Rating action

Scope Ratings GmbH (Scope) has today affirmed the European Stability Mechanism (ESM)’s 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.

For the detailed rating report, click here.

Summary and Outlook

Scope’s AAA rating on the 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 a highly concentrated borrower base and weak profitability. Its shareholder base is also highly concentrated. The Stable Outlook reflects Scope’s assessment that the ESM’s financial buffers help it to withstand external and balance sheet-driven shocks, including expected changes resulting from the revised ESM treaty. Together with other reforms, the revised treaty will empower the ESM, after ratification by all 19 ESM members, to provide loans to the Single Resolution Fund to finance a bank resolution up to an amount equal to its target size (i.e. EUR 68bn).

The ratings/Outlooks could be downgraded if, individually or collectively: i) liquidity buffers significantly reduced; ii) the capital base weakened significantly due to sustained losses caused by missed borrower payments and/or a material increase in the maximum lending capacity; iii) the asset quality of the loan portfolio deteriorated significantly; and/or iv) highly rated key shareholders were downgraded.

Rating rationale

The first driver underpinning the ESM’s AAA rating is its substantial capital position.

Scope uses an implied leverage ratio as the cornerstone of its capitalisation assessment, which assumes that the ESM operates at maximum lending capacity of EUR 500bn as per its founding treaty. For the numerator of this ratio, we include paid-in capital (EUR 80.5bn) and accumulated reserves and retained earnings (EUR 3.0bn). These resources amount to EUR 83.5bn and result in a maximum leverage ratio of about 16.7%. The ESM’s actual capitalisation ratio, based on total disbursed loans of about EUR 89.9bn at end-2021, stands at 93%, the highest among rated peers. This reflects an exceptionally high capacity to absorb losses on existing loans. The actual capitalisation ratio has remained stable since the completion of Greece's ESM programme in 2018.

The capital position is further 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 the call’s receipt, without the need for prior approval from the ESM’s governing bodies¹.

The second driver supporting the ESM’s AAA rating consists of its very high liquidity buffers.

The ESM’s investment guidelines² 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 buffers.

Considering the ESM’s cash and deposits as well as its assets available within 12 months, Scope estimates the ESM’s liquid assets at around EUR 70bn for end-2021. Conversely, ESM liabilities due within a year amounted to around EUR 38bn, while no further loans have been disbursed since 2018. On this basis, Scope calculates a weighted average liquid assets ratio for the three years during 2019-21 of around 195% (206% in 2020), 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.

In a stress scenario, the ESM’s liquidity coverage ratio would reduce to about 91%, which would still be in line with other highly rated supranationals. Such a scenario entails a severe deterioration in financial market conditions. It also assumes all member states rated below AA- will access the full amount of their respective share (2% of GDP) of the ESM’s Pandemic Crisis Support Facility, causing disbursements to increase by about EUR 65bn. So far, no euro area country has applied for the Pandemic Crisis Support.

The third driver supporting the ESM’s AAA rating is its excellent access to capital markets.

ESM issuances are designated as Level 1 high-quality liquid 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 June 2022, or about EUR 111bn, which is around one-third of 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.

The ESM’s annual funding needs amounted to EUR 8bn in 2021 and are projected to remain at this level in 2023³. Should the need for more funding arise, for example, to finance the Pandemic Crisis Support Facility⁴, Scope expects the ESM to have no difficulty raising high volumes at favourable rates, given its established capital markets presence. The ESM also has a 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). This reduces the significant refinancing risks resulting from the maturity mismatch between its lending and funding: its outstanding loans have very long weighted average maturities (32.4 years for Greece, 14.9 years for Cyprus and 12.5 years for Spain), while its funding averages a maturity of around 6.2 years.

The fourth driver underpinning the ESM’s AAA rating consists of its highly rated key shareholders and important institutional mandate.

Specifically, the ESM’s highest decision-making body, the Board of Governors, is composed of ministers designated by each of the 19 euro area member states⁵. Each minister’s voting right corresponds to their respective country’s share 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) – jointly 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. The concentrated shareholder structure is balanced by the ESM’s very strong governance record. While the Board of Governors sets the strategic direction and decides on rescue programmes, the ESM’s Board of Directors is made up of high-ranking finance ministers from each member state and ensures operations are run in accordance with the ESM treaty¹.

As a lender of last resort, the ESM’s debt issuances benefit from preferred creditor status, junior only to the International Monetary Fund (IMF), though the ESM only has a modest ability to generate income. While the ESM has been profitable every year since 2013, the large equity base, conservative investment rules and the low-for-long interest rate environment have prevented meaningful internal capital generation compared with other supranationals, even if profits are fully retained. However, the fact that shareholders provided EUR 216.2m of compensation to the ESM for negative interest charged on cash held at central banks in 2021 is further evidence of the ESM’s importance to the euro area and the support its shareholders are willing to provide.

The ESM’s strong institutional profile reflects its strong governance and important mandate for its shareholders as a crisis resolution mechanism, underlining its central role within the Economic and Monetary Union of the European Union (EMU). The ESM was set up to provide financial assistance to any of its members that experience severe financing problems, with the aim of safeguarding the financial stability of not only its members but also of the euro area as a whole. No country is under an ESM financial assistance programme following Greece’s exit from its programme in 2018. However, Spain, Cyprus and Greece remain in a post-programme surveillance stage to monitor the sustainability of their respective recoveries. In 2021, the finance ministers of the Eurogroup signed amendments to the ESM treaty confirming the adoption of the ESM reform. Once ratified, the ESM will have a bigger role in the design of future euro area stability programmes, further reinforcing the importance of its mandate to its shareholders.

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. This 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+/Stable) of EUR 59.8bn, Spain (A-/Stable) of EUR 23.7bn following EUR 17.6bn of repayments, and Cyprus (BBB-/Positive) of EUR 6.3bn. The weighted average borrower quality has improved in recent years from B+ in 2016 to investment grate of BBB- in 2021. The ESM’s three borrowers have so far repaid in full and on time. The first scheduled principal repayments are in 2022 for Spain, 2025 for Cyprus, and 2034 for Greece.

Finally, Scope notes that under very strict conditions, the ESM can also invest directly into bank equity via direct recapitalisations. This instrument poses a significantly higher asset quality risk than the granting of loans, but 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). The ESM will instead be able to provide a EUR 68bn credit line to the SRF, which would expose the ESM to the SRF’s credit quality rather than directly to any bank. This facility poses a lower risk than direct investments in bank equity because the SRF relies on payment contributions from banks relative to their covered deposits, size, business model and other risk characteristics.

Factoring of environment, social and governance (ESG)

Scope considers ESG sustainability issues during the rating process as reflected in its supranational methodology. ESG factors are explicitly captured in Scope’s assessment of the institutional profile, which Scope assesses as ‘Very Strong’ for the ESM.

Scope’s supranational scorecard

Scope’s supranational scorecard, which is based on clearly defined quantitative parameters, provides an indicative AAA rating for the ESM. 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.

No adjustment was made to the ESM’s indicative rating.

A rating committee has discussed and confirmed these results.

For further details, please see Appendix II of the rating report.

Rating committee
The main points discussed were: i) institutional profile; ii) financial profile, including capitalisation, asset quality, liquidity and funding; iii) shareholder support; iv) additional considerations; and v) consideration of peers.

Rating driver references
1. ESM Treaty
2. ESM Investment Guidelines 
3. ESM Investor Relations Presentation June 2022 
4. EU Council decisions of 9 April 2020 
5. ESM Annual Reports 

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Supranational Rating Methodology, 7 September 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months..

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit 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 Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Eiko Sievert, Director
Person responsible for approval of the Credit Ratings: Dr Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 8 May 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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