DBRS Confirms European Stability Mechanism at AAA, Stable Trend

DBRS Ratings Limited (DBRS) has confirmed the European Stability Mechanism’s (ESM) Long-Term Issuer Rating at AAA and Short-Term Issuer Rating at R-1 (high). The trend on both ratings is Stable.

DBRS rates the ESM on the basis of its Support Assessment and its Intrinsic Assessment. The ratings are underpinned by the creditworthiness of the ESM’s core shareholders and their strong and collective commitment to meet a potential call on capital. The ESM’s ratings also benefit from the institution’s high capitalisation, its strong and effective liquidity management, and its status as a preferred creditor.

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 institution. DBRS defines the ESM core shareholder group as the Federal Republic of Germany (AAA, Stable), the Republic of France (AAA, Stable), the Republic of Italy (BBB (high), Stable), and the Kingdom of Spain (A (low), Stable). These four shareholders are the largest by capital subscription size, each representing more than 10% of the ESM capital on an individual basis and cumulatively accounting for 77% of the total capital contribution key. Since Germany and France are the largest core shareholders (representing 47% of the ESM’s capital and 61% of the core shareholders’ capital), the weighted median core shareholders’ rating stands at AAA. While a one-notch downgrade of either would weaken the ESM’s weighted median core shareholders’ rating, the entity’s overall Support Assessment is likely to remain at AAA. This is because of the added benefits associated with the multiple sources of support, as well as the strong political commitment of ESM’s members to the institution.

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 which replaces the European Financial Stability Facility (EFSF) for all new financing support since July 2013. It is, therefore, evidence of the commitment of the member states to preserve the EMU. Given the critical role of the ESM mandate, DBRS believes that core shareholders are highly likely to meet their capital obligations in a stress scenario. While such commitment from core members is expected to remain strong, DBRS will continue to monitor the European political landscape throughout 2017, given upcoming elections in the Kingdom of the Netherlands (AAA, Stable), France, Germany, and potentially Italy.

The Intrinsic Assessment of the ESM is also at a level equivalent to AAA. The capital structure consists of €80.3 billion in paid-in capital, which serves as a strong backing for the ESM’s bonds and other debt securities, with another €624.5 billion in committed callable capital. The paid-in capital accounts for 16% of the ESM’s total lending capacity and 110% of its current loan book. Since the ESM is required to maintain a ratio of “paid-in capital to ESM debt” above 15%, only significant losses could trigger a call on capital based on that criteria. DBRS considers the ESM’s currently paid-in and callable capital as the main drivers of the institution’s AAA Intrinsic Assessment. The ESM’s overall capital structure is robust and helps ensure stable access to financing during periods of economic downturns or financial market stress. The ESM has a maximum lending capacity of €500 billion, of which €373 billion is currently available for new lending; €72.7 billion is disbursed and €54.3 billion is committed, but not disbursed (to Greece). Going forward, additional disbursements will depend on the country meeting the conditions set in its programme.

The ESM loan portfolio is characterized by a high degree of concentration, in the Hellenic Republic (CCC (high), Stable), Spain and Cyprus (B, Positive). The total amount of debt outstanding represents €72.7 billion at year-end 2016, of which 48% relates to Spain, 43% to Greece and 9% to Cyprus. The share of Greek loans is expected to increase going forward, given that the programmes with the two other countries have concluded and in the case of Spain, several debt repayments have already been made. The Greek programme with the ESM started in August 2015 and was agreed to provide financing up to a maximum of €86.0 billion. Of the total amount agreed, €31.7 billion has so far been disbursed. The maximum amount committed to Greece, which accounts for around 17% of the ESM’s maximum lending capacity, if provided in full, would substantially increase the credit exposure of the ESM’s portfolio to a single country. Nevertheless, the strict programme conditionality and review process coupled with the ESM’s preferred creditor status, its strong liquidity management, and high capital levels, should continue to mitigate the related credit and concentration risks.

In addition, DBRS considers that the short-term debt relief measures for Greece, formally adopted by the Boards of Directors of the ESM and the EFSF on the 23rd January 2017, having been previously endorsed by the Euro area finance ministers on the 5th December 2016, do not affect the institution’s creditworthiness. Indeed, while these imply no direct costs for the ESM and EFSF member states, they meet the ESM’s key mandate of supporting member states and exclude a nominal haircut on the Greek debt. The measures include a smoothing of the country’s debt repayment profile on the EFSF debt, a reduction in Greece’s interest rate risk (both on EFSF and ESM loans) and a waiver of the step-up interest margin on some of the EFSF financing. DBRS assesses that these measures should not have any impact on the ESM’s capital position, given that no net loss is foreseen. As a result, the institution’s loss absorption capacity remains extremely strong, given its reserve fund, paid-in capital and callable capital.

The ESM’s conservative liquidity management practices also support DBRS’s analysis of the institution’s Intrinsic Assessment. Operational guidelines require liquid assets to cover the ESM obligations coming due in the next 12 months. These assets reflect the ESM paid-in capital, which cannot be lent out as part of a financial assistance programme under any of the ESM’s existing instruments. Instead, these funds are invested in highly rated liquid assets, and act as a capital and liquidity cushion.

Finally, DBRS believes that the ESM preferred creditor status supports its Intrinsic Assessment rating by providing additional protection compared to unsecured creditors. DBRS, nevertheless, points out 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 and do not benefit from the additional seniority provided to the funding of other programmes.

RATING DRIVERS

The ESM’s ratings could come under downward pressure if there is a deterioration in the Support and Intrinsic assessments, or if there is a marked deterioration in either assessment. As a result, the downgrade of core shareholders, particularly if it reflected a weakening in the cohesion among the Euro area countries or a reduction in their political commitment to the Economic and Monetary Union (EMU), could put downward pressure on the ESM’s ratings. Similarly, a weakening of the institution’s Intrinsic Assessment, exemplified by an increase in risk exposure, the materialisation of substantial credit losses or evidence of weaknesses in the ESM’s early warning system could add pressure on the institution’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, the European Financial Stability Facility, 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 historical default rates published by the European Securities and Markets Authority (“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: Nicolas Fintzel, 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 August 2016

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