DBRS Morningstar Confirms the European Stability Mechanism at AAA, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) 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 Morningstar rates the ESM on the basis of its Support Assessment and its Intrinsic Assessment. The Support Assessment is the primary driver of the ESM’s ratings and is at a level equivalent to AAA reflecting the overall credit quality of the ESM’s core shareholders, as well as their collective commitment to support the institution. The ESM’s Intrinsic Assessment, also at a level of AAA, is underpinned by (1) the institution’s high capitalisation; (2) its strong and effective liquidity management; and (3) its preferred creditor status.

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, with respect to the Support Assessment, multiple downgrades of core shareholders or a marked deterioration in creditworthiness of a single core shareholder, particularly if it reflected a weakening in their cohesion or a reduction of their political commitment to the Monetary Union, could put downward pressure on the ESM’s ratings. A weakening of the institution’s Intrinsic Assessment, exemplified by a substantial increase in risk exposure, the materialisation of large 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

DBRS Morningstar 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, Positive). Since Germany and France are the largest core shareholders (61% of the core shareholders’ capital), the weighted median core shareholders’ rating is 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 reflects the added benefits associated with the multiple sources of support, as well as the overarching political commitment of the ESM members to the institution.

In May 2019, the European Parliamentary elections confirmed the pro-European parties’ majority, although traditional groups received fewer votes than in previous elections. The Greens and Liberals increased their share, as well as the right-wing nationalists and populist groups. DBRS Morningstar expects environmental and European integration themes to continue to dominate Parliamentary discussions, while Euroscepticism, although still a risk to European cohesion, has somewhat receded in the last quarters.

A package of reforms has been endorsed by Euro area countries in December 2018 and a revision of the ESM Treaty drafted in June 2019 that strengthens the ESM’s role. The reform include (1) the provision of a credit line of around €55 billion in support of the Single Resolution Board (SRB) for backstopping the Single Resolution Fund (SRF) by 2024; (2) a reinforced role for the ESM in future assistance programmes and debt sustainability analysis in cooperation with the European Commission; (3) the introduction of single-limb collective action clauses from 2022 in Euro area sovereign bond issues as well as a role of facilitator for the ESM in the dialogue between the country and private investors; and (4) a better effectiveness and enhanced clarity of the ESM’s precautionary credit lines. The latter includes the availability of Precautionary Conditioned Credit Line (PCCL) for countries where economic and financial situation is fundamentally sound and that meet a set of eligibility criteria (more flexibility) and Enhanced Conditions Credit Line (ECCL) for members that do not comply with some of these criteria and need to adopt corrective measures (attached conditionality).

In DBRS Morningstar’s opinion, the widening of the ESM’s mission would indicate a strengthening of its policy mandate and would support DBRS Morningstar’s assessment of the shareholders’ commitment to the institution. However, the ratification process initially scheduled to start quickly after the Eurogroup agreement in principle at the beginning of December 2019 has now been pushed back by several months, reflecting some political challenges primarily coming from Italy. While DBRS Morningstar still considers the ratification of the revised ESM Treaty as the most likely scenario, further discussions might be necessary in coming months to obtain the full buy-in from all shareholders.

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

The AAA Intrinsic Assessment of the ESM primarily reflects the entity’s capital structure, which consists of €80.55 billion in paid-in capital, serving as a strong backing for the ESM’s bonds and other debt securities, and another €624.25 billion in committed callable capital. The paid-in capital accounts for 16% of the ESM’s total lending capacity of €500 billion, of which €410.1 billion is available for new lending and 90% of its current loan book of €89.9 billion.

The ESM loan portfolio is characterised by a high degree of concentration in the Hellenic Republic (BB (low), Positive), representing 67% of the total, Spain with 26% and Cyprus (BBB (low), Positive) with 7%. In DBRS Morningstar’s view, 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.

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

DBRS Morningstar also views positively the ESM’s conservative liquidity management practices. 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 Morningstar considers that the ESM preferred creditor status supports the institution’s Intrinsic Assessment by providing additional protection compared to unsecured creditors. DBRS Morningstar, nevertheless, notes that the financial assistance programme for Spain was negotiated by the European Financial Stability Facility (EFSF, AAA Stable) prior to being transferred to the ESM and, therefore, does not benefit from the additional seniority provided to the funding of other programmes.

RATING COMMITTEE SUMMARY

The main points discussed during the Rating Committee include the reforms of the ESM and their ratification, the commitment of the ESM’s shareholders to the institution and the ESM’s risk profile.

Notes:

All figures are in Euros unless otherwise noted.

The principal applicable methodology is Rating Supranational Institutions, which can be found on the DBRS Morningstar website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include the European Stability Mechanism, the European Financial Stability Facility and the International Monetary Fund. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be 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 Morningstar 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 Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar 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 GmbH are subject to EU and US regulations only.

Lead Analyst: Nicolas Fintzel, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: April 4, 2014
Last Rating Date: July 26, 2019

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