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Fitch: Proposed Reform Could Boost ESM’s Intrinsic Risk Profile

Reforms to the European Stability Mechanism (ESM, ‘AAA’/Stable) under which it will provide the backstop facility to the eurozone’s Single Resolution Fund (SRF) could strengthen the ESM’s intrinsic risk profile, Fitch Ratings says, although this would not affect its rating, which is already ‘AAA’/Stable. This would primarily reflect the positive impact on our assessment of the ESM’s equity risk profile. Other risk metrics could also benefit, depending on the details of the reform eventually agreed by eurozone members.

EU leaders agreed at a summit late last month that the ESM “will provide the common backstop facility to the SRF”. The proposal set out by Eurogroup President Mario Centeno in a letter to European Council President Donald Tusk indicated that the backstop could take the form of a revolving credit line, with its size to be aligned with the SRF target level of EUR55 billion by end-2023, or 1% of the amount of covered banks’ deposits. It would replace the ESM’s Direct Bank Recapitalisation Instrument (DRI) – one of the six available instruments in the ESM’s lending toolkit.

Our rating approach for the ESM is based on a hypothetical medium-term scenario in which the ESM uses its entire lending capacity of EUR500 billion (its loan portfolio was EUR76.9 billion at end-May). In practice the ESM has never used the DRI, but our rating scenario assumes that the ESM deploys a combination of loans to sovereigns and equity injections into the banking system.

If the DRI capacity was withdrawn as the ESM extended a credit line to the SRF the ESM’s equity risk profile in our rating scenario would significantly improve, as equity injections into banks would no longer be assumed, while the ESM as a lender benefits from preferred-creditor status junior only to the IMF. Our rating scenario currently assumes that the ESM fully uses its equity injection instrument of up to EUR60 billion into the banking sector, resulting in a “medium” equity risk assessment.

Other risk metrics could also benefit from a credit line extended to the SRF, for example if it improved the average credit quality and diversification of the ESM’s loan portfolio. In our rating scenario, we currently assume that the average credit quality of the loan portfolio would be ‘B’ and we assess concentration risk as ‘high’ given that the ESM has no concentration limit and lending would most likely be concentrated in a few countries. The average credit quality of the ESM’s loan portfolio was ‘BB’ at end-May, including loans to Spain, Cyprus and Greece.

The Eurogroup said it will develop proposals regarding ESM reform by the end of 2018. Changes to the ESM treaty would require ratification by the 19 eurozone parliaments. Any implications for our assessment of the ESM’s intrinsic credit profile will depend on the shape of more detailed proposals, and in particular whether we felt these fully removed the risk of equity injections by the ESM.

We affirmed the ESM’s ‘AAA’/Stable rating on 8 June. We assess its intrinsic risk profile as ‘aa+’. This is adjusted up to reflect the strong capacity and propensity of the ESM’s member state shareholders to provide it with extraordinary support in case of need.
Source: Fitch Ratings

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