DBRS Confirms European Stability Mechanism at AAA Stable Trend

DBRS, Inc. has confirmed the European Stability Mechanism’s long-term issuer rating at AAA and short-term issuer rating of R-1 (high). The trend on both ratings is Stable. DBRS rates the European Stability Mechanism (ESM) as AAA on the basis of both its Support Assessment and its Intrinsic Assessment. The ratings are underpinned by the creditworthiness of the ESM’s core shareholders and their collective commitment to meet a potential call on capital. The ESM’s high capitalization, strong liquidity management, and status as a preferred creditor provide a further source of strength, making a call on capital unlikely.

However, the ESM’s ratings could be lowered if there is deterioration in both assessments or there is a marked deterioration in either assessment. Multiple notch downgrades of core shareholders could put downward pressure on the ESM’s ratings, particularly if it is the result of deterioration in the cohesion of the Euro area or a weakening of the political commitment of core shareholders to the monetary union. In addition, substantial credit losses or a significant increase in risk exposure could put downward pressure on the Intrinsic Assessment and, potentially, the ESM’s ratings.

The Support Assessment of the ESM is at a level equivalent to AAA. The Support Assessment is based on the overall credit quality of the ESM’s core shareholders and their collective commitments to support the ESM. DBRS defines the core shareholder group as the Federal Republic of Germany (AAA Stable), the Republic of France (AAA Negative), the Republic of Italy (A low, Negative) and the Kingdom of Spain (A low, Stable). These four shareholders are the largest by capital subscription size and cumulatively account for 77% of the capital contribution key.

Because Germany and France are the largest core shareholders and the sum of their subscribed capital covers two-thirds of the ESM’s total lending capacity, DBRS believes the median core shareholder rating of AAA is the best measure of the overall capacity of the core shareholder group to honor ESM liabilities. While DBRS changed the trend on France’s AAA long-term ratings to Negative from Stable on November 7, 2014, a one-notch downgrade of France’s ratings to AA (high) is unlikely to materially weaken the ESM’s Support Assessment. This is due to the strong political commitment of member states to the monetary union and the added benefits associated with the ESM’s multiple sources of support.

DBRS believes the commitment of core shareholders to support the ESM is very strong. The ESM was created to protect financial stability in the Euro area. It is a permanent mechanism and replaces the European Financial Stability Facility (EFSF) as the Euro area’s sole crisis resolution mechanism. Moreover, the ESM has been an integral part of a broader policy response to the Euro area sovereign debt crisis and an illustration of the commitment of member states to preserve the monetary union. Given the critical importance of the ESM mandate, core shareholders are highly likely to meet their capital obligations in a stress scenario.

The Intrinsic Assessment of the ESM is also at a level equivalent to AAA. The capital structure consists of €81 billion in paid-in capital, which serves as a strong backing for the ESM’s bonds and other debt securities, with another €624 billion in committed callable capital. The paid-in capital accounts for 16% of the ESM’s total lending capacity and 177% of its current loan book. Since the ESM is required to maintain a ratio of “paid-in capital / ESM debt” above 15%, any significant losses are likely to trigger a call on capital. This robust capital structure strengthens the resilience of the ESM and helps ensure stable access to financing during periods of economic downturns or financial market stress.

All ESM financial assistance programs are subject to strict conditionality. Although programs are provided to member states facing financing difficulties, policy conditionality helps mitigate credit risk. However, if a borrower defaults, losses would be absorbed from the reserve fund, followed by paid-in capital and then callable capital. Paid-in capital cannot be lent out as part of a financial assistance program under any of the ESM’s existing instruments. Instead, it is invested in highly rated liquid assets, along with the reserve fund, and acts as a capital cushion.

The ESM’s conservative liquidity management practices also support the Intrinsic Assessment. Operational guidelines require that liquid assets cover ESM obligations coming due over the next 12 months. The reserve fund and paid-in capital provide the ESM with a liquidity buffer in the event of an unexpected cash shortfall.

In addition, the ESM benefits from preferred creditor status. It is important to note that the financial assistance program for Spain was negotiated by the EFSF prior to being transferred to the ESM. Therefore, loans provided under the Spanish program are considered pari passu with other unsecured creditors. Nevertheless, in the case of the ESM loan to Cyprus and other future loans, preferred creditor status is expected to protect ESM capital by reducing the likelihood of credit losses.

However, the ESM credit portfolio is characterized by a high degree of concentration. A bank recapitalization loan facility to the Kingdom of Spain – totaling €100 billion – was approved by the EFSF in 2012 and subsequently transferred to the ESM. Of this amount, €41.3 billion was requested by the Spanish government. The remaining amount of €58.7 billion was cancelled. Spain repaid €1.6 billion of its ESM loans in July 2014. In addition, the ESM approved a €9.0 billion financial assistance program to the Republic of Cyprus (B low, Stable) in May 2013.

Notes:
All figures are in Euros (EUR) unless otherwise noted.

The principal applicable methodology is Rating Supranational Institutions and Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include the European Stability Mechanism and the International Monetary Fund. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer and did not include participation by the issuer or any related third party.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Michael Heydt
Rating Committee Chair: Roger Lister
Initial Rating Date: 4 April 2014
Most Recent Rating Update: 12 September 2015