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.

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.

Scope continues to expect an eventual ratification by all 20 ESM members of the revised ESM treaty. Alongside other reforms, this would empower the ESM 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).

For the rating report, click here.

Key rating drivers

Substantial capital position and very strong capital call mechanism

The ESM’s capitalisation is excellent also compared to peers and reflects an exceptionally high capacity to absorb losses on existing loans. 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, Scope includes paid-in capital (EUR 81.0bn), accumulated reserves and retained earnings (EUR 3.6bn) as well as 10% of the callable capital of highly rated shareholders (AA- or above), which Scope estimates at EUR 36.2bn. Together, these resources amount to EUR 120.8bn. The resulting capitalisation ratio of about 24%, results in a ‘Very High’ assessment of the ESM’s capitalisation. The ESM’s actual capitalisation ratio, based on total disbursed loans of about EUR 82.6bn as of end-2023, stands at 146%, one of the highest among rated peers.

While the ESM was profitable every year between 2013 and 2021, the large equity base, conservative investment rules and the low interest rate environment prevented meaningful internal capital generation compared with other supranationals, even if profits are fully retained. Total profits amounted to EUR 320.5m in 2023, compared with a loss of EUR 60m in 2022. The loss in 2022 marked the first loss recorded since 2012, reflecting realised losses from sales of debt securities following the rebalancing of the paid-in capital portfolio in the rising yields environment. The return to profits reflects the sharp rise in interest income on cash holdings and debt securities. The accumulated accounting profits on the investment portfolio since inception stood at EUR 1.7bn at end-2023. This includes EUR 915.4 million in extraordinary income from negative interest compensation received by the ESM in the 2017–2021 period.

The capital position is further underpinned by its 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, without prior approval from the ESM’s governing bodies¹.

Very high liquidity buffers and excellent capital market access

The ESM benefits from exceptionally high and well-diversified liquidity buffers, driven by its conservative investment guidelines², and excellent capital market access. Scope estimates the ESM’s liquid assets at around EUR 90.3bn for end-2023, which includes cash and cash equivalents of EUR 17.1bn (EUR 55.6bn in 2022), highly rated debt securities of EUR 69.1bn (EUR 41.1bn in 2022) mainly with a minimum rating of AA- and deposits of EUR 4.1bn. In response to the sharp rise in interest rates in 2023, a significant part of available liquidity was invested in money market instruments to achieve higher returns.

Conversely, ESM liabilities due within a year amounted to around EUR 24.6bn, 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 2021-23 of around 342% (302% in 2022). This is one of the highest liquidity coverage ratios among peer supranationals.

The ESM’s capital market access is also excellent. ESM issuances are designated as Level 1 high-quality liquid assets and granted a 0% risk weighting under the Basel framework and are included in several SSA and government bond indices. 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 broadly diversified investor base provides a stable source of funding, resulting in favourable funding rates and hence lending rates. The latest 5-year bond issuance on 11 March 2024 yielded 2.63%, in line with government bond yields of France (2.61%) and slightly above Germany (2.32%). The ESM’s annual funding needs amounted to EUR 8bn in 2023, stable from the previous two years and projected to decline slightly to around EUR 6bn in 2024 and EUR 7bn in 2025³. 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. As part of its strategy to diversify its funding instruments, the ESM also introduced its EUR 20bn Euro Commercial Paper programme in February 2024. This is in addition to the existing bills and bonds programmes traditionally issued.

Preferred credit status, improving asset quality, and excellent asset performance

As a lender of last resort, the ESM’s loans benefit from preferred creditor status, junior only to the International Monetary Fund. Outstanding loans, amounting to EUR 82.6bn at end-2023, were granted under strict conditionality and are subject to monitoring of the sovereign’s capacity to repay, in the context of the ESM’s Early Warning System. The loan portfolio exposures are to Greece (BBB-/Positive) of EUR 59.8bn, Spain (A-/Positive) of EUR 16.4bn, and Cyprus (BBB+/Stable) of EUR 6.3bn. This distribution results in a weighted average borrower quality of ‘BBB’, up from B+ in 2016, following the gradual improvement of Greece’s sovereign debt rating.

To date, the ESM has been repaid in full and on time by its three borrowers and has thus never recorded a non-performing loan. Spain has made nine early repayments to date, its first two scheduled repayments in December 2022 and 2023 and is on course to repay remaining loans by 2027. Repayments from Cyprus will become due from 2025, with the final payment due in 2031. Finally, Greece’s repayments will start in 2034 and end in 2060.

Highly rated key shareholders and important institutional mandate

The four largest euro area economies – Germany (AAA/Stable), France (AA/Negative), Italy (BBB+/Stable) and Spain (A-/Positive) – jointly account for around 76% of the ESM’s subscribed capital. These sovereigns thus constitute the ESM’s key shareholders, with a weighted average rating of AA-. A downgrade of the average key shareholder rating to A+, which would require at least two key shareholders being downgraded by one notch, would not impact the ESM’s current AAA rating, all other things being equal.

The concentrated shareholder structure is balanced by the ESM’s excellent 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. In addition, the ESM and European Parliament signed a Memorandum of Cooperation in May 2024, enhancing the regular dialogue with the European Parliament’s Committee on Economic and Monetary Affairs (ECON).

In 2021, the finance ministers of the Eurogroup signed amendments to the ESM treaty confirming the adoption of the ESM reform. Italy remains the only ESM member not to have ratified the revised treaty, with the country’s lower house of parliament voting against ratification on 21 December 2023. Scope still expects an eventual ratification of the treaty change⁴. When finalised, 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.

Credit challenges: concentrated shareholder base and loan portfolio, potential equity exposure

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. The largest shareholder Germany holds more than a quarter of subscribed capital, granting it a blocking majority in some decisions taken by the ESM’s board of governors. 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 in the euro area. Current outstanding loans are to three countries – Greece (BBB-/Positive), Spain (A-/Positive), and Cyprus (BBB+/Stable) – resulting in a highly concentrated loan portfolio, in line with its mandate.

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.

Outlook and rating sensitivities

The Stable Outlook reflects Scope’s opinion that risks to the credit ratings over the next 12 to 18 months are broadly balanced.

Downside scenarios for the ratings and Outlooks are (individually or collectively):

1. Liquidity buffers were significantly reduced
    
2. The capital base weakened significantly due to sustained losses caused by missed borrower payments and/or a material increase in the maximum lending capacity; and/or
    
3. The asset quality of the loan portfolio deteriorated significantly

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, and the assessment of potential climate risks under the portfolio quality.

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 indicative rating of the ESM.

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 viii) consideration of peers.

Rating driver references
1. ESM Treaty
2. ESM Investment Guidelines
3. ESM Investor Presentation – July 2024
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, 21 June 2024), 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 and Outlooks 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, Senior Director
Person responsible for approval of the Credit Ratings: Alvise Lennkh-Yunus, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 8 May 2020. The Credit Ratings/Outlooks were last updated on 21 July 2023.
 
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, as well as a list of Ancillary Services and certain non-Credit Rating Agency services provided to Rated Entities and/or Related Third Parties.

Conditions of use / exclusion of liability
© 2024 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Fund Analysis 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.