(The following statement was released by the rating agency)
Oct 8 - Fitch Ratings has assigned the European Stability Mechanism (ESM) a Long-term Issuer Default Rating (IDR) of 'AAA' and a Short-Term IDR of 'F1+'. The Outlook is Stable.
The key credit strengths that underpin ESM's 'AAA'/'F1+' ratings are as follows:
--- exceptionally strong mechanisms for exercising callable capital, including an 'early warning system' (EWS) to ensure timely management of its capital needs
--- relatively high capitalisation ratio and the requirement that paid-in capital/reserves will always be equal to at least 15% of outstanding debt
--- high-quality and liquid assets that will always be equivalent to at least 12 months of maturing ESM liabilities
--- the ESM's preferred creditor status (PCS)
--- the strength of its governance in terms of management as well as the composition of the board of governors that underscores the strong political support for the ESM
--- prudent investment guidelines adopted by the ESM for the management of its reserves and capital.
ESM is a multilateral lending institution aimed at providing emergency financial assistance to euro Area Member States (EAMS) in financial distress. It has been created as a permanent financial assistance institution, and will succeed the European Financial Stability Facility (EFSF; 'AAA'/'F1+') which is a temporary guarantee vehicle. Financial assistance will comprise loans, credit lines, loans for the purpose of recapitalisation of financial institutions, and sovereign securities purchased either in the primary or secondary market. ESM was created by a treaty signed on 2 February 2012 by the 17 EAMS and incorporated in an amendment of Article 136 of the Treaty on the Functioning of the European Union. Following its ratification by Germany, the treaty has entered into force and ESM officially started operations on 8 October 2012.
The ESM is owned by the 17 EAMS, on the basis of their contribution key, equal to their share in the European Central Bank's capital. Subscribed capital amounts to EUR700bn, of which EUR80bn will be paid in between 2012-2014. The remaining share, EUR620bn, can be called in case of need. According to ESM's founding treaty, a capital call can be launched to revise ESM's lending capacity or replenish capital in the event of credit losses. Most importantly, to avoid a default from ESM on its debt obligations, an emergency capital call procedure, unique among multinational development banks (MDBs), has been established. It allows the ESM's managing director (currently Klaus Regling), to call capital without approval of the governing bodies to ensure timely payment. Capital calls payments have to be received within seven days. The commitment of EAMS to provide callable capital is legally binding.
The ESM maximum lending capacity of EUR500bn is backed by EUR700bn of paid-in and callable capital. Moreover, 92% of the EUR500bn lending capacity (which would be financed by the ESM from public debt markets) would be covered by paid-in capital and the callable capital of EAMS shareholders currently rated 'AA-' and above by Fitch, which compares favourably to other 'AAA' MDBs rated by Fitch. The explicit and legally binding mechanism to pay-in additional capital if required to maintain the creditworthiness of the ESM is crucial for off-setting the principal credit and rating weakness relative to peers which is the potentially large and very concentrated risk exposures that it may incur.
ESM will be better capitalised than other European MDBs: it will be endowed with a substantial amount of capital, representing 11.4% of subscribed capital, and disbursed in five equal instalments (20% each), the first two being paid in 2012 and the final in H114. The founding treaty limits ESM lending to EUR500bn and stipulates that paid-in capital must represent at least 15% of debt issued during the phase-in period; as lending will be funded by debt, this implies that the ratio of paid-in capital to loan must be maintained above 15% of outstanding loans. Hence, when operating at full capacity, the equity to assets ratio will stand at 13.8%, which is in line with other 'AAA' rated European MDBs.
EAMS's strong willingness to support is also reflected in the preferred creditor status (PCS) granted to ESM. PCS materially reduces the ESM's sovereign credit risk arising from its lending facilities and enhances recovery prospects in the unlikely event of default. In contrast with other MDBs, PCS is clearly stated in the ESM founding treaty, which indicates that ESM financial assistance instruments will be junior only to the IMF. However, the PCS will not apply to EFSF facilities existing at the time of signing the ESM treaty in February 2012 that are transferred to or supplemented with additional financing from the ESM, including the EUR100bn loan agreed by the EFSF to the Spanish government in support of the restructuring and recapitalisation of the Spanish banking sector.
PCS is an important credit mitigant given the ESM's role of providing support for sovereigns in financial difficulties. In addition, ESM's financial assistance will be subject to policy conditionality as set out under a memorandum of understanding (MOU) with the national authorities that, if effective, will reduce the credit risk faced by the ESM. As with policy-conditional financing provided by the IMF, the ESM could chose to suspend loan disbursements in the event that the conditions are not met.
The ESM will always have sufficient liquidity to meet all its obligations over the next 12 months . Funds from the paid-in capital will not be lent, and used as a liquidity buffer consisting of two tranches. A short-term (ST) tranche, made of highly liquid investments with a minimum rating of 'AA', that will have to cover at least six months of future payments due from beneficiary countries, with a minimum overall size of EUR5bn. The remainder will be managed in a medium and long-term (MLT) tranche, made up of longer-term assets (three years maturity maximum) and may include euro area (EA) sovereign assets rated below 'AA' (but not the assets of sovereigns in receipt of ESM financial assistance). ESM's operational guidelines specify that the ST tranche plus 50% of the MLT tranche must cover ESM's liquidity needs for the next 12 months. They also state that the maximum amount which ESM is allowed to invest in EA sovereign bonds rated below 'AA' is limited at EUR5bn and this amount is not included in the calculation of the liquidity buffer needed to cover ESM's obligations over the next 12 months.
The rating is robust to downgrades of 'AAA' shareholders into the 'AA' rating category. However, as Fitch has previously commented, in the event that Greece were to exit from the eurozone, the ratings of all sovereign and sovereign-rated entities in the eurozone, including the ESM, would be placed on Rating Watch Negative as Fitch re-assessed the broader political commitment to the euro and the potential contagion and financial implications of a Greek exit.
ESM's ratings will be reviewed in light of any amendments to the ESM treaty or changes in Fitch's understanding of the current constraints and credit enhancements implied by the treaty and operational guidelines. For example, if under Article 19 of the treaty, the ESM were to adopt new instruments that materially changed its potential credit profile, the rating of the ESM would be subject to review.
For all of Fitch's Eurozone Crisis commentary go to
(Caryn Trokie, New York Ratings Unit)