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 ESM 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 capitalisation, strong liquidity management, and status as a preferred creditor further support the ratings. The ESM has a maximum lending capacity of €500 billion, of which €372 billion is available for new lending.

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 commitment to support the ESM. DBRS defines the core shareholder group as the Federal Republic of Germany (AAA, Stable), the Republic of France (AAA, Stable), the Republic of Italy (A low, Under Review with Negative Implications), 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.

Since Germany and France are the largest core shareholders, and 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. A one-notch downgrade of either would unlikely materially weaken the ESM’s Support Assessment. This is because of the strong political commitment of member states to EMU, and the added benefits associated with the ESM’s multiple sources of support. On 5th August, DBRS placed Italy’s A (low) long-term ratings Under Review with Negative Implications. If DBRS were to downgrade Italy by one-notch, this would not likely result in a downgrade of the ESM ratings.

DBRS believes the commitment of core shareholders to support the ESM is strong. The ESM was created to protect financial stability in the Euro area, and is an integral part of the 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, evidence 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 to 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 high, Stable) in August 2015. Under the terms of this agreement, the ESM is expected provide up to €86.0 billion, including up to €25.0 billion for bank recapitalisation and resolution. Of the total amount agreed, €28.9 billion has been disbursed, €5.4 billion of which was used to recapitalise Greek banks. The loan to Greece, which accounts for close to 17% of the ESM’s maximum lending capacity, increases the credit exposure on the ESM’s portfolio. Nevertheless, this operation is 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 should 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. Subject to Greece’s ongoing adherence to the support programme, additional debt relief measures for Greece could be adopted, including a smoothening in the repayment profile of certain EFSF loans. In DBRS’s view, if this involved a lengthening of maturities and debt swaps to replace short-term ESM bonds with longer term ESM bonds bearing lower repayment rates, the net loss to the ESM could be zero or minimal, and the ESM’s credit quality could be unaffected. On the other hand, debt relief measures, such as a reduction in the face value of ESM loans to Greece, could result in a net loss to the ESM and a decline in creditworthiness. Nevertheless, creditors have excluded a reduction in the face value of ESM bonds as a possible debt relief measure. Even in the event of a reduction in face value, however, losses would be absorbed from the ESM’s 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 loan portfolio is characterized by a high degree of concentration, in Greece, Spain and Cyprus. 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 so far repaid €5.6 billion of its ESM loans. The ESM also approved a €9.0 billion financial assistance programme to the Republic of Cyprus (B, Stable) in May 2013. The programme ended in March 2016 and only €6.3 billion was disbursed, including €1.5 billion for bank recapitalisation.

RATING DRIVERS
The ESM’s ratings could be lowered if there is deterioration in both assessments, or if 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 the reason for the downgrades was the result of a weakening in the cohesion of the Euro area, or in the political commitment of core shareholders to Economic and Monetary Union (EMU). Likewise, substantial credit losses or increase in risk exposure could put downward pressure on the Intrinsic Assessment and, potentially, the ESM’s ratings.

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.

This is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.

This rating did not include participation by the rated entity or any related third party and is based solely on publicly available information.

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.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. 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.

Lead Analyst: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: 4 April 2014
Last Rating Date: 12 February 2016

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