Italian or German enterprises producing Cassis-de-Dijon in their own countries would similarly be unable to hire their workers under the same conditions applying in Dijon. This situation arises because the current interpretation of Article 39 [ex 48] EC considers any differential in 'employment, remuneration and other conditions of work' among European workers of different nationality who are active in the same Member State to be discriminatory. Such differentiation is usually labelled 'social dumping'; a term with a pejorative ideological connotation, deriving from the historical practice of paying lower salaries to immigrants from less-developed countries. Now, however, it seems to apply to relations between highly developed nations and thus hides a series of purely national interests—most importantly, the desire of national governments not to lose any portion of social security contributions that have been paid to them. There is strong opposition to the extension of the principle of mutual recognition to the labour market and to social security. This must be taken into serious consideration in two ways: (i) by the identification of a minimum level of harmonised rules that should apply in each Member State and should be drawn from current 'best' practices within Europe (for example, youth apprenticeships in Germany, training programmes for older workers in the Netherlands, the labour cost from Ireland and the supplementary pension provision in the UK); and (ii) by proving that such an extension of the principle of mutual recognition will be a positive-sum game for society, whereby losers are subsidised by winners. We should note that some 18 million unemployed Europeans—more particularly, young and mobile first-time job-seekers—have already benefited from the regained flexibility within the labour markets that the single market has secured. Further liberalisation is in order: (i)firmswhich take advantage of higher opportunities and incentives to invest abroad within Europe should be given the chance to hire workers from preferred countries at the best contractual conditions; (ii) workers who currently enjoy a high level of social

22

Panel Discussion

protection should be allowed to maintain their privileged positions within pension schemes and health care when they decide to work elsewhere within Europe. Clearly, one can envisage that following the initial phase of the extension of the principle of mutual recognition to labour market and social security systems, whereby different workers within the same firms will be working under different conditions, workers throughout Europe will begin to 'shop' for the best contractual deal. We can already observe this tendency in European proposals for supplementary pension schemes. In its Communication of May 1999 (Towards a Single Market for Supplementary Pensions), the Commission looks at the problem of pensions in the way I have outlined above. • SEABRIGHT—I wish to focus on just one aspect of the problem with which this panel is concerned. Many of the contributions address the difficult issue of how we can decide when a particular form of state aid to industry is justified. I wish to focus on the question of 'justified for whom?' Alternatively, I wish to ask whether and to what extent, in our discussions of state aids, we run the risk of sending out a great message, but to the wrong audience? What do I mean by this? Let me approach this in a slightly roundabout way by highlighting the fact that, during the 1980s, 2% of notified cases of state aid were rejected or accepted subject to conditions. The trend, as our 'Sunshine Commissioner' has observed, is upwards, yet, even now, of the 500 cases notified annually, less than a couple of dozen are judged negatively. Is this a bad thing or a good thing? I am not suggesting that this means state aid control is too lax. Would any of us really believe that Mr Van Miert was doing his job better if the negative decision proportion were 100%? If that were so, he would certainly be the most feared man in Brussels and, indeed, in most of the European Union, but would we actually think that he were doing his job better? Of course not. Not one of us believes that all notified state aid could legitimately be thought to fall foul of Treaty provisions. Unfortunately, when discussing 'good' and 'bad' state aid, we frequently fail to distinguish between the state aid that is probably a waste of money for the taxpayers of the Member States concerned, but do not, under any reasonable criterion, actually distort competition in the single market, and the state aid that seriously distorts competition throughout the entire market. This is not simply a cheap, academic point-scoring exercise, since I genuinely believe that the confusion in much of the analysis between state aid that may be a waste of money and state aid that genuinely distorts competition is not just something which is found in the Commission's own decisions. It is also constantly found in the writings of academics and analysts. We unthinkingly confirm that economic theory suggests that it is a bad idea for the state—in reasonably competitive conditions—to subsidise activities that could otherwise be provided by markets but, at the same time, we fail to draw the conclusion that states that subsidise activities in competitive market conditions harm only

1 — Justification for State Aids

23

themselves. When market conditions are very competitive, a naive entrepreneur who pours money into an essentially unprofitable exercise might well be damaging his own bank balance, but does not really distort competition within the market. Similarly, Member States which choose to subsidise firms in highly competitive global industries, such as textiles, may be wasting their own taxpayer's money, but cannot, under any reasonable criterion, be thought to be significantly distorting the market in the community as a whole. Getting the message right is important, not simply for reasons of intellectual consistency, but because the EU's own institutions must focus their energies on those areas where, in addition to their political and legal mandate, they are better-placed to tackle the problem in terms of resources and expertise rather than individual Member States. Alternatively, were the Commission to be drawn into a discussion on whether the Spanish government is wisely using taxpayers resources to support relatively small footwear firms, it would simply be providing free advice to a Member State which might more properly pay for itself, and would not be making the best possible use of its own important and scarce resources. Accordingly, when the Commission is criticised for giving a negative decision in only two percent of cases, we must, both for reasons of intellectual coherence and for reasons of political feasibility, make sure that it has chosen the right cases. The Commission must be able to say that the two percent of cases which were singled out for negative decisions were the right two percent. They were not simply the easy targets, but were the cases that most seriously threatened competition within the market as a whole I will close by means of a brief reference to the issue of coherence between the state aid rules on regional expenditure and the Structural Funds. There has been a considerable effort in recent years to increase coherence by ensuring that regions that qualify for national regional aid are congruent with regions that are eligible for EU assistance from the Structural Funds. However, once again, it may be that we are sending the right message to the wrong parties. Why is this? Well, Structural Funds are mostly financed by the average EU taxpayer. Regional aid is financed by the average taxpayer in the Member State. These two individuals are not the same. Thus, congruence is not the sole indicator of whether a good use of resources is being made. We must instead weigh up the benefits of the finance to the funder in both cases.

• REY—Rather than focus on acceptable levels or categories of state aid, I would like to draw attention to the issue of the design of state aid. In my view, getting the design of state aid right may actually be an effective way to achieve the objective of reducing not only the volumes of state aid, but also the number of inappropriate categories of state aid. I would like to make two basic points. First, state aid should aim at correcting a clearly defined market failure. Second, state aid should be designed so as to correct the identified market failure, and should be designed to correct it as efficiently as possible, so that market forces are not unduly interfered with.

24

Panel Discussion

Equally, there should be agreement that there is clearly no better way to correct that market failure—a 'benchmark check' may be the best way to achieve this. Turning to the issue of a clear definition of market failure, economic analysis indicates that it is usually a better idea to correct the source of market failure, rather than to try to correct the undesirable consequences of the market failure. In this regard, of course, we must initially be clear regarding the types of market failure that we want to correct. The Commission's recent Guidelines on state aid to SMEs give us a very wide range of examples of market failures that are, perhaps, incongruously cast as 'justifications of state aid': the reluctance of capital and credit markets to fund SMEs; an information failure with regard to innovation and new technologies; and the fact that SMEs are more heavily affected by regulatory changes. However, if you are clear that you wish to correct the market failure and not its consequences, you will arrive at very different solution for, say, the problems faced by SMEs in accessing capital markets. Where an information failure dictates that capital markets are unwilling to lend to SMEs since they have difficulty assessing new innovations and technologies, it might be better to direct aid towards the creation of specialised financial institutions for SME's rather than giving SMEs money directly. R&D is another example in this sense. There are two possible motivations for the granting of aid to R&D projects. One is the 'free-riding problem', which makes firms unwilling to undertake R&D since outsiders will benefit from their expenditure. The other is the risk of failure inherent to R&D projects, which leads to reluctance on the part of firms to invest, and the conviction that the market mechanisms cannot appropriately solve this risk aversion problem. If the motivation for the granting of aid is one of solving the free-rider problem, more money can be given to help finance R&D projects. The grants can be given either ex ante—you want this project, I will finance half—or ex post—I will pay you for successful results. The risk aversion problem calls for different 'insurance' mechanisms—I will tax you if the project is successful, if it is not, I will offset failure. Since these solutions are very different from one another, it is important, in my view, first, to identify clearly the market failure that must be corrected. A brief word on design. I will stick with the example of R&D. The major problem of R&D aid is the identification of good projects and beneficiaries. There are two possible ways to do this: (i) via a non-specific rule that all R&D projects will benefit from some aid, although, here, there is a redundancy risk that aid is granted to projects that would, in any case, have been financed, so that aid impact is not great; or (ii), via specific aid to individual projects, although, here, the question arises as to whether the government is betterplaced to pick out winners than the market is. My own view is that aid should be designed in a manner that makes the best possible use of available information. Firms generally have some idea of whether a project is good or bad and their information may be evaluated in various ways which I detail in my paper for this volume.

1 - Justification for State Aids

25

• BUIGUES—My comments follow on those of Patrick Rey. For the economist, government intervention through state aid may be justified, as Patrick just said, with the view of correcting market failures. However, a cut in state aid may also be welfare reducing, even if there are immediate gains in terms of a reduction in public spending. I would like to take a look at the Commission Guidelines on R&D and SME state aid and highlight some of the strange results they give rise to. The Guidelines on R&D aid give us three justifications for the favourable treatment of this kind of state intervention. The first is the free-rider problem, or the positive externalities which R&D give rise to—a problem well known to economists. The second is the problem of the markets' risk aversion towards R&D. The third argument, which is a very good one, is that aid will be less likely to distort competition and trade the greater the distance there is between the market-place and the project. The latter justification leads to a set of maximum aid intensities: (i) fundamental research, distanced from the market, is eligible for 100% support; (ii) technical feasibility studies preparatory to industrial research may receive 75% support; (iii) technical feasibility studies and industrial research may receive 50% support; and (iv), pre-competitive development activities are eligible for 25% support, while innovation, which is very close to the market, receives no support whatsoever. The economic literature is broadly consistent with the EU rules on R&D. First, the social return of R&D exceeds private return by 50 to 100%. Secondly, externalities for fundamental research are far larger than for applied research and for development. Thirdly, the return on private research is higher than the return on public research, so that there is a need for incentives: state aid must to be given as an incentive. Fourthly, positive externalities decline with geographic distance, which is important in the EU context, since the relative nearness of all EU countries means that the positive externalities of R&D within Europe may be transmitted to the developing countries of the Community. Thus, in principle, the Commission Guidelines on R&D aid are fairly consistent with economic theory. However, there is a quantification problem, as the Guidelines include rules on supplementing aid intensities in the case of R&D carried out by SMEs and in less favoured regions. For example: (i) a SME may receive an extra 10% support, so that where the normal threshold is 25%, SMEs may receive 35%; (ii) Article 87(3)(a) [ex 92 (3)(a)] regions may receive an extra 10% support; (iii) Article 87(3)(c) [Article 92 (3)(c)] regions receive an extra 5%; (iv) projects carried out within the Community Framework for supporting R&D receive an extra 15%; and (v) projects carried out within the Community Framework for supporting R&D with an element of cross-border co-operation receive an extra 25%. This is a very complicated set of rules which are related to varied market failures and Community objectives—failures in the capitalisation of SMEs, European regional policy and European R&D policy. One strange result of this is that industrial research may benefit from a 75% increase in aid, whilst pre-competitive research may only benefit from a 50% increase in aid.

26

Panel Discussion

What are the justifications for state aid to SMEs? As Patrick Rey noted, SMEs have restricted access to information in competitive markets, have difficulties obtaining capital and credit, and are faced with higher cost when new regulatory legislation is introduced. We have a certain number of imperfections in the market that limit SMEs development, and therefore warrant regulatory guidelines on state aid to SMEs. However, when you look at the Commission Guidelines on state aid to SMEs, the case is similar to that of R&D—the objectives underlying permitted aid extend beyond the pure economic justifications for aid to SMEs. To conclude briefly, the Commission Guidelines are not simply based on objective economic justifications for the correction of market failures, but also extend to cover further Community policy objectives, such as regional policy, competitiveness and the Community framework programme on R&D. The guidelines are thus based on equity as well as efficiency and objective economic considerations. It is, therefore, difficult for economists to present convincing justifications for very complex aid thresholds. Equally, we are not really sure whether direct state aid is the best means with which to address such markets failures. • HOUTMAN—I intend to give the view of a practitioner here, rather than attempt to compete with the eminent economists around the table. I am a practitioner of state aid policy, which to me is the result of the combination of a set of rules and a multitude of individual decisions. These are based on the Treaty's substantive and procedural rules, and I wish to argue here that the Commission's interpretation of these rules is not guided by the quest for optimal efficiency in the economic sense, but is guided by the quest for a proper balance between different Treaty objectives and between different requirements and constraints. Although we may argue that the Treaties are primarily geared toward efficiency considerations, they also contain wider equity considerations. In addition, the requirements and constraints are of a political, administrative and legal nature. From an economic point of view, state aid approved by the Commission, though it always, in some form or another, addresses market failures, in the vast majority of cases is not likely to be the most efficient form of state intervention to address these market failures. Even though economic analysis is playing an ever more important role within EC competition policy, the legal framework and even the procedural framework still have a great influence on the results we achieve. I would now like to mention and concentrate on these legal aspects, particularly the procedural ones. The first aspect, central to state aid control in the EU and unique in the world, is the fact that we are talking about ex ante control. The consequence of this ex ante control system is that the Commission always examines the likely effects of a proposed aid measure, and not the actual impact of the aid on competition—sadly, this also implies that the benefit of the doubt cannot be

/ - Justification for State Aids

27

given to the Member States. On the other hand, the Commission control procedure is superior to other international regimes in that decisions are based on sound economic principles rather than on the notion of protecting domestic industry from state aid given elsewhere, thus potentially adding one inefficiency to another. In this regard, one possible improvement that might lead to greater efficiency would be in the form of the information upon which the Commission bases its examination. More transparent notifications would result in better justifications for the approval of state aid. Currently, notifications are limited to a simple description of the measure and omit the simulations or economic studies that the Member States surely undertook prior to granting huge amounts of aid. Alternatively, the Member States justifications for their choice of policy instrument could be used by the Commission—though this, of course, must also be balanced against the administrative costs of some studies. A second interesting procedural aspect is the fact that, while the Commission must perform ex post monitoring, such monitoring is legal rather than material in character. The Commission limits itself to a procedural process of checking whether a Member State has indeed implemented the approved measure, and does not examine whether the measure has given rise to the desired effects and has properly addressed the market failure. Here, tightened reporting requirements are a possible improvement that must, nonetheless, also be balanced against the costs of analysis and, indeed, the difficulty of assessment that was identified by Mr Buiges. There are some legal limitations to the review exercise, since the Commission corrects state aid that it has approved but that has not served its objective. All it can do is bring corrections for the future. It is equally doubtful whether Article 88(2) [ex 93(2)] allows the Commission to demand future improvement in an inefficient scheme. The third procedural aspect is that state aid control is largely a matter for the Commission and Member States. One improvement here would be an increased role for third parties who are currently under-utilised. Greater involvement of the third parties and more transparency, I am convinced, would lead to better justifications for the approval of state aid by the Commission. Finally, in defining the rules that are necessary to ensure credibility and transparency, I feel that matters would be improved were more interested parties—namely, taxpayers and consumers—brought into the debate. Again, this would lead to a better justification for the balance that the Commission strikes. • MESSERLIN—My comments are greatly influenced by my trade policy background. In trade policy, we generally feel that subsidies are a 'bad thing' and are correlated with other trade barriers. We are also very much aware, however, of how difficult it is to develop a coherent anti-subsidy policy. My comments will focus on this latter point. First, subsidies are only one of the many instruments the state has at its disposal to intervene, so that other instruments may be substituted for a subsidy that was banned or prohibited. One example, here, is the French audio-visual sector,

28

Panel Discussion

which is currently highly subsidised. Were the subsidies suddenly prohibited, however, greater use would be made of the private channel, Canal Plus, as a transmitter of subsidies through investment quotas. Alternatively, Canal Plus currently has a monopoly in terms of the ARTV channel, which is estimated to value 2 billion francs per year. It is also subject to investment quota obligations of around 8 billion francs per year. So, we have the worst of both worlds: on the one hand, we are 'clean', yet, on the other hand, we have a monopoly with a very high rent. Equally, Canal Plus has exclusive control of the French film industry, so the situation is also troublesome from this point of view. Secondly, trade theory contains a very powerful maxim: tax export is similar to tax import. This can be reduced further to the statement that subsidy to export is similar to subsidy to import. Assume a government which maintains a tax on imports that it compensates for through a subsidy to exports— bizarrely, it is quite possible (Korea is an example) that this country will approach a form of free trade position. An anti-subsidy policy would split the maxim and push the country towards protectionism. Accordingly, where (in terms of trade policy) there are no trade barriers or where (in terms of economic analysis) there is perfect competition, we might be quite relaxed about anti-subsidy policy: if individual governments and taxpayers wish to shoot themselves in their own feet, that is their problem. By contrast, trade barriers or imperfect competition will strengthen the case for the imposition of an antisubsidy policy. This might suggest that the Commission should be more severe in relation to services than in relation to manufacturing. To highlight the steel manufacturing example, I feel that there is a strong correlation between antisubsidy policy and trade policy. Although co-ordinating DG I activities with those of DG IV might be a sensitive subject within the Commission, an appropriate anti-subsidy policy for the European steel sector would be the removal of trade barriers—if the Spanish or French governments want to subsidise their owns firm, then, that is just too bad for French and Spanish taxpayers. I feel that pre-emptive anti-subsidy policies are vitally important. The Austrians have introduced such policies under the name of 'the effective rate of assistance'. The priority of DGIV should be to invest in this field of pre-emptive anti-subsidy policy. This is commensurate with accepting the notion of an effective rate of assistance. To highlight this point—does it make any sense to tax theatres and then give them subsidies? A simple rejection of this system of taxes and subsidies will bring us forward. • FINGLETON—I think that it is apparent from Mr Van Miert's opening comment this morning that that the tightening of the state aid discipline has been an uphill struggle, so there may be a danger that my comments will come from the top of the hill and will say what the colour scheme inside the house should be like before we have even built the house. Nonetheless, I think that if we are going to use market definition within state aid control, it is very important for us to ask how this can be done properly and to begin moving in that direction,

1 - Justification for State Aids

29

even if very slowly. I am not going to deal with the need for state aid control but with its form, and will, in particular, focus on notions of market definition. I argue in my paper that state aid control should be divided into per se rules and 'reason based' rules. The per se rules should determine that aid satisfying certain clear characteristics will be automatically allowed. Other forms of aid, such as rescue and restructuring aid, must be examined on a case-by-case basis in the light of a benchmark or rule of reason, such as market definition. The costs of decision-making will be saved where aid is either approved or prohibited on a. per se basis. By the same token, the costs of categorising aid will increase—ie, do per se rules apply to a certain proposed aid measure, or should it be evaluated in the light of a rule of reason?—so that we make no clear-cut predictions about savings. Turning to reason-based rules, we must ask whether the notion of market definition might play a useful role. I maintain that a rule of reason approach to the control of state aids should be based on a two-step procedure. First, it must be identified where the effects of aid are felt. Here, the notion of market definition will help in the measurement of these effects. Second, it must be asked whether this is form of aid is desirable. Clearly, some forms of aid will furnish small domestic benefit, but will also have a huge negative impact on other countries. Reason points in the direction of prohibiting such aid. Taking aid to Aer Lingus, the Irish national airline, as an example, any reasonable Irish economist would have said: 'close it down; we have Ryan Air which is much better—these privately owned airlines are doing much better'. However, although its domestic benefit is negligible and foreign effects are negative, the aid was allowed. A proper use of market definition might have led to a different outcome in this case. Therefore, acceptance of market definition in state aid cases would be a big step forward. We must then ask the following question: we have a well-developed methodology for market definition in antitrust—is this methodology relevant to state aid control, and is it adequate? State aid gives rise to counterfactual market output increases. Because of the aid received, a firm stays in business when it otherwise would not have been able to do so. Accordingly, this situation is the exact reverse of monopoly, where output contracts. In state aid cases the patterns of substitution are the exact opposite of those observed in antitrust cases. One must look at substitution by consumers in the market rather than out of the market, and substitution by recipients out of the market rather than into the market. However, this reversal of the situation is not the reason why antitrust market definitions are inadequate in state aid cases. Instead, their inadequacy arises from the fact that broad market definitions in antitrust cases are exculpatory, allowing firms to be let off the hook. In state aid cases, however, broad definitions give rise to a greater degree of culpability: the wider the market definition, the greater the overseas effects. Whereas in antitrust cases the regulator is happy with a narrow market definition, the opposite is true for state aid cases. My paper argues for the development of a different market definition approach in state aid cases, namely, one that deals with complimentarities.

30

Panel Discussion

Take, for example, a monopoly tree grower in Ireland that owns 99% of Irish forestry and supplies only domestic wood processors, since disease control prohibits the import or export of non-processed wood. If the Irish government were to give aid to this company, the formal relevant market would be domestic. Yet, tree growers in the UK would feel the effects of aid in the downstream competitive processing market. An assessment of the effects of aid (also upstream) must take due account of downstream market developments and various conditions, such as the elasticity of supply and the effect of trade or the strength of competition in the downstream market. In summary, the market definitions found within the antitrust rules must be expanded in order to avoid omissions and errors in the identification of the effects of aid. In my mind, the current EU policy has seen the adoption of a. per se type rule for R&D-aid and the application of a rule of reason analysis to cases of regional, rescue and restructuring aid. Recent Commission documents mention the term 'market definition', but only in the context of measuring excess capacity on the aid recipient's market, so that there has been no real embracing of market definition as a first-stage criterion for examining the effects of aid. Equally, such documents do not merely confuse notions of 'protecting competitors' with those of 'protecting competition', but also confuse the question of market definition with that of market power. I, personally, do not understand how market power might arise from state aid, but it is easy for me to see how state aid could damage competitors but not general welfare. I think the proper use of market definition would avoid this form of confusion. In conclusion, I agree with Commissioner Van Miert's comments that rules making control procedures more transparent will also tighten the state aid discipline. I think costs can be transferred to the Member States by obliging them to provide a first stage analysis of the relevant market in the same manner as they are obliged to do in antitrust cases. It will then be easier for the Commission to say whether this is a reasonable or an unreasonable market definition. • GUAL—I would like to talk about something that is different from, but related to, the discussion so far. Here, I will raise two questions: (i) what is our rationale for aggregate control of state aid; and (ii) is there a system that we can implement to produce an overall reduction of state aid within the EU? Simply stated, aid that is granted and meets competition policy criteria can still produce economic inefficiencies. Thus, there are good grounds for additional reductions of the state aid expenditures. Moreover, the difficulties we face in controlling overall aid levels are only aggravated by de minimis rules and guidelines that exempt aid from control. While there may be some good justifications for the granting of aid, we should still take a very close look at them. Although this is contentious, economists classify the justifications for state aid along efficiency and equity lines, and tend to believe that efficiency justifications are far more sound than their equity counterparts. Efficiency con-

1 - Justification for State Aids

31

siderations would allow aid that removes externalities, providing, of course, that the aid is proportional to the externality targeted. Similarly, equity considerations speak for the granting of aid, since most advanced economies are willing to tolerate what is basically job protection through other means, although, once again, the aid must be proportionate with the social benefit. In a recent study for DGII, we analysed aggregate EU aid levels and studied how aid was disbursed in some countries, and concluded that there was no relation whatsoever between the forms of aid disbursed in the Member States and various—since the theory here is weak, admittedly crude—efficiency indicators. Accordingly, we proposed significant reductions in aggregate state aid levels. Focusing, in particular, on this lack of proportionality between the aid disbursed and efficiency indicators, our figures were high, demanding a reduction of around 24,000 million Euro. Recent Commission Surveys reveal that real-world reduction in the last three to four years have only totalled 3,000 million Euro, so there is room for a significant (eightfold) increase in reductions. Our study also indicated big gains—most importantly, positive budgetary gains—that would be obtained with very little short term impact in terms of job displacement. In conclusion, I would like to make two points. First, in the light of the distinction between efficiency and equity objectives, one of the main problems with current EU state aid rules is that they mix objectives. This obscures any assessment of the efficiency harm caused by state aid measures—the clarifying avoidance of compound objectives will further an efficiency-oriented analysis of state aid. Secondly, big cases and, in particular, those based on equity considerations (restructuring cases) should—in addition to the usual examination of distortions in EU trade—include an explicit analysis of the economic efficiency loss induced by aid. • SCHMIDT—We present a co-ordinated macro-economic approach to the control of state aids, and argue for an overall reduction in the level of state aid expenditures and a reduction in the disbursement of state aid between Member States. In terms of background, we are highly sceptical about the value of state aid as a policy measure to correct market failures, and feel that the overall level of state aid is still far too high-—1.2% of GDP, or 2.5% of gross general government spending. Similarly, although aid has declined, we are not quite sure why. It might reflect a permanent change in attitudes: more liberalisation, open markets, efficient Commission overseeing and the disciplining effects of EMU budgetary requirements. However, the reverse may also be true. The sceptics might argue that market integration and thefiscaldiscipline required by EMU lead to an unusual and temporary lowering of state aid levels. Liberalisation and fiscal discipline must still be consolidated—indeed, the regime introduced by EMU may tempt some governments to make greater recourse to state aid. Our proposal should be seen as a supplement to the existent control system. In this regard, one should note that in the existent control system the

32

Panel Discussion

cumulative effects of different aid measures cannot be identified, and therefore it is not a suitable instrument for reducing overall state aid levels. Equally, the existent control approach focuses only the competition and trade distortions that are identified within the Treaties, whereas we would like to place more emphasis upon allocative efficiency. We also argue for a decentralised, but co-ordinated, approach to the reduction of overall aid expenditures. It may be argued that the Member States which are closer to the markets are in a better position to judge the allocative efficiency of individual aid schemes. Yet, we believe that they need some help in this judgement, so that co-ordination is appropriate. In this way not only would Member States be able to lighten their own domestic political load by referring to 'the bad guys' in Brussels, but also more pressure might be placed upon the Member States to judge whether aid is really worthwhile. We accordingly argue—somewhat crudely—that some form of stand-still system should be introduced. In other words, the average level of aid in the EU should be identified, and Member States giving more aid than the average should be encouraged to 'roll back'. Equally, the reductions should be targeted on inefficient aid. Although it may be difficult to reach agreement among the Member States on criteria for identifying inefficient state aids, a forum of economists could also play a useful advisory role. Finally, practical problems always arise, particularly when it comes to identifying reliable statistics. We based our work on DG IV surveys, which are, in turn, based on information provided by the Member States. Even at the preliminary stage, we heard complaints from some Member States saying we should not be harsh upon them since they are more 'honest' than their neighbours. Last, but not least, when you try to help people, you should not be surprised if they do not want your help. We thought finance ministers would find our survey useful; some, however, were not so keen, so we must still be politic in efforts to convince ministers that this is a good proposal. Our initial recommendation for Broad Economic Policy Guidelines and our general statement that Member States should reduce overall levels and cease to grant ad hoc sectoral and restructuring aid has yet to find approval. In addition, we will make special recommendations to certain Member States: (i) Germany and Italy should reduce overall levels of aid; and (ii), France and Spain should lessen specific aid. • Low—My paper looks at WTO subsidy rules from an economic analysis perspective. Three stylised facts underlie this discussion: (i) definitions of subsidies can be drawn too widely or too narrowly; (ii) information is imperfect, and, in some cases, the problems of lack of information are insurmountable; and importantly (iii), economic analysis is largely indeterminate, at least with regard to the ex ante question of whether you should subsidise or not, and sometimes even with regard to the ex post issues of whether subsidisation has served equity or income distribution objectives. We should never be too

1 - Justification for State Aids

33

pessimistic: some aspects of economic analysis, such as optimal intervention theory, are definitely useful. Yet, we must concede that we will not always receive the form of guidance we would like from economic analysis. When one looks at WTO subsidy rules, it is quite noticeable that they are concerned with producer interests and access to markets, and do not really entail a comprehensive welfare standard. Should something be done about this? I feel that this is the central issue in relation to WTO subsidy rules. On the related question of subsidy definition, the WTO has opted for a very narrow definition by stating that the notion of the financial contribution is a definitional element within subsidies. When I first looked at this, I thought this would merely invite policy substitution. Yet, when one thinks about the whole structure of the WTO rules, it is no longer clear whether this is a problem, since, even though the set of rules on subsidies is narrow, there remain the national treatment rules, which do cover, to some extent, all the regulatory aspects of subsidies and are based on a broader definition of what subsidies are. Equally, the technical barriers to trade rules pay due regard to notions of nondiscrimination, transparency and the least trade-restrictive measures. The specificity question is also interesting. Basically, WTO rules are by definition per se rules: a subsidy that is not specific will simply fall outside the scope of the WTO agreement. The discipline becomes more rigid the more specific the subsidy is: (i) export subsidies and other trade related measures, such as domestic content requirements, are banned; (ii) less specific subsidies are merely actionable; whilst (iii) one set of specific subsidies is nonactionable due to the existence of a notion of an overall public policy override, though this is always up for negotiations at a later stage. But what does economics tell us about specificity? I know of no economic theory telling that the more specific a subsidy is, then the greater its distorting or welfare damaging effects will be. Thus, in order to understand why specificity plays such an important role, I think one must look at what these rules are about and who they are aimed at. They look after producer interests. They are very trade oriented. They worry about things such as fairness and market access. It is thus inevitable that they will highlight specificity. However, this is not necessarily a very good idea. Finally, I would like to ask why we cannot move to a welfare standard, based upon notions such as 'benefits conferred'. The formal WTO subsidy definition does include the notion of benefit conferred. Attempts to interpret this phrase, however, have run aground. Ideas abounded about how to do it, but nobody really wanted to think seriously about what benefits conferred meant within the WTO framework. I guess the basic question is one of whether we can approach a welfare based standard by defining benefits conferred? I think this takes us into the territory of competition policy considerations, but more general considerations than market access. Instead, you need a rule of reason, which raises all sorts of thorny sovereignty issues. This also takes us close to the issues that are being discussed in relation to the internationalisation of competition policy. Here, I see a very natural marriage between the way we could be thinking

34

Panel Discussion

about subsidies and subsidy disciplines and the way we should be thinking about having international rules on competition policy. • EHLERMANN—That was the last of the presentations. We will know move on to interventions. • HOUTMAN—I would like to ask those members of the panel who proposed overall state aid reductions whether 'volume' is the real issue, and whether the Member States giving the highest amounts of state aid are the greatest sinners. If our objective is to reduce budget deficits, then maybe the question should be: which expenses within the budget are the most inefficient public expenses? I am not sure that these expenses are always state aid. If our objective is to reduce distortions of competition and inefficiencies, then maybe the question is one of whether there is a correlation: is there a correlation between volume and distortion? The debate has been a touch contradictory—some have said that high levels of aid are a pure waste of money, but are not necessarily distortive. I would also like to ask Mr Gual whether we should look for a correlation between the volume of aid and, say, the number of SMEs, rather than—as suggested by Mr Rey—with the degree of functioning of national financial markets. If we must identify a correlation between aid and market failure, the question is not one of whether the volume is correlated with the number of SMEs, but one of whether it is correlated with the functioning of the financial market, which is the market failure, not the effect. • EHLERMANN—Were not these two speakers talking about a supplementary system? • SCHMIDT—Yes, this would supplement the present control system. Furthermore, our attempts to constrain the use of public funds extend to areas beyond the field of state aid control. The overall philosophy of such reduction proposals is also that, the more the Member States accept general constraints on their state aid expenditures, the more likely they are to set correct priorities and to assess whether this or that state aid measure is really an efficient way to correct market failures. • GUAL—I would like to add that, while the theoretical analysis of capital market failures and the difficulties SMEs have in realising their growth potential are advanced, there is far less empirical analysis that this would give us good benchmarks so that we could tie the level of aid granted to the exact degree of seriousness of the market failure observed. Consequently, I share the scepticism about our general ability to identify a proportional amount of aid for SMEs— that is a difficult job. I nonetheless think it is worthwhile to continue exploring

/ - Justification for State Aids

35

along these lines and to attempt to assess the degree to which a state faced with a capital market failure can justify more aid to SMEs for these reasons. Current empirical evidence does not provide us with sufficient information to establish a clear correlation. Yet, we do not really need this: looking at current practice, even our very crude benchmarks for the existence of market failure clearly demonstrate that there is no correlation whatsoever between the occurrence of market failure and the amount of aid being disbursed. In this case, recourse to an EU average is obvious, although it does not sound good. It is nonetheless a good approximation, given the lack of any true relationship between state outlay and market failure indicators. Of course, national budgets are full of inefficiency-creating outlays; state aid, however, is one form of outlay that can distort competition throughout the EU. • HORLICK—I would like to return to the R&D issue and ask how EU rules are in fact applied. In this example, there are clearly three possibilities. First, research would, in all cases, have received private funding, so that state aid merely substitutes for own funds: this amounts to operating aid via substitution. Secondly, the project would not have been funded without the state aid, but the company is offering you its worst, most dubious, project and lowest priority research: if it is worth the effort, the firm finances itself, if not, it applies for a grant. Thirdly, there is worthwhile research that would truly not have been undertaken without the funding. No applications, however, come marked with these clear labels, so how are the three distinguished practice? • DASSESSE—Treading carefully as a lawyer among largely economic issues, I would wish to make an observation in the hope that some of the speakers can react to it. Clearly, state aid issues are now being influenced by the move to EMU and the Growth and Stability Pact. However, EMU and the Pact do not apply to, say, the UK. Is there, thus, a danger of a growing legal divide and an uneven playing field? • SCHMIDT—I think we should note here that, while the Stability and Growth Pact should put further constraints on Member States and thus contribute to ongoing cuts in the public budget, it is not in itself a direct constraint on the spending side, since it only deals with deficit in relation to GDP. Clearly, we know that Member States will not be eager to raise taxes, but the Pact does not prevent them from doing so. • HAVERMANS—To continue in Mr Schmidt's vein, I do wonder about the group exemptions to be adopted on the basis of the recent enabling regulation. There is clearly a need for effective state aid regulation, and the recent adoption of the state aid procedural regulation must also be seen in these terms, but will

36

Panel Discussion

the group exemption regulations give rise to lesser, or greater, use of public funds for state aid? • PADOA-SCHIOPPA KOSTORIS—I think the Stability Pact will impact upon the economic policy of Member States, but I would like to highlight one critique made of the Pact: it does not properly distinguish between current account expenses and capital expenses. State aid is generally seen as 'capital expense': for initial investment, for job creation, for capital accumulation and for R&D. It may be considered to be distortive and inefficient, but, in terms of the Stability Pact, it seems to pass the 'exam' of devoting greater resources to the capital account rather than to the current account. • VAN MIERT—I would like to take this opportunity to answer a series of questions. (1) The state aid rules have often been updated to take into account and/or balance efficiency and equity considerations. State aid, and their authorisation, may pursue several goals at the same time, so it is always a question of getting the balance right. As a caveat, it seems to me that we, in Europe, do veer from one extreme to the other: we were traditionally addicted to state aid, and should get away from this, but we must not see all aid as 'bad'. There might well be a good reason for aid and we should observe a balance. One might take against regional policy—that is a different matter—but, until further notice, the EU is in favour of regional policy. Most of the time, the Member States are in favour of aid, but again, we must strike the right balance. If you feel that, generally-speaking, not enough R&D activities are being developed, you must attempt to stimulate them: this may lead to inefficiency in individual cases, but the overall case for stimulating R&D still stands. However, there must still be stricter surveillance to overcome the historic tendency to label this, that, and the other, as 'R&D' in order to obtain funds. Having said all this, however, identifying maximum aid intensities is a different thing and one of the hardest tasks faced by DG IV. We often have strained discussions with other departments— specifically R&D administrators—since, even in the Commission, a mentality prevails that what is labelled R&D must be good. We, in contrast, wish to check that the label does not disguise operational aid. (2) There will always be a temptation to give money to ailing companies and to companies with poor productivity. Rover is a good example of a good company with poor productivity, which a government, which is generally anti-state aid, wishes to support in order to ensure that new investors will offset this handicap. These cases will always haunt us, regardless of the economic rational, since governments very rarely base their aid decisions on economic evidence: Spain grants aid in the Basque region to entice companies 10 kilometres down the road. Tax breaks and other instruments are being used for political purposes: this is the way things are. Accordingly, on becoming Competition Commissioner, one of myfirstdiscussions was on the introduction of economic tests within DG IV Clearly, we retained a legal approach, but introduced more

/ - Justification for State Aids

37

economic reasoning and more economic evaluation. I am clearly in favour of this; yet, reality simply shows us that not everything is decided with reference to economic principles. Thus, it all boils down to pursuing major objectives, such as a reduction in high levels of state aid, and the attempt to achieve an even playing field, which is hard enough. Only then can we take specific objectives or specific situations into account. Why is aid to the film industry not a problem? Clearly, with so many languages and cultures, Europe is simply not a level playingfieldwith regard to film, so that there are good 'equity' reasons for not pursuing an economic level playing field that can never be matched at the level of culture. It is as simple as that. The real-world demands that we always integrate the equity consideration into decision-making. These problems cannot be solved through economic criteria; this is a false assumption, a false approach. (3) We have had successes in many individual cases. In some areas, however, the road has been a long one. I was in charge of transport before becoming Competition Commissioner. Here, we attempted to introduce competition, since most companies—perhaps British Airways excepted—were in receipt of massive state aid. This, however, was a very difficult environment: a company like Sabena had never made money. It had no reason to do so. This was not a market situation. There was no competition; it was a completely different system. Here, we needed a transitional period in which a level playing field could be established. We could not do it overnight. This is why we followed the 'one time, last time' principle for the approval of restructuring aid. It gave rise to exaggeration in the case of Air France, but the objective was, nonetheless, to phase out state aid gradually. We have done this in other areas: this is how we proceed. Please bear this in mind when assessing individual cases. You can say, economically-speaking, 'that was a "bad decision"', but please do not forget where we are coming from. Step-by-step, we are trying to achieve a level playing field. (4) I would like to turn to the issue of the use of the number of negative decisions as a yardstick for success. Please note, this is not always accurate. The French textile case was one negative decision that involved thousands of companies. Yes, the increase in negative cases does reflect the Commission's determination to apply a stricter regime, but the number does not give you the whole picture. (5) I would like to underline the fact that we are endeavouring to correct the historic situation whereby state aid gave rise to an increase in capacity and thus created even greater economic problems within individual sectors. The multisectoral rules on aid to large investment projects are designed for this purpose, in order to try to go against that. Clearly, the approach must be comprehensive: the rationale behind regional aid might point to the granting of aid that nonetheless creates over-capacity in one economic sector and thus gives rise to a need for more state aid to restructure individual firms. If I were to say we have solved that problem, I would be giving a false impression: there is much yet to do. Nonetheless, we are aware of the vital need to tighten up the rules on the

38

Panel Discussion

one side and to achieve a correct balance. Such rules will continue to require updating and the balance must always be maintained. (6) We should pay attention to the current behaviour of public companies and authorities. The Deutsche Bundespost, for example, is currently acquiring a host of new companies, whilst, at the same time, it is claiming that the costs of the universal service obligation placed upon it—particularly in Eastern Germany—prevents it from doing so. They are clearly demonstrating that they have all the money they need. The same is true in Italy, where private companies cannot compete with an acquisitive postal service. This is one problem we must address. It is a difficult problem, but needs to solved. (7) I am tempted to return to the Canal Plus case, since I was puzzled by what Mr Buiges said. Competition exists and we would like it to remain that way. We have, therefore, fought against the efforts of Canal Plus to create a monopoly in France. Equally, we have extended some competition policy advantages to 'TPS', so that they might compete with Canal Plus—a good example of the manner in which state aid and competition rules should always be applied coherently. Equally, I believe the French competition authorities have tackled the monopoly position of Canal Plus withinfilmproduction. Both national and European regulators would thus seem to be supporting competition in France. (8) The 1999 survey on state aid will show a further reduction in levels of state aid. However, given that Italy currently grants six times as much state aid as the UK, an extra effort to ensure that countries such as Italy and Germany reduce, rather than increase, regional aid, may still be necessary. (9) There may be a misunderstanding about the enabling regulation and the future state aid block exemptions. First, the de minimis rule does not mean that aid 'should' be given. National authorities must make their own decisions. Secondly, the regulation only applies to areas where the rules of the game are clear. Notification may no longer be necessary, but surveillance will continue. Complaints will increase due to greater competition and will alert us to any problems. Equally, the authorities concerned must still report to the Commission, so that we will still scrutinise cases that might trigger problems. All we are doing is reducing red tape and cutting back on the time that is spent scrutinising benign cases. We will be able to focus more on important and troublesome cases. We do not, therefore, envisage any reduction in the strictness of the state aid discipline. • SARCINELLI—I was almost seduced by Mr Schmidt's comment on macroeconomic control of state aid. However, he was careful to state that this would be a supplementary form of control; yet, I do see some limits. Were we to move from a micro-economic to a macro-economic approach, we would then be required to find additional criteria to make the system workable. Various persons around the table have mentioned increased monetary discipline as a 'natural' constraint. However, Europe is still a high taxation area, so that budgetary

1 - Justification for State Aids

39

resources will always be found to help this industry or that sector. Also, I feel that we would require a form of concentration indicator. A small amount of state aid disbursed over a large area of production may not damage the single market seriously, whilst concentration in one or two sectors might be very disruptive. Equally, I feel that a macro-economic approach, per se, cannot provide us with any fixed limits for aid beyond, of course, a zero limit that would simply reflect our belief that the market makes superior decisions in all cases. • SCHUTTE—I would like to come back to a remark made by Ms. Houtman concerning ex ante control and her statement that aid that has not achieved its purpose might not be corrected. I think Ms. Houtman is probably correct as regards horizontal aid, R&D aid and such things. Clearly, it is difficult to monitor success in thisfield.Generally, you can only monitor whether or not the aid has been abused. I think the situation is quite different for ad hoc state aid. Restructuring aid, for example, always comes with conditions attached: 'positive conditions', typically meaning a reduction in the labour and a specific investment regime; and 'negative conditions', generally encompassing a reduction in capacities. In such cases, the Commission can presumably follow up by monitoring whether conditions have been respected and whether the aid has fulfilled its purpose. I would like to ask Commissioner Van Miert and Ms. Houtman how the Commission intends to follow up the monitoring process. In my experience, specifically with Volkswagen, monitoring can be difficult. Take the Rover case. Were aid to be allowed, both Rover and BMW would surely be asked to reduce capacity. However, assume that Rover meets the capacity reduction requirement, but BMW, with its seat in another country, fails to do so in its own territory, or divests itself of Rover and claims it is no longer bound by the conditions. This situation is a headache, and we have experienced it. If you require repayment of the aid from Rover, the UK government will protest and send you to the Germans. Can you continue a procedure against a company in a different Member State? Is BMW liable? • KOENIG—I have a heretical question for the economists and for Mr Van Miert. Does the EC state aid policy neglect a second level of competition, the so-called interjurisdictional competition between Member States? From an economic point of view, differences in regulation and subsidy schemes also establish incentives for the mobility of enterprises within the single market. From this perspective of interjurisdictional competition and a given market of regulations, state aid could be considered as a rebate on taxes, and thus a reduction of the price an enterprise has to pay to settle in a Member State. Consequently, state aid control by the Commission should be primarily directed against a subsidies race, dumping under infrastructure cost, and discrimination against foreign enterprises. In this logic of interjurisdictional competition, the Commission should concentrate more upon ensuring that state aid

40

Panel Discussion

is also available to foreign enterprises. This approach would reserve industrial policies to the Member States and would prevent the Commission from pursuing their own industrial policies under the exemption clause of the newly numbered Article 87(c) [ex 92(c)]of the EC Treaty. • EHLERMANN—Yes, Mr Koenig, you have indeed provoked the economists. Is it true, by the way, that economists and academics feel more at ease with individual cases than with the per se rules that have been criticised? Are you unhappy with topping up rules in R&D cases since you cannot measure externalities, market failures or inefficiencies? >• SEABRIGHT—I think the short answer to Mr Koenig's question of whether current EU policy ignores the importance of interjurisdictional competition is clearly 'yes.' I think the general lesson to be drawn from the phenomenon of interjurisdictional competition is that nothing in the EU concept of the level playing field implies that two companies competing in the European market must bear the same wage costs or operate under the same regulatory conditions. They compete between 'differently-endowed' jurisdictions, and it is extremely important to ensure that competitors do not misuse the level playingfieldconcept to protect their own position on the basis of some bogus claim about uniformity. I think this issue is highly relevant to the question of the exact relationship that exists between the type of exercise in which DG II engages, which is the macro-evaluation of state aid, and the competition evaluation of state aids, which is, I think we all agree, conceptually distinct, even though we are not sure whether it should be procedurally and institutionally distinct. Well, I have already made my views clear and would like only to make one observation which is on the importance of the overall advice that the Commission provides to Member States about their public expenditure policies. It is very clear that the Commission is in an unparalleled position to provide Member States with information about the relative character of their policies and to allow them to make comparisons for themselves. I think the Commission's efforts in this area have been a boon, enabling Member States to see what they do and how it compares to conditions elsewhere. I feel it would be unfortunate were we ever to draw a conclusion that uniformity is always desirable. The process of competition between jurisdictions provides us with a great deal of information on what works and what does not work. We very often do not know whether particular forms of aid to SMEs are effective. In such a situation, comparisons between different schemes in different countries provide us with useful experimental knowledge. • WINCKLER—I would like to pick up on what Mr Rey said about R&D. Interestingly, he says that a case can clearly be made for state aid, but immediately adds that assessing whether R&D aid is a good thing is an extremely

1 - Justification for State Aids

41

difficult task since there is a clear information asymmetry between what the Commission is aware of and what is really happening in the market. On this score, I would like to highlight the shortcomings in complaint procedures. Basically, if one wishes to raise a complaint, one can only really write a polite letter to the Commission, saying, '[I] am sorry, Commission, but maybe this aid to this airline is not a great idea.' Equally, not all preliminary investigations are published in the Official Journal. Similarly, if a note is published in the Official Journal, all one can do is send in a nice little paper saying, '[D]o you really think that reducing firm X's presence on the market by thirty percent is really adequate?' I think that great improvements could be made in this area. • EHLERMANN—Thank you, Mr Winckler. Transparency is certainly an important. I am not sure, however, whether we should really engage in too profound a discussion of legal procedures and third-party intervention rights at this stage. • BUIGUES—Just a quick remark on the complementary of the internal market programme and European competition policy. I think that our objective, when we began the internal market programme in 1985, was 'to catch up'. European competitiveness was to be increased through the removal of market inefficiencies, such as barriers to trade. The main result that we expected, of course, was that inefficient firms would leave the market. Now, this was all well and good in sectors such as banking and insurance, but, in the area of air transport, we were faced with 15 carriers, seven of which (in Portugal, Ireland, Greece, France and so on) were state-owned and received aid to keep them in business, once we started liberalisation. Accordingly, where the aim of the internal market is to increase competitiveness by forcing inefficient firms out of the market, liberalisation efforts must be complemented by a very tough competition policy. • FAULL—Just very briefly on the procedural issue: although the scope for third-party intervention was increased, we still do not get the degree of market input we would expect. I think it would be better to address the reasons for this prior to embarking on a great campaign for the expansion of third-party rights. I would like to answer Mr Schiitte's question about the UK-Germany, or BMW- Rover imbroglio. It seems to me relatively simple, but I am thinking out loud: if UK state aid is given subject to conditions, BMW must fulfil those conditions. Where it fails to do so, the UK Government must recover its aid. Whether this be through the UK or German courts does not concern the Commission. The Germans have a perfectly adequate judicial system and the issue has nothing whatsoever to do with the German government, although it is possible that the German government may yet be required to offer assistance on the basis of Article 5 EC Treaty. Pursuing your example further, and answering the question of what happens if BMW sell Rover: here, I think BMW will

42

Panel Discussion

be responsible for fulfilling any conditions that are attached to the remainder of the BMW group, whilst the purchaser of Rover must fulfil any conditions attached to Rover operations. At the end of the day, there will always be someone from whom the UK Government can recover aid: it has nothing to do with the German Government. • PETERSEN—I am happy that, in the person of Mr Winckler, this morning's panel possessed at least one voice that was not anti state aid per se, but was merely concerned with improving its implementation. Clearly, I believe that there is good and bad aid, and that the real problem is the identification of good schemes. In this respect, I am a bit concerned by the rigidity of the macroeconomic scheme that has been discussed. I would like to emphasise that improving official standards for the design of schemes is the best way to ensure that good, rather than bad, aid is implemented. Schemes that correspond to official standards are far more likely to have been motivated by reasons that are compatible with European objectives. Let me briefly mention two possible ways of improving design standards: (i) we can make better use of available information, either by asking for more detailed proposals or by delegating decision-making to bodies, such as industry investment boards, which may have better information; or (ii)—and I would like some feedback on this—we can import the 'least restrictive practice' criterion that is used in the WTO context and check whether the proposed manner of implementing the state aid is really the best way to correct the problem and that there are no other obviously better ways of achieving the same result. This seems to be an effective device in the WTO context and its systematic implementation in the EU may prove to be appropriate. • BURNSIDE—Returning again to an increase of third-party input, I would like to say that Mr Faull should encourage it since he will like the results. In the area of merger control practice, the Commission has placed extraordinary emphasis on market consultation, and to very great effect. Practitioners in this area, like myself, know a case will go well if third parties are quiet and go badly if third parties actively express a negative point of view, since they do not merely provide additional information, but also raise the temperature of debate. I would, accordingly, like to say that where you use the current lack of thirdparty input as an excuse for not increasing third-party rights, you are merely offering us a 'counsel of despair'—which is no way to crank up the system and to get it to work more effectively. Turning to level playingfields,Mr Low alone has highlighted the state of the playing field between the Community and the rest of the world, rather than between Member States. It seems to me that our discussion here is insular. I have a few questions for the economists: why, when we look at macro-economic issues, do we pay so little attention to this field? Is it because—and I do not think that this is the case—dispute settlement procedures and countervailing

1 - Justification for State Aids

43

duties are so effective that they have removed any distortion? Is it because state aid enforcement in the Community is still so ineffective that wider issues do not yet matter? Again, I do not think that this is the case. Are the issues, then, simply too difficult? • EHLERMANN—This is also a question for lawyers, since you refer to dispute settlement. • GUAL—I am afraid I am not going to provide any answer to that question. Instead, I would briefly like to return to the aggregate picture and comment— from the economist's viewpoint—on issues raised by Professor Padoa Schioppa and Mr Sarcinelli. The issue is essentially one of the forms of aid that we are observing and the form of expansion in the public budget that this aid represents. I am afraid I disagree with both speakers: even the most optimistic investigation reveals that only one third of aid spending within the EU relates to capital spending rather than core spending, since most of the aid is going to sectors that pursue equity objectives. There might also be doubt about regional items. To pursue the point further: a distinction is made between small amounts of state aid that is given to a broad area, where it might have little negative effect, and large amounts of state aid to specific industries that might be more disruptive. My presumption is that competition policy is best at tackling the second form of aid. However, my concern is that the first form of aid will go unnoticed and—to return to question of whether economists feel that rule of reason analyses are superior to the per se approach—I feel that there is an argument for the introduction of a cap on overall aid, since the economic power of the Member States is very different, so that they can take advantage of these thresholds to different extents. Clearly, underlying my remarks, there is a suspicion that this widely dispersed aid does not really pursue efficiency objectives. I fully share the view of Commission Van Miert that it pursues political objectives, which we qualify as equity objectives. I think that if we do want to pursue equity objectives, we should do it in a less distorting manner and feel that policing is in order in this regard. • SARCINELLI—Just to clarify what Professor Gual has said. My argument about the need for a concentration indicator was made with regard to a purely macro-economic approach. Mr Gual may be correct with regard to a combination of macro- and micro-economic approaches. I think that, among ourselves at least, we must agree on whether the state aid discipline concerns the level playing field or concerns the disciplining of national governments. I believe that the current legal and material constitution of the EU does not allow the Commission to discipline the activities of states in general. It can only discipline the governments in the context of defending the single market.

44

Panel Discussion

• PADOA-SCHIOPPA KOSTORIS—A small comment. I think Professor Gual might have misunderstood me. I was talking about capital expenditure in its broadest sense—ie, human, as well as, material capital. I was also referring to training and research and development—so it is a large area. The figure of 'one-third capital spending' also strikes me as odd. This is a very large amount if you consider that most Member States would seem to devote very little to capital and investment expenditure. • SCHAEFER—I would like to follow up on a comment that Mr Sarcinelli made. What are the aims of subsidy restraints? Is the goal to eliminate disruptive trade effects or is it to eliminate the wasteful spending of money? Results are obviously going to be quite different depending on the goals. Take Mr Horlick's hypothesis on R&D: (i) where thefirmwould, in any case, have invested money, state aid clearly violates the 'waste standard', but probably also violates the trade effect standard since, by virtue of substitution, it is operating aid; (ii) where the firm would not have undertaken R&D since the envisaged benefits of such research are poor, you have a violation of the waste standard, but not of the trade effects standard; and (iii), where the firm would not have undertaken R&D, but the research project is good, there is no violation of the waste standard—aid is correcting an externality—but you may have a violation of the trade effects standard. Results are always different. Equally, there is a greater likelihood of violations of the trade effects standard within a global jurisdiction (WTO). By the same token, violations in smaller jurisdiction are more likely to be of the wasteful spending variety (US states). The essential problem lies in the fact that, in a world where many subsidies are both an example of wasteful spending and distort trade, local state aid disciplines are often not well enforced, so that international jurisdictions must often both correct distortions in trade and prevent wasteful spending. I think that Patrick Low's suggestion that the WTO should lessen its focus on trade effects and concentrate more on welfare effects, leans in this direction. Finally, there is clearly a regulatory gap where rules do not address the global subsidy wars problem—in this case, domestic jurisdiction rules are irrelevant, since subsidy laws, by necessity, lead to wasteful spending and may distort trade. • Low—To qualify briefly the statement that the least restrictive trade standard should perhaps be applied in context: this standard is a pro-trade standard since it embodies an effort to prevent a surrogate being undertaken in the name of some public policy objective; but, it not necessarily be optimal in welfare terms. We should bear this in mind. Equally, to reply to the query about whether we are being a touch too incestuous and not paying enough attention to the outside world, I think we must also think about whose welfare we are trying to optimise. For example, if you look at competition law, most jurisdictions

1 - Justification for State Aids

45

have an exemption for export cartel arrangements, precisely because this is the manner in which they extract rents from foreigners. Current WTO discussions about the internationalisation of competition policy are addressing exactly these thorny issues, which include the degree to which governments will be willing to cede authority to an international body in an attempt to optimise global welfare, though always at the expense of some national welfare loss. This is a very different ball game. • MESSERLIN—To talk again about the less restrictive practice standard. It seems to me that subsidies to thefilmindustry represent substitution, since they are simply a cheap means of regulation: you cannot work out how to regulate the industry, so you give it money. Most European states have subsidised their films heavily over the last years and this upward trend has been matched by a downward trend in the number of European films that are seen outside their own country—this has an impact on EU trade. The UK is the obvious exception, where lower subsidies have been combined with complex regulations about the use of finance. UK films sell abroad. Finally, I agree about our euro-centricism. • EHLERMANN—Yes, on this point, the WTO has a number of potentially very disruptive subsidy cases in the pipeline. I am not sure whether the regulatory emphasis will be placed on export subsidies, or whether it will be widened to include other forms of subsidy and—potentially bloody—disputes. I think that subsidy conflicts are, at the very least, potentially as disruptive as international conflicts on the regulation of foodstuffs. Now, let us turn to Mr. Van Miert for the final word. • VAN MIERT—First, to underline the importance of the global picture, it is possible that the Commission will receive an increasing number of complaints from companies outside the EU about subsidies given within the EU, in the absence of a global discipline: say, a complaint about the Deutsche Bundespost from a US company. Clearly, we cannot make complaints in the other direction: our Co-operation Agreement with the US does not cover state aid questions. Politically-speaking, this could become a very hot potato. Secondly, I am highly critical of the BMW/Rover case. BMW is still making a lot of money; why can it not put its own house in order? We would need far more justifications in terms of the Rover site being in an eligible region or not: this seems to me to be a hangover from the old mentality. Surely, a company is the first responsible for solving these forms of problems: you surely cannot argue that society is not productive enough and that, therefore, we should receive state funding for restructuring purposes. Thirdly, I am not sure whether I fully understood the point about interjurisdictional competition. But, it clearly touches upon competition between

46

Panel Discussion

systems, and I would thus like to clarify my position—which, I think is also that of the Commission—on this. Clearly, our aim in the state aid field is to create some form of level playing field. Granted, we can never create a 'general' level playing field, since tax and social security systems and so forth differ so greatly from one another. These issues must be approached in a different manner. This means that, within the single market—which is, unfortunately, still very different from its US counterpart—we still have much to do. However, we are no longer calling for full harmonisation. Instead, all we would like to see is a form of 'soft harmonisation', whereby Member States and regions attempt to maintain a position that is similar to their competitors for reasons of economic rationale. Competition between systems should, generally-speaking, be an adequate harmonisation instrument. Certainly, in some limited areas there is a case for a degree of harmonisation within some formal framework. But, for the rest, we should leave it to the market—more precisely, the liberalised, single market. The state aid control process, then, is about enhancing the discipline so that aid that has an adverse effect on inter-state trade will be reviewed by the Commission. State aid that has no such effect is none of our business: this is the rule of the game. Certainly, such state aid may simply be wasted money, but, if does not break the rules, the Commission cannot take any decision. I know this is imperfect; I do acknowledge this. The main priority must now be to tighten the regime. My next remarks concern third parties. Now, there are two reasons why third parties are not more active in state aid cases. First of all, there is a legal reason. The Treaty constructs state aid cases as being a matter between the national authorities and the Commission: note, always the 'national' authorities, since regional cases are dealt with in Berlin, Madrid and so on. This is the way the Treaty is, and I am not sure whether this could be quickly or easily changed. As I mentioned earlier, some Member States might more interested in a reduction in, rather than an enhancement of, discipline and may accordingly be hostile to moves to increase discipline-enhancing third-party involvement. I am not against increased third-party involvement—we did, by the way, try and include this within our proposal. However, political and legal factors have, unfortunately enough, determined that it is unrealistic for the time-being. My last observation has to do with maximum levels of state aid for each Member State. Some two to three years ago, this was proposed by the Spanish authorities. All, in particular the Germans, indicated that this would be acceptable provided that the Member States were then given free rein to grant aid as they saw fit up to the level of that maximum. In other words, a cap became an argument for the abandonment of discipline. One must thus be careful when suggesting such macro-economic approaches, since, at the end of the day, they might result in less, rather than more, discipline. So, my final conclusion is let us keep on going, let us keep on moving in the direction we have tried to move in over the last two years. I believe that we will achieve the objectives laid down in the Treaty.

I Pierre Buigues* State Aid and Market Failures: The Quantification Issue

I. Introduction For the economist, government intervention through state aid may be justified in terms of the correction of market failures. In such a case, cutting state aid could be welfare reducing, even if there are possible immediate effects in terms of a reduction in public spending. In a report prepared for the Commission in 1998, Gual attempted to distinguish different categories of state aids in an effort to facilitate a discussion of their economic rationale: a) programmes explicitly and mainly designed to address market failures—for example, the positive externalities of R&D (research and development), capital market imperfections in relation to SMEs (small and medium sized enterprises), infrastructures in network industries and the co-ordination of exit in declining industries; b) programmes where allocative efficiency arguments are weak and equity considerations form the primary rationale—for example state aid in shipbuilding, mining and steel industry restructuring. However, as is clearly stated by the author, this form of clear-cut typology is not as simple as it appears to be. Seabright and Beslay (1998), in another report, are even less convinced about economists' capacity to distinguish between 'good' state aid and 'bad' state aid. It is not always easy to say that a specific state aid is based only on arguments exclusively related to one or the other aspects: correction of market failures or equity consideration. In practice, state aids are often based, at the same time, on a mixture of externalities and equity considerations. Distinguishing the two dimensions is quite difficult in economic terms.

* The views expressed are those of the authors and are not attributable to the Commission.

50

Working Paper I

II. Research and Development A. R & D Externalities A large number of studies have demonstrated that Research and Development investments undertaken by one enterprise produce positive spill-over effects or externalities for other firms in the same industry or in other industries. These positive externalities are of two kinds:1 a) Rent spillovers: occurring when a firm buys goods and services that incorporate R&D. However, by virtue of asymmetric information and imperfect price discrimination, the prices of goods or services will not reflect their user value. The firm buying these goods and services thus obtains a part of the rent of the innovativefirmproducing these goods and services without paying the 'true' value for them. b) Transfer of knowledge: occurring when an R&D undertaken by one firm contains new information, which is then valuable within the R&D activities of otherfirms.Knowledge spillovers are very important since they create the foundation for further knowledge. Part of the research done by one firm becomes public and is then made available to other firms outside the traditional 'market price' framework. In open economies, R&D spillovers are not hampered by national borders and are, instead, diffused internationally through the same channels as technology transfers: international trade, foreign direct investment, movement of scientists and engineers, workshops and seminars, publication in academic journals and international research collaboration. Empirical studies on international R&D spillovers show that they play a prominent role in the explaining productivity growth and convergence between productivity levels. Less developed countries can thus grow faster and converge with the productivity of the most advanced countries.2 It has been shown that when all the industrial countries raise their R&D spending by half a percentage of GDP, long run output increases by 14% in all developing countries.3 With globalisation of the economy, the importance of foreign technology sourcing could even increase. Finally, empirical studies show that the intensity of international R&D spillovers declines in line with the geographical distance between the country exporting and the country importing R&D. This is a particularly important issue within the EU, since there will be significant R&D high technology spillovers between the leading and the less developed European countries. 1 2 3

(Griliches 1993). (Grossman & Helpman 1991). (Monken & Mairesse 1999).

1 - Justification for State Aids

51

The provision of R&D is, therefore, characterised by significant market failures. Although the patenting system was created to guarantee investment return on R&D, its concomitant brake upon the free diffusion of R&D outputs within society has a cost, since technological progress is slowed. Moreover, the financing of R&D is very often marked by capital market imperfection since the capital market is generally not able to evaluate R&D activities externally (asymmetric information). In theory, therefore, state aid to finance R&D may be justified on various grounds. Public government may give subsidies in an attempt to correct the differences between the social and the private returns on R&D. However, here, the main problem is not one of justifying state aids to subsidise R&D, but is one of measuring them. To what extent do we have the capacity to judge the intensity of market failures? It may be very difficult to quantify the state aid and to determine whether the level of state aid is too low, optimal, or too high.

B. The Community Framework for State Aid and for R&D The Commission communication on the Community framework for state aid for R&D defines the allowable intensity of aid. That intensity will be 'determined by the Commission on a case by case basis'. This assessment will be based on the following criteria: the risk of distortion of competition, the effect on trade between Member State and the contribution of the R&D project to the competitiveness of European industry. This Commission's Communication introduces a scheme for the quantification of state aid that is based on the assumption that 'the closer the R&D is to the market, the more significant may be the distorting effect of the state aid'. In order to determine the proximity to the market of the aided R&D, the Commission makes a distinction between fundamental research, industrial research and pre-competitive development activity. In theory, since fundamental research is distanced from the market, a gross aid intensity of up to 100% can be awarded. For industrial research, gross aid intensity must not exceed 50% of the eligible cost of the project, and for precompetitive development activities, the maximum gross aid intensity threshold isfixedat 25% of the eligible cost. More precisely, the Community framework for state aid for R&D states that: a) Fundamental research is generally undertaken by research centres, universities or non-profit organisations. The results are widely available on a nondiscriminatory basis. The communication defines fundamental research in the following terms—'the work should not be linked to any industrial use or the commercial objectives of a particular enterprise and a wide dissemination of the results of the research must be guaranteed'. In such a case, a gross aid intensity of up to 100% may be awarded.

52

Working Paper I

b) Technical feasibility studies for industrial research are presumed to have a negligible impact on competition and trade conditions. In this case, they may qualify for a gross aid intensity of up to 75% of study costs. c) Technical feasibility studies on pre-competitive development are presumed to stand in a closer relationship with market than their foregoing counterparts. They may, therefore, qualify for a lower threshold of 50% of study costs. d) Pre-competitive development activities are, clearly, far closer to the market, and the threshold for permissible gross aid intensity is, accordingly, 25% of the eligible costs. However, the scheme is more complicated in practice. Aid intensities may be exceeded in a number of cases: SMEs benefit from an extra 10 percentage points; Article 87(3)(a) [ex 92(3)(a)] regions also benefit from an extra 10 percentage points; meanwhile, Article 87(3)(c) [ex 92(3)(c)] regions receive an extra 5 percentage points for projects or programmes undertaken within the Community's R&D framework programme, and an extra 15 to 25 percentage points where the project 'involves effective cross border co-operation'. Equally, even where the research project does not accord with the objectives of the Community's current R&D framework programme, projects may, in this latter case, still receive an 10 percentage points if certain conditions are fulfilled. The combination of all the possible increases described here may not, however, exceed a maximum gross intensity of: a) 75% for industrial research b) 50% for pre-competitive development activities. These thresholds correspond to the maximum intensities authorised by the WTO's agreement on subsidies and countervailing measures. If the Member States provide the Commission with sufficient information on the fact that competitors located outside the EU have received or are going to receive larger amounts of state aid, the EU's right to offset this competitive advantage may result in the Commission accepting an upwards alignment after notification on a case by case basis. The Commission also analyses the incentive effect of R&D and state aid: 'state aid for R&D should serve as an incentive for firms to undertake R&D' in addition to their normal work in the field. As a consequence, the general scheme on the quantification of the different maximum gross intensity of aid accepted is, therefore, necessarily complex. To what extent, however, are these figures consistent with the econometric evaluation of the R&D spillovers? C. Econometric Evaluation of R&D Spillovers A survey of empirical studies on R&D4 shows that, on average, the social rate of return of R&D exceeds the private rate of return by 50 to 100%. The differ4

(Griliches 1992).

1 - Justification for State Aids

53

ence between the social and the private returns provides us with a first approximation of the relevant benchmark. However, the results of empirical studies on externalities related to R & D are different depending on the methodology used. For Monhen and Mairesse (1999), fundamental research externalities are larger than applied research and development externalities; a finding that also corresponds with the logic of the Community framework. They have also detected higher rates of return for private research than for public research, which implies that firms must also invest independently, even if a part of the research is subsidised by the public authorities. These available empirical studies on the econometric evaluation of R&D spillovers, readily demonstrate that the quantitative evaluation of the positive R&D externalities may only be of limited use for the effort to set gross aid intensity for different cases. Moreover, as the macro level,5 R&D state aid does not appear to be distributed across the EU Member States following allocative efficiency criteria: countries with a lower level of R&D stock exhibit much lower levels of R&D state aid than do Member States with a high level of R&D stock. Table: R&D Aid and R&D Capital Stock in the European Union Country

Average State Aid GDP (%)

R&D Capital stock (as a % of GDP)

Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Portugal United Kingdom

0,08 0,12 0,07 0,06 0,05 0,10 0,06 0,04 0,05 0,12 0,02 0,04

13,5 8,3 20,2 0,8 2,9 16,2 4,6 6,7 n.a. 16,7 1,3 21,1

Source : J. Gual

III. SMEs A. Market Failures and SMEs State aids to SMEs are usually justified by market failure arguments in the credit market and export market. Above all, SMEs are faced with capital As shown in a recent report, (Gual et al. 1998).

54

Working Paper I

market imperfection. Such asymmetrical information arises since individual firms are better placed to judge the value of their products, while bankers cannot properly assess whether a product will be likely to succeed and, thus, are often reluctant to finance SMEs. The credit situation is only exacerbated by the limited guarantees which SMEs can offer to the bankers and by the lack of history which such new companies have. SMEs, therefore, have difficulty in obtaining capital and credit; a fact that can slow their development. Moreover, SMEs have restricted access to information on technologies and markets due to their limited resources. It can also be argued that SMEs generally face more risks than large enterprises since their activities are less diversified and they are more likely to find themselves infinancialdistress.

B. Community Framework for State Aid for SMEs These imperfections justify the Commission's traditionally more favourable attitude with regard to state aid for SMEs. The Commission may, accordingly, accept 15% in gross grant equivalent as a proportion of the costs of investment in fixed assets for small enterprises, or 7.5% for medium enterprises. In assisted regions, the Commission may approve aid exceeding the level of the investment aid it authorises for large enterprises by 10 percentage point in Article 87(3)(c) regions and by 15 percentage points in Article 87(3)(a) areas. Here, however, the problem is similar to the one posed by R&D; to what extent does the threshold fixed by the Commission in the Communication on State Aid for SMEs correspond with the market failure argument?

C. Economic Evaluation of the Disadvantages Experienced by SMEs Each year, the Directorate General for Economic and Financial Affairs of the European Commission analysis thefinancialsituation of SMEs in comparison with large enterprises. The aggregate conclusions reached are as follows: a) On average, the profitability of SMEs is lower than that of large enterprises. In 1996, the differential between SMEs and large enterprises was 1 percentage point for the gross and net profit ratio. b) SMEs are less capitalised than large enterprises. Equity relative to balance is some two percentage points higher for large enterprises than for SMEs. c) Conversely, SMEs have larger debts than large enterprises. SMEs compensate for lower equity ratios by acquiring long term debt. d) On average, financial institutions charge higher interest rates to SMEs than to bigger firms (one percentage point more). The higher interest rates that SMEs are charged may be explained by informational intransparencies with regard to the SME's profitability. As Gual argues, 'the interest rate spread

1 - Justification for State Aids

55

between SMEs and large companies could be an indication of SME restrictive access to capital market and a possible benchmark for this category of state aid.'6 Notwithstanding this argument, however, a fair calculation of the amount of state aid required to offset capital market imperfection is still very difficult and it is not clear whether this would be the best solution for the problem. On average, therefore, the financial structures of SMEs differ substantially from those of large enterprises, which may or may not confirm a number of hypotheses: the fact that SMEs are less capitalised than large enterprises can be explained by the difficulties that European SMEs face in obtaining equity capital funding; equally, however, entrepreneurs within SMEs may prefer bank loans above equity since they then do not have to share the control of the company with other shareholders. The picture in the US, however, is very different since American SMEs are, in fact, better capitalised than large enterprises. This may reflect on the greater importance of external financing for American SMEs thanks to the better organisation of capital markets, and, particularly, on the success of venture capital devoted to SMEs in the US. Accordingly, the question is one of whether a more favourably state aid policy towards SMEs is really the best mode in which to correct market failures in the financial markets. The answer is not very clear.

IV. Conclusions EU state aid policy may be justified by the need to correct market failures. This is particularly the case with regard to R&D state aid, where the positive externalities are obvious, and with regard to SMEs, where economists generally recognise market failures in the credit market. However, the Community's framework for state aid for R&D and for SMEs is also a very complex scheme, which attempts to synthesise the varied and distinct objectives of the EU. This complex scheme explains why, in the case of R&D, extra percentage points are added to the general threshold of gross aid intensity for SMEs, for less developed regions, for projects related to the Community's R&D framework programme, and for projects where international competition considerations demand that the EU match the support given by non-EU countries. The proposed guidelines are, therefore, a mixture of efficiency and equity considerations based on the objectives of the Treaty. From an economic point of view, it is not possible to give econometric justifications for the different threshold presented in the guidelines, notwithstanding market failure 6

(Gualetal. 1998).

56

Working Paper I

arguments. Existing studies on R&D externalities and the financial disadvantages faced by SMEs, do not furnish us with adequate guidelines for the clear quantification of state aid thresholds, which would correctly compensate for market failures. Moreover, at the macro-economic level, state aid granted by EU Member States pursuing R&D objectives, bears no relation to the factors that could justify intervention. Countries with the lowest levels of R&D stock provide, on average, lower levels of state aid with an R&D objective! Finally, it is not at all clear that state aid is the best option to address market failures. That is particularly the case with regard to SMEs, where US experience teaches us that a market-based—venture capital—solution can even result in a higher capitalisation for SMEs than for large firms.

II John Fingleton* How to Apply Anti-trust Market Definition Rules to State Aid: A Proposal

I. Introduction This paper addresses the question of whether market definition can be useful in state aid control in the European Union. The existing approach to state aid control has not traditionally relied on market definition, although tentative steps in this direction may be discerned in more recent rules. We argue that state aid may loosely be divided between one category in which it may be allowed automatically, provided some conditions apply—loosely speaking, a per se rule—and another in which it requires detailed consideration on a caseby-case basis—rule of reason. For the latter, the explicit use of a market definition criterion may improve the quality and consistency of decisionmaking. The second theme is the appropriate method of defining markets in state aid cases. State aid is fundamentally different to a merger or anti-trust case. In the latter, the central question is the effect that an 'increase' in price would have on the market. The definition of the relevant market thus focuses on buyer substitution 'to' other products and supply substitution 'from' other products. In contrast, a state aid results in a lowering of the cost of one firm, relative to the counterfactual. Thus, the market should be defined with respect to buyer substitution into the market—away from other firms—and substitution by the aided firm out of the market: the substitution patterns are in the opposite direction to those in anti-trust cases. A second issue is the assessment of effects of aid in complementary markets. Even where there is no effect on trade in the market where the aid is given, there may be a substantial indirect effect in the market for a complementary product. This assumes greater importance in a state aid case than in anti-trust. We also examine the approach to market definition in the current EU state aid policy and argue that the incorporation of a formal market definition stage in cases of both regional aid and rescue and restructuring aid may offer the potential for improved and more consistent decisions, greater transparency, and a clearer ex post understanding of decisions.

* Competition Authority and Trinity College, Dublin. I am grateful to Frances Ruane, Roderick Meiklejohn and Andres Garcia for helpful comments and suggestions and to the Graduate School of Business, University of Chicago for hospitality and support. This paper is partly a development from earlier work with Frances Ruane and Vivienne Ryan: (Fingleton, Ruane, Ryan 1999). I accept the responsibility for any errors.

58

Working Paper II

This paper is simply structured. We first set out a simple framework to discuss why state aid control is necessary and develop the idea that state aid control can be tackled by a combination of automatic and reasoned decisions {infra II). We argue that market definition can play a useful role in the latter, both in autarky and especially in a multi-country setting. Having established a role for market definition, we examine how the relevant market should be defined in state aid cases, taking as its starting point the approach to market definition in anti-trust analysis. We contend that the unique characteristics of state aid require that the anti-trust rules be modified and expanded {infra III). Section IV examines the EU approach to market definition in state aid policy and discusses how market definition might be usefully added to the procedure. A brief conclusion follows.

II. State Aid Control in a Multi-Country Setting In this section, we examine what the rules for the control of state aid should be, starting with the issues that arise in a single country and progressing to the multi-country scenario. A. The Rationale for State Aid (in Autarky) State aid consists of direct or indirect subsidy by the government or its agencies to a 'private' enterprise.1 Indirect aid in the form of favoured treatment may have very different incentive effects depending on the form of the aid. We abstract from the question of defining aid and other detailed issues and focus instead on the general—and quite representative—case where the government gives an explicit subsidy to a private firm that increases its profitability relative to what it would otherwise be. The main economic rationale for state aid is that it rectifies a market failure. An example is a subsidy that causes the recipient to increase output where a positive externality has led to underproduction—for example, with R&D.2 To 1

Investment by the state in a publicly owned firm is treated as investment, and the Market Investment Principle is used to determine any aid component in such investment. For an overview, see the European Commission, Competition Law in the European Communities: Volume IIB; Explanation of the Rules Applicable to State Aid, Office for Official Publication of the European Communities, Luxembourg, 1997. 2 Meikeljohn (1999) outlines a comprehensive list of market failures including externalities, public goods and problems due to transaction costs and imperfect information. A situation not discussed by Meiklejohn is that of stranded costs. These are rents due to an industry that is regulated and will represent a cost to thefirmsif the market is deregulated. Taxi licences are a good example. Optimal regulation may involve aid to deal with stranded costs.

1 - Justification for State Aids

59

be effective, aid must have an incentive effect that counters the externality. To be worthwhile, the net benefits from the aid should outweigh the social cost of funds. Aid may also be motivated by redistribution. An example here, let us say, is aid to firms in less developed regions of an economy which indirectly aims to transfer resources towards the unemployed. If the sole motive were to redistribute, a direct transfer to consumers would probably distort relative prices by less than a transfer to firms. However, the government may have an additional efficiency motive in distorting relative prices and this may make a state aid the most efficient policy instrument. As an example, consider aid for universal service—for example, in telephones. This clearly distorts relative prices because those in high cost—usually rural—areas do not pay the full cost and are subsidised by those in low cost areas. However, if there are network effects, charging the same price to all consumers may result in positive network externalities that increase overall efficiency. Similarly, regional aid that induces firms to increase the demand for labour may be more effective at increasing employment than any direct subsidies to consumers. The fact that aid can increase welfare is not sufficient. Other policy instruments may be more effective. For example, labour market reforms may be a superior policy instrument to increase employment. Where state aid would generate a smaller increase in welfare, it may still get chosen because the cost is borne by a more diverse group, taxpayers, than by the group adversely affected by reforms. Thus, the possibility of state aid may undermine the more efficient policy instrument. Here, the aid reduces welfare relative to the counterfactual, but not relative to the status quo. We refer to this as 'policy distortion'. However, it is also possible that influence activity, such as lobbying, could result in aid that reduces welfare relative to the status quo. The possibility of transfers from one group, taxpayers, to another, a focussed group offirms,ere-, ates a new market for political influence. If lobbying or bribery succeed in distorting aid decisions, aid may reduce welfare. This would be the case, for example, if aid to an inefficient firm restricts entry or expansion to a low cost competitor. We refer to this as 'internal rent shifting'.3 Thus, state aid may be a useful policy instrument that can increase welfare, but there is also the distinct possibility that state aid may enable policydistortion or internal rent shifting. As a result, this requires some control on state aid, even in autarky. The first question concerns the controlling unit. As the government gives the aid, how is the government expected to control itself? A common institutional way of achieving this is by constitutional type rules that can be evaluated independently. An example might be rules on public procurement that allow one branch of government to monitor how other branches of government make purchases. 3

Internal, here, refers to it being internal to a single country.

60

Working Paper II

The second question is what should be the substantive standard of a constitutional rule. Amongst the policies available, the two extremes are to allow all aid, or to prohibit all aid. Such absolute rules clearly reduce measurement costs, to zero in the case of an absolute ban, but are unlikely to result in optimal decisions. A third policy option is to have a constitutional rule that allows aid if some objective criteria are met. Although more costly in terms of measurement and monitoring, this improves the quality of decisions. The objective criteria play a central role and should achieve two things. First, they should establish a procedure that will capture all the effects of the aid. Second, they should make a decision based on these effects based on some clear welfare objective for the economy. We will refer to this as a rule of reason approach to state aid. We argue that market definition should be a component of the first stage of this rule of reason. Error can arise if some effects are omitted, or if non-effects are incorrectly included. This can be avoided if the first stage rule requires the definition of a relevant market that captures all of the effects of the aid. The welfare objective could still be distorted by altering the weights applied to different effects, but, at least, all the effects would be included transparently. For some types of aid, it may be obvious that, on average, all of the effects are positive, or not very negative. Detailed individual analysis is unlikely to improve the quality of decisions enough to justify its cost and, in such instances, it may be preferable to have a per se type rule that allows aid, subject to conditions. Market definition would not then be required.4 In summary, a single autarkic country may wish to have a system of controlling state aid. It is likely that such a system, if it is to avoid a blanket ban on aid, will both involve some combination of per se and rule of reason approaches to aid. In the case of a rule of reason approach, market definition may improve the quality of decision-making by ensuring that no distortion arises due to omitting some effects of the aid.

B. The Multi-Country Setting Where several independent countries award aid, there are additional effects. First, the need for control is greater because of cross-border externalities. Second, the set of cases that must be considered by rule of reason, rather than under a per se rule, will tend to increase.5 However, it does not alter the fact that 4

There is an analogy here with anti-trust, where horizontal price-fixing agreements, that almost always have negative effects, are per se illegal, but the control of vertical agreement requires a reasoned analysis based on the positive and negative effects. Indeed, some horizontal agreements that may have positive effects are exempt from per se prohibition. 5 We say tend to because theflowof cases where aid \sper se allowed into rule of reason may be countered by some rule of reason cases being pushed towards automatic prohibition.

1 - Justification for State A ids

61

the system of control will rely on some combination of rule of reason and per se rules, or that the rule of reason should formally incorporate market definition. A simple two-country example (see Figure 1) illustrates the greater need for control in an international setting.

Domestic Effect Foreign Effect Total Effect

Positive

Negative

Net Effect

+5 +1 +6

-4 -3 -7

+1 -2 -1

Figure 1: Numerical Two-Country Example of the Effects of Aid

Here the 'total effect' of the aid (aggregate of positive and negative in both countries) is - 1 , comprising a 'domestic effect' (within the country granting the aid) of +1 and the 'foreign effect' (within the other country) of -2. If the domestic country bases its decision on the domestic effect, it will approve the aid.6 However, the total effect is negative, so the aid should not be granted. Granting it inflicts a negative externality of -2 on the other country. In this example, there is external rent-shifting because there is a transfer of economic resources, or rent, from the foreign to the domestic country. If funds are limited, there may also be a policy distortion whereby inefficient policies are chosen.7 The situation is two-sided, as both countries can give aid. To avoid a prisoners' dilemma, both countries would prefer a system of state aid control that limited aid to cases where some measure of the welfare change was positive. This phenomenon is already well known from the trade literature and we do not discuss it further here.8 We focus, instead, on the balance between per se rules and rules based on reason. The first issue is the economic standard built into the rule: in other words, abstracting from the equity-efficiency trade-off, how should the gains and losses in the two countries be combined?. To this end, consider a slightly more general example than that given above. Suppose that the aid has a positive net domestic effect of D—assume without loss of generality that the domestic cost 6

However, if the domestic policy is not optimal, it is possible that it will approve aid even where the domestic benefit is negative. In other words, both internal and external rent-shifting could occur. 7 Consider a very simple example where a country can choose between two projects. Project A has a domestic effect of 4, a foreign effect of - 3 and thus a total effect of 1. Project B has a domestic effect of 3, a foreign effect of -1 and a total effect of 2. Globally, the best project is B, but the domestic country prefers A. 8 For two different overviews: (Besley & Seabright 1989); (Messerlin 1999).

62

Working Paper II

is zero—a positive foreign effect of B and foreign cost of C. These effects of the aid are shown in Figure 2.

Domestic Effect Foreign Effect Total Effect

Positive

Negative

Net Effect

D B D+B

0 -C

D B-C D + B-C

Figure 2: Algebraic Two-Country Example of the Effects of Aid

We distinguish two basic welfare criteria. Rule I: Allow aid where the total net effect is non-negative, that is D + B > C. Rule 2: Allow aid where the net foreign effect is non-negative, that is B 5 C. There is a basic trade-off here. Rule 1 is closer to optimal as it eliminates the most damaging rent shifting—it does not eliminate policy distortions. However, it increases the set of cases where a rule of reason approach is required. Rule 2, on the other hand, does not maximise global welfare, but avoids all external rent-shifting and is incentive compatible, in the sense that neither country has any incentive to exaggerate the domestic effect in order to distort the decision. Rule 2 thus enables greater use of a. per se rule, but at the cost of restricting some aid that would increase global welfare. This trade-off could be reduced if countries could make transfers between themselves. This is equivalent to widening the set of aid allowed. Suppose that Rule 2 is enhanced to allow the domestic country to make a payment to the foreign country. It will be willing to make a payment where D exceeds C-B which is precisely where total welfare rises. Thus, the optimal aid decision will be made. This could enable greater application of a per se rule and reduce the costs of the system of control. There are, however, some problems with this approach. First, this bilateral bargaining problem has a indeterminate price in the interval [C-B,D] and, as two-sided incomplete information is probable, inefficiency is almost guaranteed.9 Second, with 15 countries, for example, there may be further problems of co-ordination and hold-up. External rent-shifting, therefore, may mean that the international control of state aid will rely on the rule of reason analysis more than would be the case in an autarky. Besley and Seabright10 argue that much of the above analysis—and strategic trade theory generally—depends on the location of recipients beingfixed.If the efficiency of production varies with location, and a firm can choose its loca9

The best mechanism for bilateral trade will be inefficient under reasonably general conditions: (Myerson & Satterthwaitel983). 10 (Besley & Seabright 1998).

1 - Justification for State Aids

63

tion—as with foreign direct investment—state aid could have a positive efficiency effect because the most efficient location would pay most. 11 Besley and Seabright thus argue that a wider set of aid could increase efficiency. This would suggest &per se rule for foreign direct investment.12 However, where the location of recipients is fixed, the international setting may increase the need for rule of reason analysis. We digress here on the interaction between autarkic and international rules. It might be argued that countries often find it difficult to develop optimal rules to deal with solely domestic issues and that international rules may assist in such cases—a "protect me from myself" motivation for international rules. For example, it is difficult to argue that EU or US anti-dumping rules maximise domestic welfare. Even without cross-border effects, international coordination might enable countries to improve domestic policy.13 If international rules are required to deal with cross-border effects, we might then ask whether they might also be used to protect countries from themselves. Even with a narrow international rule that requires a cross-border effect, some element of this will be inevitable: international rules may establish a higher standard of transparency in domestic decision-making generally; rule of reason analysis may reveal hidden negative domestic effects; and good international rules may have an exemplary effect and encourage internal change. 14 However, it would also be possible to have a broader system of international control that decided on state aid cases regardless of whether there was a crossborder effect. The choice of rule here has implications for the use of a rule of reason approach and hence for market definition. The broader approach that also controls aid with solely domestic effects clearly brings a much larger category of aid under rule of reason, both because it increases the total set of cases and perhaps because the filter in broader rules may be less refined than that to deal with solely domestic rules. On the other hand, the narrow rule shifts this burden to domestic level and may reduce it to a more refined filter for domestic rules. However, this cost saving must be weighted against the possibility of good domestic rules not being attainable.

1

' The argument requires an externality that the aid can internalise, such as an inability of the government to commit to new infrastructure. Otherwise, the recipient could internalise the location-specific efficiency. 12 With foreign direct investment from outside the group of countries (for example, the EU) this could result in any rent from access to that market being transferred to the recipient. 13 The reasons include that interests that are weak domestically might forge coalitions abroad, that third parties add to the set of internal contracting possibilities or enable greater commitment, and that harmonising rules might encourage investment and trade. 14 An example of this might be the adoption of domestic competition laws in EU Member States.

64

Working Paper II

In summary, the control of state aid in a multi-national setting will, to some extent, rely on rule of reason analysis of individual cases and the set of cases that requires rule of reason analysis may be greater than in autarky. Thus, the need for market definition is likely to be at least as great in the international setting as in autarky. If broad international rules require control of aid with solely domestic effects, this will further increase the use of rule of reason analysis.

III. The Role of Market Definition Our focus in this section is entirely on the class of state aid where a rule of reason analysis is used and where market definition can play a useful role. In order to focus on the international effect, we will usually assume that the aid may have effects domestically and abroad and that the purpose of the market definition is to ring-fence the incidence of these effects.

A. The Relevance of Anti-Trust Rules Our starting point for a discussion of market definition in state aid cases is the well-established approach used in anti-trust analysis. The market is defined with regard to both a product and a geographic area by examining substitutability in demand and supply. The fundamental question is whether an increase in price from the competitive level would be profitable. This turns on whether consumers can easily substitute out of the market to alternative goods—which would then be part of the relevant market—or whether producers of other products could easily switch to producing the relevant product. Thus, the enquiry of interest is whether consumers can substitute 'away from' the product of interest and whether other producers can substitute 'towards' it. The direction of the substitution is important and driven by the basic question of what is the effect of a price increase. In a state aid case, the basic question is what is the effect of a subsidy. Suppose that the aid causes an increase in the output of the recipient relative to the counterfactual. This could occur either because the aid reduces the marginal cost of the firm—for example, an output subsidy—or because it reduces its fixed costs and enables it to continue in the market.15 The purpose of market definition here is to identify any competitors that might be negatively affected by this increase in output, which we may consider to be the equivalent 15

Fixed subsidies may affect output at the margin for several reasons: (Raith & Povel 1999), and (Chevalier 1995) who provides empirical evidence based on a different theory. Kovenock & Phillips (1997), look at the relationship between capital structure and output more generally.

I - Justification for State Aids

65

to a price reduction. As with the anti-trust question, the answer depends on the substitutability in both supply and demand, but there is one difference. Here, the thought experiment is a fall in the price, and, consequently, the patterns of substitution are in the opposite direction. In other words, we wish to know about the ability of consumers to switch 'towards' the product and the ability of the recipient to switch output into other markets. If there is any asymmetry in the patterns of substitutability, then the market denned using the anti-trust methodology will be incorrect. Such asymmetry may be common. In the analysis of one particular market with several products and heterogeneous consumers, it is not necessarily the case that the substitutability is symmetric.16 In other words, the cross elasticity of demand for X with respect to the price of Y may not be equal to the crossprice elasticity of the demand for Y with respect to the price of X. For example, where there are two types of consumers, one who can substitute easily and one who cannot, the group that can substitute easily may check a price increase, but may not affect the price reduction. Consider, as an example, the banana market. Suppose we accept that an increase in the price of bananas above the competitive level would not be controlled and not be prevented by the substitution of other fruits because of their unique handling and softness characteristics.' 7 This argument does not apply readily in the other direction: a fall in the price of bananas could induce an increase in demand as people substituted from other fruits. Asymmetry on the supply side is also possible and can arise if there are barriers to mobility into the recipient's product but not into another product that is a supply substitute. For example, suppose that there are two types of air routes with distinct demands: flights between premium airports where no further slots are available and flights between secondary airports with spare landing capacity. An increase in air-fares on the first market would not be checked by the second market because supply substitution from secondary to premium airports is not possible. On the other hand, suppose that a subsidy is paid to an airline operating on the premium market. In principle, there is nothing to stop this airline expanding into the secondary market, as supply substitution in this direction is possible. Thus, an anti-trust case might define the market for air routes narrowly but a state aid case might define it broadly. Another difference between state aid and anti-trust cases relates to the fact that in a state aid case the sum of the effects on the demand side and on the supply side is, in some way, limited by the amount of aid. In an anti-trust case, the 16

The Slutsky matrix of cross-price elasticities of the uncompensated or Hicksian demand of an individual consumer is always symmetric. Symmetry does not apply if there are income effects or with aggregation over consumers with different tastes. Any micro-economic textbook establishes these results (Gravelle 1992). Estimated models such as the almost ideal demand system (Deaton & Muellbauer 1980) do not assume aggregate or individual symmetry, but they often test for it. 17 In the United Brands case, the European Court of Justice accepted that bananas formed a distinct market for such a reason.

66

Working Paper II

ability to increase price can be constrained by either demand or supply substitution, so both matter. In a state aid case, the effect of the aid can be on one or the other, but is unlikely to be on both. For example, in the case of a subsidy to the airline, double counting could occur if a full effect on operators in both premium and secondary markets were included. In a certain sense, the total effect of the aid must be divided between demand and supply responses so that if a full effect is felt on the demand side—for example, in the premium market— then an effect on the supply side—for example, in the secondary market—is less likely. One possible exception is where the subsidy enables shared costs to be lower and thereby generates an economy of scope.18 This applies analogously to the definition of the geographic market with asymmetries in transport costs. Suppose that the market in question is that for breeding a rare pedigree dog. The control of rabies means that transport from the UK and Ireland to the rest of Europe is allowed but is very costly in the other direction. The relevant market for analysing a price increase by a UK breeder would probably be the UK and Irish market. On the other hand, the market for analysing the effects of a subsidy to a UK breeder could be the EU. Asymmetries in transport costs may be easy to identify, as they frequently result from regulation. Thus, we would expect the relevant geographic markets for anti-trust and state aid to coincide for most cases. However, it will always be necessary to identify the product market as well as the geographic market as otherwise there could be an error in defining the geographic market over the wrong set of products. In summary, the anti-trust approach to market definition needs to be modified in defining markets for the purposes of assessing the effects of state aid: the same method of measuring substitutability is used, but the substitutability is in the opposite direction. In many cases, the distinction will be semantic and substitutability will be symmetric. Moreover, if there is a strong substitution effect on the demand side and there are not strong economies of scope, then substitutability on the supply side is likely to be weak. This may be helpful in limiting the need to analyse supply substitutability in some cases.

B. Measuring Indirect Effects in Complementary Markets Thus far, we have addressed the direct effects of the aid on competitors in the market in which the recipient operates. A thorough analysis of the effects of aid should also examine whether there are indirect effects of aid and how these matters affect both competition and competitors in other countries. Although the discussion here might also apply to anti-trust market definition, mutatis mutandis, there are two reasons why indirect effects assume particular importance in state aid cases. First, aid to a monopolist could have indirect effects in 18

In this case, efficiencies may arise, as with natural monopoly.

1 - Justification for State Aids

67

complementary markets that are not manifest in the monopolist's own market. This does not arise in anti-trust cases because, there, a narrow market is inculpatory. In a state aid case, a broad market tends to be inculpatory so that it is necessary to search for the broadest possible extent of the market.19 Second, aid is often given precisely because it has indirect effects in complementary markets. Regional aid, for example, is often justified on the basis that it has positive knock-on effects in upstream input markets, generating growth in the regional economy generally.

Domestic Country

Foreign Country

Tree Growers

Tree Growers

Processors

Processors

International Market for Processed Wood Products

Figure 3: Structure of the Markets in the Wood Example

Two products are complements if their outputs are correlated. Products or services that are vertically related—manufacturing, distribution, and retailing—are generally complements for each other in the sense that an increase in the output of one, leads to an increase in the output of another. Computer hardware and operating systems are horizontal complements in the sense that both are purchased by computer makers infixedproportions and then sold on to consumers. We assume throughout that the strength of complementarity can be measured in the same way that the strength of substitutability can, that is, by econometric estimation of elasticities—or by more crude and subjective characteristic-type approaches. In order to illustrate the issues that arise, we consider an example where the complementarity is vertical with an upstream market for growing wood and a downstream market for processing timber, and make a number of assumptions. First, there is a strong complementarity between wood and processed timber and 19

This is the converse of the point on page above that the sum of the effects is constrained by the size of aid. If the aid has no effect in the market for substitutes, it is necessary to see if it has effects via complements. This may, to some extent, underlie the US Illinois Brick principle that anti-trust injury must occur in the direct, rather than indirect, market.

68

Working Paper II

wood-processing uses wood and other inputs in fixed proportions. Second, there are two countries with parallel industries. Third, the upstream wood product is not traded because of disease controls, but downstream processed timber is easily traded and highly competitive across national boundaries. Figure 3 gives a simple diagrammatic view of the market. We take the product markets as given, and focus on the geographic extent of the market. We consider two scenarios: aid to the downstream industry and aid to the upstream industry. First, consider aid to downstream processors in one country that reduces their marginal costs. Given that trade occurs, we would normally expect a negative effect on processors abroad either because the recipients expand or because they do not contract. However, this assumes that the supply of trees is elastic—changes in output of trees do not affect price. If the domestic supply is inelastic—ie, tree production is at capacity—domestic processors will not be able to increase output.20 Thus, even if the processors cut their prices, their market shares will not expand and the aid will rest as an economic rent to be divided in some part between the upstream and downstream industries. If the foreign supply is inelastic, the aid does not prevent foreign processors from expanding because they could not have expanded even if the aid had not been given. Hence, if the upstream supply is inelastic in both markets, the aid is unlikely to have a cross-border effect even if the product is traded.21 Conversely, if the upstream supply is elastic, the effects of the aid will be mirrored in the upstream market with an expansion of the domestic upstream industry—as demand from its processors is higher—and a contraction of the foreign upstream industry. If the downstream market is keenly competitive, it is possible that the most of the effects of the aid could be manifest in the upstream markets. In other words, the effect of the aid might be that domestic growers of trees benefit and foreign growers lose out because they compete with each other indirectly via the downstream market. Second, consider aid to upstream growers of trees that lowers their costs. Depending on the elasticity of supply and price rivalry upstream, lower costs upstream will translate into downstream firms facing lower prices for—and/or increased availability of—trees. Because the input is not traded, only the domestic downstream industry has access to this lower cost. Thus, the upstream aid becomes, at least in part, aid to the downstream industry. Consequently, the aid has downstream effects in the same direction as if aid were given directly in the downstream market. As with thefirstcase, the effects of the aid are not contained entirely within the market in which the aid is given. If the upstream supply is completely inelastic, then it is likely that the aid will be retained as a rent upstream. In summary, ignoring the indirect effects of the aid in complementary markets could result in three types of error: 20

The assumption of fixed proportions is important here and the effects would be different if the elasticity of input substitution were high. 21 This depends crucially on the upstream product not being traded as, otherwise, the expanding sector could import its inputs.

I - Justification for State Aids

69

a) damage to foreign competitors is inferred because the recipient's product is traded when no effect is possible because of rigidities in a complementary market; b) no effect is seen in the aided market because the effects get passed on to the non-traded complementary market; and, c) damage to competitors is ruled out because the recipient's product is not traded, when the effects are reflected in a traded complementary market. In all cases, therefore, complementary products need to be identified. If both the recipient's market and the complementary market are national, then the effect of the aid is contained domestically. Otherwise, it is necessary to examine the conditions of competition and tradability on the complementary market. The central factors suggested by the above example are the elasticity of upstream supply—for example, capacity constraints—the elasticity of input substitution, the strength of any complementarity, whether the complement is traded or not, and how much rivalry there is in the complementary market. Although the example is for vertical complements, the arguments are relevant to horizontal complementarity. Suppose aid is given to a domestic software producer and that hardware and software are used in fixed proportions. The increase in software production will induce an increase in hardware production. If the hardware is non-traded, then the direct effects on software will be mirrored as indirect effects in hardware. On the other hand, if hardware is traded, then the indirect effects will tend to cancel each other out as the increase in demand is borne by an international hardware market rather than just by a domestic hardware market. The purpose of this discussion is to develop a notion of market definition that encompasses all the possible effects of an aid. We have argued that both substitutes and complements may, in general, be affected by state aid and that any approach to market definition should endeavour to capture both. In capturing substitutes, the traditional anti-trust approach must be modified to deal with asymmetries in substitutability. In addition, this method does not address the issue of complementarity and thus some additional enhancement of the market definition is required to deal with complementarities. There are two ways in which this can be done. Anti-trust Approach: Modify the existing anti-trust approach to deal with the asymmetry and use this as the Stage 1 market on which the effects will be examined. In the examination of the effects of the aid at Stage 2 (the welfare objective stage), complementarity will be introduced. Enhanced State Aid Approach: define the market to include the recipient's product and its substitutes (the anti-trust market) plus any complements of the recipient's products, and the substitutes and complements of both of these.22

22

In general, the complements of the substitutes may not be equal to the substitutes of the complements.

70

Working Paper II

In the context of aid to a wood grower, thefirstapproach would give the market for wood in the single country as the relevant market and the second would give the market for trees and wood-processing in both countries. The second is clearly attractive in that it fulfils our objective of encompassing all of the effects: there is a distinct danger that the use of the first could omit some and thus lead to a distorted decision. On the other hand, the first approach is already generally accepted and might win more ready acceptance in a process of institutional change.

IV. Application to EU Policy on State Aid The EU policy on state aid is set out in the first instance in Articles 87-89 [ex 92-94] of the Treaty of Rome and, at a secondary level, by both case law and documents published by the European Commission.23 We focus primarily on Article 87 [ex 92] and the framework that has been established, in particular, under Article 87(3). Article 87(1) prohibits any aid which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods, in so far as it affects trade between Member States. We note several things about this rule. First, it only relates to aid that has an external effect: there is no "protect-me-from-myself" type of control. Second, the distortion of competition must come about because there are negative effects on some producers and positive effects on others. Third, an important element in deciding whether the prohibition applies, namely, whether trade and competitors are effected, implicitly assumes some idea of the market on which the aid has effects. Any idea that Article 87(1) represents a blanket ban on aid is completely undone by the exemptions allowed in Articles 87(2) and 87(3): the general prohibition largely works as a device for the notification of aid. In practice, aid is almost always allowed. The exemptions come in two forms. The first, outlined in Article 87(2) are types of aid that are what we call per se exempt. Thus, for example, nondiscriminatory social aid granted to individual consumers and aid for natural disasters are exempt in, and of, themselves and require no further justification, although they must be notified and the Commission must be satisfied that they fall within a per se category in Article 87(2). In contrast, the exemptions in Article 87(3) only apply after the European Commission has examined the aid and decided that the exemption applies.24 Exemptions allowed here include regional aid, aid for R&D, and aid for rescue and restructuring. Over the years, the Commission has increasingly sought to codify its approach to the exemptions in Article 87(3) by the publication of 23 24

A helpful overview is given in European Commission, op. cit. n. 1. This power is given t o the Commission in Art. 88 [ex 93].

1 - Justification for State Aids

71

rules in the form of guidelines, frameworks and notices..25 This has had the effect of bringing some of the Article 87(3) exemptions under a. per se umbrella, and leaving others in the rule of reason realm. We deal with these in turn. The EU rules on R&D allow aid if there is an incentive effect whereby the research would not occur without it.26 The intensity of aid allowed is greater the further the research is from commercial application. The basis for general exemption here is two-fold. First, the aid is unlikely to have an effect on competition in product markets, and does not eliminate competition in the market for R&D projects.27 Second, even with an effect on competition, there is a public good problem that aid may rectify. A similar approach is adopted by the Commission in its de minimis rules and rules applying to aid to small and medium sized enterprises.28 Here, the justification is that substantial negative competitive effects are unlikely. The efficiency rationale may also exist in some individual cases, but it is not generally obvious that aid to small firms improves efficiency. In all of these instances, aid that meets certain criteria is generally allowed without examination of the specific effects of the aid in each case. As a result, there is no need for market definition. In contrast, such a general approach is not possible with regional aid,29 and rescue and restructuring aid.30 Both clearly raise the question of competitive effects, the former at regional industry level (where aid is general) and the latter at firm level (where aid is specific to a firm). While regional aid, in being restricted to disadvantaged regions, may have some general efficiency rationale, this is less likely to be the case for rescue and restructuring aid. Thus, both types of aid require assessment at individual case level. We examine several issues with regard to EU policy in this area. a) Is any use made of a market definition as part of the analysis? b) If so, what approach to market definition is adopted and how does it compare with the approaches outlined on page 69 supra. c) Could the absence of a market definition stage in state aid cases affect the quality of decisions? Conversely, could the introduction of a market 25 These cover aids related to rescuing and restructuring, research and development, regional development, environmental protection, small and medium sized enterprises, employment creation, and training. The relevant documents are listed in the footnotes that follow as a n d when they arise. A full set of guidelines c a n be viewed at http://europa.eu.int/comm/dg04/lawaid/en/98cl07.htm. 26 See, Community Framework for State aid for Research and Development (OJ C45 17/02/1996). 27 Although the guidelines d o not appear concerned with the problem, there is a danger of co-operation leading to collusion that also arises with joint-ventures. 28 See, the Community guidelines on State aid for small and medium-sized enterprises (SMEs) (OJ C213 23.7.1996). 29 See, the Guidelines for National Regional Aids (OJ C74 10/3/1998) and the Multisectoral framework on regional aid for large investment projects (OJ C107 07/04/1998). 30 See, the Community guidelines on state aid for rescuing and restructuring of firms in difficulty (OJ C368 23/12/1994).

72

Working Paper II

definition stage that embraces all the effects of the aid improve the quality of decisions?

A. Use of Market Definition Generally, market definition has not played a role in the analysis of state aid. The determination of whether there is an effect on trade and a distortion in competition has instead employed a somewhat crude sector-based analysis. This is confirmed in the Commission Notice on market definition31 which states: The focus of assessment in state aid cases is the aid recipient and the industry/sector concerned rather than identification of competitive constraints faced by the aid recipient. Thus, the industry has been used as a proxy for the market. The difference could be substantial as an industry could contain many individual anti-trust markets—for example, air routes in the aviation industry—and a market could span several industries—for example, different modes of transport such as the Eurotunnel, ferries and air compete on individual markets. There may be merit in such an approach. Market definition is a timeconsuming process and the Commission has limited resources and is legally obliged—by the prohibition in Article 87(1)—to consider a large number of cases. The combination of a simple sectoral analysis with an presumption of an impact on competition and trade, unless there is strong evidence to the contrary, might capture many or all of the effects of the aid. More recent guidelines on regional aid and rescue and restructuring aid refer to the relevant market in the context of measuring excess capacity on the recipient's markets. The role that market definition plays here is to limit the effects of the aid in that dimension. It is, thus, part of a condition under which aid is allowed, rather than a general ring-fencing of all the effects of the aid as we propose above.

B. Approach to Market Definition Only the multi-sectoral framework of the regional aid rules gives any idea of how the relevant market is to be defined in a state aid case. This suggests an approach similar to that used in anti-trust. The relevant product market(s) for determining market share comprises the products envisaged by the investment project and, where appropriate, its 31

See the Commission Notice on the definition of the relevant market for the purposes of Community competition law (OJ\ C372\ 09/12/1997), at Footnote 1.

1 - Justification for State Aids

73

substitutes as considered by the consumer—by reason of the products' characteristics, their prices and their intended use—or by the producer—through flexibility of the production installations. The relevant geographic market usually comprises the EEA or, alternatively, any significant part of it if the conditions of competition in that area can be sufficiently distinguished from other areas of the EEA. Where appropriate, the relevant market(s) may be considered to be global.32 Some additional insight may be gleaned from the Commission guidelines on market definition which, in referring to the use of market definition in state aid cases, states: When consideration of market power and, therefore, of the relevant market are raised in any particular case, the elements of the approach outlined here might serve as a basis for the assessment of state aid cases.33

There is no indication in either setting that asymmetry in substitutability or complementary effects might matter. The wording of the second quotation is sufficiently vague that it would certainly permit either of the approaches outlined at page 69 supra. The last quotation suggests that the relevant market be examined only where there is a question of market power. State aid may enable a firm to maintain a high market share in the face of more efficient entrants, but this is not market power although the symptom (deterred entry) is similar. If market power is meant literally, then the scenario envisaged is not plausible. If market power really means market share, then different standards would apply where the economic effects are identical. The effects (per unit) of aid to inefficient firms that prevents more efficient entrants will be the same regardless of the market share of the recipients. We argue that the relevant market should be measured in both scenarios.

C. Embracing All the Effects The approach of EU policy towards both regional aid, and rescue and restructuring aid emphasises the conditions under which aid is generally acceptable. In regional aid, the conditions endeavour both to allow aid where there is a positive impact on a poor region and to avoid negative competitive effects. They thus limit aid to designated regions, tie it to job creation and require it to be generally available rather than being awarded to specific firms. The conditions in rescue and restructuring aid relate to restoring the recipient to long-term viability quickly and without the need for further assistance. In both cases, there is a strong emphasis on tying aid to reductions in capacity where the 'industry' 32 33

Multisectoral framework, OJ C107 07/04/1998 at para. 7.6. The quotation here is the sentence that follows that referenced in footnote 31.

74

Working Paper II

is characterised by excess capacity—and this is where the relevant market gets mentioned. We wish to argue that this approach does not include all the possible effects of the aid. Consider an example of aid given to an inefficient firm that enables it to maintain a higher market share than it would otherwise manage, with two scenarios. In the first, the recipient is marginally less efficient than its competitors and a welfare analysis would allow the aid. In the second, the recipient is substantially less efficient and welfare would be increased by the firm exiting from the market. Two problems can arise here. First, a decision based on excess capacity in the industry may not relate closely to relative efficiency on the market. For example, excess capacity in the aviation sector would not bear any relation to the relative efficiency of the different modes of transport that are in the same market. Second, even if the industry sector and market were aligned, the rescue and restructuring guidelines could easily achieve the same result in both cases, tying the aid to a reduction in capacity that bears no relation to the relative efficiency. The introduction of an explicit market definition requirement could avoid the first problem and make it more difficult to ignore relative efficiency differences in the second. This may also apply to regional aid. Consider our example of aid to a wood processor. First, general aid to all wood processors or growers in a region does not preclude a negative effect on foreign competitors in precisely the same way as aid to an individual firm. Second, even if there is an efficiency effect, such as increasing employment, there will be no guarantee that there is not a corresponding negative effect in a poor region elsewhere. Thus, if aid is justified on the basis that it will have knock-on benefits in local upstream supply industries for non-traded inputs, it is necessary to check that it does not have corresponding negatives elsewhere. Third, if poor areas were the most efficient locations to grow trees, aid would have little or no efficiency effect although it is possible that it could enable an inefficient domestic industry to withstand competition from a more efficient foreign industry. Thus, existing policy may prevent the location of production where it is most efficient. Again, an explicit market definition criterion could improve the analysis. We conclude that the existing policy toward state aid does not make use of a clear and consistent market definition criterion and that the adoption of such a criterion could improve the quality of decisions in cases where a rule of reason analysis applies.

V. Conclusion This paper has presented two simple arguments. One is that market definition can play a useful role as a first stage in state aid cases where a rule of reason approach is used. The second is that the definition of the relevant market in

1 - Justification for State Aids

IS

state aid cases could be based on a modified version of the anti-trust rules that incorporates additional facets of the market. The main argument for a market definition stage is to embrace all of the possible effects of an aid: the second stage would base a decision on some weighted sum of these effects. This would add consistency and transparency to the overall decision by eliminating distortions that arise because effects are accidentally or intentionally omitted from the analysis. We have taken no view in this paper on how effects should be weighted, but merely argue that all the effects need to be included. The method of defining the market to embrace all of the effects must have regard to the characteristics of aid. If we take the anti-trust approach as a starting point, two modifications are required. First, substitution is in the opposite direction and the anti-trust approach could err if substitutability is asymmetric. Second, state aid can have effects in complementary markets that do not arise in the same way in anti-trust analysis. It is a moot point whether it would be better to incorporate the latter as part of the definition of the market, or as a formal part of the second stage analysis based on a narrow market at the first stage. We have also argued that this theoretical discussion is highly applicable to the EU policy on state aid and, in particular, to the policy on regional aid and rescue and restructuring aid. There, a rule of reason analysis attempts to allow aid in cases where some criteria are met. However, it is not clear that these criteria capture all the effects of the aid. As a result, aid with very different (omitted) effects could be determined in identical fashion. We thus believe that there is an argument to be made for requiring a market definition criterion in this area of EU policy towards state aid.

Ill Jordi Gual* Aggregate Targets for State Aid Reduction in the European Union

I. Introduction The objective of this paper is to analyse whether the policy of state aid reduction in the European Union could benefit from an aggregate approach based on binding limits on the state aid granted by Member States. The possibility of such an aggregate target is becoming of increasing interest for two reasons: first, the need to maintain budgetary figures within the limits established by the Stability and Growth Pact, which requires a strict control of public spending; secondly, the elimination of state aid controls on many small programmes, with an increased concentration of Commission effort on the most important cases. Such an approach may be invalidated in the absence of a cap on the programmes that remain outside the control of the Commission. This paper is based on the results of a study commissioned by the Directorate General for Financial and Economic Affairs of the European Commission between 1997 and 1998.' The study discussed the methodological difficulties inherent to such an aggregate exercise and proposed criteria for aggregate state aid reductions. This paper summarises the analysis and compares the recommended cuts with recent data on state aid.

II. The Objectives of State Aid State aid may pursue efficiency and equity objectives. This paper will focus on the elimination of state aids which are not justifiable using allocative efficiency * Professor, IESE Business School, Barcelona 1 State Aid and Convergence in the European Union (May 1998), report prepared for the European Commission by the Fundacion de Economi'a Analitica: Contract Number /11/09170 Macro and micro-economic impact of a reduction in state aids spending. This report benefited from the collaboration of Professors P Videla (IESE), A Sembenelli (CERIS-CNR, Italy), X Vives and J Brandts (IAE, Barcelona), C Crombez (KU Leuven) and LH Roller (WZB, Berlin). This project was carried out during 1997 and completed by mid-1998. In the meantime, the European Commission completed the Sixth Survey on State Aid in the European Union in the Manufacturing and certain other sectors COM(1998) 417final.This survey was published on 1.07.1998 and was not available during the preparation of the report. The Seventh Survey was published in 1999.

78

Working Paper III

criteria. Since many state aids pursue equity objectives, this dimension is also considered even if the evaluation of equity goals is more controversial. Government intervention through state aid may be undertaken with the goal of correcting market failures. If this is the case, cutting state aid could be welfare-reducing despite its positive immediate effect in terms of reduced public spending. This paper provides an evaluation of the degree to which state aids can be reduced across the EU without jeopardising the broader goal of improving overall social welfare. It is assumed that observed levels of aid pose no problems from a competition policy viewpoint. This may be the case because there is no negative effect on intra-EU trade. It could be also that competition concerns are outweighed by the broader objectives of aid, in terms of externalities or equity goals being targeted. This means, of course, that an aggregate approach will provide only an upper bound on the level of permissible aid, since some of the aid granted on grounds of efficiency may be causing competition policy problems. The background study covers only those types of transfers which can be characterised as aid following the definitions of the European Commission (EC) surveys on state aids. It relies on the evaluation of state aids in all Member States using the data provided by the EC surveys on state aids and harmonised data for all Member States.2 With respect to the industry coverage, the analysis considers the industries included in the Fifth Survey.3 The period of analysis covers the periods analysed by the 2nd, 3rd, 4th and 5th surveys. That is, from 1986 to 1994.4 State aid objectives are classified in eight categories: R&D, SME, Trade, Steel, Shipbuilding, Coal, Railways and Regional Development. It is considered that aid under R&D, SME and Trade objectives may be justified on 'efficiency grounds' under certain circumstances. At the other extreme, aid to Steel, Shipbuilding and Coal is based solely on 'equity goals'. Finally, aid to Railways and Regional aid may be targeting both 'efficiency and equity' concerns. For each aid objective, a first set of indicators measure the magnitude of aid by assessing the extent of aid relative to the activities that are being subsidised—for example, support to SMEs relative to the size of the SME sector, see Box 1. These indicators are compared over time across the countries of the EU. As a general principle, the study assesses the impact of eliminating excess deviations from optimal aid levels for the period 1992-94. 2 The background study includes four country studies that undertake a closer inspection of state aids in Germany, Italy, Belgium and Spain. 3 The individual country studies cover all manufacturing as well as banking and airlines, but exclude energy and all regulated service industries (except railways). Since the data on aid to agriculture andfisheriescontained in the Commission's surveys are highly unreliable, no detailed analysis was undertaken. The conclusions, however, should take into account that aid to agriculture constitutes a significant, though unknown, part of total state aid. 4 The country analyses focused on more recent periods depending on data availability.

1 - Justification for State Aids

79

III. A Methodology for Aggregate State Aid Reduction Optimal aid levels can be established theoretically when aid pursues allocative efficiency objectives. That is, when aid attempts to correct market failures. In principle, rates of aid across countries should be equal, unless there are differences with regards to the magnitude of the externality being targeted. Since this externality is not observable, a second-best approach can be based on allowing deviations from a common rate of aid when justified by divergences in the set of factors which determine the magnitude of the externality. The empirical use of this theoretical approach faces two main problems. First, the character of the market failures that justify intervention make it difficult to specify the determinants of the magnitude of the externality properly. Moreover, data availability is a major constraint. Secondly, the correlation between observed aid rates and the factors determining the magnitudes of market failures will be weak if actual aid is not disbursed according to efficiency objectives. Nevertheless, if this is the case, this will be indeed a very important piece of information. If aid is not disbursed according to efficiency goals the procedure is equivalent to the simple elimination of excess deviations from the EU mean. Indeed, this was the 'base scenario' in this study, since for many aid objectives there is no relationship between aid levels and underlying proxies for the externality being targeted. In an alternative scenario (Scenario 2), the cuts have been computed, taking into account the factors that may justify the existence of aid. Justification of aid on efficiency grounds is used for the following aid objectives: R&D, SME, Trade, Railways and Regional. Box 1 provides a summary of the indicators or determinants of aid that have been used. Whenever aid pursues equity objectives, divergences across countries in aid levels can only be justified by differences in the social problems being tackled. Assessing these divergences is, however, very difficult. Since most aid programmes with equity goals have the aim or protecting jobs—and income levels—one possibility is to impose similar levels of aid per worker supported across countries. Given the differences in the purchasing power of wages across the Union, however, similar levels of aid will be denned with reference to the median or average wage measured within each Member State. Since aid granted for equity objectives causes distortions in output markets, the final objective should be, in principle, its elimination. This is, of course, very drastic and possibly inappropriate given the fact that subsidies are provided to the unemployed on equity grounds in almost all EU countries. The extent of these unemployment subsidies is used as a benchmark for the reduction of the levels of aid per employee. Justification of aid on equity grounds is used for the following aid objectives: Steel, Shipbuilding, Coal, Railways and Regional Development. Boxes 1 also

80

Working Paper III

provides a summary of the relevant indicators.5 The base scenario again takes into account only convergence towards the EU mean. Scenario 2, by contrast, considers the equity dimension for Steel, Shipbuilding and Coal. This is not the case in Railways and Regional Development, where only the efficiency considerations have been taken into account.6 Finally, the ultimate objective of the study was to assess whether state aid reduction could contribute significantly to the budget consolidation efforts of EU Member States. As a consequence, the assessment of state aid was compleBox 1. A methodological summary (I) Efficiency Objectives

R&D

SME

Trade

Aid as a % of GDP

Aid as a % of GDP

Aid as a % of extra-EU export

Aid as a % of SME turnover

Aid as a % of GDP

Measures of rate of aid

Optimal types of aid

B1A, D1A

B1A.C1A, D1A

CIA, D1A

Indicators that proxy the marginal efficiency

R&D undertaken by Government

Average firm size (employees per firm)

(Extra-EU exports as a % of GDP)

R&D capital stock as a % of GDP Other relevant indicators

Extra-EU export intensity

Average number of patents

A1A: Grants A2A: Tax exemptions B1A: Equity participations CIA: Soft loans D1A: Guarantees

5

The study also assesses the extent to which aid is provided through different mechanisms. The types of aid we will use are those considered in the state aid surveys: a) subsidies and tax deductions, b) equity participations, c) soft loans and deferred taxes and d) guarantees. Economic analysis is used to propose simple hypotheses about what the desirable structure of these indicators should be (for example, aid to SME might be best given through soft loans, since that may alleviate the potential capital market distortion). 6 The detailed country studies provide a complete listing of all the relevant state aid programmes and classify them by aid objectives. This provides a contrast of the indicators and aid cuts proposed in the overall analysis.

1 - Justification for State Aids

81

mented with an analysis of its impact in terms of the budgetary position of Member States. Two time dimensions were considered. In the short term, the decline in direct spending through state aid reduction is accompanied by induced temporary changes in spending and revenues—for example, additional spending in unemployment benefits when workers employed in aided firms are laid off, or reductions in tax revenues as workers cease to pay income tax and social security contributions. In the long term, these negative effects disappear and the assessment takes into account the beneficial effect of eliminating inefficient state aid: economic welfare will increase and this will contribute to an overall improvement in the performance of the public sector and the economy. Box 1. A methodological summary (II) Equity Objectives

Measures of rate of aid

Steel

Shipbuilding

Coal

Aid as a % of VA

Aid as a % of GDP

Aid to current production as a % of GDP

Aid per employee

Aid to current production per employee

Employment (relative to Germany) Number of ships built (relative to Germany) % domestic employment

Production (relative to Germany)

Aid as a % of GDP Optimal types of aid Indicators for the Aid per employee assessment of equity objectives Other relevant indicators

Production (relative to Germany) % of domestic industrial value added % domestic employment

% domestic employment

IV. Recommended State Aid Cuts The overall state aid cuts are based on the addition of the individual impacts of aid cuts by objectives. No general equilibrium effects are taken into account, nor do we take into consideration the fact that the reduction of certain types of aid could be linked to increased social pressure for other subsidies—ie, eliminating support for specific industries could lead to renewed pressure for regional support in some regions specialising in the industry. The reduction of aids is summarised in Tables 1 and 2. Tables labelled (a) refer to the 'base scenario', and Tables labelled (b) to scenario 2, or the 'alternative scenario', which takes into account efficiency and equity objectives.

82

Working Paper III

Box 1. A methodological summary (III) Efficiency/Equity Objectives

Measures of rate of aid

Railways

Regional

Aid as a % of GDP

Aid as a % of GDP Aid as a % of GDP of relevant areas

Optimal types of aid

A1A

Aid aiming at exit/entry decisions

Indicators that proxy the marginal efficiency

Passenger-km per person

Income disparity indices

Indicators for the assessment of equity objectives

Aid to current production per employee

Income disparity indices corrected for income per capita differentials (revised income disparity indices)

Other relevant indicators

% domestic employment

Unemployment rates

Network extension (km) Freight ton-km

The country perspective is presented in Tables la and lb. These Tables show the aggregate cuts by country. The bulk of state aid reduction in the EU involves Italy and Germany, and, to a lesser extent, France and Spain. All of them together account for 97% of total aid cuts. Thesefiguresare not substantially different in the alternative scenario. In terms of the relative importance of aid reductions within the domestic economies, the picture is somewhat different. Cuts are very important in Italy (1.21% of GDP), and significant in a group of countries where they represent between 0.70% of GDP and 0.30% (Germany, Spain, Greece and Luxembourg). At the other extreme, in countries with a tradition of less state intervention in the economy, such as the UK and the Netherlands, suggested cuts are negligible. These results are not sensitive to the scenario that is being used (see Table lb). Table 2 provides us with the breakdown of suggested cuts by objective. The results are consistent with the basic methodological approach that emphasises the need of concentrating aid cuts on non-efficient aid schemes. The summary data by objective shows that most of the aid reduction is focused on regional aid (46%) and industry specific aid (42%). Cuts required in horizontal

83

1 - Justification for State Aids

Table la. Total aid cuts by country (Base scenario) Total Country

Savings M. ECUs (1994)1

Savings (% GDP)

Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Portugal United Kingdom

209,40 161,09 10291,94 251,53 1141,18 1225,17 9,92 10585,25 48,66 84,61 72,73 0,00

0,11 0,13 0,62 0,39 0,28 0,11 0,02 1,21 0,53 0,03 0,11 0,00

1% 1% 43% 1% 5% 5% 0% 44% 0% 0% 0% 0%

MEAN ST. DEV. EU

2006,79 3961,13 24081,47

0,30 0,35 0,42

8% 16% 100%

Distribution of cuts by country

Table lb. Total aid cuts by country (Scenario 2) Total Country Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Portugal United Kingdom MEAN ST. DEV.

EU

Savings M. ECUs (1994)

Savings (%GDP)

Distribution of cuts by country

115,40 99,10 8747,66 71,27 1166,91 590,36 0,00 9232,16 48,19 84,61 85,00 0,00

0,06 0,08 0,52 0,11 0,29 0,05 0,00 1,05 0,52 0,03 0,13 0,00

0,57% 0,49% 43,22% 0,35% 5,77% 2,92% 0,00% 45,61% 0,24% 0,42% 0,42% 0,00%

1686,72 3429,41 20240,66

0,24 0,32 0,36

8,33% 16,94% 100,00%

84

Working Paper III

Table 2a. Aid cuts by aid objectives. Base Scenario Mn ecu (1994)

% of EU GDP

R&D SME Trade Steel Shipbuilding Coal Transports Regional Dev.

777,81 561,10 1578,24 537,89 163,41 4363,19 5039,01 11060,82

0,01 0,01 0,03 0,01 0,00 0,08 0,09 0,19

3% 2% 7% 2% 1% 18% 21% 46%

TOTAL

24081,47

0,42

100%

Distribution by objective

Table 2b. Aid cuts by aid objectives. Scenario 2 Mn ecu (1994)

% of EU GDP

R&D SME Trade Steel Shipbuilding Coal Transports Regional Dev.

777,81 125,74 187,13 82,00 178,15 2790,00 5039,01 11060,82

0,01 0,00 0,00 0,00 0,00 0,05 0,09 0,19

3% 1% 1% 0% 1% 12% 21% 46%

TOTAL

20240,66

0,36

100%

Distribution by objective

programmes are minor (12%) and correspond to the reduction of aid in countries which provide non-proportional support relative to the EU average. The alternative scenario, which explicitly accounts for efficiency considerations and compares equity objectives across industries, reduces aid cuts in horizontal and sector specific aid, and thus increases the relative weight of regional aid. The aid cuts, however, are not substantially different because, for most of the aid objectives, the data show that, even if an efficiency rationale for aid exists, the pattern of aid across the EU does not show that aid is being disbursed in relation to the magnitude of the market failure being targeted. Similarly, the taking into account of equity considerations across industries, only has a substantial effect on aid to the coal industry. If we consider detailed objectives, we see that the cuts in industry-specific aid fall most heavily on the industries with the largest amounts of aid (transport and coal).

1 - Justification for State Aids

85

Not surprisingly, cuts in these industries are very important in terms of their relative impact on the economy, even if, for sectors like railways, they constitute a comparatively small reduction in relative terms (16%).

V. Budgetary Impact The suggested aid cuts are not negligible in terms of the GDP of some Member States and, as a consequence, the analysis of the budgetary impact has to take into account the overall macro-economic effect of aid reduction. Moreover, aids represent a large part of the EU budget deficits, especially in some Member States. In fact, in Germany and Italy, the cuts involve a substantial reduction of the deficit (see, Table 3). The direct and indirect effects of these important changes in budgetary policy must be appraised. This study approximates the aggregate impact of state aid reduction on the budgetary situation of Member States on the basis of the estimates of the micro-economic gains. Indeed, the basic tenet of the micro-economic approach used in the background study is that reducing state aid can contribute to overall economic welfare, provided that aid cuts do not affect programmes which are commensurably targeting properly defined market failures. The limited amount of information that can be used at this aggregate level of analysis implies that the selection of aid cuts has been rather coarse, based on general criteria which evaluate the existence of an efficiency justification for aid and the proportionality between the amount of aid and indicators of the magnitude of the possible market failure. In assessing the budgetary problem, it is assumed, therefore, that all suggested aid cuts represent net gains for society—ie, the elimination of aid does not generate social efficiency losses. We consider a 'baseline case' and two time horizons, focusing consecutively on the 'short and the long-run'. All results are computed for both aid cuts scenarios: the base scenario of eliminating deviations relative to the EU mean, and Scenario 2, where equity and efficiency goals are explicitly incorporated. The 'baseline case' considers the budgetary situation after state aid cuts by simply deducting them from 1997 actual balances7 (see, Table 4a and b). The improvement at EU level is remarkable (a reduction of the deficit of 0.3 as percentage of GDP) and is particularly important in the countries which are close to the 3% Maastricht limit (Germany, France, Italy, Spain, Belgium and Portugal). The first scenario, which we label as 'short-term', takes into account the fact that the suggested state aid cuts are likely to lead to temporary job losses and, 7

These are projected budget balances as of late 1997 (data from the European Commission).

86

Working Paper III

Table 3a. Retrospective budget balance (1992-94) with state aid reduction (% of GDP). Base scenario

Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Portugal United Kingdom EU

Actual balance

Actual aids

Aids as a % of actual balance

Suggested cuts

Cuts as a % of actual balance

-6,60 -3,43 -2,90 -12,87 -5,57 -5,00 -2,20 -9,37 1,70 -3,50 -5,43 -6,97

1,96 1,06 2,62 1,76 1,16 1,36 1,51 2,23 2,30 0,80 1,19 0,44

30% 31% 90% 14% 21% 27% 69% 24% 135% 23% 22% 6%

0,11 0,13 0,62 0,39 0,28 0,11 0,02 1,21 0,53 0,03 0,11 0,00

2% 4% 21% 3% 5% 2% 1% 13% 31% 1% 2% 0%

637 5232 47651 562 20864 0 0 91528 482 0 2268 0

-5,45

1,71

31%

0,423

8%

169224

Shortterm job losses

Table 3b. Retrospective budget balance (1992-94) with state aid reduction (% of GDP). Scenario 2

Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Portugal United Kingdom EU

Actual balance

Actual aids

Aids as a % of actual balance

Suggested cuts

Cuts as a % of actual balance

Shortterm job losses

-6,60 -3,43 -2,90 -12,87 -5,57 -5,00 -2,20 -9,37 1,70 -3,50 -5,43 -6,97

1,96 1,06 2,62 1,76 1,16 1,36 1,51 2,23 2,30 0,80 1,19 0,44

30% 31% 90% 14% 21% 27% 69% 24% 135% 23% 22% 6%

0,062 0,081 0,523 0,123 0,289 0,053 0,000 1,053 0,524 0,031 0,131 0,000

1% 2% 18% 1% 5% 1% 0% 11% 31% 1% 2% 0%

640 0 30086 562 23175 0 0 61938 482 0 2754 0

-5,45

1,71

31%

0,239

4%

119637

consequently, to a temporary increase in spending (social benefits) which may partially offset the straightforward impact of aid reduction. This offsetting short-term impact is relevant for industry-specific aid, which will include steel, railways and coal. Given the specific nature of the skills required in these industries, it is assumed that displaced workers are unlikely to

1 - Justification for State Aids

87

find alternative employment. This will not be the case for workers affected by cuts in horizontal and regional aids. The budgetary cost of job losses has been computed assuming that jobs decline proportionately to the cut in aid (see the last column in Table 3). This means that we assume that the aid received byfirmswas granted with the objective of covering operating losses. Moreover, we are also implicitly assuming constant returns to scale, which means that for sectors such as shipbuilding or steel, we are again likely to obtain an upper limit to the potential job losses. Indeed, as aid and output are reduced in these industries, unit costs are likely to increase, which will mean that output declines less than proportionally. Finally, we are, of course, also assuming that firms are efficiently using the labour input. The cost in ECU per job lost is computed using data on annual compensation for EU countries and assuming that the social (unemployment) benefits per job lost would be around 75%, which is the average replacement rate for the EU countries. The analysis of the results in Table 4a shows that the short-term impact in terms of job losses—even when considering, as we do, a worst-case scenario— is negligible. Job losses are presented in Tables 3a and b, and in both cases they are very small. The deficit reduction effort is reduced only marginally, on average 0.01% of GDP at the EU level (Table 4a), and not even that in scenario 2 (Table 4b). The 'long-term budgetary impact' of aid reduction must take into account a different set of considerations. First, job losses will be neglected since we will assume, as usual in this type of analysis, that the economy converges towards its non-accelerating inflation rate of unemployment (NAIRU) over the years. Secondly, the benefits from state aid cuts must take into account both the gains in terms of a reduced debt burden, as well as the gains from the disappearance of a recurrent spending item in future government budgets. Thirdly andfinally,the elimination of useless spending—remember that we assume no cuts in aid pursuing efficiency objectives—carries an additional bonus, since each ECU saved involves the elimination of a tax distortion in the economy whose value exceeds, by somewhere between 20 and 50%, the amount of ECU directly saved. Note that this benefit from reduced tax distortions is not lessened by the fact that current aid cuts may simply reduce the deficit rather than the tax burden. As argued in the public finance literature, reduced current spending will ultimately lead to a reduction of the tax burden in future periods. For the purpose of this study, it has been assumed that the efficiency gains from reduced taxes are similar to those in the US, and the mid-range of estimates has been chosen as a benchmark (ie, a 35% gain). The long-term scenario in Tables 4a and 4b shows the gains from state aid reduction when considering both the present value of reduced future public sector liabilities, plus the efficiency gains from less taxes. As the Table shows, the

88

Working Paper III

Table 4a. Alternative budget balance scenarios with state aid reduction. Base scenario. Projected 1997*

Baseline case**

Short-term scenario***

Long-term scenario****

Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Portugal United Kingdom

-2,9 -0,3 -2,9 -6,5 -3 -3 -0,9 -3,3 0,5 -2,5 -2,9 -3,5

-2,79 -0,17 -2,28 -6,11 -2,72 -2,89 -0,88 -2,09 1,03 -2,47 -2,79 -3,50

-2,79 -0,17 -2,29 -6,11 -2,72 -2,89 -0,88 -2,09 1,03 -2,47 -2,79 -3,50

-2,60 0,06 -1,24 -5,46 -2,24 -2,70 -0,84 -0,04 1,93 -2,42 -2,60 -3,50

Average

-2,6

-2,30

-2,31

-1,80

* European Commission November 1996. Table 48B, General Government Data. DirectorateGeneral for Economic and Financial Affairs ** Projected 1997 budget with suggested aid cuts. *** Takes into account short-term job losses **** Takes into account interest savings and the efficiency gains of reduced taxation. Neglects short-term job cost.

Table 4b. Alternative budget balance scenarios with state aid reduction. Scenario 2. Projected 1997*

Baseline case**

Short-term scenario***

Long-term scenario****

Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Portugal United Kingdom

-2,9 -0,3 -2,9 -6,5 -3 -3 -0,9 -3,3 0,5 -2,5 -2,9 -3,5

-2,84 -0,22 -2,38 -6,38 -2,71 -2,95 -0,90 -2,25 1,02 -2,47 -2,77 -3,50

-2,84 -0,22 -2,38 -6,38 -2,71 -2,95 -0,90 -2,25 1,02 -2,47 -2,77 -3,50

-2,73 -0,08 -1,49 -6,17 -2,22 -2,86 -0,90 -0,46 1,91 -2,42 -2,55 -3,50

Average

-2,6

-2,36

-2,36

-1,95

European Commission November 1996. Table 48B, General Government Data. DirectorateGeneral for Economic and Financial Affairs Projected 1997 budget with suggested aid cuts. Takes into account short-term job losses Takes into account interest savings and the efficiency gains of reduced taxation. Neglects short-term job cost.

1 - Justification for State Aids

89

long run impact of state aid reduction is remarkably higher than the short-term effect, with the most significant improvements being found in Italy, Germany, Greece, Luxembourg, and Spain.8

VI. Conclusions State aids in the European Union have followed a declining trend in recent years. Using data from the EU (Second to Fifth State Aid), state aids declined from 2.17% of GDP in the period 1986 to 1988 to 1.71% in the period 1992 to 1994. Recent data show (for EU12) that total aid drops from 101,464 million euro in 1993 to 1995 to 88,466 million euro in 1995 to 1997 (Sixth and Seventh Survey). Such a trend is, to a large extent, the result of a successful policy of EU-wide state aid reduction. This study shows that, without jeopardising efficiency objectives, additional state aid cuts could total 24,000 million euro. If we exclude industries that have not been covered in this study—such as agriculture,fisheriesand financial services—the recommended cuts correspond to 32% of a total 1994 aid of 76,000 million ecu. This reduction compares favourably with the 3,000 million euro reduction registered between 1994 and the period 1995 to 1997 for the same aid aggregate. The results of this study indicate that aggregate efficiency-based aid cuts would affect all countries, although they concentrate most heavily on the Member States which have consistently provided more aid to firms over the last years. These are Germany and Italy, although cuts in France and Spain are also important. In terms of objectives, most of the suggested cuts focus on industry specific support (for steel and shipbuilding, etc,) as well as regional aid. This is consistent with the widely accepted view that aid should be of a horizontal nature, if it is to support and complement private market activity without distorting competition and altering the functioning of free markets. Overall aid cuts are proposed which (with 1994 data) amount to 0.42% of GDP with an estimated long run contribution to budget consolidation at the EU level of 0.80% of GDP. The results of the specific country studies support the general view obtained in thefirstpart of the study. The only important divergence arises in the case of Germany where there seems to be a significant difference between the aid levels obtained through the EC state aids surveys and those with the data collected at 8

The case studies for Spain, Belgium and Italyfindaid cuts (using the EU average reference point plus additional information on the extent to which programmes pursue efficiency objectives), which do not differ significantly from those obtained with the coarser EU average approach. The German case study favours the use of a narrower concept of state aid. Despite this change in the magnitude of aid, if aid is cut to the levels suggested in the general study, the impact in the budget continues to be substantial.

90

Working Paper III

the national level. The differences are due to the use of alternative concepts of state aid. However, even in the case of a narrower definition of state aid, the German study reports a substantial effect of state aid reduction on budget consolidation efforts. In general, the country-specific results do not, thus, alter the overall perspective and the specific cuts determined at the country level confirm the general focus of reducing aid programmes, which do not pursue efficiency objectives, and the importance of such a policy in the deficit reduction effort pursued by EU countries. From a more general perspective, the background study reported in this paper provides a clear indication that the aggregate approach to state aid reduction can be useful. This method is appropriate in light of the difficulties of monitoring all aid programmes. The use of aggregate macro-economic targets when dealing with efficiency-based—mostly horizontal—aid makes sense because the aggregate objectives can be tailored to the magnitude of the distortion in particular countries. Nevertheless, the evidence shows that, even when programmes pursue an efficiency objective, the actual disbursement of aid across countries bears no relationship to reasonable proxies of the magnitude of the market failures being targeted. This justifies simple policies of aid reduction which tend to eliminate aid spending in countries which provide support above the EU average. For equity-based aid, simple indicators of the proportionality between aid granted and the magnitude of the social problems may be used. Two conclusions stand out with regards to policies which aim predominantly at equity objectives. First, the use of compounded objectives obscures the analysis of aid justification and should be reduced, particularly because it involves the mixing of equity and efficiency goals. Similarly, it appears that the regular competition policy examination of sectoral and regional aid would benefit from a strengthening of the analysis of the efficiency impact. The objective is to make clear what are the costs—both in terms of intra-EU trade but also efficiency—of achieving what are mostly equity objectives.

IV Anne Houtman* EC State Aid Control: In Search of the Right Balance

I. Introduction EU state aid policy, as it results from the combination of a set of rules and a multitude of individual decisions, is based on the Treaty's substantive and procedural rules. This paper argues that, as interpreted by the Commission, these rules imply a search for the proper balance between the different objectives of the Treaty and between different requirements and constraints, rather than a search for optimal efficiency. The basic objectives of the Treaty, though primarily geared towards efficiency, also include equity considerations. Requirements and constraints are mainly of a political and administrative nature. From an economic point of view, state aid approved by the Commission, although it always addresses some form of market failure—in the broad sense of the failure of the market to achieve a stated objective—is rarely likely to be the most efficient form of state intervention to address these market failures. Rather than providing a theoretical economic analysis of the justification for state aid, the paper examines the main elements of the legal framework that affect the balancing exercise performed by the Commission when it assesses aid and adopts new rules. It also looks at the steps that have already been taken, and hints at others that could still be taken, to ensure more efficient state intervention. In addition, factors not directly related to state aid rules, such as budgetary constraints, are likely to push the equilibrium point towards more efficiency.

II. The Procedural Rules A. Ex Ante Control One of the key features of the Community regime for state aid is that it is based on an ex ante control by the Commission. Member States have an obligation to notify all their state aid projects to the Commission and they may not put such projects into effect prior to receipt of Commission approval. The Community * Head of Unit, State Aid Policy, Directorate General for Competition, European Commission. Since September 1999, a Member of the President's Office.

92

Working Paper IV

regime differs in this respect from the system set up by the GATT/WTO subsidy rules. This crucial procedural feature of Community control is not without consequences for the mode in which state aid approved by the Commission must be justified. The Commission's evaluation of state aid concentrates on the expected or likely effect of the aid on competition and trade between Member States, rather than on the actual impact of the aid—possibly in the middle or long term—on the industry of the Member State concerned and on the industry of the other Member States. It performs a balancing exercise between those expected effects and the objectives pursued by the aid. Where such objectives cannot be achieved by market forces alone, a distortion of competition through the granting of a—properly limited—state aid can be considered to be acceptable ('compatible with the common market'). In principle, this system allows decisions to be based on sound economic theory. Where the procedural steps are respected by Member States, it also has the great advantage of preventing the implementation of measures whose harmful effects on competition are disproportionate, or simply not justified in view of the objective pursued. By contrast, the system in force under international subsidy rules tends to add the inefficiencies of countervailing measures, often designed to protect domestic industry, to the inefficiencies of aid already implemented. However, once a decision to allow state aid has been taken by the Commission, the Community system does not easily allow for correction on a case-by-case basis. As the next section will show, the procedural system foreseen in the Treaty for the monitoring of existing aid was not designed to allow the Commission to penalise Member States on those occasions when it later turns out that the expected effects of aid have been miscalculated or that the objective pursued was not achieved. In addition, where a margin of appreciation exists, as may be the case in establishing the aid character of a measure, a system based on ex ante control will leave the benefit of the doubt to the Member States. Typically, for example in applying the private investor principle to check for the presence of aid in a transaction between the state and a public enterprise, the Commission need only satisfy itself that there is a sufficient likelihood that the transaction will fall in the lower end of a scale of transactions that would be 'acceptable' to a private investor. The efficiency of this ex ante examination would be greatly enhanced were Member States obliged to give any detailed background studies that they carry out in order to design aid projects to the Commission. Governments rarely implement costly measures without undertaking studies or simulations to evaluate their likely impact. However, notifications are often limited to a mere description of the measures proposed and rarely provide information on background economic studies that may have served as a basis for the choice of a specific measure to address the problem.

1 - Justification for State Aids

93

B. Monitoring Monitoring by the Commission of its decisions is another important element of state aid control. It is also one where the recently adopted procedural regulation has not only clarified matters but has also enhanced the Commission's power.' All existing aid systems are subject to permanent review by the Commission through an obligation that is imposed on Member States to submit annual reports. However, this review does not allow for the correction of past approvals. Such corrections can only occur where the aid measure, and any conditions attached to it, were not properly implemented or where aid was misused by the beneficiary. As for the future, the review allows for correction only in the case of schemes. But here, too, Member States will only be asked to modify existing schemes or abolish them where, in view of the evolution of the common market, the Commission's policy has changed with respect to the type of measure concerned and not where the scheme proves to be an inappropriate way to reach its stated objectives. The annual reports provided by the Member States mainly describe the implementation of the measure in terms of spending, beneficiaries and sector breakdowns, but never provide indications of the success of the measure in correcting the market failures they address. At first sight, there appears to be room for improvement, both in the content of the reporting obligation and in the use of the reports provided. Not only would better reports allow for the proper adjustment of existing schemes, but they could also serve as a basis for a review of the Commission's future policy. There are, of course, limitations to such exercises. They can be found, first, in the Member States' reluctance to take on an increased administrative burden. Their resources are limited, just as those of the Commission are. In addition, the gathering of useful information is not only very costly, it is also difficult to design properly. Measuring the effect of an employment aid scheme is difficult enough in the country or region concerned. The measuring of its negative spill-over in other countries may prove to be impossible.

C. The Decision-Making Process: A Procedure Between the Commission and Member States A third aspect of the present legal framework is also relevant to the issue under discussion. As foreseen by the Treaty, the procedure for state aid control essentially takes place 'between' the Commission and the Member State concerned. The role of interested parties, in particular, competitors of the putative 1

Council Regulation (EC) No 659/1999 of 22 March 1999 laying down detailed rules for the application of Art. 88 [ex 93] of the EC Treaty, OJ (1999) L83/1.

94

Working Paper IV

beneficiary, is limited: they can lodge complaints, they can submit written observations where the Commission invites them to do so by opening the formal investigation procedure and they can challenge Commission' decisions before the Court of First Instance. The new procedural regulation has confirmed this situation. In this respect, it adopts a rather narrow interpretation of Treaty procedure and of the Court's jurisprudence. However, the present possibilities of intervening in the procedure are largely under-utilised by interested parties, who submit comments in only half of the formal investigations. More intense and better informed third-party intervention would provide the Commission with input and so would aid it to reach balanced solutions and to gain a more informed view of economic reality. Similarly, the procedure would also be improved were the Commission to open the formal investigation procedure more frequently and were parties who submitted information during the procedure given a right to participate in the decisional debate. Third parties are also absent from the debate on state aid rules. When new rules are being drafted, it may, however, be argued that wide consultation within the Commission ensures the representation of various opinions and policy goals and ensures the reaching of a proper balance. The recent adoption by the Commission of the first draft regulations exempting certain categories of compatible aid from the notification obligation,2 will widen the debate on EC state aid rules as the draft regulations will be published so that interested persons and organisations can submit comments. Not only have directly interested parties been somewhat absent from the decision-making process but other parties, who in our opinion are also concerned, are likewise fully excluded from the debate: citizens in their capacity as consumers and taxpayers. While consumer lobbies do contact the Commission on many internal market issues, they are noticeably absent from the debate on competition policy in general and even more so in state aid policy. Yet, the search for the optimal allocation of resources in markets requires the participation of all potential parties to a transaction and all stakeholders. This is to say, all parties concerned should not only have a voice but should also have proper access to information. It is likely that, when confronted with a set of facts, rational people will not be too far away from one another at the end of the day.

2 Draft Commission regulation on the application of Arts. 87 and 88 [ex 92 and 93] of the EC Treaty to de minimis aid; Draft Commission regulation on the application of Arts. 87 and 88 [ex 92 and 93] of the EC Treaty to training aid; Draft Commission regulation on the application of Arts. 87 and 88 [ex 92 and 93] of the EC Treaty to aid for SMEs, adopted on 22 July 1999.

1 - Justification for State Aids

95

III. Substantive Rules and their Application A. General The objective of the Treaty in creating a common market relies on the assumption, later well formulated in the Cecchini report,3 that 'non-Europe' is an economically inefficient situation resulting in the waste of scarce resources. State aid, in so far as it affects trade and competition, clearly introduces inefficiencies into competitive markets and is, thus, considered to be incompatible with the common market in principle. However, by providing for derogations from this principle, the Treaty implicitly recognises that market forces alone may fail to attain some objectives of common interest for the Community. According to the provisions of Article 87 [ex 92] of the Treaty, 'aid to facilitate the development of certain economic activities or of certain economic areas'—to limit ourselves to the main derogation used—may be considered to be compatible with the common market when it does not 'adversely affect trading conditions to an extent contrary to the common interest'. This derogation implies that the Commission, which has broad discretion in doing so, must balance the objective of undistorted competition in the internal market with other Community objectives that the aid may promote. When searching for the right balance, the Commission performs a double test of the necessity and the proportionality of the aid. Contrary to the way it is often phrased, the first test is not a test of whether aid is necessary to correct market failure, but rather a statement that market failures are a necessary precondition for the granting of aid. Hence, it aims to check whether market forces alone would achieve what is considered to be in the common interest and whether the aid project was designed to promote such an objective. Public intervention may, thus, be necessary to achieve the goal but, among the possible forms such intervention may take, state aid may very well not be the most efficient one to address the market failure. It can be argued that this is based on a literal reading of the Treaty, whose wording reads 'aid to promote' and not aid 'effectively promoting', or even less aid as 'the only way' or 'the most efficient way' to promote common interest. The real balancing exercise comes in the second test, which assesses whether the distortion introduced by the aid is not disproportionate in view of its effects in achieving Community objectives. Aid should be kept to the minimum necessary to reach the objective(s) sought, so that its overall impact on welfare is positive. However, this exercise could be claimed to be rather subjective, as the loss of efficiency resulting from the distortion, as well as the possible gains in reaching Community objectives, are hard to measure. 3

Research on the 'Cost of non-Europe', Volume 1-3, published by the Office for Official Publication of the European Communities, 1988.

96

Working Paper IV

If the Commission were to search for optimal efficiency—including the efficient use of public resources—its decision would, in many cases, challenge the decision of the Member State concerned to use aid as an instrument to correct market failures. This would impact upon the sovereignty of Member States in the choice of their policy mix. The competition rules of the Treaty do not provide the right legal basis for pursuing such an objective. Improving efficiency in the use of public resources is an objective better pursued in the context of a broader dialogue aiming at the co-ordination of the Member States' macro-economic policies. This dialogue should not be restricted to the Council and the Commission, but should also involve the social partners and the European Central Bank. In the context of budgetary constraints, the efficiency of public aid is increasingly becoming a preoccupation of Member States, even those traditionally more favourable to this kind of public intervention. France, for example, recently appointed a 'Commission d'enquete parlementaire' to examine the efficiency of public aid granted to large industrial groups to achieve the objective of a higher level of employment. This analysis could prove useful in encouraging co-operation between Member States, which should be directed to an examination of alternatives to state aid and should promote best practices. When applying state aid rules, the Commission has chosen to concentrate its resources on cases where its examination can effectively help to achieve the objective of undistorted competition. This choice is reflected in the move towards a system of block exemptions for certain categories of relatively harmless aid, coupled with the introduction of more stringent rules for the examination of aid to rescue and restructure enterprises in difficulty4 and for the individual examination of the largest cases of regional investment aid.5

B. Rules and Decisions 1. Regional Aid The imperfect mobility of labour and physical capital justifies the granting of state aid to encourage investments and job creation in some regions of the Community whose socio-economic situation lags behind the EC average, the so-called 92(3)a [ex 87(3)a] regions, or below the national average, the so-called 92(3)c [ex 87(3)c] regions. In order to ensure equality of treatment and the predictability of its decisions, the Commissionfixesthe parameters of the proportionality test by determining, with due regard to its individual socio-economic situation, an allowable aid ceiling for each region. 4

Community guidelines on state aid for rescuing and restructuring firms in difficulty, OJ(1999)C368/12. 5 Multi-sectoral framework on regional aid for large investment projects, OJ (1998) C107/7.

/ - Justification for State Aids

97

With the exception of a few specified sectors and large investment schemes, compliance with these ceilings leads to the approval of the aid notified to the Commission, usually in the form of aid schemes. This is, of course, a second best solution: the effect of aid and its possible negative spill-over in other Member States or regions varies greatly, depending of the intensity of competition and trade in the sector concerned. An optimal solution could only be reached through the disproportionate use of administrative resources and would result in longer delays by virtue of the performance of market analysis and impact studies for all aid cases; assuming again that the factors in the balance are measurable at all. State aid to attract investment in less-favoured regions also appears to be a short-term solution to create employment and promote regional development. Where regions compete to attract mobile investment, it may also be a rather expensive solution. But it also allows for more direct and thus visible effects in the region concerned. It is, however, indispensable that such a solution be combined with other forms of public intervention that aim to improve the business environment through better infrastructure, education and training, more efficient public administration and a fight against forms of criminality that act as a deterrent to private investment. 2. Aid for Rescuing and Restructuring Firms in Difficulty This is surely the most controversial type of aid from an economic point of view. There also seems to be a—broadly North-South—cultural split, which relates to the.perceived role of government intervention to prevent the failure of inefficient firms. However, this split does not merely coincide with different public perceptions of state intervention in general, but also, and logically so, coincides with different degrees of institutional rigidities in the labour market: job losses are less traumatic where there is a future prospect of new jobs. The negative judgement on rescue and restructuring aid is, of course, fully justified by the direct threat that such aid constitutes for the proper functioning of markets and by the fact that such aid is usually made up of large amounts of public funds granted to large firms. By maintaining less efficient firms on the market and raising the costs of more efficient firms, such aid may also damage the long-term competitiveness of European industry. Moral hazard is also a strong argument against such aid: the belief that if the worst comes to the worst, 'government intervention will prevent it from happening', is surely not an incentive for firms to take the right decisions at the right moment. The perception that Community control of this type of aid cannot secure equality of treatment reinforces this negative judgement. First, aid is concentrated in a few Member States, meaning that approval of aid by the Commission naturally only concerns a limited number of countries. In addition, no aid ceilings can befixedin advance as afixedpercentage of some welldefined costs (the so-called 'aid intensity'), as is the case for most other types of

98

Working Paper IV

aid. The allowable aid amount is fixed on a case-by-case basis and through the application of the general principle that it must be limited to the minimum necessary to implement a restructuring plan that will ensure the long-term viability of the firm. The type of market failure that justifies regional aid may, however, in some instances, also justify aid for the rescuing and restructuring of firms in difficulty. The acceptance of such aid is largely governed by equity rather than by efficiency considerations. Efficiency considerations only play a role in the rare instances where the disappearance of the ailing firm may result in an inefficient monopolistic or oligopolistic situation within the market. But here, too, state aid seems to be the short-term and, possibly, most costly solution to unemployment problems. Member States should also balance its use against—or possibly combine it with—the use of longer-term solutions to improve the general business environment and the opportunities for job creation. Politically, such long-term solutions do not appear to give a satisfactory answer to workers in regions whose economy may be heavily dependent on the activities of the failing firm and who are, understandably, not open to the argument that jobs may potentially be lost in other regions where their enterprise is artificially maintained, nor are likely to be able to relocate easily in regions providing more employment opportunities. 3. Aid for R&D {Research and Development), Training and Environmental Protection This category encompasses aid that is justified by market failures in the form of externalities. The positive externalities that are associated with R&D and with training are well known. Enterprises cannot reap the full benefits of the research they perform, nor of the training they offer to their employees. Imitation, the use of publications or patent documents and the mobility of researchers, allow other firms to reap part of the benefits of the research performed. The skills that workers have acquired in one firm can be used in another. Under normal market conditions, enterprises thus tend to underinvest in research and training in comparison with the social optimum. Equality of treatment in the proportionality test performed by the Commission is ensured through a system of aid ceilings (expressed as percentages of a standardised set of expenses related to the research or training activity, the so-called 'aid intensities') set in advance and published in the form of 'frameworks'.6 These aid ceilings are meant to reflect the size of the positive externalities expected: the closer the research or training activities come to the specific products, processes or services of the firm, the smaller the externalities and thus the lower the ceilings for allowable aid. 6

Community framework for state aid for research and development, OJ (1996) C45/5. Framework on training aid, OJ (1998) C343/10.

1 - Justification for State Aids

99

It may, of course, be argued that the since externalities cannot be measured exactly, thresholds are somewhat arbitrary. The arbitrary nature of thresholds, however, must be balanced by the arbitrary nature of case-by-case Commission decisions that are based on the characteristics of each specific research or training-aided project. The predictability of Commission decisions and equality of treatment among Member States and enterprises are often objectives which conflict with the search for an optimal solution, tailored to each individual situation, that aims to ensure that the level of aid does not go beyond what is needed to correct market failures. In the presence of non-measurable factors, the solution opted for by the Commission probably strikes a good balance. Pollution is a negative externality of a firm's activities. In the absence of a correct price system reflecting such externalities, aid may be justified as an incentive for enterprises to invest in clean technologies. To enhance the political acceptability of the introduction of new environmental taxes, it may also be indispensable to reduce temporarily the cost of such taxes for certain categories of enterprises facing direct competition from countries where similar taxes have not yet been introduced. In all three cases identified in this section, a question arises as to whether state intervention in the form of state aid—that is, through the selective reduction of the costs of certain enterprises by means of the direct or indirect use of state resources—is the most appropriate answer to the market failures it is meant to address. Whilst, from the point of view of state aid control, the issue is essentially a legal one of determining the appropriate instrument—state aid rules or approximation of legislation—and of the competence—Commission or Council—to tackle possible distortions of competition and obstacles to the proper functioning of the internal market, it also raises questions about the efficiency of specific as opposed to general measures. Specific measures modify the allocation of resources among sectors and are more prone to government failure. General measures cannot be orientated towards the projects most in need of intervention, in particular, those of broader scientific or technical interest and those that involve the highest risk. However, general measures can also have specific distorting effects on certain sectors or categories of enterprises. The Treaty provides instruments—though they are never used by the Commission—to eliminate, where necessary, the latter forms of distortion.7 4. Aid for SMEs (Small and Medium Sized Enterprises) Asymmetric or imperfect information and risk aversion within financial markets may make it necessary for governments to provide financial support for SMEs in their expansion phase. This factor justifies Community rules8 that allow a limited amount of state aid, in order to support investment in and 7 8

See Arts. 96 [ex-101] and 97 [ex-102] of the EC Treaty. Community guidelines on state aid for small and medium-sized enterprises, OJ (1996) C213/4.

100

Working Paper IV

technology transfers to SMEs. Here again, the fact that market failures cannot be measured exactly, calls the appropriateness of fixed thresholds into question. Accordingly, the Commission has once again sought to identify a balance between predictability and optimal efficiency, between equality of treatment and arbitrariness. The tendency, both within the European institutions in the administration of various funds and among Member States in their mode of addressing the needs of SMEs, is to direct public intervention towards capital markets, providing various forms of incentives to increase the supply of risk capital for SMEs. The direct addressing of market failures, rather than a correction of their effects, will surely allow for the more efficient use of public resources to facilitate the development of SMEs. Community rules are, unfortunately, ill-adapted to the challenge of assessing such (relatively) new forms of intervention. On the one hand, these rules essentially limit intervention to investment in fixed capital and do not generally allow for aid in the form of share acquisitions or the provision of working capital. On the other hand, they require that the Commission identify and quantify distortions of competition, in order to evaluate the aid in the light of allowable levels and to ensure equality of treatment. In the case of public intervention in venture funds, aid may potentially affect competition both at the level of financial operators and at the level of the final beneficiaries of the funds. In addition, its quantification is a difficult exercise, involving risk assessment, and it is further well known that law and uncertainty make a lousy couple. State aid rules are in need of modernisation in this field: competitivity factors are increasingly less linked to material investment, whilst market failures mostly affect SMEs in their start-up phase of development and innovation. Accordingly, working capital (rather than investment subsidies) and financial incentives favouring the provision of risk capital to SMEs (rather than direct subsidies) seem to be the mechanism which satisfy the tests of necessity and proportionality best.

5. Ad hoc Aid and Aid to Specific Sectors It is unlikely that, where market failures exist, they will affect only specific sectors or enterprises. Yet, apart from the so-called 'horizontal rules' covering the categories of aid discussed above, most Community rules on state aid are devoted to the assessment of state aid in specific sectors. This state of affairs can, of course, be traced back to the historical circumstances that led to sector-specific Treaties (ECSC and Euratom) and to the common policies within the EC Treaty, notably in the agriculture and transport sectors. No such background can be found for the car, textile or synthetic fibres sectors, which have only the existence of strong lobbies, common to the traditional— and mostly declining—industries, in common with the previously mentioned sectors.

1 - Justification for State Aids

101

The successive surveys published by the Commission9 also show that ad hoc aid and aid to specific sectors account for the largest amounts of state aid. Without being of the opinion that aid volume is the right issue in the context of competition policy, nor of the opinion that a correlation can be established between aid volumes and the distortion of competition or inefficiencies, I accept that this uneven distribution of aid among sectors of the economy and between horizontal and sector specific aid strongly suggests that aid is at least as much the result of the strong bargaining power of these sectors as it is the answer of governments to market failures and welfare deficiencies. The progressive re-alignment of EC sector-specific rules on state aid in line with general rules and common principles would greatly contribute to shifting the balance in the application of these rules towards more efficiency.

IV. Conclusions The full elimination of state aid is neither economically desirable nor is it foreseen by the Treaty. Market forces alone would fail to achieve some of the objectives of the European Union. Government action through the granting of state aid is thus justified in principle in some instances. In recent years, Commission policy has moved towards a stricter approach to state aid. However, looking at the published figures on state aid expenditure in the Union and at their very uneven breakdown among Member States and sectors, one can only conclude that a good deal of this expenditure creates inefficiencies. The simple application of the state aid rules of the Treaty will not provide an optimal policy response to this problem. On the one hand, these rules do not constitute an appropriate legal basis for a macro-economic evaluation of the impact of global state aid spending on European economic performance. Commission decisions are taken on a case-by-case basis, always, of course, applying the same set of criteria, but without a consideration of the possible cumulative or combined effects of each aid project with other aid approved in the same or another Member State, in the same or in another sector. In addition, various procedural aspects and the need to reduce bureaucracy and ensure the predictability of Commission decision-making tend to work against the finding of optimal solution in each individual case. On the other hand, as we have seen, state aid rules do not constitute an appropriate legal basis for the Commission to question the choice of Member States to use state aid as a policy instrument to address market failures. These considerations indicate that the application of competition rules by the Commission should be combined with a broader dialogue with the Member States on the co-ordination of their economic policies. The success of such 9 Seventh Survey on State Aid in the European Union in the Manufacturing and Certain Other Sectors, COM (99) 148 final.

102

Working Paper IV

dialogue will rest upon a clear definition of the 'right' questions and objectives. The objectives of reducing public deficits and the distortion of competition, though not wholly unconnected, should be clearly distinguished. In addition, any dialogue that is overly focused on the issue of disparities in aid volumes cannot be successful: not only since it gives rise to strong negative political reactions in some Member States, but also since there is no clear evidence of a direct correlation between global aid volumes and the degree of distortion of competition, and since a reduction of state aid expenditure is likely to have a relatively minor effect on overall spending, especially when compared with rationalisation in other areas, such as social security spending. A dialogue directed to the identification of the proper governmental action that is called for to combat unemployment—a reduction in regional disparities, increased innovation, the facilitation of SME development and an improvement in environmental protection—would seem to be more promising. Member States should examine together whether state aid is an efficient instrument to reach the stated objectives and to exchange best practices on the appropriate levels and forms of aid. This dialogue should not preclude a debate on so-called 'general measures' that do not fall under EC state aid rules but which, in the context of monetary union in particular, may have no less distortive effects than state aid. Finally, a collective effort will not only be more effective, it will also be politically easier for Member States to engage in reforms at a national level that may be combined together to create a European strategy. At the end of the day, the key factor that is most likely to improve efficiency in national state aid spending appears to be increased transparency. In the framework of the individual decisions of the Commission, this mainly means an enhanced role for third parties, both in the decision-making process and in policy formation. In the context of economic co-ordination among Member States, transparency requires the peer review of a Member States' aid performance.

V Patrick Low* The Treatment of Subsidies in the WTO Framework

I. Introduction This paper evaluates the WTO rules on subsidies, primarily from an economic perspective. It starts by summarising briefly the well-known welfare propositions derived from economic analysis about the effects of subsidies. The discussion then focuses on the various elements of the WTO framework that seek to regulate subsidy policies—specifically the Agreement on Subsides and Countervailing Measures (SCM), the Agreement on Agriculture, and the General Agreement on Trade in Services (GATS)—and draws conclusions about the subsidy rules against the background of economic logic. Since key aspects of the WTO rules are not readily justifiable in economic terms, the paper also considers whether practical options exist for ahgning the subsidy rules more closely with what economic analysis prescribes. This discussion is not only about how rules and policies appear deficient when measured against a welfare standard—it also takes account of the limitations of economic analysis in providing sound guidance on some aspects of subsidy policy. Two significant limitations on analysis in this field deserve mention at the outset. First, the problem of definition is particularly acute with respect to subsidies. No definition of a subsidy appeared in the multi-lateral trading rules until the Uruguay Round SCM Agreement came into force in 1995. The definition in that agreement is narrow, in that a subsidy is deemed to require a financial outlay by government. A broader definition would encompass various kinds of government action, which could be fiscal, regulatory, or even macroeconomic in nature. The point is that any intervention that affects relative prices or the conditions of competition in a market can, at least in theory, be expressed as a subsidy or tax equivalent. The fact that a broad notion of 'subsidy' is relevant to many government interventions means that in judging rules on subsidies, one should also take into account the nature of the rules governing other aspects of policy. Secondly, it will be clear from what follows that once the confining assumptions of perfectly functioning markets are dropped, there are many instances in which economic analysis cannot tell us ex ante what the consequences would be of a given subsidy. The outcome depends on a range of specific circumstances * The author is Director, Office of the Director-General, WTO. Geneva. The views expressed here are his own. Helpful comments from Henrik Horn and discussions with Jesse Kreier and participants in the Florence workshop are gratefully acknowledged.

104

Working Paper V

and pre-existing conditions, and may be positive or negative from a welfare standpoint. This means that it is not possible to establish a comprehensive prior set of rules about the permissibility of subsidies that will reflect an optimal welfare outcome. To the extent that the rules seek to pursue an economic rationale in this ex ante sense, they tend to do so approximately or, in some cases, not at all. Economic analysis remains useful, however, when it comes to judging the design of the rules, and it is indispensable to a proper analysis of a given intervention (including its economic cost) once a set of circumstances has been specified. A further complicating factor for analysis is that reliable welfarebased conclusions about the desirability of subsidies require a very considerable amount of information about the circumstances at hand.

II. The Basic Economics of Subsidies What is the economic case for government intervention, and what can economic analysis say about the appropriate choice of a particular intervention? A typical economics textbook will explain that a subsidy1 to an enterprise will lower production costs. Under the standard assumptions of perfect competition throughout the economy, this leads to output of the subsidised product in excess of the efficient level. The consequent loss in efficiency will reduce aggregate income below what it would be in the absence of the subsidy. A subsidy, therefore, results in a market distortion, and should be discouraged. The conclusion is the same if the subsidy falls on consumption rather than production, since a reduced consumer price will provoke additional production in a similar way to a direct subsidy on production. In those cases where a subsidy is funded through taxes collected or foregone, the concern about distortions is relevant also to the manner in which taxes are collected—only lump-sum transfers are non-distortionary. From an international perspective, a subsidy may be more or less trade distorting within this framework. A subsidy that falls on exports or import substitutes will directly distort trade, while other subsidies will not, so that directly trade-related subsidies can also indirectly affect trade, for instance, through their effects on factor prices. The WTO rules on subsidies are predicated in part upon the objective of controlling or eliminating such distortions.

1 It can be assumed that a subsidy in this context is a direct payment by government, but this assumption is not strictly necessary to the argument—other interventions with a comparable impact on relative prices could have a similar effect.

1 - Justification for State Aids

105

A. Market Failure Yet, the rules of the WTO also recognise that subsidies may not always be distorting, as suggested by the over-simplified framework of perfect markets.2 Many markets are far from perfect for a variety of possible reasons, and governments may also wish to pursue social objectives through subsidisation that cannot be properly judged in economic terms. Among the reasons why markets may be less than perfect are the presence of externalities, increasing returns to scale and information asymmetries. For any of these reasons, markets may fail to align social and private costs and benefits. The existence of such wedges between social and private marginal returns constitute market failures that governments may, at least in theory, seek to correct. Externalities can be positive or negative, and they result in the underproduction or over-production of something from a social perspective. An example of a positive externality is where private agents cannot benefit fully from investment in knowledge generation (R&D) because rapid diffusion of new knowledge makes it impossible for investors to capture the full returns of their initial outlay. A typically cited example of a negative externality is a situation in which producers pollute the environment, imposing a social cost for which they do not pay. Government interventions in these circumstances can take a variety of forms, including subsidies and regulations. The 'subsidy equivalent' of such interventions is intended to ensure a socially optimal level of production and can be shown, in theory at least, to increase welfare. A key assumption of the perfect market construct is the absence of economies of scale in production at the level of the firm. The picture changes significantly when economies of scale are introduced. A distinction can be made between static and dynamic economies of scale. Static economies of scale are present in a situation where entry costs are high because of 'lumpy' investment requirements, and the level of output becomes a determinant of unit production costs. Dynamic economies of scale involve 'learning by doing,' so that unit production costs fall as experience is accumulated over time and production techniques improve. In the presence of economies of scale, one of the central features of perfect competition—marginal cost pricing—is unfeasible: if a firm were to set a price equal to marginal cost, with marginal cost (by the assumption of economies of scale) being lower than average costs, its price would be lower than its average cost, and the firm would consequently be making a loss. Hence, in the presence of internal economies of scale, firms have to set prices above marginal costs. In 2

Art. XV of the GATS, for example, states that 'Members recognise that, in certain circumstances, subsidies may have distortive effects on trade in services.'The implication is obvious that this may not always be so. The article goes on to call for negotiations on subsidy disciplines that recognize 'the role of subsidies in relation to the development programmes of developing countries and take into account the needs of Members . . . forflexibilityin this area.'

106

Working Paper V

a closed economy, domestic consumers incur the costs associated with this inefficiency through higher prices. In an economy open to trade, however, the economic rent might be collected from foreign consumers where a monopoly or oligopoly producer is exporting. It is possible in these circumstances that the losses in the domestic economy arising from loss of-consumer welfare due to reduced consumption, could be offset or exceeded by higher prices charged to foreigners. This is the crux of the case for permitting domestic monopolisation in order to extract profits in foreign markets. It is also an essential building block for the case for a 'strategic trade policy', which is a policy aimed at improving the competitive position of domestic firms vis-a-vis their foreign counterparts, in a situation where they compete in an imperfectly competitive market. A production or export subsidy can, under certain circumstances, be used in order to pursue such a strategic trade policy to the benefit, not only of the domestic firms, but also national welfare. In principle, this strategy can work unless a subsidy induces too much rent-dissipating entry into the domestic industry, or other governments seek to offset such behaviour through retaliatory measures. A third element of market imperfection relates to the availability of information. If there is asymmetric information among economic agents, private decisions may not necessarily reflect a socially optimal allocation of resources. It could be the case, for example, that interest rates are higher in the capital market than they should be from an efficiency standpoint, because lenders have a misinformed view of the degree of risk associated with particular investments in contrast to the correct view of prospective borrowers. More generally, governments might intervene in the belief that there will be under-investment in socially profitable industries because private investors are ill informed about the true nature of the returns involved. This position has been questioned on the grounds that governments may not be any better placed that the private sector to assess risks and returns, and therefore to 'pick winners.'

B. 'Non-Economic' Motives for Intervention The concepts of efficiency and welfare maximisation used within the framework discussed above, largely disregard income distribution questions. Yet, extending the analysis, if a government considers that a particular income distribution is socially unacceptable, it may seek appropriate means to redress the perceived inequalities. Interventions aimed at this objective can take several forms. Luxury goods may be more heavily taxed than essentials, income taxes may be made progressive according to income levels, or direct subsidies may be paid to particular income groups. Broader social pplicy, relating to such matters as subsidised education, may also be justified, in part, on distributional or social justice grounds. Economic analysis can offer little by way of prescription when it comes to avowed distributional objectives. Yet, economics does provide

1 - Justification for State Aids

107

essential guidance in identifying the best means of meeting such objectives and assessing the costs and consequences of particular interventions.

C. Optimal Intervention The theory of optimal intervention is concerned with 'by-product' distortions arising out of interventions designed to eliminate a pre-existing market imperfection. A core insight of this analysis is that any government intervention should be as close as possible to the source of the distortion it is designed to remedy, otherwise the intervention will itself become a source of welfare loss.3 If, for example, it could be shown that manufacturing employment generated higher social returns than agricultural employment, the best intervention would be to subsidise firms to hire more workers. A broader-based subsidy to manufacturing production would carry unwanted by-product distortions by, for instance, also encouraging increased use of other inputs such as, say, fertilisers. As noted above, in the presence of scale economies, there may be a case for intervention to expand output in order to lower unit prices. But what kind of intervention would be appropriate here? It may well be that the problem of resource allocation could be addressed effectively by remedying deficiencies in the capital market. Misperceptions about risk could mean that the interest rate was higher than the social cost of funds, inhibiting borrowing by investors in privately and socially profitable enterprises. If the net discounted present value of future income deriving from an investment is greater than zero, a correctly functioning capital market should be willing to finance the investment. This argument would apply both in the case of high fixed entry costs, or with regard to the initial losses from production before learning-by-doing efficiency gains take hold (dynamic economies of scale). Interventions that fail to address the workings of the capital market directly would be sub-optimal. The precise nature of the required intervention would depend on the nature of the problem, but it could be as simple as facilitating the flow of information about risk. If, on the other hand, the reason for intervening is to increase welfare through the extraction of rents from foreign consumers in an oligopolistic market, then the most appropriate measure might turn out to be a subsidy to production. In this case, an intervention in the capital market would be ineffective. A second layer of reasoning emerging from the optimal intervention literature, addresses situations where the optimal intervention turns out to be impractical or impossible for some reason. It may be, for example, that capital markets simply cannot be made to work efficiently because of overriding institutional constraints. Or, governments may be incapable of raising revenue to 3

Optimal interventions should equalise the marginal rates of transformation in production, consumption and trade.

108

Working Paper V

pay subsidies and so they decide to levy taxes instead. In cases such as these, the theory of the 'second best' shows that it is strictly an empirical matter whether a sub-optimal intervention is preferable to no intervention at all. It may be that the costs of by-product distortions exceed the benefits arising from the putative remedy. An additional point alluded to in the introduction is the fact that the information requirements for making a welfare analysis of government interventions may be very high, sometimes even prohibitively so. What this means, in practical terms, is that the desire to intervene should be tempered by the realisation that it is not difficult to get things wrong from an economic efficiency perspective. Much of the discussion about different interventions turns on a few wellknown arguments. Perhaps the most frequently deployed argument for subsidisation in recent years—particularly prevalent within industrial countries—has been based on the idea that R&D is under-supplied by the private sector by virtue of the significant spillovers, or externalities, that are believed to be associated with R&D investments. Indeed, there can be few governments that do not support R&D through subsidisation of one kind or another—including direct subsidies to firms, research grants to institutions of higher learning and government research establishments, or defence-related contracts. A generalised extension of the case for R&D subsidies is the notion that hightechnology industries should be encouraged. Whether the case for R&D subsidisation can be defended from a welfare perspective depends, in part, on the nature of the intellectual property protection regime in place. Another consideration is whether public investment in thisfieldhas the effect of 'crowding out' private initiatives, leaving the supply of R&D unchanged. The broader argument made for supporting high-technology industries generally raises rather different questions, including the question of whether governments have better foresight than risk-takers in the private sector. Another variety of the same basic reasoning is the 'infant industry' and 'infant marketing' arguments for intervention, which are frequently encountered in a developing country context. Here, the essence of the case is that state support will allow learning-by-doing externalities to be internalised. The immediate question, as noted above, is one of why the capital market does not recognise the benefits of the required investment. Second-best arguments for fiscal intervention or trade protection are likely to be shaky on empirical grounds. The infant marketing argument is sometimes used to justify export subsidies, and many countries finance export promotion activities on similar grounds. Another argument for subsidising interventions is regional development. Here, the target of the intervention is often less clear. It may aim to increase employment, to redistribute income, or simply to even up disparities among regions. The welfare calculus is complicated by this potential multiplicity of objectives and by the fact that regionally based support measures are very likely to have a differential impact on sectors within the economy. Finally, state support may be mooted as a means of protecting the environment. It is unclear, for example,

1 - Justification for State Aids

109

how else environmental clean up might be financed, except perhaps through retroactive charges on polluting activity that may be difficult to collect. Some governments also choose to support investments in pollution abatement technologies. A prior question, however, is why subsidies are preferred to taxation on polluting activities or to preventive regulation. D. Public Choice Theory and Rent-Seeking Enough has been said to make it clear that providing authoritative welfare analysis of government intervention, in terms both of when and how to intervene, is a daunting task. The task is made even more challenging when the lessons of public choice theory are taken into account. The basic premise of public choice theory is that individuals with the power to make decisions that affect the allocation of resources will choose the outcome that maximises their welfare and not necessarily the welfare of society at large. Within this framework of analysis, the political process is essentially an economic system, where decisions further the interests of individuals or groups within society. A market develops for political influence, and the income distribution and resource allocation implications of the interplay of forces within this market may have little to do with social welfare. One conclusion that emerges from this analysis is that the way to avoid inefficient outcomes deriving from this exercise of market power is to foster a system with a minimal role for governments. This proposition translates into a political economy case against subsidisation. A recent study of the political economy of state aids in the European Community concluded that political regimes and institutions were a significant determinant of the allocation of state aids.4 The concept of rent-seeking5 is linked to the public choice literature. Rentseeking involves the use of real resources to influence the political decisionmaking process. Such resources are more or less unproductively spent from a social point of view; although private returns may be very high, a rent-seeker is successful in influencing a decision in a favourable manner. Some studies suggest that rent-seeking can consume a significant level of resources.6 Again, the policy conclusion often drawn is that the removal of governmental authorities from decision-making in the economic sphere would greatly reduce the problem. An alternative approach is to seek ways of reducing discretion in decision-making processes.

4 3 6

(Neven 1994). (Krueger 1974) and (Bhagwati 1982). See, for example, (Mohammad and Whalley 1984).

110

Working Paper V

III. The WTO Rules on Subsidies This section will not attempt to explain the WTO rules on subsidies in all their detail. 7 Rather, the purpose here is to identify the salient features of the WTO's rule-making approach to subsidies, and to assess these rules in terms of the logic of economic analysis, as outlined in the previous section. The SCM Agreement, the Agreement on Agriculture and the GATS will each be taken in turn. 8

A. The Agreement on Subsidies and Countervailing Measures 1. The Rules The twin aspects of the SCM Agreement—rules and remedies—will be addressed separately. The agreement clearly reflects a desire to regulate, or even abolish, some subsidies, but, at the same time, it seeks to protect the right of Members to subsidise in certain circumstances. This duality reflects what the economic literature tells us, namely, that subsidies can be both welfare diminishing and welfare enhancing. But this does not mean that the manner in which these two aspects of subsidisation are accommodated necessarily leads to economically optimal outcomes. The basic reason why the subsidy rules do not necessarily underwrite a welfare-based outcome is that their primary focus is upon producer interests and access to foreign markets. 1.1. The 'Financial Contribution Criterion Two definitional features of the SCM Agreement are key in determining its scope and the nature of the disciplines it imposes. One concerns the definition of a subsidy per se, and the other relates to the specificity concept. A subsidy is deemed to exist, 'if there is a financial contribution by a government or any public body within the territory of a Member' 9 or, 'if there is any form of income or price support in the sense of Article XVI of GATT 1994.'10 For a subsidy to exist, Article 1.1 (b) of the Agreement further requires that a benefit is conferred. As discussed below, However, the concept of a benefit conferred is not fully developed and used in the agreement.

7

A number of such treatments are available. See, for example, (The WTO Secretariat 1999: 90-102). 8 The plurilateral Agreement on Trade in Civil Aircraft also contains certain subsidy-related provisions, but these are not addressed here. 9 Art. l.l(a)(l) of the SCM Agreement. 10 Art. l.l(a)(2) of the SCM Agreement. Art. XVI of GATT 1994 refers to any form of income or price support 'which operates directly or indirectly to increase exports . . . or to reduce imports of any product..."

7 - Justification for State Aids

111

Afinancialcontribution may entail a direct transfer of funds, foregone revenue, state provision of goods or services other than general infrastructure, state purchase of goods, or payments to a funding mechanism. Income and price supports will often imply a financial outlay of some kind by the government, although in the case of price supports, it is possible to devise a minimum price regime whereby consumers pay. If the government decrees a minimum price and can find an effective way of enforcing this price regime, then no financial outlay is involved. And such a regime can certainly distort trade in a GATT 1994 Article XVI sense. On the other hand, if the government guarantees producers a minimum price and makes up the shortfall between what the product in question fetches on the market and the guaranteed minimum price, then a financial outlay is clearly involved. Apart from this apparent exception in the case of certain price support regimes, any intervention that does not involve a financial outlay is not considered a subsidy for the purpose of the SCM Agreement. A key question as far as this definitional aspect of the SCM Agreement is concerned, is thus one of whether the WTO rules are structured in a manner that ensures symmetrical treatment between the interventions falling within the scope of the agreement and those that do not. If such symmetry is absent, and there is potential for policy substitution, then the SCM Agreement will be partial in its impact on policy in the sphere that it purports to oversee. It may be noted in passing that the distinction between subsidies involving a financial contribution and subsidy-equivalent measures that do not involve such a contribution, is not meaningful from an economic point of view. The welfare-based case for or against intervention, discussed below, does not depend on whether the government itself has had to make a financial outlay or whether the transfer implicit in the intervention has been financed by other economic agents in the economy.11 It may be possible, at least in theory, that regulatory interventions can be used instead of subsidies to achieve a comparable outcome in some circumstances, and the WTO disciplines on regulation are quite different from those on subsidies. But before concluding that this is a lacuna in the WTO system of rules, or that it significantly weakens the effective coverage of the supposed domain of the SCM Agreement, it is necessary to consider more carefully the circumstances in which the WTO regulatory regime renders policy substitution practicable. It is also necessary to consider the role of the national treatment principle (Article III of GATT 1994) in constraining certain kinds of discriminatory intervention. In essence, public policy (regulation) within the WTO is subject to challenge in terms of whether the declared policy objective is attained in a nondiscriminatory manner, using the least trade-restrictive intervention available to 1

' The manner in which a subsidy isfinanceddoes, of course, carry resource allocation and welfare implications as well, which are addressed, for example, in the optimum intervention literature, but this is a separate point.

112

Working Paper V

meet the objective. Public policy objectives themselves are not, for most practical purposes, open to question. Article 2.2 of the Agreement on Technical Barriers to Trade, talks of 'legitimate' objectives, and provides illustrative examples only; including, national security, the prevention of deceptive practices, protection of human health and safety, animal or plant life or health, or the environment. Technical regulations, then, are not conceived as instruments to protect domestic producers from foreign competition, and any incidental trade distorting effects are intended to be minimal.12 The question remains, therefore, as to what scope there might be for using regulatory interventions as de facto subsidy equivalents. It seems safe to conclude that the rules on nondiscrimination in Article III, together with the strictures on the pursuit of public policy in the least trade-restrictive manner possible in Article XX (Exceptions) and the Agreement on Technical Barriers to Trade, limit the opportunity for policy substitution in the sense noted above. But neither strictures against discrimination, nor the limitations imposed on trade-distorting approaches to policy intervention, will always make impossible subsidisation that goes further than what is permitted under the SCM Agreement. A careful analysis of the opportunity for policy substitution in this sense is beyond the scope of this paper. 1.2. Specificity The second element of definition referred to above, specificity, creates a situation in which the level of subsidy discipline rises according to the degree to which the subsidy is targeted on sectors or enterprises. In other words, the more generally available a subsidy, the less pernicious it is considered from a WTO perspective. Non-specific subsidies are defined residually by reference to specificity, and, as with subsidy-like measures (regulations) free of a financial contribution, they are excluded from the purview of the agreement. Article 2 of the SCM Agreement defines a subsidy to an enterprise, industry or group of enterprises or industries as specific in terms of a number of criteria designed to ensure that the agreement will cover any subsidy that benefits a subset of producers or industries. Even in situations where there is no prior presumption that access or eligibility to a subsidy will be restricted in this way, specificity may still be found to exist, if only a limited number of producers are de facto beneficiaries of a subsidy programme. Having defined specificity, and thus an additional element of the coverage of the SCM Agreement, three categories of specific subsidy are then identified. The first is the prohibited category, which includes export subsidies and subsidies contingent upon the use of domestic over imported goods. The second category is actionable subsidies. This is essentially a residual category of specific 12

It is noteworthy also that Art. XX, which allows Members to depart from their WTO obligations in order to meet a specified set of public policy objectives, is subject to similar disciplines as the Technical Barriers to Trade Agreement in respect of the least-trade restrictive standard.

1 - Justification for State Aids

113

subsidies and the Agreement stipulates that no Member should cause through the use of covered subsidies: a) injury to the domestic industry of another Member; b) nullification or impairment of benefits; or c) serious prejudice to the interests of another Member. The definition of serious prejudice was an innovation in the SCM Agreement, most notably for the creation of a presumption of serious prejudice if a subsidy level exceeds 5 percent of the value of the subsidised product. Other elements that provoke the presumption of serious prejudice are subsidies to cover the operating losses of an industry, subsidies to cover the operating losses of an enterprise (other than one-time, nonrecurrent measures), and direct forgiveness of debt. Serious prejudice can refer either to the situation in the market of the complaining Member or to that Member's export interests in a third country, and the affected Member has the right to dispute settlement procedures in such circumstances. Subsidies causing injury in a Member's domestic market can be countervailed. An important consequence of the introduction of the concept of serious prejudice is that a rebuttable presumption of this adverse effect is created, thereby reversing the burden of proof and placing it upon the allegedly subsidising Member. No particular economic logic can be attached to the definition of serious prejudice. The choice of a 5 percent cut-off point for the value of a subsidy causing serious prejudice can only be explained as a negotiating outcome. It may be noted that the serious prejudice provisions found in Article 6.1 apply on a provisional basis forfiveyears beginning in 1995, after which they shall be reviewed. The third category is non-actionable subsidies. These include non-specific subsidies that are excluded from the coverage of the agreement and three categories of specific subsidies. The three categories of non-specific subsidies are placed beyond the reach of dispute settlement and countervailing remedies, as if they were non-specific subsidies, except that the Committee on Subsidies and Countervailing Measures can, in some circumstances, require the modification of a subsidy programme, even if it is consistent with the criteria set out for these measures. The three types of measure are assistance for R&D activities, up to and including the pre-competitive development stage, assistance to disadvantages regions pursuant to a general framework of regional development, and assistance to promote adaptation of existing facilities to new environmental requirements. Each category is carefully defined and qualified as to the level and kind of assistance that may be given. The creation of these categories of non-actionable specific subsidies is also provisional and subject to review after five years. A basic motivation behind the degree of discipline applied to each kind of subsidy defined in the agreement turns on concerns about 'fairness' in international trade. If a subsidy is seen as unfair or distorting in terms of its impact upon trade flows, it is subject to harsher treatment. This is why subsidies to exports, or contingent upon trading behaviour—the measures that are seen as having the most direct impact on trade flows—are outlawed. And the greater the degree of specificity of subsidies, the more trade distorting and unfair they are assumed to be. From an economic perspective, a problem here is that

114

Working Paper V

subsidy rules based on specificity, or on the concept of unfairness in trade, do not correspond to a recognisable welfare standard. An actionable subsidy, and perhaps even a prohibited one, might be shown to be welfare-enhancing for the country giving the subsidy. Equally, subsidies that are declared non-actionable may be sub-optimal from a welfare standpoint. The SCM Agreement might thus, in some circumstances, frustrate the attainment of the most efficient economic outcome. One important qualifying observation is in order here. In a world where it may be possible to make a welfare case for a subsidy, but where retaliation is possible, the existence of pre-commitment through multi-lateral rules to refrain from certain kinds of subsidising behaviour may lead to a superior welfare outcome than a situation where a subsidy is applied and subsequently retaliated against. This conditional conclusion holds both for a national and a global welfare standard. The notion of specificity clearly responds more to interests in market access for foreign goods and to concerns about fairness in trade policy than it does to welfare and efficiency concerns. It must be concluded, therefore, that, notwithstanding the cautionary note sounded in the previous section about too loose a prescriptive use of economic analysis, the reliance on a specificity criterion to define acceptable behaviour in the field of subsidies carries uncertain welfare implications. There is no economic theory indicating that the narrower the number of beneficiaries by sector, activity or enterprise of a subsidy, the worse the measure from a welfare standpoint will be. Neither, for that matter, is there any body of economic analysis affirming that the greater the trade effects of a subsidy, the more damaging that subsidy is in a welfare sense, either for the subsidising country or for the country importing the subsidised product. On the other hand, the absence of a clear welfare standard to underpin ex ante behavioural rules based on a specificity criterion, should not necessarily deter public authorities from regarding sectorally concentrated and large subsidies as prima facie more distorting than broader-based subsidies. This may well turn out to be the case in practice. This kind of reasoning supports the idea that a way to bridge the divide between economic analysis on the one hand, and a set of rules that respond to specific trade interests and the realpolitik of inter-governmental negotiations on the other, would be through a political economy analysis that redefines the welfare calculus. Such an analysis would have to show that restraining governments from certain kinds of action, and tying them into prior commitments about subsidy behaviour, will ultimately yield higher welfare than a more ex post oriented 'made to measure' approach to rule-making. 1.3. Benefits Conferred The definition of a subsidy in Article 1 of the SCM Agreement requires that a benefit is conferred. But this provision has not been accorded any real operational meaning in the Agreement. It may well be obvious that a benefit has been conferred if a subsidy takes a direct and visible form, such as a cash grant. But more opaque interventions may raise doubts. Seemingly, one reason why this concept was not developed in the Agreement is because some governments

1 - Justification for State Aids

115

wanted to assess whether a benefit existed by reference to a commercial benchmark of some kind, or to the cost to a subsidising government, while others preferred a methodology that focused directly on the recipients of subsidies. A question for consideration is whether provisions requiring a closer examination of the effects of a subsidy would bring the agreement closer to an economist's welfare standard. On the remedy side, effects are already important, since countervailing duties may only be levied if injury has been caused to a domestic producer by subsidised imports. But what about some kind of effects doctrine in relation to permissible subsidy activities? In principle, this would appear to be a way in which welfare-related questions could be more easily asked. The focus could be broadened to consider the conditions of competition in a market and the nature of the deficiency or need that a subsidy intervention was designed to address. At least three reasons can be mentioned as to why this approach to a benefitsrelated analysis would be unlikely to prosper in a WTO context. First, it would require Members to accept that the objective of improved market access alone was insufficient. Some allowance would have to be made for welfare considerations in other countries. In other words, the rules would move beyond welfare maximisation in a narrow national context. Secondly, such an approach would entail making an assessment of subsidy policies more on a case-by-case basis. It would not be possible in many instances to say ex ante whether or not a subsidy was desirable. This is analogous to the need in thefieldof competition policy to rely on 'rule of reason' as well as 'per se' judgements. Thirdly, such arrangements would have to operate at an international level. National jurisdictions would have difficulty in ceding such authority to a supranational entity of any kind. These three considerations are precisely the ones that complicate the search for strong and binding multi-lateral rules on competition. 2. The Remedies By providing recourse to anti-subsidy remedies, the SCM Agreement creates a mechanism that will restrain subsidisation and the remedies should, therefore, be regarded as an integral part of the disciplines on subsidies. The SCM Agreement follows two different tracks when it comes to remedies—the dispute settlement option and the unilateral countervailing duty option. There is some overlap in the availability of these remedies and, in such cases, Members can choose which remedy to pursue. In effect, both remedies can be pursued together, but only one can be applied. The countervailing duty remedy can only work where injury can be shown to a domestic industry. It will not be applicable where serious prejudice is alleged to export interests in third markets. Not much can be usefully added to the above discussion in terms of the dispute settlement remedy. This is available to Members desiring to enforce their legal rights according to the rules that have already been discussed. The countervailing duty option, however, raises different questions. The fact that countervailing duties can only be imposed when a subsidy is deemed to

116

Working Paper V

cause injury to a domestic producer interest would seem to suggest recognition of the potential welfare gain to a country from lower-priced imports benefiting from a subsidy. The calculus as to whether such imports are beneficial depends, to a degree, on the view taken about the likely longevity of such subsidy practices in relation to the adjustment costs that an economy might have to assume in the face of subsidised imports. If subsidised imports provoke resource shifts in the domestic economy, as well as attendant adjustment costs, these costs are only worth assuming if the benefit of low-cost imports is lasting. If foreign subsidy policy is short-lived or unstable, and a resource shift has to be reversed soon after it is made, the welfare benefits of subsidised imports become less clear. This argument is akin to the predation case sometimes made in defence of anti-dumping measures, and it is open to question whether it has any greater empirical justification than the latter. In any event, as with most national legislation, the question as to whether consumers benefit from foreign subsidies is regarded within the WTO frame-, work as being of secondary importance where injury to producers is deemed to have occurred.13 These arrangements emphasise the primacy of the desire to protect domestic producers from import competition, by reference to a fairness standard, notwithstanding the possibility that the welfare calculus might show a net national gain from foreign subsidisation. This point has often been made about both anti-dumping and anti-subsidy remedies. The suggestion is that consumer interests, or a broader welfare standard, should be applied in determining whether to act against low-priced imports that are dumped or subsidised.

B. The Agreement on Agriculture The Agreement on Agriculture establishes different rules for the agricultural sector to those applying to other goods under the SCM Agreement. For the most part, the differences make for weaker rules in agriculture, reflecting the reluctance of many industrial countries to liberalise trade in this sector. The rules will be briefly discussed here, and it will be clear that, for the most part, they do not raise many new analytical questions to those touched on above. Separate provisions exist for domestic support measures and export subsidies. Export subsidies, defined as subsidies contingent upon export performance, are subject to a phase-out schedule. This is in contrast to the SCM Agreement, where export subsidies are disallowed (subject to phase-out in developing countries), but it does not reflect a different view as to the tradedistorting nature of export subsidies. Rather, it reflects what was politically pos13 The SCM Agreement defines interested parties in a subsidy investigation to include importers of the product concerned, but not consumers. No requirement exists to take consumer interests into account.

/ - Justification for State Aids

117

sible when the agreement was drawn up. Export subsidies are countervailable in accordance with the provisions of the SCM Agreement, although Article 13 of the Agreement on Agriculture calls for 'due restraint' to be shown in initiating countervailing duty investigations. Domestic support measures are subject to certain rules as well as specific phase-out commitments. The rules distinguish three separate categories of measures that are exempt from phase-out commitments, and also define a de minimis support level—5 percent (10 percent for developing countries) of the value of the product concerned—that is exempted from phase-out commitments. The three exempted-measure categories are the 'Green Box', a series of special and differential measures for developing countries, 14 and the 'Blue Box.' The Green Box defines measures that have a minimal trade-distorting effect or effect on production, and which are designated non-actionable. 15 These measures must be publicly-funded and not involve a transfer from consumers, and they must not constitute price support measures. The former requirement is presumably intended as a transparency measure, but the allocative effects of this requirement are not clear. Among the Green Box measures are general services, such as research, pest and disease control, extension services, inspections services and training, public stockholding for food security purposes, and domestic food aid. An important additional item in the Green Box is direct payments to producers decoupled from production, prices or factors of production. Included in this category are income insurance, safety-net programmes, relief from natural disasters, structural adjustment assistance, environmental programmes, and regional assistance. That such measures may have less direct impact on trade flows does not necessarily mean that they can be defended on welfare grounds. On the other hand, many of these programmes may well be justified, at least in part, on distributional grounds, about which conventional analysis will have little to say. A particular feature of the agriculture rules that is not present in the SCM Agreement, is the objective, under the Green Box, of designating benefits with a minimal effect on production and not just on trade. This objective would seem to respond to the desire to ensure that measures designed to aid farmers, which may, in essence, be characterised in many cases as income support measures, do not have unwarranted distortionary effects on agricultural production. As such, it is an application of the theory of optimal intervention. The Blue Box deals with direct payments under 'production-limiting' programmes. The rules surrounding these payments are designed to ensure that they are directly linked to reductions in output, or at least to no output 14

Developing countries are afforded greaterflexibilitywith respect to certain development-related support measures, including investment subsidies, agricultural input subsidies, and measures to support diversification away from illicit narcotic crops. 15 Green Box measures are the only ones in the Agriculture Agreement exempted from countervailing actions, and from challenge on grounds of serious prejudice and nullification and impairment.

118

Working Paper V

expansion. As such, they are partially decoupled, and exert less direct influence on product and factor prices than measures subject to reduction commitments. It appears that such measures are needed to counteract the effects of other support measures that have the effect of protecting farmers and expanding output. To the extent that this is an accurate description of their function, economic analysis would suggest that it is inefficient to super-impose one policy measure upon another in order to counteract the effects of the first one. A more efficient approach would be to remove the original measure. This is unlikely, however, to prove feasible in the short-term in the agricultural sector.

C. The General Agreement on Trade in Services Article XV of the GATS establishes a negotiating mandate on subsidies, but no actual rules. The mandate also calls for consideration of the need for countervailing measures. This situation reflects the inability of governments to agree during the Uruguay Round on what rules should be established. It is important to note, however, that this does not mean the GATS is a clean slate as far as subsidy disciplines are concerned. While in GATT, subsidies are exempted from the national treatment provisions of Article III, in GATS, the arrangement is quite different. National treatment is not a principle intended to apply across-theboard, but rather it is negotiated on a sector by sector basis as part of the specific market-access commitments assumed by Members. Where governments have assumed national treatment commitments as a result of such negotiations, these will apply to subsidies unless an explicit indication is given to the contrary. The non-discriminatory obligation embodied in national treatment is a significant subsidy discipline in its own right. No obligation in GATS requires a Member to take measures outside its territorial jurisdiction, which means that a Member is not obliged by the national treatment obligation to extend a subsidy provided to suppliers in its territory to suppliers outside its territory. An interpretative complication does arise, however, with respect to the question of whether the national treatment obligation extends across modes of supply. The GATS defines trade in services in terms of four modes of supply—cross-border, consumption abroad, commercial presence and the movement of natural persons. The key question is whether services are considered 'alike' regardless of the mode of supply. Can a Member provide national treatment within a single mode and not do so in another mode with respect to the same service? If so, a full cross-border commitment on a given service, for example, could be rendered worthless by the provision of a subsidy to domesticallybased suppliers of the same service in the commercial presence mode. Until this issue is clarified, it remains uncertain what the value is of a national treatment commitment, including in respect of the non-discriminatory provision of any subsidies offered. It is important to remember that national treatment does not impose any restraint on the level of subsidies that may be granted, but only upon

1 - Justification for State Aids

119

their discriminatory use. Moreover, the degree to which even the national treatment discipline applies in services, remains a function of the willingness of governments to assume trade liberalisation commitments at the sectoral level. From an economic welfare perspective, therefore, the same questions arise as those outlined above when it comes to judging subsidies in services. Given that any national treatment commitments that do apply will not set limits on the number or value of subsidies granted, it should be emphasised that little else exists in GATS to control subsidy practices, with the exception of the rules in Article VIII on monopolies and exclusive service suppliers. Article VIII: 1, requires Members to ensure that monopoly service suppliers do not use their monopoly power to negate their most-favoured-nation commitments or to undermine their specific market-access commitments. Paragraph 2 of Article VIII, states that where a monopoly competes in a sector outside the domain of its monopoly power, and the sector in question is subject to a specific commitment, a Member must ensure that the monopolist does not abuse its monopoly position to undermine the specific commitment. The objective of this provision is to control cross-subsidisation. These provisions apply also to exclusive service suppliers, which exist when a Member formally or in effect authorises or establishes a small number of suppliers and substantially prevents competition among them within activities or territories. Monopolies and exclusive service suppliers are defined in GATS to include both public and private monopolies, thereby addressing both public and private sector behaviour—or, in other words, both subsidisation and 'dumping' issues. The provisions of GATS Article VIII, are rather narrow in scope. But they do seem to raise an interesting alternative to the GATT approach to subsidy issues. The question is one of to what extent, if at all, a competition-based approach could work effectively as a discipline on subsidies in the WTO context. The idea would be to think of restraints on subsidy practices primarily in terms of their effects on the conditions of competition in the market, rather than in terms of the rights of market access of a subset of suppliers. This issue calls for further reflection.

IV. Conclusions The simple argument that all subsidies are undesirable because they distort economic activity and reduce welfare is based on excessively simplistic assumptions about perfectly functioning markets. A theoretical case can be made for welfare-enhancing subsidisation, built around the existence of market imperfections of various kinds. In particular, the notion at the heart of the problem facing competition policy is market power, or imperfect competition. The basic economic problem associated with market power is under-production. Hence, subsidisation could, in principle, be seen as a 'substitute' for competition policy interventions.

120

Working Paper V

Yet, the case for subsidies, and indeed for intervention generally, must also be treated with circumspection. A complex set of interactions is at work in any economy and interventions designed to eliminate market imperfections may do more harm than good if they are poorly conceived or implemented. A lack of adequate information can lead to uncertain and potentially damaging outcomes. In addition, political capture can result in serious resource misallocation. And where a case for intervention is sustainable, the nature of the chosen measure is crucial to a successful welfare outcome. Little can be said ex ante about the desirability or otherwise of a subsidy intervention. If governments adduce income distribution or 'non-economic' arguments to support the case for subsidisation, conventional welfare analysis may be of little help. On the other hand, economic analysis is very useful in identifying the costs of subsidisation and informing the choice among alternative interventions. In sum, one should be careful not to claim too authoritative a role for economic analysis in the area of subsidy policy, but there is no reason for nihilism or agnosticism either. The primary focus of the WTO's rules on subsidies is producer interests in domestic and foreign markets. The promotion of producer interests does not necessarily contribute to improved conditions of competition in markets. It will do so, however, when the rules succeed in restraining governments from anticompetitive subsidisation, and this is clearly an important objective of the WTO rules. The SCM Agreement seeks to identify a well-defined area within which its disciplines apply. Subsidies are only covered by the Agreement, for example, if they involve a financial contribution. Apart from the lack of any obvious economic logic in treating 'subsidy-like' interventions that involve a financial outlay differently from those that do not, a problem of consistency arises in circumstances where a more or less equivalent outcome can be secured with and without the outlay. A government may be able, for example, to find a way of taxing consumers via price controls to fund a subsidy, rather than pay a subsidy directly to the beneficiary group. The outcome would be similar, but the applicable rules may be entirely different. Before concluding that this is a problem, however, it is necessary to analyse other aspects of the WTO rules to see whether such policy substitution is indeed possible. It was argued above that the national treatment requirement, as well as certain rules concerning government regulation, would have a similar constraining effect on 'subsidy-like' behaviour as does the ACM Agreement in the areas that it covers. The specificity criterion for defining subsidy disciplines is another example of an expedient approach to controlling subsidies, which is regarded as the most egregious. In the absence of a clear theoretical rationale for judging the welfare implications of a greater or lesser degree of specificity in a subsidy intervention, this criterion may nevertheless be considered a valid rule of thumb for focusing on those subsidies that are likely to be the most distorting. It should also be recognised, of course, that the central concern with producer interests and access to markets in the WTO subsidy rules, as opposed to economic welfare more broadly defined, will also make the specificity criterion attractive.

1 - Justification for State A ids

121

Comparable differences are to be found between what strict economic analysis may prescribe and the other subsidy rules in the WTO—those on agriculture and services. This paper has only touched generally on the seeming divergences between subsidy rules and economic logic, and more analysis is required to clarify these issues further. Such analysis will need to take adequate account of at least four important factors. First, economic analysis itself is not equal to the task of providing clear ex ante prescriptions from theory that would allow optimal rules to be drawn up and applied automatically. Too much of the underlying welfare analysis required turns on circumstances particular to each situation. Secondly, even where economic prescriptions might otherwise be offered with a reasonable degree of confidence, governments may be pursuing public policy objectives, such as distributive goals, about which welfare analysis can say little. In these circumstances, the contribution of economics is limited to a more positive role of determining the relative efficiency of different ways of attempting to secure a specified objective. Thirdly, the public choice literature reminds us that even the best intentions can be frustrated through political capture, leading to outcomes from interventions that do not correspond to the putative intentions of governments, nor to recognisable welfare prescriptions. This is a reason for caution in promoting policies or designing interventions that rely on discretion. Finally, given the motivation for much subsidy-related activity by governments, and the difficulties that diverse national jurisdictions would encounter in operating jointly at the international level in this area, it will be a long time before subsidy rules can be made to look more like an aspect of competition policy, and less like a 'fair' trade instrument focusing primarily on the terms and conditions of market access, generally on behalf of a subset of economic agents.

VI Patrick A. Messerlin* Antisubsidy Policies and Justification for State Aids

I. Introduction This paper focuses on 'antisubsidy' policies, rather than on subsidies, and refers mostly to the European Community (EC) context. Following two decades of combat between recidivist 'subsidising' Member States and a Commission mandated by the Treaty of Rome to implement the antisubsidy policy, the period since the early 1990s has been one of relative peace, at least with regard to goods. There is a much wider recognition within Europe—particularly in Member States fond of subsidies—that subsidies have many negative aspects; meanwhile, current European public opinion has a far greater understanding of the need for an economically sound—that is, limited—subsidy policy than it did ten years ago. The time is, therefore, ripe for a further step: the addressing of issues that could not be raised during the two last decades, when the priority was merely to stop the follies inherent to European industrial policies. This paper focuses on three such additional issues: the partial overlapping of subsidy and antisubsidy policies; the degree of convergence between state aid and competition policies and; a 'constitutional' framework for an antisubsidy policy better suited to less hostile—less fond of subsidies—environment. Subsidy and antisubsidy policies differ in two key respects, which are often neglected. First, optimal antisubsidy policies should take all of the consequences of eliminating, or redesigning, subsidies into account. In particular, this requirement raises the issue of substitutability between subsidies and other instruments, a well as the issues of the impact of the alternative instruments that are available to governments or private actors—a problem that is mirrored by the difficulties inherent to a definition of subsidies. Second, optimal antisubsidy policies can only be achieved where their relationship with competition policies is clearly articulated. Fortunately, the Rome Treaty places these two policies within the same chapter, and subjects them to almost the same legal environment. In both cases, there are trade-offs between fewer state aids—more competition—and other major Treaty objectives, such as; (a) the 'fair' competition objective, which is included in the Treaty Preamble and implies that antisubsidy and competition policies can be used to protect 'competitors', as well as, competition; (b) Article 2 and 3 [ex 2 and 3] objectives, which—with every Treaty revision—extend to an ever greater number of objectives—social * Professor of economics, Institut d'Etudes Politiques de Paris, and Director, GEM (Groupe d'Economie Mondiale).

124

Working Paper VI

cohesion, promotion of research and the increased competitiveness of Community industry—that potentially conflict with antisubsidy and competition policies; and (c), the 'common market' objective found in Article 87 [ex 92], which specifies that state aids must be 'incompatible with the 'common market", and not with competition. Within this common broad environment, there are many points at which EC antisubsidy and competition policies must be examined together, in order to fine tune antisubsidy policy, so that it is better adapted to the relevant issues. The paper first tackles the issue of substitutability between subsidies and other mechanism and suggests that 'active' antisubsidy policies—those aiming to ban or redesign subsidies—could be less strict if (a big if) there is no (or little) risk of an accumulation of market power within the market examined (infra II). Section III examines whether the three main branches within existing economic literature on subsidies furnish us with strong enough arguments to refute the previous conclusion. Section IV analyses the elements of EC competition policy that could be usefully introduced into EC antisubsidy policy. Section V argues for a broader definition of antisubsidy policies—'pre-active' antisubsidy policies—which would also presuppose an improved institutional framework for the implementation of EC antisubsidy policy.

II. Antisubsidy Policies: Substitutability It is well known that an exact definition of subsidies is elusive. Practitioners who devote much time to definitional issues admit that their working catalogues of measures to be monitored under the EC and GATT Treaties are based on broad generalisations. Economists are convinced that the almost endless range of variants that are used to identify subsidies essentially derive from the constructivist role assigned to government by society and from the prevailing vision of 'governmental creativity'. Snape (1991) notes that 'virtually every government action can be regarded as a subsidy for someone, and virtually all such actions can affect international trade'. Further, as Snape asks: 'is 'free' education for electronic wizards a subsidy for the electronic industry?' This question is far from being an academic one, as best illustrated by the US 'countervailing'—that is, 'antisubsidy' in GATT-WTO parlance—cases that interpreted general education policies within agriculture as being an export subsidy for farm products, and subjected such policies to countervailing duties, despite their minimal importance in relation to production costs. A similar observation might be made about OECD methodologies for the estimation of 'consumer or producer subsidy or support equivalents' in relation to agricultural products: a marked difference exists between estimates made under the old and new methodologies, since they are based on distinct considerations, ranges of issues and focus on divergent interests. This situation explains why many economists find the EC Treaty definition—seemingly very broad in legal

1 - Justification for State Aids

125

scope—to be too narrow. The terms, 'any aid granted by a Member State or through state resources, in any form whatsoever', would clearly seem to encompass many kinds of subsidies, but nonetheless leaves some room for doubt: for example, it leaves open the question of whether state guarantees given without financial disbursement would fall within its scope,1 and, further, simply ignores many other mechanisms that might be substituted for subsidies. Thus, the requirement that all entrants within the French telecommunications market must be established in each end every 'departement' is tantamount—through its unnecessary raising of entrance costs—to the subsidisation of France Telecom. The subsidy for the TGV (high speed train) connection to the Air France, Roissy terminal constitutes an implicit subsidy to Air France. Equally, implicit subsidies to Airbus—scale economies in engine production—may constitute a worsening of Boeing's competitive situation—lower input prices for Boeing— an important issue since, although Boeing has never lodged an antisubsidy complaint in the US, it would be (almost) certain to win the case. It does not suffice to identify alternative mechanism. Instead, a better grip on the substitutability issue can only be acquired through a shift from a 'partial equilibrium' framework—only one market is under examination—to a 'general equilibrium' framework—several inter-related markets of goods and services are taken into account. A simple and well-known illustration of such a general equilibrium approach can be found in the international trade literature. The socalled Lerner symmetry theorem shows that, under certain conditions, the subsidising of exports of good A is equivalent to the subsidising of imports of good B. Of course, the Lerner symmetry theorem also implies that the taxing of exports of good A is equivalent to the taxing of imports of good B. As a result, a country could conceivably implement these two actions—subsidising and taxing—to the same degree, and combine them in order to reach the point where its import-increasing policy—export subsidies on good A—exactly counterbalances its import-reducing policy—tariffs on good B. In other words, the 'relative' domestic prices—including subsidies and taxes—prevailing in the country would be equivalent to relative prices created by free trade. In this case—and assuming no added implementation costs—an active antisubsidy policy 'alone' would clearly be inadequate: it would push the country from a free trade to a protectionist order. In fact, international trade policy literature has examined in detail many cases of optimal substitution between alternative instruments, looking at the relative costs and benefits of substituting various forms of subsidies—on export, production and input—with other trade measures, such as tariffs or non-tariff barriers or, to non-border measures, such as indirect taxes. This rich literature should be used more intensively in the future implementation of antisubsidy policies. Two lessons can be drawn from this simple point about substitution between instruments applying to different products and services—note, in this section, antisubsidy policies are defined as the banning or the redesigning of subsidies, 1

(Koening 2000); (Schneider 2000).

126

Working Paper VI

as is the case in the EC, and not as the imposition of countervailing measures, which is the rule under the GATT-WTO regime. The first lesson is that the intensity with which antisubsidy policies should be enforced in the future should also take, as far as is possible, the possible degree of substitutability—between instruments applying to different goods and services—into account. The narrower the definition of a subsidy is, the more the related antisubsidy policy may appear to be successful in attaining its limited goal—the elimination of the subsidy examined—but the greater is the danger that it may economically fail to eliminate the 'subsidising process' comprehensively. The importance of this lesson is underlined by EC history. A few industries have successfully combined all possible measures of protection: thus, in the early 1990s, six EC industries—textiles, synthetic products, clothing, glass, steel, and motor vehicles—benefited from higher than average border protection, subsidisation rates—and from non-competitive markets.2 Although far stricter state aid control was applied after 1987, this move was followed by recourse to a wider range of less transparent subsidies, as well as to new 'secondary' sources of subsidisation—local authorities and statefirms.3Of course, all of these evolutions could have had other causes, such as a deterioration in public budgets or the privatisation process, but substitution between instruments may yet be an important factor. The second lesson is that taking the substitution problem into account will profoundly change the nature of the current procedure. To date, EC antisubsidy policy generally consists of a determination of the existence of a subsidy, of an examination of whether or not the subsidy might be covered by one of the Treaty exceptions and, where no exception exists, of the taking of appropriate measures, such as prohibition or restructuring. The inclusion within this process of an examination of substitution measures would bring EC practice closer in line with the 'rule of reason', case by case, approach followed in competition policy. This move is not without risk, since, through its weighing up of a complex set of factors, the rule of reason approach is far more sensitive to political pressures, which are already too visible within current antisubsidy enforcement. Consequently, a limit must be set upon the 'rule of reason' approach: more refined, but more 'capturable' than the current, more systematic, procedure. This limit should be the existence of market power: in such cases, the EC antisubsidy policy should remain as strict as it is. Since they must also include a more complete and sophisticated economic analysis (see infra and supra), cases will require much more effort. In order to fulfil its obligations in these cases, the Commission should restructure its efforts, becoming less strict in cases that do not involve market power, or, alternatively, finding a way of devolving some of its powers to the Member States. This conclusion is, in fact, an approximation of lessons taken from trade theory. In the case of a 'small' country—that is 2 3

(Messerlin 2000). (Messerlin 2000).

1 - Justification for State Aids

127

unable to influence international terms of trade and is, thus, comparable with a firm under perfect competition—the act of subsidising domestic firms subject to foreign competition, or, say, to free trade, makes little sense in the absence of well-defined justifications, such as externalities or distortions that the Member State can identify better than the Commission; equally, where it fails to do so, it, rather than the other Member States, must bear the costs. However, this conclusion about the acceptability of 'benign neglect' in the context of cases where market power is not at issue does not survive the introduction of market power into the equation: in such cases, the risk that a laxer antisubsidy policy will be captured becomes too large. These two lessons are more logically robust than current international practice which regards import taxes (tariffs) that reduce imports, and hence exports, as acceptable, but bans the use of export subsidies that increase exports and hence imports. They are equally consistent with an observation that is rarely made, though intriguing at a first glance: there are few elaborated antisubsidy disciplines in 'old' federal states—American states can subsidise freely, in particular, through tax exemptions—or in centralised states. It even seems that the younger the federal states are, the stricter the antisubsidy policies are, Germany and the EC being exemplary. This observation might be explained by history—subsidisation was not an important issue when the US was founded—and/or by the financial capacity of sub-central entities to subsidise. However, this leniency with respect to intra-federal/central subsidies could also be explained by the fact that 'old' federal or centralised states 'trust' in the internal high mobility of goods and services—'free trade' within the country in question, with states or regions 'small' enough not to threaten this free trade too deeply—to discipline subsidies. By contrast, the major sources of antisubsidy policies are the GATT text and the Treaty of Rome, as well as other regional trade agreements: in all these legal sources, the existence of antisubsidy policies is almost invariably related to inter-state relations, rather than to tightly intertwined markets.

III. A Brief Review of the Literature Does economic analysis provide us with a strong argument to refute the two principles of action—a more refined, though, excepting the case of market power lenient antisubsidy policy—developed in the previous section? It does not seem that this is the case. In fact, each one of the three major branches of economic analysis—traditional trade theory, strategic trade theory, and political economy—has both a positive and a negative view on subsidies, with the equilibrium between these two views relying on economic factors (externalities) that characterised by the fact that there is generally no hard information available about them and, in particular, about regulatory externalities, such as services under regulatory reform.

128

Working Paper VI

First, traditional trade theory, based on perfect competition and no externalities, perceives subsidies as a trade impediment, and hence condemns their use. By contrast, the derived general equilibrium analysis of 'distortions'4 sees production (consumption) subsidies as being necessary for a welfare-improving free trade policy in case of distortions—be these distortions related to market power or to externalities—and as better than trade measures (tariffs or VERs) if the distortions in question are not trade-related. This first branch of economic theory does not look at the substitution issue between subsidies and other trade measures expressly. But, on the one hand, it has a deep understanding of the wide range of possible measures: in fact, nothing in the theory says that it is the role of the government to implement anti-distortion measures—something has to be done collectively, but this could be handled by private groups or institutions acting collectively—so that it covers both private as well as public subsidies. On the other hand, thisfirsttheoretical approach has a tendency to allocate one instrument to one problem—suggesting there is a limited degree of substitution between the available instruments—although there are cases where two instruments can be perfect substitutes; for example, a product subsidy and a factor subsidy can be used indifferently if all factor prices are subject to the same distortion to the same extent. Secondly, strategic trade theory provides us with an additional reason to use subsidies, which is rent-shifting: market power on foreign markets provides rents to domestic firms operating on these markets and hence, arguably, to the home country of the firms involved. As a result, this literature has a positive view of subsidisation. However, in the case of regional trade agreements, such as the EC, its gives rise to ambiguous results for two reasons. First, it does not furnish EC antisubsidy policy with a consistent approach: on the one hand, the EC should ban such subsidies when operated by Member States since rent shifting could occur between Member States, hence be detrimental to the EC as a whole; on the other hand, the EC should grant such.subsidies in order to obtain rents from the non-EC countries.5 Secondly, the strategic trade literature tends to perceive subsidies as being non-substitutable with other instruments. In fact, its most important result may be the tight relation between the instrument to be used and the existing market structure: a subsidy that is welfare-enhancing within a given market structure is welfare-deteriorating within another market structure;6 a key lesson to be taken into account as an argument for antisubsidy policy. In the context of subsidies and antisubsidy policies, the economic geography literature is a derivative of the strategic trade approach to the degree that 4

(Bhagwati 1971); (Corden, 1974). In fact, the situations are likely to be more complex. Arguably, the EC could approve on a Member state's 'strategic' subsidy, if the subsidising Member State could compensate the other Member States (by transferring part of the rents it gets from nonEC countries). The EC might equally be obliged to face the complex consequences of a EC strategic subsidy (shifting rents from non-EC countries to the EC) within individual Member States. 6 (Eaton & Grossman, 1986). 5

1 - Justification for State Aids

129

domestic externalities (positive or negative) related to locational issues may be combined with externalities emerging from relations with the rest of the world. As a result, economic geography literature substantially qualifies the somewhat subsidy-supportive strategic trade literature. Lastly, the political economy approach also contains two opposing views on subsidies. On the one hand, it focuses on the ability of pressure groups to capture the government. Lobbies, it argues, can obtain state aids in an amount disproportionate to that which would be suggested by the 'distortion' approach or by the 'strategic trade' consideration,7 thus implying a no-subsidy policy.8 It also insists on the use of subsidies for goals other than their official purpose and, thus, on the wide range of substitution between instruments for the achieving of a goal. It underlines the fact—often ignored by antisubsidy policies of the countervailing type—that where export subsidies adversely affect the terms of trade of the subsidising country, and possibly of its competitors, they improve the terms of trade of the rest of the world since the rest of the world is, by definition, a net importer with respect to the subsidising exporting country. On the other hand, the political economy literature recognises governments as being producers of laws and regulations—the object of lobbying and potential capture—and hence as competitors; an approach which corresponds closely with the Tiebout approach.9 In this context, subsidies are seen as an instrument of competition, which leads this second group within the third branch of economic literature to qualify the negative stance adopted by a first group within the same school. This brief review of the economic literature thus leads us again to the conclusion that subsidies should be judged upon in line with a 'rule of reason' approach to the externalities involved. It does not provide us with good reason to reverse the principles of action suggested in the first section.

IV. Antisubsidy and Competition Policies A 'rule of reason' approach would bring EC antisubsidy policy in line with competition policy. In particular, it would force EC antisubsidy policy to pay much more attention to a crucial concept within competition policy, which it tends now to ignore: the definition of the 'relevant market.' This current neglect is only conceivable because antisubsidy policy focuses on the allocation of subsidies to 'boxes': prohibited, or authorised under such or such an exemption. 7

(Moore & Suranovic, 1994). A no-subsidy policy is not equivalent to an antisubsidy policy, since even antisubsidy policies can be captured by vested interests (for instance, industries protected by tariffs could reject export-subsidies which reduce their protection). 9 (Besley&Seabrightl998). 8

130

Working Paper VI

Yet, this neglect also considerably weakens the Treaty's injunction—further developed in Commission practice—to judge subsidies with regard to their capacity systematically to giveriseto a distortion in competition. The best illustration of potential inconsistencies and conflicts between antisubsidy and competition policies is provided by the 1994 SST-GmbH case10 As SST-GmbH was the sole producer of a specialised yarn within the EC at this time, a judgment on the competitive distortion created by the state aid granted to the firm required a careful examination of the degree of substitution with the rest of the EC production: as noted by Jenny (1998) in the case of no noticeable substitution (and complementarity), it would be hard to justify the ban of the state aid on the ground of a competition distortion. However, this conclusion is still incomplete. The concern about market power determines that approval of the state aid—assuming no noticeable substitution—should be 'conditional' upon the absence of any present and 'future' barrier to imports, in order to ensure that the market power issue can be reexamined at any time. In other words, assuming that the market relevance analysis shows no competition distortion arising out of the state aid granted, the Commission must make it clear that its approval of the subsidy will be cancelled immediately if import barriers are raised—for example, if an antidumping complaint is lodged with regard to the product under consideration; a complaint is already a severe enough threat to competition from foreign producers. Antisubsidy policies must also be drawn into line with competition policies with regard to the notion of the competitive nature of the conditions under which a state aid is authorised. As underlined by Ehlermann (1995), the multigoal approach of the Treaty of Rome has induced the Commission to pay much attention to the interests of the 'competitors' of the aid beneficiaries. This may induce the Commission to balance the acceptance of the subsidies by imposing restrictions on the business strategies of the subsidisedfirms,as best illustrated by developments in the airline and banking industries. In the airline cases, subsidised firms have been prevented from acquiring other airlines, from expanding aircraft fleet, from increasing the number of flights or seats on specific routes, and from pricing aggressively on specific routes. In banking, the operational constraints imposed on subsidised banks have included quantitative limits on growth rates, a mandatory distribution of revenues between shareholders and other possible beneficiaries—both conditions to be met for a few years— and a mandatory maintenance of a stable bank solvency ratio—a condition to be fulfilled over many years." 10 SST-GmbH, where a state aid was granted for the installations of new facilities for the production of polyester staple fibre. 11 The mentioned conditions refer to the Air France and Credit Lyonnais cases, the last case raising both the issues of state aid rules and regulatory (prudential) supervision, or the extent to which the difficulties faced by Credit Lyonnais have been generated or amplified by the failure of the French supervisory authorities, Credit Lyonnais OJ (1996) C390/7; Credit Lyonnais, OJ (1995) L308/92; Credit Lyonnais, OJ (1998) L221/28;

1 - Justification for State A ids

131

The primary problem is not that these restrictions make the restructuring of the subsidised firms more difficult—giving them good reason to request new subsidies, and making it more difficult for the Commission to enforce its 'one time, last time' principle. It is, instead, that such restrictions impose severe limits on the competitive nature of the markets in which subsidised firms will be operating 'and' in substitute or complementary markets. For instance, limiting airline seat capacities ultimately facilitates the collusion between subsidised and non-subsidised airlines: being aware of the constraints imposed upon the subsidised firm, non-subsidised firm can strategically align their prices (or quantities) with those permitted for the subsidised airline on the constrained routes, and use the resulting non-competitive rents for cross-subsidising their price strategies on other routes and for developing long-term strategy. It is as harder to limit the collusive impact of antisubsidy policies than to limit the collusive impact of subsidies: for example, the competitors of a subsidised bank may be indirectly subsidised where the state aids granted allow both them and the subsidised bank to maintain stable assets.

V. A Better Institutional Environment The foregoing conclusions imply the implementation of a more lenient antisubsidy policy in cases where there is robust domestic and foreign competition; the foreign component being the most important since foreign competitive pressures are difficult to influence without recourse to visible instruments, such as import barriers. As a result, the Commission's attention and energy could (and should) be focused on those cases which raise more severe risks of a distortion of competition and, in particular, on those cases involving market power. There are two further points that are worthy of attention; both being based on an alternative definition to the narrow definition of antisubsidy policies used to date. In other words, whereas the previous sections have looked at 'active' antisubsidy policies, this section examines the case of 'pre-active' antisubsidy policies. First, since externalities are barely measurable by definition, 'active' antisubsidy policies run the serious risk of under or over-estimating such externalities; hence, one reason for the attractiveness of a more lenient approach that places the costs of errors on the shoulders of the Member State in question. By contrast, pre-active antisubsidy policies would aim at improving the internalisation of externalities by economic units before any attempt is made to subsidise. For instance, a pre-active antisubsidy policy would impose measures imposing on farms requiring them to maintain a 'green accounting book' of polluting Air France (1994) OJ C152/6; Air France v. Commission [1996] ECR 11-2109; Air France OJ (1994) L254/73; (Tresor and Banque de France are under investigation in France).

132

Working Paper VI

elements, so that each farmer would be able optimally to spread the polluting output over his/her land in order to reduce his/her need for environmental subsidies.12 The generalisation of this approach would make pre-active antisubsidy policies a source of 'better'—less discriminatory, more stable and more factrevealing—instruments or regulations than subsidies.13 Secondly, 'active' antisubsidy policies are, in many respects, based upon a 'bureaucratic' rather than political process. This certainly gives rise to a degree of contradiction, since externalities are difficult to grasp and estimate: for example, the examination of whether subsidies should be granted to French films relies upon the public perception, first of culture, and secondly of French culture relative to other cultures. Accordingly, the prohibition or restructuring of such subsidies requires a measure of legitimacy which no international institution—including the EC Commission—may claim to possess. On the other hand, however, an acceptance of this political constraint is necessarily mirrored by the acceptance of heavy distortions within the economy.14 There is nonetheless an alternative option: the 'Prince', or 'the People' within democratic regimes, must be awoken. In this respect, the primary role of a pre-active antisubsidy policy would then be to reveal the magnitude of subsidisation within the domestic economy, with all the above mentioned caveats about the definition of subsidies. This is the purpose of the so-called 'effective rate of assistance' approach adopted by the Australian Productivity Commission: it aims to aid the government to assess the pros and cons of the subsidies it has granted—and of all of the other measures it may conceivable have taken—and the pros and cons of the corresponding antisubsidy policy. If based upon transparent domestic procedures put into place by all the trading partners, such a cost-benefit analysis could also improve international relations. In this respect, it would prove useful to create two levels of co-operation between the institutions that are in charge of antisubsidy policies in Europe. On the one hand, the Commission—the Directorate General for Competitioncould model itself on the Australian Productivity Commission, thus becoming an 'auditing' institution for active antisubsidy policy. On the other hand, the Commission could establish a 'network' of the national institutions that are involved in pre-active antisubsidy policy, such as the Cour des Comptes in France and its equivalents in the other EC Member States. The first form of cooperation would be largely oriented towards technical issues, whereas the second type of co-operation would serve the goals of providing better (reciprocal) information and building up broader support amongst the public. 12 13 14

(Mane & Ortalo-Magne 1999). This is a development of the Tiebout's analysis. The average rate of subsidisation of Frenchfilmsis estimated to be at least 100%.

VII Fiorella Padoa-Schioppa Kostoris in co-coperation with Sascia Lubicz* State Aid and the Principle of Mutual Recognition

I. Introduction State aids may be evaluated on efficiency or on equity grounds. Economists are usually uneasy on the latter subject, while they are accustomed to treat the former topic under the benchmark of perfect competition. Competitive conditions, however, cannot be assumed to exist when state aids occur, because, state aids only arise when market failures emerge. 'Second best theorems' tell us that it is, in principle, impossible to say whether therapies provided by government interventions are better than market pathologies. Specific state aids must, therefore, to be evaluated for their efficiency and equity on a case-by-case basis. This task is not only difficult of itself, but is has become increasingly troublesome as one particular market failure, which entails both efficiency and equity costs, has had an ever greater impact upon the European economy: unemployment, affecting almost 18 million people. In our evaluation of state aid in the following pages, we will consider only labour market failures. In our conclusions, we will demonstrate the alternative instruments that could be used to address these labour market disequilibria using some very basic principles of the European Economic Constitution.

II. State Aids and Labour Market Failures The most important economic policy goal within Euroland now seems to be employment growth. At the 'federal level', the EU does not appear to possess many instruments to combat large-scale unemployment. Traditional 'public budget' instruments for combating unemployment are limited by the small size of the European federal budget (approximately 1.2% of European GDP), by the supply-sidefiscaltightening implicit within the Maastricht Treaty and in the Stability and Growth Pact and by the limitations imposed on European Union public spending at Member State level (state aid) and at European federal level (Structural and Cohesion Funds). Indeed, only two major industrial policy instruments are available to the Member States or are centrally promoted by the EU: first, Treaty exemptions and derogations—the use of which is allowed by the Commission or the Council—to the general rule according to which 'the aid granted by a Member * University of Rome for Studies and Economic Analysis and Institute for Studies and Economic Analysis.

134

.

Working Paper VII

State or through state resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings ... is incompatible with the Common Market' (Article 87 EC [ex 92]); secondly, the direct use of the 'federal' European budget for the Structural and Cohesion Funds. The latter instrument should be, but not is always, consistent with the former, as Structural Funds are sometimes supplied to regions that are not authorised to receive state aid.1 More often, however, the objectives of Structural and Cohesion Funds2 are the same as those listed in Article 87 derogations. Their rationale consists in the acceptance or promotion of government interventions, 1 Community documents such as the "Council Regulations on the Tasks of the Structural Funds" (OJ (1988) L185) provide us with information on how aids are granted. In general aids are assigned to secure either productive investment and/or job creation. The Community identifiesfivemajor categories of acceptable aid tofirms:(a) aid for initial investment, or 'an investment infixedcapital' to set up a new establishment or extend an old one; such aid is calculated as a percentage of the investment's value— this value being established on the basis of a uniform set of items of expenditure (standard base) corresponding to the following elements of investment—land, buildings plant/machinery 'including certain categories of intangible investment' (Guidelines on National Regional Aid, OJ (1998) C74/06 at 8); (b) aid for job creation, tied to capital accumulation, where job creation is 'linked to the carrying-out of an initial investment project' (Guidelines on National Regional Aid, at 11), and the amount of aid does not exceed a certain percentage of the wage cost; (c) operating aid, which reducesfirms'current expenses, is normally prohibited, but is exceptionally approved where it 'is justified in terms of its contribution to regional development and its level is proportional to the handicaps it seeks to alleviate' (Guidelines on National Regional Aid, at 11); (d) aid to employment, not linked to investment that 'takes the form of grants and exemptions for certain firms from employers' social security contributions or from certain taxes' (Guidelines on Aid to Employment, OJ (1995), C334/04 at 5); (e) other employment policies such as those which concern individuals, do not affect trade between Member States, are general rules or are not covered by Art. 87; (e) training aid, since '[M]ost public financing in the training sphere does not fall within the scope of the competition rules; and is, in fact, directed to individuals (Art. 87(2)(a))—'[H]owever, where Member States introducefinancialand tax incentives to encouragefirmsto invest in training their workforce [. . .] it is for the Commission [...]. to examine training measures which are liable to constitute aid within the meaning of Article 87' (Framework on Training Aid, OJ (1998) C343/07 at 2), this being a typical case of externality that falls within the scope of Art. 87(3)(b). 2

On June 21, 1999, the Council adopted (in line with Agenda 2000), Council Regulation (EC), laying down general provisions on the Structural Funds (OJ (1999) L 161). The objectives of the Structural Funds have been reduced from seven to three: (a) they shall promote the development and structural adjustment of regions whose development is lagging behind; (2) they shall support the economic and social conversion of areas facing structural difficulties; and (3) they will lend support to the adaptation and modernisation of policies and systems of education, training and employment. It is clear that these three objectives are very similar to Art. 87(3) exemptions; indeed the Commission states that 'the consistency being sought [would] ensure that the regions in each Member State which are eligible under the Structural Funds could also be covered by a regional State-aid scheme' (Communication from the Commission to the Member States on the Links between Regional and Competition Policy, OJ (1998) C90/3 at 2).

1 - Justification for State Aids

135

either because 'initial conditions' are not competitive (the aid responds to damages caused by natural disasters or exceptional occurrences) or, because externalities make social benefits different from private ones (important projects of European interest, cultural heritage conservation, general education and training), or, finally, because acknowledged market failures arise (insufficient regional development, abnormally low standard of living, serious underemployment). The Rome Treaty declares state aids to be incompatible with the common market, only insofar as they distort competition and affect trade between Member States. Paradoxically, therefore, were state aids ineffective in combating and promoting unemployment they would, by definition, be nondistortionary and thus acceptable according to Article 87: effective state aids are only incompatible with the common market where they affect trade between Member States, so that state aids designed to implement the objective of reducing labour market disequilibria in Europe, should be encouraged only if they are effective in terms of stabilisation and growth, and do not affect the allocative function of the government. Unfortunately some experts are sceptical and others are very critical about the effectiveness of state aids and of the Structural Funds (less so of Cohesion Funds). All agree that these forms of European public budget intervention should never be open-ended. In some cases, the economic analysis of state aids suggests that their effect on market integration is not positive, and that they delay inevitable structural adjustments or trap Member States within a negative-sum game, which benefits some firms, but not the rest of society.3 In other cases, state aids are criticised for being both distortionary and ineffective, since they are specifically targeted, rather than being general in nature,4 or because they are not directed to the primary source of the market failure.5 However, if one looks for the basic sources of market failures, one finds general causes for the poor functioning of markets, and, in particular, nominal and real rigidities in price mechanisms or rigidities in rules and regulations that inhibit the proper working of economic agents and institutions. In this regard, state aids should not be encouraged in the absence of 'deep' structural changes, or should not be allowed at all, albeit for reasons different from those listed in Article 87. In any case, the underlying principles that sustain Article 87 exemptions and derogations, the use of Structural and Cohesion Funds and the understanding of their direct and indirect effects (for example, by means of the distinction made between tax impact and tax shifting), are theoretically complex. Moreover, they require a legislative approach in direct opposition to the 3

Martin & Valbonesi (1999). For example, with regard to tax exemptions on labour costs, the distinction between regional, cross-sectoral and industry-specific state aids is relevant, (European Commission 1997). 5 State aid to SMEs, for example, should be redirected to the capital market, whose imperfections result in underfinancing for SMEs; Community guidelines on state aid for small and medium sized enterprises, OJ (1996) C213. 4

136

Working Paper VII

European Simplification Procedure (SLIM), that has already been taken forward in three steps in 1996, 1997 and 1998.6 The theoretical and legal complexities inherent to state aids are not easy to tackle in operational terms and, as a consequence, state aids tend to be political hot potatoes since they give rise to many inter-country tensions, the numerous efforts to harmonise national practice in this area notwithstanding.7

III. Preliminary Conclusions on State Aids and Unemployment While derogations, exemptions, exceptions to the general competitive rule and concomitant governmental intervention (i) are considered necessary (ii) because growth and full employment have to be reached for equity purposes and for the maintenance of social and political stability such measures are also undesirable to the extent that they are cumbersome, logically incoherent and even more difficult to manage from a political viewpoint. A much neater manner to promote equity without compromising the balance between efficiency and competition within the basic principles of the EU, is to favour employment in a totally different manner. When market failures and absence of competition are observed, the EU, rather than allowing or promoting budgetary intervention, should encourage regulatory reforms that reinforce competitive conditions in line with the objectives of the single market: 'The internal market shall comprise an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured .. .'8

IV. The Principle of Mutual Recognition and Labour Market Failures Such an approach could entail the extension of the mutual recognition principle to labour contracts and national social security systems. According to 6 Council Resolution of 8 July 1996, on legislative and administrative simplification in the field of the internal market, (OJ (1996) C224/5-6). 7 The first attempt (since abandoned) to harmonise European state aid rules is described by Chassard (1999). The last attempt was afiscalone; this is a possible interpretation of the European Commission Report of October 22 1996, stating that in order 'to develop the taxation conditions for an optimal Single Market, the Commission will [. . .] clarify the scope and improve the consistent application of the Community competition rules, including the State Aid rules [...] The Community action in taxation must take full account of the principles of subsidiarity and proportionality. It does not seek harmonisation of taxation systems' (European Commission 1996). 8 Art. 14 EC [ex 7(2)(a)], introduced by the SEA].

1 - Justification for State Aids

137

Article 28 EC [ex 30], 'quantitative restrictions on imports and all measures having equivalent effect shall be prohibited between Member States'. This principle is now applied fairly comprehensively to the capital and commodity markets9—though, in view of the pharmaceutical products' example, is not fully applied even here—but has certainly not been adopted in the services and labour markets.10 Thus, in the 1979 Cassis de Dijon judgment,11 the ECJ ruled that any product imported from another Member State must, in principle, be admitted to the territory of the importing Member State if it has been lawfully produced: i.e., if it conforms with the rules and processes of manufacture that are traditionally accepted in the exporting country and it is marketed in the territory of the latter.12 It is, thus, sufficient that the objectives or effects of the relevant rules and regulations in other Member States are equivalent (not identical) to those of the importing country to be compelled to accept that import, which cannot be inhibited merely because technical specifications differ between countries; the idea is that all Member States care for their citizens and cannot be assumed to tolerate the production of unsafe or unhealthy products.13 Thus, over the last 20 years, the Cassis de Dijon principle has ensured that Germany or Italy cannot ban the import of French alcohol purely on the basis of the fact that German or Italian standards on the production of alcohol differ from French ones. However, following the current interpretation of the European Economic Constitution, French enterprises that supply Cassis de Dijon are still inhibited from producing the same alcohol within the Rhine Valley or the Chianti under the same contractual conditions that apply in the Cote-d'Or. If a French enterprise were to decide to open a subsidiary in the Rhein Valley or in 'Chiantishire', it would not be able to pay the same salary to its workers—even those moving for as little as 12 months and a day—once they had moved to Germany or to Italy; they would no longer be subject to their

9

The Commission's White Book on the completion of the internal market (European Commission 1985:18) declares that, while harmonisation should be limited in the future, mutual recognition should be the basic principle infixingessential rules in health and security areas. The principle of the mutual recognition has recently been extended to educational and service provision fields. 10 Padoa-Schioppa (1998). 1 ' Cassis de Dijon, ECR [1979]. 12 (Pelkman, Vos 8 di Mauro 1999). 13 According to Art. 30 EC [ex 36], restrictions on imports, exports or goods in transit are legal only if justified 'on grounds of public morality, public policy or public security; the protection of health and life of humans, animals or plants; the protection of national treasures possessing artistic, historic or archaeological value; or the protection of industrial and commercial property. Such prohibitions or restrictions shall not, however, constitute a means of arbitrary discrimination or a disguised restriction on trade between Member States'. Apart from these exemptions, the general rule is free movement and the absence of barriers to entry.

138

Working Paper VII

'home' compulsory pension schemes;14 equally, workers might not even be allowed to keep their supplementary pension schemes. A fortiori, the French enterprise would not be able to hire in Italy or in Germany Italian or German workers under French contractual conditions; meanwhile, Italian or German enterprises willing to produce the Cassis de Dijon in their country would be unable to hire their workers under the same conditions pertaining in Dijon.15 This situation arises since the current interpretation of Article 39 EC [ex 48] considers any differential in 'employment, remuneration and other conditions of work' among European workers of different nationality active in the same Member State to be a form of discrimination. This is usually labelled 'social dumping', a word with a strong ideological connotation that derives from the historic practice of paying lower salaries to poor immigrants from underdeveloped countries, but is now applied to labour mobility between wealthy countries. The social dumping thesis currently masks national interests or, more often, particular interests within each Nation that may give rise to contradictions both within and between Member States. A particular interest which is protected by the alibi of the social dumping thesis is the one of resident workers in each Member State who do not want any competition from outsiders, including non resident workers of another Member State; of course some social competition would, on the contrary, benefit the whole society of all States. Another example of internal contradiction is found in the rules on detached workers, whereby workers seeking personal social security privileges must make reference to their country of destination, while Governments are anxious not to lose any social security contribution and require a reference to the country of origin. It is obvious that if the principle of mutual recognition is not adopted in all four markets mentioned above (capital, labour, services, commodities), the single market will not fully exist. If this principle is not applied comprehensively, EU rules will themselves create barriers to entry, so inhibiting the full working of competition. Opposition to the extension of the principle of mutual recognition to the labour market and to social security systems is strong. It must be paid due attention in a dual manner: a) by setting a minimum or threshold level of harmonised rules that must apply in all Member States and that is set with benchmarking reference to the best practices in Europe (youth apprenticeship schemes in Germany(?), Dutch training programmes for older workers(?), UK supplementary pension schemes); French minimum wage(?); Irish tax rates and regulatory flexibility on labour (?) )and, b) by ensuring that the extension of the 14

Workers abroad moving for less than a year continue to pay social security contributions in the country of their immediate origin. 15 Regulation No. 1408/71 of the Council, on the application of social security schemes to employed persons and their families moving within the Community; Directive 96/71/EC, concerning the posting workers in the framework of the provision of services.

1 - Justification for State A ids

139

principle of mutual recognition is a positive-sum game for society, whereby the losers will be subsidised by the winners. Certainly, Europe's 18 million unemployed would benefit from the improved working of EU labour markets that would be created by the complete elimination of barriers to entry; in particular, young, first-time job-seekers, by definition 'outsiders' and far more mobile in geographic terms. Equally, firms would benefit from the higher opportunities and incentives to invest abroad and inside, within Europe being able to hire workers from preferred countries at the best contractual conditions. Finally, workers from states with high levels of social protection would be able to maintain their privileged treatments within their own national pension and health care schemes.

V. Preliminary Conclusions on the Principle of Mutual Recognition, the Labour Market and the Welfare State Clearly, the initial phase of the extension of the principle of mutual recognition to labour markets and to Welfare States may be followed by further innovations. Labour supply, employability and employment would all increase. Initially, workers of different nationality with different labour contracts and social security provision would be found within the same firms. Soon, however, each worker, regardless of nationality and residence, would be likely to begin to shop around for the best labour contract and social security provision. Such a tendency is already visible within current European proposals for supplementary pension schemes. The portability of supplementary pensions, however, will remain limited if current European rules are not changed. This explains why the European Commission Communication of May 1999 has addressed this problem in two interlinked ways:16 a) Pension funds should be able to call upon the services of approved asset managers for the management of their assets, wherever these are located in the Union. Service providers of supplementary pension products should be able to operate in all Member States [. . .]. b) [. . .] The mutual recognition of prudential regimes will also be needed. If a proposal for a directive could allow for such mutual recognition, it would be a first step towards cross-border membership. 16

European Commission (1999).

VIII Patrick Rey* On the Form of State Aid

I. Introduction Market forces have long been recognised as being a suitable instrument for the promotion of economic progress and efficiency. Still, there also exist wellknown examples of market failures, where a pure 'laissez-faire' approach may be inadequate, and where government intervention may thus be justified. This is the case, for example, for the provision of public goods and for those industries where economies of scale or scope call for a monopolistic or tight oligopolistic structure. Market failures also often arise from externalities that the markets do not properly internalise; pollution, for example, comes immediately to mind. The last two decades have seen a large emphasis placed on yet another reason for market failure, namely, informational asymmetries between the economic agents who are directly involved in transactions. This latter argument has, for example, been used to explain structural unemployment, credit rationing, and so forth. Market failures call for remedies and some form of government intervention, and state aid can provide such a remedy. Unfortunately, these 'remedies' can also be used for the wrong reasons (because of insufficient information, political capture and private agendas), so that the need for clear guidelines has become evermore apparent. The thrust of this paper is that government intervention should: (i) aim to correct a clearly identified market failure; (ii) correct this failure as efficiently as possible—and in particular, limit any interference with the desirable properties of market forces as much as is possible; and (iii), be subject to transparency rules, which should include, whenever feasible, the elaboration and publication of performance measures. While this act of faith may sound reasonable, if not trivial, the practice of state aid suggests that these three principles do not always clearly prevail. I will first consider the case of state aid in favour of R&D (research and development) which has a clear motivation, and which I will mainly use to illustrate point (ii). I will then comment on state aid for SMEs (small and mediumsized enterprises) and for the rescuing and restructuring of firms in difficulty, in order to illustrate point (i), before arguing that more effort should be devoted to the elaboration of performance measures.

* Professor, Institut d'Economie Industrielle, Universite des Sciences Sociales de Toulouse, France.

142

Working Paper VIII

II. State Aid for R&D: Which Form? R&D (and particularly fundamental research) is a public good and is, therefore, a good candidate for market failures: When considering whether to invest in an R&D project, a firm takes its own benefit into account, but not the positive externality for other firms or consumers who may also benefit from the project. As a result, a pure 'laissez-faire' regime generates too little R&D.1 This creates a clear motivation for public intervention,2 which can take several forms: patent policy and the granting of targeted and untargeted subsidies at both the ex ante investment stage and the ex post patenting stage. I will only concentrate here on state subsidies and, while they have been widely criticised for being wasteful, ineffective and too prone to political lobbying, I will focus more on their design than on their overall merits. A first important concern lies in the choice of beneficiaries. Consider, first, the case of targeted subsidies, aimed at particular sectors or firms, which involve much discretion in the choice of beneficiaries. Since knowledge spill-overs may be difficult to evaluate, and R&D projects involve much unpredictability, this discretion furnishes ample room for error. Moreover, it triggers a wasteful lobbying competition for subsidies and involves informational asymmetries between the government and the beneficiaries about the effective impact (additionality) of the subsidies. Subsidies not targeted at any particular firm or industry involve less discretion and are, thus, less subject to political lobbying. Unfortunately, however, they are even more likely to be redundant than targeted subsidies: since they do not specifically aim at projects that are 'marginal' (that is, that would not be undertaken in the absence of subsidies), untargeted subsidies are more likely to be wasted in financing infra-marginal investment that would have taken place anyway. While this concern may not apply to fundamental research, which does not offer many direct profit opportunities, it may be quite important for firms involved in various types of investment that they can easily cross-subsidise.3 The choice between targeted and untargeted subsidies thus resembles a choice between two types of inefficiency, which amounts to the granting of too much authority either to uninformed parties (the government or the agency in 1

The externality need not always be positive; for example, a successful R&D project may only allow a new entrant to 'steal' business from existing firms. The social value of such a project can be close to zero, and is clearly smaller than the private value for the entrant. For the sake of presentation, we will ignore this issue here and assume, instead, that R&D projects indeed generate positive externalities. 2 The Commission's Framework for State Aid for Research and Development (OJ(1996) C45) also refers to the 'considerable financial requirements and risks of R&D operations', which points to a rather different rationale, closer to a 'credit market imperfection' argument and, thus, potentially calls for different remedies. 3 According to Philippe Aghion and Peter Howitt (1998: 489), more than 50 percent of R&D-motivated fiscal deductions are considered to be redundant in France and several other OECD countries.

1 - Justification for State Aids

143

charge of targeting state aid), or to informed parties (firms) who may divert the aid into non-research activities by 'subsidising' research investments that firms would undertake anyway. This dilemma suggests that we should look for alternative approaches, striking a balance between the costs and advantages of these first two approaches. Paul Romer4 has, for example, proposed the delegation of the financing of R&D inputs to industries. Firms would take the initiative of creating 'industry investment boards' designed to subsidise R&D investments and, conditional upon their contributing to thefinancingof these boards, could benefit from government subsidies in the form of tax exemptions: a) Firms would submit proposals for the creation of an investment board. Proposals could, for example, involve the financing of relevant fundamental research {eg, within universities), of applied research activity within the industry, or of human capital investments, such as training or education, that help in the implementation of new technologies. b) The government would then review the application and, in particular, evaluate the balance of positive and negative externalities generated by the types of investment proposed by the firms. c) Applications accepted by the government would then be submitted to a vote among firms in the industry and would become operational once approved by a qualified majority of firms {eg, representing a given percentage of total industry sales). Once operational, approved investment projects would be financed by a tax on the firms output and the result of the research would be diffused in a non-discriminatory manner. Clearly, this reliance on the 'industry' raises several difficulties: how does one define an industry? What about projects that are relevant to several industries or projects leading to the emergence of a new industry? One concern here is that proposals might be biased toward incumbent firms and existing industries, and so facilitate collusion among them. The management of the investment boards might also raise difficult issues: if they share the same objective, firms may be tempted to free-ride on each others monitoring efforts, whilst, where objectives differ, the board may become unmanageable. Still, this proposal suggests that there may be clever ways to elicit, credibly and transparently, information from the firms on interesting research projects. I will now turn to the form of the subsidy, assuming that the choice of the beneficiary has already been made. Subsidies can take several forms: public investments in research centres or high-tech industries, research grants, participation in R&D funds, input subsidies or procurement contracts in sectoral programmes and credit guarantees. I will focus here only on one design dimension: ex ante versus ex post subsidisation. While, in practice, most targeted subsidies are given on an ex ante basis, economic analysis suggests that this may undermine the firm's incentives to run the research project efficiently.

(Romer 1993:345-390).

144

Working Paper VIII

Suppose, for example, that a research investment costs / and is successful with a probability that depends on the firm's 'effort' in running the project. The motivation for public intervention comes from the fact that the social value of a successful project, W, exceeds its private value, V. Therefore, it may be the case that a project is socially desirable but not privately profitable. For example, denoting by p(e) the probability of success as a function of the firm's effort e, and by c(e) the firm's cost of effort, this will be the case whenever: m&xep(e) W- c(e) > I > ma.xep(e) V- c(e). Two forms of subsidies can then ensure that the firm undertakes a socially desirable project: an ex post subsidy, given in the case of success and equal to the difference between the social and private value of the result of the research; or an ex ante or up-front subsidy, equal to the difference between the expected social and private values. While both types of subsidy ensure that the firm undertakes socially desirable projects, and only those, the latter type of subsidy does not contribute to the correction of the firm's incentive to run the project efficiently. For example, with the notation introduced above, the efficient level of effort would equate the marginal cost of effort, c - (e), to its social return, p = (e) W; in the absence of any correcting device, the firm will instead equate the marginal cost of its effort, c = (e), to its private return, p - (e) V, which is smaller (since the social value of the project is larger: W > V). As a result, the firm has too few incentives to provide the effort to run the project. In this context, an ex post subsidy, equal to W - V in case of success, successfully aligns the private and social returns of effort, and thus provides the firm with correct incentives to run the project efficiently. In contrast, an ex ante subsidy has no impact at all on the firm's choice of effort.5 Note that an ex ante subsidy can even have a negative impact on the firm's incentive to run the project, when it consists of an advance that is repayable in the case of success. Such a scheme actually works as an ex post tax on successful research projects and thus, other things being equal, discourages the firm from running the project efficiently. The fact that in 'the event of failure of the research concerned, the Commission (...) may allow a higher level of aid intensity' 6 may have similar perverse effects. 5 Since it cannot correct thefirm'sinsufficient incentive to run the project efficiently, it may be the case that an ex ante subsidy does not allow thefinancingof a project that could otherwise be socially desirable. In the example considered above, this will be the case when p(e™)W- c^e™) > I > pte^W- c^*), where e w and e v < e w , respectively, denote the socially efficient and the privately optimal levels of effort; in that case, an ex ante subsidy equal to the expected difference/>(ev)( W- V) does not suffice to induce the firm to undertake the project; conversely, an ex ante subsidy equal to p(ew)(W- V)) would ensure that the project is undertaken, but this is not socially desirable since the project will still not be run properly. 6 Para. 5.6 of the Framework for State Aid for Research and development (OJ (1996) C45). This leniency with regard to failure also favours, from an ex ante perspective,

1 - Justification for State A ids

145

Of course, good reasons may explain the prevalence of ex ante subsidies in practice. One factor may be a lack of credible commitment on the behalf of the government, further reinforced by the length of research projects and the nonverifiability of the ex post innovations. However, reputation may largely contribute to solve this type of problem, since we are not dealing with one-shot programmes, but with ongoing and repeated public support for R&D. Another reason may come from the fact that, due to the risks involved and the asymmetry of information between firms and creditors about highly specific projects, R&D firms are credit-constrained ex ante. However, this fact refers to an argument that is different from the 'public good' argument, and may thus call for a different type of public intervention (see the discussion of state aid for SMEs, infra). Note, finally, that neither form of subsidy deals with the source of the market failure, namely, the fact that the research may benefit parties other than the firm engaged in the project. In other words, a subsidy may ensure that the firm undertakes the project, but does not ensure that the other parties that could benefit from it do, in fact, receive those benefits. This has lead Michael Kremer7 to suggest an alternative form of intervention, which also addresses the informational problem mentioned above: once a research project is successfully completed, the government should run an auction for the patented result of the project, in order to identify the private value of the innovation. The government should then apply an appropriate multiplier to account for the externalities generated by the research, buy the patent at the multiplied price 8 and make its content universally available. This mechanism has several interesting properties: a) it allows the government to obtain the information regarding the (private) value of the innovation that is available to firms; b) it rewards the innovator appropriately, thus giving adequate incentives to invest in R&D (it works as an ex post subsidy); c) it allows all interested parties to benefit from the innovation. Of course, the first point relies on convincing auctioning. Monopolistic or collusive behaviour may, for example, prevent the government from identifying the true private of the innovation. 9 Moreover, this mechanism supposes that the

those projects that are less likely to succeed. And while subsidising failed projects may, ex post, be less likely to affect competition (an argument given in the same para, of the Framework to justify this leniency toward failure), the same is not true from an ex ante perspective. 7 (Kremer 1998:1137-1167). 8 The government must actually commit itself to leave the patent to the winner of the auction. 9 In particular, the firm that has conducted the project has an incentive to overbid for (keeping) the patent and to collude with other firms to raise the winning price. Kremer proposes dealing with this issue by using the third or fourth bid price to compute the social value of the innovation.

146

Working Paper VIII

government knows the value of the multiplier.10 Yet, this mechanism offers interesting perspectives for the implementation of public support for R&D. The bottom line is that, whenever possible, it would be useful to resort to 'competitive mechanisms' (auctions) to determine the beneficiaries of aid, as well as its level and its form.

III. Identifying the motivation While state aid for R&D can clearly and specifically be motivated by the existence of knowledge spill-overs (even though, as already mentioned, other motivations such as credit-rationing due to large risks and informational problems are also sometimes put forward), other forms of state aid are sometimes more loosely motivated, so that the link between the source of the market failure and the proposed remedy is less transparent. The case of restructuring aid is an extreme example. In its Community guidelines on state aid for rescuing and restructuring firms in difficulty, the Commission mentions that such aid 'may be warranted, for example, by social or regional policy considerations, by the desirability of maintaining a competitive market structure (. . .), and by the special needs and wider economic benefits of (SMEs)'. This constitutes a range of very different motivations, calling for different types of remedy. If, for example, the primary motivation is the social cost of lay-offs, it may be desirable to attach the aid to the workers rather than to the firms in difficulty: for example, the aid could take the form of tax relief attached to the workers, in order to help them move to other firms or industries (the same argument applies to employment aid, which currently seems to be attached to firms that maintain or create jobs for certain types of workers, rather than directly attached to those workers)." Rescuing and restructuring aids are also troublesome in that they may have perverse dynamic effects. First, when large internal agency problems prevent firms from behaving efficiently, state aids may further exacerbate those agency problems and result in exactly the opposite result of what they aim at.12 10

Based on previous empirical work, Kremer argues, for example, that 2 would constitute a reasonable value of the multiplier for the pharmaceutical sector. 11 German experience with regard liberalisation of the rail transport industry is interesting here: a new structure was created, and the employees of the old railways companies were required to choose between being directly employed by DBAG under private sector labour conditions and joining the new structure with their civil servant status. DBAG can use the services of these employees under the private contractual conditions; the federal government subsidises the difference. With this mechanism, DBAG does not support non-competitive cost conditions, while its former employees preserve their social advantages. 12 See (Aghion, Dewatripont & Rey 1998), for an analysis of this point, and (Neven et al 1999), for a detailed scrutiny of firms confronted with large agency problems.

1 - Justification for State Aids

147

Secondly, even in the absence of such internal agency problems, state aid introduces an element of 'soft-budgetary constraint' that reduces the firm's incentives to adapt themselves. Both problems demonstrate that a very cautious attitude must be taken towards this aid and that a burden of proof must be placed on the parties who propose such aid.13 Similarly, in its Community guidelines on State aidfor small and medium sized enterprises, the Commission justifies aid in favour of SMEs with reference to: the difficulty in obtaining capital and credit, the chief causes of which are imperfect information, the risky nature of financial markets and the limited guarantees that SMEs are in position to offer; SMEs limited resources also restrict their access to information, notably regarding new technology and potential markets. The introduction of new regulatory arrangements often entails higher costs for SMEs.

This again represents a vast array of motivations, the economic foundations of which—and thus their remedy—are not always clear. For example, the fact that SMEs have more limited access to information, or suffer more from regulatory changes, can be seen either as a form of inefficiency (which should not be artificially corrected, since this would discourage the adoption of more efficient ways of conducting business), or as a characteristic of the cost structure (large fixed costs that cannot be supported by small businesses), which might best be addressed by promoting information on SMEs (eg, through an aid for firms that provide such information, or by facilitating co-ordination among SMEs in this domain), or by reducing the regulatory burden of SMEs, rather than by attaching aid to the investments made by SMEs. Similarly, the imperfect information argument brought forward to explain the particular difficulties faced by SMEs in accessing credit and capital, may best be answered by a policy supporting the emergence of rating agencies specialised in SMEs, rather than by directly subsidising investment in SMEs. This brief discussion suggests that it may be desirable to require a clear specification of the market failure that the aid aims to correct, together with an explanation of why the proposed aid is likely to be the best remedy for this market failure, for example, as compared with remedies more directly targeted at the source of the market failure rather than at its consequence.

IV. Performance Measures Measuring the performance of state aid is certainly a difficult task. Still, it is striking to see that very little effort is devoted to this task. The last report from 13

This is not to say that industries in decline do not call for some type of public intervention. The management of overcapacities, for example, may lead to disasters (in the form of attrition wars or simultaneous breakdowns) due to co-ordination failures; this may, however, call for more leniency towards horizontal agreements among the firms aiming at 'organising the exit', rather than that of subsidies artificially prolonging the activity of the existing firms.

148

Working Paper VIII

the Commission on state aid,14 for example, gathers together a large set of data on the volume and trend of aid (by sectors and by type), but says nothing about the impact of this aid. This is reminiscent of the problem of Jules Dupuit, who knew the cost of a bridge, but not its value—which eventually lead him to develop the notion of consumer surplus. An insistence on performance measures would have several merits. First, it would reinforce the need for clear and explicit justifications: governments, for example, could not offer performance measures without first stating the motivation for the aid precisely. Secondly, it would promote a greater efficiency and equity within the Community, by identifying the return on various state aids. Thirdly, it would serve an advocacy role, by making more of the relationship between the costs and the benefits of various forms of aid transparent. Fourthly, it might enhance the state aid mechanism, for example, by allowing the renewal of an aid to be based upon its observed performance. Lastly, if the implementation of state aid control is to be decentralised at national level, such performance measures may help to maintain a certain level of coherence within the EU. Again, I do not wish to understate the difficulties associated with the measuring of the impact of a particular aid. Still, it may be difficult to claim that a particular aid is warranted and, at the same time, to assert that its impact cannot be measured at all. It may, thus, be fair to require the proposers of a state aid to give at least some indication of its performance. 14 Seventh Survey on State Aid in the European Union in the Manufacturing and certain other Sectors, COM (99) 148 final.

IX Paul Seabright* Are Cohesion Policies Coherent? Microeconomic Tensions Between State Aids and Regional Policy

I. Summary of Argument a) State aids policy and Structural Funds policies both screen aid to projects. b) They use different criteria of evaluation. c) These create incompatibilities: projects acceptable on one set of criteria are not acceptable on the other. d) However, these two policies should not use the same criteria. e) This is partly because the projects are financed from different sources, and also because of different assignments of Treaty responsibilities. f) It is, therefore, reasonable to seek to eliminate unnecessary inconsistencies, but not to hope for complete compatibility between the criteria of evaluation used by the two sets of policies. g) In order to improve compatibility, there should be explicit use of costbenefit analysis of those state aids in assisted areas that appear, on a first screening, to threaten to distort competition.

II. The Inevitability of Inconsistency The Structural Funds and the control of state aids are two mechanisms through which EU policy aims to influence economic activity in the Member States in harmony with the cohesion objective. Both involve the EU in evaluating projects that commit resources to finance economic activity in the Member States. Yet, these two sets of policies operate in very different ways, and evaluate the projects concerned according to different criteria of evaluation. The Structural Funds involve the expenditure of the EU's own resources in an attempt to raise income levels in the less prosperous regions of the Union. State aid control is not about spending EU resources but about screening the proposals Member States make for spending their own resources. And the question to be asked about state aids is not whether they represent a good use of Member States' own resources but (according to Article 87(1) [ex 92(1)]) whether they distort competition in the common market. Only if the answer to this question is positive does it become appropriate to argue in mitigation (under Article 87(3) * University of Cambridge.

150

Working Paper IX

[92(3)]) that the resources in question serve to raise income levels of less prosperous regions. Given the different character of these two kinds of policy it is hardly surprising that there is potential for inconsistency between them, or that the rigorous application of one may detract from the effective implementation of the other. It is clear that, if different criteria of evaluation are used under the two types of policy, projects that are acceptable under one set of criteria will sometimes be unacceptable under the other. Inconsistency may arise for one of two main reasons.

A. Who Pays? The source of the resources expended in the two cases are not the same. EU Structural Funds are financed from the EU's own resources, and thus come out of the pocket of the average taxpayer in the EU as a whole. State aids in the Member States are financed from the Member States' own resources, and therefore come out of the pocket of the average taxpayer in the Member State concerned. Whether or not a given project contributes to cohesion, depends not just on who benefits but also on who pays. Consider, for example, aid to a project in the Lisbon area. Assume the project is not quite profitable according to ordinary criteria of cost-benefit analysis. The question nonetheless arises as to whether it contributes sufficiently to cohesion to compensate for this. Lisbon is poor relative to the EU as a whole, but rich relative to the rest of Portugal. If the project is financed from EU resources, it will probably contribute to cohesion, since it will involve a transfer to Lisbon from the rest of the EU. If it is financed from Portuguese taxes it probably damages cohesion, since it involves a transfer to Lisbon from the rest of Portugal.

B. Whose Initiative? The EU has quite different responsibilities in respect of state aid control and the management of the Structural Funds. Where the Structural Funds are concerned, the EU's responsibility concerns the issue of whether the expenditures indeed advance the goals of cohesion. This, in turn, involves the satisfaction of two criteria. First, is the region in which it takes place one of those designated as beneficiaries of EU regional aid? Secondly, and conditional on thefirst,is the expenditure reasonably productive; that is, does it actually raise incomes in the region concerned to a satisfactory degree? When it comes to state aid control, by contrast, the Treaty gives the EU the right to intervene only if the expenditure 'distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods'. It is true that the latter criterion is vague, but only by coincidence would it screen projects in the same way as the

1 - Justification for State Aids

151

former. However, if a given state aid project does indeed threaten to distort competition, one of the grounds on which it may be exempted is that it promotes the development of a region with abnormally low living standards.

III. How Much Consistency Can We Reasonably Hope to Achieve? The argument so far has shown that the screening process in state aid control and that in the Structural Funds give different answers because they ask different questions. They are further constrained to ask different questions because they reflect different constitutional responsibilities, and also because they involve the expenditure of resources from different pockets. However, that does not mean that consistency is irrelevant. On the contrary, the least one can hope is that these policies will ask similar questions whenever their constitutional responsibilities allow them to do so. It is also reasonable to hope that, when and to the extent that these policies do ask similar questions, they employ criteria that will lead to similar answers. There does not seem much scope for consistency between the questions required by Article 87(1) and those required of the Structural Funds. Whether aid distorts competition depends upon the conditions of competition in the markets concerned and not upon the issue of whether the region is eligible for special treatment under EU Regional policy. So, in particular, if aid does not distort competition, there is no constitutional basis for the EU to intervene in its allocation on the grounds of its contribution or lack of contribution to the cohesion objective. Still less is there a basis for the EU to criticise it on grounds of general efficiency. If the aid is a waste of the Member State's own resources, but does not distort competition, Article 87 gives the EU no right to intervene. However, if the aid does distort competition, Article 87(3) then legitimates the posing of very similar questions to those required by the allocation of Structural Funds. If aid to a project distorts competition, then one important argument in its defence is that it contributes to raising the income of a region that is particularly deserving on cohesion grounds. If a region is deserving of the EU's tax resources on cohesion grounds, then it is also deserving, on those very same grounds, of the EU's indulgence for any distortions of competition it may inflict on other Member States in pursuit of the cohesion objective. To this extent, it is reasonable for the list of eligible regions for Structural Funds to be the same as the list of regions eligible for indulgent treatment in the event that their state aids risk inflicting distortions of competition on the common market. The recent changes which require congruence between the lists of regions eligible for EU aid and those eligible for favourable treatment under Member States' own aid are indeed based on a reasonable idea. This idea is that cohesion may require a sacrifice of efficiency in the use of the resources of the

152

Working Paper IX

remainder of the EU, and the regions in which this sacrifice can reasonably be required, should be the same under the two types of policy. However, this does not imply that the criteria for evaluation of projects in the regions concerned should, therefore, be the same. Even if projects take place in underdeveloped regions, this does not (or should not) imply that they are automatically approved. It needs to be shown that they do indeed contribute to the cohesion objective. As has already been pointed out, the resources for Structural Funds and for state aids come from two different pockets. State aids are paid for by the taxpayers of Member States, while Structural Funds are paid for by the taxpayers of the whole EU. This means that the stringency of the tests a given state aid project needs to pass before it can be deemed to contribute to the cohesion objective should depend on whether the region is underdeveloped relative to the Member State rather than relative to the EU as a whole.

IV. Current EU Policy and the Effects of the Recent Changes Besley & Seabright (1999) have recently examined EU state aids policy in some detail. They conclude that policy is insufficiently systematic, and, in particular, that it fails to identify cross-border effects before diagnosing a distortion of competition. Often the existence of trade between Member States in the sector in question is treated as a sufficient condition for the aid to be distorting, even when the firm has negligible market power. Fortunately, the inclusion of a competition factor in the evaluation of aid in the new Multi-sectoral Framework will allow for some improvement in this respect, though it falls far short of the kind of systematic treatment that is recommended. Regional aid guidelines are likewise unsatisfactory, since they stipulate arbitrary ceilings on aid intensities, without any judgment as to whether the aid concerned contributes to the cohesion objective. Here, recent changes are unlikely to lead to much improvement for two reasons: a) As of the year 2000, Article 87(3)(a) and the new Objective 1 regions assisted by the EU Structural Funds will fully overlap. However, the changes require consistency between the beneficiaries of regional policy under the two regimes, without recognising that there is no consistency in the sources of funds to finance the projects concerned. Whether aid contributes to the cohesion objective depends as much on the latter factor as on the former. b) The new aid ceilings are lower, but remain as arbitrary as the old ones. In principle, as has already been argued, aid cannot be assumed to contribute to the cohesion objective unless some assessment is made as to its effectiveness in raising incomes in the cohesion regions. In particular, aid to one cohesion region at the expense of taxpayers in another cohesion region will not contribute to the cohesion objective unless its benefits in the former region out-

I - Justification for State Aids

153

weigh its costs in the latter. This means that, if there is to be a proper coherence between the policies, some form of (perhaps simplified) cost-benefit analysis is an inescapable part of the process of evaluation. Cost-benefit analysis has, in fact, been introduced to a limited degree in the new Community Framework for Aid to the Motor Vehicle Industry. Its actual implementation remains somewhat contradictory, however, because it essentially allows for aid to be approved according to the cost handicaps suffered by a firm undertaking investment in an assisted area (relative to setting up in some alternative location). Perversely, this implies that aid is more likely to be approved if the project has high costs—whereas it should be the benefits to the assisted area that count! However, the principle that not all aid in assisted areas is equally valuable is an important principle to establish. Extending such a principle to all aid (not merely to the motor vehicle industry) should be a priority of EU policy. But, in practice, it is important for such aid to be evaluated according to its benefits to the assisted area rather than its costs to the assisted firm. Provided such evaluations take fully into account the fact that the resources involved may also come at the expense of taxpayers in an assisted area, they may contribute significantly to an improvement in the coherence of EU policy towards assisted areas.

V. Conclusions In conclusion, EU Structural Funds and EU state aid policy will inevitably classify aid projects somewhat differently, because they necessarily ask different questions of the projects concerned. State aid policy asks, first, whether the project distorts competition in the common market, and only if the answer to this question is positive does it consider the overall justification of the aid in terms of the cohesion objective. This means that many projects that do not contribute to cohesion will be approved since they do not distort competition, and there is nothing the EU can or should seek to do about this. However, it is quite reasonable for the EU to seek to ensure that, when the contribution of a project to the cohesion objective is evaluated, this should be done according to consistent criteria. The following constitutes a structured list of questions that should be asked of all state aid projects that, on a first screening, do threaten to distort competition in the common market: a) Is the project taking place in one of the Objective 1 assisted areas? If not, there are no cohesion grounds for accepting the risks to competition posed by the project—there may, however, be other grounds, such as aid to SMEs or to R&D. b) If the answer to question a) is positive, does the project contribute to increasing income in the area concerned? This involves assessing its benefits,

154

Working Paper IX

suitably weighted by the extent of backwardness of which the area concerned. c) What are the costs of the project in terms of the tax resources used to finance it? This involves weighting the fiscal costs according to the backwardness of the regions from which the tax resources come. For instance, if the aid is from the Portuguese national budget, its contribution to cohesion will depend on the average income of the assisted area relative to Portuguese national income. If the aid comes from the budget of the Land government of Bavaria, its contribution to cohesion will depend on the average income of the assisted area relative to the average income of the Bavarian region. Obviously, administrative and time constraints will limit the rigour with which this analysis can be performed. But, microeconomic consistency cannot be achieved unless some approximation to this analysis is undertaken. The recent changes in state aid guidelines represent a small, though inadequate, step in the right direction.

X Fabienne Ilzkovitz, Roderick Meiklejohn and Jan Horst Schmidt* The Control of State Aid: A Proposal for a Co-ordinated Approach

I. Introduction State aid that is likely to distort competition and affect trade between Member States is subject to Community control. This control of state aid is almost unique to EU competition policy. Only within EFTA is there in a similar system of supranational control over the subsidies granted by states to enterprises: a system which owes its existence to the need to harmonise competition policies in the European Economic Area. Other regional economic groupings, and even federal states, lack mechanisms for controlling the subsidies granted by their constituent parts. For example, in the US, the federal government has no mechanism for controlling or even co-ordinating the aid granted by the states, even though such aid is covered by the GATT Subsidies Code. The benefits of state aid control are clear. The distortions of trade that result from state aid can lead to disputes between national governments and to retaliatory measures which would be harmful to the cohesion of the Community. By subjecting state aid to common rules, enforced by a supranational authority (the European Commission), the Treaty has largely eliminated an important potential cause of friction between Member States. Community control also has strong advantages from a more strictly economic point of view. In many circumstances, subsidies can reduce economic welfare, because they can weaken the incentives for firms to improve their efficiency and so can enable the less efficient to survive, or even expand, at the expense of the more efficient. Furthermore, unless some form of supranational discipline is imposed, competition between governments to attract investment can lead to costly races for subsidies. These risks are reduced when state aid is scrutinised by an external body on the basis of objective criteria. From the point of view of economic integration, the EU's system of control of state aid makes an important contribution towards the breaking down of barriers which might impede the functioning of the single market and Economic and Monetary Union. This paper surveys the main problems raised by state aid in terms of competition distortion and budgetary discipline, and further suggests that the European Commission's control of state aid needs to be supplemented by a concerted self-discipline effort on the part of the Member States themselves. We * The authors are officials of the Directorate-General for Economic and Financial Affairs of the European Commission but the views expressed in this paper do not necessarily reflect the official position of the Commission.

156

Working Paper X

stress that the proposals made here are not intended to replace, but to reinforce the existing system of control. In analysing the problems posed by state aid, it is important to take a critical view of the arguments put forward in their support. In addition to the assessment of the competition effects, every state aid raises the following questions: a) Is there a need for government intervention? b) Is state aid the most appropriate form of intervention, or would other policy instruments be more effective? c) Given the objective of the intervention, is the state aid targeted on the right beneficiaries? d) Is the amount of the aid sufficient to induce firms to change their behaviour in the desired way, without being excessive? e) Do the conditions attached to the aid create the right incentives, or do they rather encourage rent-seeking behaviour? f) Is the aid cost-effective? This paper argues that, although all the above questions are, to some extent, relevant to the assessment of state aid under the EU's competition rules, they are also questions of vital importance to the Member States themselves. It is in each Member State's own interest to review existing aid and to evaluate proposals for new aid in the light of the answers to these questions. Furthermore, the superior information available to the national authorities places, them in a better position to make a thorough assessment covering all these aspects. Consequently, national self-discipline is an essential complement to Community control. In view of the cross-border spillover effects of state aid, this self-discipline would be more rigorous and politically more acceptable if the efforts of the Member States were to be co-ordinated. To this end, the Commission has included recommendations on state aid in the 1999 Broad Economic Policy Guidelines (BEPG), which, as from this year, will pay much greater attention to structural reforms in the Member States. The monitoring of the implementation of the Guidelines will provide a framework for the exchange of information and concerted action to reduce the level of aid.

II. The Benefits and Costs of State Aid A. Benefits Essentially, the justifications for state aid are based on the identification of market failures. The standard model of perfect competition demonstrates that total welfare would be maximised by the free working of market mechanisms given a number of radical assumptions, such as perfect information and foresight,

1 - Justification for State A ids

157

perfect factor mobility, no economies of scale and no externalities. However, since the real world does not correspond to these assumptions, government intervention may increase total welfare. Article 87(3) [ex92(3)] of the EC Treaty implicitly acknowledges this rationale by foreseeing a number of grounds for derogation from the principle of prohibition established in Article 87(1) [92(1)]. Nine main types of market failure are relevant to the analysis of state aid: a) public goods, for example, lighthouses, street lighting, policing; b) merit goods, for example, cultural and educational services; c) increasing returns to scale, which tend to lead to oligopolistic or monopolistic markets; d) externalities, both positive (for example, pollution) and negative (for example, vocational training or research and development); e) imperfect or asymmetric information—notably in capital markets—which may affect the ability of small and medium-sized enterprises and innovative firms to obtain finance; f) institutional rigidities, notably in the labour market; g) imperfect factor mobility, which is relevant to the problems of unemployment and regional disparities; h) frictional problems of adjustment to changes in markets, which constitute a special aspect of imperfect factor mobility; and i) subsidisation of foreign competitors. Income redistribution constitutes an additional reason for government intervention. In general, state aid seems to be a poor instrument for achieving this objective, since it is difficult to target it on those most in need of aid and since, by favouring particular activities or products, it distorts patterns of consumption and production. Indeed, state aid is an appropriate means of intervention, only if the government wishes to influence economic behaviour in some way. Consequently, if an aid has a purely redistributive effect, with no impact on behaviour—other than a general increase in consumption or saving by the recipients—this would normally indicate that the state aid has failed to achieve its purpose. Even when a market failure is correctly identified, government intervention should not be a foregone conclusion. Whether such intervention will actually be welfare-enhancing depends on a number of factors, including, in particular, whether it is unduly influenced by certain interest groups (government capture) and whether the government possesses better information than market players. A study carried out for the Commission1 could find little or no correlation between the Member States' relative expenditure on various types of aid, and indicators of the importance of the market failures that they are deemed to address. For example, aid to SMEs was found to be unrelated to the relative importance of SMEs in each Member State's economy. To a limited extent, this 1

Fundacion de Economia Anah'tica (1998), 'State aid and convergence in the European Union' (not published).

158

Working Paper X

can be explained by the disparity in the budgetary resources of the different Member States and by the difficulty of classifying aid unambiguously,2 but it also reflects differing assessments of the importance of the market failures and the effectiveness of subsidies, as well as different responses to pressure from the favoured industries. Assuming that there is a real need for intervention and the government is, in principle, capable of doing so effectively, state aid is not necessarily the appropriate instrument for achieving the objective. The correct type of instrument has to be chosen from a wide panoply, including regulation, direct government provision of certain goods or services, taxation and state aid. Each of these instruments has its own peculiar advantages and disadvantages. Consequently, each deserves separate analysis and, indeed, each is subject to different rules in the EC Treaty. The fact that we concentrate on state aid should not be taken to imply that it is necessarily the most distortive or the least efficient instrument. Whichever instrument is chosen, the precise rules governing the intervention must be carefully considered in order to minimise distortion of competition, evasion, abuse or the creation of perverse incentives. The interaction of aid with other government measures also needs to be taken into account.

B. Costs 1. Budgetary CostlEfficiency Cost of Public Funds The government's expenditure in implementing any policy must be financed. From the public finance point of view, this raises the question of determining priorities, given the constraints imposed on the budget by the politically acceptable level of taxation and the sustainability of the public debt. From the standpoint of welfare economics, it raises the issue of the marginal cost of public funds, or, the loss of efficiency due to taxation. In budgetary terms, expenditure on state aid in the EU is not vast: on average, 2.4% of General Government Expenditure in 1995-1997, although more than 3% in Germany, Ireland and Italy 3 Nevertheless, state aid competes for scarce budgetary resources with many other important activities. In addition, public funds have an efficiency cost, due to the distortions in the economy caused by taxation. These distortions are of two basic types, the importance of which depends on the structure of taxation: distortion of con-

2 For example, in Member States whose entire territory is eligible for regional aid (Greece, Ireland, Portugal), much aid for SMEs may be classified as regional aid. 3 These figures exclude aid to agriculture. Total state aid including agriculture amounts to 2.8% of Gross Government Expenditure in the EU. European Commission (1999), 'Seventh Survey on State Aid', SEC(99)148 of 30.3.1999.

1 - Justification for State Aids

159

sumer choice and distortion of incentives. American estimates of the marginal welfare cost of taxation are in the range of 15-50%.4 2. Competition Distortion The distortions of competition caused by state aid are, of course, the main focus of attention in the European Commission's analysis. They are important for two reasons. The first of these is political: when aid affects trade, it has a potential to cause serious disputes between Member States. Without control by the European Commission, these disputes could lead to a spiral of retaliatory measures. The second reason is economic: competition distortions damage the allocative efficiency of the European economy. As there is a vast literature on the problem of the trade distortion caused by subsidies, it is not necessary to discuss this aspect in detail here. However, it is important to bear in mind that the competitive conditions within a country can be distorted by the aid granted by its own government. Thus, for example, domestic welfare can be reduced by aid given to an inefficient company, which enables it to maintain or increase its market share at the expense of more efficient competitors. 3. Distortion of Allocation Between Economic Activities Assuming that state aid influences the behaviour of the recipients, aid granted to promote one industry will cause a shift of scarce private resources to that industry and away from others. This is obviously true in a closed economy with full employment, but it is also true in real-world situations where we see underemployment and a degree of mobility of the factors of production. 4. Rent-Seeking Behaviour and 'Capture' of Government by Industries The possibility that subsidies might be obtained, inevitably leads to lobbying by firms, sectoral organisations and employees' representatives. Effort may be devoted to such activity at the expense of innovation and the development of measures designed to promote adaptation to changes in the market. Governments may be especially vulnerable to such lobbying in areas where the governing party's electoral support is insecure. Because the budgetary cost is spread widely over the whole tax base, while the benefit to the recipients is large and clearly perceived, subsidies can be used by governments to strengthen their political position in selected areas, or amongst selected social groups, with a risk that they will suffer a substantial loss of support elsewhere. Even if we assume that governments are not influenced by such considerations, they can still be 'captured' because they do not possess the specialised 4

All such estimates are extremely sensitive to the underlying assumptions and estimated parameters (Browning 1987).

160

Working Paper X

information available to the industries concerned. Skilled lobbyists can, therefore, use biased or false information to persuade governments to grant subsidies or to influence the amount of the subsidies granted. The risk that firms may be encouraged to divert their efforts to rent-seeking, as well as the danger of 'government failure', suggest that a cautious attitude towards state aid is the best general policy. 5. Perverse Incentives Another danger presented by state aids is that, unless carefully designed, they can create perverse incentives. An obvious example is a subsidy covering the difference between the market price of a product and its average cost. Clearly, such a subsidy would remove the incentive for the recipients to reduce their costs. Similarly, a subsidy for the cost of disposing of waste materials in an environmentally acceptable manner, could discourage firms from seeking ways to reduce the amount of waste produced. 6. Moral Hazard As far as state aid is concerned, moral hazard is principally a problem in relation to support for failing firms. The expectation that, if the worst comes to the worst, the government will not allow the company to fail may lead some managers to delay the taking of difficult decisions on restructuring and may tempt others to expose their companies to excessive risks. Lenders may also be tempted to underestimate commercial risks in cases where the borrower is perceived to be 'too big to fail'.

C. Need to Weigh Benefits Against Costs The measuring of the costs and benefits of a government action is usually a difficult task. For small items of expenditure, or actions that are unlikely to impose large social costs, it is not cost-effective to apply elaborate evaluation methodologies. However, where the budgetary cost or the potential social cost is high, it is worthwhile undertaking formal cost-benefit analyses, both ex ante and ex post. In particular, it is essential to review major aid schemes regularly, in order to ensure that they are still necessary and that they are producing the expected results. The principle problem of evaluation is that of defining the counterfactual: what would have happened in the absence of intervention? Various methods are available for dealing with this problem. None are perfect but all have, at the very least, the virtue of drawing attention to the need for evaluation and of requiring policy-makers to formulate their objectives and assumptions explicitly. Furthermore, we can expect that techniques will improve if greater political importance is attached to the task of evaluation.

1 - Justification for State Aids

161

When account is taken of the opportunity cost of public funds (the alternative uses to which they can be put) and their efficiency cost, subsidisation is often an inferior way of correcting market failures. The evaluation of state aid should, therefore, always include a comparison with the alternative instruments which could be used to achieve the same policy objectives. In applying the competition rules of the Treaty, the Commission's primary focus must be on the competitive distortions created by state aid. The Commission cannot take full account of all the costs and benefits involved, both because of the legal limitations on its competence and because of its relative lack of information. It is better that the Member States consider the wider aspects when they draw up new aid schemes or review existing ones. The Member States are better placed than the Commission to assess whether a state aid is the most appropriate means of achieving the desired objective or whether an alternative approach (for example, regulatory changes) would be not only feasible but also more effective.

III. The Need for Stronger Discipline: A Co-ordinated and Decentralised Framework Despite the existence of state aid control at Community level, there is a need for stronger discipline within the Member States. A strategy for reducing relatively inefficient aids, and so contributing to a better use of public resources, will be particularly important with the advent of EMU, because it will contribute to theflexibilityof product markets and will help governments to resist pressures from companies facing increased competition. Together with a macro-economic framework geared towards stability, flexible product markets are an important ingredient of a well-functioning EMU. Without a sufficient degree of competition, product prices and mark-ups will be set too high and companies will be less efficient and innovative. This not only leads to the sub-optimal utilisation of economic resources, lower growth and employment, but it can also affect the capacity of the economy to adapt to macro-economic shocks. In the absence of a rationale for state aid, such as market failures, subsidies tend to prevent markets from working efficiently and lead to welfare losses. Thus, competition policy, and, in particular, the control of state aid, have an important role to play in safeguarding or enhancing the flexibility of product markets within EMU. However, by increasing price transparency, reducing cross-border transaction costs and eliminating exchange rate risk within the Euro area, EMU will also increase the competitive pressures on companies. Thus, some companies will inevitably experience difficulties and Member States are likely to come under strong pressure to protect these companies by means of state aid, notably rescue and restructuring aid. Such aid can lead to important distortions of competition at the expense of more efficient companies. Another danger

162

Working Paper X

associated with such aid is that it will perpetuate the old, unviable structures rather than promote a genuine adjustment to new economic realities. The knowledge that government is willing to intervene to rescue firms in difficulty may also give rise to the 'moral hazard' problem mentioned above. Finally, the instruments at the Commission's disposal for the direct control of state aid (Articles 87-88 [ex 92-94] of the Treaty) are directed at individual cases or schemes. But no instrument exists to control total aid volumes. Thus, a strategy of state aid reduction would be more successful, if it were it to rest upon the self-discipline of the Member States. This exercise of selfdiscipline would be more efficient and rigorous if the efforts of the Member States were to be co-ordinated. Indeed, several reasons plead in favour of the co-ordinated reduction in state aid. First, there are negative spillovers associated with state aid. These negative spillover effects occur not only because national governments ignore international externalities—risk of trade distortion, risk of adverse impact on the operation of the Single Market—but also because they deliberately use state aid as a strategic weapon: for example, the risk of the bidding-up of subsidies. Given these cross-border effects, the welfare impact of a reduction in aid expenditure could be better assessed at Community level. The risk that aid volumes will be inflated by competitive bidding between Member States also gives them an incentive to participate within the process the co-ordinated reduction of state aid. Second, the political acceptability of state aid reduction and the incentive to undertake such reductions would be greater if all the Member States were simultaneously engaged in such actions. A process of peer-review, with reference to common benchmarks, would help to maintain the pressure for strict discipline and would encourage national authorities to resist increased pressures from companies in the more competitive environment created by the single market and EMU. It would also provide a forum for the exchange of information and the diffusion of the best practices. Third, the Member States are better placed than the Commission to assess whether a state aid is the most appropriate means of achieving the desired objective or whether an alternative approach—for example, regulatory changes—would not be more effective. The case-by-case analysis made by the Commission only looks at distortion of competition in the markets concerned and not at the overall efficiency effects. The Member States are better-equipped to measure the effectiveness of their aid and to compare it with alternative instruments. They are also in a better position to control their total expenditures on subsidies and to decide upon the best allocation of budgetary resources. Finally, the case-by-case assessment carried out by the Commission does not permit an evaluation of the combined effects of the many aid schemes operated by the Member States. Lastly, at the Cardiff European Council in June 1998, European leaders highlighted the need for better the co-ordination, not only of macro-economic policies, but also of structural reforms. This co-ordination should enhance the

1 - Justification for State Aids

163

success of these reforms, which are essential to foster growth and employment in Europe. A co-ordinated effort by the Member States to reduce the level of aid would, therefore, fit into the broader context of the surveillance of structural policies that was decided upon by the Cardiff European Council. For all these reasons, it would be very useful if the Member States were to agree upon a co-ordinated programme for the reduction of state aid, ultimately setting targets for eliminating the aid which is the most distortive of competition and which has a negative impact on overall welfare. In this area, there is also a role for the Commission, which must continue to strengthen the effectiveness of Community state aid control and help to identify the types of aid which merit close attention because they are inefficient and wasteful. The Commission could also contribute to the organising of the monitoring of progress made towards these targets, which would be subject to periodic peer review.

IV. Framework for a Co-ordinated Reduction of State Aid The proposed co-ordinated approach could be based on the principles that the self-discipline regime should mainly be exercised in the Member States where state aid is disproportionately higher and should be concentrated on aid which is inefficient and wasteful.

A. Greater Self-discipline in the Member States Where the Level of Aid is High At a macro-economic level, an indicator of the importance of aid can be given by the ratio of aid to GDP, and the dispersion of state aid can be measured by the degree of deviation from the EU aid average in each Member State. As a first step, self-discipline should be most strongly exercised in the Member States where the ratio of aid to GDP is above the EU average. The objective of this co-ordinated programme would be a reduction in the level and the degree of dispersion of state aid across the EU and it should further ensure that the amount of aid is proportionate to the magnitude of the market failure being targeted, or is justified by equity considerations. Global targets could be fixed for each country according to two basic rules: a) No Member State aid should increase its overall level of aid as a percentage of GDP; and b) Member States which currently grant an above-average level of aid should be required to reduce it. As far as is possible, this approach should be refined in a later stage, and adapted to the different categories of aid. For each category, indicators

164

Working Paper X

characterising the level of aid relative to the activities being subsidised would be defined and compared across countries. This comparison would be made taking into account specific country characteristics that might justify the existence of the aid. For example, one might the amount expect regional aid to be comparatively higher in countries with high regional income disparities. On the basis of this analysis, more refined targets for state aid cuts could be defined by aid category and by country.

B. A Selective Reduction of Inefficient and Wasteful State Aid The economic rationale for state aid is the correction of market failures. Aid can be justified to the extent that it is targeted at real market imperfections and is an efficient instrument for their correction. In this case, cutting state aid could reduce welfare despite its positive immediate effects in terms of reduced public spending. Yet, a review of state aid would no doubt show that some of it is unnecessary because its objective could be achieved through market mechanisms. Other aid may prove to be inefficient or even counter-productive if it creates perverse incentives. Thus, it is necessary to identify the inefficient aid which should be the main subject of any reduction strategy. This identification could proceed in two stages. In a first stage, one should identify the specific categories of aid that are the most distortive and attempt to reduce these specific categories of aid. In a second stage, a more in-depth analysis could be carried out within the remaining categories, in order to select the aid which is relatively inefficient and costly. Broadly speaking, state aid can be classified into two main categories: ad hoc aid, which targets specific firms or sectors, and generic aid, which is given to all firms that meet certain criteria. Rescue and restructuring aid and sectoral aid fall into the first category, while aid to small and medium enterprises (SME), aid to research and development (R&D), and regional aid fall into the second.5 It is generally considered that ad hoc aid is likely to be more distortionary than generic aid as the latter is thought to be motivated by the correction of market failures and the former by rent-shifting. Efficiency arguments can, indeed, be used to justify SME and R&D aids. They are less strong in the case of regional aid and simply do not apply to rescue and restructuring aid and sectoral aid. However, for the last two categories of aids, equity considerations can be taken into account in order to support a policy of subsidisation.

5

The classification used by the Commission in its surveys on State Aid coincides with the one proposed here if we consider aid to agriculture, fisheries, steel, shipbuilding, transport, coal and other sectors under the heading of 'Rescue and Restructuring Aid and Sectoral Aid' and if we include trade aid under the SME heading.

1 - Justification for State Aids

165

Aid to SMEs is usually justified on efficiency grounds with reference to their disadvantaged position in export and credit markets.6 SMEs have more difficulties in acquiring information about foreign markets and in dealing with administrative procedures. They are also more affected by capital market imperfections since they have a lower self-financing capability and a lesser ability to raise the collateral necessary to ensure access to credit. R&D aid is grounded on the basis of the significant externalities that R&D expenditure generates for the economy. Finally, regional subsidies can be used to avoid the geographical concentration of production and can contribute to the take-off of poorer regions. However, the distribution of aid among the assisted regions does not necessarily reflect their degree of poverty because of budgetary disparities within the EU. By contrast, rescue and restructuring aid and sectoral aid often simply delay or prevent adjustments in declining industries. They are only efficient if they are temporary, but, very often, they tend to be repeatedly prolonged because of the pressure exerted by the beneficiaries. There is also a greater risk of distortion, which arises when large amounts of aid is concentrated on a few firms, and a moral hazard problem if firms expect that the state will support them if they run into difficulties. From an efficiency perspective, such aid hinders the operation of the internal market and masks the market signals which would allow efficient resource allocation. Finally, this aid may create artificial cost advantages for low-tech, low-demand sectors. A part of the resources devoted to the financing of this aid could be diverted to other structural measures aimed at innovation promotion, the accumulation of human capital and the boosting of productivity. All these arguments tend to indicate that rescue and restructuring aid and sectoral aid should be scrutinised with great attention. However, Besley and Seabright (1998)7 point out that the distinction between generic aid and ad hoc aid is not completely satisfactory. Generic aid may bring about significant distortions if, for example, it is applied to imperfectly competitive industries or industries characterised by a limited number of firms, since, in this case, they do allow rent-shifting. On the other hand, distortions due to rent-shifting are limited if the market power of firms is small. Thus, a selection of inefficient and wasteful state aid should go beyond this first characterisation and, in a second stage, should also take into account features of market structure. But, other criteria can also be considered in this second stage of analysis, depending on the category of aid considered. For example, in the case of R&D, subsidisation is less necessary when the rate of appropriability of the returns from innovation is high. All this shows that the implementation of this co-ordinated approach raises several problems and that, accordingly, the benchmarks should be used with someflexibility.These issues are discussed in the next section. 6 There is no clear case for support to SMEs on the basis of a disadvantage in terms of 7R&D (Symeonides 1996). (Besley & Seabright 1998).

166

Working Paper X

V. Problems of Implementation Implementing the sort of concerted action envisaged above will pose a number of problems. The first of these will be the reaching of a consensus about the acceptable level of aid, i.e., the quantified targets at which the Member States should aim. Member States are, naturally, inclined to set the benchmark close to their own current performance. Thus, Member States with low aid levels, such as the Netherlands and the UK, are likely to favour ambitious targets for aid reduction, while those with persistently high aid levels, such as Germany and Italy, are likely to favour more modest targets. It is a reasonable assumption that the higher the overall aid level, the more likely it is that substantial reductions will be welfare-enhancing. However, it will certainly not be possible to demonstrate convincingly that there is some ideal overall level of aid at which all Member States should aim. The benchmarks for a co-ordinated policy on state aid should be considered as rough indicators of the room for improvement in each Member State's performance, rather than as inflexible targets. They could befixedeither at the level of total state aid expenditure or at a more disaggregated level, taking account of the specific characteristics of each Member State and each type of aid. The global approach has the advantage of simplicity. The peer-review process would only be concerned with the total volume of state aid granted in each Member State and would not address the problem of selecting the types of aid to be reduced. A disadvantage of this approach is that it does not ensure that the cuts fall on the aid which is least efficient or most distortive. Welfareenhancing aids may be reduced simply because they are supported by weaker lobbies. On the other hand, the establishment of benchmarks at a more disaggregated level would make it possible to take account of the different problems of each Member State as well as the different cross-border spillovers generated by different types of aid. For example, while it is generally safe to assume that the cross-border effects of most types of aid will be negative, this is not necessarily true of aid for environmental purposes or for R&D. However, the effectiveness of the co-ordinated approach will be undermined if it becomes too disaggregated and complex. Furthermore, there is a danger of duplicating the existing Community guidelines and rules, which treat all the major types of aid separately. The study on 'state aid and convergence', mentioned above {infra IIA), examines eight broad categories of aid in relation to the problems which they are intended to tackle. The results show that it is difficult to establish appropriate benchmarks at a disaggregated level because of the wide differences in the policies of the Member States. The most practical approach might be to establish benchmarks at the aggregate level, expressed as a percentage of GDP, but also to try to achieve a consensus concerning the types of aid on which the reduction effort should be

1 - Justification for State Aids

167

concentrated, because of their limited effectiveness or important negative spillover effects. These benchmarks would be used in aflexibleway to guide the Member States, which would have the ultimate responsibility of deciding which state aid was the most wasteful. To this end, more refined criteria would be used. In the foregoing discussion, we confined our remarks to state aid subject to Community control as defined in Article 87(1) EC. It could be argued that the process that we envisage should also be extended to cover the aid which does not affect trade between Member States, such as aid for housing. Since the proposed approach not only tackles the competition aspects of state aid, but also addresses their budgetary implications and their effects on the flexibility of domestic labour, capital and product markets, it might seem logical to cover the whole range of aid. However, Member States are likely to give a higher priority to a strategy which concentrates on the types of aid which have clearly identifiable cross-border spillover effects. It, therefore, seems advisable to restrict the exercise to aid covered by Article 87(1).

VI. The Pragmatic Approach Followed in the BEPG The pressure on Member States to protect companies by means of state aid requires the Commission to maintain strict application of the state aid rules, but the Member States themselves constitute the first line of defence. Because of the rigidities which can result from state aid, as well as the need for budget discipline, the Member States have a strong interest to resist this pressure. In this context, the Cardiff European Council of 15-16 June 1998 called for surveillance of the functioning of markets and emphasised 'the need to promote competition and to reduce distortions such as state aid'. This line was followed in the latest recommendations made by the Commission to the Member States in the 1999 Broad Economic Policy Guidelines. More precisely, the Commission recommends that 'for state aid, the efforts of the Commission should be supported by continued action by the Member States to reduce the level of state aid and to switch away from sectoral, ad hoc and restructuring aid'.8 Two Member States (Germany and Italy) are requested to reduce the overall level of aid and five Member States (Germany, France, Italy and Portugal) to take measures in order to improve the structure of aid by reducing the share of sectoral, ad hoc and rescue and restructuring aid. State aid is still one of the major sources of distortions within the single market. Over the period 1995-1997, total non-agricultural aid represented 8 European Commission, 'Commission's recommendation for the Broad Guidelines of the Economic Policies of the Member States and the Community', COM(1999) 143 final, 30.03.99.

168

Working Paper X

1.2% of the Community GDP, compared to 1.5% over the period 1993-1995. Although this ratio has fallen regularly during the 1990s—thanks to stricter budgetary discipline in the Member States—it still remains high. As Table 1 shows, there are also wide variations in the levels of aid in the different Member States, although the degree of dispersion has diminished somewhat since 1990, as shown by the coefficient of variation,9 which has fallen from 0.41 in the period 1990-1992 to 0.31 in 1995-1997. In the latter period, the level of aid was still particularly high in Italy (1.7%) and Germany (1.6%), although a positive evolution was recorded in the latter country. By contrast, Finland, the United Kingdom, the Netherlands and Austria have very low levels of aid (between 0.4% and 0.7% of GDP). Despite the encouraging overall decline in state aid, regional aid is in need of closer scrutiny, while aid to the coal industry, and rescue and restructuring aid are two areas of concern. Regional aid accounts for some 26% of total non-agricultural aid (see Table 2). Even though higher aid intensities are allowed in the least favoured regions, the more prosperous Member States (especially Germany and Italy) tend to give much more regional aid per head of population in the assisted areas than the poorer Member States (Greece, Spain, Ireland and Portugal). For example, aid per head in German assisted regions greatly exceeded the level in the assisted regions of the 'cohesion countries'. These results suggest that efforts to develop the least favoured regions may be jeopardised by the large amounts of aid available to attract investment in the more prosperous Member States. Although the Commission has recently adopted new guidelines for regional aid which foresee reductions in the geographical coverage of assisted areas, as well as in permissible aid intensities, the question of the disparities in budgetary resources also needs to be addressed if a solution is to be found to this problem. Aid to the coal industry accounts for 9% of total non-agricultural aid. Of this aid, 77% is aid to current production while the rest is for social purposes. This high percentage of aid to current production is stable, compared to the period 1993-1995. Aid to coal is particularly high in Germany and Spain (see Table 3), and in these countries aid for current production accounts respectively for 96% and 72% of total aid. Given these important amounts of aid to current production, competition between coal industries continues to be stifled and the impact of this aid on other markets (such as electricity) cannot be ignored, especially, given that—since these markets are being integrated with the completion of the single market—competition is becoming increasingly important. There is also a worrying increase in the amount of aid granted to rescue and restructure firms in difficulty. Excluding aid granted in the context of the special measures in favour of the new Lander of Germany, the share of such aid in total increased from 6.7% in 1993-1995 to 8.4% in 1995-1997. France (air transport, and financial services), Italy (airlines, financial services and various 9

The standard deviation divided by the average.

1 - Justification for State Aids

169

other industries) and Spain (steel, and shipbuilding) account for more than 80% of this rescue and restructuring aid. Compared to the period 1993-1995, increases in this aid have been recorded in France and Spain, while Germany has enjoyed an important reduction. This aid, which often simply delays adjustment in declining industries, should be scrutinised with great attention and preference should be given to generic measures to improve the ability of firms to adapt and innovate.

VII. Conclusion This paper has shown that state aid needs to be scrutinised with great attention, particularly with the advent of EMU. As EMU will increase the competitive pressures on Community enterprises, it is likely to lead to demands for increased subsidies. Since EMU also makes budget discipline and market flexibility all the more important, it is essential not only to resist pressure for new aid, but also to make a determined effort to reduce the inefficient and wasteful aid. This strategy is also in keeping with the political will to undertake coordinated action in the area of structural policies, which has been highlighted on several occasions. Resources liberated by a possible reduction in state aid could be reallocated to more efficient aid schemes, be used to implement other structural measures or contribute to the continuation of the budgetary consolidation effort. The Commission's control over state aid under the Treaties is limited by the need to take a case-by-case approach. Although such case-by-case control is indispensable, it provides no means of controlling the total volume of state aid. The Member States, on the other hand, are in a better position to evaluate the effectiveness of the aid which they grant, and to control their total expenditure on subsidies. Thus, the effort to reduce state aid should concentrate on the promotion of self-discipline within the Member States. The enforcement of a strict discipline at Member State level would be more politically acceptable and more effective if the efforts of the Member States were to be co-ordinated. This paper proposes a co-ordinated approach, based on the use of indicative benchmarks, such as the ratio of aid to GDP, together with guidelines for the identification of the form of that should be the main subject of a reduction strategy—for example, rescue and restructuring aid. The Member States would then make an internal assessment of their state aid policy in the light of commonly defined criteria, such as those proposed above. There should also be regular surveillance of progress made. Surveillance reports should be taken into account within the annual Broad Economic Guidelines, which should be better-focused on structural issues.

Working Paper X

170

Table 1: Evolution of state aids {excluding agriculture) in percentage of GDP

1990-1992 B DK D GR E F IRL I L NL A P FIN S UK EUR 15 EUR 12 Coefficient of variation (EUR 12)

State aids in % of GDP 1995-1997 1993-1995

2.9 1.0 2.4 1.9 1.3 1.7 1.2 2.4 2.4 0.9 n.a. 1.5 n.a. n.a. 0.5 n.a. 1.8

1,38 0,95 2,26 0,97 1,14 1,19 1,25 1,94 1,49 0,59 n.a. 0,97 n.a. n.a. 0,46 n.a. 1.48

1,17 0,89 1,64 0,98 1,16 1,12 1,09 1,71 0,50 0,61 0,65 0,98 0,43 0,76 0,52 1,20 1.24

0.41

0.35

0.31

Source: European Commission, Fifth and Seventh Surveys on State Aid in the EU.

1 0% 10 1% 16 0% 1 0% 46 1% 33 0% 12 2% 89 1% 0

0%

2 0% 0 0% 4 0% 3 1% 9 1% 26 1% 252 0%

MECU

%

MECU

MECU

MECU % MECU % MECU % MECU %

%

MECU

%

MECU

%

%

MECU

%

MECU

%

MECU

%

MECU

%

MECU

%

MECU

%

MECU

%

14%

11681

15% 13 19% 509 27% 364 31% 106 13% 273 63% 115 8% 396 8%

2540

18% 101 16%

2448

2 0% 543 10%

444 18% 615 51% 3214 11%

73 4% 43 4% 117 14% 33 8% 71 5% 207 4% 4402 5%

1%

744 2% 1 0% 1602 30% 380 3% 156 25% 673 4% 1

8%

94

208 8%

Sectorspecific measures

93 5% 130 11% 314 37% 77 18% 208 14% 1038 22% 21597 26%

49%

285 11% 16 1% 9589 32% 655 68% 328 6% 1456 11% 139 22% 7238 44% 33

Regional

Source: European Commission, Seventh Survey on State Aid in the EU.

EUR15

UK

S

FIN

P

A

NL

L

1

IRL

F

E

GR

D

DK

B

Fisheries

Horizontal measures

Manufacturing industry

0 0% 0 0% 0 0% 0 0% 0 0% 0 0% 5866 7%

0%

0 0% 0 0% 5045 17% 0 0% 773 14% 48 0% 0 0% 0 0% 0 0 0% 0 0% 1 0% 0 0% 0 0% 868 18% 1780 2%

0%

0 0% 0 0% 211 1% 0 0% 297 6% 405 3% 0 0% 0 0% 0

Others (mainly social aid)

Coal Aids to current production

Table 2: Distribution of non-agricultural aids by sector and objective, J995-1997.

0% 0 0% 0 0% 0 0% 2702 3%

2

0 0% 0 0% 0 0% 0 0% 0 0% 2265 17% 58 9% 377 2% 0 0% 0 0% 0 0%

Financial services 0 0% 0 0% 273 1% 0 0% 0 0% 516 4% 23 4% 202 1% 0 0% 0 0% 0 0% 223 26% 0 0% 0 0% 0 0% 1236 2%

Airlines

32080 39%

46%

2163

73%

1106

64% 647 55% 76 9% 46 11%

1200

21 31%

1545 62% 467 39% 11310 37% 301 31% 1777 33% 6016 44% 133 21% 5271 32%

Others

Transport

2483 100% 1202 100% 30402 100% 959 100% 5365 100% 13566 100% 622 100% 16389 100% 67 100% 1876 100% 1184 100% 842 100% 432 100% 1509 100% 4698 100% 81597 100%

TOTAL

*§;

if

1

r*

a *$>

cati

MECU % MECU % MECU % MECU % MECU % MECU % MECU % MECU % MECU % MECU % MECU % MECU % MECU % MECU % MECU % MECU %

1,3 0% 10 1% 16 0% 0,8 0% 46 1% 33 0% 12 2% 89 1% 0 0% 2 0% 0 0% 4 0% 3 1% 9 1% 26 1% 252 0%

936 38% 725 60% 13547 45% 657 69% 2472 46% 4284 32% 395 64% 10451 64% 46 69% 674 36% 537 45% 537 64% 383 89% 394 26% 1640 35% 37680 46% 0% 16 3% 183 1% 0,7 1% 0 0% 3,6 0% 19 2% 0 0% 0 0% 0 0% 1126 1%

3

3,2 0% 0 0% 29 0% 0,2 0% 869 16%

Of which: Steel

Source: European Commission, Seventh Survey on State Aid in the EU.

EUR 15

UK

S

FIN

P

A

NL

L

I

IRL

F

E

GR

D

DK

B

Fisheries

Manufacturing industry

Table 3: Distribution by sector of non-agricultural aids, 1995-1997.

0 0% 66 5% 513 2% 0,4 0% 514 10% 21 0% 0 0% 227 1% 0 0% 51 3% 0 0% 16 2% 25 6% 0 0% 10 0% 1444 2%

Shipbuilding

3% 0 0% 0 0% 0 0% 0 0% 0 0% 1 0% 0 0% 0 0% 868 18% 7646 9%

453

0 0% 0 0% 5255 17% 0 0% 1070 20%

Coal 0 0% 0 0% 0 0% 0 0% 0 0% 2265 17% 58 9% 377 2% 0 0% 0 0% 0 0% 2 0% 0 0% 0 0% 0 0% 2676 3%

Financial services 1545 62% 467 39% 11583 38% 301 31% Mil 33% 6532 48% 156 25% 5472 33% 21 31% 1200 64% 647 55% 298 35% 46 11% 1106 73% 2163 46% 33316 41%

Transport

0 0% 0 0% 273 1% 0 0% 0 0% 516 4% 23 4% 202 1% 0 0% 0 0% 0 0% 223 26% 0 0% 0 0% 0 0% 1236 2%

Of which: Airlines 2483 100% 1202 100% 30402 100% 959 100% 5365 100% 13566 100% 622 100% 16389 100% 67 100% 1876 100% 1184 100% 842 100% 432 100% 1509 100% 4698 100% 81571 100%

TOTAL

I

i

PANEL DISCUSSION

PARTICIPANTS

Colin Bamford Pierre Buigues Alec Burnside Clifford R Dammers Marc Dassesse Claus-Dieter Ehlermann Jonathan Faull Jordi Gual Anne Houtman Charles Ilako Christian Koenig Alfonso Papa Malatesta

Asger Petersen Gian Michele Roberti Wulf-Henning Roth Mario Sarcinelli Paul Seabright Matthew Schaefer Uwe Schneider Michael Schutte Peter Schutterle Romano Subiotto Antoine Winckler Giuseppe Zadra

2 - Problems Arising from State Aids in Banking Sector

177

Panel Two: State Aid Problems in the Banking Sector • EHLERMANN—Let us begin with the more general presentations. • PETERSEN—I will address state aid policy in the banking sector as it has been developed within the decisions of the Commission and within jurisprudence of the European Courts. My paper analyses many of the state aid cases that have been dealt with since the 1990s and demonstrates that there has been little deviation from the normal state aid rules within the banking sector: the market investor principle is fully applicable to cases of intervention by national supervisory and regulatory bodies. Thus, for example, intervention relating to the solvency ratio directive has been measured in the light of the market investor principle in several cases. This has created no particular problems. Equally, aid from the lender of last resort to banks is evaluated with reference to the market investor principle. The cases—for example, Banco di Napoli and Banco di Sicilia—confirm that no state aid is involved where a supervisory body intervenes in an independent form and/or in accordance with the market economy investor principle. The cases also confirm that national law on intervention can be properly assessed under the normal state aid criteria and the market economy investor principle. Both Italian and French cases have shown that intervention made under national law can be properly assessed: I believe the Commission has always felt that intervention that occurs under open market conditions will not constitute state aid. The same is true for the Commission's assessment under Article 87(3)(c) [ex 92(3)(c)] EC of the 'compatibility' of state aid with the internal market in banking cases: the normal assessment criteria—the proportionality of the aid, the real need for aid and the presence of adequate consideration of the aided operation's viability—apply. As we heard this morning from Commissioner Van Miert, one Member State attempted to have the banking sector exempted from the scope of Article 87 by means of the 'Amsterdam Declaration'. This effort nonetheless failed. The neutrality of ownership is fully respected under Article 295 EC [ex 222] and I am particularly glad that Professor Koenig's paper underlines the need for a change in forms of ownership—away from state ownership—that will satisfy the state aid regime. Accordingly, the only issue that remains troublesome is the issue of 'systemic crisis'. However, I believe that Article 87(3)(b) [ex 92(3)(b)] can still be applied in these cases-there was no better example of the 'too big to fail' problem than the Credit Lyonnais case, where the argument that there was a severe risk of systemic crisis simply did not hold true. In 1992, we were on the brink of taking a negative decision. If the French had not signalled their acceptance of our minimum requirements at the very last hour, the decision would have been negative. This is a clear indication that risks of systemic crisis very rarely arise in reality. The Credit Lyonnais decision was not an easy one to take: we widely consulted with companies and individuals that have a very wide experience of conditions within the banking sector—all advised us that there

178

Panel Discussion

would be no risk of systemic crisis if the bank were wound up in an 'orderly' manner. The second Credit Lyonnais case concerned rescue aid, in relation to which the Commission has traditionally been more lenient. We will, however, correct this in the future by means of the proposed new framework on emergency aid to banks. This measure will tighten up procedures. Where the national supervisory authority signals that aid is needed, the responsible Member of the Commission will be empowered to take a decision within 24 hours. • SARCINELLI—I think it is worth recalling that the history of banking is marked by many episodes of crisis and panic. We might think that technological and financial advance has changed the banking industry: I nonetheless conclude that banks are still very fragile financial intermediaries. Three factors contribute to this fragility. First, creditors/depositors are not in a position to monitor the conduct of banking business. Secondly, the bank's usual liabilities are used as money, and the debt to asset ratio is not only much higher, but also gives rise to a mismatch of securities, which, in my opinion, is the peculiarity that makes the bank quite different from other financial intermediaries. Thirdly, according to the theory of isometrical information, bank panic arises as a consequence of bad news concerning a macro-economic event, which makes the depositor doubtful about the quality of the bank's assets. This is tantamount to saying that the bank operates on a fractional reserve system: it only maintains a relatively small percentage of the deposits it has collected as reserves to fulfil its contractual obligations, and its contractual obligations are mainly made up of deposits in the form of money. Thus, in the absence of a central bank or a regulatory and supervisory framework, the fractional reserve system would result in frequent and highly destabilising bank runs and bank panics. Does a competitive environment have a negative influence on the stability of banks? I conclude that this may be the case. As in all economic sectors, competition is necessary within the banking industry in order to increase product efficiency and reduce inefficiency. Crucially, regulatory and competition authorities must ascertain whether increased competition will intensify the fragility of individual banks or of the banking system as a whole. In the latter case, macro-economic stability is at stake. In general, there is no clear-cut answer. However, a presumption can be established: stronger competition will encourage banks to undertake riskier activities and this may increase the probability of their failure. What can we do to tackle the intrinsic fragility of banks? One radical measure would be the introduction of a 100% reserve system through the separation of contractual fulfilment functions from credit provision functions. Secondly, we can adopt the historical solution of recourse to a lender of last resort. As we all know, rules—which I will not restate her—were established in the late 19th Century to govern central bank intervention in the case of a liquidity crisis. The

2 - Problems Arising from State Aids in Banking Sector

179

last 50 to 60 years have witnessed the use of regulation to offset market failure—for example, compulsory deposit insurance, minimum capital requirement and asset portfolio constraints. However, many economists who investigate this area have concluded that governmental presence can intensify market failure: (i) banks, which are more powerful than dispersed depositors, may 'capture the regulatory process; (ii) regulation is a tax-burden, since implementation structures must be established; and (iii), regulation, as the Italian example demonstrates, slows down market entry and exit. My conclusion is that the specifities within the banking market determine that a different regime must apply. Rescuing and restructuring regimes, in particular, call for different treatment. If current EU law and jurisprudence does not allow for differentiation, the Commission—which has acknowledged the special character of banking—must, at the very least, allow for intervention by regulatory and supervisory authorities in any form that is deemed fit to avoid more serious, systemic, consequences. • BAMFORD—I would like to focus on the question of the status of guarantees given by state or state entities to banks or bond investors that are subsequently deemed to involve unlawful aid to third-party beneficiaries. This is an issue in which banks and bond investors have become involved only very reluctantly: they have no wish to be involved in questions of state aid at all. They simply wish to lend their money and receive a reasonable rate of return. The issue is nonetheless important to them, since the enforceability of a guarantee or credit support arrangement will affect the value of their asset. Equally, commercial banks are concerned with the issue since non-enforceability also impacts upon their required capital adequacy. The Commission has developed a novel indirect approach: it is attempting to control the activities of Member States by applying pressure to the institutions which deal with the Member States. The hope would seem to be that commercial banks will cease to deal with Member States where there is any concern that a guarantee is 'undesired'. A number of people feel this approach to be unfair: why should the private citizen, including banks, be required to pay for the defaults of the Member States which are parties to the European Treaty. My own organisation, the Financial Law Panel, preferring a Nietzchean view, has not questioned the morality of the Commission's approach, and has, instead, asked whether it is useful. In this regard, we identify two failings. First, the Commission has publicly indicated—both informally and in writing—that such guarantees given will be enforceable. This is simply not true with regard to English law: it is great simplification of the legal position. Differences are noticeable in the legal position across the Member States. Secondly, and, I think, more importantly, no thought has been given to the further consequences of illegality. The process does not stop with a declaration of unenforceability: the holder of a guarantee may take action against the state which issued the defective document. This is not true in the UK, however, where, for a thousand years, the legal system has

180

Panel Discussion

worked on the basis that the government would never do anything to damage its citizens, so that its citizens will never have reason to bring a claim against the government. Here, the buck will stop with the bank or the bond investor. This may not be the case throughout the rest of the EU. Accordingly, the Commission's efforts to clear up anti-competitive situations might simply result in the creation of differentiated banking markets throughout Europe. Of course, this is not the intention, but it may be the effect. We feel that the correct means to achieve stated matters of policy is by legislation. My paper argues that illegality and unenforceability in each Member State must be established by means of a directive. A more simple solution— which I thought of in the shower this morning—would be an individual piece of legislation, without wider consequences for the rule of law, stating that guarantees will not be held void or unenforceable simply because they are given in connection with an unlawful state scheme. This solution delivers a more acceptable product: the legal position of the guarantee is not changed at all—it is simply protected from the consequences of illegality. A final sting in the tail would be the requirement that each recipient of a guarantee must register its existence in a national register maintained by each Member State. The Commission, of course, should be happy, since it is really looking for a notification scheme and these guarantees could be achieved by this route. Equally, the grandfathering of existing guarantees should not be an issue, since one can also require that all existing guarantees are registered within a month of their coming into effect. Now, this idea is only five hours old and there may be some terrible defects in it; however, it points a way forward without damaging either the interests of the banks, or those of the Commission. • DASSESSE—I, too, would like to focus on the issue identified by Mr Bamford and illustrate it further within the aid of an example: I am in a dispute with a commercial company—I claim to have bought a car from them, but the company says, 'no, we have rented it to you and have retained the title'. Now, we can argue the niceties of this case until the cows come home. However, the determining factor is the factual one of whether the company still identifies the car as one of its assets on its balance sheet. However, within the banking world, a further complicating factor is the presence of the regulator. Here, I think, we have some dichotomies. Take, for instance, a bank that is approached by a credit-worthy company and lends '100' credits. In this case, EC solvency requirements demand that the bank has ownfunds of '8' to cover this risk. Indeed, supervisors are required to check these own-funds. Now, along comes another, 'non-creditworthy', company which can nonetheless produce a state guarantee. In this case, the bank need no longer provide eight percent of own funds in order to make this credit. It can give many thousands of credits to various companies with public guarantees; there is no own-funds requirement. Equally, in the presence of a guarantee, there are no worries about credit-worthiness. In contrast, where the solvent company

2 - Problems Arising from State Aids in Banking Sector

181

later defaults, the banking supervisor will require the bank to make a write-off on that loan and eat into its own funds. Thus, I frankly believe that we are barking up the wrong tree by warning banks that guarantees may not be valid. The real problem occurs at the level of the banking supervisor who is, after all, also a part of the state and bound to observe Community law. Can a supervisor really accept a zero rating on a credit that is supported by a guarantee without ascertaining, for himself, that the guarantee will be valid and that it has been notified and approved? I think the supervisor is in a far better position to undertake such checks than the bank is. • ILAKO—My paper is not written from a legal perspective, but from a 'personal', regulatory consultant's perspective. I argue that the case for state aid in the banking sector will diminish in due course. Anti-trust policy focuses on market efficiency and consumer welfare. By the same measure, these are the key factors that justify the granting of state aid across all sectors, including the banking sector. This is also consistent with the objectives of banking supervision, which are, first, to ensure market stability and, secondly, to protect the interest of depositors. Now, taking the protection of depositors as a starting point, it is my opinion that the 1994 depositor guarantee directive has largely satisfied consumer protection requirements, so that—and where consumers, in fact, are aware of their rights—state aid cannot really be justified on consumer protection grounds. I therefore feel that the real challenge in the banking sector relates to the issue of market efficiency. If we were to have an efficient EU market, there would only be a limited case for state aid within this sector. Considerable progress has been made over the past ten years in relation to supervision and regulation. Supervision, at both EU and global level, now extends to issues of authorisation, passporting rights, the proper character of senior bank officials and questions of financial regulation and enforcement. We have a whole host of banking directives which deal with issues such as cap adequacy and passporting rights. We are similarly seeking greater convergence with regard to supervisory practices. The market has also seen a series of developments: consolidation, overlaying and a single currency. Market analysts predict that, within 10 to 15 years time, we will be talking about a far smaller number of, 'global', banks: how many of these will be European? Having said all of that, I think it is also clear that the regulatory and the supervisory framework are far from complete: most supervisors simply apply minimum standards. The risk-based supervisory approach has only just begun to be evolved, still we are not quite there yet. There is still no global convergence on the issue of liquidity requirements, which is intrinsically related to the issue of a lender of last resort—a vitally important issue in the state aid context. I think there is a strong argument for far greater convergence in this particular area, and while the European Commission has drafted a fairly comprehensive action plan in this area, it does tend to focus more on issues such as corporate governance, accounting disclosure, the winding up directive, distance selling

182

Panel Discussion

and e-commerce, the European Company Statute Directive, and the issues of take-overs and mergers. In other words, there is still a lack of clear guidance and while we are moving in the right sort of direction, there is still some way to go and we have yet to achieve a level playing field across the EU. The issues are clearly complex, in particular, in relation to state aid. State aid must not be allowed to distort the market: Mr Dassesse is quite correct that some sort of framework must be developed to manage capital adequacy benefits which guarantees confer, so that the competitive advantage is minimised. Yet, there is a second aspect to the problem of ensuring that state aid does not distort the market. Namely, what is the market? Within the banking sector, we are really dealing with a three-tiered market, which operates at national level, EU (or Eurozone) and global level. Many banks operate at all levels and in many jurisdictions. We must also always bear in mind the fact that banks are, to some extent, expected to play a social policy role at EU level: we are sending out the message that they must provide a universal banking service to EU citizens. Yet, at global level, banks must compete in a free market. How do we design a policy to reconcile all those three tiers? There is no easy solution. However, my paper draws three conclusions on state aid. Firstly, we must have a greater degree of convergence and consistency between EU and global regulation. Secondly, we must strike a better balance between social policy and free competition. Thirdly, the EU must continue to focus on the role that EU banks are playing and will play within the global financial market. There will far fewer banks in the future. I do not think that we can expect one bank from each Member State to be on the list—we must consider that fact when addressing state aid issues. I conclude with a brief comment on the decentralisation of state aid control—I do not think that, with regard to a tiered banking structure, decentralisation will provide us with an optimal solution for EU banks over the next ten to fifteen years. • ZADRA—I will take a historical approach: I think we must look at where we started. In the last six to seven years, we have switched from a public to a private banking system. We have privatized 75% of our public banks, so that where public ownership is considered to be a form of state aid, the regime has essentially been dismantled. Equally, we have also seen a change in terms of the activities that governments mandate their banks to undertake. The 1995 Directive on public procurement was a turning point. The table in my paper demonstrates that lending functions performed on behalf of the government must be auctioned and are now performed by a large number of, say 15-25, banks. Auctions are competitive and banks must prove their competency and professional experience in long-term lending. Again, speaking historically on the issue of public guarantees, you are clearly aware that we are coming out of an era when state-owned corporations were prevalent. Most of these corporation were granted 'general' state guarantees by law. With the aid of the Banking Federation, we are attempting—in partnership

2 - Problems Arising from State Aids in Banking Sector

183

with the Commission—to correct this situation. However, whilst awareness of the problem does exist, there are difficulties. Most particularly, it is very difficult to trace guarantees granted through the law, since they were not granted through an 'evident' individual act. Equally, with regard to state intervention within banking crises, I think we have largely managed to privatise and restructure the market so that large-scale state intervention is a thing of the past. We now have two private depositor protection schemes that are crystallised in directive form, and that were adequate instruments to tackle the small and medium size banking crises of the 1990s. We had a real crisis in the early 1990s: there were failures within industry and commerce which threatened some banks. The two large or medium-large banks that were saved through public intervention were Banco di Napoli and Banca di Sicilia. The rescue schemes, however, were developed in co-operation and collaboration with the Commission. I feel that whilst the banking sector is 'clean', the real distortion, or anticompetitive practice, is to be observed in relation to Italy's 'informal banking' activities carried out by post offices. Some EU countries have already solved this problem; some have not. This activity, which is not exactly an economic activity in legal terms, but is just a group of activities performed by state entities, is actually the largest bank activity in terms of assets bought, and we are clearly not able to compete on purely competitive terms. I raise the issue in the hope of diverting the attention of some of our European colleagues to the problem. • EHLERMANN—I would us like to move on now to presentations on specific issues, beginning with rescue and restructuring. • SUBIOTTO—Generally-speaking, my paper ties in with issues raised by Commissioner Van Miert within Panel One, and, more particularly, with the fact that whilst many Member States have declared that the state aid regime should be far stricter, very few of them have acted in line with their own declarations. Accordingly, I think the Commission should apply a stricter regime. I see no justification for a less strict approach in thefieldof state aid than in other fields of competition policy. In addition, I think that the Commission should provoke the two European Courts into stricter decision-making. I feel that recent judgments will be unhelpful to the Commission in the long-term, since they will not help it to resist political pressure in high-profile state aid cases. Equally, picking up on Commissioner Van Miert's remarks about gradualism, I think that this is an interesting concept, but that it should be limited to newly liberalised industries, such as the airline sector, and should not be applied to the banking sector, where competition has been 'ripe' for many years. Applying all this to restructuring within the banking sector, I think that we are all aware that although restructuring plans must be designed so as to restore the long-term viability of their beneficiaries, the Commission has, all too often,

184

Panel Discussion

simply accepted the Member States' declarations that restructuring plans submitted to the Commission will definitely restore the beneficiaries' viability. I need only refer to the Haas case, in which an airline presented a restructuring plan that was only 14 pages long and contained vague declarations and statements of intention, such as, '[w]e will work much harder since this will increase our productivity by 33%'. By the same token, the Court of First Instance declined to assess the Commission's positive evaluation of the plan and indicated that the Commission had provided 'sufficient reasons' simply by stating that the restructuring plan was viable. In contrast to the legal service of the Commission, I feel that restructuring plans must also be evaluated in the light of measures that have proved to be successful in the same sector in the past. Unfortunately, however, the CFI confirmed the Commission's view that cases should be dealt with on a case-by-case basis, thus leaving open the possibility that political pressure will be bought to bear in individual cases of ad hoc state aid. Seen from the outside, France is very good at exerting pressure on the Commission. The standards against which the legality of a restructuring plan are measured should not be allowed to vary according to the belligerence of the work force in each Member State: French workers, in contrast to their counterparts in other states, will block motorways and airports if they are unhappy. Sadly, the two Courts seem to have confirmed that the relative belligerence of national work forces will be taken into account in determining whether a plan is viable, so that French plans might be a deal more vague than, say, UK plans. By the same token, the case of Air France, reversed on appeal by the ECJ, underlines the importance of encouraging the CFI to qualify a manifest error of appreciation as 'a manifest error of appreciation' and not as a 'sufficient statement of reasons'. Similarly, I would like to highlight the case British Airways v Commission, and argue that the Commission does not need a wider margin of discretion when reviewing the viability of restructuring plans than when evaluating whether a measure constitutes state aid. In this case, the CFI strictly reviewed the Commission's evaluation of the nature of state aid, but indicated that it would only intervene with regard to the viability of a restructuring plan where there was 'a particularly manifest error of appreciation'. This amounts to a new test that affords almost total discretion. Finally, a word on proportionality. The basic principle here is the Phillip Morris principle that a beneficiary should be required to deploy its own 'noncore' assets before applying for state aid. Accordingly, the Commission must determine what the non-core assets—assets that are not necessary for the running of core business—of a potential beneficiary of state aid are. In reverse, it must determine what the core assets of a firm are: is Credit Lyonnais a French bank or a global bank? Should it have corporate customers in New York, Frankfurt, and London, or should it just be limited to France? Once this decision is made, the beneficiary should be asked to sell non-core assets. Where immediate sale is not possible, these assets should be put into a 'independent' trust that will sell the assets as the opportunity arises; a method widely used in

2 - Problems Arising from State Aids in Banking Sector

185

the merger context. By contrast, I see little justification for placing the bank's bad assets in wholly-owned hive-off vehicles, which are often under the de facto control of the beneficiary. In some cases—most notably, the case of Credit Lyonnais—such solutions can give rise to political conflict: why was Credit Lyonnais not required to divest its interests in AOM, a French airline, after 1995? Why did it not sell AOM in order to raise money in order to reduce the amount of state aid that it needed? State aid must, in the final analysis, be proportional. • WINCKLER—I would like to concentrate on three issues: (i) statutory guarantees; (ii) systemic risk; and (iii) state aid and discrimination. Beginning with statutory guarantees, I must first define my terms. A statutory guarantee is explicitly provided for by law; one example being that of guarantees granted to German 'Landesbanken'. My paper concludes that these guarantees should generally be treated in the same manner as normal state aid, with, perhaps, one or two exceptions, such as the public interest exception provided for in Article 87(2) [ex 90(2)], although, even here, the Member State must prove that the advantage derived by the bank is proportionate with the public interest gain. My experience, however, tells me that this proof is difficult to establish. From the simple technical standpoint, balance sheets and accounting systems must be designed to allow for this evaluation. A second exception would be that of statutory guarantees issued as a reasonable alternative to a capital investment. Here, however, normal state aid rules should continue to apply and the state should be obliged to prove that its investment return is comparable with the return that would be expected by a private investor. It is clear that state aid has a huge impact on competition. A recent article in the Economist notes that for every 100 billion DM borrowed by the Landesbanken, there is a potential return of 250 to 500 million DM. Not an insignificant figure. Moving on to systemic risk, we must recognise the complexity of the issue since the existence of systemic risk justifies implicit guarantees for large financial institutions throughout the EU. Clearly, implicit warranties cannot be notified. My paper concludes that this problem must be tackled, on the one hand, by designing sufficiently soft and flexible rules to allow the Commission to react quickly, and, on the other, by being open to the solutions which the Member States must rapidly develop. The 1996 Credit Lyonnais case, for example, clearly demonstrated the Commission's willingness to accept the need for an urgent solution, since its reaction came within less than one week after notification. Credit Lyonnais also demonstrated the Commission's willingness to be flexible with regard to the rescue aid guidelines, which stated that aid should only be granted in one of two forms: a state loan or a state guarantee. In this case, neither option was feasible and the Commission accordingly approved the injection by the French state of four billion francs into the bank's capital, in order to allow the bank to meet its required solvency ratios.

186

Panel Discussion

By contrast, the state aid regime must also be tough enough to minimise moral hazard problems in relation to systemic risk. In other terms, a failure to supervise the market properly cannot justify capital injections into failing entities. I think this is now very much accepted, but let me refer again to the Credit Lyonnais case. Credit Lyonnais is interesting to the extent that it entailed both a supervisory and a market failure: the disaster had really begun in the 1980s when—in a classic example of regulatory capture—personal contacts between the Director of Credit Lyonnais and the French Central Bank contributed to the failure to admit the gravity of the situation. And then, it is interesting also to note, and this is less well known, that there was also a market failure. However, disaster was also sealed by market failure—private credit rating companies failed to note Credit Lyonnais' risk exposure. Moving to state aid and discrimination, I would like to state that there is a clear need for convergence between state aid control and financial regulatory activities. Taking the example of Germany, beneficial treatment of 'Sparkassen' by the regulatory authorities—they are only required to 'set aside' a fraction of the sum that would be required in other countries, thus giving consumers cheaper access—is a clear example of discrimination in the application of the same rule and strongly militates in favour of European regulation, for regulatory and state aid reasons alike: we must be sure that there is a level playing field. Finally, one difficult point. Officially-speaking, the Commission claims neutrality with regard to the distinction between public ownership and private ownership. Yet, in thefinancialarea, the factual situation seems to be different: privatisation was a precondition for the approval of state aid to Credit Lyonnais. • ROBERTI—I am going to talk very briefly about the EFIM case and the effects of legal public guarantees. The Commission's envisages two consequences in the case of the illegal granting of public guarantees, the second more controversial than the first: (i) the suspension or the recovery of the illegal aid from the beneficiary; and (ii) the requirement that the state need not to honour the guarantee, so that it is not enforceable. This approach is not merely stated in the Draft Notice, it has also been developed in practice and the main case is that of EFIM Here, Article 236(2) of the Italian Civil Code imposed unlimited liability for all the debts of the controlled company upon the unique shareholder. According to the Commission, the application of Article 236(2) to a public company in financial difficulty would amount to state aid; the aid element corresponding with the total indebtedness of the affected company. As a consequence, the Italian state might not satisfy creditors. The same statement was made in subsequent cases, so we do have a degree of established, if not 'settled', practice. • ROTH—I would like to argue that state guarantees which are considered to be aid to a borrower of a loan are to be regarded as unenforceable if there has been no notification under Article 88(3)(3). My argument hasfivepoints:

2 - Problems Arising from State Aids in Banking Sector

187

(1) Article 88(3) is directly applicable. National courts must apply the concept of aid laid down in Article 87, but have no competence to look for its legality. Direct effect is not influenced by the final decision of the Commission, which has only ex dune effect. (2) Article 88(3) prohibits any national measures designed to implement aid. (3) What are the consequences of this prohibition? To be sure, there is no equivalent sanction to the anti-trust sanction of invalidity in Article 81(2) [Ex 85(2)], but the ECJ has been explicit: '[T]he validity of measures giving effect to aid shall be affected [. . .] [T]he legal consequences of such invalidity must be determined by national law [...]. [Determination by national law shall be influenced by two considerations. The Court of Justice demands that national courts draw all appropriate conclusions from the infringement and requires that national courts decide in the light of whether the national legal system can ensure that a system of aid cannot become operational before the Commission has had a reasonable period in which to study the proposed measures'. The Court has called directly for legal consequences in national law: national courts are obliged to transpose the Court's ideas into national law. Article 88, to be sure, does not precisely define the scope of its application. In particular, it does not make it clear whether it is to apply to contracts in which third parties are used as instruments to transfer state aid. I would argue that Article 88 is textually open-ended. It allows an interpretation that serves the purpose of Article 87, namely, to encompass all aid that is directly or indirectly transferred, via third parties, to the recipient. Proposed measures, therefore, include measures addressed to third parties, to the degree that such measures are instrumental in the conveyance of aid to the recipient. (4) Are the legitimate interests of third parties effected in a negative way? I would answer no, to the extent that the third party is aware that it is conveying state aid to a recipient of the loan. Any credit institution that is approached by a state to conclude a loan agreement on the basis of a state guarantee must be aware of the Article 88(3) prohibition. It is reasonable not to expect a credit institution to honour the loan agreement, prior to Commission' approval of the aid. (5) What are the appropriate conclusions to be drawn in national law? I have no wish to bore you with German civil law, yet, I wish to register my surprise about the lack of fantasy in German doctrinal thought. Doctrine generally argues that such guarantees are void. I, in contrast, argue that the provisional unenforceability of the guarantee is an adequate solution up until such a time that the Commission reaches a negative decision. I have further argued the case in my paper: where the Commission approves the aid, the agreement will become—ex nunc—enforceable. If a negative decision is reached, the aid will be void. German law provides for this solution in anti-trust cases. My suspicion is that other Member States, particularly the UK, will arrive at the same solution of provisional unenforceability. I also think that Member States are obliged to make provision for this solution, if it is not already available.

188

Panel Discussion

I conclude that the legal sanction of provisional unenforceability is neither unfair to credit institutions, nor does it neglect their legitimate expectations. Credit institutions know that Member States must conform with Article 88. Provisional unenforceability serves the goals of Article 88, ensuring that aid is not implemented before the Commission has studied the implications, and guaranteeing that a credit institution will only be ready to act on the basis of such a guarantee when it has definitely become valid. • EHLERMANN—Thank you very much, Mr Roth. Do I understand that you take this position on the assumption that the beneficiary of the aid is not the bank, but a third party? • ROTH—Always.

• EHLERMANN—There is, however, one complication that you have not discussed: banks are sometimes beneficiaries of state guarantees given to them in order to help them to maintain solvency ratios. Equally, banks may systematically engage in guarantee business for a certain clientele. Where access to state guarantees is reserved, there might be a hidden motive for aiding the banks. We have not yet discussed this issue. • SCHUTTE—Indeed, Mr. Chairman, let me immediately start on this point. I think that the first thing that we must concentrate on, when looking at Article 87 and 88, is identifying the aid element and the aid relationship. We have just heard one premise: the bank is not the beneficiary of the aid. Therefore, the relevant question is one of whether Article 88 provides for an overriding preventive provision. Are these Treaty Articles really designed to prohibit all conduct falling within their scope, even when undertaken by a third party? Assume that a programme for state guarantees has been notified and approved by the Commission, subject to certain conditions. The Member State believes these conditions have been fulfilled and then says, 'I no longer have to notify the programme.' The Commission, however, later comes to a different conclusion. Must the bank bear the risk under these circumstances? I think Advocate General Jacobs dealt very well with the question of how to prevent the granting of aid in the Alfa Romeo and ENHLanerossi cases. In these cases, Italy had been required to obtain repayment from Alfa and Lanerossi. The repayment, however, was made not to the Italian state, but to ENI. The Commission argued that this was insufficient, even though ENI was a stateholding. There was still a danger that aid might still be disbursed and, accordingly, the aid should be repaid to the state budget. Endorsing this decision, AG Jacobs made it clear that it represented a preventive provision and was designed to ensure that aid granted would not be paid out. The ECJ did not follow his reasoning and ENI retained the money.

2 - Problems Arising from State Aids in Banking Sector

189

I mention these cases to underline my point that we need only to ensure that competitive distortions are removed. In the case of guarantees, even the Commission has recognised that there is no competitive distortion with regard to the bank: it is not the beneficiary of aid. Now, although it is clear that where aid is illegal, it must be repaid, we must still consider the exact position of the bank. Is it satisfactory to say that the bank was involved in the tripartite relationship—state, borrower, bank—and should, therefore, have no claim to repayment? Should the state be required not to honour the guarantee? What has caused the competitive distortion? Clearly distortion is caused by the lending of money to the borrower. Therefore, it is precisely that money that must be recuperated. The bank is totally irrelevant in this whole context. The question of whether the bank is paid or not has no impact on the removal of the distortion. Let us, accordingly, leave the bank out of the picture. In much the same manner as state owned banks, the bank is no more than ah agent of the state. The real focus for attention must be on the repayment of monies paid to the borrower, which the state has secured. Clearly, if, once assets have been used up, or the company has been liquidated, funds are left over, the state should hand these back to the bank.

• SCHUTTERLE—I am in agreement with the Commission's 1993 Communication: I think that the bank's claim should be honoured. This is a good position and there is no convincing reason to modify it. As a practitioner, my experience tells me that the transparency of law is a value in itself. Accordingly, the Commission must either make it clear that the 1993 position will be maintained, or make a statement—based on unconvincing reasons— that the position has changed; however, in this latter case, banks will merely increase their fees. In my view, however, greater damage is done to financial markets by intransparency than by increased fees. Transparency must be established by means of an internal Commission policy decision, which must then be discussed with the Member States. A further question—not directly bearing on the position of banks—is one of how to evaluate the state aid granted to innovative, entrepreneurial enterprises, whose risk capital everyone, including the EU, wants to see increased. Some countries, such as Germany, have developed systems whereby local or regional authorities compete with one another to grant aid. I feel that the aid value within such systems should not be ascertained through a complex calculation, but with reference to a lump sum. The German government has proposed that a lump sum of 0.5% of the value of such guarantees should be regarded as state aid. I think the Commission must very quickly produce a clear proposal to increase transparency in this area. Further, I cannot share Professor Roth's views on the legality of guarantees in relation to the position of the bank. I simply do not think that this is necessary. Both the Commission and the Court have hinted that they feel that banks should not be able to force the state to honour guarantees. I do not believe that

190

Panel Discussion

this is the case under Community law. Community law merely requires that the aid to the recipient can be recovered when and where a guarantee is regarded as being void. Germany has satisfied this requirement. Equally, there are some indications within Community law that, should the Commission change its position, it can nevertheless not make aid that has been previously considered legal null and void. To conclude, however, the Commission has simply not yet done enough to increase transparency. Why is the general information collected on national and regional aid programmes not made public? Is there a secret? Issues of commercial secrecy only arise in relation to individual notified aid. Equally, the Commission should include the conditions upon which aid is granted in the notification. In the HIBEG case, for example, the fee for the guarantee was around 1.5% too low. Yet, nobody knew about this since it was part of a state aid scheme. I know that this is a difficult issue, but it is important to provide transparency. The Commission has declared that it would like to receive more complaints from third parties. I note, however, that the Commission never receives complaints against programmes. Instead, complaints are always made in individual cases. The amount of state aid granted through programmes is, I think, far higher. It may be harder to identify competitive disadvantages. Yet, at the moment, those who are affected by a sudden alteration in regional aid programmes can only complain through political channels. Similarly, it is very difficult for individual firms to ascertain whether their competitors will be advantaged. I think that the number of complaints would increase if we were to apply the new rules of procedure to state aid falling under group exemption regulations as well. I would also invite banks to satisfy their own vested interests in fair competition by enquiring whether state guarantees have been authorised. The Commission should make use of the internet to disseminate such details. I know the resources of the Commission are overtaxed, but why not simply publish information on the internet so that all can have access to it? • EHLERMANN—Thank you. Let us now move on to the issue of the Landesbanken. • SCHNEIDER—Hearing Mr Van Miert's presentation this morning, I offered thanks to God that we have a Commission which is in a position to solve problems that we cannot solve internally. For me, the best example of this is public radio within Germany. Here, the waste of money and the degree of trade distortion are enormous: the balance sheet total of public radio in Germany is 20 billion marks, which is equivalent to the budget of six universities. I think we need to shed more light on the issues of 'Anstaltslast' and 'Gewahrtragerhaftung', beginning with their translation. The current English translations of Anstaltslast and Gewahrtragerhaftung are 'maintenance obligations' and 'guarantee obligations', which I feel to be totally misleading. Now,

2 - Problems Arising from State Aids in Banking Sector

191

it is very difficult to translate legal terms into other languages: can 'building society' be translated into French? The same is true of Anstaltslast and Gewahrtragerhaftung. Reading some of the papers for this work, I get the impression that Anstaltslast and Gewahrtragerhaftung are forms of contractual guarantee. This is not true. Anstaltslast and Gewahrtragerhaftung form a part of German public corporation law. Accordingly, we must first understand that Landesbanken are public corporations. We must then compare the forms of public corporations with the concepts of private corporations, such as stock corporation, partnership co-operatives and mutuals, which leads to the conclusion that the same concepts underpin both public and private corporations. I begin with Anstaltlast, which I would translate as a 'concept of recapitalisation.' Internally-speaking, this concept works in the same way as rules on stock corporations and on companies with limited viability do. The shareholders of an undercapitalised stock corporation must inject new capital if they want the company to continue trading. The same is true of public corporations. The founder of a public corporation must secure itsfinancialbasis so that it can trade. The same is true of the stock corporation: if the shareholders of an undercapitalised stock corporation want it to continue trading, they must provide new capital. That concept is also laid down in the second EC Directive on company law. The same is true for Gewahrtragerhaftung, which should not be translated as 'guarantee', but as the concept of 'subordinated unlimited liability'; a concept that is also found in relation to co-operatives and partnerships. The essential questions are thus: can the state play a role in a partnership, and can it play a role in a co-operative that is governed by a concept of unlimited subordinated liability? If you answer, 'no, this is illegal aid', can you think of any other legal form within public or private corporation law which would be suited to state banks? Moving on to banking supervisory law. In my opinion, the great problem is that, in banking supervisory law the 'hot issue' is how can we prevent the bankruptcy of a bank? Large banks are sheltered by the 'too big too fail' umbrella. This is a de facto 'subordinated unlimited liability' concept and is it identifiable within the ratings of private rating agencies, not only in relation to the ratings of Deutschebank and BNP, but also in relation to the ratings of the Landesbanken. Consequently, I see no real difference between the de facto concept of subordinated unlimited liability (too big to fail) and the statutory concept of subordinated unlimited liability (Gewahrtragerhaftung) within the banking supervisory system. To conclude, I would like to give you the balance sheet figures for Deutschebank and the Landesbanken: (i) the Deutschebank now has a balance sheet total of 1.6 trillion DM, up fifty-fold from 38 billion DM in 1970, and equivalent to three times the German state budget; (iii) all 13 Landesbanken together, have a balance sheet total of 1.8 trillion DM. Now, increased concentration in the banking sector—a trend evidenced by the dramatic increase in Deutschebank's assets—increases the risk of systemic risk. A decentralised

192

Panel Discussion

banking system gives us a smaller degree of systemic risk. If Germany were required to dispense with the concepts currently laid down in its public corporation law, we would see an increase in concentration and systemic risk. This is something I do not wish to see. • KOENIG—A word of apology to Mr Schneider since I will misleadingly translate the two terms, Anstaltslast and Gewahrtragerhaftung, as 'statutory maintenance obligation' and 'statutory guarantee obligation'. Neither is an ad hoc guarantee and both are given on a permanent, statutory law, basis. This, I think, is neglected by my colleague: permanent state guarantees—particularly, statutory maintenance obligations and statutory guarantee obligations— obtain better ratings for public financial such as the Landesbanken, and thus favour them above private banks. Most Landesbanken are greatly advantaged in the field of refinancing. This represents a 'statutory' advantage over private competitors. This is clearly state aid within the meaning of the EC Treaty. Clearly, the costs that the banks incur in fulfilling public functions can be compensated for. Article 86(2) EC, however, does not provide for a general exemption. This Article only allows for sectoral exemptions. Statutory maintenance and guarantee obligations, however, favour the profitable portions—for example, the derivatives market in Eastern Asia—within public banks by improving their international financial ratings. The declaration on public credit institutions in Germany, which was only half-heartedly passed at the EU Amsterdam summit, creates no general exemption in favour of the Landesbanken or savings banks (Sparkassen). If anything, the Amsterdam declaration confirms the applicability of the EC state aid regime. Thus, public banks are exempted from the regime only in so far as they support regional financial infrastructures by helping local authorities to make a comprehensive and efficient financial infrastructure available within their regions. Accordingly, the international business—bond, currency and derivatives trading—of the Landesbanken is exposed to the EC state aid regime to the extent that it can be proven that statutory and maintenance obligations are unfairly advantageous. Generally, the principles of legitimate expectations and property ownership prohibit the withdrawal of the guarantees from creditors who are not involved within a state aid relationship. The Landesbanken, however, are the beneficiaries of Anstaltlast and Gewahrtragerhaftung. Here, the creditors—for example, bonds' creditors—are third parties who have 'paid for' the state aid element through the receipt of lower interest rates on loans to the Landesbanken. The state aid element that is present here can only be abolished if interim regulations afford sufficient protection to such third parties. Whether the aid in question is an existing aid or a new aid under Article 88 is irrelevant. If the Commission demands the abolition of Anstaltlast and Gewahrtragerhaftung, lucrative foreign business would be transferred to private corporations. The sectors of business which are necessary for the establishment of a regional financial infrastructure should be retained in the hands

2 - Problems Arising from State Aids in Banking Sector

193

of the Landesbanken and should still be protected by Anstaltlast and Gewahrtragerhaftung, instruments which would then be justified on the basis that they are paid for through the provision of public services. This particular model would avoid the total privatisation of the Landesbanken and would ensure that property is respected in line with Article 295 EC. • PAPA MALATESTA—I begin with a question: what is a service of general economic interest under EC law? Does the provision of a basic financial infrastructure qualify as a service of general economic interest? Are the Member States free to decide for themselves what constitutes a service of general economic interest? Now, public banks do, in fact, provide services which may be in the general public interest. The Commission evaluates such services on a caseby-case basis, which, I think, is a good approach. Equally, the Amsterdam declaration is an acknowledgement by all the Member States that such services must be evaluated in the light of the Treaty. Returning to state guarantees, I think the current Commission position is that creditors can enforce a guarantee against the state: the act of giving the loan does not, of itself, constitute state aid. Imagine a perfect world where the aim is to declare state aid void and to ensure the reimbursement of the state aid element—the difference between the true and market rate of interest—to the state. Why should we think in terms of the state not honouring its guarantees to the bank? This would be a disproportionate consequence. The situation in EFIM, if I am correct, was slightly different: certain creditors of EFIM were also members of the group: allowing the state to reimburse the creditors of EFIM, would thus have constituted indirect aid to EFIM. Returning, finally, to the case of the rescue and restructuring of banks, where the Commission has indicated that it is aware of the specific nature of the banking sector but generally claims to apply its normal rules. The situation over the last years has not been satisfactory: the notion of 'too big to fail' has forced the Commission to subordinate the state aid regime to other economic factors. On the other hand, we cannot expect the Commission to take the sole responsibility for prompting a systemic crisis. Every crisis is a potential crisis, so that the guidelines cannot be applied too strictly. In the last Credit Lyonnais case, the Commission stressed the need to rethink crises strategies. The main aim must surely be the orderly winding-up of the bank. This is a market solution. State regulatory intervention should then seek to ensure that big banks are wound up in an orderly manner with the aid of mechanisms such as temporary state guarantees, which would prevent a more general crisis. • SUBIOTTO—I would like to state that I do not agree with the view that a state guarantee should become unenforceable. We should clarify one issue with the aid of the Cityflyer case. Here, the Commission insisted that the aid element to be re-imbursed be the difference between the lower rate of interest received by virtue of a state guarantee by the borrower and the true market rate. The Court

194

Panel Discussion

confirmed this view. Accordingly, if this remedy is to be truly effective, we cannot make the loan agreement void, since to do so would also be to negate the market rate. By the same token, if the loan is not automatically void, any other related contractual instrument should not be automatically void, either. Assume a situation where the borrower has reimbursed the state aid element and is now paying the market interest rate. Where the bank continues to benefit from a state guarantee, it is arguable that it is now benefiting from a state aid. Accordingly, we must argue at this stage, though not before, that the guarantee should no longer be enforceable: I am not convinced that we can regard a state guarantee to be unenforceable prior to the borrower having taken steps to cure the state aid element. • EHLERMANN—I think that, prior to moving on to the discussion, we should quickly note that the discussion on state guarantees at the time of the Commission's 1993 communication was not particularly advanced. The triangular relationship between the state, the banks and a borrower has only recently become controversial. In this context, the fundamental issue for me is whether—independently of the question of whether the banks are benefiting or are not benefiting—Article 87(3) has direct effect, as Mr Roth maintains, or whether different national legal systems may continue to apply different solutions. Does Article 87(3) require us to 'taint' the guarantee, since it is a corollary to the granting of illegal state aid? • DAMMERS—As a practitioner, I have been working on the question of whether Anstaltlast and Gewahrtragerhaftung violate Article 87 for four years. However, even following today's discussion, I am still confused about the issue. We keep forgetting that the issue only arises in relation to German Landesbanken: I have spent a fortune translating articles for my members to keep them informed. I would like to make a plea for greater transparency. Take an investor, The Teacher's Retirement Fund in Arkansas, which wants to buy some bonds: should he buy from Landesbanken or from Italian state-owned corporations? If there is no clarity, what can this investor do? My personal view is that banks or bondholders are not beneficiaries of the guarantee. The interest rate paid on the guarantee loans is the market rate for a guaranteed loan. Whatever the right answer is, I think we are entitled to a clear statement from the EU. We now have an intolerable situation. There are at least three Draft Notices. One day, someone is going to go into court and say, '[W]ell, your lawyer knew about this Draft, so you should have known what the current thinking in the Commission was.' It is clear to me that the Commission wants banks to enforce a rule that it cannot itself enforce. We need a clear rule. The current Draft Notice is not clear: you are asking the bank to change drastically the way they do business in a highly competitive field on the basis of unclear rules. I also think we need grandfathering for existing deals on the basis of the payment of a guarantee fee. The Commission's current Draft suggests that a

2 - Problems Arising from State Aids in Banking Sector

195

guarantee fee must be paid and states that the guarantee will be illegal. The reason for this double sanction is very clear, if unstated: the Commission knows that the Member States are not good at recouping aid. This indicates to me that we are operating in an area where politics is more important than law. This is unfortunate. However, if you do want the banks to be the policemen, you must give us clear rules. • PETERSEN—I would like to distinguish between the situation where the bank is not the immediate beneficiary of aid and the situation where the bank is the immediate beneficiary of aid. In the first context, I think we have a double problem: on the one hand, we have the 1993 communication stating that illegality does not affect the state's obligation to honour its guarantee; on the other hand, I think that it is clear that national law governs the situation in relation to such guarantees. Accordingly, we will see differences between Member States that can only be ironed out through a lengthy period of harmonisation. Now, the Commission's new Notice seems to me to entail a warning to banks: '[Y]ou can no longer rely on the 1993 communication'. Banks must now bear a very real risk. The ECJ has clearly stated that banks must exercise normal prudence and diligence in relation to the legality of acts. Banks cannot, therefore, rely on legal expectations. I also feel that the Court will take a long and hard look at the question of whether the banks are instrumental in relation to the illegality of an act; whether they are instrumental in the conveyance of legal aid to a recipient. We clearly do have a vast problem with the volume of unnotified aid. Now, we are not using the banks to solve this problem, we merely recognise that the Member States do tend to use third parties to convey their aid—this is a growing problem in relation to the stability pact. Thus, I believe that the risk of action against third parties is very great and that the Commission is correct to have sent out a warning to the banks. Moving on, however, I am doubtful about Mr Dassesse's argument that the bank is also an immediate beneficiary of the aid, since guarantees do not figure in the bank's risk engagement for purposes of solvency monitoring. Nonetheless, to turn to Mr Schneider's assertion that Anstaltlast and Gewahtragerhaftung are mere equivalents of the 'too big to fail concept', I think that we need note not only that Anstaltlast and Gewahtragerhaftung seem to be equivalent to Paragraph 236(2) of the Italian Civil Code, but also that Article 86 EC requires the Member States to desist from any measures that would amount to discrimination under the terms of Article 6 EC. Anstaltlast and Gewahtragerhaftung do constitute discrimination and thus are contrary to the state aid rules. Equally, I, personally, do not think that the concept of 'too big to fail' really exists in the banking world. We have recently seen the failure of a number of 'big' banks, I would finally just like to stress, in relation to neutrality of ownership, that we have never made privatisation a condition for state aid.

196

Panel Discussion

• EHLERMANN—Thank you very much. I think Mr Winkler underestimates the EFIM problem. If national rules introduce further EFIM-type support for public companies, they will be very difficult to justify under the neutrality provision. • SCHNEIDER—A few points in answer to Mr Dassesse. Anstaltlast and Gewahrtragerhaftung are very difficult to explain: they are state law, rather than federal law, concepts. Equally, they are not found in statutes but form a part of an unwritten body of law which is a part of our public corporation law. Accordingly, if the Commission were to decide that Anstaltslast and Gewahrtragerhaftung are illegal state aid, this would not invalidate contracts, but would invalidate rules of corporation law. This would be a novel situation. Furthermore, where you allow states to engage in business, they should be given the possibility of choosing between public and private forms of incorporation. The EU ha,s yet to harmonise public corporation law. The Second Company Law Directive partially harmonises private corporation law, and attempts to protect creditors through various concepts: (i) a prohibition of the distribution of the hidden reserves and profits of stock corporations; (ii) afixedcapital for stock corporations; and (iii) the direct liability of shareholders in relation to undercapitalised corporations. Turning this final concept around, we might argue that it gives shareholders a choice: either you inject capital or you cease to trade. This is a direct equivalent of Anstaltslast. Accordingly, were the state to choose to trade in the market in the form of a stock corporation, we would be faced with the same problem. Next, the Federation Bancaire would come and say, look you have these rules of lifting the corporation veil, you have rules of the duty to recapitalise. The same is true of subordinated unlimited liability: members of co-operatives have unlimited liability. If the state joined a cooperative, would unlimited liability amount to state aid? If the answer is yes, corporate law rules would be invalidated; an unacceptable situation. Alternatively, we could opt for the US 'Delaware' system of competition between rules of incorporation. This would be a very new discussion. To conclude: if you allow the state to engage in business and choose between corporate forms, you will be faced with exactly the same problems, whether you are talking about Anstaltlast and the duty to recapitalise, or about Gewahrtragerhaftung and unlimited liability. • WINKLER—Just four points. (1) Although current uncertainty about guarantees makes things difficult, it does seem to be working. I am presently involved in a case where the underwriters in a very large investment project are refusing to underwrite the bonds of an issuer who has a state guarantee problem. (2) Crime by association does exist in certain cases. I believe a due diligence obligation must be attached to banks in receipt of a state guarantee. Any reasonable businessman should be able to evaluate whether or not there is reason for the Commission to intervene.

2 - Problems Arising from State Aids in Banking Sector

197

(3) Let me be a touch provocative on state ownership. It is my impression that the Article 295 neutrality principle is, under state aid rules, discriminatory in the financial sector. In other words, banks benefit from public ownership and access to indefinite guarantees, since they are, thus, given access to cheaper capital. I do not know what the answer is. Maybe, we just have to live with this. (4) Fourth and last point with respect to liquidation. I sometimes feel that liquidation is a very costly procedure and sometimes more distortive of competition than other restructuring means. To give you an example, the Credit Lyonnais hive-off vehicle, which is, in fact, a form of liquidation, has given rise to far higher costs in relation to a number of assets. These losses would not have arisen had the assets remained within Credit Lyonnais. • KOENIG—To quickly answer Mr Schneider, of course the state has a choice, but it must also comply with competition. The public entity is not prohibited. Instead, guarantees must be constructed so as to comply with the competition regime. As a brief response to Mr Dammers' concerns about pension funds in Arkansas, I would say "do not be overly worried" since the principle of the protection of legitimate expectations should prevent the withdrawal of the beneficial effects of a guarantee from the creditors who paid for it without knowing of the issue. To make it crystal clear, the Landesbanken benefit from Anstaltslast and Gewahrtragerhaftung. Creditors are merely third parties, and their interest will need to be protected through interim regulation. • DASSESSE—It strikes me that we have failed to talk about the Eurozone. From the first of January 1999, the ECB will be the only institution within Europe with the competence to increase money supply. And, at the end of the day, you require cash to back a guarantee. While you can also raise taxes, the days of high taxation are over, and thus printing money is an attractive option. What strikes me is that we are speaking solely about the Commission. Now, current Treaty rules require that the ECB be consulted should any measures that might effect the stability of financial markets be taken. Yet, the Draft Notice contains no indication that the ECB has been consulted. The one justification for not consulting the ECB would be that the measure had no impact on financial stability; but a period of grace is granted in order to lessen the danger that markets will be upset. Now, I think our discussions must pay due attention to the fact that competences have been passed to the ECB. Accordingly, my suspicion is that a blessing for existing guarantees can only be given in consultation with the ECB, since, where we put future guarantees in jeopardy, we will inevitably see a calling in clauses and an impact upon the market. • DAMMERS—I hope that Mr Koenig's assertion that third-party rights will not be affected is correct, but I fear that this is not current thinking within the

198

Panel Discussion

Commission. One draft prior to the current Notice suggested that bondholders should recoup monies lost by suing the lead manager of the transaction. My members are not looking forward to this with particular pleasure. We have talked about banks policing the state aid rules but perhaps the real policemen should be the lawyers who advise the banks and are turning a blind eye to the problem. Of my collection of prospectuses on guarantees issues, only three or four disclose the problem: are counsels to issuers and underwriters doing their jobs properly if they do not force disclosure? And I do not mean talking with the assistant vice-president, which is the normal manner in which a lawyer covers his ass, I mean taking it up to the board level. This problem plagues our industry. Just as competition between international banks leads them to turn a blind eye, competition amongst law firms leads them to permit their clients to do things which are foolish. • FAULL—It is clear that we in the Commission must quickly do something to clarify the situation. However, to turn to Mr Schneider, the fact that Anstaltlast and Gewahrtragerhaftung are hallowed provisions of German corporation law will not protect them from the Rome Treaty. This afternoon, I have learned that Anstaltlast is sometimes incorporated into an unlimited liability arrangement by custom. By virtue of my common law background, this does not shock me at all. However, we will take the problem back to Brussels. We cannot continue with the system whereby various sections of various drafts are leaked. Personally, I do not want to leave the Council to decide on this issue. Nor do I want it to be settled by the judges. It is the Commission's responsibility. • SCHUTTE—Just a little teaser. If I understood Mr Koenig correctly, he said that public banks pass on the advantage of their cheaper loans to their creditors. Is this correct? If so, the Landesbanken are no longer beneficiaries of aid, they are merely passing on benefits to their creditors. Similarly, I wonder if Article 87 can really be extended in jurisdictional scope to covet any competitive advantages which the Landesbanken may have in Asia? • KOENIG—The Landesbank is a beneficiary because benefits are derived from a preferential rating due to the statutory guarantees. These benefits remain within the bank and do not move to a third party. Bondholders pay for any benefit they receive from the AAA rating of the Landesbanken through lower interest gains. That is the construction. • FAULL—On Asia, I think it is clear that any European bank that benefits from Anstaltlast and Gewahrtragerhaftung is competing with other European banks in the Far East and thus fall under Article 88(1).

2 - Problems Arising from State Aids in Banking Sector

199

• ILAKO—Just one specific comment. It is suggested that auditors, or reporting accountants, could play a role in checking guarantees. I feel that this role would be limited and that auditors should not be asked to second-guess the bank's lawyers. Although firms such as my own also have legal divisions, these are separate divisions. All that the law requires an auditor to do is to check certain prudential returns. The scope of this activity is clearly defined and does not require an auditor to second guess the legality of a contract. • GUAL—Just a brief economic intervention: I have been dumbfounded by some of the debate this afternoon. It seems to me that there is no doubt that banks in receipt of guarantees benefit from lower capital costs and can thus compete more effectively in the marketplace. • SUBIOTTO—Yes, returning to the Asian question, I thought Air France had confirmed that the ECJ feels that extra-territorial competition between EC firms is relevant. This was one of the reasons why the decision was annulled: extra-territorial competition between EC firms must be taken into account in the evaluation of state aid. • SCHUTTERLE—A question to Asger Petersen on his remark that the Draft Notice is a clear warning to banks that guarantees may not be safe. I thought the 1993 Communication had clarified the situation. What does 'a warning to the banks' mean? Intransparency? I would be very grateful if this issue were settled quickly. • BURNSIDE—I am bemused by the round of finger-pointing as to who is at fault; but it must stop. Mr Dammers says the lawyers are at fault for non-disclosure of the guarantee problem in prospectuses—'let us kill all the lawyers', as Shakespeare once wrote—yet, although I am not active in this practice, it seems to me that my colleagues are aware of the problem and have been aware of it for some years. However, the market perception of the problem has not yet crystallised to the degree where it is thought to affect market practice. I, too, do not think accountants can be held responsible. It seems to me that we are all aware of the problem and, when the market feels it to be a sufficient problem, its effects will be felt through the rating agencies. This issue is being passed from desk to desk. It has wound up on Mr Faull's desk and he says he will deal with it soon. But, there is no current consensus that we have illegality and this conditions the view of the market. • EHLERMANN—But, Mr Burnside, we have greater clarity now on these issues than we have ever had. Similarly, the real complexities of the problems—such as, is the bank a beneficiary?—have only just been recognised. The great merit of this discussion is that it has further highlighted these complexities.

200

Panel Discussion

• ZADRA—A quick remark for Mr Faull. It seems to me that the Commission has failed in its duty to pursue the matter. The 1993 Communication stated that the rule would not be applied. This is why the guarantee problem is not disclosed in prospectuses: the law is not perceived as a risk. • SARCINELLI—To bring in more economic views, the essential problem to me would seem to be that the German Government requires banks to undertake a public function, but over-compensates them by lowering their capital costs. I do not understand Mr Koenig's last intervention for this reason. The bank's benefit might be transferred to the depositor in the form of the highest rate of interest, or to the creditor in the form of the lowest rate of interest. More probably, however, it will be transferred into higher labour costs. Thus, many markets might be disturbed. If the German Government could find a proportionate means to compensate banks, the problem would no longer arise; unless, of course, the Commission has a right to intervene in order to define what the general economic interest is. • HOUTMAN—Just two short remarks. Firstly, I do not think the question of who receives the aid is relevant: were Mercedes able, by virtue of state aid, to borrow at a lower cost and were it to pass on cost benefits to consumers, we would still be talking about state aid to Mercedes. The bank is a beneficiary since it can borrow more cheaply on the markets. Secondly, if Mr Petersen is right that the status of illegal state guarantees is a matter for national law, what can the Commission do to make the situation more transparent? • EHLERMANN—Thank you. I do not want to sum up, but we are clearly talking about two separate problems. One is the problem of Anstaltlast and Gewahrtragerhaftung. This is a problem of transition. The other is the problem of individual, rather than institutional, guarantees which are given to incite a bank to grant a loan that it otherwise would not grant. Here, we have a far greater transitional problem, since the problem is not restricted to Germany but extends to the whole of the Union. A lack of Commission clarity is understandable in this case: the problem is huge. We may not be able to solve it quickly, but we can raise (elite) awareness.

I Colin Bamford* Unapproved State Guarantees for Bank Loans and Other Borrowings: Legal and Policy Issues

I. Introduction Among the best security which can be given to bank lenders or bond investors is the guarantee of the government of an OECD member. Bond investors and banks (referred to below collectively as 'lenders') are prepared to advance money at good rates, even to borrowers of secondary credit standing, since: a) the existence of the state guarantee switches the credit risk to the state, which is eminently creditworthy; and b) for the purposes of regulatory capital, such guaranteed loans are treated as being risk-free. No capital is needed to support the lending. 1 This saving allows the 'lender' to reduce the interest rate even further. For 'lenders', state guaranteed debt is attractive, if unexciting, business. The low profit margins are compensated for by the strength of the state's covenant. A difficulty nonetheless arises within the EU when a Member State's motivation in agreeing to guarantee the debt of the borrower is improper or otherwise flawed, in particular, where the Member State wishes to provide aid to the borrower in breach of Articles 87 and 88 [ex 92 and 93] of the Treaty of Rome. Rather than make a cash grant or 'soft' loan to the company which the Member State wishes to assist, it might instead agree with the company that the Member State will guarantee a loan taken out by the company or a bond issue made by it. The agreement of the State to give that guarantee induces the lender to advance funds to the aided company at rates which are appropriate for the credit standing of the Member State, rather than at rates that reflect the unaided status of the borrower. In some cases, the Member State guarantee

* Chief Executive, Financial Law Panel, London. This paper is the responsibility of the writer and does not necessarily represent the views of the Financial Law Panel or any of its members. It does, however, draw heavily on the work on this topic of the FLP's expert working group. I would, therefore, like to thank Dr Mads Andenaas of the Institute of Advanced Legal Studies, David Harris of Lovells, Katherine Holmes of Richards Butler, Dorothy Livingston of Herbert Smith and William Long of the National Provident Institution. Further details of this complex topic may be found on the FLP's website http:llwww.flpanel.demon.co.uk (password 'subscriber'), or from the Panel's Secretariat on 00 44 207 489 1601. 1 See, Council Directive 89/647 on a solvency ratio for credit institutions, OJ (1989) L386/14.

204

Working Paper I

induces a lender to advance funds to a company which it might not otherwise accept as a customer. In some Member States, the aid to a borrower can be made without the need for the state itself to take any positive action at all. Where local law provides that, under some circumstances, a shareholder is liable for the debts of a wholly-owned subsidiary, a lender may be induced to deal with a company on the simple basis that the company is owned by a state entity. The mere existence of a relationship between the state entity and the aided company places a credit support obligation on the State, which, in economic terms, amounts to a 'virtual' guarantee. Under the terms of the Rome Treaty, there may, of course, be circumstances in which the action of the Member State in providing credit support to the borrower may amount to state aid to that borrower. If the requirements of Articles 87 and 88 are not met, the action of the state will be unlawful. The Commission may then require that the Member State desist from granting any further aid, and may further require that the effects of any existing aid be nullified. If appropriate, the borrower may be required to pay a guarantee fee to the Member State that raises the total cost to the borrower of taking the loan from the lender to the level which it would have had to pay had it raised the loan without the benefit of the state guarantee. The difficult question to which these circumstances give rise and which has troubled the participants in the banking and capital markets for some years is: 'To what extent is the lender affected by the illegality of the arrangements made between the Member State and the borrower?'

II. The View of the Commission The Commission's view upon this question is to be found in its recent Draft Notice,2 and its thinking may be summarised as follows: a) The Commission accepts that, in such circumstances, the 'lender' is not the recipient of state aid. The lender provides a commercial service (the provision of the loan to the borrower) on commercial terms (i.e., at an interest rate which reflects the credit risk). The contract of guarantee between the Member State and the lender is not, therefore, itself aid and cannot be regarded as illegal upon that ground. b) Since the Member State's decision to give the guarantee in the first place is part of an illegal arrangement between the Member State and the borrower, the guarantee entered into following that arrangement is unenforceable by the lender, even though the lender receives no aid, and can be thought of as being 'innocent' of any involvement in an unlawful activity. 2

Commission Notice on the Application of Arts. 87 and 88 of the EC Treaty to State Aid in the form of Guarantees (nyr).

2 - Problems Arising from State Aids in Banking Sector

205

The Commission's conclusion is a harsh one for lenders who may have committed no unlawful act, nor benefited commercially from any state aid. The pill is particularly bitter for bond investors who may have purchased the borrower's debt in the secondary market and be unaware of the original circumstances surrounding the giving of the state guarantee. Nonetheless, the Commission considers the results to be beneficial. An extreme consequence of the such putative illegality is that lenders may not be in a position to afford to accept a guarantee which might be contaminated by a Member State's unlawful act. The banking sector will thus police compliance by the Member States with their Treaty obligations to notify the granting of aid and to have it cleared by the Commission.

III. The View of the Financial Law Panel The Commission's approach is regarded with some concern by the Financial Law Panel (FLP). This unease, however, is not a response to the policy decision that the commercial banking sector and capital markets should be used to ensure the Member States' compliance with their Treaty obligations. Rather, the worry is that the Commission's policy approach is based on a generalised and possibly incorrect view of the legal status of the guarantees concerned. The legal position may not be consistent as between individual sets of circumstances and as between different Member States. Furthermore, there has been no proper investigation of the legal consequences in individual Member States of a finding that a guarantee is unenforceable. Where one is unsure that the legal position will give rise to consistent consequences across the single market, one can similarly not be certain that market participants will react in the same manner. If this is the case, the imposition of the Commission's policy may have the effect of distorting competition, rather than the opposite.

IV. Enforceability of the Guarantee The reasoning which leads to my conclusion that the Commission may be distorting, rather than supporting, competition is as follows: a) In English law, an arrangement or contract which is illegal is almost invariably unenforceable. On this basis, any arrangement between the state and an aided company which infringes Article 87 or 88 would be unenforceable in the English courts. b) The matter becomes much more complex, however, when one examines the effect of the illegality on contracts which are, in an economic sense, connected with the illegal arrangement. The question for the court is, then, one

206

Working Paper I

of whether the illegality has the effect of 'tainting' the connected contract, so that the parties to that linked agreement should be treated as if they were involved in the arrangement which is illegal. The question of whether a particular linked contract is 'tainted' by illegality is extremely complicated and very heavily dependent upon the facts of the case concerned, the knowledge of the parties and their intentions in entering into the arrangements. The Law Commission, the statutory body whose function is to consider questions of law reform, has recently published a Consultation Paper on this issue.3 This paper supports the view that the exact limit of the 'tainting' principle is not clear and depends upon the particular circumstances of the case. The Law Commission is currently actively considering proposals for a reform of this area of law. However, until any such reforms are introduced the position will remain unclear. c) In English law, the Commission's view that a Member State's decision to enter into a guarantee in favour of a lender, as part of an unlawful aid package to a borrower, will always result in the guarantee being unenforceable by the lender, is an over-simplification. The guarantee may be enforceable or unenforceable as the facts dictate. d) Although the FLP has made no investigation of the law in other Member States, it nonetheless presumes that the complexities of the English legal position are also to be found in many other Member States. e) It should similarly not be overlooked that the law in States outside the EU may also be relevant. In particular, a bond issue by an EU company which is guaranteed by a Member State may contain a clause determining that the bond is governed by the law of New York. Such a bond may be traded in the secondary market in New York and held, for example, by US pension fund managers who have never heard of Articles 87 and 88. If a bondholder sought to enforce its rights under the guarantee against the Member State in the courts of New York, applying New York law, it is possible that a New York court would hold that the enforceability of the guarantee was unaffected by the Member State's breach of its obligations under the Treaty. If, as I believe, it is true that the enforceability of a state guarantee in these circumstances is unpredictable and complex, one may, in terms of competition policy, argue that the same result has been achieved as would have been the case were the guarantee to be clearly unenforceable. In neither case may a lender confidently accept a guarantee, unless it is clear that Articles 87 and 88 have not been breached. Thus, the particular policy objective of forcing private sector lenders to police the behaviour of the Member States appears to be as well served by the uncertainty of the legal status of state guarantee as it is by the certainty that they are unenforceable.

3

Illegal Transactions: The effect of illegality on contracts and trusts, Law Commission Consultation Paper No. 154.

2 - Problems Arising from State Aids in Banking Sector

207

V. Consequences for Competition This is not, however, the end of the legal story. The fact that a particular contract is unenforceable or void does not necessarily mean that no legal remedy is available to an innocent party. In particular, a lender whose position was prejudiced as a result of the breach by the Member State of its Treaty obligations might have a claim against that Member State for damages arising out of its wrongful act in inducing the lender to believe that its guarantee was both valid and valuable. The availability and legal form of any such claim will, once again, be different under the law of each Member State. Indeed, such a remedy is likely to be much more readily available in some legal systems than in others. Whilst it is dangerous to generalise in these areas, it is fair to say that under English law such a claim against the UK Government would be very difficult to sustain. In English law, therefore, where a state guarantee is unenforceable, the loss is likely to fall upon the lender. In other Member States, however, a lender might find it easier to mount a claim for compensation. The FLP, in common with the Commission, has yet to undertake detailed research upon this point. If the Commission's policy proposals are to be implemented, it is nonetheless vital that this research be undertaken as a matter of urgency. The implementation of this policy, in circumstances where its substantial effect is different across the EU, could have the effect of distorting competition within the single market. Thus, while lenders in Member States where the legal status of bank guarantees is uncertain (or where it is certain that they are invalid) may not be prepared to accept them without confirmation that the terms of the Treaty have been met, since to do so would involve a substantial risk of non-repayment, potential lenders in other Member States may take a more relaxed view if they are assured that, even where the guarantee is invalid, they will be able to recover the same amount by a different legal route.

VI. The Need for Certainty The present position of uncertainty is unsatisfactory. The matter will not be improved by the terms of the Commission's Draft Notice. It is essential that clarity and certainty are introduced into this area since: a) it impacts upon the integrity and security of the system of bank supervision which applies within the EU and world-wide. If banks are to be able to evaluate their capital needs (and regulators to be satisfied with this evaluation) they need to be sure of the legal status of the assets which they hold. b) if the goal of free and fair competition across the single market is to be attained, it must be certain that the legal status of guarantees, and of the consequences whichflowfrom their grant, should be the same in each of the Member States.

208

Working Paper I

In my view, the only way to achieve this objective is through legislation at EU level. If we have a policy that guarantees in support of unnotified state aid are to be of no value, this must be confirmed at Community level. In addition, any national rules or procedures which have the effect of diluting that policy must then be repealed.

II Jacques H. J. Bourgeois* EU Rules on State Aids and WTO Provisions on Subsidies Compared: The Case of State-Owned Banks

I. Introduction This paper investigates the extent to which, where the state is the investor,1 state-owned banks and certain of their operations (investments, granting of loans, issuing of guarantees) are to be considered as state aid within the meaning of Article 87(1) [ex 92(1)] EC Treaty (Section II) and as subsidies with the meaning of Article 1 of the WTO Agreement on Subsidies and Countervailing Measures (the SCM Agreement). This analysis will be followed by a brief comparison (Section IV). The paper does not, however, deal specifically with the various forms of subsidies that may be granted by the state to privately-owned banks.2

II. EC Rules Pursuant to Article 87(1) EC Treaty,3 state aid is denned by means of four conditions: the aid must be 'granted by a Member State or through state' resources; it must distort or threaten to distort competition; it must affect trade between Member States; and it must favour certain undertakings or the production of certain goods (i.e., the so-called 'selectivity' or 'specificity' theory). This paper examines the first of these conditions.

* Partner Akin, Gump, Strauss, Hauer & Feld (Brussels), Professor at the College of Europe (Bruges). 1 The text of the SCM Agreement can be found in (WTO 1995:264). 2 (Dassesse 1997). 3 'Save as otherwise provided in this Treaty, any aid granted by a Member State or through state resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the common market.'

210

Working Paper II

A. The 'Market Economy Investor' Test under EC Rules 1. The Test The European Commission has developed the market economy investor test as a tool to establish when state investment, with regard to which the EC Treaty is expressly neutral, is to be qualified as state aid within the meaning of Article 87(1) EC Treaty.4 This approach has been endorsed by the ECJ.5 The Commission has elaborated this test as 'the terms which a private investor would find acceptable in providing funds to a comparable private undertaking when the private investor is operating under normal market economy conditions.'6 In its decisional practice, the Commission has developed a series of objective criteria that put flesh on the bones of the 'market economy investor principle.'7 The Commission has identified six typical cases where the market economy investor test is prima facie not met:8 1. Where the financial position of the company—in particular, the structure and volume of its debt—is such that a normal return on the capital invested (in dividends or capital gains) cannot be expected within a reasonable period; 2. Where, by virtue of its inadequate cashflowif for no other reason, the company would be unable to raise the funds needed for an investment programme on the capital market; 3. Where the holding is a short-term one, with duration and selling price fixed in advance, so that the return to the provider of capital is considerably less than he would have expected on a capital market investment over a similar period; 4. Where the state's holding derives from the taking over or the continuation of all or a part of the non-viable operations of an ailing company through the formation of a new legal entity;

4

The European Commission restated its position in an amended 'Communication concerning the application of Articles 87 and 88 [ex 92 and 93] of the EC Treaty and Article 5 of Commission Directive 80/723/EEC to public undertakings in the manufacturing sector' (OJ 1993 C307/3). 5 Judgment of 4 July 1982, France, Italy and UKv. Commission [1982] ECR 2545; see also Judgment of 10 July 1986, Belgium v. Commission [1986] ECR 2263; of 14 February 1990 France v. Commission [1990] ECR 1-307; of 21 March 1990, Belgium v. Commission [1990] ECR 1-959; of 21 March 1991, Italy v. Commission [1991] ECR 1-1433; Judgment of 14 September 1994, Spain v. Commission [1994] ECR 1-4103; CFI, Judgment of 30 April 1998, Cityflyer Express v. Commission [1998] ECR 11-757. 6 Loc. cit, n. 4, para. Ill (11). 7 For a review, (Evans 1997). 8 Commission 'statement on public authorities' holdings in company capital', Bull. EC 9/1984.

2 - Problems Arising from State Aids in Banking Sector

211

5. Where the injection of capital into companies whose capital is divided between private and public shareholders results in a substantial proportional increase in the state's holding and a concomitant disengagement of private shareholders due to the companies' poor profit outlook; 6. Where the amount of the holding exceeds the real value (net assets plus value of any goodwill or know-how) of the company, except in the case of certain companies.9 This test raises two more general points of interest. First, when the state acts as a market economy investor why is no state aid is involved? Second, to what degree is the comparison of the state investor with a market economy investor justified? 2. The Raison d'etre of the Test The initial question is now one of why state investments which satisfy this test are not to be qualified as state aid. This, in turn, also raises a further question: in order for investment to qualify as state aid, is it adequate that benefits accrue to the recipient, or must such a benefit also be accompanied by a loss of revenue or a cost on the part of the state? This paper argues that the test in fact requires that benefit be balanced by state costs or a loss of state revenue. However, the constitutive element within the test of 'state costs' or 'a loss of state revenue' must be distinguished from the question of whether the benefit to the recipient does, or does not, involve 'state resources'. The use of state resources does not necessarily involve state costs or a loss of state revenue since, for example, the state may borrow money at a more favourable interest rate than the going market rate and invest money, expecting a return lower than the market rate, and so experience no costs other than opportunity costs—though in the latter case, it may also be argued that a cost or loss of revenue has arisen since the state might have invested in another project offering a higher return. However, a lower return is not a cost and a private economy investor may also opt for an investment with a lower return. a) The Financial Resources of the State While the relevant literature often contains a plea for an 'effects doctrine' in relation to state aid,10 and various writers draw upon various ECJ judgments in an effort to qualify measures that do not involve the financial resources of public authorities as state aid, it is nonetheless questionable whether the overall case law supports such an interpretation. The case of Caisse Nationale de Credit Agricole involved a so-called 'solidarity grant' made to farmers by a state-owned bank from the surplus proceeds 9 This test raises a series of questions, which are not dealt with here; cf, for a review, 1999); (Evans 1997); (Abbamonte 1996). (Keppenne 10 (Geelhoed 1998).

212

Working Paper II

of private funds held by it. The ECJ noted that '[a]s is clear from the actual wording of Article 87(1), aid need not necessarily be financed from state resources to be qualified as state aid', yet, it held that this, in fact, was state aid on the grounds that the grant had been decided and financed by a public body and its implementation had been subject to the approval of the public authorities." As Mancini noted,12 the reserves which were used to pay the 'solidarity grants' were built up during the financial years in which the Caisse Nationale de Credit Agricole was not subject to tax or was only subject to partial taxation. In the case of Fonds Industrie! de Modernisation (FIM), the French Government had established a fund offering loans to undertakings at rates below those of the market rate. The fund was financed out of private shortterm deposit accounts (called Codevi) which were exempt from income tax. The ECJ confirmed a Commission decision that held the interest subsidy, which had made the below market rate loans possible at all, to be a state aid upon the grounds that: the combination of the tax exemption for Codevi and the use of the money deposited on such accounts tofinanceFIM loans amounted to the granting of an interest subsidy to the borrowing undertakings to the detriment of the state's tax revenue.13 Sloman Neptune involved the partial non-application of German employment law to foreign crews on shipsflyingthe German flag. The ECJ did not consider this to be a state aid: . . . only advantages which are granted directly or indirectly through state resources are to be regarded as state aid within the meaning of Article 87(1) of the EEC Treaty . . . The distinction between aid granted by the state and aid granted through state resources serves to bring within the definition of aid not only aid granted by the state, but also aid granted by public or private bodies designated or established by the state.14

It seems fair to conclude that, as matters stand, state aid within the meaning of Article 87(1) EC must involve state financial resources, either as resources used or revenue foregone. Funds of private origin, which do not register within the state budget, but are nonetheless created by virtue of mandatory contributions are also included within state financial resources.

11

Judgment of 30 January 1985, Commission v. France [1985] ECR 439, para. 15. [1985] ECR 440 at 442. 13 Judgment of 13 July 1988, France v. Commission [1988] ECR 4067. 14 Judgment of 17 March 1993, [1993] ECR 1-887, para. 19; in Kirsammer Hack, the exclusion of a category of business from national rules on unfair dismissal of workers was held not to be state aid as it did not entail any direct or indirect transfer of state resources to those businesses (Judgment of 30 November 1993, [1993] ECR 1-6185 para. 17); cf, also, Judgment of 7 May 1998, Viscido [1998] ECR 1-2629 para. 14. 12

2 - Problems Arising from State Aids in Banking Sector

213

b) Cost to the State As noted, measures involving statefinancialresources may confer an advantage upon a recipient without creating a cost for the state. The question thus arises as to whether a state cost must be proven prior to such measures being qualified as state aid. The relevant literature contains conflicting views.15 The European Commission has repeatedly stated that there must be a cost to the state, arguing in March 1999, that 'all aid represents a cost or a loss of revenue to the public authorities and a financial benefit to recipients.'16 The ECJ appears to share the Commission's view. Ecotrade raised the question of whether the Italian 'Prodi' Law establishing a procedure of extraordinary administration for insolvent companies meeting certain requirements constituted state aid within the meaning of the ECSC Treaty. Among the elements that led the ECJ to conclude that this was the case, were the advantages conferred by the Prodi Law that 'might also entail an additional burden for the public authorities in the form of a state guarantee, waiver in practice of public debts, exemption from the obligation to pay fines or other pecuniary penalties, or a reduced rate of tax'.17 3) The Extent to Which 'General Economic or Social Considerations' May Come into Play One of the most controversial points questions within the debate is one of whether this test should be applied so as to subsume the state within the concept of a private investor and so deny the state the opportunity to take wider economic or social policy considerations into account in its investment decision. The European Commission argues that the test should be applied strictly; a stance which has found support within the ECJ.18 15

Stressing the benefit, (Waelbroeck and Frigani 1997); requiring a charge on the public account, (Mederer 1999); also, (Soltesz 1998); stressing that the 'financial resources of the state' criterion does not mean there must be a 'cost to the state', (Keppenne 1999: 111) 369; state aid does not necessarily involve a charge on the public account, (Slotboom 1995). 16 European Commission, 'Vllth Survey on State Aid in the European Community in the Manufacturing and Certain Other Sectors' (SEC (99)) 148 at 365. 17 ECJ, Judgment of 1 December 1998, Ecotrade Sri and Altiforni e Fernicre di Servola Spa para. 43 (nyr). Fennelly AG, noted that 'the general regulation of auditor-debtor relations [...] ordinary falls outside the scope of Community law regarding state aid' but added that 'special rules in any of thesefields,which shift the normal burden in favour of certain categories of undertakings or of production, wholly or predominantly at the expense of the state, constitute, in my view, a form of aid' (para. 27). 18 For example, in Belgium v. Commission (Meura) (Judgment of 10 July 1986 [1986] ECR 2263) where the ECJ held, in relation to capital subscriptions by public authorities to a Belgian producer of equipment for the food industry, that any such subscription would constitute aid unless a private shareholder, having regard to the foreseeability of obtaining a return and leaving aside all social, regional-policy and sectoral considerations, would have made it.

214

Working Paper II

In a 1992 decision, the European Commission argued that to allow economic or social policy considerations to come into play would be tantamount 'to granting Member States the power to rescue companies in difficulties on the basis of pure national interests [and] . . . would amount to emptying the market-economy-private investor principle of its meaning.'19 On appeal, the ECJ rejected the Spanish government's argument which attempted to justify its investment in the light of the political, social and economic costs which closure would have entailed, and upheld the Commission's qualification of the investment as state aid on the grounds that: a private investor pursuing a structural policy . .. and guided by prospects of viability in the long term could not reasonably allow itself, after years of continuous losses, to make a contribution of capital, which, in economic terms, proves to be not only costlier than selling the assets, but is, moreover, linked to the sale of the undertaking which removes any hope of profit, even in the longer term.20

While the test might conceivably be rendered more flexible through the introduction of a measure of regard for the actions of a 'reasonable' investor21— thus allowing for a more qualified assessment of state investments—it is, at present, founded fully upon an examination of the actions which a private market economy investor would undertake. 4) To What Extent is the Subsumation of the State Under the Concept of a Private Investor Justified? This designation of the 'state as an investor' as a 'private investor' has been much criticised upon the grounds that it oversimplifies the relationship maintained between the state and the market.22 Such a critique may be correct. However, it should also be borne in mind that EC rules do not necessarily qualify state investment which has been given in circumstances where a 'market economy investor' would not invest, as being state aid that is contrary to EC law. Article 87(3) [ex 92(3)] EC gives the European Commission the power to exempt state aid from the Article 87(1) prohibition. Equally, pursuant to Article 86(2) [ex 90(2)] EC, the Article 87(1) prohibition applies to state investment in an undertaking entrusted with the operation of services of general economic interest or having the character of a revenue producing monopoly, only in so far as it does not obstruct the performance, in law or in fact, of the particular task assigned to that undertaking, and provided that the development of 19 20

26.

Hilaturas y Tejidos Andaluces Decision (OJ 1992L 171/54). Judgment of 14 September 1994, {Spain v. Commission) [1994] ECR 1-4103 para.

21 'The reasonable investor or holding company [which] must, in order to act responsibly, secure a normal return on its investments, even if in so doing it may have regard to a wider social and economic context', cited by Van Gerven AG in Italy v. Commission [1991] E C R 1-1603 at 1-1626. 22 (Evans 1997:58); (Waelbroeck & Frignani 1997:347).

2 - Problems Arising from State Aids in Banking Sector

215

trade is not affected to an extent that would be contrary to the interests of the EC. 23

B. Relevance to the banking sector According to the European Commission, the total officially recognised state aid granted to the financial services sector in the 1993-1997 period was relatively small (2,702 million Euro) and was predominantly granted in France, and to a lesser extent in Ireland, Italy and Portugal. However, the bulk of the state aid granted went to a small number of companies. As the growth capacity of banks is limited under the solvency requirements of the EC banking rules, capital injections or equivalent forms of state aid have a direct impact on their operation and may distort competition far beyond what would have been expected if only the nominal value of the state aid is taken into consideration.24 In this regard, it should be noted that although the Communication of 1993 on public undertakings and state aid is limited to the manufacturing sector, it states that: [t]his will not preclude the Commission from using the approach described in this communication in individual cases or sectors outside manufacturing, to the extent that the principles in this communication apply in these excluded sectors and where it feels that it is essential to determine whether state aid is involved.25

1. State Investment in Banks as State Aid The willingness to intervene in banking is illustrated by the case of Credit Lyonnais. At the time of the Commission decision, the French state held 55% of the capital, the rest of the capital being held by Thomson-CSF (a subsidiary of the state-owned Thomson group), Caisse des Depots et Consignations (a state-owned credit institution) and private shareholders. Faced with a crisis in Credit Lyonnais' business—1.8 billion Franc loss in 1992 and a 6,9 billion Franc loss in 1993, which threatened to bring Credit Lyonnais' solvency ratio below the 8% legal minimum—the French government put together an initial rescue package consisting of a capital increase and the underwriting of certain non-performing assets. In 1995, in the face of further expected losses, the 23 For an example, see CFI, Judgment of 27 February 1997 (Federation Francaise des Societis d'Assurances e.a. v. Commission) [1997] E C R 11-229, which involved tax concessions granted to La Poste. The CFI upheld the European Commission finding that the state aid were not subject to the prohibition of Art. 87(1) as they were necessary for the performance of the public service obligations assigned to La Poste. This Judgment was upheld on appeal, ECJ, Judgment of 25 March 1998, [1998] E C R 1-1305. 24 'Vllth Survey on State Aid in the European Union in the Manufacturing and Certain Other Sectors' (SEC (99) 148) at 47. 25 European Commission Communication, loc. cit. n. 4, para. 1(3).

216

Working Paper II

French Government put together a second rescue package which entailed the establishment of a specific hive-off vehicle to assume 135 billion Francs of assets. The vehicle limited the accounts loss for 1994 to 12.1 billion Francs. The European Commission applied the market economy investor test in order to determine whether the financial assistance given to Credit Lyonnais constituted state aid. With regard to the capital increase of 4,9 billion Francs underwritten by the French state, the European Commission held that: a market economy investor would not have agreed, as the French Government did in May, 1994, to inject capital into Credit Lyonnais at a price of 774 Francs per share without a [. . .] study of the bank's account and without a [. . .] restructuring plan showing that Credit Lyonnais would return to viability within a reasonable period.26

Equally, with regard to the hive-off operation, the Commission held—largely due to the fact that such features were absent from similar operations carried out by other French banks27—that there was a substantial element of state aid within the mechanism, in particular, with regard to the state's underwriting of the risks attached to the assets transferred and its underwriting of the loanservicing costs. In addition, the existence of state aid could be deduced from a number of facts: it was necessary to Credit Lyonnais' survival;28 its duration was unusually long; the degree of risk was very high; and, no adequate return for the investment could be expected.29 One further interesting aspect of the 'market economy investor' test illustrated by Credit Lyonnais is the question of whether, on balance, the cost of further capital injections is higher or lower than the costs of liquidation. In this case, the Commission considered that 'there is no reason to believe that the total foreseeable cost of this [hive-off] mechanism to the French state is any lower than the cost to the state as a shareholder in the event of a supervised liquidation or any other solution involving sale or restructuring'.30 It added a number of observations to the effect that a 'market economy investor' would not have let things get out of hand and would have taken corrective action earlier.31

26

Credit Lyonnais Decision (OJ 1995L 308/92) para. 6.1.1. Credit Lyonnais Decision para. 6.1.2. 28 Query: is this a factor that would induce a 'market economy investor' t o refrain from such operations? 29 Credit Lyonnais Decision para. 6.1.3. 30 Credit Lyonnais Decision para. 6.1.3. 31 A similar criterion was used in the European Commission Notice on state aid to Ilva (OJ 1993 C 213/6). In its Banco di Napoli, Decision the European Commission referred t o the fact that the reasons for the Banco di Napoli's losses were specific t o it and appeared to be related, to a large extent, to its aggressive commercial and credit policy and inadequate control procedures for risk (OJ 1999 L 116/36 para. 5.1). 27

2 - Problems Arising from State Aids in Banking Sector

217

2) Transactions by State Banks as State Aids A further issue in the banking sector is one of whether, and to what extent, the transactions undertaken by a state-owned bank can be considered as state aid in themselves: for example, in cases where a state-owned bank grants a loan at a rate lower than the prevailing market rate, grants an unsecured loan to an undertaking that, under normal circumstances, would be unable to obtain credit without security, or makes a risky equity infusion. This may distort competition and favour certain undertakings. But is it state aid? This question has two aspects. First, are such transactions to be considered as state aid on account of the fact that they are made with state resources? According to the ECJ, the distinction between 'aid granted by a Member State' and 'aid granted through state resources' is intended merely to bring within the definition of state aid both the advantages which are granted directly by the state and those which are granted by a public or private body designated or established by the state.32 On this basis, it would seem that transactions by state-owned banks fulfil this first condition. The transactions of a state-owned bank are funded by state resources to the extent that the working capital of the bank is supplied by the state (or is made available to it by private parties as a result of obligations imposed on them by the state). In its Air France decision, the Commission found that securities issued by Air France and taken up by a subsidiary of the state-owned Caisse des Depots et Consignations (CDC) involved state aid. The Commission did not address the question of whether state resources were involved. Instead, it limited itself to demonstrating the state's role within the transaction. It acknowledged that the CDC subsidiary was a limited liability company whose corporate purpose consisted mainly of the managing of an investment fund. It considered, however, that all the conditions were fulfilled in order to allow it 'to connect the granting of the aid in question with the intentions of the state'. The subsidiary was not an entity autonomous of the CDC which was itself subject to the control of the French public authorities. The Commission concluded that the capital injection into Air France was 'an act which is imputable to the French state within the meaning of the Court's case law on Article 87(1).'33 On appeal, the CFI upheld the finding that the CDC was a public body whose conduct was attributable to the French state.34 On appeal, Air France argued that, since the funds managed by the CDC were made up of the deposits of private parties and savings banks, no state resources were involved. The CFI held that Article 87(1) EC 'covers all the financial means by which the public sector may actually support undertakings, irrespective of whether or not these means are permanent assets of the public 32

Viscido, loc. cit., n. 14, para. 13, referring to earlier Judgments. OJ1994L258/26at31. 34 Judgment of 12 December 1996 (Air France v. Commission) [1996] E C R 11-2109, para. 61. 33

218

Working Paper II

sector'.35 Arguably, this was not a departure from the requirement that state financial resources must be involved within the transaction since the funds administered by the CDC are often deposited pursuant to a legal or a statutory obligation. There is, however, also a second condition, i.e., the existence of a governmental cost, a charge upon the public account.36 A transaction by a stateowned bank will only be considered to entail state aid where the bank suffers a net cost as a consequence, or, as the ECJ has expressed it, the transactions constitute 'an additional charge'37 on the state-owned bank. The granting of a loan at an interest rate below the market rate lowers the revenue of the bank; yet, arguably, there is no net cost as long as the interest rate equals or exceeds the cost of money to the bank. Interestingly, in its Air France decision, the Commission did not refer to this condition but instead examined whether a market economy investor operating under normal commercial conditions would have entered into an arrangement such as that entered into by CDC's subsidiary. On the basis of a number of elements (Air France's prior financial and operating performance, its inability to carry out a restructuring programme, the manifest insufficiency of any other programme to redress the situation), the Commission concluded that a market economy investor would not have made the capital injection into Air France.38 On appeal, Air France put forward a series of arguments attempting to show that a private investor would have made the capital injection in question. The CFI rejected all these arguments. The CFI held that the Commission had correctly appraised the context of the investment decision.39 Moreover, it held that, even though the interest rates and the internal return of the securities issued by Air France were comparable to other allegedly similar securities, these securities did not involve risks comparable to those of the Air France securities.40 It also held that the fact that prudent private sector investors of the same size as the CDC subsidiary would not have risked an investment of 1.5 billion Francs was readily demonstrated by the fact the private and public banking sector subscriptions to the Air France securities made up a negligible part of overall subscriptions.41 The Air France Case appears to confirm that the 'market economy investor' test demands that there be a cost to the Government or a charge on the public account. In the final analysis, CDC's purchase of Air France securities was held, in the end, to be a measure of state aid on the grounds that a comparable private investor would expect to incur a loss by purchasing such securities. 35 36 37 38 39 40 41

Ibid, para. 67. For this two step analysis, (Mederer 1999: 1856). Ecotrade, loc. cit. n. 17, para. 35. Loc. cit. n. 33, at 34. Loc. cit. n. 34, para. 110. Ibid., para. 135. Ibid, para. 148-149.

2 - Problems Arising from State Aids in Banking Sector

219

By the same token, this conclusion would seem to dictate that the granting of a loan by a state-owned bank at a rate lower than the prevailing market rate will not be considered to be state aid where the state-owned bank covers its costs or where the lower interest rate is not offered by virtue of the fact of state ownership. Should the mere fact that a stated-owned bank grants a loan at a rate lower than the prevailing market rate be held to constitute state aid, this would arguably run counter to the principle that the public and private sectors are to be treated equally. In this regard, it might be argued that the EC Treaty definition of state aid is too narrow in that it does not encompass various actions by Member States which, in economic terms, have the same effect on intra-EC trade and on competition as does state aid, rigidly defined.42 However, it need also be noted that a measure that does not involve a charge on the public account but artificially improves the competitiveness of undertakings in a Member State may be subject to other EC Treaty provisions and secondary EC law. Alternatively, such a Member State measure may be substituted for by an European measure, or brought into line with measures in other Member States under EC directives, so as to establish a level playingfieldwithin the EC.

III. The WTO Rules on Subsidies A. Introduction The WTO SCM Agreement defines subsidies as follows: 1.1. For the purpose of this Agreement, a subsidy shall be deemed to exist if (a)(l) there is afinancialcontribution by a government or a public body within the territory of a Member (referred to as in this Agreement as 'government'), i.e., where: (i) a government practice involves a direct transfer of funds (grants, loans, and equity infusion), potential direct transfers of funds or liabilities, for example, loan guarantees); (ii) government revenue that is otherwise due is foregone or is collected (for example,fiscalincentives such as tax credits); (iii) a government provides goods or services other than general infrastructure, or purchase goods; (iv) a government makes payments to a funding mechanism, or entrusts or directs a private body to carry out one or more of the type of functions 42

See, for example, Messerlin in this volume; (Slotboom 1995:295-299) who argues that the charge on the public account is not inherent in the notion of state aid.

220

Working Paper II

illustrated in (i) to (iii) above which would normally be vested in the government and the practice, in no real sense, differs from practices normally followed by governments; or (a)(2) there is any form of income or price support in the sense of Article XVI of GATT1994; and (b) a benefit is thereby conferred. In regulating subsidies, this Agreement draws a distinction between export subsidies, 'actionable' subsidies and 'non-actionable' subsidies. Export subsidies, which WTO Members are prohibited from granting or maintaining,43 are defined as: 'subsidies contingent, in law or in fact, whether solely or as one of several other conditions, upon export performance . . .' and 'subsidies contingent, whether solely or as one of several other conditions, upon the use of domestic over imported products.44 Actionable subsidies are defined as subsidies which fulfil the 'specificity requirement'45 and 'cause adverse effects to the interests of other WTO Members': measures, for example, that causes injuries to the domestic industry of another WTO Member, that nullify or impair benefits accruing to another WTO Member under GATT 1994, or that seriously prejudice the interests of another WTO Member.46 Strictly speaking, 'actionable subsidies' are not prohibited: a simple duty is placed upon WTO Members not to cause 'adverse effects'. Non-actionable subsidies are either subsidies, other than export subsidies, which do not fulfil the specificity requirement, or subsidies, other than export subsidies, which are specific but which meet certain conditions set out in the SCM Agreement,47 such as R&D subsidies, assistance to disadvantaged regions, environmental subsidies. For the purposes of this paper, the relevant issue is one of the definition of 'subsidy'. As Article 1 of the SCM Agreement states, the definition of a subsidy rests upon the existence or otherwise of a specific 'financial contribution' from the government, that is, in the form of government revenue foregone or revenue not collected that is otherwise due. One of the main issues that marked negotiations on the SCM Agreement was the question of whether a subsidy might be defined solely on the basis of a 43 44 45 46 47

S C M Agreement, Art. 3.2. S C M Agreement, Art. 3.1. As set out in S C M Agreement, Art. 2. S C M Agreement, Art. 5. S C M Agreement, Art. 8.1.

2 - Problems Arising from State Aids in Banking Sector

221

benefit to the recipient through the means of financial contribution from government, or whether an added element of governmental cost should be include within the definition. In other words, the EC defended the view that subsidies must involve a 'cost to the government'. Others, among them the US, disputed this reading. The text of the SCM Agreement does not expressly address this point and, as a consequence, conflicting views are defended with reference to different substantive contexts.48 This is anything but an academic issue. It should be noted that there are two sorts of remedies available to any WTO Member that considers itself to have been harmed by subsidies granted by another WTO Member. First, such a WTO Member may make recourse to the Understanding on Rules and Procedures Governing the Settlement of Disputes (the DSU)49 that applies to disputes under the SCM Agreement. Second, such a WTO Member may avail itself of its right to take 'countervailing measures',50 since, within the WTO framework, subsidies are one of the very few measures to which Members may respond by these means. Such measures are effectively derogations in that they are unilateral. Moreover, such measures are a departure from the non-discrimination rules since they may be used against individual WTO Members. Thus, the broader the definition of 'subsidy', the greater the scope for unilateral action. Equally, from the point of view of individual WTO Members, the broader the definition of 'subsidy', the more constraining the WTO discipline is with regard to an important economic and social policy instrument. In Canada: Measures Affecting the Export of Civilian Aircraft, the WTO dispute settlement Panel thus rejected Canada's argument that 'benefit' is conferred only when a financial contribution from entails a cost for the government.51 The Appellate Body confirmed the Panel's interpretation in substance.52

B. The State as Investor and the WTO rules on Subsidies 1. Equity Infusion by the State as a Subsidy As results from Article 1.1a) (ii) of the SCM Agreement referring to equity infusions, a financial investment made by a state falls under the subsidy definition 'where a benefit is conferred by such financial investment upon the 48 For example, the views of the parties in Canada: Measures Affecting the Export of Civilian Aircraft, Report of the Panel, 14 April 1999, WT/DS70/R, paras. 5.28 to 5.34 and 5.42 to 5.50. This is an old debate, pro (Depayre & Petriccione 1991) a n d contra (Quick 1991). 49 (WTO 1995:404). 50 SCM Agreement Arts. 10 et seq. 51 hoc. cit. n. 48 para. 9.120. 52 Canada: Measures Affecting the Export of Civilian Aircraft, WT/DS70/AB/R, adopted 2 August 1999, paras. 154-161.

222

Working Paper II

recipient. State capital injections may confer a benefit upon a state-owned bank without causing cost since the cost of money is normally lower to the state than to the average investor. As noted, both a WTO panel and the WTO Appellate Body have rejected the argument that 'cost to the government' is a constitutive element of the notion of subsidy as defined by the SCM Agreement. The same WTO panel considered that a 'financial contribution' from a government confers 'benefit' and thus constitutes a 'subsidy' within the meaning of Article 1 of the SCM Agreement, when the recipient is advantaged relative to the applicable commercial benchmarks, i.e., whenfinanceis provided on terms that are more advantageous than those that would be available on the market.53 The Appellate Body has upheld this interpretation of the SCM Agreement.54 At first sight, this may have far reaching consequences, determining that where a state establishes a bank or becomes majority or sole shareholder in an existing bank, this in itself will constitute a 'subsidy', whether or not the state incurs costs. Such far reaching consequences are, or could be, mitigated through the application of the 'private investor' test to the state investment, thus requiring verification of whether a private investor would make the investment in the bank if it had access to capital at the same cost as the state. A private investor test, seemingly inspired by the EC's 'market economy investor' test, appears in Article 14(a) of the SCM Agreement. It states that: Government provision of equity capital shall not be considered as conferring a benefit unless the investment decision can be regarded as inconsistent with the usual investment practice (including for the provision for risk capital) or private investors in the territory of that Member.

The question of whether this provision is relevant for the purposes of the definition of 'subsidy' was initially uncertain. On the one hand, it can be argued that it is irrelevant: it forms a part of an Article that deals with the calculation of the amount of subsidies and is, moreover, expressly confined to Part V of the SCM Agreement, regulating countervailing measures. On the other hand, however, one can argue that Article 14 is to be read in systematic conjunction with Article 1. The matter was ultimately settled by the Appellate Body which held that Article 14 constitutes relevant context matter for the interpretation of the term 'benefit' in Article l(l)(b) of the SCM Agreement,55 which is itself one of the elements of the 'subsidy' definition. 2. Some Possible Implications under WTO Law A number of questions nonetheless arise with regard to the possible consequences of designating the creation of a state bank or the acquisition by a state 53

Loc. cit. n. 48, para. 9.120. Canada-Measures Affecting the Export of Civilian Aircraft, loc. cit. n. 52, paras. 154-161. 55 Ibid, pam. 55. 54

2 - Problems Arising from State Aids in Banking Sector

223

of an existing bank as a subsidy under WTO law. Further questions arise in relation to the activities of such banks. a) The Scope of the SCM Agreement The SCM Agreement is included in Annex 1A, Multi-lateral Agreements on Trade in Goods. The SCM Agreement, consequently, does not relate to the provision of services and is not designed to impose the WTO regime on subsidies granted to banks as providers of financial services. This matter is dealt with by the General Agreement on Trade in Services (GATS), whose Article XV only provides that Members shall enter into negotiations with a view to developing the necessary multi-lateral regimes to avoid distorting effects in trade in services. As a result, any qualification of a state bank as a subsidy within the meaning of the SCM Agreement will bring this state bank within the scope of this agreement only in relation to trade in goods. In other words, the provisions of the SCM Agreement apply to such a state bank only to the extent that its activities consist of grants, equity participation, loans, and loan guarantees either for the export of goods or for the domestic production of goods, in which case the state bank activities would also have to produce 'adverse effects' within the meaning of Article 5 of the SCM Agreement. This determines that where the creation of a state bank or the acquisition by the state of an existing bank may generally be qualified as a subsidy, it will be subject to the provisions of the SCM Agreement only in so far as its operations can be qualified as export subsidies or as 'actionable' subsidies for goods. Any distortion in competition which derives from the financial service providing activities of banks that qualified as subsidies are not, to date, covered by WTO rules. b) State-ownership and Bank Activities under GATT One of the more intriguing interpretation questions which the SCM Agreement has given rise to is the issue of when a state-owned bank's equity participation or its extensions of a loan relating to the export or the production of goods is to be considered to be a subsidy. Under Article 1.1 of the SCM Agreement, there are three constitutive elements for the definition of a subsidy: a) a 'financial contribution' is given by the state-owned bank which is a 'public body'; b) the investment takes one of the forms specified; c) a benefit is conferred by the investment. The issue is, thus, one of whether satisfaction of these individual elements suffices for the definition of a subsidy. Were this to be the case, however, the SCM Agreement would create a iuris et de iure presumption that any equity participation or loan extended by a state-owned bank, which confers a commercial advantage against a set benchmark, would be a subsidy merely

224

Working Paper II

by virtue of the state-owned bank's assumption of equity participation or granting of the loan. A second possible interpretation would be one of some form linkage between the three constitutive elements so that, for example, commercial advantage must directly derive from the involvement of the state within the state-owned bank. Were such a link not to be required, state-owned banks would be penalised as regards their private counterparts wherever they manage, on their own initiative, to engage in risky equity participation or to grant a loan at a competitive rate. One might doubt that this was the intention of the WTO Members in concluding the SCM Agreement. This interpretation seems to have been followed by the WTO Panel in US: Countervailing Duties on Carbon Steel, where one of the main issues was one of whether subsidies granted to British Steel in the form of equity infusions could be deemed to have passed on to, and to have continued to 'benefit', the two companies that acquired British Steel following its privatisation. The Panel did not expressly accept the EC's argument that Article 1 of the WTO SCM Agreement requires a causal relationship between 'financial contribution' and 'benefit'. It did so, however, implicitly by considering that, since fair market value had paid for all the productive British Steel assets acquired by the two companies, any 'financial contribution' bestowed indirectly on them could be regarded to be a 'benefit' within the terms of the SCM.56 If this second interpretation is correct, the need arises for a test to assess when the benefit conferred by a 'financial contribution' from a state-owned bank is to be qualified as a subsidy. If the 'financial contribution' takes the form of an equity infusion, the 'private investor' test might be appropriate. If the 'financial contribution' takes the form of a loan, an appropriate test might be an examination of whether the competitive interest rate charged by the stateowned bank can be justified in light of the criteria employed by a privatelyowned bank.57

IV. A Tentative Comparison In commenting on the SCM Agreement, one of the WTO's expert analysts opined that the EC had managed to introduce the EC rules on state aid into the SCM Agreement. However, while it is true that the regulatory scheme of the 56

W T O / D S 138/R, adopted on 23 December 1999, para. 6.81. F o r example, in Canada—Measures Affecting the Export of Civilian Aircraft (Joe. cit. n. 52) the Panel found that debt financing by Canada's export credit agency was a 'financial contribution' by a relevant 'public body'. It also found, however, that Brazil, the complainant, h a d failed to make aprimafacie case that the agency's net interest margin did n o t reflect the riskiness of its loan portfolio, bearing in mind that the agency's net interest margin compared favourably with that of certain commercial banks (para. 9.174). 57

2 - Problems Arising from State Aids in Banking Sector

225

SCM Agreement can be compared with the EC regulatory scheme up to a point, substantial differences nonetheless remain. First, the scope of the EC rules is wider. They are not limited to the impact of state aid on trade in goods. They also apply to financial services and aim to prevent distortion of competition in the banking sector itself. Equally, the WTO institutional system and the EC institutional system differ from one another. Within the EC framework, it is possible to have a set of broadly worded rules composed of a prohibition and exceptions that can be enforced by an administrative body to which discretionary powers have been delegated. This allows for a far greater degree of flexibility in the matter of establishing a balance between the combating of competitive distortions and the pursuit of economic and social policy aims. In the WTO system, there is no such administrative body and the rules reflect this. On the one hand, WTO Members can take unilateral measures to counteract subsidies granted by other WTO Members. On the other hand, however, an outright prohibition exists only in the case of export subsidies, while all other subsidies are 'actionable' only when they cause 'adverse' effects. While the WTO dispute settlement system performs functions comparable to the judicial review found in the EC system, it is nonetheless handicapped in the absence of a body that has functions comparable to those of the European Commission. This handicap is compounded by the legal quality of the WTO rules on subsidies which are characterised by certain 'creative ambiguities' that reflect the process of compromise on which the SCM agreement is founded. In addition, while the object and purpose of the EC rules on state aid, as expressed in the EC Treaty, is to avoid distortions of competition, no such object and purpose was expressly assigned to the SCM Agreement—presumably since there was no agreement between WTO members on this point.58 Finally, to highlight the specific issue tackled by this paper, the European Commission continues to work with a notion of state aid only where the state has incurred cost. The SCM Agreement, by contrast, entailing no notion of state cost, is probably unduly broad, although a measure of compensation does exist in that 'actionable subsidies', i.e., subsidies other than export subsidies, are not prohibited by the WTO which, instead, requires the WTO Members not to cause 'adverse effects'. 58 There are at least two schools of thought: the 'Injury-Only School' and the 'AntiDistortion School'. See, for example, (Bourgeois 1991).

Ill Marc Dassesse* The Many Faceted Application of EU Competition Law to the Banking Sector After the Move to the Single Currency

I. The Issue of the Lender of Last Resort A. The Single European Currency Following the move to the single currency, a fundamental distinction must be drawn between Member States who are 'in' and Member States who are 'out'— in the following, the UK will be the primary example of an 'out' Member State. The European Central Bank (ECB) and the National Central Banks (NCBs) of the 'in' Member States are committed under the Maastricht Treaty to: (i) the principles of a free market economy; and (ii), are also prohibited from lending without adequate collateral. These provisions do not apply to the 'out' Member States. Equally, the provisions pursuant to which the NCBs of the 'in' Member States must be independent from the national government of the 'in' Member States are, similarly, not applicable to the 'out' Member States. The Commission's Draft Paper on emergency rescue aid does not differentiate between the 'in' and the 'out' Member States. Yet, it is only in relation to the 'in' Member States that Community law compulsorily demands the independence of national NCBs. Equally, the issue arises as to whether emergency rescue aid to a branch within the Community of a bank which has its head office outside the Community does not warrant (at least in some respects) separate consideration.

B. The Neutrality of NCBs Even 'independent' NCBs are not above the application of the general principles of the law, including the obligation to make good any damage for which they may be held to be liable in the performance of their duties vis-a-vis third parties, and, in particular, in the performance of their duty as (direct) supervisors of credit institutions.1 * Professor at the Institute for European Studies of the Free University of Brussels (ULB). 1 Case C-l 10/84, Hillegom v Hillenius, judgment of 11 December 1985. The Hillegom case arose out of an alleged failure of the Dutch NCB to supervise a local credit institution properly.

228

Working Paper III

The neutrality of the NCBs of the 'in' Member States vis-a-vis their respective political authorities does not translate into objective guarantees of impartiality when it comes to assessing the validity of emergency rescue aid for a bank that they themselves supervise, either 'directly', as is the case in a number of Member States, or 'indirectly': even in Member States where banks are supervised by a separate supervisory body rather than the NCB, the NCB nonetheless has a large input into that statutory body, since, for example, one or more representatives of the NCB are elected to that body. One must therefore recognise the existence of an objective conflict of interests when one enquires of a supervisor whether he has done a good job.

C. Rubber Stamps? The Commission's Draft Paper, nonetheless, appears to give a competence to the Commissioner in charge of competition to rubber stamp rescue aid if a 'certificate' is produced by an NCB. However, the Commissioner must give reasons for his decision where a competitor objects to approval.2 This, in turn, raises two questions. a) Can the Commission, in effect, abdicate its vetting powers in favour of an NCB, including an NCB within an 'out' Member State that, by definition, is not subject to the statutory (EC law) guarantees of independence which, in the view of the Commission, warrant the effective abdication of its own vetting powers in the first place? b) How can judicial control of the Commission's decision be possible if the Commission limits itself to questions of whether a certificate has been issued by an NCB? Must one demand that the reasons for the granting of a certificate by the NCB are enumerated so that they can be the subject of judicial review? Alternatively, do issues of professional confidence require that the certificate must be accepted at face value?3

2

An eventuality that is more likely to occur in the context of the 1989 Second Banking Directive (Council Directive Directive 89/646/EEC, OJ (1989) L386/14): the competitor may have operations in the Member State concerned, yet he may operate in that country by way of a branch that now escapes supervision by the local NCB, or separate banking supervisor, as a result of the single banking licence issued by another Member State. The move to the single currency has resulted in the removal of the residual powers of the host country supervisor with regard to (local) liquidity and national monetary policy requirements—in the case where both the home country Member State and the host country Member State are 'in' Member States. 3 Cf., for an interesting parallel, Hillegom v Hillenius, be. cit. n. 1.

2 - Problems Arising from State Aids in Banking Sector

229

II. The Application of Articles 87 and 88 [ex 92 and 93] of the EC Treaty to State Aid in the form of Guarantees A. Beneficiaries? The Commission's Draft Notice appears to take it for granted that the 'lender' is the sole beneficiary of state guarantees, to the exclusion of the lending institution.4 However, the Commission's approach fails to take into account the impact of the rules on credit ratios for the lending institutions. If a bank has a capital of 8 and lends 100 to company X, which is solvent, at 12% (market rate), and the cost of funds to the bank is 10% (market rate), the bank makes a gross profit of 2 with a capital outlay of 8. If the same bank lends to a company with the benefit of a state guarantee, its capital requirement (in terms of banking supervision rules) is zero. The bank can, therefore, make 'two loans' with a capital of 8, and make a gross profit of 4 (2+2). In other words, an element of unfair competition exists, not only between the borrower and other competitors who do not benefit from a state guarantee, but also between a bank which is willing to lend on the basis of an (illicit) public guarantee and a bank which is not willing to do so.

B. False Parameters? More fundamentally, the Commission's draft notice appears also to rest on parameters which do not usually exist within banking practice: if a borrower has adequate collateral, the market is, as a rule, sufficiently efficient to make it possible for the lender to obtain funding without ever having to turn to the state to seek a public guarantee. In other words, the statement that a public guarantee does not involve an element of public aid where the lender is charged a fee equivalent to that which he would have had to pay to obtain a similar guarantee from a private bank simply does not square with reality.

C. Lack of Clarity? Equally, the Commission's Draft Notice is far from crystal clear on the question of whether sums that have been paid pursuant to a guarantee that has not received approval must be repaid by the bank which has received them.

4

Cf., now, Commission Notice on the application of Arts. 87 and 88 of the EC Treaty to state aid in the form of guarantees, OJ (2000) C71, of 4.03.2000.

230

Working Paper III

D. Bonds Similarly, the statement to the effect that, 'in the case of guarantees for bonds issued to obtain financing for undertakings, [the] third parties [affected] are the financial institutions involved in the issuance of the bonds' is, it is submitted, erroneous, especially in the case of bearer bonds: the guarantee is attached to the bonds, and the financial institutions which brought the bonds to the market can make no call on it if they are no longer the owners of the bonds. The only issue that can arise for the banks in this context, is the question of a potential liability for them vis-a-vis the bondholders, should the guarantee attached to the bonds prove to be worthless.5 Such an issue is, however, totally distinct from the question of repayment of illicit state aid.

E. The European Central Bank (ECB) It is also submitted that the Commission's Draft Notice fails to differentiate between the position obtaining in Member States that have joined the Single Currency and Member States that have not. In the case of the 'in' Member States, the ECB must be consulted by the Commission on any proposed measure that might affect the stability of the financial markets.6 The Commission itself acknowledges 'the sensitivity of [the] issue [of public guarantees] for the financial markets',7 yet it consistently fails to acknowledge the need to consult the ECB on this issue, or to state that such a consultation has taken place.

F. Ambiguity? Finally, the Commission's willingness 'not to call into question payments made by Member States to lenders pursuant to those guarantees, provided that recovery procedures are pursued by the state against borrowers who have benefited from illegal and incompatible aid paid under those guarantees' is ambiguous. What is the position with regard to bonds that carry an illicit guarantee? What is the position with regard to numerous credit agreements that provide that the credit must be reimbursed immediately, should the guarantee issued by a public body be terminated?

5 A parallel can be made, in this regard, with the liability (for damages) of the lead underwriter vis-a-vis sub-underwriters for lack of due diligence. 6 Art. 105(4), Maastricht Treaty. 7 Credit Lyonnais OJ (1996) C 390/7.

IV Charles Ilako* State Aids and the Banking Sector

I. Introduction As the paper for the Workshop notes, antitrust policy is now focusing on 'market efficiency' and 'consumer protection' as the two key justifications for state aid. The Commission, however, has made its position clear: general state aid rules must be applied to the banking sector, even though it recognises that there are 'special' facets to the role of banks within the economy. This paper is not written from a lawyer's viewpoint and does not focus on the specific legal issues surrounding state aid, but instead takes a broader approach to some key issues facing banking in the EU today. As a regulatory consultant, I note that these two concepts fall very much in line with the bank regulatory/supervisory view of their dual, sometimes conflicting, roles of: (i) ensuring the stability of thefinancialsystem; while (ii), protecting the interests of depositors and investors. The questions raised by the relationship between state aid and banks highlight the two aspects of state aid vis-a-vis the banking industry: a) Direct use of state aid to rescue and reconstruct banks. b) Indirect benefits supposedly gained by banks through the illegal use of state guarantees. This paper looks mainly at thefirstissue (with some mention of the second) but from this broader perspective.

Consumer Protection and Market Efficiency Protection of the consumer has provided some justification for direct use of state aid to rescue banks in the past. But with the passage of the Deposit Guarantee Directive1 in 1994, the need for such state assistance to fend off 'systemic risk' within a local banking environment—the risk of a run on otherwise solvent banks by scared depositors—should be minimal, as long as the

*1 Pricewaterhouse Coopers Consultants, London. Directive 94/19/EEC.

232

Working Paper IV

consumer is made fully aware of his/her rights and the extent of the protection that is offered.2 With consumers adequately protected and informed, direct assistance to failing institutions should no longer be necessary nor justifiable within the EU on the basis of consumer protection. Market efficiency justifications should, in theory, no longer apply either: with an adequate regulatory framework and supervisory structure, banks of any size, which cannot survive normal market conditions, should be allowed to fail. The issue, of course, is whether the current legislative and regulatory framework is indeed adequate. There have been examples—Banesto, Barings, BCCI—where market mechanisms have been used effectively in the case of bank collapse without recourse to state aid. There are other examples, of course, where market mechanisms did not work—or were not allowed to work—effectively. We have made considerable progress during the 1990s in creating a viable EU banking market. The EU banking industry has been considerably strengthened—and made more resilient—through the introduction of capital adequacy and other prudential requirements. In addition, in response to market overcapacity, the EU banking industry has consolidated considerably, although mostly within national borders. Such consolidation has enabled the larger banks to develop a strong domestic base from which to compete in the international markets. In a number of the Member States, a relatively small number of large banks hold the majority of bank deposits within the national territory; for example, in Ireland, the Netherlands and the United Kingdom. Faced with the globalisation of the industry and with the introduction of the euro, the likelihood that banks will begin to look at leveraging across borders in the Eurozone becomes stronger: particularly as the date for introduction of euro notes and coins draws closer. There are some signs of this already; for example, with the foreign interest recently shown in the Societe Generate/ Paribas/Banque Nationale de Paris situation. There have already been a number of significant cross-border mergers which have created substantial financial conglomerates. Yet, the EU banking legislative framework is not complete: there are still some important gaps and, at this point in time, the legislative upgrading process lacks the speed necessary to keep pace with the rapid changes in the market place. The Commission's Action Plan, released on 11 May 1999, establishes a number of important steps which are required tofinalisethe single market and to speed up the legislative process. In addition, the EU legislative framework relies on 'harmonisation' and minimum standards: it has not created a level playing field. 2 The Deposit Guarantee Directive introduced minimum standards but a number of Member States already had a higher level of guarantee in place before its passage and have maintained these levels. These discrepancies have endangered transparency. Banks with 'better' deposit insurance have not been allowed to advertise this fact for fear of competitive distortions.

2 - Problems Arising from State Aids in Banking Sector

233

Through studies that we have undertaken for the European Commission reviewing the transposition of certain EU banking directives, it has become patently clear that, from a regulatory perspective, a free market for the banking sector in the EU has not been achieved because the directives themselves provide for a significant degree of latitude in interpretation. A 'minimal' approach—one that both recognises and utilises the majority of Member States' options and discretions—as opposed to a 'super-equivalent' approach— which does not recognise/use many of the options and discretions and which, as is possible under certain directives, imposes additional or more stringent requirements on banks—produces significantly different results although both approaches may be in total compliance with the terms of the Directives concerned. Tommaso Padoa-Schioppa,3 during an LSE lecture, stated that the arrival of the euro could herald the deregulation of national markets as Member States take steps to avoid the negative effects of regulatory arbitrage where banks take advantage of the 'single passport' freedoms from another location which is 'less onerous' from a regulatory perspective. The (final) passage of the European Company Statute and legislation which permits companies to change their legal seat within the Union increases the possibilities of 'regulatory arbitrage'. While the removal of any redundant 'general good' measures will obviously improve the efficiency of the markets, this 'deregulation' could also raise the spectre of the 'lowest common denominator' effect from a regulatory perspective: risking the competitive position of EU banks in the longer-term and also the stability of the financial system. Given the Commission's view that special treatment of banks in respect of direct state aid is not appropriate, it is essential that much more work is done to level the regulatory playingfieldwithin the EU before market mechanisms can become consistently reliable instruments in every Member State in the event of bank failures. But the issue is more complex: in light of the globalisation of the financial markets and the introduction of the euro, the real question we should be asking is: 'which market?' As we move into the next millennium, we need to reflect carefully on how the EU will continue to develop in terms of the completion of the single market and expansion. While we should avoid competitive distortions within the single market, caused inter alia by illegal state aid, we need also to consider the role of Europe's banks within the global market in which so many banks now compete. There are some specific questions: a) Is it really viable to create a 'perfectly' competitive market within the EU banking arena? Is this really necessary? Who is actually competing with whom? 3 EMU and Banking Supervision, Lecture by Tommaso Padoa-Schioppa, Member of the Executive Board of the European Central Bank at the London School of Economics, Financial Markets Group on 24 February 1999.

234

Working Paper IV

b) Should our approach to state aid, in fact, become more sophisticated in order to take into account the challenges of the Eurozone and of a global banking market?

II. Is A 'Perfectly' Competitive Market in the EU Viable and/or Necessary? Who is Competing with Whom? Article 1, first indent of the First Banking Directive4 establishes that: credit institution means an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account. The Second Banking Directive5 establishes that 'credit institutions' may also be permitted to undertake, in addition to these 'primary' functions, the activities set out in the Annex to the Directive, points 2 to 12. In effect, a number of Member States have taken a significantly broader view of what constitutes a credit institution, including institutions which do not primarily receive deposits and grant credits, and apply the same prudential requirements to such institutions as to 'real' credit institutions. Others do not. This creates the first, fundamental 'distortion' in the banking market: there is no equivalence from one Member State to another, thus creating interesting dimensions with regard to the concept of 'mutual recognition' and, indeed, cross-border services. However, with the euro, the markets themselves are converging. The euro is acting as a powerful catalyst, rapidly changing the banking market infrastructure within Europe and accelerating key trends—such as globalisation and the blurring of the barriers between segments of the financial services industry— which were already underway. We now have the Eurosystem, pan-European real-time gross settlements systems, large volumes of public debt denominated in the same currency, alliances formed between stock and derivative exchanges within the region, and so forth. As previously mentioned, banking consolidation is taking hold throughout the Union. For EU banks, there are, in fact, three levels of competition—and three key markets: a) The national market; b) The regional (EU/Eurozone) market(s); c) The global market. Some banks compete in all three, some in one or two. The competitive issues are not the same in each: at national and EU level, the banks are often the instruments of governments in implementing social and regional policies.

4 5

Directive 77/780/EEC. Directive 89/646/EEC.

2 - Problems Arising from State Aids in Banking Sector

235

A. National Market As mentioned above, the Commission has recognised the special role that banks can be required to play in national economies. This role could simultaneously become both more important and less important with the euro. As we are well aware, the introduction of the euro has centralised the conduct of monetary policy. Governments are no longer able toflexinterest rates or, in extreme cases, devalue their currencies to combat national economic problems. This 'one size fits all' monetary policy has come under heavy criticism, being cited in the UK as one of the key reasons why the UK should not join Economic and Monetary Union. With a viable internal market within the Union, such concerns would not be so well-founded. However, for now, many fear that this 'one-size fits all' monetary policy could seriously exacerbate existing regional problems. In the US, regional employment problems can be overcome by people moving to where the jobs are. In the EU, single market imperfections—for example, the pensions situation—and cultural and linguistic issues currently restrict the level of labour mobility within the Union. Although steps are being taken to address such issues, this will take a considerable amount of time. The potential for regional market inefficiencies is probable. 'State aid'—focusing on regional market efficiency—could be one tool by which to combat this problem, in the short-term: after all, what is De Silguy's proposal for a 'regional fund' if not 'state aid' at EU level?. The declaration on the Protocol to the Amsterdam Treaty on the German Landesbanken— followed by similar declarations from Austria and Luxembourg—has followed this concept: the Landesbanken can continue to obtain 'preferential treatment' when they are the instruments of regional policies but not when they are competing in their own right on the international markets. It must not be forgotten, however, that the use of state loan guarantees, for example, to support one national region, or industry, can have negative externalities, not simply in the national market (or markets), but across borders. Consequently, the EU-wide impact would need to be considered, as well as the national/regional interest. Consequently, these considerations argue against the idea of decentralising control of state aid: and also against the possibility of making banks responsible for monitoring the legality of state aid.

B. EU Wide Market This social policy aspect also has an impact at EU level. Currently, consideration is being given to the need for 'universal services' for EU citizens in key areas such as postal services, telecommunications and banking. Such 'universal service' requirements are already recognised in some Member States. From the banking perspective, it has been suggested that every EU citizen should have

236

Working Paper IV

the right to a bank account. 'Credit institutions' would be obliged to support this initiative, regardless of the fact that a proportion of such customers could not be considered viable from a commercial perspective. Another example of this social policy role is the role that banks were expected to play with regards to the introduction of the single currency. The 'no compulsion, no prohibition' principle applies to all commercial entities, in theory—except the banks. Banks were not only obliged to convert their systems in time for the launch of the single currency and were also charged with promulgating information about the euro to educate businesses and the public at large.

C. But Who is Competing with Whom? The issue of state guarantees for Sparkassen in Germany, however, highlights another issue. Deutsche Bank and the Sparkassen are both 'credit institutions' in terms of Article 1 of Directive 77/780/EEC. In theory, therefore, they are competitors within the German banking market. Obviously, indirect state aid to Sparkassen, through, inter alia, state guarantees, may put the savings banks at a competitive advantage in terms of prudential capital requirements with regards to certain (less attractive) business opportunities in Germany. But can we really say, in this or any other context, that the Sparkassen are competitors of Deutsche Bank? And how much of a competitive distortion does this really create? On the other hand, this type of indirect support to the Sparkassen may, in fact, impact far more seriously on institutions from other Member States which are trying to provide services across borders. Once again, an EU approach would seem beneficial here. As suggested above, the markets within Europe are redefining themselves: in the context of the globalisation of the financial markets. Further consolidation and intensification of competition can be expected as the euro brings transparency in the prices of banking services, making anomalies from country to country increasingly obvious as electronic banking becomes more widely used.6 Expensive branch networks will be rationalised in order to cut costs; banks will search for organisational efficiency—for example, centralising treasury functions—and economies of scale and scope as the euro brings additional possibilities of offering increasingly homogeneous financial products across borders. National markets will not disappear overnight and there may remain 'niche' opportunities here for some time to come because the older population is likely to remain loyal to traditional service providers. However, in the longer term, even small banks will face more intense competition on a multi-national basis; at first, from banks originating from 'psychologically close' territories; then from other areas of the EU. Within a few years, a 'national' banking market could well be an anachronism. 6

Assuming, of course, that adequate security measures are, in fact, introduced.

2 - Problems Arising from State Aids in Banking Sector

237

III. A More Sophisticated Approach to State Aid? So, perhaps, now is the time to begin thinking through a more sophisticated approach to state aid: one which recognises the role played by institutions at national, European and global levels. To recap, within the context of the European Union, banks are currently tools for the execution of certain social and potentially regional policies both nationally and within the EU. But, under competition and state aid rules, the banking markets are expected to be free from competitive distortion. The simple fact is that they cannot be free of competitive distortion when other such agendas need to be catered for. It is a question of degree. A narrow focus on the competitive internal workings within the Union obscures the fact that many banks do not just operate nationally or within the EU, they operate on an international or, indeed, a global level. We should not become totally blinded to the fact that there are different types of banks with different competitors operating in different markets: even if they are authorised in EU Member States. Treatment of banks, from a competition and a state aid rule perspective, would ideally reflect this situation. Rather than focusing purely on the completion and functioning of the single banking market in the European Union, should we not be thinking through the EU's approach with regards to its banks' current and future role in the global financial markets? In this context, we must not lose sight of the fact that banks, and the financial system, are intrinsically linked to economic and monetary policy. Analysts project that, in twentyfiveyears, there will be only very few 'global banks'. How can we ensure that ABN-Amro or Deutsche Bank, say, is one of these? How can we ensure that European banks are proportionally represented in terms of GDP size or, potentially, in relation to the role of the euro as an international currency? Can we really expect that there will be at least 15 banks from the EU on this global list—one from each Member State? In the 1970s, the governments of Germany, France, Britain and Spain agreed to set up Airbus Industries to stave off the threat of American predominance in the aircraft manufacturing industry—with the associated consequences for Europe's future access to both civil and military aircraft. Airbus is holding its own against Boeing and is its only significant competitor. It could be argued that, given the links to economic and monetary policy, strong European banks have a similar medium to long-term strategic importance to the EU. We should be asking ourselves now whether we want a certain number of our banks to be major global players in the years to come. And, considering the steps that need to be taken to ensure this happens, focusing not on the European internal market solely but with a strong parallel emphasis on the global market in which these banks operate. Finally, while the creation of the single market in Europe is an important initiative, we should not overlook—or underestimate—the fact that our banks are not 'stand-alone': daily transactions on the international financial markets

238

Working Paper IV

interconnect many times with banks from all over the world. The failure of a major European bank would not be without repercussions, possibly serious ones, internationally. We might risk becoming 'isolationist' if we focus exclusively on the functioning of the EU single market—for instance, the nonapplication of state aid—to the detriment of the EU's role in the world's economy and our relationship with third countries. Our role in the world economy, with the introduction of the euro, may become ever more significant as time progresses. We must not forget that the EU needs to play an active part as a good 'global citizen'.

V Christian Koenig* State Guarantees for the German Landesbanken and the EC State Aid Regime

I. Introduction This paper tackles the two major legal issues raised by the discussion on state guarantees for regional banks, or Landesbanken: the maintenance obligation and the guarantee obligation (Anstaltslast and Gewahrtragerhaftung). It is clear that the Landesbanken, which are regulated by public law (Anstalten des offentlichen Rechts), are paying from 0.25% to 0.5% less on the capital market for money than large private banks are. This is a result of the statutory state guarantees granted by their supporting public law entities (offentlich-rechtliche Tragerkorperschaften). Thus, according to current estimates, the Westdeutsche Landesbank alone saves around DM 300m on the cost of refinancing.1 This advantage, acquired through the first-class credit rating which state guarantees effect, distorts competition by favouring Landesbanken that carry out crossborder business over the banks of other Member States.

II. The Amsterdam Declaration on Public Law Credit Institutions in Germany A decision was taken in the German Bundesrat2 to attempt to set out the refinancing advantage enjoyed by the Landesbanken and savings banks (Sparkassen) in Treaty law in the form of a protocol. However, this goal was not achieved at the EU summit in Amsterdam in June 1997.3 The German suggestion of a binding protocol, laying down an exception to EC state aid rules in favour of the Landesbanken and savings banks, was considered to be too extreme in terms of competition policy and, thus, was not to receive the required ratification.4 Instead, a compromise joint 'declaration', not requiring

* Director, Centre for European Integration Studies, University of Bonn. 1 Capital 1998/3, p. 20. 2 (Herdegen 1997:1130). 3 (Koenig 1997a:1279); (Koenig 1997b:18); (Schmid & Vollmoller 1998:716). 4 Article 311 EC [ex 239]: 'The protocols annexed to this Treaty by common accord of the Member States shall form an integral part thereof.' Cf., (Koenig 1997a).

240

Working Paper V

ratification, was issued.5 By virtue of its legal character, this declaration merely constitutes guidance when interpreting the competition rules set out in the EC Treaty. The declaration's lengthy introduction mainly preserves the Commission's original view on state guarantees and, in fact, the half-hearted wording of the declaration might soon prove to be an own goal for the German Federal Government: The Conference notes the Commission's opinion to the effect that the Community's existing competition rules allow services of general economic interest provided by public credit institutions existing in Germany and the facilities granted to them to compensate for the costs connected with such services to be taken into account in full.

The declaration does little to satisfy the German government's aspirations. Massive opposition within the Council of the EU meant that it was not possible to make a general exception to the EC state aid regime in respect of state guarantees for agencies regulated by public law (Anstalten offentlichen Rechts) such as the internationally very well positioned Landesbanken. The declaration does not protect the Landesbanken in their business on the international financial markets. The Amsterdam Declaration only protects the Landesbanken when they act to further the regional financial framework, particularly in their role as municipal savings banks. Thus, according to the declaration, the association of Landesbanken and savings banks (Landesbanken- and Sparkassenverband) is exempt from the EC state aid regime only when a member institute 'enables local authorities to carry out their task of making available in their regions a comprehensive and efficient financial infrastructure'. However, it has also been argued that this comprehensive and efficient financial infrastructure could be safeguarded, even where the Landesbanken and savings banks no longer have the status of publicly regulated bodies. When compared with the rest of Europe, Germany appears to be slightly 'overbanked'. Its banks offer 814 points of service per million inhabitants, while the European average currently stands at 528 points. Critics argue that cash-dispensers and telephone and Internet banking are reducing the importance of the local 'high street' bank. The socio-political arguments repeatedly advanced by the German Federal Government and the President of the Association of Savings Banks do not convince the critics of the public banking system, especially in view of the fact that the whole of the private banking sector is also involved in the 'current account for everybody' ('Girokonto fur jedermann') initiative.6 Finally, it cannot be convincingly argued that international financial transactions, for example, dealing in derivatives or emitting foreign currency loan commitments, serve the comprehensive regional financial infrastructure. Landesbanken enjoy a privileged position since state guarantees practically exclude the possibility of their bankruptcy. Thus, the cost of refinancing for the 5 Both the failed German suggestion for the protocol on Article 222 EC [ex 295] and the declaration accepted are published in (1997) WM1280. 6 Capital \99$/H3, 20.

2 - Problems Arising from State Aids in Banking Sector

241

Landesbanken on the international financial markets is lower than the cost of refinancing for private banks. The Commission's critical view of this advantage is demonstrated in its recent 'non-paper'. The Amsterdam Declaration cannot protect the Landesbanken from the EC state aid regime. In fact, the Declaration, and its reference to a regionally grown 'comprehensive financial infrastructure' in particular, create the impression that the degree of protection from European competition policy that was secured by the German Federal Government is restricted to the network of the system of savings banks. Landesbanken appear to be fully exposed to the EC state aid regime when operating internationally. Contrary to the German proposal, the maintenance obligation and guarantee obligations for agencies regulated by public law (Anstalten offentlichen Rechts) remain subject to EC competition law: Such facilities may not adversely affect the conditions of competition to an extent beyond that required in order to perform these particular tasks, and/or when they are contrary to the interests of the Community. Where no preliminary solution is agreed upon, the Commission will be obliged to initiate proceedings according to Article 88 EC Treaty [ex Article 93]. It must then consider the extent to which statutory state guarantees for the associations regulated by public law (offentlich-rechtliche Korperschaften), which act as supporting bodies (literally, Carriers, or Trager) for the obligations and losses of Landesbanken, violate the state aid regime and whether they should be repealed. Should the Commission finally initiate proceedings and demand the repeal of the maintenance obligation and guarantee obligation, a concept would have to be worked out to restructure the Landesbanken (Infra, VI. 3.).

III. Are the Maintenance and Guarantee Obligations Indispensable Institutions of Financing and of Liability for the Functioning of the Public Banking System? A. The Legal Concepts of Maintenance and Guarantee Obligation German law distinguishes between the supporting body's internal maintenance obligation towards its public law financial institution (Innenverhaltnis), i.e., the protection of the Landesbanken's financial well-being (Ausstattungsverpflichtung), and its external guarantee obligation as regards the creditors of the Landesbanken (AuCenverhaltnis).7 Both obligations are legal institutions of financing and liability within public law, in particular, the law of agencies

(Koenig 1995): (Schmid & Vollmoller 1998:717).

242

Working Paper V

(Anstaltsrecht). These obligations are based on the state (Lander) laws which regulate the savings banks (Sparkassengesetze).8 The maintenance obligation9 obliges the supporting entity to guarantee the stable economic basis of the agency, ensure that the agency is able to function for the full length of its existence and avoid possiblefinanciallacunae (Unterbilanz) by injecting capital or by other suitable means.10 Whereas partners in private law corporations cannot be obliged by a majority decision to increase the capital base,11 the supporting body of the agency (Gewahrtrager) is faced with an internal obligation to keep the institution functioning.12 The ability to function is measured by reference to the agency's purpose. The maintenance obligation, in the form of a public law duty to equip the agency with the necessary capital, arises only when the fulfilment of the agency's public functions is endangered and the agency is wholly reliant upon the supporting body for its continued existence.13 Similarly, however, the guarantee obligation14 created by regional savings banks laws, also places a public law obligation upon the supporting body to furnish external creditors with a bail-out guarantee (Ausfallgarantie). Yet, this guarantee obligation only arises where the claims of a creditor cannot be satisfied from the agency's own capital base. In this context, the guarantee obligation for such agencies (Anstalt offentlichen Rechts) is justified with reference to the assistance provided by supporting bodies to the agencies in the fulfilment of their public functions (offentliche Aufgaben).15

B. Article 86(2) EC [Ex 90(2)] and the Prevention of the Fulfilment of Statutory Public Functions by Public Law Financial Institutions The application of the Article 87(1) EC state aid regime to the maintenance obligation and the guarantee obligation is opposed by pressure groups within 8

Cf, for example, §3 and §26(2) of the Savings Banks Law of the RhinelandPalatinat for the savings banks and the Landesbank of Rhineland-Palatinat. 9 Cf, §3(2) Savings Banks Law of the Rhineland-Palatinat: 'The supporting entity (Gewahrtrager) ensures the fulfilment of the functions of the savings bank [maintenance guarantee (Anstaltslast)].' 10 Cf, the report on the investigation into distortions of competition in the credit sector of 18. 11.1968 by the Wettbewerbsenquete-Commission of the Federal Government; BT-Dr V/3500, pp 47 et seq; (Oebbecke 1981). 11 Mehrbelastungsverbot; cf, §180(1) of the law governing joint-stock companies [AktG], and §53(3) of the law governing companies with limited liability [GmbHG]. 12 (Schneider 1983:242). 13 Ibid, at 245. 14 Cf. §3(1) Savings Banks Law of Rhineland-Palatinat: 'The supporting entity (Gewahrtrager) is liable without limit for the obligations of the savings bank. A creditor of the savings bank can only require disbursement from the supporting entity when they have not been received satisfaction from the capital of the savings bank [guarantee obligation (Gewdhrtrdgerhaftung)].' 15 (Nierhaus 1984:669).

2 - Problems Arising from State Aids in Banking Sector

243

the public lawfinancialinstitutions on the grounds that the savings banks and Landesbanken fulfil public functions. However, this counter-argument, based on Article 86(2) EC requires proof that, were the maintenance obligation and the guarantee obligation to be abolished, the fulfilment of these statutory public functions would not simply be obstructed,16 but would be wholly prevented. It is argued that maintenance and guarantee obligations constitute distinctive public law institutions of financing and of liability, which are essential prerequisites for the functioning of public financial business.17 Furthermore, public financial business can only be properly conducted by public law agencies and cannot be devolved to private law corporations. Yet, Member States are obliged by Article 86(1) in conjunction with Article 10(1) and (2) EC [ex 9(1) and 5(1) and (2)] to take all the necessary (legislative) measures to ensure that their public undertakings conform, as far as possible, with the competition rules of the EC Treaty. The Amsterdam Declaration indicates that the Commission's position is as follows: supporting bodies should be allowed to support financial agencies, through the maintenance and guarantee obligations, on a sectoral basis and when such support is necessary in order to compensate for disadvantages incurred by the agencies by virtue of the fulfilment of their public function. In addition, this support will only be acceptable when the balance cannot be redressed through other means, such as the transfer of gains from profitable business sectors. However, a general exemption from the state aid regime is excluded.

IV. The Maintenance Obligation and the Guarantee Obligation as State Aid under Article 87(1) EC A. Aid in any form Whatsoever' The term 'any aid . . . in any form whatsoever' is understood to cover benefits for the recipient18 that are not reciprocated. The legal nature and the purpose of the unilateral benefit are irrelevant. The substantive analysis of the functioning of such aid prevails over the legitimation strategies and administrative institutions of the Member States. This analysis is, thus, pivotal to the application of the EC state aid regime, which acts 'autonomously' from national laws, both when interpreting the criteria of a distortion of competition, and when investigating whether trade between Member States has been affected.19 16 Cf, on the criterion of prohibition, Commission Decision IV/29.995, [1982] OJ LI67/39, at 48. 17 (Schneider 1992:773). 18 [1987] ECR 901 (at para. 7); Deufil [1974] ECR 709 (at 26-28); cf, (Koenig 1995); (Schmid & Vollmoller 19998:719; (Wyatt & Dashwood 1993:522). 19 (Schroder 1988:401).

244

Working Paper V

The first test employed is the 'market economy test', which investigates whether or not the benefit would have been available to the recipient on the relevant market at the moment the measure was taken, albeit at less favourable conditions. According to this test, gratuitous guarantees are to be regarded as state aid under Article 87(1) EC, even if the guarantee remains unfulfilled.20 Conversely, benefits granted under normal market conditions do not constitute state aid.21 In its ENI-Lanemssi decision, the Commission considered whether financial means had been granted under conditions that would have been unacceptable to a private investor acting under normal market conditions.22 In the light of this approach, the subscription of capital constitutes state aid if the public authority cannot expect a return on its investment in the long run.23 With regard to state guarantees, the Commission considers the definition of state aid to be fulfilled if the guarantee covers all the obligations of the undertaking. In the EFIM case the Commission noted that a statutory guarantee for all the debts of a public undertaking constitutes a guarantee which a market investor would normally not undertake without prior reassurance that the additional risk would be balanced by additional gains.24 Maintenance and guarantee obligations procure a better rating for public law financial institutions, particularly the larger Landesbanken, in comparison with many private banks. Thus, public lawfinancialinstitutions have a considerable advantage in matters of refinancing. This statutorily-endowed advantage over private competitors meets the criteria of state aid according to Article 87(1) EC. However, an additional question arises as to whether the maintenance and guarantee obligations placed upon the supporting bodies find their compensatory counterpart in the fulfilment by the savings banks and Landesbanken of their statutory municipal and regional public functions. In this case, the state aid regime will not be applicable. Were financial agencies regulated by public law to be privatised, all services, including those offered in the public interest, would be compensated for on the basis of the market value of the services offered. Conversely, the question of whether financial aid may be characterised as state aid is determined solely by the one-sidedness of the aid, since it lacks a counterpart. In other words, the aid has to be given in the absence of a factual compensatory counterpart, and its legal construction is ignored: the maintenance and guarantee obligations made by public law supporting bodies must be adequately compensated for, in the context of a real exchange, in the form of 20

Commission Decision of 18.5.1979, [1979] OJ L138/ 30. Italy v. Commission (ENl-Lanerossi) [1991] E C R 1-1433 (20). 22 Commission Decision of 20.1.1989, [1989] O J LI6/52 (55); similarly, France v. Commission (Boussac) [1990] ECR 1-307 (39 et seq.); Alfa Romeo [1991] ECR 1-1603 (19 et seq.) ; Italy v. Commission [1991] ECR 1-4437 (12). 23 Commission Notice to Air France, [1994] O J C152/6; Italy v. Commission, [1991] E C R 1-1433 (21); Belgium v. Commission (Tubemeuse), [1990] E C R 1-959 (no. 22); Leeuwarder Papierwarenfabriek, [1985] E C R 809 (20). 24 Commission Notice, EFIM, [1993] OJ C349/2 (4). 21

2 - Problems Arising from State Aids in Banking Sector

245

the fulfilment by the Landesbanken and savings banks of their public functions. However, the existence of adequate compensation does not preclude the presumption of state aid in each case. On the contrary, in the context of the Article 88 EC [ex 93] state aid regime, the maintenance and the guarantee obligations must also be examined in the light of a possible over-compensation which might distort competition. The primary question which arises is thus one of whether a 'market economy investor'25 would have offered maintenance and guarantee obligations that are unlimited in amount or kind (stipulated correspondingly in a private law contract) as recompense for the rendering of (public) services. The value of the services rendered by financial agencies is hardly quantifiable in practice. The value would need to correspond to the market value of an unlimited guarantee sustained by the quasi optimal credit rating of public law supporting entities. At first glance, the situation appears similar to the structures of liability in the private banking sector: for example, where a parent company offers declarations of patronage (Patronatserklarungen)26 or promises to cover the potential losses (Verlustdeckungszusagen)27 of its subsidiary.28 However, the comparison cannot ultimately be drawn in this context. Such patronage declarations, or promises to cover losses, are ultimately only supported by the limited amount of capital held by a private law corporation. There is, therefore, an underlying risk that the money involved will be lost. The maintenance and guarantee obligations for a Landesbank, on the other hand, are backed by the immeasurable financial resources29 of the State and, thus, by the State's almost optimal credit rating. A comparable credit rating could never be achieved on the private market.

B. Criterion of the Aid being Granted 'by a Member State or Through State Resources' The criterion that aid must be granted 'by a Member State or through state resources' is also applicable to benefits granted by the autonomous supporting bodies of Landesbanken and savings banks. Although neither the Association of Public Law Savings Banks (Sparkassen und Giroverbande), nor the Lander 25

Ibid. Such a 'strong' declaration of patronage vis-a-vis creditors includes the promise of the parent company to supply its subsidiary with the means necessary t o meet its obligations. If a declaration of patronage is breached, the creditor can claim damages. Thus, the declaration of patronage can be compared t o the guarantee obligation: (Michalski 1994); (Schneider 1989). 27 Promises t o coyer losses concern the relationship between parent company and subsidiary (Innenverhaltnis). Thus, they are similar t o the maintenance obligation, cf., (Schmidt 1984). 28 (Schneider & Busch 1995). 29 EF1M, loc. cit. n. 25, at 3. 26

246

Working Paper V

and municipalities are party to the EC Treaty, the aid awarded by them can be traced back to the Member State, in this case the Federal Republic of Germany.30 The ECJ applies this rule to 'all aid financed from public means'. Consequently, state aid granted by regional or local bodies within the Member States is covered by Article 87(1) EC, regardless of the status or the title of the body.31 This far-reaching jurisdiction is justified by the fact that the Member States are obliged by Article 10(1) EC to ensure that the primary and secondary law of the EC is also applied to their autonomous public law associations. This obligation should be fulfilled without prejudice to the national constitutions, even if it requires legislation. Thus, it may be argued that the legislators of the Federal Republic of Germany could introduce an obligatory minimum capital for public law financial agencies, in order to replace the maintenance and guarantee obligations.

C. Distortion of Competition and Impact on Intra-Community Trade The Article 87(1) EC ban on state aid only arises where there is both a distortion of competition and an impact on intra-Community trade. In this regard, a (refutable) argument may be made that intra-Community trade will, in any case, be hindered if the granting of the state aid causes, at the very least, a potential distortion of competition by improving the competitive position of the beneficiary as compared to the position of competitors from other Member States.32 In this context, it suffices that the beneficiary 'might' compete with businesses from other Member States.33 There is no doubt that there is an 'appreciable' distortion of competition {de minimis rule)34 in the case of Landesbanken who undertake cross-border business. The refinancing advantages enjoyed by the larger Landesbanken by virtue of their first-class credit rating helps them to save several hundred million Marks in comparison with private banks in other Member States. The Westdeutsche Landesbank alone currently saves approximately DM 300m each year on the cost of refinancing.35 Thus, in the case of Landesbanken operating in cross-border business, there is clearly an impact on intra-Community trade within the meaning of Article 87(1) EC. On the other hand, as savings banks generally limit themselves to fulfilling either public tasks at a regional level, or the public tasks particular to 30

Italy v. Commission (ENI-Lanerossi), [1991] E C R 1-1433 (11). Germany v. Commission, [1985] E C R 1814. 32 Philip Morris v. Commission [1980] E C R 1-2671 (11); Greece v. Commission [1988] E C R 2869. 33 France v. Commission [1988] E C R 4067 (19). 34 Belgium v. Commission [1990] E C R 1-959 (43); Opinion of the Advocate General, in Belgium!Commission [1986] E C R 2272 (2274); Philip Morris v. Commission, loc. cit. n. 32. 35 Capital 199S/3, pp. 20. 31

2 - Problems Arising from State Aids in Banking Sector

247

savings banks, they do not, as a rule, enter into competition with banks from other Member States.

D. No Special Exemption from the Prohibition on State Aid A special exemption from the prohibition on state aid does not exist.36 Maintenance and guarantee obligations are thus subject to the state aid regime of the Community, as well as to the duty to notify and to refrain from putting measures into effect contrary to Article 88(1) to (3) EC.

V. Commission Supervision of State Aid and the Article 88(2) EC to alter or abolish Member State Aid Article 88 EC provides for a review procedure, under which the Commission might determine the compatibility of state aid with the common market in several stages. When aid is incompatible with the common market, the Commission decides that the respective Member State has to 'alter or abolish' this state aid (Article 88(2)(1) EC). The restructuring or abolition of aid that is incompatible with the common market is not, therefore, within the purview of the Community or of the Commission. Instead, the national legislature and executive bear exclusive responsible for the alteration or abolition of state aid that is incompatible with the common market.37

A. Differentiation Between New Aid and Existing Aid Article 88 EC differentiates between 'existing aid' and 'new aid', aid which is still to be granted or restructured. Article 88(1) and (2) EC submit existing aid to a constant review by the Commission. Existing aid is aid which had already been established when the EEC Treaty entered into force on 1 January 1958 or, in the case of a later accession, at the time of the accession. Furthermore, 'existing aid' also comprises aid which may lawfully be implemented once it has passed the Article 88(3) EC procedure.38 In contrast to this, 'new aid' encompasses plans to grant or restructure aid that isfinancedby the State.39 Pursuant 36

Article 87(2)(a-c), (3)(a-d) EC. ( K o e n i g & Sander 1997:364). 38 (Nicolaysen 1996:294), referring, however, t o the time of the conclusion of t h e contract. 39 Namur-Les assurances du credit SAIOffice national du ducroire and the State of Belgium [1994] E C R 1-3829 (3870). 37

248

Working Paper V

to Article 88(2) EC, the Commission can demand that existing aid cease or be restructured in the future. However, it is only possible to recover new aid that has been paid out illegally.40

B. Classification of Maintenance and Guarantee Obligations in the Supervision of State Aid Within the legal literature, the predominant view argues that maintenance and guarantee obligations must be considered to be 'existing' aid under Article 88(1) and (2) EC by virtue of their incompatibility with the common market.41 This hypothesis is based upon the opinion that public law guarantees derive from a general (unwritten) rule of law, which had already been applied when the EEC Treaty came into force. In this case, however, it need also be proven that the codification of maintenance and guarantee obligations laid down in the relevant legal bases of the Landesbanken and savings banks merely constitute a general principle of law already in force or a statement of customary law.42 The guarantee obligation is based on statutory law, and may be commercially opportune with regard to the excellent credit rating of Landesbanken and their subsequent refinancing advantages. However, it is neither an axiomatic condition for the meaningful existence of public law agencies, nor is it an absolute prerequisite for the fulfilment of their public functions.43 A report of the Federal Government to the German Parliament on competition44 traces the guarantee obligation back to 'statute or ordinance' (Satzung), so that the maintenance obligation also has to be judged in this form.45 Given the difficulties of proving the existence of a principle of law already prior to January 1st, 1958, neither the maintenance obligation nor the guarantee obligation can generally be qualified as 'existing aid'. The dogmatic attempt to ground maintenance and guarantee obligations in the 'ancient' customary law of the Lander must fail due to a lack of contingency, or the absence of a continuous and consistent tradition of the supporting bodies (consuetude/). After all, cases of liability for Landesbanken losses have been extremely rare. Furthermore, there is no juridical belief (opinio iuris) that supporting bodies should generally be obliged to undertake such activities purely on the basis of customary law.46 40

Heineken Brouwerijen v. Inspecteurs der Vennootschafpsbelasting [1984] E C R 20. ( G r u s o n 1997:359); (Gruson & Schneider 1995:345); (Scherer & Schodermeier 1996:178). 42 F o r the maintenance guarantee, (Schneider & Busch 1995:602:603). 43 (Koenig 1995:824); (Koenig & Sander 1997:365) citing further sources. 44 Wettbewerbsenquete, loc. cit. n. 10, at 48. 45 BVerwGE 75, 318 (324 f.); BVerwGE64, 248 (257 f.); c / , the discussion in the literature, o n the o n e side; (Koenig 1995:823), (Koenig & Sander 1997:365) citing further sources; a n d , on the other side, (Schneider & Busch 1995:603), (Gruson 1997:359). 46 (Koenig 1995:826) citing further sources. 41

2 - Problems Arising from State Aids in Banking Sector

249

In other words, the integration of the maintenance obligation and the guarantee obligation in the state aid supervision system is dependent upon individual proof that each of these legal institutes of financing and of liability existed in statute or in ordinance prior to 1 January 1958. Where this is not the case, maintenance or guarantee obligations must be regarded as new aid, covered by the Article 88(3) EC duty to notify. This 'new aid' classification may have particular relevance for Landesbanken in the new German States. The ECJ laid down the principles which might govern the inclusion of maintenance and guarantee obligations within the state aid supervision system in the case of Namur-Les assurances du credit SA. Thus, the decisive factor when classifying an aid as new aid is, that either the focus of the state aid itself or, indirectly, the agency's geographic or substantive area of impact has changed, so that a formally continuous mechanism of state aid now has a different degree or form of substantive impact which impairs upon cross border competition.47 Where the financial agency's geographic or substantive area of activity has been altered, the (existing) aid must also have been modified so as to give an appreciably modified degree of competitive impairment (ratione personae), or market related impairment (ratione materiae) within the common market. Obviously, mergers of Landesbanken appear to comply with the criteria of new aid laid down in Article 88(3) EC in the view of the effects the aforementioned mergers cause. The prerogative to decide in such cases resides with the Commission.48

VI. Protection of the Legitimate Expectations of Creditors where the Guarantee Obligation is Incompatible with the Common Market To date, there has been insufficient discussion on the recovery of state aid with regard to the margin of discretion open to the Commission and the means of Member States to grant protection of legitimate expectations.49 Whereas the Landesbanken benefit from the maintenance and guarantee obligations by being partially exempted from the need to give adequate consideration, creditors themselves do not benefit from the aforementioned state aid. They always provide sufficient consideration, for example, as purchasers of loans made by Landesbanken, and must, therefore, be integrated within the scheme of the protection given by the public law guarantee. Such creditors provide 'payment' for the credit rating of their obligations with regard to guaranteed loans made by

47 48 49

'Namur', loc. cit., n. 39. Ibid., opinion of AG Lenz at 3854. (Koenig & Sander 1997:366).

250

Working Paper V

Landesbanken, in the form of interest gains lower than those that they would have received on loans given by institutions with a worse credit rating. Thus, such creditors do not enjoy a commercial advantage without a compensatory counterpart. In the context of the recuperation of state loans, it is similarly necessary to 'unravel' the triangular relationship of supporting entities, Landesbanken and creditors. If a creditor, as the owner of a loan granted by a Landesbank, is not to be considered as beneficiary of state aid under Article 87(1) EC, his trust in the guarantee obligation, statutorily secured at the time of the purchase of the loan, must be protected where state aid is altered or abolished. If the creditor has paid for the better security of his claim in the form of lower interest yield, he must not be deprived of the value of the security of the state guarantee. In this context, the said creditor is protected by the principle of legitimate expectations and the protection of property contained in the German Constitution. Regardless of whether the aid in question has been classified as new or existing, any abolition of the guarantee obligation would be illegal (initially under German law) if it did not protect legitimate expectations by means of generous interim rules on the 'old obligations' entered into with creditors in the past. Further, the protection of legitimate expectations and the protection of property are valid legal principles within the legal framework of the Community.50 They prohibit the full or partial withdrawal of securities bought in exchange for lower interest yields by a creditor who was impartial to the state aid relationship, by means of the abolition or restructuring of state aid granted contrary to EC law. In the absence of rules to protect third parties, and especially those creditors who are not party to the state aid relationship, the abolition of the guarantee obligation is simply not feasible. Equally, the differentiation between new and existing aid is simply not relevant to the issue of the protection of legitimate expectations.

VII. Restructuring Models Which Conform to EC Law A. Strict Restriction of Maintenance and Guarantee Obligations to Those Sectors Necessary for the Fulfilment of Public Functions by Public Law Banks In line with this restructuring model, the activities of the larger Landesbanken which are not directly necessary for the fulfilment of their public functions (for 50

Cf., Article 6(1) EU Treaty, based on the case law of the ECJ: 'The Union is founded on the principles of liberty, democracy, respect for human rights and fundamental freedoms, and the rule of law, principles which are common to the Member States.'

2 - Problems Arising from State Aids in Banking Sector

251

example, loans in foreign currencies, innovative derivatives, 'risk management' for international customers51), would no longer benefit from the state guarantees. Considered in the abstract, this idea appears to be a fair one. However, put into practice, it would nonetheless lead to fatal legal insecurity on the financial markets, since the feasibility of making an exact distinction between the general business of a universal bank and its 'fulfilment of public business functions' may be strongly doubted.52

B. Compensation Model Compensation for the benefits accrued through refinancing via maintenance and guarantee obligations can be considered to be a fitting measure of abolition.53 In cases where guarantees are concerned, the Commission generally assumes the existence of state aid in the case of a state guarantee without a commission payment.54 However, this model of compensation is faced with a series of notable difficulties. The benefit arising from maintenance and guarantee obligations would have to be quantified. Yet, the transformation of a statutorily-grounded continuous form of state aid, such as maintenance and guarantee obligations, into a (fictitious) immediate state aid equivalent is barely conceivable in theory, especially as these state guarantees cover indeterminate amounts of losses or liabilities. Furthermore, maintenance and guarantee obligations would have to be evaluated differently or, at the very least, separately from one another in relation to the individual sectors of the business of a Landesbank. A different benefit factor would have to be applied in the loans sector, for example, than applied in the derivatives sector. Finally, the calculation of state aid and of compensation depends upon a prognosis of the future acts of a Landesbank when refinancing. The concrete value of the state aid, and thus the relevant amount of compensation, can only be identified once the Landesbank has, on the basis of its first class rating, procured the more conveniently priced capital for refinancing on the financial market. Having established the (preliminary) amount of compensation, the value of the fulfilment of public functions by a Landesbank (for example, for the financing of public infrastructure projects), itself barely quantifiable, would also need to be subtracted from the compensation amount. Thus, in the final analysis, the compensation solution would fall foul of the past decisions of the Commission, in so far as the Commission generally makes its calculations at the time when the obligation is entered into, and not at the later time when the security was, in

51 52 53 54

(Koenig 1995: 318). (Koenig & Sander 1997:368). (Immenga 1996). HIBEGIKrupplBremer Vulkan [1993] OJ L185/44 (47).

252

Working Paper V

fact, in use.55 To put it in a nutshell: the compensation solution cannot adequately address the practical heeds of the sector.56

C. Transferral of Business not Directly Relating to the Fulfilment of Public Functions to a Private Law Corporation Landesbank AG The difficulties arising out of restructuring could be avoided by devolving the international business activities of the larger Landesbanken, which themselves do not serve public functions (for example, loans in foreign currencies or derivatives) to a private law corporation (or Landesbank AG). The private Landesbank AG would not benefit from maintenance and guarantee obligations. Such a corporation would engage in refinancing through the market in the same manner as a corporation in a consolidated group, thus avoiding the illegality of state aid founded on maintenance and guarantee obligations. By contrast, the Landesbanken's activities which serve public functions (in particular, their function as a central bank for the savings banks) would remain within the purview of a public lawfinancialagency and would thus continue to be protected by maintenance and guarantee obligations. The Landesbanken adequately compensate for their receipt of the benefits of the maintenance and guarantee obligations through fulfilling public functions. Thus, in the core area of public functions, such as the case of refinancing prior to the financing of a municipal infrastructure project by means of a loan, no state aid contrary to Article 87(1) EC could be imputed. Creditors would know in advance whether they were about to enter into legal and business relationships with the Landesbank AG or the public law Landesbank. This model of restructuring would avoid the need for total privatisation and transformation,57 since only the business sectors that are not necessary for the fulfilment of public functions would be transferred from the public law Landesbank to a private law corporation, the Landesbank AG. This model of restructuring is, therefore, one that would 'in no way prejudice the rules in Member States governing the system of property ownership' (Article 295 EC).58

55 Cf, the rough draft of a Commission communication ' o n the application of Articles 87 a n d 88 E C on state aid granted in the form of guarantees' of 7.3.1995, quoted at Immenga (n ), at 98: cf, now, Commission Notice on the application of Articles 87 and 88 of the EC Treaty to state aid in the form of guarantees, O J (2000) C71, of 4.03.2000. 56 ( K o e n i g & Sander 1997:369). 57 In favour of full privatisation, The Economist (4.1.97), 'German banking: can dachshunds be whippets?'. 58 ( K o e n i g & Sander 1997:369).

2 - Problems Arising from State Aids in Banking Sector

253

VIII. Conclusion State guarantees (maintenance obligation and guarantee obligation) ensure a better credit rating for public law financial institutions, predominantly the big Landesbanken, favouring the latter over many private banks. Thus, the Landesbanken possess a substantial advantage as regards refinancing; a statutorily-grounded advantage over private competitors, which must be considered to be state aid under Article 87(1) EC. The costs of fulfilling (sometimes unprofitable) public functions can be compensated on a sectoral basis, in so far as it is necessary to balance disadvantages incurred by those fulfilling public functions in order to ensure these functions are fulfilled, Article 86(2)(1) EC does not provide for a general exemption from the prohibition on state aid. Sectoral exemptions are permitted only in so far as the fulfilment of the public functions would otherwise be impossible. Further, a general statutorily-grounded maintenance obligation and guarantee obligation indiscriminately favours the profitable sectors of public lawfinancialagencies by improving their rating on the international financial markets. The 'Declaration on Public Credit institutions in Germany', only halfheartedly passed at the EU Amsterdam summit and, not being binding in any case, does not create a sectoral exemption for maintenance and guarantee obligations in favour of the Landesbanken and savings banks. If anything, all the Declaration does is to confirm the validity of the EC state aid regime as an interpretational aid: the member institutes of the German system of Landesbanken and savings banks are protected from European Commission measures only in so far as they truly advance the regional financial infrastructure, especially by enabling 'local authorities to carry out their task of making available in their regions a comprehensive and efficient financial infrastructure'. The many international areas of the Landesbanken's business (for example, loans in foreign currencies or derivatives), in which their optimal credit rating has positive effects, are exposed to the EC state aid regime only in so far as it cannot be shown that such activities support the regional 'comprehensive financial infrastructure'. The classification of maintenance and guarantee obligations under the EC state aid regime (Article 88 EC) is dependent upon the date on which individual statutoryfinancingand liability were implemented. The distinction between aid that is considered to be 'existing aid' (privileged in the context of recovery) and aid that is considered to be 'new aid' (less privileged in the view of the Landesbanken which benefit from state aid) is not a general one and must be made on a case-by-case basis. Maintenance and guarantee obligations not grounded in statutes or ordinances that predate 1 January 1958 must be regarded as new aid and be notified according to Article 88(2) EC. The principles of the protection of legitimate expectations and of property prohibit the withdrawal of securities from a creditor who is not directly involved in the state aid relationship and who has 'paid' for the security through lower interest yields. Therefore, any abolition or restructuring of state aid that

254

Working Paper V

falls foul of the EC regime may not take benefits away from creditors so that guarantee obligations may only be abolished in the presence of interim regulations which protect third parties, in particular, loan creditors. Should the Commission demand the restructuring of maintenance and guarantee obligations, the international business activities of the Landesbanken that are not necessary for the fulfilment of their public functions could be taken out of the public law sphere and transferred to private law corporations (Landesbank AG). By contrast, the business sectors which serve the regional financial infrastructure (in particular, where Landesbanken act as central banks for savings banks and finance municipal infrastructure projects) could remain within the public sphere and thus benefit from maintenance and guarantee obligations. The social value of creating infrastructure is such as to compensate for the benefits accruing from maintenance and guarantee obligations, so that where Landesbanken fulfil core public functions (for example, refinancing prior to infrastructure projects) state aid in the sense of Article 87(1) EC does not arise. This model of restructuring offers a way of avoiding the complete disappearance of the larger Landesbanken and thus 'in no way prejudice^] the rules in Member States governing the system of property ownership' (Article 295 EC).

VI Asger Petersen* State Aid and Banking

I. Introduction Following a survey of state aid cases in the banking sector, this paper examines the various state aid problems that the specific structures of the banking sector have given rise to in these cases. The paper examines the question of whether a deviation from normal state aid policy might be justified in the banking sector due to: a) Treaty provisions, such as Articles 86(2) [ex 90(2)] and 295 [ex 222]; b) conflicts with the secondary law of the Communities, such as Council directives on banking matters; c) conflicts with national regulatory measures d) the risk of systemic crises.

II. A Succinct Summary of State Aid Cases in the Banking Sector A. Commission Decisions 1. Banco di Sicilia and Sicilcassa1 In 1992, the Commission did not regard the 915.5 billion ITL re-capitalisation of Banco di Sicilia—in line with Law No. 218/90 (the 'Amato' law) and Regional Law No. 39/91—which transformed the bank from a public entity into a public limited company, to be state aid. The difficulties of the bank continued and were further complicated by its take-over, in 1997, of a small regional saving bank, Sicilcassa, placed under a forced administrative liquidation procedure. The total support consisted of: (i) 1000 billion ITL from the Italian inter-bank deposit guarantee fund (Fondo Interbancario di Tutela dei Depositi) to Sicilcassa in liquidation, in order to allow for the transfer of fairly healthy assets and liabilities to Banco di Sicilia; and (ii), a guarantee of 1000 billion ITL from the Banca d'ltalia, to cover *1 Former Deputy Director General, State Aid Control, DGIV. OJ (1992) C160: Opening of Procedure, OJ (1998) C297.

256

Working Paper VI

further losses caused to Banca di Sicilia by this transfer from the public bank, Mediocredito, and by the transfer, by the Treasury to Banca di Sicilia, of its stake within a small public regional development company, Irfis. Although the Commission established that the intervention by the guarantee fund did not, in the present case, constitute state aid, it initiated an Article 88(2) [ex 93(2)] procedure as regards the other three public interventions. 2. Banesto2 Banesto, one of the largest Spanish banks, ran into difficulties in 1993. A rescue plan was set up by the Spanish Central Bank, based on support from the Spanish Depositors Guarantee Fund; a fund financed by voluntary contributions from banks. The ingredients of the plan were: a) the use of all of Banesto's reserves and share premiums and a reduction in its share capital, in order to offset losses to the amount of 20 billion PTAs; b) a capital increase of 180 billion PTAs by the Depositors Guarantee Fund; c) the purchase by the Depositors Guarantee Fund, and immediate resale to Banesto, of deteriorated assets, with a loss of 285 billion PTAs; d) an interest-subsidised loan from the Depositors Guarantee Fund of 315 billion PTAs over four years, with an estimated cost for the Fund of 41 billion PTAs in foregone interest; e) the replacement of Banesto's President and Management Board. Following this exercise, the Fund sold its stake in Bannesto to Banco de Santander for 313 billion PTAs, and recovered a part of its initial costs. The Commission concluded that no state aid was involved in the transaction. 3. Comptoir des Entrepreneurs3 The bank concerned is specialised in housing loans, both for social housing and the (non-means tested) professional housing market. Due to the 1993-95 real estate crisis, it experienced serious difficulties and received state aid totalling 31.447 billion FF in the form of capital injections, loans and thefinancingof a defeasance operation. After having verified the viability of the restructuring and the adequacy of the compensation offered for the distortive effects of the aid—in particular, the closure of all the bank's foreign branches, a 50% reduction in market share, a 54% decrease in administered loans, and the endorsement of the plan by its future main shareholder AGF (Les Assurances Generales de France), whose privatisation, or so the French government declared, would be imminent—the Commission approved the scheme as restructuring aid. 2 3

Not published. OJ(1996)C70/7.

2 - Problems Arising from State Aids in Banking Sector

257

The case deals with state aid issues under Article 86(2) of the Treaty, the prudential norms laid down in Community directives, and the risk of a systemic crisis. 4. Credit Lyonnais Decision of 26th July 19954 Credit Lyonnais, Europe's largest bank in terms of assets, began, after five years of rapid growth, to record losses in 1992 and 1993. The aggressive lending and expansion policies of the 1980s and early 1990s, together with a general slow-down in economic activities and the rapid deterioration of the real estate market, exposed the bank to a serious crisis, which caused its public shareholders to make a capital injection of 4.9 billion FF and to hive-off bad assets of 135 billion FF into a defeasance structure, financed and underwritten by the state. The Commission approved this state aid, taking into account: a) the expected revenues to the state from the realisation of some of the bad assets (leading to an estimated net cost to the state of 45 billion FF) b) the imposed interest squeeze between the cost of the 135 billion FF loan granted by Credit Lyonnais to the public body responsible for the operation of the defeasance system, and the income to this body from the loan carried on to the defeasance structure; c) the coupon zero bond of 10 billion FF, issued by Credit Lyonnais; d) the better fortune clause that ensured that a considerable part of future pretax profits would be reserved for the coverage of the losses of the defeasance structure, and; e) the proposed future privatisation of Credit Lyonnais. The aid was approved as restructuring aid, on the condition that a considerable cut be made in Credit Lyonnais' commercial capacity—at least 35% with regard to foreign commercial operations (50% of which in Europe)—and that its future growth be curbed, in order to allow for the financing of the defeasance structure. The decision touched upon the issue of the relationship of state aid rules with secondary Community law—for example, the setting up of a solvency ratio for credit institutions—and to national banking rules. It was also raising the issue of a systemic crisis. Decision of 25th September 1996s The approval of aid notwithstanding, the situation of Credit Lyonnais continued to deteriorate during 1995, due to a general weakening in the market, its 4 5

OJ(1995)L308/92. OJ(1996)C390.

258

Working Paper VI

weakened credit rating and a concomitant increase in the cost of raising capital on the market and the particular costs incurred through the financing of the interest squeeze on the 135 billion FF loan to the defeasance system. In its 1996 decision, the Commission approved both the neutralisation of the interest squeeze on the loan to the defeasance structure and the non-issue of the 10 billion FF coupon zero bonds during 1995 and 1996, as rescue aid (a total of almost 4 billion FF). At the same time, it initiated an Article 88(2) [ex 93(2)] procedure for the other planned supplementary aid. Once again, the decision concerned the risk of a systemic crisis. Decision of 20th May 19986 An additional net aid of 61-106 billion FF (bringing total aid to Credit Lyonnais to 102-147 billion FF) was approved, comprising coverage for significant supplementary losses in the defeasance system, a modification of the interest squeeze on the loan to the defeasance structure, the definitive abandonment of the 10 billion FF coupon zero bonds and a modification of the better fortune clause. As counterpart for this aid Credit Lyonnais was obliged to: a) Become a predominantly domestic bank. It was required to sell or liquidate 620 billion FF of its international assets, which had a book value of 960 billion FF, prior to its privatisation, at the very latest, in October 1999. Of its European assets, Credit Lyonnais was only allowed to keep those maintained in London, Luxembourg, Frankfurt and Switzerland. b) Reduce its branches to 1850 by year the 2000 (in 1994, it possessed 2475 branches). c) Accept a system curbing its future growth through the imposition of a minimum dividend of 58% of its net results up until 2003 and through the setting of a ceiling on the progress it would be allowed to make up until the end 2001 of 3.2% a year on its consolidated results. From 2001 to 2014 this ceiling would be set at maximum, the solvency ratio being reached by 2001. The Commission came very close to reaching a negative decision—and mandated the Commissioner responsible for competition to inform the French Government that it would take a negative decision on the aid unless the French Government acceded to the Commission's conditions, amounting to a reduction of 620 billion FF in its assets—and the case is thus an important illustration of the issues surrounding the risk of a systemic crisis, should state aid to a leading bank be refused. In this regard, it should be noted that the Commission was assisted in its considerations by a group of wise men, made up of three former governors of NCBs in the Member States. The decision also dealt with the issue of the relationship between state aid rules, secondary Community law and national banking regulations. 6

OJ(1998)L221/28.

2 - Problems Arising from State Aids in Banking Sector

259

Furthermore, it illustrates the risk, predominant in the case of a public bank, of a confusion between the role of the state as a shareholder and the role of the state as a regulator who is responsible for the protection of the general public interest. All three decisions were challenged by a (French) competitor of Credit Lyonnais before the European Court of Justice. 5. Banco di NapolP The public bank, Banco di Napoli, the seventh largest bank in Italy, sustained significant losses in 1994 and 1995 leading to state intervention. The Commission concluded that a debenture loan of 2365 billion ITL did not constitute state aid, because a significant part of that sum was contributed by private banks. The same conclusion was drawn as regards a 283 billion ITL capital injection made under the 'Amato' law, which transformed the company from a public entity into a public limited company with a view to privatisation. As regards Banca d'ltalia's release, in favour of Banco di Napoli, of ITL 1450 billion of mandatory reserves held by it as a deposit guarantee, the Commission regarded this to be state aid, but concluded that this was 'compatible' rescue aid, taking account of the particular sensitivity of the banking sector. Remaining state support was subject to the opening of the Article 88(2) procedure: a) a capital injection by the Treasury of 2000 billion LIT; b) advances granted by the Banca d'ltalia to offset losses incurred by Banco di Napoli by virtue of the liquidation of a bank belonging to the group (Isveimer Bank); and c) a tax concession linked to an exemption from payment of a registration fee for the transfer of enterprises, branches or assets. The final decision, taken in July 1998, concluded that the advance from the reserves of the guarantee deposit did not constitute an aid, as it did not convey an advantage to Banco di Napoli. Other forms of state support, including the hiving-off of bad assets of 12400 billion ITL into a defeasance structure, was regarded to be state aid. The total aid of 2217 billion to 11895 billion ITL was approved as restructuring aid. Approval was based on the viability of the restructuring plan, which was endorsed by the purchase by the private insurance company, INA, and the Banca Nationale del Lavoro (which itself is being privatised) of 60% of the bank in the course of privatisation. Furthermore, the distortive effects of the aid were offset by important achievements, such as, a 43% reduction in the bank's balance sheet over three years, the closure of 77 branches in Italy (10%) and a reduction in international branches from 13 to 6 (70%) over two years. Opening of procedure, OJ (1996) C 328/23.

260

Working Paper VI

6. Banque Hervet8 Banque Hervet is a small, publicly owned, French bank dealing with loans to SMEs and property development. Having paid its shareholders dividends during the previous 10 years, it suffered losses in 1992 and 1993. The state supported a restructuring plan comprising two capital injections totalling 900 million FF. Concluding that the restructuring plan would re-establish the profitability of the bank, the Commission accepted, in 1995, that the intervention of the state/shareholder did not constitute state aid. 1, Credit Fonder de France9 Credit Foncier de France is a medium-sized financial institution under public control, dealing with loans for building low cost housing, the issue of mortgage bonds, the payments of premiums under house savings contracts to credit institutions and loans to property developers, local authorities and transport companies. It does not accept deposits from private investors. In 1995, it suffered immense losses, leading to a dramatic downgrading of its ratings and, accordingly, of its ability to raise loans on commercial terms. The state acted—partly through its wholly-owned Treasury bank, la Caisse des Depots et Consignations—by putting an overdraft facility of 20-25 billion FF at the disposal of Credit Foncier for eighteen months, and by according a guarantee, unlimited in time and amount, that a.11 the credit institution's securities debts would be fully honoured and that steps would be taken to ensure that the credit institution would be able to carry on its activities in accordance with existing prudential rules. The Commission has commenced an Article 88(2) procedure in relation to all three measures. 8. Credit Agricole10 The Credit Agricole is a credit institution which enjoys the exclusive right of being authorised to receive mandatory deposits from notaries. No interest is payable upon these deposits, beyond the payment of a 1% commission to the notary. Credit Agricole has offered a counterpart for this exclusive right since 1991, in the form of the yearly payment of a sum to a fund for the coverage of the financial charges imposed upon farmers. The Commission opened a procedure, pinpointing the element of state aid within the mechanism as the advantage conveyed to a specific bank by the state's imposition of an obligation upon notaries to make deposits at a specific bank and the relief which the bank is granted from its normal duty to remunerate such deposits. 8 9 10

Not published. Opening of procedure, OJ (1996) C275/2. Opening of procedure, OJ (1998) C144/6.

2 - Problems Arising from State Aids in Banking Sector

261

The one remaining issue was one of whether the payment made to farmers by the bank, and the 1% commission paid, was a sufficient counterpart for the exclusive right under Article 86(2) of the Treaty. Since the arrangement predated the creation of the European Communities, however, it seems clear that, should aid be identified, it is existing aid and that Article 88(1) [ex 93(1)] should have been applied from the outset. 9. Credit Mutuelu In a similar case, an exclusive right was granted to the Credit Mutuel to offer a special savings account, the so-called 'Livret Bleu', with regard to which depositors receive a tax-emption on two-thirds of the interest received on savings up to 100,000 FF. In opening a procedure, the Commission established that the monopoly granted to the banks comprised state aid, since Credit Mutuel was given an advantage by the state's tax waiver. This waiver did not appear to be offset by the general economic interest obligation placed upon the bank: an obligation imposed upon the bank, in 1991, to use a part of the 'Livret Bleu' deposits to fund social housing (increasing from 10% to 100% in the year 2001) for which a commission of 1.3% is paid to Credit Mutuel. The Commission has raised doubts as to whether, where a 1.3% commission is paid to the bank in order to compensate it for the social housing project in line with Article 86(2), a public tender might not prove to be a cheaper way of providing the funds for that purpose. 10. Societe Marseillaise de Credit12 Societe Marseillaise de Credit is a local public bank operating in the South of France. The bank began to suffer losses in 1991, due to low productivity and its heavy involvement in the real estate market. During the period 1993-98, the state made various capital injections, totalling 5868 million FF and awarded a state guarantee of 423 million FF. The Commission approved this aid as restructuring aid on the basis of a restructuring plan, the viability of which was proven by the purchase of the bank by the private bank, Banque Chaix, in June 1998. The French Government ensured adequate counterparts for the aid by curbing the bank's activities, both in the banking field and in related areas. The case touched upon the issue of the relationship of state aid policy to national banking law. Bank Austria13 Austria's largest bank, Bank Austria, won a bid to assume the state's shareholding in Austria's second largest bank, Creditanstalt- Bankverein. An 1

' Opening of procedure, OJ (1998) C146/6. Opening of procedure, OJ (1997) C49. Extension of procedure, OJ (1998) C249. 13 No publication. 12

262

Working Paper VI

unsuccessful bidder complained to the Commission that the bidding procedure was distorted by state aid, mainly because Bank Austria benefited from an unlimited guarantee, for which no compensation was required, from one of its part-owners, the Anteilsverwaltungssparkasse Zentralsparkasse, and from the City of Vienna. The Commission rejected the complaint, stating that if the state guarantee were a state aid, it was an existing aid that was already in force before Austria entered the EU, and, therefore, did not illegally affect the take-over. At the same time, the Commission noted the Austrian Government's statement that it would, in future, take steps to ensure that state guarantees given under the Austrian savings bank law would conform with market conditions. 11. Westdeutsche Landesbank14 WestLB is a public law institution, 100% publicly owned, with the Land of North Rhine-Westphalia being the major shareholder. It is the third largest bank in Germany and has a triple function to act: (i) as a central bank for the local saving banks in North Rhine-Westphalia; (ii) as state bank for its public shareholders, funding debts and handling financial transactions for them; and (iii), as a normal commercial bank in its own right. With effect from 1 January 1992, the Land of North Rhine-Westphalia transferred another public law institution belonging to it, the Land Housing Promotion Fund (Landeswohnungsbauvermogen) to WestLB. The net discounted value of this capital transfer was 5.9 billion DM. The German banking authorities only accepted 4 billion DM as being additional capital of 'core' quality under the German banking law (subsequently, adapted to the Solvency Ratio Directive15). Since, at the time of transfer, the average solvency ratio of the WestLB, was only 6.3%, compared with the 8% required by the new Community rules, 1.5 billion of the new 4 billion DM of core capital was, allegedly, required to underpin the Housing Fund's risk adjusted assets, leaving it with 2.5 billion DM to increase its activities and to improve its competitive situation on the market. As compensation for this advantage, WestLB pays a yearly remuneration of 0.6% of its net profits on the invested capital to the Land.16 The case illustrates possible conflicts between state aid rules and national law, will set a precedent for Germany, where many Lander have transferred public housing funds or public land to their Landesbanken, and will hinge on the question of whether a market economy investor would regard the 0.6% p.a. return on the invested capital as adequate compensation for the advantage conveyed to the WestLB.

14 15 16

Opening of procedure OJ (1998) C 140/9. Council Directive no 89/647 EEC. Equivalent to around 1% before tax.

2 - Problems Arising from State Aids in Banking Sector

263

B. European Court Decisions 1. Ziichner v. Bayrische Vereinsbank11 Although it does not deal with state aid directly, but with Articles 81 and 82 [ex 85 and 86] of the Treaty, the case is worth mentioning since it highlights the Court's opinion that banks are not exempted from compliance with the competition rules, in their role as operators of international money transfers, by reference to Article 86(2) or to Article 101 [ex 104] EC. 2. Banco Exterior de Espana v. Ayuntamiento de Valencia18 This case concerned the imposition of a municipal establishment tax upon a bank, which maintained that it was exempted from such a tax under national law in its character as a public credit institution. The case demonstrates that a public credit institution performs a task of general economic interest under Article 86(2), when, as a non-profit making exercise, it administers the public provision of credits without any prejudice to the commercial or industrial credits granted within competitive banking business. AG Lenz addressed the relationship between Articles 86(2), 87 and 88 EC, and concluded that Article 86(2) has no direct effect in state aid matters and takes effect only once the compatibility of the aid has been assessed under Articles 87(2) and (3). We can deduce from these conclusions that, as regards the relationship between the procedural rules of notification found in Articles 88(3) and 86(3), Article 86(2) will therefore apply as an exemption rule only when state aid is present and its 'compatibility' has been assessed. The Article 88(3) notification rules prevails. The Court limited itself to ruling that an existing aid was present and that the distinction between existing and new aid also applies to Article 86(2), so that the aid could be implemented in the absence of Commission intervention under Article 88(1). 3. Husbanken19 The sole banking activity of the Norwegian State Housing Bank (Husbanken) is the financing of housing in Norway, both through means-tested loans or grants for under-privileged groups (one third of loans/grants) and through financing that is not subject to a means-test. The loans are low interest loans, and losses on loans and guarantees are covered by a state indemnity fund. The EFTA Surveillance Authority (ESA) rejected a complaint made by the Norwegian Bankers' Association, stating that state support did not go beyond 17 18 19

ECR [1981] 2021. ECR [1994] 877. EFTA Court case, E 4/97 Norwegian Banking Association v. ESA.

264

Working Paper VI

what was necessary to ensure that the Husbanken would be able to perform the services of general economic interest entrusted to it.20 The EFTA Court concluded that state aid was involved, and that the aid was existing aid, predating the signature of the EEA Agreement. The Court also stated that it was 'primarily' the task of ESA to determine whether cases involved services of general economic interest (Article 59(2) EEA), and further noted that this authority had not manifestly erred in its analysis. However, further applying the proportionality test on the necessity of state aid measures and their potential effect upon trade, the Court concluded that ESA had failed properly to justify its decisions, since it had not identified the relevant market (means-tested or non means-tested financing) and had not properly addressed the applicant's argument that Norwegian housing policy might be pursued in a manner that is less distortive of competition. The Court, therefore, annulled ESA's decision.

III. State Aid Policy Confronted with the Specific Nature of the Banking Sector A. Derogations under Treaty Articles Other than Articles 87 and 88 The basic question for analysis here is one of whether, in the light of the caselaw detailed above, other Articles within the EC Treaty may prevent the application of the state aid regime laid down in Articles 87 and 88 EC.

1. Article 86(2) At the instigation of Germany, the Amsterdam Summit of the European Council adopted the following Declaration to the Protocol on Public Credit Institutions in Germany in June 1997: The Conference notes the Commission's opinion to the effect that the Community's existing competition rules allow services of general economic interest provided by public credit institutions existing in Germany and the facilities granted to them to compensate for the costs connected with such services to be taken into account in full. In this context, the way in which Germany enables local authorities to carry out their infrastructure is a matter for the organisation of that Member State. Such facilities may not adversely affect the conditions of competition to an extent beyond that required in order to perform these particular tasks and which is contrary to the interests of the Community.

20

Art. 59(2) of the EEA Agreement, which is similar to Art. 87(2) of the EC Treaty.

2 - Problems Arising from State Aids in Banking Sector

265

Austria and Luxembourg added their own Declarations to the Protocol, stating that a similar regime would apply to public credit institutions within their territories. The German initiative was due to its increasing nervousness about the danger of Commission intervention against two forms of state guarantees for local saving banks and Landesbanken under its state aid control regime. Both guarantees are established under public law and raise issues similar to those raised in the case of Bank Austria: the first, 'Anstaltlast', is a remuneration free maintenance guarantee, which endows benefit in the absence of remuneration; and the second, 'Gewahrtragerhaftung', is an unlimited guarantee for liabilities that cannot be met with the bank's own assets. Paraphrasing, the Declaration to the Protocol of the Amsterdam Treaty states that gratuitous state guarantees to public credit institutions in the three countries concerned will be considered to be compatible state aid under Article 86(2) if: (i) they do not exceed what is just compensation for the services of general economic interest assigned to these banks; and (ii) are not contrary to Community interests. At the same meeting, however, the European Council, taking note of the Declarations of the three Member States, decided to take a pan-European stance on the issue and invited the Commission: (i) to examine whether similar cases exist in other Member States; and (ii), to apply, where appropriate, the same standards to similar cases, and to inform the ECOFIN Council of its activities. The Commission accordingly required all Member States to furnish detailed information on their banking sectors. The results of this examination were submitted to the ECOFIN Council in December 1998. The investigation showed that only three Member States—Germany, Austria and Sweden—entrusted credit institutions with the task of providing a basic financial infrastructure, forming a 'universal service', for a given territory. Having imposed a universal service obligation on their public saving bank systems, which include both regional saving banks and Landesbanken, Germany and Austria both acknowledged that this 'public task' is performed in concert with the systems' normal banking activities and in tandem with other credit institutions—which do not have the same obligations, but operate comparably dense networks of banking agencies—so that any form of compensatory system is excluded. The German Government, in fact, argues that gratuitous state guarantees are not justified by the assignment to the saving bank system of universal service obligations, but by the particular public ownership status of these credit institutions, thus invoking Article 295 of the Treaty (see, infra). The issue of universal service within Sweden is linked to Posten AB, which the Swedish government itself does not consider to be a credit institution, but which is required to provide a nation-wide payment service network alongside its postal activities, for which it receives compensation for non-profitable services rendered in sparsely populated areas where no banks are present. Accordingly, the Council, having taken note of the content of the Commission's report, asked the Commission to examine the situation in the

266

Working Paper VI

three countries on a case-by-case basis. With the exception of the Swedish case, the investigation seems to demonstrate that no universal public service obligations exist in the banking sector, which might justify non-compliance with state aid rules. The investigation also revealed that several Member States listed a number of specific tasks that were assigned by them to specialised credit institutions, particularly in the areas of social housing loans, promotion of SMEs, the granting or guaranteeing of export credits, the financing of infrastructure projects, and regional development. Consequently, the investigation touched upon issues similar to those raised in cases such as Comptoir des Entrepreneurs and Banco Exterior de Espana (distribution of public loans), Credit Agricole (farmers' fund), and Credit Mutuel ( social housing). In order for the Article 86(2) derogation to apply, there must be an explicit act of public authority (law, regulation, concession, 'cahier des charges', or a combination of these acts), defining and assigning the particular public service task to one or more selected undertakings.21 According to ECJ rulings,22 Member States enjoy a large degree of freedom to define what a task of general economic interest is. There seem, however, to be limits upon that freedom. In Zuchner v. Bayrische Vereinsbank, the Court stated that the task of carrying out normal money transfers from one bank to another inside the Community on behalf of clients is not sufficient to justify the qualification of banks as Article 86(2) undertakings. In Husbanken, the EFTA Court stated that is was 'primarily the task of the EFTA Surveillance Authority to assess whether certain services are services of general economic interest within the meaning of Article 59(2) EEA'. Equally, and in any case, departure from the state aid rules through the assignment of public service functions is limited by the proportionality principle, which determines that non-compliance with state aid rules is only acceptable where this is necessary in order to ensure that the public service task will be performed. The burden of proof lies with the Member State concerned, the Commission has a wide margin for judgement, and such judgements can only be overruled by the Court in cases of manifest error. In each case, the Commission must strike a balance between the Member States' right to invoke the exemption and the Community's interest in ensuring a minimal distortion of competition. Normally, open tendering and the attribution of the public service task to the bidder most favourable to the state would completely eliminate the state aid problem. However, as stated in Husbanken, one might not demand 'that the measure adopted is the least restrictive possible. A reasonable relationship between the aims and the means employed is satisfactory.' So, even if the Member State does not choose the most efficient undertaking, the decision cannot be overturned where reasonable objective justification is given for the choice. 21 BRT/SABAM E C R [1974] 313; Ahmed Saeed E C R [1989] 807; Commission v. FranceECR [1997] 5815. 22 Ladbroke v. Commission ECR [1994] 1015; FFSA v. Commission ECR [1997] 229.

2 - Problems Arising from State Aids in Banking Sector

267

On the other hand, if a given banking service is widely available on the commercial market at commercial terms, the proportionality principle will usually lead the Commission to disallow distortion through state aid in favour of a specific bank entrusted with the same service under Article 86(2). Nor can the Commission be expected to accept state aid paid as compensation that exceeds the incremental costs caused to the undertaking by of public interest task entrusted to it: over-compensation may lead to cross-subsidisation for activities carried on under competitive market conditions. These considerations have led the Commission to question the status of the state aid concerned in the cases of Comptoir des Entrepreneurs, Credit Mutuel and Credit Agricole. First, because it seems that the losses covered by the state aid do not originate from the special banking services assigned by the state to Comptoir des Entrepreneurs, but from its other banking activities. Secondly, because the benefit granted to Credit Mutuel in the form of exclusive rights to operate the 'Livret Bleu', greatly exceeds the compensation given by it in the form of social housing loan obligations. Similarly, in the third case, Credit Agricole does not appear to offer a convincing counterpart for the exclusive right to receive notaries' deposits, since its contributions to the Farmers' Fund appear to be an integrated commercial part of the bank's normal activities. 2. Article 295 This Article states that the Treaty shall not prejudice the rules in Member States governing the system of public ownership. The application of the market economy investor principle to banking cases, in order to evaluate the state/shareholder's conduct and to distinguish between the role of the state as a commercial market operator and its role in securing the public good, is in line with the acknowledged principle of non-discrimination as regards ownership, and is, therefore, not specific to the banking sector. The same holds true for the fact that, in certain cases, the future privatisation of a public bank was laid down as a condition for aid, or was a determining element in the Commission's approval of aid: for example, Comptoir des Entrepreneurs, Societe Marseillaise de Credit and Credit Lyonnais. In these cases, privatisation was regarded, both as a decisive proof of the viability of the restructuring plans, and—in particular, in Credit Lyonnais—as a condition sine qua non for the future viability of the bank, once public ownership, the injection of massive support notwithstanding, had failed to turn the tide. The German response to the Commission's investigation on services of general economic interest provided by public credit institutions (see above p. 265) focused on Article 295. The German authorities argued that the gratuitous state guarantees granted to the German Landesbanken are not merely justified since they relate to the performance of services of general economic interest, but are, instead, also legitimated by virtue of the status granted to these publicly-owned banks by public law; a status to which the public guarantees are

268

Working Paper VI

linked automatically.23 The Commission, however, argues that whilst Article 295 imposes a principle of neutrality, Article 86(1) nonetheless requires Member States to ensure that their public undertakings neither enact, nor maintain in force, any measures that are contrary to the rules of the Treaty, in particular those provided for in Article 12 [ex 6] and Articles 81-87. While public ownership may take very different legal forms—note, the 'Amato' law's transformation of Italian 'public law' banks into public limited companies— Article 86(1) would seem to oblige the Member States to opt for forms of public ownership which are in conformity with the competition and state aid rules of the Treaty. The opening procedure in WestLB, thus, notes that: The Commission agrees with your Government that the Treaty's state aid rules do not rule out the assignment of property of a company to a public authority provided that a legal form of ownership is chosen which does not per se contain elements of state aid. If a form of public ownership is chosen, which automatically entails the two types of state guarantees concerned, the mechanism could nonetheless be brought into line with Article 86(1), were the banks required to pay a premium for the guarantees in conformity with market conditions; a step proposed by the Austrian Government in the light of Bank Austria.

B. Possible Conflicts with Secondary EU Law One of the main issues raised by state aid investigations into capital injections into banks, has been the question of whether state intervention may be justified where it is undertaken in order to satisfy the terms of directives such as the Solvency Ratio Directive,24 the Own-Funds Directive25 and the Security Directive.26

1. The Solvency Ratio and Own-Funds Directives The Solvency Ratio Directive imposes a ratio between own funds, risk-adjusted total assets and off-balance sheet items of at least 8%. Article 10(3) of the Directive stipulates that, where the ratio falls below 8%, the competent authorities shall ensure that the credit institution in question takes the appropriate measures to restore the ratio to the agreed minimum as quickly as possible. The Own-Funds Directive lays down the forms of funds that are to be regarded as 'core' capital and the forms of funds that are to be regarded as additional 23

See, in that context, (Gruson & Schneider 1995:425), in which it is argued that the two forms of state guarantee are merely a public law equivalent to private law concepts serving the protection of creditors, and substituting for the undercapitalisation of Landesbanken, exempted under German law from normal requirements to maintain minimum capital. 24 Council Directive 89/647 EEC of 18.12.1989 23 Council Directive 89/299 EEC of 17.04.1989 23 Council Directive 94/19 E E C of 30.05.1994

2 - Problems Arising from State Aids in Banking Sector

269

own-funds, setting the limits for ratios between the two types of funds. It also forbids, for reasons of competition, that state guarantees to public institutions count as own-funds. In Comptoir des Entrepreneurs, in Credit Lyonnais (one and three), in Banco di Napoli, and in WestLB, it was argued that capital injections made to help banks in difficulty to meet the criteria laid down in these directives should not be regarded as state aid. However, as stated in the pre-amble to the Solvency Ratio Directive, minimum solvency ratios are not merely designed to control banking risks and ensure the stability of the banking system, but are also imposed in an effort to create a level playing field and prevent the distortion of competition through the imposition of common solvency standards. Therefore, banking supervision and fulfilment of the solvency ratio requirement must not entail a breach of competition or state aid rules. As stated in the first Credit Lyonnais decision: An automatic injection of capital to meet the solvency ratio requirement or any other equivalent measure by the state would have the effect of endorsing the failing institution's unfair competitive practice prior to the crisis.

The state aid character of capital injections made under such circumstances must, therefore, be assessed on the basis of the market economy investor principle alone, and not on the basis of the need to satisfy the Solvency Ratio Directive In WestLB, the question was one of how much of the capital contribution granted through the transfer of the Housing Promotion Fund made up tier-one capital, allowing the bank to increase its competitive activities in accordance with the solvency ratio rules. This question plays an important role in the assessment of the aid character of the transaction, and if aid is present, in its quantification. As expressly stated in Banco di Napoli, the existence of a solvency constraint on banks establishes, within the EU, a direct relationship between the capitalisation of a bank and the activities, weighted according to their risk, it may perform. If a capital injection is made in the form of state aid, the competitive distortion can be measured in the light of the additional 'risk-weighted' activities that a bank can perform whilst still respecting the 8% minimum solvency ratio, and the net return from these activities. 2. The Security Directive This Directive obliges Member States to set up a guarantee deposit system for banks, ensuring, in the case of a financial crisis, that each depositor will be covered for deposits with the bank up to a minimum recovery sum of 20,000 ECU. All credit institution in receipt of deposits must be members of a collateral guarantee fund. Such guarantee funds, which are normally established on the basis of mandatory contributions from domestic banks that are often topped up by the Central Bank, may give rise to problems of 'moral hazard'. This danger, however, is reduced by the fact that the schemes do not offer full protection, and that banks are always subject to strict solvency surveillance. To the degree

270

Working Paper VI

that guarantee schemes are limited in scope—only securing individual, low risk, deposits—the issue of moral hazard is insignificant. Thus, to the extent that the system is mainly intended to protect individuals and does not have a significant influence on competition between banks, it may not always be regarded as state aid. The Directive, however, does not stipulate the manner in which the guarantee system should be established and organised. Nor does it contain rules on the circumstances that would justify intervention. The cases discussed above, however, furnish some indication of the criteria which the Commission can be expected to apply in its assessment of the possible presence of state aid should such funds be activated. The case of Banco di Sicilia, for example—where the Italian 'Fondo Interbancario di Tutela dei Depositi' intervened in order to absorb the losses of Sicilcassa—demonstrates that when contributions to guarantee funds are imposed on a mandatory basis, the funds will normally be qualified as state aid resources, even where they are financed by private undertakings.27 Thus, where funds are not simply used to reimburse depositors, but are also used to ensure the survival of the bank, there is a presumption of state aid. In this case, however, the Commission concluded that intervention by the fund did not constitute state aid since: (i) members of the decision-making body of the 'Fondo' represented all banks operating in Italy, except cooperatives, through their formal votingrights,which were not influenced by the public authorities (a significant number of non-public banks participated in the decision); and (ii), since intervention was the least costly of the three existing solutions that were available under the Fondo's statutes.28 In Banco di Napoli, the Commission argued that Banca d'ltalia's release of mandatory reserves held by it to Banco di Napoli constituted state aid, since Banco di Napoli would otherwise have been forced to raise the amount needed to overcome its problems at higher net costs on the financial market, but nonetheless concluded that the aid was justified as rescue aid. In Banesto, the Commission closely scrutinised the establishment and functioning of the Spanish Depositors Guarantee Fund, but finally concluded that no state aid was involved in the rescue operation: whilst the Spanish Central Bank also contributes to the Fund, most contributions are made on a voluntary basis by commercial banks. In addition, the Fund establishes a ceiling coverage in order to avoid the 'moral hazard' problem. Of the eight members of its board, four are from the Central bank, the other four from the private sector. Its intervention in the case of a severe banking crisis is governed by the following principles. It must:

27 Steinike & Weinlig v. Germany ECR [1977] 595 and France v. Commission ECR [1987] 4393. 28 i) reimbursement of depositors of banks in forced administrative liquidation, ii) intervention in transfer of assets and liabilities, iii) intervention to support a bank under extraordinary administration.

2 - Problems Arising from State Aids in Banking Sector

a) b) c) d) e) 0 g)

271

act to prevent systemic consequences when a bank fails; implement the least expensive solution to protect depositors; consider whether the bank has sufficient recovery prospects; ensure that some rescue costs are paid by the shareholders; consider taking control over the bank; be able to ask for changes in the bank's management team and policy; and by injecting fresh capital, be able to take control with the aim of selling the acquired stake, by auction to competitors, within a year

Having verified that the rescue operation was carried out in accordance with these principles, the Commission concluded that no state aid was involved in the financial transaction. The case study confirms that intervention by a deposit guarantee fund in favour of a bank—and not its depositors—will be regarded as state aid, unless the decision to intervene conforms with the market economy investor test and is taken by a body that is independent from the state authorities. C. Possible Conflict with National Regulatory Measures In the banking cases detailed above, the issue of whether national prudential banking may justify non-compliance with EU state aid rules has mainly centred around Central Bank intervention in favour of banks in difficulty, either in the form of direct financial intervention or in the form of a request to other banks, or the shareholders, for assistance. Central Banks often feel it is their duty— either as the national banking supervisory body or within the ambit of their duty to maintain financial stability—to intervene as a lender of last resort to distressed banks. In Banco di Sicilia, the Banca d'ltalia—in accordance with a ministerial decree law issued by the Treasury in 1974—provided a 24 month advance at 1% interest on long term Treasury bonds in order to assist Banco di Sicilia to take on the business of Sicilcassa. In its opening of procedure, the Commission commented that the financial intervention of Banca d'ltalia was likely to be state aid, especially since Banco di Sicilia was able to acquire Sicilcassa, a bank in liquidation, in the absence of a transparent and open tender procedure. A similar 24 month advance was made by the Banca d'ltalia, on the basis of the same decree law, to Banco di Napoli, with the purpose of supporting this bank's winding up of its subsidiary, the Isveimer bank. Here, however, whilst expressing doubts at the commencement of its procedure, the Commission finally concluded that no state aid was involved since Banco di Napoli was able to demonstrate that, as its outstanding debts with Isveime were fully mortgaged, it would enjoy no advantage from Banca dTtalia's advance, which only served to protect the other creditors of the bank in liquidation. The cases of Comptoir des Entrepreneurs, Societe Marseillaise de Credit and Credit Lyonnais (one to three) touched upon the status of Article 52 of the French banking law in the state aid context. This Article authorises the

272

Working Paper VI

Governor of the Bank of France to invite the shareholders of a credit institution to offer any necessaryfinancialsupport and has been argued by the French Government to place a legal obligation upon the principal shareholders (les actionaires de reference). The Commission has, nonetheless, persistently rejected the notion that this law is a valid obstacle to the normal application of state aid rules in the banking sector, on the basis that: a) an 'invitation' does not constitute an obligation, and that, as a matter of fact, private shareholders have refused to meet the request in several cases— the principle of 'non-obligation' was confirmed by the Paris Appeal Court in January 1998;29and b) as stated in the final Credit Lyonnais case, such an obligation would also create an inequality between public and private banks since public shareholders have unlimited financial resources—this could provoke an irrational allocation of resources, obstruct the normal functioning of the market and distort competitive conditions in the banking sector. Accordingly, Community law prevails in this case of conflict with national law, so that any capital support from the shareholders will be subject to the market economy investor principle. The case study further confirms that the Commission will endorse intervention by a Central Bank only if intervention is undertaken in accordance with the bank's duty to maintain the stability of thefinancialmarket, is undertaken on open market conditions and is neutral as regards competition.30 Conversely, where a Central Bank, intervening to correct the solvency crisis of an individual bank, accords a competitive advantage to this bank on conditions that are not in conformity with market terms, state aid will usually be held to be involved. The same is true for intervention by other governmental authorities, such as the Treasury. The application of Italian Law No. 218/90, the so-called Amato' law in Banco di Sicilia and Banco di Napoli, was justified by the fact that this law, which facilitated the transformation of public banks into public limited companies, was competition-friendly, because it facilitated the elimination of existing inequality between public and private banks by replacing unlimited state guarantees for previously under-capitalised public banks with a limited a shareholding capital responsibility. By contrast, the Commission established that an intervention made by the Treasury, in favour of Banco di Napoli, under decree law 163 of 27 March 1996 (as amended by decree law 497 of 24 September 1996 and converted into law 29 In this decision the Court stated that a letter from the Governor of the Bank of France issued in accordance with Art. 52 of the 1984 banking law and inviting the shareholders of the construction company BTP, which did not meet the legal solvency requirements, to inject 800 million F F in that company, did not constitute a legal obligation for the shareholders, who had not responded positively to the invitation. 30 See, for example, the Banesto rescue operation, which was orchestrated by the Spanish Central Bank.

2 - Problems Arising from State Aids in Banking Sector

273

no. 588 of 19 November 1996) and providing for a number of financial measures for the restructuring and privatisation of banks was state aid. It based this decision on the fact that only the public shareholder participated in the capital increase and that it did not act as a normal private market investor would have done in a similar situation^

4. The Risk of Systemic Crisis The assertion that the risk of a systemic crisis—following on from the failure of a major bank or of several credit institutions inside a Member State—justifies specific sectoral rules on state aid to the banking sector is one of the main arguments presented to the Commission when it applies its state aid control regime in state aid cases concerning major banks. It was an important issue that led to the involvement of banking experts in the Credit Lyonnais cases and was also addressed in Comptoir des Entrepreneurs and Credit Fonder de France. A risk of a systemic crisis is present if the collapse of a bank prevents banking customers from utilising the necessary financial services of the market within a reasonable time and so results in an overall reduction of economic activities within a Member State. Consequently, it is most likely to occur in the case of the collapse of all or one of the major banks inside a Member State, such as happened in Sweden, Norway and Finland in the early 1990s. If a single major bank collapses, it is true that a panic driven chain reaction may arise, which endangers the whole system, but this can normally be avoided where the necessary and appropriate precautions are taken. Small depositors are protected by deposit guarantee funds. Larger depositors, not fully covered by the deposit guarantee funds, will only suffer losses to the extent that the liquidation costs of the bank exceed its net accounting value. Professional, large scale investors, who place their funds in full knowledge of the market rating of the bank, and typically deliberately weigh off risks against increased returns on their investments, have knowingly placed themselves in a position of risk. In this context, it should be kept in mind that the Consolidation Directive31 and the second Banking Law Co-ordination Directive32 laid down rules establishing the transparency of banking groups and limiting the participation of credit institutions in non-banks. As to the bank's debtors, they will normally not have difficulties in finding other banks and, in cases where the collapse of the distressed bank is due to its loan policy, collapse will only accelerate the already existing need for the restructuring of. those debtors that are in the most unhealthy financial state. Rapid action will prevent a crises from spreading. Here, the Central Banks may have a crucial role to play by creating the necessary stability by providing, at market conditions, the required temporary guarantee for liabilities, thus opening up a breathing space during which other banks may take over the 31 32

Council Directive 83/350 EEC of 13.06 1983. Council Directive 89/646 E E C of 15.12 1989.

274

Working Paper VI

healthy parts of the failing bank, thereby offering maximum protection to its clientele, and allowing for an orderly winding up of the remaining part of the bank. If, contrary to this assertion, the risk of a systemic crisis is accepted as a valid reason to set aside state aid rules, the consequences for the effort to ensure a fair and sound competition policy might be disastrous: this move would favour big banks above small banks and would strengthen restrictive and distortive concentration tendencies within the banking sector to the detriment of economic development as a whole. In its final Credit Lyonnais ruling, the Commission endorsed the opinion expressed by the French Banking Commission in its 1995 report that: an orderly restructuring of the (French) banking system implies that credit institutions, which are undertakings like other and which, therefore, should not be sheltered from sanctions of the market, may disappear. While several cases demonstrate that the Commission accepts that the great sensitivity of thefinancialmarket determines that the banking sector is specific in nature and also acknowledges that systemic crises may occur, these decisions also clearly show that it is convinced that this circumstance does not justify any deviation from the normal application of state aid rules, and even feels that such deviation might be extremely harmful for competition. As regards the situation where a systemic crisis is most likely to arise, namely the collapse of all or most of the major banks of a Member States (as in Scandinavia and Japan), the state aid rules embodied in Article 87(3)(b) ('remedies for a serious disturbance in the economy of a Member State') are available. As regards the collapse of only one major bank, the Commission has demonstrated its conviction that state aid can be avoided in most cases through the swift and resolute intervention of the banking surveillance authorities and Central Banks—on open market conditions in a manner that is neutral to competition—and the orderly winding up of the non-viable parts of the failing bank: instances, such as the Barings and the BCCI collapses prove this point. If state aid nevertheless proves to be necessary, the Commission is convinced that the normal state aid rules are applicable, in particular, the rules on rescue aid and restructuring aid to companies in difficulty laid down in Commission Guidelines33 adopted under Article 87(3)(c) of the Treaty. However, given the particular need for swift action and confidentiality in such cases, the Commission has also been considering the introduction of special procedural rules for the urgent treatment of cases of notified rescue aid cases within the banking sector. Normal procedures under Article 87 are fairly slow and do not meet the particular need of the banking sector to be able to react overnight to a sudden banking crisis—this is true, even though the Commission was able to approve the rescue aid granted to Credit Lyonnais in September 1996, within a few days of its notification. This was atypical and 33

OJ (1994) C368.

2 - Problems Arising from State Aids in Banking Sector

275

only due to the fact that the bank was under close Commission scrutiny due to previously approved restructuring aids. If rescue aid is paid without the Commission's prior approval, the aid is illegal, and competitors may proceed against the unlawful aid directly before national courts, just as the Commission, under the new Procedural Regulation, may issue an injunction for immediate recovery. The new rules on rescue aid to the banking sector under consideration are based on the principle that the Commission must be allowed to delegate its powers of decision to the Commissioner responsible for competition, so that he or she can take a decision on the aid within two days of its notification—provided, of course, that: (i) the urgency of the aid and its limitation to what is strictly necessary is certified by a letter from the Governor or President of the Member State's Central Bank—in particular, with regard to the liquidity situation of the bank, its inter-bank exposure and its market shares; (ii) that the intervention is temporary and limited to a maximum of six months and consists of loan financing at normal market terms or, of a guarantee; and (iii), that the Member State concerned presents either a restructuring plan or a liquidation plan for the bank—or the proof that all aid has been recovered—within three months.

IV. Conclusions The case analysis shows that some Member States have placed pressure upon the Commission to deviate from its normal state aid practice when dealing with cases in the banking sector. It also shows that the Commission has stuck to the position that there are no particular rules in the Treaty which exempt the banking sector from the application of normal state aid rules. Nor does the Commission want to propose a special sectoral treatment for state aid in this sector. The Commission has established that there is no conflict of interest between competition policy and the various prudential rules applicable to the banking sector, as both aim to achieve the same Community objective, namely the development of a healthy and competitive banking sector. In this context, it has established that the prudential rules linked to the minimum solvency ratio play an important role in creating a level playing field for competition and, furthermore, set a significant yardstick for the quantification of state aid. The Commission acknowledges the important role played in rescue operations by the Central Banks, who are responsible for the monetary policy of the Member State, but is of the opinion that their financial interventions in favour of banks in difficulty can frequently be limited to interventions made on open market terms that are neutral to competition. The Commission does not deny that systemic crises may arise in relation to bank failures, but defends the opinion that, where state aid is accessary, it can

276

Working Paper VI

be assessed under the normal state aid rules found in Article 87(3)(b) and (c) of the Treaty. However, it is also considering specific procedural rules which will allow it to react rapidly and confidentially to notifications of rescue aid to banks.

VII Gian Michele Roberti* Public Guarantees and Community Control of State Aids

I. Introduction This paper focuses on two issues. First, it considers the principles currently applied by the Commission to 'atypical' state guarantees: i.e., public measures which, without taking the form of a contractual guarantee, can produce equivalent effects upon competition. In this regard, reference will be made to certain national regimes which—whilst having different legal bases and featuresenable firms to raise finance on particularly advantageous conditions. As confirmed by recent Commission practice, these measures may be assessed under Articles 87 and 88 [ex 92 and 93] by virtue of the their potential distortive effects. Secondly, the paper will consider the legal consequences of unapproved public guarantees vis-a-vis the firm (the recipient of the aid) and third parties (essentially, the lenders of the secured loans). In particular, it will examine the current Commission approach, according to which the state may not honour guarantees if they have not been notified under Article 88(3).

II. Atypical State Guarantees in Recent Commission Practice. A. Financial Transactions involving an Aid element: General Criteria Article 87(1) of the Treaty does not define the term 'aid'. Nevertheless, according to settled practice, the notion of aid within the meaning of Article 87(1) should be construed in very broad terms, as encompassing any measure financed by public authorities that has the effect of granting a gratuitous advantage to one or more undertakings. On the basis of this approach, the Community rules on state aids are applied to: a) aids pursuing every form of economic or non-economic goal (development of certain regions or economic sectors; restructuring of ailing firms; R&D; protection of the environment; promotion of SME's; job-creation; energysaving; promotion of culture); b) aids granted in any form whatsoever (subsidies, tax relief measures, reductions in social charges, public shareholdings, reduction in interest rates, public guarantees, transfer of goods or services at preferential conditions). Studio Legale Tizzano.

278

Working Paper VII

Although many theories consider that the identification of the aid (and the precise calculation of the 'aid element') does not raise particular problems, the analysis may, nonetheless, be far more complex in certain cases. This is especially so when an aid element is involved infinancial/commercialtransactions between a firm and the public authorities—or, more frequently, between a firm and an economic entity that is controlled by the state, such as, public holdings, state-controlled firms or credit institutions. Complexity may arise since: (i) such transactions do not necessarily entail an aid element (the aid is deemed to exist only if specific criteria are met); and (ii), the relevant transactions frequently take the form of financial/commercial relationships (sometimes infra-group), normally based on (and governed by) civil law and identical to those commonly established by private operators. As a consequence, these relations are often characterised by a certain degree of 'opacity', which makes it more difficult for all of the interested parties to verify whether or not the relevant transactions entail an element of aid. This situation is most prevalent with regard to financial relations between the state and public undertakings. According to settled practice, public shareholdings, loans provided by the state (or by an intermediary of the state) and public guarantees are not per se state aid. Such interventions, however, can be considered to be aid if they would not have been undertaken by an investor operating under normal market conditions: in other words, a private investor would only have provided the funds on less favourable terms, or would not have provided them at all. Thus, a capital injection entails an element of aid when the structure and future prospects of the recipient company are such that a normal return (by way of dividend payments or capital appreciation) cannot be expected within a reasonable time. Similarly, loans provided by the state are considered to be an aid when the borrowing firm obtains conditions of credit that are not consistent with current market conditions and, ultimately, are more favourable. It is noteworthy that, in this case, the aid element amounts to the difference between the rate which the firm should have paid (calculated in accordance with itsfinancialstanding) and the rate actually paid. In the extreme case where an unsecured loan is given to a company that is not creditworthy, the total amount of the loan is deemed to be an aid.'

1 Similar criteria are applied where the public authorities acquire from (or transfer to) an undertaking goods or services. When assessing these transactions, the Commission examines whether the terms of the relevant contracts meet normal commercial and financial criteria. These principles are also applied in the case of the privatisation of public undertakings, where the Commission verifies whether the price obtained by the state correctly reflects the market value of the privatised assets. A similar approach is adopted when the state or a state-controlled body supplies energy (or other goods/ services) on preferential conditions (i.e., conditions not justified by objective economic reasons).

2 - Problems Arising from State Aids in Banking Sector

279

B. Public Guarantees as State Aids 1. Definitions In line with the above-mentioned criteria, a public guarantee may entail an aid element when it confers an artificial financial advantage on certain firms.2 In general terms, a public guarantee constitutes an aid within the scope of Article 87(1): (i) if it allows the beneficiary firm to obtain loans at more favourable conditions (better interest rates); (ii) if it allows the beneficiary firm to obtain loans that thefirmwould otherwise have not obtained; and (iii), if the guarantee is granted on preferential conditions (the premium paid by the beneficiary is not consistent with current market practice). 2. Aid Element In the first case, where the guarantee ensures better credit conditions, the aid element would amount to the difference between the rate which the borrower would have paid under normal market conditions and the rate actually paid, net of any premium paid for the guarantee (Commission Decision 97/765/EC, SKET). In the second case, where the beneficiary firm is not creditworthy, the aid element would amount to the secured loan itself (see Commission decision 94/696/EC, Olympic Airways). Finally, in the third case, the aid element will correspond to the difference between the premium actually paid and the premium level that would have been applied in normal circumstances (Commission notice 97/C 395/05, Stahlwerke).

C. Atypical Public Guarantees. As the Commission has affirmed in its Communication concerning the Application of Articles 92 and 93 of the EC Treaty to Public Undertakings in the Manufacturing Industry, even where it does not grant a guarantee, the state may nonetheless engage in actions that have a similar effect. In this regard, the Commission has underlined that public undertakings:

2 In line with the more recent case-law, public guarantees—like any other kind of state aid—must be financed by the state. As a consequence, a system of guarantees set up by the state butfinancedentirely out of the premiums paid by the beneficiaries does not constitute state aid since it does not entail the use of public funds. This is the case of a Dutch guarantee scheme that is (a)financedby the recipients firms and (b), subject to a possible adjustment of the premiums rates in the case of deficit of the scheme (Commission Notice C 49/91 concerning the Regeling bijzondere financiering).

280

Working Paper VII

whose legal status does not allow bankruptcy are, in effect, in receipt of permanent aid on all borrowings equivalent to a guarantee when such status allows the enterprises in question to obtain credit on terms more favourable than would otherwise be available [or to obtain credit that would have otherwise not been granted at all]; and further added that, where a public authority: takes a hold in a public undertaking of a nature such that it is exposed to unlimited liability instead of the normal limited liability, the Commission will treat this as a guarantee on all the funds which are subject to unlimited liability (see 38.1 and 38.2).

D. Exemption of Certain Enterprises from the General Rules on Bankruptcy and Liquidation In its recent practice, the Commission has confirmed that national regimes that exempt certain firms from the general rules on bankruptcy can be assessed under Article 87 of the Treaty.

1. The BFM I Case In the first Breda Fucine Meridionali case, the Commission examined the distorting effects of a provision (Article 7(2)) within the ad hoc regime adopted by the Italian state for the restructuring, privatisation and liquidation of the EFIM group (Law No. 33/1933).3 Article 7(2) provided for the non-application to members of the EFIM group, which included BFM, of the mandatory rules contained in Articles 2446 and 2447 of the Italian Civil Code, which provide that firms which have a share capital lower than the legal minimum of 200 million ITL must be wound up. The application of these Articles of the Civil Code to BFM would probably have led to its bankruptcy and disappearance from the market. By contrast, by virtue of the ad hoc derogation from the general system introduced by Article 7(2), BFM could remain on the market and avoid being wound up, unlike a private firm in similar circumstances. According to the Commission: This provision, which is not a general but a specific measure intended to benefit a specific firm, constitutes state aid as it enabled BFM to avoid repaying its public debts, its debts to public enterprises, and its debts towards publicfinancialinstitutions.

3 It should be recalled that the Commission began a procedure under Art. 88(2) of the Treaty in 1992 that took several provisions of the EFIM Law into consideration. Nevertheless, the potential distorting effects of Art. 7(2) of the Law were not examined in this occasion. The Commission thus only seemed to have noticed the impact on competition of this rule in 1994.

2 - Problems Arising from State Aids in Banking Sector

281

The Commission also noticed that: The provision in question would thus enable BFM to remain in operation without repaying state aid declared incompatible and without being wound up. As a result, this Decision would be deprived of its effectiveness.

In other words, the BFM decision seems to work upon the assumption that measures that have the effect of exempting ailing firms from general national bankruptcy provisions are akin to (rescue) aid. It must be underlined that the Commission did not calculate—nor exactly define—the potential aid element present within the provision at hand. Nevertheless, on the basis of the reasoning of the Decision, one may assume that the aid element should, at the very least, correspond to the financial benefit obtained by BFM as a result of the prolonged non-repayments of its debts towards public creditors.4 2. The Prodi Law Both the Commission and the Court have examined the compatibility of provisions laid down by the 'Prodi Law' (Italian Law No. 95/1979) with state aid rules. The Law establishes special rules for the administration of large insolvent firms ('extraordinary administration'). According to the law, thesefirmsmay be allowed to continue to operate for at least two years, rising to a maximum of five years, under the governance of one or three trustees appointed by the government. During this period, the trustees must draw up a restructuring plan and list the investments needed for the restructuring and/or the winding-up of the firm. The law also provides for Treasury guarantees for debts contracted by the trustee in the course of day-to-day administration and the implementation of the restructuring plan. The extraordinary administration procedure comes to an end once total assets are distributed, credit is exhausted, or the firm is once again able to met its obligations. According to the Commission (see Commission Notice 97/C 192/04), the extraordinary administration procedure falls under the scope of Article 87 of the Treaty since: a) the procedure is not 'generally available', but limited to certain categories of firms. Moreover, the procedure applies on the basis of a discretionary appraisal by the national authorities which are, inter alia, empowered to authorise the continuation of business; 4 In the Decision, the Commission noted that the derogation provided for in Law No. 33/1993 enabled BFM to: (i) benefit from a grant of 2 710 million ITL from the liquidator of EFIM to pay wages; (ii) freeze the amount owed to suppliers, totalling 9 941 ITL million; (iii) suspend interest payments, totalling 4 478 million ITL, to banks from 17 July 1992; (iv) suspend repayment of loans totalling 6 609 million ITL granted by the (public) financial establishment Isveimer and IMI. Only the last element was directly considered in the Decision (Art. 1)—maybe, because the Commission estimated that only this specific benefit clearly involved 'state resources' within the meaning of Art. 87 of the Treaty.

282

Working Paper VII

b) the continuation of a firm's activities is not foreseen by general insolvency law. Within this scheme, the temporary continuation of business is an 'exception' which may be allowed if it preserves or increases the value of the firm's assets, and thus is in the interests of the creditors. By contrast, the extraordinary administration procedure establishes the continuation of business as the norm, seeks to protect firms from the consequences of insolvency and enables them to carry on in business. In this regard, the Commission argues that the extraordinary administration procedure is a measure that aims to rescue or restructure firms in difficulty and is, therefore, a measure, which, 'by its very nature, tends to distort competition and affect trade between Member States'. In addition, the extraordinary administration procedure entails further transfers of state resources to the ailing firm: tax and social security exemptions and the granting of Treasury guarantees. 3. Conclusion In conclusion, one can assume that national regimes which: (i) exempt certain categories of firms from general bankruptcy or liquidation rules and (ii), have the effect of enabling these firms to carry on in business are likely to be considered as (rescue) aid within the meaning of Article 87(1) of the Treaty. As a consequence, the Member State concerned will be obliged to notify the Commission both of the regime and of instances of its individual application in accordance with Article 88(3). It should be underlined, however, that it is not always clear if, or to what extent, the benefit enjoyed by the beneficiary firm must entail a financial burden for the state. This question might raise complex theoretical issues. The Commission, and more recently the Court, seem to be following a 'pragmatic' approach: they appear to have confirmed that the national measures that protect firms from bankruptcy may also encompass provisions that entail a decrease in state income (tax exemptions, public debt write-offs, and so forth) as well as provisions that ensure that the state assumes (part of) the liabilities of the insolvent firm.5

E. National Measures Establishing Unlimited State Liability for the Debts Of Certain Firms 1. Unlimited Liability under Article 2362 of the Italian Civil Code. As noted above, the Commission considers that the unlimited liability of a public shareholder is equivalent to a public guarantee. This hypothesis has been 5

The point is still controversial (cf, case C-200/97, Ecotrade).

2 - Problems Arising from State Aids in Banking Sector

283

examined in several cases on Article 2362 of the Italian Civil Code. Article 2362 establishes that shareholders holding 100% of the capital of an insolvent limited company are directly responsible for all of its debts. According to the Commission,6 Article 2362 may be considered to be a state aid when applied to public undertakings in financial difficulty: This is because the state has, effectively, infinite financial resources which are unavailable to a market economy investor. Therefore, the creditor of a 100% state-owned company will have higher security to receive full repayment in the event of liquidation. This allows a public undertaking, notwithstanding its increasing debts, to continue trading long after a comparable private undertaking would have been placed in liquidation. When a company wholly-owned by a market economy investor goes into liquidation, the creditors' repayment is limited to the amount that can be raised by the sale of the company's and its shareholders' assets. As these are not infinite, the whole company's indebtedness will normally not be repaid. The Commission also specifies that the final beneficiary of the aid in such cases is the 100% state owned enterprise and not its creditors. In fact: aid is involved even if the company is in liquidation, as in the present case, as the payment enables an operating company to continue in business by the elimination of infra-group indebtedness. The fact that it is the creditors and not the company which receive payment is irrelevant as these operating companies are the final beneficiaries of such aid payment. The rationale underlying this approach is that a private shareholder would seek an enhanced return for the assumption of unlimited liability. Indeed, the granting of a guarantee for the total debts of an undertaking is an act which market economy investors would not normally undertake if the additional risk is not outweighed by additional gains. Moreover, a market economy shareholder would contain this 'unlimited' responsibility by taking the decision to put a company into liquidation at the very moment that it was feared that an undertaking's debts would exceed the value of its assets. In other words, the private shareholder would be obliged to act far earlier, since an insufficient return on the investment would force him to make whatever monies he could from the liquidation, and, if possible, reinvest these monies elsewhere to gain a higher return. In the EFIM case the Commission stated that: given EFIM's historicfinancialprofile it is clear that the state did not apply such diligence in either making a timely disposal of its holding in EFIM or taking other appropriate remedial actions to redress the company's financial performance. The need for such action would have become clear when no satisfactory return could be expected within a reasonable time horizon. The consequence of this lack of action has been an increase in EFIM's indebtedness to an abnormal level which a market economy investor would have avoided by taking appropriate action (such as disposal of the companies) at a considerably earlier point in time. 6

Commission Notice 93/C 349/02.

284

Working Paper VII

In conclusion: guaranteeing and taking over this indebtedness, thereby allowing subsidiaries of EFIM to continue to trade, is therefore, akin to aid; it cannot be considered as being the normal behaviour of a shareholder under Article 2362 of the Italian Civil Code. As to the quantification of the aid element, the Commission assumes that all the liabilities of the ailing firm taken over by the state must be considered to be an aid. In other words, the Commission seems to presume that the total indebtedness transferred to the state by virtue of Article 2362 is, by its very nature, aid. As stated in the subsequent Iritecna and Enichem decisions (Commission decisions 95/524/EC and 96/115/EC), liabilities that are guaranteed by the shareholder under Article 2362 of the Italian Civil Code, 'are, by their very nature, aid'. In Iritecna, the Commission specified that: such a guarantee has existed since Iritecna was created in 1991, while the company has continued to be heavily loss-making over this period. Under these conditions, a private investor would have tried to limit the commitments with regard to the subsidiary, by deciding to put it into liquidation from the moment it could not reasonably expect a restoration of its financial viability and at a moment when its assets/liabilities position still showed a surplus.

2. Other Cases Member States which finance the restructuring of public undertakings usually argue that their behaviour is consistent with the market economy investor principle, since the public shareholder will, in any case, be liable for the debts of a public firm in liquidation so that the restructuring of the firm—even if it involves the granting of vast resources—is a less costly solution. The Commission approach to this argument can be summarised as follows (c/., Commission Decision 98/204/EC, GAN: a) In principle, the Commission admits that, in order to verify whether a given financial intervention involves aid, the cost of all alternative options must be assessed. In particular, it will assess 'whether the solution chosen by the state is, both in absolute terms and compared with any other solution including non-intervention, the least costly, which would lead, if that were the case, to the conclusion that the state has acted like a private investor'. b) The Commission will also examine whether the state-owner has acted diligently and promptly in order to preserve the value of its investment. In other words, and in line with EFIM, the Commission will evaluate whether the cost of the restructuring would have been lower had the state-owner acted earlier. c) Moreover, the Commission will also take note of the fact that a shareholder of a limited company is not liable beyond the limits of its holding. As stated in GAN, 'a distinction must be drawn between the costs to be borne by the state as shareholder and those which the state might be called upon to bear

2 - Problems Arising from State Aids in Banking Sector

285

in its capacity as the authority responsible for monetary and financial stability. The Commission and the Court of Justice have already rejected the argument extending the responsibility of the state as a shareholder for the liabilities arising from a liquidation beyond its share in a company's capital, on the grounds that such an extension of responsibility would confuse the state's role as shareholder with its role as the body responsible for social policy'. On the basis of these criteria, the Commission reaches the following conclusions: a) Both private and public shareholders may not be held liable beyond the value of the capital and guarantees provided by them (subject to there being guarantees granted on commercial terms which do not constitute state aid). b) As a consequence, the calculation of the liquidation costs must only include the costs incurred by the state as a shareholder, and must not include other costs that derive from a dejure or de facto unlimited liability for all the debts of the firm. c) In any event, national rules imposing unlimited liability on public shareholder may not be applied, since this would enable the Member States to circumvent the proper application of Article 87 of the Treaty and would contradict 'the legal principle that a person may not found an argument on his own mistake {nemo auditur propriam turpitudinem allegans)' (cf, GAN).

III. The Effects of Unapproved Guarantees A. General principles The procedural obligations that arise in relation to public guarantees may be summarised as follows: a) In principle, Member States must notify public guarantee schemes and public guarantees granted on an individual basis (i.e., not within the framework of a general regime approved in advance by the Commission).7 b) Prior notification is not required when individual guarantees: (i) do not cover the total amount of the loan and (ii) are granted for a limited duration, (iii) to creditworthy firms, (iv) against payment of premium corresponding to the usual commercial rate. 7 In order to avoid and to assess properly the possible distortion of competition implied in a guarantee scheme, it is essential to assess it at the granting stage. In the view of the Commission, the mere fact that a firm receives a guarantee—even if it is never called upon—may allow it to continue trading, and eventually force competitors who do not enjoy analogous advantages out of business.

286

Working Paper VII

c) Prior notification of public guarantees schemes is not required when: (i) the terms of the scheme provide for a realistic assessment of risk; (ii) the premiums cover both the risks associated with the granting of the guarantee and the administrative costs of the scheme; (iii) the terms of the scheme can be revised periodically on the basis of the recorded rate of default; (iv) the guarantees can only be granted to creditworthy firms (able to obtain loans from the private sector without public guarantees) and do not cover the total amount of the loan; (v) the start-up capital provided by the state to guarantee funding will generate a normal rate of return. In general terms, a violation of the Article 88(3) procedural obligation determines that: a) The unapproved aid is illegal. b) Interested parties (essentially, competitors of the beneficiary firm) can challenge the aid before national courts and demand effective legal protection for their rights and legitimate interests. National judges should further establish the illegality of the aid, granting, where appropriate, positive measures, such as orders for the recovery of the aid or other interim measures. c) The Commission can adopt interim measures (cf, Boussac), requiring the suspension/repayment of the aid. d) In principle, illegal and incompatible aid must be recovered in its entirety.

B. The Legal Regime Applying to Illegal Public Guarantees According to the Commission's Draft Notice on public guarantees: a) the aid element inherent to the illegal and incompatible guarantee must be recovered;8 b) since the guarantee is illegal, it may not be honoured by the state. As a consequence, a violation of Article 88(3) will not only affect the beneficiary firm, which must repay the aid, but will also affect third parties, such as the lenders of secured loans, who may not demand the payment of the guarantee. The Commission has consistently applied this approach since EFIM. In this case, the Commission affirmed that the Italian state might not honour its obligations vis-a-vis third parties: The indebtedness of EFIM and its wholly owned subsidiaries has has grown over a number of years. This indebtedness has employed, as security, the unlimited guarantee for total debts resulting from Article 2362 of the Italian Civil Code. Permitting the repayment of these debts by the Italian state, would represent the honouring of an aid 8

According to the circumstances, the aid element as made up of the preferential premium conditions, the preferential loan conditions or the loan itself.

2 - Problems Arising from State Aids in Banking Sector

287

and would distort competition by the elimination of infra-group indebtedness, currently extended to companies which are, and may continue to be, active in various industrial sectors.

As a consequence, the Commission authorised the payment of the sums due on the basis of Article 2362 only after having ascertained that the aid fulfilled the conditions of compatibility set forth by Article 87(3) of the Treaty. In this perspective, the Commission stated that: if the provision of the guarantee by the state were impeded or the aid raised from Article 2362, on which the financial community has based its credit assessment of Italian public undertakings, were required to be reimbursed, this would lead to a severe deterioration in the business environment in which the active components of the EFIM group continue to operate. Furthermore, such a prohibition would undermine corifidence and, even, financial market stability in a wide range of sectors. Such a situation would have a negative effect not only in Italy but also for other Member States' industries trading with Italy.

It is also noteworthy that the EFIM Law was approved by the Commission on the basis of certain specific conditions that were accepted by the Italian government. Pursuant to an agreement made between the Commissioner for Competition and the Italian Minister for Foreign Affairs (the Andreatta-Van Miert Agreement), the Italian authorities committed themselves: (i) to the restoring of the sound financial status of all wholly state-owed public undertakings, (ii) to the speedy attainment of this goal (in principle, three years) and (iii) to the submission of an annual report to the Commission, containing all the relevant information on the evolution of thefinancialsituation of the enterprises concerned.9 The Commission took a similar line in other cases on the unlimited liability of public shareholders (cf, GAN for a summary). In these cases, the Commission argued that: a) although it could not be proven that national rules provided for unlimited liability, b) a national rule or legal principle had imposing such unlimited liability might never be applied within the national legal order. In conclusion, the case indicates that illegal public guarantees might never be honoured and that third parties (mainly the banks granting the secured loan) may not claim protection for their rights. This view may be justified since, as confirmed by the ECJ in Federation Nationale du Commerce Exterieur (case C-354/90), acts implemeting an unapproved aid are invalid from the outset since they infringe Article 88(3), which is directly applicable. In this view, the act involving the aid—i.e., the act that is not consistent with the market economy investor principle—is the granting of the 9

The Agreement concerned, along with the EFIM group, the two other major stateowned groups, IRI and ENI.

288

Working Paper VII

public guarantee. Thus, this is the act that must be endowed with 'illegality', whilst the effects of this illegality must be secured both at the Community level and before national judges and administrations—ex officio or on the request of interested parties—such as the competitors of the beneficiary firm or even competitors of the lender of the secured loan. Moreover, it should be accepted that this approach will, probably, improve the effectiveness of Community control of public guarantees. The fact that third parties are exposed to the risk of a decision that will prevent the guarantee from being honoured will induce these parties to take a proactive attitude vis-a-vis the grantor of the guarantee, in order to verify whether it was given in compliance with state aid rules. In practice, some recent examples confirm that credit institutions are increasingly aware of the risks linked to public guarantees and, thus, diligently verify whether the grantor has respected the substantive and procedural provisions of the Treaty. Notwithstanding these considerations, the approach envisaged by the Commission may yet give rise to some objections. From a theoretical point of view, one could argue that Article 88(3) only imposes an obligation upon the Member States. In the case of its infringement, Community law provides for different remedies, which seek, ex ante, to prevent the implementation of the aid and, if possible, try, ex post, to neutralise the distorting effects of an aid that has already been enacted. In the worst case, the ultimate sanction is the recovery of the illegal (and incompatible) aid. If an aid is illegally granted in the form of a public guarantee, these principles can be effectively applied without affecting third parties. An illegal public guarantee might be blocked ex ante or recovered ex post. In both cases, the remedy enforced will affect the grantor of the aid (the public entity providing the guarantee) and the beneficiary firm, without having a negative impact upon third parties. In particular, where a guarantee has been already granted, its illegality might give rise to an obligation to ensure the recovery of the aid element. As a consequence, the beneficiary firm will be required to reimburse the sum given by means of a differential interest rate or a differential premium rate. In an extreme case in which the total amount of the secured loan is deemed to be an aid, the beneficiary will be required to reimburse the total sum lent to the grantor of the guarantee (the state),10 who, in the meanwhile, will have repaid the lender. In all such cases, recovery will be governed by the same rules that are currently applied to other forms of aid and will lead, mutatis mutandis, to the same practical consequences—i.e., restoration of the status quo ante. Seen in this light, one may conclude that the state aid regime could be applied effectively to unapproved public guarantees without affecting the rights of

10 In this case, the repayment of the aid will probably result in the liquidation of the company. In an such event, the state must register the debt due to the repayment of the aid among the liabilities of the company (case 142/87, Tubemeuse).

2 — Problems Arising from State Aids in Banking Sector

289

third parties and that, therefore, there are no grounds for demanding that the state should refrain from honouring public guarantees. The question is nonetheless controversial and has not yet been settled. In any event, given the complexity of the issue and the need for legal certainty (particularly for all third parties concerned), it would be preferable if a definitive word were to be said on the matter by the legislator in an ad hoc regulation based on Article 89 [ex 94] of the Treaty.

VIII Wulf-Henning Roth* State Guarantees as Aid: The Consequences of Article 88(3) [ex 93(3)] EC for State Guarantees and their Validity in German Law

I. Introduction Following the Commission letters of 5 April and 12 October 1989, and the Communications of the Commission concerning the application of Articles 87 [ex Article 92] and 88 [ex Article 93] EC and Article 5 of the Directive 80/723/EEC,1 an intensive debate began on the legal consequences of an infringement of the notification procedure of Article 88(3) EC.2 Steindorff, in particular, had argued in favour of invalidity of the contract as an appropriate sanction3 for an infringement of Article 88(3) EC as early as 1988. The German Civil Code (Burgerliches Gesetzbuch (BGB)) provides in § 134 for the invalidity of a contract which contravenes a legal prohibition (at least in cases where the prohibition itself does not provide otherwise). According to Steindorff, this civil law sanction should also be applied to state guarantees that amount to state aid. However, this position has met with considerable opposition: there appears to be a widespread consensus that Community law does not require, and that German law does not provide, that state guarantees infringing Article 88(3) EC must be considered to be void.4 In this paper, I will review the main arguments that have been put forward pro and contra the nullity of a state guarantee. I will argue that a state guarantee offered to a financial institution with regard to a loan falls under Article 88(3) EC if it amounts to state aid. The obligation placed on the Member State not to put its proposed measures into effect demands collateral consequences in civil law: a contract which contravenes this obligation must be regarded as being 'provisionally invalid' (unenforceable as opposed to void) on the basis of § 134 BGB, for the period of Commission screening of the aid. Where the Commission rejects the aid (Article 7(5) Regulation 659/1999),5 the contract becomes void. • Bonn. 1 OJ (1991) C 273/2 and OJ (1993) C 307/3. 2 Cf., (Frisinger & Behr 1995): (Habersack 1995); (Klanten 1995); (Hopt & Mestmacker 1996); (Pechstein 1998); (Scherer & Schrodermeier 1996); (Schroder 1996); (Schiitte & Kirchhof 1996); (Steindorff 1997); (Deckert & Schroeder 1998); (Triantafyllou 1999). 3 (Steindorff 1998); (Steindorff 1996a); (Steindorff 1998b); concurring, (Groeben/ Thiesing/Ehlermann 1991) on Art. 93 No. 56. 4 See the references cited in footnote 2. 5 OJ (1999) L 83/1.

292

Working Paper VIII

II. Community Law: The Framework 'Aid' which is to be granted by a Member State or by its sub-units must be notified with the Commission according to Article 88(3) EC and Article 2 Regulation EC 659/1999. Following notification, the Commission must decide, within a period of two months, 6 whether the measure amounts to aid,7 and whether it will open a formal proceeding.8 Article 88(3)(3) EC provides that the: Member State concerned shall not put its proposed measures into effect until this procedure has resulted in afinaldecision. The message of Article 88(3) EC is clear: the Member States shall refrain from 'implementing' the envisaged aid until the Commission has given 'green light' to the aid. 9 The 'enforcement' of Articles 87 and 88 EC differs substantially from the competition rules of Article 81 [ex 85] as far as direct effect is concerned. Articles 87 and 88(1) and (2) cannot be applied by national courts. It is up to the Commission to implement the rules on state aid. By contrast, the case of Lorenz confirmed that 'direct effect' is attributed to Article 88(3)(3) EC. 10 Article 88(3) EC requires: national courts to apply it without any possibility of its being excluded by rules of national law of any kind whatsoever . . . " Yielding to the principle of direct effect, national courts will be forced to apply the concept of aid as set forth in Article 87(1) EC, without, however, having the corollary competence to exempt the aid by virtue of the reasons set forth in Article 87(3) EC. Direct effect extends to all aid that has been implemented without having been notified. In the event of being notified, the principle of direct effect operates during a preliminary period of two months (Article 4(5) Regulation 659/1999) up until the time of the final decision of the Commission. 12 The principle of 'direct effect' found in Article 88(3)(3) EC is not affected by the final decision of the Commission, even where it approves of the aid. The decision of the Commission is only attributed ex nunc effect (in contrast to competition law and Article 6(1) of Regulation 17/62). In FNCE, the Court explicitly declined to give a Commission decision the effect of validating ex post facto the implementing measures which were invalid because they had been 6

Art. 4 (5) Regulation 659/1999. Art. 4 (2) Regulation 659/1999. Art. 4 (4), Art. 6 Regulation 659/1999. 9 SFEI, ECR [1996] 1-3547, 3590 consideration 38. 10 Ibid., 3590 consideration 39; Lorenz ECR [1973] 1471, 1483 consideration 8. 11 Lorenz ECR [1973] 1471,1483 consideration 8. 12 SFEI, ECR [1996] 1-3547, 3590 consideration 39; FNCE, ECR [1991] 1-5505, 5527 consideration 11. 7

8

2 - Problems Arising from State Aids in Banking Sector

293

taken in breach of the prohibition laid down by the last sentence of Article 88(3) of the Treaty.13 The Court explains the ex nunc effect of a Commission decision with reference to the purpose of ensuring the effectiveness of the procedural rule of Article 88(3) EC: . . . otherwise, the direct effect of the prohibition would be impaired and the interests of individuals, which . . . are to be protected by national courts, would be disregarded.14 This argument refers to the important role the 'national courts' are supposed to play during the period when the Commission has not taken its final decision. Since the implementation of the envisaged aid may lead to a distortion of competition, national courts must be in a position to enjoin such consequences. The implications of the Article 88(3)(3) EC prohibition 15 for national measures implementing the aid are far from clear when one looks at the text of Article 88 EC itself. In contrast to Article 88(3) EC, Article 81(2) EC explicitly states that any agreement or decision prohibited pursuant to this Article 'shall be automatically void'. Such explicit language is absent from the Article 88(3) EC, as it is also absent from, for example, Article 82 EC, concerning the abuse of a dominant position within the common market by an undertaking. What are the consequences that have to be drawn therefrom? Are the legal consequences a matter for the discretion of the Member States or does Community law set standards for the application of national law? The Court, not surprisingly, has given a two-fold answer: a) Community law demands that: the validity of measures giving effect to aid is affected if national authorities act in breach of the last sentence of Article 88(3)16 of the Treaty.17 b) The legal consequences of such invalidity must, however, be determined by national law.'8 Such a determination by national law will be influenced by three considerations: a) The direct effect given to the Article 88(3) EC prohibition and the refusal to give retroactive effect to a Commission decision are meant to ensure that the interests of individuals—above all, the interests of the competitors of the recipient of the aid—are not disregarded.19 The consequences of invalidity in national law must be discussed in this perspective: with regard to direct 13 14 15 16 17 18 19

FNCE, ECR [1991] 1-5505, 5528 consideration 16. FNCE, ECR [1991] 1-5505, 5528 consideration 16. FNCE, ECR [1991] 1-5505, 5528 consideration 13. Ex Art. 93(3). FNCE, ECR [1991] 1-5505, 5528 consideration 12. Lorenz ECR [1973] 1471, 1483 consideration 9. FNCE, ECR [1991] 1-5505, 5529 consideration 16.

294

Working Paper VIII

effect, Community law is to be interpreted in such a way that the nonobservance by the Member State of Article 88(3) EC shall not be regarded as being irrelevant.20 b) National courts must draw 'all appropriate conclusions' from the infringement of the Article 88(3) EC prohibition.21 The appropriateness of the conclusions to be drawn must be judged in the light of the demands of direct effect and the purpose of the prohibition. It is: designed to ensure that a system of aid 'cannot become operational' before the Commission has had a reasonable period in which to study the proposed measures in detail.. ,22

c) A third guideline should be added: legal consequences in the law of the Member States must satisfy the general requirement that Member States must ensure that infringements of Community law are sanctioned under conditions which are analogous to those applicable to infringements of domestic law of similar nature and importance.23

III. The Scope of Article 88(3) EC The Article 88(3) prohibition does not define its scope of application in a clear manner: The Member State concerned shall not put its proposed measures into effect until this procedure has resulted in afinaldecision. The term 'proposed measures' refers, of course, to Article 87(1) EC and the notion of 'aid granted by a Member State or through state resources in any form whatsoever'. The direct effect of Article 88(3) EC compels national institutions (with the aid of the Article 234 EC procedure) to determine, on their own account, whether a measure amounts to an aid. At this point, two comments are in order: a) The terminology of Article 87 EC—'any aid granted . . . in any form whatsoever'—serves to indicate that it is the 'effect' and not the form of the aid that is decisive.24 A Member State cannot escape the application of Article 87 EC by granting the aid, not in a direct way (in a two-party relationship), but in a more indirect manner, using private institutions to transfer the aid to the recipient. 20

FNCE, E C R [1991] 1-5505, 5529 consideration 16: There should be 'no favourable outcome to the non-observance by the M e m b e r State concerned ...'. 21 SFEI, E C R [1996] 1-3547, 3590 consideration 40. 22 France v. Commission, E C R [1990] 1-307, 356 consideration 17. 23 Draehmpaehl, E C R [1997] 1-2195, 2222 consideration 29. 24 (Hancher/Ottervanger/Slot 1993:19,2-002).

2 - Problems Arising from State Aids in Banking Sector

295

b) The scope of Article 88(3) EC must be determined and delimited by the 'purpose' of the notification procedure and the 'goal' of the prohibition upon putting the proposed measures into effect: the Article 88(3) EC prohibition encompasses all activities that 'effectuate' the aid. In quite another context, the Court has stressed the need to 'restrict' the effect of a notification requirement in the law of the Member States. Tackling Council Directive 83/189/EEC, which lays down a procedure for the provision of information in the field of technical standards and regulations,25 the Court held that a breach of the obligation to notify technical regulations constitutes a substantial procedural defect. Such a defect would render the national technical regulations in question unenforceable against individuals, in as much as the regulations hinder the marketing of an imported product which is not in conformity with them. However, the unenforceability of the technical regulation would not have the effect of rendering unlawful any use of a product that has been produced in conformity with such unnotified regulations.26 The decisive point of the judgment seems to be that it is the 'purpose' of the notification procedure, which directs and limits the scope of the sanction of unlawfulness. The following analysis will proceed in three steps: a) I will begin with the simple case of a 'loan agreement' between a Member State and an undertaking which is to be classified as aid to the borrower and will discuss the legal consequences of an infringement of Article 88(3)(3) in German Civil Law {infra IV). b) I will then turn to a state guarantee offered to a financial institution with regard to a loan agreement, where the guarantee is to be considered as aid to the lender {infra V). c) Thirdly, I will discuss the case where the state guarantee offered to a financial institution amounts to aid to the borrower {infra VI).

IV. State Loan Agreements In the case of a loan agreement concluded between a Member State and an undertaking, Article 87(1) EC will be found to be applicable where the undertaking is not able tofindafinancialinstitution that is prepared to lend money on any terms. The loan agreement will, moreover, amount to aid if the financial terms (interest rate and securities to be provided by the borrower) are more favourable to the borrower than those that are available from private creditors.27 25 26 27

OJ (1983) L109/8. Lemmens, E C R [1998] 1-3711, 3735-3736 consideration 35. (Evans 1997:30).

296

Working Paper VIII

A. The Implications in EC Law What are the implications of Article 88(3)(3) EC and Article 3 Regulation 659/1999 for such a loan agreement? Article 88(3) EC offers a clear answer: the Member State that intends to assist an undertaking by means of a loan on favourable conditions, must notify the Commission of its plans. According to sentence (3) of Article 88(3) EC, it must 'refrain' from undertaking any measures that will put the aid into effect. Given the aim of Article 88(3) EC to ensure that no aid becomes operational prior to the Commission having been informed of it and having screened the arrangement, the Member State is left with only two modes in which to proceed: a) the Member State refrains from concluding the loan agreement up until such a time as the Commission may or may not act on the notification of the planned agreement according to Article 4 Regulation 659/1999; or, b) the Member State enters into the agreement, but makes its obligation to honour the loan agreement 'conditional' upon a (positive) Commission decision according to Article 4 (2), (3), (6) or Article 7 (2), (3) Regulation 659/1999.28 In neither case is the borrower given a legal and enforceable claim against the Member State since the loan agreement does not become operational.29 Should the loan agreement be concluded in an unconditional manner, Article 88(3) EC and Article 3 Regulation 659/1999 demand legal consequences to the extent laid down in Article 88(3)(3) EC: the loan agreement must be treated in such a way as to prevent the enforcement by the borrower of a legal claim based upon the contract. This is what the Court demands in its FNCE judgment: it must be held that the validity of measures giving effect to aid is affected.30

B. The Implications in National Law It is left for national law to decide upon the 'specific' legal consequences of the 'invalidity' of a loan agreement. In German law, a loan agreement made between public authorities and private undertakings may be concluded in two different ways: through a loan agreement governed by public law (offentlich-rechtlicher Vertrag) or, through the unilateral act of a public authority (Verwaltungsakt) which creates a loan agreement that is governed by private law. Since the public authority is free to choose between these alternatives, the legal consequences deriving from an 28 29 30

(Grabitz & Hilf 1997), N o . 60. France v. Commission, E C R [1990] 1-307, 356 consideration 17. FNCE, E C R [1991] 1-5505, 5528 consideration 12.

2 - Problems Arising from State Aids in Banking Sector

297

infringement of Article 88(3) EC should not differ according to the specific manner in which the agreement is concluded. 1. Public Law Leaving legal niceties aside, the solution that is offered by the Federal Administrative Procedure Act (Verwaltungsverfahrensgesetz (VwVfG)) for the case of public law contracts is straightforward and simple: § 58(2) VwVfG provides that a contract which requires the consultation or approval of another public authority shall not be valid as long as the public authority has not participated in the procedure in the prescribed manner. The EC Commission is to be regarded as a public authority that—according to Article 88(1) EC—must be involved in the procedure.31 The legal consequences of § 58(2) VwVfG are quite simple: where the loan agreement has not been notified or, where it has been notified but the Commission has yet to reach a decision, the loan agreement is to be regarded as being 'provisionally invalid' (unenforceable). If the Commission declines to approve the aid, the contract becomes 'definitely invalid'. Where the Commission gives a 'green light' to the aid, the contract becomes valid from the day of the decision of the Commission. Thus, the solution found in German public law may be argued to be in full accord with the exigencies of Article 88(3)(3) as set forth by the ECJ. 2. Private Law Should a public authority opt for the conclusion of a loan agreement that is governed by private law, the validity of the loan agreement32 must be determined in accordance with Article 88(3) EC. The borrower should not have an enforceable claim against the public authority until the notification procedure has been concluded. German civil law provides a sanction for cases of contractual infringement of a statutory prohibition: the contract shall be deemed to be void in so far as the statutory prohibition does not provide otherwise (§ 134 BGB). This provision stands—as we shall see—at the centre of the German discussion on state guarantees (infra IV.B.2.2). 2.1. Nullity under §134 BGB In the context of a simple loan agreement between a public authority and an undertaking, the application of § 134 BGB requires the clarification of a number of questions related to its interpretation. The statutory prohibition which may lead to the nullity of a contract is, first of all, envisaged to be a prohibition set forth by 'German' law. However, it is 3 ' 32

For details, (Schneider 1992:1199). As for the public act granting the aid, see §45(1) No. 5: '[I]t is to be regarded unlawful (not void), but may become lawful in the event that the Commission approves the aid'.

298

Working Paper VIII

generally acknowledged that a prohibition set forth in 'Community' law must be treated on equal terms;33 for example, the prohibition of abuse of a dominant position as provided for by Article 82 [ex 86] EC is regarded as just such a prohibitory regulation which may have the effect of nullifying a contract.34 Equally, the question of whether the § 134 BGB legal sanction of contractual 'nullity' will apply must be determined with reference to the 'purpose' of the prohibitory regulation. As a rule of thumb: a prohibition designed to protect third-party interests or the public interest will lead to the nullity of the contract; a prohibition which is addressed only to one of the two contracting partners will not—in most cases—affect the validity of the contract.35 In this latter regard, however, nullity may yet arise where contractual invalidity of the contract serves the exact purpose that the prohibition is meant to ensure. Two examples may illustrate this point better: a) Article 82 EC is, without doubt, only addressed to firms with a dominant position in the common market. However, the purpose of the prohibition on the abuse of market power is the protection of undertakings and consumers who may be harmed by abusive behaviour. Such protection can be furthered by the invalidation of contracts concluded by the dominant firm during the exercise of its market power. b) A prohibition (formerly found in § 56 Gewerbeordnung) upon the 'doorstep' sale of loan agreements is directed towards the agents of financial institutions, but is designed to protect consumers. German courts have persistently applied the sanction of invalidity to back up the aim of consumer protection.36 The Article 88(3)(1) EC (Article 2(1) Regulation 659/1999EC) notification requirement and the Article 88 (3)(3) EC (Article 3 Regulation 659/1999) prohibition on the implementation of the proposed measures, are clearly only directed towards the Member States.37 As has been demonstrated, however, one cannot simply argue that such a one-sided prohibition does not, 'as a rule', invalidate a contract.38 Instead, the 'purpose' of the prohibition must be considered and a decision be reached as to whether this purpose 'requires' the invalidity of the contract. Given the aim of Article 88(3) EC to prevent the distortion of competition through the implementation of aid prior to a Commission' 'green light', an 'appropriate' legal sanction should provide that the borrower 'cannot enforce' its contract-based claim against the Member State. 33

Cf., (Heinrichs, Palandt BGB, 1999), on § 134 No. 2. (Mayer & Maly, Miinchener Kommentar, 1995), on § 134 No. 36; (Immenga & Mestacker 1997), Art. 86 No. 26-32. 35 Cf, (Hopt & Mestmacker 1996:806) who break off their analysis at this point. 36 See, for references, (Westermann, Miinchener Kommentar, 1998) § 607 No. 31 a. 37 One might argue that there is a corresponding prohibition to receive the concerned aid. 38 But see (Scherer & Schrodermeier 1996:184). 34

2 - Problems Arising from State Aids in Banking Sector

299

Such a conclusion leads, of course, to the next issue: the 'sanction of invalidity' (nullity) as set forth by § 134 BGB. 2.2. Provisional Invalidity under § 134 BGB Academic discussion on the application of § 134 BGB with regard to state aid centres on the question of whether or not the sanction of invalidity goes too far: nullity may be regarded to be an unproportional sanction.39 However, this argument proceeds upon the assumption that § 134 BGB offers only a simple alternative between nullity and validity,40 with validity being the preferable option. It is nonetheless argued here that the public law solution found in § 58(2) VwVfG—provisional invalidity (unenforceability)—is a solution that is also appropriate with regard to loan agreements governed by private law and that this solution can be achieved within private law, notwithstanding the wording ('void') of §134 BGB. Provisional invalidity (unenforceability) is a legal consequence in German civil law when the validity of a contract is made dependent on the 'approval' of a public authority. Provisional invalidity is to be distinguished from voidness by virtue of two essential features: a) in contrast to a void contract, a provisionally invalid (unenforceable) contract may become valid upon approval with ex nunc effect; b) the parties to a provisionally invalid (unenforceable) contract may be under an obligation to do their best to gain the approval of the competent authority. To give an example: Provisional invalidity is an accepted feature in German cartel law, both with regard to certain agreements which are awaiting approval from the competent authority (§§ 1-8 GWB),41 and in relation to merger control (§ 24a(4) GWB 1990; § 41(1) GWB 1999).42 It is also a generally accepted—but sometimes overlooked43—legal sanction under § 134 BGB, and, as such, an alternative to the nullity-validity dichotomy. As a rule, provisional invalidity will 'replace' nullity as a sanction whenever the 'purpose' of the regulation calls for such a modified sanction.44 Regulations which require a contract to be approved by a 39

(Schutte & Kirchhof 1996:190). (Hopt & Mestmacker 1996:805). (Huber & Baums, Frankfurter Kommentar zum GWB, 1993), § 1 No. 638-641; (Immenga & Mestmacker 1992) § 1 No. 393-396. 42 (Immenga & Mestmacker 1992), § 24a N o . 39 with further references; Bundesgerichtshof 31 October 1978, WuW/E B G H 1547; 1557. See also (Immenga & Mestmacker 1992), on Art. 7(5), Art. 7 FusionskVO, No. 11; (Langen & Bunte 1998), on Art. 7 FusionskVO No. 6. 43 (Hopt & Mestmacker 1996:805); (Scherer & Schrodermeier 1996:184). 44 As to the different concept of nullity (unenforceabilty) as an appropriate sanction for the breach of a statutory prohibition protecting one partner, (Beckmann 1998:274). 40

41

300

Working Paper VIII

competent authority are the striking example with regard to such an approach.45 It is, therefore, suggested that provisional invalidity is the appropriate legal consequence46 of an infringement of both Article 88(3) EC and Article 3 Regulation 657/1999, irrespective of whether the loan agreement is governed by public or by private law. Some final points need also to be touched upon. a) It is sometimes argued that § 134 BGB cannot be applied to prohibitions that are merely 'formal' in character, and that Article 88(3) EC amounts to little more than a prohibition with purely procedural implications.47 Such a view, however, misconceives the function of Article 88 (3)EC as a device to prevent any distortion of competition prior to the conclusion of the Commission's screening process. The fundamental nature of Article 88(3) EC is underlined by the fact that an approval of the aid by the Commission is not attributed retroactive effect.48 b) Some authors deny the applicability of § 134 BGB by arguing that Article 88 (3) EC cannot be regarded as a prohibitory norm (as required by § 134 BGB) since Article 87(1) EC, which Article 88(3) EC is meant to serve, has no direct effect.49 It is nonetheless suggested that Article 88(3) EC should be left to stand upon its own feet, as regards its purpose of preventing the Member States from taking any measures taken prior to the Commission's green light. The attribution of direct effect to Article 88(3)(3) EC—in contrast to Article 87 (1) EC—underlines the importance of this provision. c) Finally, some authors argue that the legal consequences which may be derived from Article 88(3) EC should not, and cannot, go beyond the consequences of a decision by the Commission, based on Article 87(1) EC, requiring recovery of illegal aid. As the Commission may only demand repayment of the aid element, the validity of the contract, as such, should remain untouched.50 However, this argument does not pay adequate attention to the autonomous nature of the Article 88(3) EC prohibition: it is the purpose of this provision to prevent the 'enactment' of any measures that may amount to aid, as long as the Commission has not given green light. The conclusion of an enforceable contract would entail such a measure.

45

(Heinrichs, Palandt BGB, 1999) on § 134 No. 12; (Mayer & Maly, Miinchener Kommentar, 1995), on §134 N o . 7—the regulation requiring approval serves as lex specialis to § 134 BGB; (Sack, Staudinger BGB, 1996), § 134 No. 103. 46 (Triantafyllou 1999:57-58). 47 (Frisinger & Behr 1995:712). 48 49 50

Loccitn. 13.

(Frisinger & Behr 1995:712). (Hopt & Mestmacker 1996:761).

2 - Problems Arising from State Aids in Banking Sector

301

V. State guarantees: Aid to the lender The foregoing analysis on loan agreements seems also to provide us with a clear answer to the problem of contractual validity in cases where state guarantees amount to aid 'to the lender'. Such is the case when a state guarantee is given ex post in respect of a loan (or some other financial obligation) already entered into without an alteration in the terms of the loan agreement. In such a case, the security of the loan is increased, a result which may be qualified as aid.51 It thus seems to be an inescapable consequence of our foregoing analysis that such a guarantee agreement, if concluded unconditionally between a public authority and a financial institution, must be regarded as being provisionally invalid (unenforceable) where Article 88(3) EC has been infringed52—regardless of whether the guarantee is governed by public or by private law.

VI. State guarantees: Aid to the borrower In the common case, the aid beneficiary is the borrower and not the lender (financial institution): either the state guarantee enables the borrower to obtain financial terms for the loan that are better (lower interest rate and fewer securities) than those normally available from a private creditor, or the guarantee works as a precondition for the loan as such. The 'aid is granted' at the time that the guarantee agreement 'is concluded', rather than at the time at which the guarantee is invoked by the financial institution, or the time at which payments are made. As the financial institution is not the beneficiary of the aid, the pertinent question is one of whether the Article 88(3)(3) EC prohibition also has an effect vis-a-vis 'third parties'—ie, parties who are not recipients of the aid.

A. The Situation in European Law The Article 88(3) EC prohibition on the implementation of the proposed measures is related to Article 87(1) EC, which regards any benefit that is passed on from the Member State (or one of its sub-units) to the recipient as being incompatible with the common market. It is this relationship that defines the scope of Article 87(1) EC. However, Article 87 (1) EC is not restricted to factual cases in which the benefit is transferred 'directly', but also applies to cases of 'indirect' conveyance: Article 87(1) EC encompasses 'any aid . . . in any form 51 52

(Habersack 1995: 677). In accord: (Schutte & Kirchhof 1996:190); (Triantafyllou 1999:57-58).

302

Working Paper VIII

whatsoever' ,53 It is not the form but the economic effect which counts. This position seems to be undisputed54 and, of course, also forms the underlying basis for the discussion of the question of whether, to what extent and under which conditions, the Commission may require repayment of the value of the aid contained in the state guarantee.55 Despite the open-ended language of Article 87(1) EC, there seems to be widespread agreement within the academic discussion that Article 88(3) EC cannot, or at least, should not, be applied to relationships between Member States and third parties, since the language of Article 88 (3) EC (alternatively, § 134 BGB) would not justify such an approach.56 The Commission has refrained from issuing a specific opinion. Its Notices 91/C 273/0257 and 93/C 307/03,58 do not touch upon the issue of the legal consequences of Article 88(3) for a state guarantee. In the draft communication on the application of Articles 87 and 88 to state aid in the form of guarantees,59 the Commission deals with the consequences of failure to notify by referring to the jurisprudence of the ECJ. With regard to 'third parties', the Commission argues that the illegality of the guarantee may have an impact upon third parties involved as intermediaries. However, there is no explicit statement on the consequences which Article 88(3)(3) EC entails as regards the validity of the guarantee. The Article 88(3) EC prohibition on implementation prior to the conclusion of the notification procedure is similarly open-ended as well:60 its wording does not restrict its scope to the bipartisan relationship between the Member State and the recipient of the aid. Accordingly, the 'proposed measures' to which Article 88(3) EC refers may also encompass measures addressed towards third parties, so long as such measures are instrumental for the conveyance of the aid to the recipient. Such a textual interpretation of Article 88(3) EC is sustained and required by the very purpose of the prohibition: when third parties are integrated into the transfer of the aid, the Member States must refrain from acting through third parties prior to Commission screening. The purpose of Article 88(3) EC calls for its application to any arrangement involving intermediaries, such as a financial institution. 53

M y emphasis. (Schiitte & Kirchhof 1996:189); ( H o p t & Mestmacker 1996:802). (Habersack 1995: 682); ( H o p t & Mestmacker 1996:759). 56 (Deckert & Schroeder 1998:316); (Habersack 1995: 679); (Hopt & Mestmacker 1996:806). 57 O J (1991) C 273/2 consideration 38. 58 OJ (1993) C 307/3 consideration 38. 59 Draft communication 1998/1999: cf, now, Commission Notice on the application of Arts. 87 and 88 of the E C Treaty t o state aid in the form of guarantees, OJ (2000) C71, of 4.03.2000. 60 Contra: (Deckert & Schroeder 1998:316), who contend that Art. 88(3) EC refers only t o the relationship to the recipient o f the aid. (Habersack 1995: 680) argues that Art. 88(3) E C does not go beyond the scope of Art. 87(1) EC. 54 55

2 - Problems Arising from State Aids in Banking Sector

303

It is suggested that such an interpretation of Article 88(3) EC does not impact upon the legitimate concerns and expectations of the third parties involved, as long as it is, or should be, apparent to the third party that it is involved in a conveyance of a state aid to the recipient of the loan. Financial institutions, which either demand a state guarantee on their initiative or are approached by a Member State to conclude a loan agreement that is secured by a state guarantee, must be aware of the implications of Community aid provisions in general, and the Article 88(3)(3) prohibition in particular. It is up to the financial institution not to honour the loan agreement before the Member State has passed on information that the Commission has either approved the aid (Article 7 Regulation 659/1999) or has not rejected it (Article 4 Regulation 659/1999).61

B. The Position in National Law Given this interpretation of the scope of Article 88(3) EC, the analysis must turn to the question of how the 'appropriate conclusions' have to be drawn in accordance with national law.62 At this point, § 134 BGB once again comes into play, but this time we may be brief: a) The Article 88(3) EC prohibition may be interpreted as only demanding the 'provisional invalidity' (unenforceability) of the state guarantee (as opposed to the 'nullity' as set forth by the text of § 134 BGB), as long as the notification procedure has not come to an end. Provisional invalidity (unenforceability) is a sanction which can be based on § 134 BGB.63 b) Though the Article 88(3) EC prohibition is only addressed to the Member State, the underlying purpose of the provision nonetheless also requires the application of § 134 BGB to contracts that are instrumental for the conveyance of the aid. c) The legal sanction of provisional invalidity is neither unfair to the third party (financial institution), nor does it neglect its legitimate expectations. The financial institutions are aware of the Community aid control system. They should know that state guarantees may only be offered conditional upon the Commission giving a green light to the aid. d) Provisional invalidity (unenforceability) of the guarantee effectuates the purpose of Article 88 (3)(3) EC: it ensures that the system of aid will not become operational before the Commission has had time to study the 61 In the event that the Member State misinforms thefinancialinstitution on the state of the notification procedure, the latter will have legal remedies based on culpa in contrahendo. 62 Cf., SFEI, ECR [1996] 1-3547, 3590 consideration 40. 63 More precisely: the very purpose of the prohibitory provision.

304

Working Paper VIII

measure64 and that a financial institution will only be ready to act on the basis of such a guarantee when it can be sure that the guarantee has definitively become valid.65 64 65

France v. Commission, E C R [1990] 1-307, 356 consideration 17. According t o either A r t . 4(2), Art. 4(6) or Art. 7(2)-(4) Regulation 659/1999.

IX Mario Sarcinelli* State Aids in Rescuing and Restructuring Operations: Should Banks be Treated Differently from Other Businesses?

I. Introduction The history of the banking sector is populated with many episodes of crises and panic, as the classical analysis by Kindleberger shows.1 Governments have usually intervened, allowing the central bank to perform the function of lender of last resort in an assumed liquidity crisis by introducing more or less stringent regulatory standards, and, where such measures fails, by operating rescue schemes or promoting restructuring. Whether performed directly, via an ad hoc regulatory and supervisory agency, or through the central bank, all these interventions involve public money and are a cost to the taxpayer. These forms of state intervention have been traditionally justified by the need to preserve the viability of the banking and payments system, as well as by the protection of small depositors. As governments have always been very sensitive to money and the role it plays at macro- and micro-economic level, it should not be surprising to discover that they are very keen to avoid the collapse of thefinancialsystem through a systemic failure. The development of financial markets and the spread of information technology, however, have changed the market structure of the banking system and may have modified the role of banks in the financial sector. The new financial environment, the turmoil within financial markets over the last years, and the successful launching of the euro, which has brought about a single monetary policy and an eleven-country playing field for its transmission channels, demand a reconsideration of banking, a revisitation of the rationale of banking regulation and its adaptation to the newfinancialscene appearing in most developed countries. Last but not least, the requirements of a single market that has been enhanced by monetary unification, demand a thorough investigation of any state aid. Similarly, individual banks or the whole of the banking system in almost all parts of the world have become the beneficiaries of huge rescue and restructuring programmes in the last ten to fifteen years. Here, one need only mention the funds appropriated by the US Congress to resolve the Savings

* I am particularly grateful to Dr. P Ciocca, Prof. M Mare, Prof. A Roncaglia, and Dr. P Zamboni for reading earlier versions of this paper and for making many valuable suggestions. It goes without saying that responsibility for the views expressed and any remaining mistakes are fully mine. 1 (Kindleberger 1978).

306

Working Paper IX

and Loan Association crisis, the temporary nationalisation of the banking sector in the Scandinavian countries, the various packages approved by the Commission to save Credit Lyonnais in France and the Banco di Napoli in Italy, the strenuous efforts by the Japanese authorities to save their banking system from the disastrous effects of poor management and asset disinflation. The aim of this paper is to review the main economic reasons behind government intervention in the banking sector in the light of what is taking place in Euroland. If this bird's-eye view confirms that the nature of banks and banking is not going to change fundamentally, we shall go deeper into the history and theory of banking to see whether the role of government in regulating and supervising banks is not only still required, but whether there is still sufficient justification for public intervention to rescue and restructure banks.

II. What is a Modern Bank? Banks perform different functions in different time and space contexts. While a short history of banking would provide some insight into the development of the ideas and problems we are concerned with, it would be inappropriate to dwell on it in a paper that, necessarily, is going to be rather long. Let us keep in mind, however, two points: i) that banking evolves in response to macroeconomic conditions, as well as financial, technological and regulatory innovation; and ii), that prior to the approval of the Second Banking Directive in 1989, there was no operational legal definition of a bank within the EU. It is convenient to start from the very general definition—sometimes under different names—of the universal bank, current within Europe and now also gradually taking hold in the US since the partial repeal of the Glass-Steagall Act (1933) by the Riegle-Neal Act (1994). As is well known, any universal bank can be subdivided in three main areas: i) retail banking; ii) investment banking; iii) asset management. The first category covers commercial banking—lending to consumers and firms, collecting demand, time and savings deposits, and executing transactions connected with them. It also includes credit card business and the selling of insurance policies, as well as the management of the private portfolios of small . customers—the management of wealthy clients usually being the province of private banking. The second banking area concerns the arrangement and managing of corporate finance on the market: for example, syndicated loans, securities underwriting, mergers and acquisitions. The last banking segment entails the management of institutional assets, such as pension funds and large savings instruments. Despite a lengthy tradition of universal banking within Europe and the broad bank definition accepted by the second directive—which also covers much of what falls under the heading of investment business—it is not uncommon for many Europeans and most Americans to identify the business of bank-

2 - Problems Arising from State Aids in Banking Sector

307

ing as being of the commercial variety, since ordinary people usually cannot distinguish between the basic and payment services offered to them by a bank and those offered by other depository institutions, such as mutual savings banks and savings and loan associations. Notwithstanding the emergence of a host of new intermediaries in response to the great surge infinancialinnovation, banks do not seem to be on the wane, as foreseen by those who saw the cause of their long-term decline in the reserve requirement and in other regulatory constraints. The conclusion that banks are still holding their ground is based upon the data that modern bank balance sheets display in the section 'above the line'. As is well known, securitisation makes for a lean balance sheet, since the bundling and selling of loans, originating from and still monitored by the bank, no longer appear on the assets side, which would make for a better capital/asset ratio. Moreover, reverse repo, which are no different from collateralised loans, have become widespread in Europe, while securitisation is rife in the US. Finally, as regulators know very well, derivative contracts in which the bank plays a role are recorded 'below the line'. While, over the last two decades, the pressures of competition and diversification have prompted commercial banks to enlarge their mission to include new functions such as portfolio management and market-making in particular securities, the three roles of a commercial bank—organisation of payments, maturity transformation, and liquidity provision—still form the backbone of their activity. These functions have certainly been influenced by recent developments in the financial industry: thus, money-market mutual funds have made inroads into the payment system, while financial intermediaries or the general public provide funding for securitised loans. Although these assets are no longer on the bank's books, they are still monitored by the bank, which, in so doing, retains the private information privilege or natural monopoly that is particularly enhanced by a long-term relationship with the customer.2 It is this private information that makes for the 'uniqueness of bank loans'. In a market-orientated environment, where swaps and credit derivatives are available, maturity transformation may increasingly become troublesome as banks hedge their risks. However, to the extent that they remain active in the origination of loans and in the secondary markets where those loans are traded, long-term financing is mainly available to medium and small enterprises, and liquidity is still provided for depositors. Notwithstanding the increasing recourse to the selling of financial instruments on the market to raise funds by large firms, they will still rely on the banks for liquidity in the form of lines of credit or guarantees. If funding remains sufficiently important in the banking business, which is very likely, its association with the provision of liquidity will continue to assure a prominent role for banking, even in a market-dominated financial context.3 2 3

(Diamond 1984). (Fama 1985).

308

Working Paper IX

III. Why a Bank is Fragile? From what has been said, we can look at a bank as a financial intermediary that participates in the payments system and finances entities in financial deficit using the funds of entities in financial surplus, thus making a maturity transformation. What is peculiar to the banks is the ability to create money, in a broad sense: demand deposits, savings deposits, short-term deposits to be used in making payments and settling accounts. This definition captures the essence of what a bank does, since it highlights the three functions that have been singled out as peculiar to (commercial) banking: in other words, maturity transformation, liquidity provision, and payment execution. In order to understand better why a bank is a fragile enterprise, it is useful to concentrate our attention on the following statement:4 The specificity of banks is that their 'creditors' are also their 'customers'. Contrary to non-financial firms, whose debt is held in majority by 'professional investors' (banks and venture capitalists), the debt of banks is held, in large part, by uninformed, and dispersed, small agents—mostly households—who are not in a position to monitor the banks' activities. It is true that large corporations are also financed by the public: stocks and bonds issued by large companies are, indeed, widely diffused. However, there are two differences: these securities are not used as a means of payment, and the debt-to-asset ratio is substantially higher for financial intermediaries than for nonfinancial firms.

The three critical elements in the previous quotation are as follows: the creditors or depositors are unable to monitor how the banking business is being conducted; the bank's typical liabilities are used as money; the debt-to-asset ratio is not only much higher, but also gives rise to a mismatch of maturities. It is the last feature that is worrisome from the point of view of stability, which, thus, makes the bank a fragile entity. For instance, if the return that depositors can get on their funds is, at a subsequent date, higher than the interest that they were promised by the bank, they will certainly cash their balances and force the bank into a liquidity crisis, unless there is a market or a special entity, for example, a central bank, that undertakes refinancing. Another failure of the same type may occur whenever a sudden drop of confidence in the bank makes depositors run to withdraw their money. Refinancing is also needed in this case, but the market might be unwilling to provide it if the run on the bank is, to a degree, information-based. A central bank is, in contrast, better placed to know whether refinancing is warranted. According to the theory of asymmetrical information, a bank panic arises as a consequence of bad news concerning a macro-economic event, which makes uninformed depositors doubtful about the asset quality of banks.5 The question of whether a panic is a rational or an 4 5

(Freixas-Rochet 1997:264). (Gorton 1988).

2 - Problems Arising from State Aids in Banking Sector

309

irrational response seems to be irrelevant, to the extent that solvent banks become abruptly illiquid in both cases. This is tantamount to saying that the bank operates on a fractional reserve system, thus maintaining only a relatively small percentage of the deposits it has collected as reserves to fulfil its contractual obligations. And deposits are money. . . . In well-developed countries, the traditional runs by depositors on particular banks or the banking system as a whole are now very rare, almost unknown, incidents. Accordingly, one might be led to conclude that there is no longer any reason to worry about crises, sincefinancialmarkets and central banks are here to cope with the problem, and regulation and supervision are relied upon to reduce the probability of their occurrence. Two remarks, however, are now in order. First, crises of liquidity are still possible, although they are no longer triggered by a sudden drop in confidence of depositors, unless there is political turmoil, as in Indonesia in 1997, owing to a computer failure, as happened at the Bank of New York in 1985, or a stock market crash, similar to that suffered by Wall Street in 1987. Secondly, solvency crises are still rife and have affected almost all countries, developed as well as emerging, in the last ten to twenty years, at a pace that seems to be accelerating. Banking crises seem to be an evergreen.. . . As the disenchantment with all the mechanisms that have been developed to cope with banking instability has affected some academics and opinion leaders, making them strong advocates of forms of free banking, a cursory mention of the US experience under this regime is justified. Prior to 1934, the US suffered a large number of bank failures, individual bank runs and bank panics because of its decentralised regulation. According to Miron, the probability of a bank panic in a given year was almost one in three between 1880 and 1908. The impact of panic was such that while the real average GNP growth rate is 3.75%, this figure rises to 6.82% if the years affected by bank panics are excluded.6 Friedman and Schwartz examined five bank panics between 1929 and 1933, which was a very difficult period infinancialhistory.7 One case that was highly investigated was the Chicago banking crisis of 1932, which witnessed huge, disorderly withdrawals of deposits from all the main banks of the city. The failure of sound and solvent banks was avoided by virtue of the intervention of the clearing house, which issued its own loan certificates.8 In Maryland and Ohio, bank panics erupted as late as 1985. Continental European countries and the UK had similar experiences both prior to the establishment of the Bank of England and in the 19th Century. In the absence of a central bank and a regulatory and supervisory framework, bank runs, bank panics and solvency crises would be frequent and highly destabilising, owing to the fractional reserve system. If anybody is tempted by the notion of free banking as a means to overcome current dissatisfaction

6 7 8

(Miron 1986). (Friedman-Schwartz 1963). (Calomiris-Gorton 1991); (Calomiris-Mason 1995).

310

Working Paper IX

about the cost of the regulatory framework, he should not only ponder historical experience, but should also heed Tobin's wise words:9 Before we seriously recommend free banking to the public, perhaps we should examine our faith that the long-run self-interest of profit-maximising competitors offers sufficient protection to the customer of a public utility. Dishonest, inefficient, and flyby-night operators may not survive in the long-run equilibrium, but they can do great damage in the meantime: a drug firm that kills its customers will not survive either, but it is small consolation. [. . .] The United States has a history of wildcat banking that no one would wish to repeat. [...] Compulsory deposit insurance is certainly one of the most successful reforms ever adopted in the US, as even a cursory glance at banking history before and after demonstrates. It is amazing that anyone would seriously propose to scrap it, ignoring the lesson of history in favour of a doubtful abstract principle.

IV. Does A Competitive Environment Influence Bank Stability? Following the lead of their American counterparts, banks in Europe are undergoing an important process of consolidation and restructuring. The American experience may, mutatis mutandis, help us to understand what is taking place in Europe. Since the beginning of the 1990s, bank regulation in the US has been loosened and has allowed banks to expand geographically, to compete in previously restricted local markets for loans and deposits and to increase the range of financial products they can offer. Consequently, the market distortions created by control of bank capital have largely disappeared. Yet, deregulation alone would have been unable to bring about a consolidation process that has halved the number of American banks in the last twenty years. One factor widely quoted is the great technological advance in the field of computers, of which banks are major users, and, above all, in that of finance, which has caused a reduction in costs, an enlargement of the product spectrum, and—by added virtue of globalisation—has enabled supply in a much wider area. All this presupposes that new or additional economies of scale and scope must now be available. A further factor is diversification, which goes hand in hand with the previous argument and brings about a reduction of risk. There is no reason to doubt that the economic forces believed to be responsible for the consolidation process in the US will not also be at work in Europe. Regulation is different on the two sides of the ocean to some extent, but the widening of the American market through the repeal of geographic restrictions can be equated to the formation of Euroland with its single currency and common monetary policy. While financial markets are still segmented, one should not downplay the current efforts to set up computer-operated exchanges, reaching into different corners of Euroland in order to trade government bonds, mid-cap firms, 9

(Tobin 1967: 508).

2 - Problems Arising from State Aids in Banking Sector

311

and blue chips. Sooner or later, the purely national regulatory framework, which currently relies mainly on co-operation, will have to make way for a European structure. The 1990s have witnessed an important increase in the level of competition in Europe. The main factors responsible for the breaking of formal or informal barriers to entry, collusive arrangements, and regulatory appeasement have derived from the enforcement of the Second Banking Directive, the single market programme, the privatisation of publicly-owned banks, and, above all, the abolition of any residual capital and foreign exchange control. The launch of the euro has resulted in the disappearance of currency diaphragms and the major part of interest rate differentials. In due course, it should make for more bank competition on the much enlarged playingfield.However, different regulatory institutions, non-regulatory barriers such as national languages, differences in corporate law and taxation, as well as historical and cultural factors, have impeded and will continue to hamper full competition among the various national commercial banks, thus preventing their consumers and firms from reaping the benefits of economic integration and monetary unification. Thus, bank consolidation in Europe is likely to remain confined within national boundaries for the time-being, in contrast with the US experience where mergers and acquisitions have taken place at interstate level. If the consolidation of the banking sector takes place domestically, this might result in an increase in the market power of banks. In an effort to benefit from the economies of scale and scope through mergers and acquisitions, the process of consolidation of the national banking industries may thus similarly restrict the scope of competition. Who will suffer from this situation is quite clear: namely, consumers and small firms that have no or, at best, difficult access to financial markets. What is at stake, however, is the expected dividend of the single currency. The majority of Europeans have not seen reductions in costs as a result of a larger market and a single currency. The most natural and appropriate answer is to encourage cross-border consolidation within Euroland by removing legal, tax, and regulatory barriers to international mergers by deregulating the banking industries and/or harmonising regulatory practices to a greater extent. This would entail a much smoother level playing field for commercial banking, an industry that has, to date, been regarded as highly local. Cross-border mergers might reduce local monopoly power to the extent that concentration in the enlarged market is lower than in any of the previously segmented markets, notwithstanding the fall in the total number of banks. This is an area of paramount importance for European competition policy and, to the extent that cross-border mergers make for more uniform transmission channels, for European monetary policy, too. However, there is a natural tendency towards mergers and acquisitions within national boundaries in thefirstphase of banking consolidation; almost a pecking order. It would be a mistake to resist such a market inclination, since the macroeconomic risk diversification that American banks pursue through interstate mergers, is achieved in Euroland by mergers or acquisitions within national

312

Working Paper IX

boundaries, owing to the lower degree of production specialisation within the European economies as compared with those of American states. Yet, competition authorities must be alerted to the risk of too great an increase in concentration in local markets. What has been said makes it clear that the changes now taking place will not lead European banks to resemble their American competitors, because the introduction of the euro cannot, in itself, create a single financial market in Europe. Instead, some degree of market segmentation will persist as a result of a lack of harmonisation in regulatory practice, differences in taxation and corporation law, as well as linguistic and cultural factors. As in all other sectors, competition is needed to achieve greater efficiency in banking, or to increase productive efficiency and to reduce X-inefficiency. The crucial issue for regulatory and competition authorities here is an understanding of whether increased competition can intensify the fragility of individual banks or of the whole banking system; in the latter case, macro-economic stability would be at stake. In general, there is no clear cut answer. However, a presumption can be established that the stronger competition that results where banks are required to undertake riskier activities may increase the probability of their failure. A synthetic statement of the dilemma that any regulator faces is as follows:10 Competition reduces market power. Yet, market power raises the opportunity costs of going bankrupt, and hence increases the bank's charter value, which, in turn, reduces a bank's incentives for excessive risk-taking. [...] the decline of charter value due to deregulation and liberalisation has been blamed for the increase in bank failures starting in the 1980s [. . .] In the extreme, institutions which run into problems because they cannot cope with an increase in competition tend to 'go-for-broke'—as the case of the American S&L's illustrates.

Competition reduces market power, but more market power tends to lower the moral hazard the bank faces, as a bank with more market power has a stronger incentive to monitor the projects or firms it financed. Regulatory and competition authorities are confronted with a dilemma: on one side, there is a need to increase competition in banking to benefit consumers and firms and to reduce productive inefficiencies; on the other, the increase in competition can have ambiguous effects on welfare and upon the probability of collapse and failure.

V. How to Deal with the Intrinsic Fragility of Banks To draw together the main conclusions of the last few paragraphs, we may restate that any (commercial) bank is based on the fractional reserve system 10

(Danthine et al. 1999:21-22).

2 - Problems Arising from State Aids in Banking Sector

313

which entails the use of balances at the bank as if it were money, a transformation of maturities as these balances are used to finance much longer loans, and a lack of monitoring of the bank lending activity by the creditors who are too small and dispersed to have an economic incentive to perform such a function individually; in the latter case, free-riding occurs as the costs are very high to monitor, while benefits accrue to all depositors and borrowers. Moreover, to the extent that competition is increasingly relied upon to foster efficiency, bank fragility may be increased and give rise to more bank failures. The classical dilemma between stability and efficiency will continue to bedevil regulatory authorities, while competition watchdogs are confronted with the choice between tolerating a level of market power for banks which is higher than that acceptable for other sectors, in order to reduce the risk of failure.

A. One Hundred Percent Reserve System Many economists who have investigated radical solutions for the problem of intrinsic bank fragility have come up with a simple and, therefore, appealing idea. For a synthetic, lucid statement of the recommended fundamental cure, we may quote from Milton Friedman who, in a 1976 US Congress hearing,11 testified as follows: The historical reason for the regulation of the lending and investing activity of depository institutions has been the close linkage between these activities and the provision of money—the circulating medium. The justified concern with assuring a stable monetary system has led, in my view, to an unjustified concern with controlling the lending and investing activities of financial institutions. I have long believed that the most effective way of reducing regulation is to separate the monetary functions of commercial banks from their credit functions. The way to do this is to require institutions offering demand deposits transferable by check to keep 100 per cent reserves. They would become depository institutions in fact and not, as now, simply in name. . . . The lending and investing of today's commercial banks would be carried on by new institutions created by them . . . which would raise their funds through time deposits or debentures or stock. These institutions would then be freed almost entirely from regulation.

No government has followed such a piece of advice, as far as we know. The reason is rather simple: it would be tantamount to putting the clock back, denying the validity of the history of banking, and to depriving the economy of a very flexible intermediary, able to supplement, in response to demand, the basic supply of money provided by the central bank. Whatever the reasons for not engaging in a sweeping transformation of banking as we know it—which presumably include the opposition of bankers—the conclusion to be drawn is that public policy wishes to retain banking in its current form, which is shaped by economic, financial, and regulatory developments. 11

(Friedman 1976: 2167).

314

•

Working Paper IX

An answer in line—up to a point—with radical reform, which goes under the name of 'narrow banking', has come from the market. In the US, financial innovation has made for the development of monetary market mutual funds, which specialise in short-term bond investments and allow the bearers of their certificates to draw by cheques on the mutual fund for sizeable sums. Thus, this intermediary is able to offer a return on monetary balances that would be difficult or impossible for a depositor to secure from a bank, and can further remain fully liquid by investing in risk-free assets. The only limitation concerns the minimum amount to be drawn, which makes the instrument inconvenient for every day's transactions. The payments mechanism, therefore, mainly remains a province of the commercial banks. This particular—but incomplete—instance of 'narrow banking' fostered by the market can take place almost everywhere, provided that there is a very liquid bond market.

B. Bank Refinancing Through a Lender of Last Resort If (commercial) banks are allowed to have a mismatch of maturities, sooner or later they will incur liquidity problems. If they arise at one particular bank that has a good reputation, it is likely that the market will provide the necessary refinancing. If the reputation is not particularly high and, above all, if the rumours about illiquidity are, to some extent, information-based and concern most banks, the price or rate of interest to be paid for market funds may fail to compensate the lenders for the highly subjective risk of refinancing liquiditystripped banks. This market failure could itself act as a trigger for a confidence crisis and for a bank panic. In fact, in a liquidity crisis situation, a bank, to say nothing of a banking system, would have to transmit reliable information, since its credibility is at a low point. In Bagehot's words:12 Every banker knows that if he has to prove that he is worth of credit, however good may be his argument, in fact his credit is gone. That results in a market failure that cannot be tackled through market refinancing because of asymmetric information between the two sides of the liquidity market. Thus, central banks, which provide the basic supply of money, have developed a 'lender of last resort function' to help the banks overcome a liquidity shortage and, above all, a liquidity crisis. Bagehot did not merely make explicit the rationale for a lender of last resort, but he laid down the rules that this type of lender must follow in order to perform its function correctly. Although well known and much celebrated, they are worth recalling: i) the lender of last resort must lend to illiquid, but solvent banks, which means that, if reliable information cannot be conveyed in time of need, the lender of last resort must keep a watchful eye on banks throughout 12

(Bagehot 1873: 68).

2 - Problems Arising from State Aids in Banking Sector

315

their lifetime; ii) these loans must be granted at a penal rate to ensure that all market refinancing options are exhausted and, above all, that recourse to the lender of last resort is not made merely to expand lending activity; iii) liquidity support operations are to be guaranteed by good collateral, not only to allow the central bank to recover its money, but also in order to induce the bank to manage its own portfolio in a way that would make the recourse to the lender of last resort successful; and iv), in order to make the whole operation credible within the market, the lender of last resort must make it known that it will lend any amount, provided the borrowing bank is solvent and has good collateral to offer. Even time-honoured principles or rules are the object of criticism. The most obvious critique here is that a clear-cut distinction between a liquidity crisis and a solvency crisis is difficult to establish beforehand. Most, if not all crises, start as an instance of illiquidity so that its true nature only becomes apparent later, but, sadly, too late. Moreover, even when there is suspicion of insolvency, the risk of contagion may still induce the lender of last resort to intervene. Moreover, those who are afraid that direct lending from a lender of last resort to a bank might imply hidden preferences or subsidies, prefer market operations that are open to all interested parties, notwithstanding the fact that there are various types of credit of last resort.13 Such a preference may be detected in the Maastricht Treaty, as well as in the ECB statute, since no mention is made of the lender of last resort function.14 Finally, central banks do not adhere to the philosophy of stating in advance the rules that would apply in the case of a liquidity crisis: they believe that by doing so, the moral hazard would be increased. In order to minimise it—according to central bank thinking—the lender of last resort should demonstrate a 'constructive ambiguity' as regards the availability of refinancing.15 That is why the Maastricht Treaty is silent on this issue, according to some interpreters.16 However, in addition to the high degree of discretion that it would confer upon the lender of last resort, this approach would also result in a boost for large banks and a disadvantage for smaller ones, since depositors would expect the lender of last resort to run to the rescue of institutions that are 'too big to fail'.

C. Regulation as a Remedy for Market Failures The third element which makes a bank a special agent among financial intermediaries is the large number of its creditors, usually for relatively small amounts, who do not have the individual competence, time or will—in one 13 14 15 16

(Sarcinelli-Ripa di Meana 1990). (Sarcinelli 1992). (Giannini 1998). (Smits 1997).

316

Working Paper IX

word, the incentive—to monitor bank managers and their conduct. Clearly, the same characteristics of claim dispersion and smallness make it impossible for the depositors to gather together and mandate a private, professional organisation to do the monitoring on their behalf. However, before we turn to the specific instruments to which the public sector has recourse in order to cope with this problem, it is advisable to investigate the reasons that justify the regulation of certain sectors in general. Historically, governments have chosen different forms of intervention in the economy. The reasons for public sector involvement are well known in economics and public finance theory. The textbook rationale for state regulation can be identified in one of the following situations: i) the existence of public goods, where the free-rider behaviour of individuals makes it impossible for the market to supply goods such as defence and justice efficiently; ii) the presence of externalities, such as the environment, in the production and consumption activities of firms and individuals,; iii) the prevalence of monopoly conditions in some industries, in particular, those characterised by natural monopoly—in fact, there is an aspect of natural monopoly in the provision of information, which makes the small borrower a bank's natural customer; and iv), the occurrence of conditions of asymmetric information, namely, moral hazard and adverse selection, where the market will not supply certain goods or products— the case of health insurance or the annuities market—or will supply them in a sub-optimal way. Economists have become highly suspicious of regulation in the last few decades, and the public interest and capture theories that provided the initial underpinnings for it have been strongly criticised.17 The (new) economic theory underlines not only the benefits that regulation is able to provide producers with,18 but also the rent redistribution that cross-subsidisation performs among consumers.19 All this gives rise to a political support function that the regulator tries to maximise.20 Finally, regulation can be looked upon as part and parcel of a set of theories that explain the political process in representative democracies.21 As the winds of competition and globalisation have grown stronger and stronger and the costs of regulation have soared, all industries that were at one time subject to regulation have undergone a deregulation or reregulation process (or cycle?), which can be interpreted in the light of one or more of the above-mentioned theories. Banking is no exception, and the main change has been, in most countries, from a prevalently structural mode of regulation to an almost exclusively prudential approach. In fact, deposit insurance is the only, or the major, feature of protective regulation. Notwithstanding the

17 18 19 20 21

(Goodhart 1989). (Stigler 1971). (Posnerl971). (Peltzman 1976). (Noll 1989a and 1989b).

2 - Problems Arising from State Aids in Banking Sector

317

anti-regulatory attitude of many academics,22 most 'real-world' economists and all practitioners are still convinced that banks need regulating.23 There is, however, no consensus in academe—and none among banking specialists and government officials—on why and how banks should be regulated. The first mode traditionally advanced is the protection of bank depositors' liquid balances. As individuals and households normally deposit their money holdings with the banking industry, bank failures cause negative externalities to depositors, as well as to the firms indebted with the failed bank. In order to maintain the integrity of the payments system24 and to assure its smooth functioning, the payments system may be regarded as a public good that the market cannot itself supply. Regulation, therefore, combats the danger that a bank failure will undermine the reliability and efficiency of the payments mechanism and adversely affect the wealth of depositors in the segment of their demand or very short-term claims, and, in turn, the economy. Moreover, bank failures would imply serious consequences—diseconomies—for other banks, which, for the conduct of their business, must have multiple and intensefinancialrelationships among themselves; thus, regulation aims to avoid a collapse of the system. This is the well-known argument in favour of regulation as insurance against systemic risk, or the risk that a failure of a particular bank would spread to other institutions, be they banks or firms, linked to the failing bank by financial contracts such as"interbank loans, deposits or derivatives.25 The intensity of the spillover mechanism is, in effect, higher in banking than in other sectors, since banks are closely intertwined through interbank borrowings and loans, as well as through payment-clearing arrangements and derivative contracts. Secondly, however, bank failure can also be treated as a case of asymmetric information between bank managers, stockholders and depositors. Savers are not cognisant of financial operations of their banks and banking decisions on loan financing are dominated by imperfect information. In this scenario, externality and moral hazard are accumulative causes of government intervention. Latterly, the development of financial markets and the diversification of the financial assets of households—with increasing access to the stock market and the discovery of new instruments—can be construed as a weakening of the significance of this argument in justifying the regulation of banking. While it is true that (commercial) banking nowadays takes a smaller share of the financial industry, the rational for regulating banks cannot be affected by a reduction in their role within the financial industry.

22

(Dothen-Williams 1980). (Tobin 1967). The discussion of the regulation rationale for the banking sector is also found in: (Ciocca 1982); (Kareken 1986); (Lewis-Davis 1987), (Pecchioli 1987); (Dewatripont-Tirole 1993); (Freixas-Rochet 1997). 24 (Hoenig 1997). 25 (Freixas-Rochet 1997). 23

318

Working Paper IX

A modern, brilliant way of rationalising bank regulation is through the 'representation hypothesis'.26 As we said before, the small depositors who provide most of the funding to (commercial) banks are unable and unwilling to undertake, both individually and collectively, the monitoring of the bank. Thus, the government has to step in, but it should exercise the monitoring and control function as the depositors would have done, had they been prepared to perform such a function. The representation hypothesis begs the question of the optimal governance structure of a firm, which cannot be dealt with here, but also allows us to understand the limits, instruments, and intensity of regulation. a) As regard its limits, this hypothesis posits that the government provides representation services to small bank creditors, including a 'voice' to monitor, control, and in the worst cases, discipline bank managers. As banks have a relatively low capital-to-debt-ratio, shareholders may have a weak or no incentive to perform such a task and may side with the managers. The minimum capital recommended by the BIS and made compulsory in the EU through a directive is also instrumental in promoting a greater involvement of shareholders in bank governance. b) The instruments to be used in such an approach are those that the collectivity of small depositors would have applied, if they had been able to exercise their right to control, for example, the loan agreement covenants that large creditors make when the financing is agreed. These covenants include capital adequacy, risk restrictions, activity limitation, accident and casualty insurance, minimum liquidity, information duty and non-compliance penalties. To a large extent, many of the regulatory instruments in current use can be reinterpreted in the light of the contractual terms and conditions just mentioned. The representation hypothesis provides us with a much wider framework than the purely guarantee approach, according to which protection of small depositors requires only compulsory insurance. In this case, the deposit insurance institution has no other duty but to reduce, as far as is possible, the moral hazard problem that any insurer meets. c) The intensity of regulation has much to do with the riskiness of bank loans and assets. It changes over time as a result of micro-economic and macroeconomic factors, new legislation, judicial decisions, and acts of God. Thus, the level of risk that a bank embodies requires a continuous assessment, but may also demand increasing 'doses' of monitoring, control, and disciplining. In the worst cases, the regulator, in the character of the 'representative' of the dispersed population of small depositors, may ask or decide to remove the managers, invite the shareholders to increase the bank's capital, take control of the bank for a short period, or liquidate it. Regulation, therefore, is the unavoidable consequence of a failure of the market, which can be traced back to various reasons: in the case of banking, we have more than one. 26

(Dewatripont-Tirole 1994: 32-38).

2 - Problems Arising from State Aids in Banking Sector

319

D. Is Regulation a Solution or a Problem? There is no denying that regulation can remedy market failures, but, in turn, it generates problems. Textbooks on financial economics list no less than four major failings.27 a) First and foremost, the presence of government causes moral hazard to occur. The existence of a public safety-net for bank deposits relieves the savers of any preoccupation concerning the standing of the institution they bank with if the regulator applies rules valid across the board of the banking system and this regime is thought to be stable. If the regulator retains a noticeable degree of discretion, the 'too big to fail' argument will push depositors towards the largest, but not necessarily the most efficient, banks. Moreover, the belief that banks will, in the end, be rescued or, at least, that small depositors will suffer no loss, but only some inconvenience, encourages bank managers to take greater risks in their lending policies in search for higher returns. b) The regulatory process can be 'captured' by banks, since producers or bankers are certainly more influential and powerful than a dispersed population of small depositors. Capture may distort the regulatory instrument, particularly if regulators are allowed to move from the regulatory agency into the banking world without an appropriate intermission. c) Regulation is costly to the taxpayer, since a structure has to be set up and maintained in order to formulate rules and oversee their implementation. Equally, it makes for higher costs at the regulated banks, which have to assure compliance with the regulator's prescriptions. The cost increase may affect prices—fees and interest rates charged, or compensation paid to depositors by the banks—depending on the degree of competition and the type of cost. d) The presence of regulation slows down the process for entering or leaving the banking market, which is a bonus for the incumbents and a cost to potential new entrants. Competition and efficiency might be affected through the convergent behaviour of the regulator, who privileges stability above all, and that of bank managers, who may prefer to maximise expenditure or size, instead of profit and value for the common shareholder. This is why believers in the free market, and in its ability to assure competition and welfare, see regulation as a source of monopolistic power, particularly when it inhibits or makes more difficult mergers and acquisitions.

27

(Howells-Bain 1998).

320

Working Paper IX

VI. The Structure of Bank Regulation for Euroland While the role of the (commercial) bank has been stressed, banks within Europe—or, at least, the great players thought to be 'too-big-to-fail'—have been undergoing a genetic transformation. They have become large, capitalmarket intermediaries. Consequently, regulation should take note of this progressive change in their basic business and avoid, on the one hand, giving them (indirect) protection as if they were pure (commercial) banks, and on the other, should adapt regulatory instruments to take account of the transformation. As banks incur more and more market risks, particularly in thefieldof derivatives, the regulatory approach relying on monthly or quarterly checks on capital requirements and portfolio restrictions is becoming inadequate: the balance sheet may change many times during a day if there is turmoil on the markets; the income and loss account becomes very sensitive to the trends of the market and to the forecasting ability of bank managers; direct lending is being replaced by the provision of liquidity to an ever greater degree. Thus, as is customary for financial intermediaries, disclosure, market discipline, and risk control models must progressively replace the older instruments of bank regulation. The transition might not be easy, as the double nature of the (new) large banks will warrant the addition of new layers of regulation. The different institutional frameworks of the countries making up Euroland as regards banking regulation, as well as the imperative to entrust the ECB with just one objective—price stability—in order to avoid any trade-off, explain why the Treaty of Maastricht assigns the new monetary policy-maker a role which limits it to counselling and monitoring in the regulatory area. Although a very elaborate procedure allows the Council to confer specific tasks upon the ECB in the field of prudential credit business regulation—absent insurance companies—the likelihood that this procedure will be used in the future is nil. This raises the question of whether the centralisation of monetary policy and the decentralisation of banking and financial regulation are a recipe for disaster.28 In principle, if there is sufficient exchange of information, co-ordination of action, and harmonisation—for example, of risk measurement, monitoring, and management—this organisational set-up and the resulting distribution of responsibilities can work. However, the number of supervisors in each country may be higher than one, since only four countries in the EU have concentrated all regulatory functions in one agency, while, in the others, functions are still apportioned on the basis of their objective principle or some other criterion. The network of relations is extensive and based on bilateral agreements that may not assure uniformity or timeliness in the transmission of information. Centralisation would certainly entail more uniformity in dealing with moral hazard problems, and possibly less heterogeneity in rescuing and restructuring 28

(Sarcinelli 1998).

2 - Problems Arising from State Aids in Banking Sector

321

policies. However, decision-making in this area would remain mainly in the hands of supervisors, whose function is presumably going to remain decentralised. Moreover, if, as a result of EMU, the strong interpenetration of financial markets develops, the position of home country control—the basis for assigning the responsibility to supervise banking and financial institutions in the EU—will be challenged. A computerised platform linking various countries has already become operational to trade government bonds, while similar infrastructures are being actively promoted in order to allow the continuous buying and selling of European 'blue chips' or mid-cap companies across frontiers. Who is going to regulate and monitor these markets? The question has been raised by baffled supervisors. Coming back to banking, if a process of denationalisation is going to affect the major banking intermediaries in Euroland to an extent that justifies a European incorporation and a European charter, a central regulatory agency is fully warranted. To avoid the suspicion that central bank money is injected to hide a possible supervisory mistake or loophole and to enhance transparency and accountability in the rescuing or restructuring of a bank in trouble, the functions of money supplying and bank regulating should be kept apart.29 An analysis over the period 1970-92 shows a higher preference for bank liquidation in countries where a separation regime exists.30

VII. Conclusions At the end of this paper, no peroration is needed to reaffirm the special character of (commercial) banking as a financial activity based on a fractional reserve system that is pivotal in operating the payments system, providing both money to depositors and financing to borrowers through maturity transformation, and requiring regulation on the basis, for example, of the 'representative hypothesis', in order to overcome the free-riding attitude of small and dispersed depositors. If governments are not prepared to accept responsibility for an industry which is particularly flexible in supplying liquidity and financing, and allows the functioning of a fully decentralised economy through the payments system, but is inherently fragile, they may decide to implement the alternative of 'narrow banking'—a one-hundred-percent reserve system which would separate the responsibility for providing payment services from that for granting credit. In the EU, the largest banks are increasingly becoming intermediaries that are also operating on the capital market, which requires an adaptation of regulation in favour of more transparency and risk control. However, the majority of banks are still providing the services and performing the functions 29 30

On this vexata quaestio, (Goodhart-Schoenmaker 1995). (Goodhart-Schoenmaker 1993).

322

Working Paper IX

highlighted in the paper. This means that an individual bank crisis with possible systemic consequences, notwithstanding all the regulatory constraints and the supervisory checks, may materialise. Owing to a macro-economic shock, for instance, a sudden fall in asset prices, the whole banking system may be at risk, with possible spillovers across the frontiers. By deciding not to insulate the payments system, the government has implicitly or explicitly accepted responsibility for the risk the economy incurs. It must play the role of the ultimate insurer. One might be tempted to say that the government has already discharged its duty by providing a safety net for small depositors and making a regulatory framework for all aspects of banking activity available. Thus, if a bank fails because of fraud or plain bad luck, the community may allow it to go under without having a guilty conscience. However, two points need pondering. First, whatever the wrongdoings of the failed bank managers, if the systemic consequences are thought to be very serious, it is unlikely that a government will decide not to intervene. Secondly, where pervasive regulation and watchful supervision exist, the government may bear the moral responsibility for the failure to detect early signs of the insolvency syndrome or for forbearance. In both cases, moral hazard is present and must be minimised, lest strategic behaviour on the part of bank managers become widespread. It is a common understanding that most bank crises are first thought to be minor and that their true insolvency character only becomes apparent later. This results in an early intervention by the lender of last resort who, when the bank appears to be insolvent, may decide to continue rescuing it in order to avoid public criticism for making the wrong diagnosis. Such an occurrence is more likely where the lender of last resort is also the regulator. Finally, from what has been said, it follows that the state aid regime must be applied differently within the banking sector. If current EU legislation and judicial interpretation does not recognise this, the special character of banking has, at the very least, been acknowledged by the European Commission, which should allow the intervention of the regulatory and supervisory authorities as soon as possible and in any form that is deemed fit to avoid more serious, possibly systemic consequences.

X Alfonso Papa Malatesta* A Focus on State Aids and the Banking Sector

I. State Aid for Rescuing and Restructuring of Banks A. Rescue and Restructuring Aid in General The policy regarding state aid for the rescue and restructuring of undertakings was illustrated for the first time by the Commission in 1979 in its annual report on competition policy. It then found specific application in a series of decisions, some of which also passed the scrutiny of the Court of Justice. Drawing on the experience matured, in 1994 and 1997 the Commission made known in more detail its own thinking on the admissibility of this type of state intervention, also in the agricultural sphere.' A new version of the guidelines was issued in 1999.2 Community policy in the matter of aid to help ailing3 enterprises consists of the identification of the conditions which are indispensable to authorise a derogation from the prohibition on granting aid laid down by Article 87(1) of the Treaty establishing the European Community (EC Treaty). The legal basis for the concession of the exemption is to be found in Article 87(3)(c) of the EC Treaty which provides that 'The following may be considered to be compatible with the common market: [. . .]) aid to facilitate the development of certain economic activities [. . .] where such aid does not adversely affect trading conditions to an extent contrary to the common interest'. The Commission maintains that rescue and restructuring aid can, if certain conditions are met, satisfy the requirements envisaged by the aforementioned EC Treaty provisions. As has been recognised by the EC Court of Justice, in the ambit of the application of the exemptions provided for in Article 87(3), the * Ceradi Luiss University, Rome 1 Community guidelines on state aids for rescuing and restructuring firms in difficulty in OJ (1994) C368/12; OJ (1997) C283/2. Specific rules exist for shipbuilding, the motor vehicle industry and the aviation sector. 2 Community guidelines on state aids for rescuing and restructuring firms in difficulty, 8 July 1999 (not yet published in the Official Journal at the time of the writing of this paper. The new guidelines shall enter into force on the date of their publication in the OJ and remain in force forfiveyears; see point (97) of the same guidelines). 3 According to the Commission, a firm is in 'difficulty' 'where it is unable, either through its own resources or with the funds it is able to obtain from its owners/ shareholders or creditors, to stem losses which, without outside intervention by the public authorities, almost certainly condemn it to go out of business in the short or medium term' (see, 1999 Guidelines, point (4).

324

Working Paper X

Commission enjoys considerable discretionary powers, the exercise of which involves making evaluations of an economic and social nature in a Community context.4 In principle, the Commission distinguishes between rescue and restructuring aids.5 The distinction is based on the different nature and purposes of the intervention, rescue measures being of a temporary character aimed at dealing with a serious crisis for the time strictly necessary to put together a plan suited to remedying the situation.

1. Rescue Measures In order to be authorised the rescue measure must be grounded on 'serious social difficulty and have no unduly adverse spill-over effects in other Member States'; it must be limited to the disbursement of the sums strictly necessary to keep the undertaking going while a recovery plan is being worked out and assessed (as a rule six months, or until the Commission takes its decision on the restructuring plan submitted by the Member State); it must be envisaged as a one-off measure, and, for this reason, it must be less easily admissible as regards industries undergoing a structural crisis.6 According to the Commission, as a rule rescue aid must, as a rule, be disbursed exclusively in the form of credit guarantees or repayable loans subject to (at least comparable) market rates of interest.7 An exception may be made in 4

Case 730/79, 17 October 1980, Philip Morris Holland B. V. v. E.C. Commission, [1980] ECR 2671, par. 24. 5 The distinction should, moreover, be significantly reflected in terms of the different rules which govern the two hypotheses, since rescue measures are admissible in conditions which differ from those requested for the admissibility of restructuring operations, to the extent that, for example, the Commission maintains that the authorisation of rescue aid does not in any way circumscribe a decision on successive restructuring aid. In substance, in all cases, the Commission recognises that it is often not possible to establish if the aid under examination represents a rescue measure or a restructuring one. What can happen, therefore, is that the Commission can find itself having to deal with a mass of state intervention aimed at stemming the crisis and permitting the undertaking to remain in the market or alleviate the consequences of the undertaking's possible exit from the market. In these cases, it is evident how difficult it is to split the part relating to the rescue measures from that relating to the restructuring for the purposes of subjecting it to two types of analysis, with the net result that it is difficult to find application for the cumulative conditions of admissibility. 6 Rescue aid should be individually notified to the Commission, accompanied by some strict obligation on the part of the Member States to communicate the restructuring or liquidation plan, or the proof that the aid has been reimbursed or terminated; see 1999 guideline, cited above, point (23)(d). 7 However, in this regard, see Case 323/82, 14 November 1984, Intermills SA v. EC Commission [1984] ECR 3809, in which the EC Court of Justice, annulling a decision by the Commission, held that aid in the form of an equity participation in an undertaking is not necessarily incompatible with the rules relating to rescue aid. Moreover, according to the Commission, the aid must be linked to loans that must be reimbursed within a term of one year after the last instalments to the firm.

2 - Problems Arising from State Aids in Banking Sector

325

the case of the rescue of banks, in order to allow them to comply with the solvency ratio obligation and thus continue carrying out their activity. In these cases, accordingly, the rescue aid can also take the form, for instance, of capital injections.8 2. Restructuring Aid Restructuring aid, on the other hand, is that destined for a 'feasible, coherent and far-reaching' recovery plan, aimed at restoring the long-term viability of the undertaking. The admissibility of this different type of intervention must be rigorously evaluated, since, in the words of the Commission, it can unjustly shift the burden for structural adjustment and the relative social, industrial and agricultural difficulties on to other producers who manage to operate without aid and on to other Member States. These considerations imply that the interest in restructuring must, in some way, coincide with an interest of the Community 9 in such a way that the negative effects on competition caused by granting the aid must find a trade-off in a certain Community interest, according to the principle of 'compensatory justification' generally applicable in cases of state aid. 10 In this context, the general conditions for the authorisation of aid for restructuring purposes are essentially identified in the guarantee that the recovery plan is capable of restoring the long-term viability and autonomy of the enterprise within a reasonable time; that the state intervention also prevents or 8 See the new 1999 rescue an restructuring guidelines, mentioned above at footnote n. 2, at point (23), footnote 18. See, also, the Commission decision concerning the rescue aid granted to Credit Lyonnais, NN 113/96, of 25 September 1996, O.J. C390 of 24.12.1996. 9 Community guidelines on state aids for the rescue and restructuring of firms in difficulty, OJ (1997) C283/2, par. 3.2.1. In the new version of the guidelines, the former positive requirement of the 'interest of the Community' has been converted into the less strict negative requirement of the proof that the restructuring aid 'does not run counter the Community interest'. 'This will only be possible if strict criteria are met and it is certain that any distortions of competition will be offset by the benefits stemming from the firm's survival (in particular, where it is clear that the net effect of redundancies resulting from thefirmgoing out of business, combined with the effects on its suppliers, would exacerbate local, regional or national employment problems or, exceptionally, where the firm's disappearance would result in a monopoly or tight oligopoly situation') and, where appropriate, there are adequate compensatory measures in favour of competitors', point (28). 10 Mortelmans (1984:405). In the Philip Morris case [1980], referred to above, the Court of Justice confirmed the importance of assessing the necessity for a justification of the aid from a Community standpoint which compensates the distortion caused by the aid itself, approving the decision of the Commission, which had held that the aid under scrutiny in that particular case could not be justified on the grounds of the necessity to guarantee the development of the market in the cigarette production industry as, in the circumstances of the case, the free interplay of market forces was capable of ensuring such development even in the absence of state support.

326

Working Paper X

compensates for the undue distortion of competition caused by the granting of the aid (for example, through a reduction in the productive capacity of a market in which there is a structural over-capacity, or with other compensatory measures, such as a significant limitation of the presence that thefirmenjoys in its market at the end of the restructuring period); that the aid is proportional to the costs and benefits of the operation, it being limited to the minimum necessary to allow the restructuring (ensuring, for example, that the recipient firm gives a significant financial contribution to the restructuring costs, or ensuring that the aid will not end up being doubled in real terms by reason of a tax allowance deriving from the inclusion in company accounts of the losses covered and any tax credits matured) and it being commensurate with the benefits perceived at Community level;11 that the plan be fully implemented by the undertaking on the conditions imposed by the Commission; that compliance with the aforementioned conditions is capable of being verified (a possibility which can be realised through an obligation to produce regular reports concerning the implementation of the plan); that,finally,restructuring aids should be meant, as a rule, to be granted as an una tantum intervention (a 'one time, last time condition').12

B. State Aid to Banks and the Applicable Norms in this Regard Banks do not enjoy any particular treatment with regard to the application of Community norms on competition. This is a principle that has been well established ever since the Zuchner case.13 Likewise, no specific provisions exist for banks in terms of the application of the norms on state aids or the relationship between States and their undertakings. The credit sector is fully included among those contemplated by the directives on transparency in financial relations between States and public undertakings.14 Notwithstanding this, the Commission has, on more than one occasion, affirmed that it is aware of the particular character of the banking sector as well 11 In the 1999 guidelines, referred to above, the requirement of the proportionality of the amount and the intensity of the aid with the benefits at Community level disappeared (see, for the new philosophy which is behind this change, what has been mentioned above, at footnote 9). 12 The 1999 Guidelines contain a new paragraph which allows amendment of the restructuring plan during the restructuring period. Such faculty was not explicitly mentioned in the former guidelines; nevertheless, the Commission, as in the Cridit Lyonnais case, had de facto accepted amendments of the plan in the course of the restructuring period. 13 EC Court of Justice, Case 172/80, Zuchner v. Bayrische Vereinsbank, 14 July 1981, ECR 1981, 2021. 14 See the EC Commission Directive 80/723 EEC, OJ (1980) L195/35, as amended by the Commission Directive 85/413/EEC of 24 July 1985, OJ (1985) L229/20.

2 - Problems Arising from State Aids in Banking Sector

327

as to the great sensitivity of financial markets even to the difficulties limited to one bank or another, circumstances that are to be taken into account in the application of the rules on state aid.15 In its XXIV Report on Competition Policy—1994,16 the Commission affirmed that the rules governing aid had to be applied to the banking sector taking account of the fact that intervention by a State could be necessary to avoid a crisis in the whole system and panic on the financial markets. A situation of this type should, moreover, be governed by the provisions of Article 87(3)(b) which envisages that aids may be authorised in cases where it is destined 'to remedy a serious disturbance in the economy of a Member State'. In the (above mentioned) Credit Lyonnais case [1995], the Commission declared that, even in this case, the aid should have been granted in a neutral fashion and, thus, setting an example to the entire banking system, without exceeding what was strictly necessary.17 When aid is directed towards assisting a single, ailing major bank (which is too big to fail), state intervention might be warranted because, even if the difficulties of the credit institution in question is not such as to imply per se an automatic lack of faith in the whole system, the difficulties may, at the same time, be capable of generating negative effects on otherfinanciallylinked banks and, from there, possibly on the system as a whole. It is necessary to bear in mind, moreover, the particular seriousness of any decision to go ahead and put a bank into liquidation due to the characteristically higher ratio of third-party funds to own funds which exists in the credit business in comparison with other industries. In these cases, the decision to authorise the aid must be made in the light of Articles 87(3)(a) and 87(3)(c).18 In particular, as the Commission has many times recognised, the general criteria governing aid for rescuing and restructuring enterprises in difficulty are applicable to such hypotheses. Compliance with the conditions laid down to authorise that type of aid is held to be sufficient to consider the aid given to credit institution as not being 'contrary to the common interest' and thus compatible with the EC Treaty.19 15 Commission Decision in the Credit Lyonnais case of 26 July 1995, 95/547/EC, OJ (1995) L308/92 of 21.12.1995, par. 3.1. See, also, Waelbroeck (1997:26). 16 European Commission XXIVth Report on Competition Policy—1994, Office for Official Publications of the EC, Brussels—Luxembourg, 1995, p. 188-189. 17 In a case in which the crisis in the system is caused by exceptional occurrences, it will without doubt be legitimate to enquire as to whether the state measures aimed at limiting the damage might not actually fall within the aids which are compatible ipso iure pursuant to Article 87(2)(b). Such a case might arise in the presence of exceptional and external factors, extraneous to any possibility on the part of both the state authorities and the affected enterprises either to foresee or to control, and produce afinancialor liquidity crisis which the State is obliged to remedy by recourse to extraordinary measures. 18 See the above-mentioned Credit Lyonnais decision of 1995, at par. 3.2. 19 See the following state aid cases concerning the banking sector: Banco di Sicilia, OJ (1992) C160; Banesto, press release of 15 December 1994 and XXIVth Report on Competition Policy—1994, p. 189; Credit Lyonnais (first case) mentioned above,

328

Working Paper X

C. Identification of the Aids and the Judgement as to Compatibility As for other cases of state aid, as is the case for aid granted to ailing banks, the Commission must proceed, first of all, by verifying the existence of the aid and, secondly, it must thereafter evaluate the compatibility of the aid with Article 87(3)(c) in the light of the applicable principles described above. The presence of aid elements is also verified in the case of banks—and, in particular, those controlled by the State—by recourse to the 'market economy private investor' principle. The ratio and method of applying this principle, which, based on the rationale of the private commercial investor operating in normal market conditions, identifies the parameters for establishing whether or not aid exists, have often been described by the Commission, especially in its Communication 93/C3O7 of 13 November 1993 (see, in particular, point 27) and need not be set out here. The identification of the aid is the first logical step in the procedure; general rules can found application and should not be recalled here. Instead, we will concentrate on some special features concerning the banking sector. 1. Identification of the Aid Among restructuring measures, one of the methods of financial support, which seems not to meet with excessive disfavour in the Commission's analysis, is that involving deposit guarantee schemes in which the bank in difficulty participates. In the case of the Spanish bank Banesto,20 the Commission considered that the rescue of Banesto by a voluntary deposit guarantee fund fulfilled the market economy private investor principle and therefore did not constitute state aid. In the case of the Banco di Sicilia and Sicilcassa operation, as in the Banesto operation, the rescue was also effected through the intervention of a deposit 95/547/EC, OJ (1995) L3O8/92; Comptoir des Entrepreneurs, NN193/95, of 24.01.96, in OJ (1996) C70/7; Societe Marseillaise de Credit, NN194/95, of 18.09.1996, in OJ (1997) C49 (opening of the procedure), C42/96 in O.J. (1998) C249/11 (extension); C1998/3210 of 14.10.1998, in OJ (1999) L198/1 (conditionally approving the aid); Credit Lyonnais (second case), mentioned above, NN113/96, of 25.09.1996, in OJ (1996) C390; Credit Fonder de France, C30/96, NN44/96 of 03.07.1996, in OJ (1996) C275/2; Gan Group, 98/204/CE of 30.07.1997, in O.J. L78/1 of 16.03.1998; Societe de Banque Occidental— SDBO, C44/96, NN101/96 in OJ (1996) C346/5 and see also C44/96, in O.J. C207/5 of 08.07.1997 (extension of the procedure); Banco di Sicilia and Sicilcassa, C16/98, NN 10/98, of 11.03.1998, in OJ (1998) C297; Credit Agricole, C89/97 NN 185/95, in OJ (1998) C144/6; Credit Mutuel, C88/97, NN183/95, in OJ (1998) C146/6; Credit Lyonnais (third case), C1454/1998 of 20.05.1998, in OJ (1998) L221/28; Banco di Napoli, C2495/1998 of 29.07.1998, in OJ (1999) LI 16/36. 20 Not published, see press release of 15 December 1994 and XXIVth Report on Competition Policy—1994, p. 189.

2 - Problems Arising from State Aids in Banking Sector

329

guarantee fund.21 The Commission considered that this intervention was not state aid in the sense of Article 87. It is clear that the evaluation regarding the nature or otherwise of aid from such bodies must take account of the actual form of intervention as well as the characteristics of the fund itself. If the fund does not intervene in favour of the banks but only in favour of the depositors, there is no aid since no producing enterprise is advantaged. Should, however, the fund also intervene to support the relevant bank in difficulty, for example, by participating in the disposal of the activity of the bank itself, it could be termed as state aid, given that the obligatory nature of the contributions paid by the participants is sufficient to classify the said contributions as public resources. In this context, the first element which, according to the Commission, may, however, ensure that the intervention of the fund does not constitute aid is represented by the possible character of the relationship between the fund and its participants. If the participation in the scheme is allowed adequate consideration, the fund can be considered as a type of insurer of the risk of trouble, provided always the contribution to the fund is congruous. Another element which may serve to exclude support coming from a fund being considered aid is the fund's independence from public authorities. In this regard one must note how the supervisory authorities may be capable of strongly influencing, through mechanisms of moral persuasion, the decisions of these bodies whose management organs are after all emanations of banks which are supervised by those very supervisory authorities. Furthermore, in order to seriously assess the independence of the said bodies with respect to the State, it is necessary to take into account the influence which representatives of State controlled banks may have within their decision making organs. Last but not least, it is usually the supervisory authority to provide the fund with the relevant data concerning the financial situation of thefirmin difficulty. The independence of the fund decision making process is then heavily dependent on the quality of such information. An aid which causes distortion, may not manifest itself directly in favour of the enterprise in difficulty but in favour of the transferee of the liabilities of a bank in trouble or in favour of the company which has taken over the bank itself. This happens when State resources are directed towards entities which intervene for the rescue operation. In the case of Italy, a Treasury decree in force since 1974 authorises the Bank of Italy to grant advances on treasury bonds at a 1% rate in favour of banks which take over a liquidated bank's position vis-d-vis the latter's depositors. Recourse to the possible advances is in proportion to the losses eventually suffered by those banks to the extent that the credits they have been subrogated to end up by being irrecoverable, as is likely. In this case, even if the recipient of the aid is not the ailing bank, the

21

See Banco di Sicilia and Sicilcassa, C16/98 NN10/98, of 11.03.1998, in OJ (1998) C297, in particular, par. 3.1.

330

Working Paper X

intervention can distort competition, as it could enable the rescuing bank to pursue the activities of the wound-up establishment.22 Looking at it more closely, the existence of a distortion in this case depends above all on the possibility for the State to favour one bank over another as the transferee of the business of the credit institution in liquidation. The danger that an intervention in the form of discrimination will harm competition will be greatly reduced where the sale of the bank in liquidation occurs by means of auction. It is clear then that it will be even more difficult to term the operation as unlawful, even in cases of public intervention, when the entirety of the assets and liabilities of the credit institution is transferred to a group of banks which contains a significant private presence, provided the latter voluntarily participate in the operation, in the absence of influence on the part of public or supervisory authorities. In the Banco di Napoli case, above mentioned, the advances granted by the Bank of Italy under the 1974 Treasury decree took a rather peculiar form, as they were granted directly to the Banco di Napoli rather than to a third (rescuing) bank. The Bank of Italy intervention permitted Banco di Napoli to make a loan to the hive-off vehicle without incurring in risks for the losses caused by the possible insolvency of the borrower. The loan was used by the hive-off structure to acquire the least-performing assets on the Banco di Napoli balance sheet. The hive-off vehicle paid the market interest-rate on the loan to the Banco di Napoli. In this way, the least-performing assets of the ailing bank turned into full-performing assets. The intervention of the State under the Treasury decree was considered by the Commission as State aid. The identification of the aid is a necessary step also for the purposes of quantifying the aid. Quantifying the aid is, in turn, an indispensable element in assessing its compatibility or otherwise with Community law.

2. Quantifying the Aid Experience has demonstrated the particular difficulty involved in gauging the size of the aid in bank restructuring cases. In the first Credit Lyonnais case, for example, the French government maintained—with data at hand—that the entire restructuring operation would have a net final cost of zero while the competing banks estimated that the aid could amount to as much as 60 billion French francs. The Commission, in the end, estimated that the aid could amount to 41 billion francs, allowing a margin of error of 10%. In the second Credit Lyonnais case (or third case, if we take the approval of rescue aid granted to the group in 1996 also into account) the Commission had to accept the idea of new aids to the bank for an unspecified amount, foreseen to be between 61

22

See the Banco di Napoli case, C2495/1998 of 29.07.1998, in OJ (1999) L116/36, at. par. 3.2.1. and the Banco di Sicilia and Sicilcassa case C16/98 NN10/98, of 11.03.1998, in OJ (1998) C297, at par. 3.2.

2 - Problems Arising from State Aids in Banking Sector

331

and 106 billion Francs. In this case, too, the Commission estimate was contested by the third parties.23 This difficulty is, in general, linked to the nature of credit activity, the difficulties inherent in the valuation of the risks connected to it and the complex forms which aid for the rescue of banks usually takes. Both in the Credit Lyonnais case and the Banco di Napoli case, and, in part, in that relating to the Banco di SicilialSicilcassa and GAN Group operations, the principal objective of the measure was that of clearing the credit institutions' balance sheets of their respective bad debts and other activities of dubious value which required large reserves, conversely increasing the banks' own resources in order to restore solvency ratios. The transfer of assets is often carried out by means of split-off or hive-off vehicles, directly or indirectly financed by the State. The estimate of the future possible income of these vehicles remains uncertain, and these estimates are in turn reflected in the calculation of the actual costs of the operation. It must be reiterated how, as already mentioned, the quantification of the aid disbursed in concrete terms is of particular relevance for the decision to authorise the restructuring since, as has already been seen, it is necessary to verify— before granting any authorisation—that the measures adopted are limited to the minimum required to support the restructuring, that the measures are not disproportionate to the advantages to be gained from the restructuring itself and that the measures are offset by a sufficient quid pro quo in favour of competitors. It is clear that situations of a very marked uncertainty as to the overall amount of the aid render the application of the relevant criteria a rather abstract exercise. In large scale operations involving numerous public and private entities, which are bound to be drawn out over time and possibly modified to meet changing circumstances, it is evident that the evaluation scheme constructed by the Commission, which relies on quantification of the aid as a yardstick, risks ending up being hollow. In this respect, it is embarrassing to notice that the 'feasible, coherent and far reaching' recovery plan which was authorised by the Commission in the Credit Lyonnais case (the first) on the base of the estimate amount of the aid has proved—in a one-year lapse of time—to be a failure, and that such plan was then followed by urgency aids and moreover by a second, heavier, restructuring plan. Moreover, with regard to the Credit Lyonnais affair, it should also be pointed out that another possible infringement of state aid regulations may be found to have occurred in the SDBO acquisition.24 In the course of the restructuring, Credit Lyonnais was buying, at 'special condition', one of its former subsidiaries that had been restructured via the authorised aids.

23

See the Societe Generate recourse to the Court of First Instance, in OJ (1998) C 358/20. 24 Societe de Banque Occidentale—SDBO, C44/96 (NN101/96) in OJ (1996) C346/5 and see also C44/96, in OJ (1997) C207/5 (extension of the procedure).

332

Working Paper X

In the case of the aids granted to the GAN Group25 the second State intervention reached an amount of aids which was seven times higher than the amount of aids approved by the Commission for the first rescue and restructuring operation. In both cases the Commission recognised that—contrary to one of the conditions fixed in its previous authorising decisions—the recovery plans had been modified without prior notification. In the Banco di Napoli case the Commission quantified the aid in 2.217 ITL billion. But it declared compatible with the common market a potential maximum of 11.895 billion. In the same decision are thus approved aid for the amount of 'X' and for an amount of five times 'X'. Moreover, methodologically speaking, it does not seem a perfect solution that the estimate of the aid was commissioned by the Commission to the same merchant bank who was entrusted by Banco di Napoli to draw up the restructuring plan to be submitted to the Commission itself. The overall picture is that of the Commission being not in the condition to effectively give guidance to the process in cases where banks are 'too big to fail'. 3. Appraisal of the Aid Once the nature of the aid measure has been recognised and its quantity assessed, in cases where the said aid affects or can affect trade among Member States, its compatibility with the criteria laid down for the granting of an exemption from the prohibition contained in Article 87(1) of the EC Treaty must be examined. It has already been said that, in the case of banks, the Commission does not intend to depart from the criteria laid down in general in connection with the authorising of rescue and restructuring aid. Accordingly, this type of aid must meet the conditions mentioned above, as better specified in the Communication and practice of the Commission, to which reference should be made.26 Just one point might be underlined here. No aid may be granted on the basis of Article 87(3)(c) when such aid would affect trading conditions to an extent contrary to the common interest. The Commission has specified that it always intends to consider the possible distorting effects of restructuring aid rigorously since such distortion can end up being a burden on efficient enterprises which could not benefit from the aid. This attitude of the Commission must not 25

Gan Group, 98/204/CE of 30.07.1997, in OJ (1998) L78/1. Also in the case of banks does the Commission consider privatisation of the enterprise to be salvaged as one of the guarantees of the success of the restructuring plan: the success of the privatisation demonstrates the implementation of the plan and at the same time reduces the risk of the granting of further aid. This kind of preference on the part of the Commission has, however, raised some doubts as to legitimacy in relation to Article 222 of the EC Treaty. See, Ballarinom & Bellodi (1987:195-6). For a case where the privatisation plans assumed primarily importance for the assessment by the Commission, see the decision concerning the aid granted to the Societe Marseillaise de Credit, referred to above at footnote 19. See also, Roberti (1998:84, sub d). 26

2 - Problems Arising from State Aids in Banking Sector

333

end up being a mere declaration of intent in the case of aid to banks which 'are too big to fail'. As the Commission itself wished to underline in the first Credit Lyonnais case, the harmonisation at Community level of the minimum solvency ratios which banks have to maintain constitutes a fundamental requirement of the parity of competitive conditions in the banking and financial services market in which the banks themselves operate. The large credit institutions are precisely those which are capable of behaving in a way which is least sensitive to the stimuli of competition. At the time of evaluating the risks to assume in the course of business, these credit institutions must not be able to count upon any immunity by virtue of their size. An implicit 'guarantee of recovery' linked to the degree of the banks' exposure would constitute an element wholly distorting of competition. The prohibition on aid must not be subject to automatic exemptions based on the size of the enterprise that seeks assistance. In the Credit Lyonnais case the Commission—given the enormity of the aid granted—affirmed that it wished to demand strong compensatory measures as a condition for granting its authorisation. This quid pro quo, according to the Commission, had, in the first place, to downsize the business of the institution in question through the disposal of some of its activities. The Commission clarified that the activities to be sold off could not consist solely of poorly performing assets. The reasoning of the Commission would seem to indicate, in straightforward language, that the cost of the recovery must above all be borne, to the extent possible, by the institution to be rehabilitated. While this approach may not be liked very much from the point of view of the States and of the undertakings directly involved, it is certainly welcome from the point of view of competitors and, as a result, of the market as a whole. A competitor which, through aggressive and (risky) policies, has reached a dominant or eminent position on the market cannot hide itself under its own shadow at the moment of crisis and cannot, if it is a publicly-owned undertaking, continue to enjoy special advantages by virtue of its status. If its elimination from the market would represent too costly a route for the whole system to take, the undertaking should be downsized to the extent strictly necessary to guarantee its autonomous survival.27 27

In Italy, the credit institutions' supervisory authority, the Bank of Italy, is also entrusted with antitrust functions in the banking sector. In the Banco di Sicilia and Sicilcassa operation [1998], referred to above at footnote 19, the merger between the two local banks was the core of the restructuring plan. From the antitrust point of view, the merger clearly, created a dominant position as a result of which effective competition would be significantly impeded in the Sicilian banking market. Actually, both banks had a strong position on the Sicilian market, owning together 543 operative branches and, in some areas, more than the 50% of the market quotas. The Italian Competition Authority (Autorita Garante della Concorrenza e del Mercato), which has only consultative power with regard to antitrust policy in the banking sector, formulated the opinion that the merger could be declared compatible with antitrust law subject to the condition of structural modification in the banks' network in Sicily, to be effected by the selling of a significant quota of operative branches to competitors (opinion of 29.01.98, n. 5657, in Bollettino Autorita Garante della Concorrenza e del Mercato n. 15/1998). In

334

Working Paper X

These observations also regard the role and the behaviour of national supervisory authorities. The broad powers which they enjoy—and which represent constraints on the freedom of individual economic initiative—must be offset by the efficiency and impartiality of their action. As the Commission has pointed out, the work of supervisory authorities contributes to minimising the aid eventually necessary for the recovery of credit institutions. The same principle of home country control cannot but be based on a minimum common level of efficiency in carrying out supervision. From another point of view, one can also think of imposing a separation between the authority charged with day-by-day prudential supervision and the authority entrusted with the management of the crisis, which acts as suppliers of aids or as the regulatory body in the course of the liquidation proceedings. This can reduce the risk of having supervisory bodies (too) interested in rescuing and restructuring firms to hide failures in supervisory tasks. To summarise, Commission applies to aids granted for rescue and restructuring of banks the ordinary rules applying to industrial and commercial firms. The existence of aids is then evaluated by applying the market private-investor test. Peculiar forms of intervention are represented by hive-off operations financed by the State. Deposit guarantee funds are also sometimes involved in the rescue operations; seemingly, they encounter the favour of the Commission. Quantification of the aids has proved to be very uncertain when it concerns the rescue and restructuring of credit institutions. The experience of last years shows that the very nature of the banking activity and the risk of systemic crisis force the Commission into a subordinate position with regard to the initiative of the States towards the decision to rescue banks that are 'too big to fail'. In the light of the above considerations, one should wonder whether it is not the case to re-think the subject matter of the rescue and restructuring of banks having an impact on the EC. In the last Credit Lyonnais case, such a need was stressed by the Commission with regard to the strategies of the States facing such crises. The core of this new approach should be—according to the Commission—the reinforcement of the principle that the normal solution of the crisis is the winding up of the firms, i.e., the market solution. State regulatory intervention should then be aimed at ensuring that, in the case of major banks, the winding up will be carried out in an orderly manner, using the appropriate measures, such as the recourse to guarantee schemes or temporary state guarantees, which can prevent a more general crisis. One may also wonder whether there is sufficient justification for the introduction of specific rules and procedures at EC level to face possible crises of major banks. itsfinaldecision of 03.04.98, n. B122 (in Bollettino Autorita Garante della Concorrenza e del Mercato n. 15/1998), the Bank of Italy, which was also involved in the rescuing and restructuring operation of the two banks, declared the merger compatible with Italian antitrust law, subject to the main condition of the selling of 21 (twenty-one) branches (on a combined total of 543!) in the two sucessive years. The decision by the Bank of Italy does not contain clear indication of the 'weight', in terms of market quotas, of the branches to be sold.

2 - Problems Arising from State Aids in Banking Sector

335

II. State Guarantees for Loans Granted by Banks A. The Issue According to Community Law Can banks—which are not the beneficiaries of state aid in the form of guarantees—claim payment from the state if guarantees for loans granted by them to companies have not been approved by the Commission? The question is based on the following hypotheses: • that state guarantees for a loan amounts to state aid which is incompatible with the common market; • that such aid is directed towards the borrowers and, accordingly, the banks— which are the lenders—are not the beneficiaries of the aid. In this context,28 my answer to the question is that Community law does not mandate the cancellation of the state guarantee given to the third parties which granted the loan. In other words, Community Law does not permit the State to refuse to honour the guarantee given to the lender. 1. The Commission position in the Communication of 13.11.93 This solution is sufficiently clear from the Commission Communication to the Member States on the application of Articles 92 and 93 [now 87 and 88] of the EC Treaty and of Article 5 of Commission Directive 80/723/EEC on State Enterprises in the Manufacturing Industry (in O.J. C307/3 of 13.11.1993). Paragraph 38 of the said communication provides that if the guarantee given by the State is aid,29 then that aid shall correspond to the difference between the interest that the creditor would have paid on the open market and that which was actually obtained thanks to the guarantee, net of the cost (any premium) of the guarantee itself.

28

The hypotheses do not consider cases of bad faith in the lender. By letter of 5 April 1989, SG(89) D/4328, the Commission informed the Member States of the criteria that it intended to adopt in examining guarantees given by the States. The Commission referred t o 'All guarantees given by the State directly or given by the State's delegation through financial institutions as falling within the scope of Article 92(1) [87(1)] of the Treaty. Each case of the granting of State guarantees has t o be notified under Article 93(3) [88(3)] of the E E C Treaty whether the granting is done in application of a general guarantee scheme or in application of a specific measure'. The Commission also pointed out that it proposed only to examine the regimes which set u p guarantees and n o t all the cases of application of such regimes save for the cases in which guarantees were given outside the scope of a precise regime (letter of 12 October 1989 to the Member States, SG(89) D12772). 29

336

Working Paper X

According to the Commission: Creditors can only safely claim against a government guarantee where this is made and given explicitly to either a public or a private undertaking. If this guarantee is deemed incompatible with the Common Market following evaluation with respect to the derogations under the Treaty, reimbursement of the value of any aid will be made by the undertaking to the government, even if this means a declaration of bankruptcy, but creditors' claims will be honoured. These provisions apply equally to public and private undertakings and no additional special arrangements are necessary for public enterprises other than the remarks made below. It is made clear that, in order for the creditors to be validly able to claim against the state guarantee, the latter must have been granted in an explicit manner. If the guarantee is held to be incompatible with the Common Market, the enterprise will have to reimburse the amount of the aid granted by the State, even if this may lead to a declaration of insolvency, but the demands of creditors should be satisfied. The approach adopted by the Commission, even if contained in a document relative to aids granted to State enterprises in the manufacturing sector, is also valid as regards the case in which a State guarantee is envisaged in favour of a private enterprise whether it be in the manufacturing sector or not. This inference can be drawn both from the text of paragraph 38 cited above and from the introduction to the communication itself, where it is said that the Commission may rely upon the criteria contained in the communication also with respect to cases different from those expressly contemplated therein.30 A state guarantee can amount to aid solely for the fact that the State declares itself willing to grant it, since this, in itself, is already sufficient to facilitate the acquisition of the financing by the enterprise which is a potential beneficiary of the guarantee. The aid is granted when a guarantee is promised and not when it is honoured. 31 Should the enterprise have managed to obtain the loan and even if the State does not have to intervene concretely as a guarantor, the remedy of annulling the guarantee is not sufficient, as the solely effective measure is the recovery of 30

In the Commission Communication relative to de minimis aid OJ (1996) C68, two systems to calculate the subsidy for a given year in the case of loan guarantees granted by the State are indicated: subject to deduction of the premiums paid, the benefit is equal to the reference interest rate and the interest rate effectively obtained thanks to the state guarantee; or equal to the difference between (a) the amount of the residual debt guaranteed multiplied by the co-efficient of risk (probability of non-payment) and (b) the premium paid, in other words: (the sum guaranteed x risk)—premium. The risk co-efficient should mirror the cases of non-payment recorded for loans disbursed in analogous circumstances (sector, size of the undertaking, level of general economic activity). The discount t o the current value must be operated as indicated above'. For an application, see Decision of 26 June 1997, SKET SMM, 97/765/EC, O J (1997) L314. 31 See XXIV Report on Competition Policy, par. 346; Decision of the Commission Nuova Cartiera di Arbatax, 96/434 of 20 March 1996, OJ (1996) LI80/31, at par. IV.

2 - Problems Arising from State Aids in Banking Sector

337

the aid subject to the calculation of the economic advantage enjoyed by the undertaking in having obtained the loan.32 If the financial conditions of the enterprise would not have allowed it to enter the loan market without the backing of the state guarantee, the size of the aid corresponds to the whole financial support granted to the enterprise. In this case, the entire loan must be given back to the State even if such repayment may have, as a consequence, the bankruptcy or liquidation of the undertaking which had originally been the beneficiary of the aid. In cases of this type, the guarantee translates into a real subsidy.33 In this hypothesis, too, it can be affirmed that the lender may, in any case, rely on the guarantee against the State since the lender is not the beneficiary of the aid and the possible dissolution of the State's obligations towards it would not be justified by any purposes of Community law. In any case, once it has honoured the guarantee, the State should exercise its right of subrogation towards the principal debtor, according to domestic law. It cannot renounce to recover the sums it had to pay to the lender, because this could amount to another form of state aid. Even when the lender decides to grant the loan (or is obliged directly or indirectly to do so, as in the case of banks controlled by the State) on conditions which would not be considered normal according to banking practice, an aid element exists, which needs to be quantified and which, if considered incompatible in the light of Community rules on state aid, must be repaid by the undertaking which benefited from it, in accordance with the general principles governing state aid (see par. 42 of the Communication cited above). It is necessary, therefore, to conclude that in the case of aid granted in the form of a state guarantee, the obligation of the State where the loan has already been granted is to demand the restitution of the aid element (calculated as indicated above) and not to revoke the guarantee given to third parties. Following the disbursement of the loan, this latter course of action would be ineffective and, by hitting the lender, it would, moreover, be unjustified and disproportionate with respect to the aim of re-establishing the status quo ante in the market in which the undertaking which had originally received the aid operates: it is only the enterprise which has received the aid which must suffer the consequences of any incompatibility of the same with competition rules since it is precisely that enterprise which has benefited from a competitive advantage and it is normally the market in which it operates and not the one

32

In any case, the State should withdraw the grant of the guarantee, abolishing o r revoking the statutory or administrative measure which provide for it. The willingness of the State to guarantee the firm's debts must cease in as much as it enables the latter to obtain better financial terms for a loan than those normally available on the market (see, for a case, the Commission decision concerning the Portuguese firm EPAC, 9 July 1997, 97/762/CE, in OJ (1997) L311/25. 33 Decision of the Commission, 94/696, on the aid granted to Olympic Airlines, OJ (1994)L273/32.

338

Working Paper X

in which the credit institution operates34 which has, in some way, been distorted by the aid. Furthermore, with the revocation of the guarantee, an element of disproportion would also exists with respect to the borrowing undertaking which benefited from receiving the guarantee since, on closer analysis, what is incompatible with the EC Treaty is not the giving of the guarantee in itself but the fact that this allows, or has allowed, a loan to be obtained on advantageous conditions in comparison with those given by the market (given thefinancialposition of the relevant enterprise). 2. The Position of the Commission in the Recent Draft Commission Notice on the Application of Articles 87 and 88 of the EC Treaty to state aid in the Form of Guarantees In a draft notice recently circulated, the Commission announced a change in its opinion on the effects of the illegality of a state guarantee on third parties.35 According to the draft notice: the illegality of the guarantee may not only affect the borrower (who is the beneficiary of the aid) but also third parties' (par. 6.3.1. of the draft notice). [...] 'A decision, preventing an illegal guarantee from being honoured, not only affects the borrower, but also the third parties. Similar consequences follow if the Commission uses its powers to adopt interim decisions. If the Commission adopts afinalpositive decision stating that the guarantee is compatible, then it may be given and, if necessary, honoured. If, on the other hand, the Commission adopts a negative decision, then the state aid must be repaid and the guarantee, being based on an illegal act, cannot be honoured (par. 6.3.2. of the draft notice). The opinion in the draft notice cannot be shared. As has already been said, Community law does not require the dissolution of the legal relationship between the State and the lender. What is illegal is the aid and not the State obli34

Only if there were state measures which enable individual credit institutions t o grant loans to borrowers benefiting from state guarantees could one also speak in terms of a distortion of competition amongst lending banks. 35 A communication o n state guarantees was already drafted in 1995 (see XXIV Report on Competition Policy, cited above, par. 346). One should hope that, in accordance with principles of sound administrative action, the Commission will finally give formal publication to the new draft rather than continue to circulate it unofficially among experts and other interested institutions. The problem of the validity of the guarantee in cases of illegal state aid arose in the EFIM case (OJ (1993) C267). The Commission said, in a very ambiguous language, that it would not have permitted the payment of the guarantee, even if, in the end, it authorised the Italian government to pay the creditors. The case is not a real precedent, because the State was also the 100% shareholder of the principal debtor, because the payment of the guarantee would (seemingly) have eliminated the intra-group indebtedness, and (mainly) because the Commission communication has a very poor statement of reasons which does not allow a sufficient understanding of the subject matter (with the same perplexities, see the comment of Radicati (1993:539).

2 - Problems Arising from State Aids in Banking Sector

339

gation towards third parties. There is no rule of EC law that causes the invalidity of such an obligation. The Commission decision should impose the reimbursement of the aid and prevent the State from continuing to grant guarantees, but it does not affect, per se, the State's legal relationship with third parties which have already arisen and which do not amount to an aid. As the Court of Justice stated in the case Federation nationale du commerce exterieur,36 only the acts which give execution to an illegal aid are invalid from the beginning. Honouring the obligations towards third parties raised by the guarantee legal relations does not execute the unapproved aid, because the payment from the State to the lender is not state aid. Independent financial institutions are not the watchdogs of state aid Community regulations. Their rights and legitimate expectations cannot be frustrated by a too extensive interpretation of the law on illegal state aid. Moreover, it should be considered that there could be cases where the aid has proved to be illegal ex post facto, because the State or the undertaking did not respected the condition attached to the Commission positive decision, because the positive decision was revoked, or because the individual guarantee or the guarantee scheme were wrongly regarded by the State as belonging to a category which did not have to be notified. In all these cases, it would be clearly unjustified to make the lender run the risk of a Commission intervention that would impede the functioning of the guarantee obligations.

B. The Issue From the Point of View of National Law Although it may be clear that recovery of the aid originally made possible by the state guarantee is sufficient to re-establish parity of conditions among competitors in the guaranteed undertaking's market, it is necessary to consider that, in concrete terms, the recovery of the aid, as well as the claims of the lender towards the State, must be effected in accordance with the provisions of national law. And it is precisely from the point of view of national law that problems may arise in maintaining the State's obligations as guarantor in a case in which a Commission decision has declared the aid to be contrary to Community law and has ordered that the State recover the aid. As regards Italian law, one can imagine, for example, that, as part of the process of recovery, there may have been an administrative order to the effect that the act which gave the right to the borrower to obtain the state guarantee must be revoked or annulled, thus, in turn, rescinding the obligations which have been entered into with the creditors.

36

21 November 1991, C354/90, [1991] ECR I 5505; see also Case C17/91, Georges Lornoy en Zonen NVv. Belgium [1992] ECR 1-6523,1-6545.

340

Working Paper X

Even if, as mentioned above, such a consequence would not be necessary from the point of view of Community Law, it is nonetheless evi