DBRS Confirms the European Stability Mechanism at AAA, Stable Trend

DBRS Ratings Limited (DBRS) 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.

KEY RATING CONSIDERATIONS

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 a very strong Intrinsic Assessment given the institution’s high capitalisation, its strong and effective liquidity management, and its status as a preferred creditor.

RATING DRIVERS

The ESM’s ratings could come under downward pressure if there were to be a deterioration in the Support and Intrinsic assessments, or if there was a marked deterioration in either assessment. For example, 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 downward pressure to the institution’s ratings.

RATING RATIONALE

The Support Assessment Reflects the ESM’s Core Shareholders Commitment to the Institution

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, 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 lower the ESM’s weighted median core shareholders’ rating, the entity’s overall Support Assessment could 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 the ESM’s members to the institution.

The ESM was created to preserve 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 has replaced the European Financial Stability Facility (EFSF, AAA, Stable) for all new financing support since July 2013. Its creation 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.

In DBRS’s view, the 2017 election outcomes in France, in the Kingdom of the Netherlands (AAA, Stable), in Austria (AAA, Stable) and in Germany, reinforce the commitment from core members to Europe and its institutions. DBRS will, however, continue to monitor the European political landscape going forward, particularly following election results in Italy in March 2018 and the formation of a coalition government between the two main anti-establishment parties. Although the new government platform includes Eurosceptic elements, DBRS remains of the view, that the risk of Italy leaving the euro area is still very low. Any potential renewed Euroscepticism is, therefore, likely to be limited in DBRS’s view, by concerns regarding adverse market reactions.

The ESM’s Intrinsic Assessment Largely Reflects its Very Strong Capitalisation

The Intrinsic Assessment of the ESM is also at a level equivalent to AAA. The capital structure consists of €80.48 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 103% 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 downturn or financial market stress. The ESM has a maximum lending capacity of €500 billion, of which €383 billion is currently available for new lending; €77.9 billion is outstanding; and €39.1 billion is committed, but not disbursed (to Greece). By the time the Greek programme concludes on 20 August 2018, the Eurogroup announced that an additional disbursement of €15 billion can be expected. This disbursement, which remains subject to the completion of national procedures, will correspond to the fifth and last tranche of the programme and will be used for €5.5 billion to cover debt servicing needs and for €9.5 billion to build up the country’s cash reserves.
The ESM’s High Loan Portfolio Concentration is Inherent to its Mission

The ESM loan portfolio is characterized by a high degree of concentration in the Hellenic Republic (B (high), Positive), Spain and Cyprus (BB, Positive). The total amount of debt outstanding represents €77.9 billion as of 30 June 2018, of which 58% relates to Greece, 34% to Spain and 8% to Cyprus. Of the total amount initially agreed under the Greek programme (€86 billion), €46.9 billion has so far been disbursed. This amount should reach a maximum of €61.9 billion when it concludes later this year, increasing the ESM concentration to Greece to around 65%. Despite this scheduled increase, the strict programme conditionality and review process, 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 and medium-term debt relief measures announced for Greece do not affect the institution’s creditworthiness. Indeed, 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 Greek debt.

These measures include a deferral of EFSF interest and amortisation by 10 years and an extension of the maximum weighted average maturity (WAM) by 10 years. Contingent on compliance with the terms of the enhanced post-programme surveillance, the Eurogroup agreed to return eligible ANFA and SMP profits to Greece in equal bi-annual instalments and to waive the step-up interest margin on loans of the second adjustment programme that relate to the debt buy-back. 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.

ESM’s Strong Liquidity Management and Preferred Creditor Status Also Support the Institution’s Creditworthiness

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.

DBRS believes that the ESM preferred creditor status supports its Intrinsic Assessment rating by providing additional protection compared to unsecured creditors. DBRS, nevertheless, notes 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.

Finally, DBRS views the expected extension of the ESM’s financial stability mission to also provide credit lines in support of the Single Resolution Board (SRB) for backstopping the Single Resolution Fund (SRF), as unlikely to affect its credit assessment of the institution. The potential widening of the ESM’s mission is, in DBRS’s opinion, an indication of the strengthening of its policy mandate, a feature supporting DBRS’s assessment of the shareholders’ commitment to the institution.

RATING COMMITTEE SUMMARY

The main points discussed during the Rating Committee include: Greece debt relief measures, ESM’s risk profile, ESM’s core shareholders commitment to the institution.

Notes:

All figures are in Euros unless otherwise noted.

The principal applicable methodology is Rating Supranational Institutions, which can be found on the DBRS website www.dbrs.com at 32TUhttp://www.dbrs.com/about/methodologiesU32T. 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 at 32Thttp://www.dbrs.com/ratingPolicies/list/name/rating+scales32T.

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 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:
32Thttp://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml32T.

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

Lead Analyst: Nicolas Fintzel, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions and Sovereign Ratings Group

Initial Rating Date: 4 April 2014
Last Rating Date: 2 February 2018

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