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.

Rating rationale

Scope’s AAA rating on the ESM reflects the supranational’s substantial capital position, very high liquidity buffers, excellent capital markets access and highly rated key shareholders. 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 20 ESM members, to provide loans to the Single Resolution Fund (SRF) 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 were 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.

Key rating drivers

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 81.0bn) and accumulated reserves and retained earnings (EUR 3.3bn). These resources amount to EUR 84.3bn and result in a maximum leverage ratio of about 16.9%. The ESM’s actual capitalisation ratio, based on total disbursed loans of about EUR 86.2bn at end-2022, stands at 98%, the highest among rated peers. This reflects an exceptionally high capacity to absorb losses on existing loans. After remaining broadly stable since 2014, paid-in capital increased in March 2023 since Croatia’s membership, and is set to continue growing gradually until 2035, to EUR 81.5bn, once all instalments from ESM members are received.

While the ESM was profitable every year between 2013 and 2021, the large equity base, conservative investment rules and the low-for-long interest rate environment prevented meaningful internal capital generation compared with other supranationals, even if profits are fully retained. The ESM generated a total loss of EUR 60.2m in 2022, compared with EUR 311m profits in 2021, its first loss recorded since 2012. This reflects realised losses from sales of debt securities following the rebalancing of the paid-in capital portfolio in the rising yields environment, which were only partly offset an upswing in interest income related to derivatives operations. Unlike in previous years, only part of the negative interest charged on cash held at several central banks was compensated. While the ESM received EUR 15.2m from the Netherlands, potential compensation from Germany, France and Italy amounting to EUR 175.8m was withheld as some conditions were not met. The resulting accounting loss reduces the EUR 1.5bn of accumulated profits on the investment portfolio since inception, which includes EUR 915m in extraordinary income from previous negative interest compensation.

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 65.1bn for end-2022. Conversely, ESM liabilities due within a year amounted to around EUR 31.6bn, 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 2020-22 of around 199% (195% in 2021), 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.

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. 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/EFSF’s investor base is dominated by the euro area (55%), followed by the UK and Switzerland (21%) and Asia (13%). Its debt stock is held by a variety of investors, dominated by banks (39%), asset managers (30%) and central banks (25%). This broadly diversified investor base provides a stable source of funding, resulting in favourable funding rates and hence lending rates. Over 2022, the average yield on ESM bills shifted from a negative to a positive yield environment in line with market developments. The latest 10-year bond issuance on 15 May 2023 yielded 3.05%, slightly above government bond yields of France (2.97%) and Germany (2.39%).

The ESM’s annual funding needs amounted to EUR 8bn in 2022, stable from the previous year and projected to remain at this level in 2023, before declining to EUR 6bn in 2024³. Should the need for more funding arise, Scope expects the ESM to have no difficulty raising higher 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). The ESM has a stable redemption profile over the coming years, with the average maturity of outstanding debt at 6.86 years as of July 2023. Medium-term assets with a maturity of 1 to 5 years (EUR 40.1bn) almost fully cover liabilities with the same maturity horizon (EUR 41.0bn), which significantly limits refinancing risk. The three-year weighted average maturity gap is 76% as of 2022, in line with that of other supranational peers, while the ESM continues to hold a large portion of its assets as cash and deposits.

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

The ESM’s highest decision-making body, the Board of Governors, is composed of ministers designated by each of the 20 euro area member states. 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/Negative), Italy (BBB+/Stable) and Spain (A-/Stable) – jointly account for around 76% 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.

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. 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. As a lender of last resort, the ESM’s debt issuances benefit from preferred creditor status, junior only to the International Monetary Fund. 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. After approval from the German Constitutional Court in December 2022, the reform will enter into force once it is ratified by the Italian parliament⁴. Once this process is completed, 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 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 59.8bn, Spain (A-/Stable) of EUR 20.1bn, and Cyprus (BBB/Stable) of EUR 6.3bn. The weighted average borrower quality has improved in recent years from B+ in 2016 to investment grate of BBB- to date, primarily owing to the gradual improvement of Greece’s sovereign debt ratings. The ESM’s three borrowers have so far repaid in full and on time, with Spain making early repayments of EUR 17.6bn over 2014-18, before its first schedule principal repayment of EUR 3.6bn last year.

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 SRF after full ratification of the reform treaty agreement. 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 ‘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 the rating report.

Rating-change drivers

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 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 Annual Reports
4. European Council - Agreement Amending the Treaty Establishing the European Stability Mechanism              

Methodology
The methodology used for these Credit Ratings and Outlooks, (Supranational Rating Methodology, 11 August 2022), 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 Outlooks and the principal grounds on which the Credit Ratings and Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.
 
Regulatory disclosures
These Credit Ratings and Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and 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. The Credit Ratings/Outlooks were last updated by Scope Ratings on 22 July 2022.
 
Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use/exclusion of liability
© 2023 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Fund Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin.