Scope assigns European Stability Mechanism first-time credit rating of AAA with Stable Outlook
Scope Ratings GmbH has today assigned the European Stability Mechanism first-time AAA long-term issuer and senior unsecured foreign-currency ratings, along with a short-term issuer rating of S-1+ in foreign currency. All Outlooks are Stable.
Summary and outlook
The AAA rating assigned to the European Stability Mechanism (ESM) reflects the supranational’s highly rated key shareholders, substantial capital position, very high liquidity buffers and excellent capital markets access. However, the ESM’s mandate to lend to crisis-hit countries results in weak asset quality, and its shareholder base is highly concentrated. The Stable Outlook reflects Scope’s assessment of the ESM’s financial buffers to withstand external and balance-sheet-driven shocks.
The rating could be downgraded if: i) highly rated key shareholders are downgraded; ii) liquidity buffers significantly reduced; and/or iii) the ESM recorded sustained losses via missed repayments from borrowers, resulting in a lower capital base and its preferred creditor status being effectively repealed.
The ESM’s AAA rating is supported by the institution’s highly rated shareholders. Specifically, the supranational’s highest decision-making body, the Board of Governors, is composed of ministers designated by each of the 19 euro area member states, whose voting rights correspond to their respective shares of the ESM’s subscribed capital. On this basis, the four largest euro area economies – Germany (AAA/Stable), France (AA/Stable), Italy (BBB+/Stable) and Spain (A-/Stable) – together account for around 77% of the ESM’s capital. These sovereigns thus constitute the ESM’s key shareholders, with a weighted average rating of AA- per Scope’s methodology.
From this starting point, the ESM’s AAA rating is further underpinned by its strong institutional set-up, including its high capitalisation level under the assumption of full leverage in line with the ESM Treaty and the benefit of having preferred creditor status1. Specifically, the ESM’s available and credible resources amount to around EUR 465.5bn. These include paid-in capital (EUR 80.5bn), accumulated reserves and retained earnings (EUR 2.1bn), retained profits (EUR 0.3bn as of 2018), and the callable capital of the eight shareholders rated AA- or above (EUR 382.6bn). Dividing these assets by the maximum potential liabilities, defined in the ESM Treaty at EUR 500bn, results in a ratio of 93%. This implies that if the ESM were to operate at full capacity as allowed under its treaty, its institutional set-up can ensure available and credible resources would cover almost all its potential liabilities. This is the highest capitalisation level among supranationals by far, underpinned by a very strong capital call mechanism requiring ESM members to irrevocably and unconditionally honour emergency capital calls made by the ESM’s managing director within seven days of receipt, without the need for prior approval from the ESM’s governing bodies1.
In addition, in line with its mandate, the ESM is a lender of last resort and its debt issuances benefit from preferred creditor status, junior only to the IMF, as stated in the ESM Treaty1. This characteristic will also apply to the ESM’s credit line to the Single Resolution Fund once implemented, at the latest in 2024. Overall, the highly rated shareholders, strong capital base, including a credible emergency callable capital mechanism and preferred creditor status, provide the ESM with a very strong institutional set-up relative to peers.
The ESM’s AAA rating also reflects its conservative capital and liquidity management. The ESM’s investment guidelines stipulate that i) the market value of its investment portfolios be at least 15% of its maximum lending volume of EUR 500bn (or EUR 75bn); ii) at least EUR 75bn be invested in assets rated AA- or above; iii) at least 30% of assets, excluding cash, be invested either in supranational institutions or outside the euro area, with no sovereign exposure to an ESM member state representing more than its capital key; and iv) ‘available funds’ cover all payments due over the next 12 months. As a result, the ESM has very high and well-diversified liquidity buffers2.
Specifically, considering the ESM’s cash and deposits as well as its financial assets rated AA- or above, Scope estimates the ESM’s liquid assets at around EUR 86bn for end-2018. Conversely, ESM liabilities due within a year amounted to around EUR 22bn while disbursements of loans totalled EUR 21.7bn3. This brings total liabilities and disbursements due within one year to around 43.7bn at end-2018. On this basis, Scope calculates a weighted average liquid assets ratio for the three years during 2016-18 of around 231% (197% in 2018), which implies available liquid assets can cover all outstanding liabilities and all disbursements due within a year for almost two years without a need to access capital markets. This is one of the highest liquidity coverage ratios among peer supranationals.
Scope also notes that this liquidity assessment uses past disbursements as a proxy for future disbursements, reflecting the ESM’s mandate to continue activities precisely when economic and financial circumstances deteriorate, as could be the case over the coming months via member states accessing the Pandemic Crisis Support facility of up to EUR 240bn. Under a conservative assumption in which member states rated below AA- accessed their entire respective share of this facility, disbursements would increase by about EUR 80bn. All else being equal, this would reduce Scope’s calculation of the liquid coverage ratio for 2018 to about 70%, which would still be above those of other highly rated supranationals.
The ESM’s AAA rating is further underpinned by its strong capital markets access. ESM issuances are designated as Level 1 HQLA assets and granted a 0% risk weighting under the Basel framework, are included in several SSA and government bond indices, and are eligible for the European Central Bank’s asset purchase programmes. Based on ESM data, the European Central Bank holds about 47% of the EFSF/ESM’s outstanding stock of eligible debt as of March 2020, or about EUR 113bn, which is slightly above one-third of the total outstanding debt issued by both institutions. This preferential regulatory treatment together with its strong shareholder and capital base has allowed the ESM to establish itself as a European benchmark issuer. This is evidenced by its 10-year bond yields being near or below 0%, the roughly seven-year average maturity of its issuances, and its diversified funding strategy in terms of instruments and, since the launch in October 2017 of its inaugural US dollar bond, also currencies4.
Prior to the Covid-19 outbreak and the EU Council’s decision to establish the Pandemic Crisis Support facility5, the ESM’s annual funding needs were projected at around EUR 11bn in 2020 and EUR 8bn in 20214. Should the need for more funding arise, Scope expects the ESM to have no difficulty in raising high volumes at very favourable rates, given its established capital markets presence. The ESM’s proven ability to issue across the yield curve, using various instruments (including cashless transactions to recapitalise banks) at very long maturities (up to 40 years), also reduces the significant refinancing risks resulting from the maturity mismatch between its lending and funding: its outstanding loans have very long weighted average maturities (32.3 years for Greece, 14.9 years for Cyprus and 12.5 years for Spain), while its funding averages a maturity of around seven years.
Finally, the ESM’s high capitalisation – which results in a low leverage ratio of around 119% as of end-2018, and which would be around 600% if the ESM operated using its maximum lending capacity of EUR 500bn – compensates for its modest ability to generate income. While Scope notes positively that the ESM has been profitable every year since 2013, the large equity base, conservative investment rules and the low-for-long interest rate environment prevent meaningful internal capital generation compared with other supranationals, even if profits are fully retained. However, the fact that Germany and France provided EUR 216.1m of compensation to the ESM for the negative interest charged on cash held at their national central banks in 2018 is further evidence of the ESM’s importance to the euro area and the support its shareholders are willing to provide.
Despite these credit strengths, the ESM also faces the following credit challenges:
First, despite the benefits afforded by the substantial callable capital of its highly rated shareholders, the ESM’s shareholder base is highly concentrated compared to other supranationals, which increases its dependence on any one shareholder’s ability to honour capital calls. At the same time, while no capital call has ever been made, Scope believes shareholders would be willing to honour such a capital call given their ownership and control of the institution.
Second, the ESM was set up to provide financial assistance to crisis-hit countries, resulting in a weak and concentrated loan portfolio. Loans are granted under strict conditionality and subject to ongoing monitoring of the sovereign’s capacity to repay in the context of the ESM’s Early Warning System. Current outstanding loans are to Greece (BB/Positive) of EUR 59.9bn following a EUR 2bn repayment, Spain (A-/Stable) of EUR 23.7bn following EUR 17.6bn of repayments to date, and Cyprus (BBB-/Stable) of EUR 6.3bn. While the weighted average borrower quality is thus non-investment grade, the ESM’s three borrowers have so far repaid in full and on time. First scheduled principal repayments are in 2022 (Spain), 2025 (Cyprus) and 2034 (Greece).
Finally, Scope notes that under very strict conditions, the ESM can also invest directly into banks’ equity via direct bank recapitalisations, which in principle, can amount up to EUR 60bn. While this poses a significantly higher asset quality risk than the granting of loans, this instrument has not been used to date. In fact, it will be terminated once the ESM functions as the backstop to the Single Resolution Fund (SRF), at the latest in 2024. At that point, the ESM will be able to provide a credit line of around EUR 55bn to the SRF (1% of bank deposits), indirectly exposing the ESM to the SRF’s credit quality rather than that of any requesting bank. The possible credit risk to the ESM from this facility is thus likely to be lower than via direct investments in bank equity, because the SRF relies on payment contributions from all euro area banks (and, going forward, from banks of non-euro-area EU countries participating in the Banking Union) relative to their covered deposits, size, business model and other risk characteristics.
Scope’s supranational scorecard
Scope’s supranational scorecard, which is based on clearly defined quantitative parameters, provides an indicative ‘AAA’ rating for the European Stability Mechanism. Additional considerations allow Scope to incorporate idiosyncratic characteristics that cannot be assessed in a consistent and comprehensive manner across all supranationals, but which may still affect the creditworthiness of the issuer.
For the ESM, no additional consideration has been identified.
A rating committee has discussed and confirmed these results.
For further details, please see the Appendix.
Factoring of Environment, Social and Governance (ESG)
Scope considers ESG sustainability issues during the rating process as reflected in its supranational methodology. Governance-related factors are implicitly captured in Scope’s assessment of the ‘fundamental rating’, which Scope assesses for the European Stability Mechanism with a ‘AA’. Environmental and social factors are considered during the rating process, including the risk to ‘stranded assets’ and the benefits from issuing green and/or social bonds, but these had no an impact on this rating action, even though Scope acknowledges that ESM bonds make structural reforms more sustainable and socially easier to implement, and further, that the ESM itself has invested about EUR 475mn in social or green bonds.
The main points discussed were: i) key shareholders and institutional set-up; ii) preferred creditor status and mandated activities; iii) liquidity management and buffers; iv) funding activity; v) asset quality, including existing loans and the Pandemic Crisis Support facility; vi) profitability; and vii) peers.
Rating driver references
1. ESM Treaty
The methodology applicable for this rating and/or rating outlook, ‘Supranational Entities’ dated 4 September 2019, is available on https://www.scoperatings.com/#!methodology/list.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.
Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the rating process. The rating process was conducted:
With Rated Entity or Related Third Party Participation NO
With Access to Internal Documents NO
With Access to Management NO
The following substantially material sources of information were used to prepare the credit rating: public domain.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.
This credit rating and/or rating outlook is issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Rating prepared by Alvise Lennkh, Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first released by Scope on 8 May 2020.
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.
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