DBRS Confirms European Stability Mechanism at AAA Stable Trend

DBRS Ratings Limited (DBRS) 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 strong 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.

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 a weakening in the cohesion of the Euro area or in the political commitment of core shareholders to the Economic and Monetary Union. Likewise, 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. This is based on the overall credit quality of the ESM’s core shareholders as well as 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, Stable) and the Kingdom of Spain (A low, Positive). 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 honour ESM liabilities. While DBRS changed the trend on France’s AAA long-term ratings to Negative from Stable on 7th November 2014, a one-notch downgrade of France’s ratings to AA (high) would be unlikely to materially weaken the ESM’s Support Assessment. This is because of the strong political commitment of member states to the Economic and 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, as an integral part of a broader policy response to the Euro area sovereign debt crisis. It is a permanent mechanism and replaces the European Financial Stability Facility (EFSF) for all new financing support as of July 2013. It is, therefore, an illustration of the commitment of member states to preserve the monetary union. Given the critical role 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 €80.5 billion in paid-in capital, which serves as a strong backing for the ESM’s bonds and other debt securities, with another €624.3 billion in committed callable capital. The paid-in capital accounts for 16% of the ESM’s total lending capacity and 127% 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.

Following a request from the Greek government in July 2015, the ESM Board of Governors approved a three-year Financial Assistance Facility Agreement with Greece (CCC, Stable) in August. Under the terms of this agreement, the ESM will provide up to €86.0 billion, including up to €25.0 billion for bank recapitalisation and resolution. Of the first tranche approved for €26.0 billion, €21.4 billion has been disbursed. The loan to Greece, which accounts for about 17% of the ESM maximum lending capacity, increases the credit exposure on the ESM’s portfolio. Nevertheless, this operation will be in line with the ESM’s mandate. Moreover, strict programme conditionality, and the ESM’s preferred creditor status, strong liquidity management, and high capital levels will continue to mitigate credit and concentration risks.

All ESM financial assistance programmes are subject to strict conditionality. Although programmes 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 programme 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 portfolios provide the ESM with liquid assets in the event of an unexpected cash shortfall.

Moreover, the ESM benefits from preferred creditor status. It is important to note that the financial assistance programme for Spain was negotiated by the EFSF prior to being transferred to the ESM. Therefore, loans provided under the Spanish programme 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 Spain – totalling €100.0 billion – was approved by the EFSF in 2012 and subsequently transferred to the ESM. Of this amount, €41.3 billion was disbursed to the Spanish government and the remaining €58.7 billion was cancelled. Spain has repaid €5.6 billion of its ESM loans up to end 2015. The ESM also approved a €9.0 billion financial assistance programme to the Republic of Cyprus (B, Stable) in May 2013, with €6.3 billion already disbursed.

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

The principal applicable methodologies are 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.

These can be found on www.dbrs.com at: http://www.dbrs.com/about/methodologies

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.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Information regarding DBRS ratings, including definitions, policies and methodologies are available on www.dbrs.com.

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.

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 outlooks and ratings are under regular surveillance.

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.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

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Lead Analyst: Adriana Alvarado, Assistant Vice President, Global Sovereign Ratings
Initial Rating Date: 4 April 2014
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Last Rating Date: 21 August 2015

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