ECB Says Mix of Bad Bank, Asset Guarantees Cuts Costs

By Meera Louis and Matthew Newman

Feb. 10 (Bloomberg) -- The European Central Bank said governments should consider combining a so-called bad bank with guarantees of securities to achieve the most cost-effective way of ridding lenders of toxic assets.

In draft guidelines being discussed at a meeting of European finance ministers in Brussels today, the ECB said the credit crisis shows no sign of ending and that the number of illiquid assets on banks’ books will probably rise.

Lawmakers from Washington to Berlin are studying how to clear the toxic assets clogging bank balance sheets and preventing them from lending. Economist Nouriel Roubini says global bank write-offs could triple to $3.6 trillion, and the ECB is seeking to provide a framework to deal with further woes.

“The credit crisis has not yet reached the bottom of the cycle,” the ECB said in a report obtained by Bloomberg News and dated Feb. 9. “The amount of impaired assets is likely to continue growing in the future.”

In the U.S., Treasury Secretary Timothy Geithner later today will announce a plan to help banks remove illiquid securities from balance sheets. Officials haven’t yet decided on the specific mechanics of a facility, though it would create a public-private investment fund to take on older assets in lieu of the bad bank of earlier proposals.

Luxembourg’s Jean-Claude Juncker, who led talks yesterday among euro-area finance chiefs, said there is a “vital” need to tackle toxic assets in Europe. He said ministers discussed the issue “at length” and hope to reach agreement among all 27 European Union finance chiefs today.

‘Upping the Tempo’

“The various instruments that might be deployed could be used in some countries for some banks in certain situations,” Juncker said at a press conference in Brussels last night. “We continue to coordinate the European approach to toxic assets, and in the next few weeks, we will be upping the tempo there.”

The guidelines aren’t “a one-size-fits-all proposal,” EU Monetary Affairs Commissioner Joaquin Almunia said after yesterday’s meeting, which he attended along with European Commission President Jose Barroso. “We need to guarantee a level playing field,” Almunia said. “This does not mean that all the formulas should be the same.”

While acknowledging that the best strategy varied depending on the bank and country, the ECB noted that Switzerland recently extended aid to UBS AG through a “hybrid scheme” involving elements of a bad bank and insurance. The Swiss National Bank and UBS set up a special fund to buy as much as $60 billion in toxic investments from UBS.

Commission Support

The strategy also found support in a separate draft report by the European Commission, which was prepared with ECB input. To control costs “one could consider combining a bad-bank approach and asset insurance whereby bad assets are transferred to a single entity which benefits in some way from a government guarantee,” the commission, the EU regulator in Brussels, said in the report dated Feb. 6.

European leaders may hold another informal meeting to discuss how to cope with the economic crisis before the end of the month, the EU said in a statement yesterday. In addition, finance ministers and central bankers from the Group of Seven countries are meeting in Rome on Feb 14.

The ECB said a bad bank would work best in an environment in which there was uncertainty regarding the future quality of bank assets or the impaired securities are concentrated in a few institutions. Insuring the assets may be the best approach if they are hard to value or governments have bloated public finances, it said.

Consistent Treatment

The commission also said governments should agree on the criteria for pooling impaired investments to ensure “the consistent treatment of assets” for banks with cross-border activities. An agreement is needed on the range and criteria for eligible assets and how they should be valued “to prevent that differences in approach result in opportunities for cross-border arbitrate and competition distortions,” it said.

The commission, which ensures that state aid doesn’t distort competition in the 27-member EU, said governments must avoid a subsidy war, which could hurt public finances. Jonathan Todd, spokesman for EU Competition Commissioner Neelie Kroes, had no comment on the guidelines.

In setting out broad parameters for asset-support programs, the ECB said participation should be voluntary and priority given to those with large amounts of impaired assets. The definition of assets eligible for support should be kept broad and valuation of the assets is key to any plan’s success.

Banking System

Risk should be shared between the state and the banking system, while the program should be allowed to run possibly as long as it takes the assets to mature, according to the ECB report. The banks should be allowed to be run according to business principles and there should be yardsticks established to judge the success of the plan, it said.

“I think there will not be an agreement on a single methodology of how to deal with toxic assets today,” Czech Finance Minister Miroslav Kalousek told reporters before today’s meeting. “But I hope we will further advance discussions.”

To contact the reporters on this story: Meera Louis in Brussels in Brussels at mlouis1@bloomberg.net; Matthew Newman in Brussels at mnewman6@bloomberg.net.