Answering The Open Questions On Europe's Bailout Fund
Despite the ongoing barrage of pronouncements out of Europe on a weekly if not daily basis, discussing the imminent launch and even more imminent success of the ESM, the reality is that many questions remain: such as will Germany just say nein again today, in the constitutional court's verdict, especially after the President asked Merkel over the weekend why it is that Germany has to keep bailing out Europe, a proposition which no longer impresses about 54% of the German public. More importantly, even though the debate over the explicit subordination of the ESM may be resolved (it never will be as the bailout funding will always be implicitly senior to general bondholders no matter how many pieces of paper are signed), a bigger debate now emerging is just who will guarantee the bank losses. Below, we answer that question, and virtually every other outstanding one, courtesy of this DB analysis, which removes most of the lack of clarity surrounding the European bailout mechanism. Yet the main axis of inquiry in our opinion is different: what is the timetable of funding rollout. Because as DB explains, "It follows that from July to October, the ESM can only lend about EUR 100bn. If that is committed to Spain, there is nothing left in the ESM until October. Any other intervention before October would have to be under the EFSF." In other words, assuming a smooth acceptance of the ESM today by the German court, and no further glitches, the best case scenario is one which provides for funding to Spain... and there is no other cash until virtually the end of the year under the ESM, whose implementation is staggered as the chart below shows.
And another key question:
What happens if a member state is downgraded? The impact on the ESM would probably differ from that on the EFSF as the former does have cash – i.e. paid in capital. Furthermore, the ESM does not have to be rated AAA from a legal point of view. True, a lower rating would lead to higher borrowing costs which would have to be passed on to the borrowing country thus increasing the challenges of the adjustment process. In the worst case scenario, one could argue that if one or more AAA countries were to be downgraded by several notches, the maximum amount that the EFSF would be able to raise on the market would decrease.
For every other open item, read below.
1) When will the ESM be operational?
The ratification of the ESM treaty requires the approval by ESM members (euro area countries) whose initial contributions represent no less than 90% of the paid in capital. The paid in capital is based on the capital keys/contribution at the ECB (for example Germany has an ESM key of 27.1%, France 20.4% and so on). Thus larger countries have a greater vote in the ESM.
There is the possibility that the ratification process will not be concluded by July, as originally planned. Indeed, the following euro-area countries have not ratified the ESM yet: Estonia, Italy and Germany.
Estonia is waiting for the ruling of the Constitutional Court on 12 July then the parliament will very likely approve the ESM.
Unsurprisingly, constitutional complaints were filed right after the German Bundestag and Bundesrat approved the ESM and Fiscal Compact last Friday (see accompanying article in this issue of Focus Europe).
In anticipation of the constitutional complaints, both chambers of the German Parliament agreed to set the ratification standard of the ESM laws higher than required – from a simple majority to a qualified majority of two-thirds – in order to ensure constitutionality. In the end, three-quarters of the MPs ratified the ESM and approved the respective financing law.
With this broad ratification in parliament and the fact that parliamentary involvement is already widely given, the possibility of the Court’s obstructing ratification altogether seems unlikely.
Italy does not yet have a binding timeline on its ratification process. The Foreign Senate Commission has ratified both the Fiscal compact and the ESM but both houses have a very busy agenda hence there is the possibility that ratification of the ESM will be moved to the first week of August.
To make a complex process more complicated, the ESM ratification also requires the modification of Article 136 in the Treaty on the Function of the European Union. This requires all 27 EU countries to approve the modification. EA countries have or will vote on the modification of Article 136 of the TFEU together with the ESM (apart from Belgium where the former has not been formallyapproved). As of 4 July the UK and Bulgaria have not approved the modifications to Article 136 yet. Hopefully this is not a sign that these countries are aiming at extracting concessions in exchange for their approvals.The first installment of the capital has to be paid by each ESM member within 15 days of the ESM treaty entering into force.
So if Italy is the last euro-area country to approve the ESM and UK as well as Bulgaria do not slow down the process, the ESM will not be in a position to lend money until the last 10 days of August.
2) What is the EFSF/ESM lending capacity?
At the end of 2010 EU leaders agreed to create a permanent crisis management institution in a new stability architecture for the euro area. It was announced that the EFSF (European Financial Stability Facility) activities would be taken over by the ESM (European Stability Mechanism) starting this summer even if the former closes in July 2013. The ESM will also take over the activities of the EFSM (European Financial Stabilisation Mechanism).
With the accelerated entry into force, the ESM will now operate alongside the EFSF for 12 months. The ESM will have a subscribed capital of EUR 700 billion in the form of EUR 80 billion as paid in capital and the rest as callable. The theoretical ESM lending capacity is of EUR 500bn.
On 30 March the euro-area finance ministers made two significant decisions (see Eurostress article in Focus Europe on 30 March):
- The total ESM-EFSF liability ceiling was raised from E500bn to E700bn. Thus that total theoretical new lending is now E500bn.
- The ESM E80bn paid-in capital will be made available by end June 2014 rather than mid 2017. This is important because it will build up the available capacity faster since the ESM paid-in capital cannot fall below 15% of ESM’s outstanding loans
The theoretical firepower of the ESM is EUR 500bn (EUR 80bn of paid-in capital divided by the above 15% threshold). But besides ESM-EFSF liability ceiling of E700bn, other constraints should be taken into consideration: ability to raise funds on the market and timing.
The actual firepower of the ESM will depend on the ability to raise funds in the market, which is difficult to predict. A reasonable approach, in our view, is to include the entire subscribed capital – callable and paid-in capital – of AAA countries (including France) and only the paid-in capital of the other countries. Note that the new Greek programme includes a contribution for Greece’s paid-in capital. Similarly the EC report on the Portuguese programme third review requires Portugal to include the ESM paid-in capital contribution in the March supplementary budget.
This approach leads to an effective ESM firepower of around EUR 440bn (with a capital ratio of 18% – see the broken line in Figure 12). The underlying assumption in the previous bullet point is that even if Italy and Spain need to tap the ESM, their rescue programmes would take into account their ESM paid-in capital contributions as for Greece and Portugal.
This is important as without their capital contribution the ESM could not lend more than EUR 374bn without breaking the 15% capital lower bound (bottom line in Figure 1).
As we mentioned above the ESM paid in capital cannot fall below 15% of ESM’s outstanding loans. Hence, the ESM will reach its maximum capacity only in June 2014.
Two tranches of capital will be paid in 2012, the first one in July – bringing the ESM firepower to EUR 107bn – and the second one by October – increasing the ESM firepower to EUR 213bn. Another two tranches will be paid in 2013 and a final tranche in the first half of 2014.
That said, in line with the ESM Treaty, the payment of the capital can be accelerated if needed to maintain a 15% ratio between the paid-in capital and the outstanding amount of ESM issuances.
In any case, the actual firepower of the euro-area rescue mechanisms can also count on the EFSF up to July 2013 (there are also about EUR 12bn left in the EFSM). The EFSF uncommitted lending capacity of around EUR 248bn (see page 8 in Focus Europe on 13 April). So we think that the total combined lending capacity after the ESM enters into force will be above EUR 360bn until October 2012 and at least EUR 440bn thereafter.
It follows that from July to October, the ESM can only lend about EUR 100bn. If that is committed to Spain, there is nothing left in the ESM until October. Any other intervention before October would have to be under the EFSF.
Other events limiting ESM’s capacity
What happens if a member state is downgraded? The impact on the ESM would probably differ from that on the EFSF as the former does have cash – i.e. paid in capital.
Furthermore, the ESM does not have to be rated AAA from a legal point of view. True, a lower rating would lead to higher borrowing costs which would have to be passed on to the borrowing country thus increasing the challenges of the adjustment process.
In the worst case scenario, one could argue that if one or more AAA countries were to be downgraded by several notches, the maximum amount that the EFSF would be able to raise on the market would decrease.
Investors have other questions on the basic structure of the ESM. The ESM Treaty does not appear to address a scenario in which a member state does not pay its paid-in capital on time (if, for example, this were a problem for Italy or Spain). It covers only the eventuality when an EMU country does not satisfy immediately the call for extra capital by the ESM board of governors to cover losses.
Only in this case, the other member states make up the difference (Art 25). We think this clause does not cover the payment of initial paid-in capital; hence any delay would constrain ESM lending capacity.
3) What are the decision-making rules of the ESM?
The ESM can use five disbursement options:
1. Loans to a sovereign,
2. Bank recapitalisation
3. Precautionary financial assistance
4. Purchase of government bonds in the primary market
5. Purchase of government bonds in the secondary market
All five options are covered by a "mutual agreement" decision. That is, every member of the ESM Governor Board has a veto right:
“The adoption of a decision by mutual agreement requires the unanimity of the members participating in the vote. Abstentions do not prevent the adoption of a decision by mutual agreement.” (Article 3, paragraph 3)
However, there is an "emergency" decision procedure. This applies when "the Commission and ECB both conclude that a failure to urgently adopt a decision to grant or implement financial assistance would threaten the economic and financial sustainability of the euro area" (Art. 3, p. 4). Under this rule, ESM members covering 85% of the capital can approve the financial aid. Note, Finland, Slovakia and Netherlands only amount to 8.3% of the capital. Even adding, for example, Austria only boosts this to 11.1%.
4) Will direct bank recapitalisation require a Treaty change?
Article 3 setting the purpose of the ESM is to some extent ambiguous:
“The purpose of the ESM shall be to mobilise funding and provide stability support under strict conditionality, appropriate to the financial assistance instrument chosen, to the benefit of ESM Members which are experiencing, or are threatened by, severe financing problems, if indispensable to safeguard the financial stability of the euro area as a whole and of its Member States. For this purpose, the ESM shall be entitled to raise funds by issuing financial instruments or by entering into financial or other agreements or arrangements with ESM Members, financial institutions or other third parties.
So Article 3 does not states that the financial aid has to be directed to the ESM member, i.e. the sovereign, but rather to its benefit. A direct bank recapitalisation would ‘benefit’ Spain, for example.
However, Article 15 on the financial assistance for the recapitalisation of financial institutions of an ESM member states that “The Board of Governors may decide to grant financial assistance through loans to an ESM Member for the specific purpose of re-capitalising the financial institutions of that ESM Member”. Here the room of maneuver is less evident, although one could argue that the Article does not explicitly state that loans to an ESM member are the “only” option. Though this narrow opening, Article 5 could provide a possible means to avoid treaty change:
“The Board of Governors shall take the following decisions by mutual agreement… to change the list of financial assistance instruments that may be used by the ESM…” (Article 5, paragraph 6i).
Similarly Article 19, referring also to the above Article 15, states that “The Board of Governors may review the list of financial assistance instruments provided for in Articles 14 to 18 and decide to make changes to it.”
So technically, one could argue that direct capitalization could be introduced via a unanimous decision by the ESM Board. However, the political hurdles will be very high (see also question 7 for cases of disagreement among ESM members).
Much will probably depend on what is meant by "direct bank recapitalisation". If it is what the market defines as "direct" recapitalisation -- no recourse to the sovereign and not a senior loan -- it will likely necessitate a Treaty revision.
Alternatively, the solution could be a “hybrid” direct recapitalisation where Spain provides a form of guarantee to the ESM which would not affect Spanish debt/GDP as measured by Eurostat. That may be disappointing from the market perspective but it may represent a realistic compromise. Such a solution has some parallels with how NAMA is accounted for in Ireland.
5) Will removing the presumption of seniority require a Treaty change?
As we have stated in Focus Europe several times, ESM seniority is not in the legal clauses of the ESM Treaty, but in the political preamble (Bullet 13). This means that it takes only a statement from the Eurogroup to remove the presumption of seniority.
This is what happened at the 28-29 European Council meeting. In their statement, the euro-area leaders affirmed that in the context of Spain:
“We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status.”
In our view the above statement provides a precedent that is likely to be repeated for other countries’ rescue programmes. This does not mean that there is no opposition. As widely reported by the press, the Finnish Government said it expects collateral in exchange for any aid commitments that strips the ESM’s preferred creditor status.
So although last Friday’s removal of the automatic seniority presumption was a positive, investors’ uncertainty has not been fully removed.
6) What conditionality is applied to ESM?
Article 3 states that: “The purpose of the ESM shall be to mobilise funding and provide stability support under strict conditionality, appropriate to the financial assistance instrument chosen…”
So conditionality is an integral component of ESM’s intervention. Indeed ECB President Mario Draghi in the Q&A session on 5 July said that conditionality is what gives credibility to the ESM.
The first question is under what conditions the ESM will lend for bank recapitalisation. More specifically we do not know yet what precise conditions will be applied, for example how much dilution of existing equity will there be? Will the FROB/Spanish government gain effective
Last week, our understanding was that on 9 July we would receive some answers by the planned Eurogroup meeting as it was expected to formally approve the MoU on Spanish bank recapitalisation aid. However, according to Reuters the signing of the MoU will be delayed until a new Eurogroup meeting on 20 July.
Secondary market intervention
The euro leaders’ statement on 29 June did nothing except remind us of the minimal conditionality on EFSF/ESM primary and secondary market intervention.
There were no evident concessions. A secondary market intervention requires a MoU. We think that this is not a negative feature. For example, it could give investors more confidence that the beneficiary sovereign will carry out the necessary structural reforms. In other words it decreases the moral hazard associated with external help.
While we are not too concerned about the potential stigma associated with signing a MoU, we do recognize that the ESM suffers from a potential credibility issue in terms of secondary market intervention. There are three problems (i) seniority (ii) liquidity and (iii) size.
The first can be dealt with as discussed above. Given that the ESM bank license idea was rejected by the ECB on legal grounds, the liquidity issue could be removed by combining the ESM and the ECB’s SMP. But Draghi seems to have closed also this door at Thursday’s press conference.
Even if the liquidity problem is overcome, the current size of the ESM is not large enough to provide a fully convincing deterrent. True, if fully credible, it could help the adjustment process of countries such as Spain and Italy. But its limited size reminds us of those exchange rate crises where a central bank was unsuccessfully trying to support the exchange rate while depleting its limited foreign reserves.
7) What if there is disagreement about the interpretation of the treaty among ESM members?
Article 37, second paragraph, states that “The Board of Governors shall decide on any dispute arising between an ESM Member and the ESM, or between ESM Members, in connection with the interpretation and application of this Treaty, including any dispute about the compatibility of the decisions adopted by the ESM with this Treaty. The votes of the member(s) of the Board of Governors of the ESM Member(s) concerned shall be suspended when the Board of Governors votes on such decision and the voting threshold needed for the adoption of that decision shall be recalculated accordingly.”
Does this mean that the opposition of a country can be easily over come? Not quite, indeed the third paragraph of Article 37 that if an ESM Member contests the decision referred to in paragraph 2, the dispute shall be submitted to the Court of Justice of the European Union. The ruling of the Court of Justice is final.
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