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Strengthening EMU and the ESM

Strengthening EMU and the ESM

The heads of state and government of euro area countries endorsed a package of reforms to strengthen Economic and Monetary Union (EMU) and the ESM at the Euro Summit on 14 December 2018. This includes the further development of ESM instruments, enhancing the ESM’s role and setting up a common backstop for the Single Resolution Fund (SRF).

The scope of new tasks for the ESM was agreed by the euro area finance ministers in their report to the Euro Summit on 4 December 2018:

  • Stronger role in preparing and monitoring future financial assistance programmes
  • New role outside financial assistance programmes
  • Backstop (i.e. extending a credit line) to the Single Resolution Fund
  • Improving the effectiveness of ESM precautionary credit lines (PCCL and ECCL)
  • Greater involvement in debt sustainability issues

Enhancing the role of the ESM will further strengthen the crisis prevention and resolution capabilities of the euro area and its resilience. The extended mandate will come into force when the ESM Treaty is amended. That requires ratification by all 19 ESM Members.

 

Explainer

The heads of state and government of the 19 euro area countries endorsed a package of proposals on deepening Economic and Monetary Union (EMU) at the Euro Summit on 14 December 2018. The proposals included the introduction of the common backstop for the Single Resolution Fund (SRF), to be provided by the ESM, as well as the further development of the ESM’s financial assistance instruments and the role of the ESM. Also, the Euro Summit endorsed an agreement between the ESM and the European Commission on the cooperation between the two institutions that strengthens the ESM’s role. The package of proposals had been agreed by the euro area finance ministers at their Eurogroup meeting on 4 December 2018.
 
Enhancing the role of the ESM is not a goal in itself. It is a means to strengthen the euro area and to make it better prepared to weather future crises.

The Single Resolution Fund (SRF) is a fund established by the EU in the context of Banking Union for resolving failing banks. It is financed by contributions from the banking sector, not by taxpayer money. In the event that the SRF resources are not sufficient, the ESM can act as a backstop and lend the necessary funds to the SRF. If non-euro area Member States join the Banking Union, the ESM and non-euro area Member States will together provide the common backstop to the SRF, through parallel credit lines.

The common backstop will be in place at the latest in 2024. The size of the credit line will be aligned with the SRF funds, which by then will be around €60 billion, or 1% of covered deposits in the Banking Union. If the credit line is used, the SRF will pay back the ESM loan with money from bank contributions within three years, although this period can be extended by up to another two years. As a result, it will be fiscally neutral over the medium term.

The common backstop can be introduced earlier than 2024 provided that banks make sufficient progress in reducing their exposure to risks, notably non-performing loans. This assessment will be made in 2020. The criteria for which risk reduction will be measured can be found in the “Term sheet on the European Stability Mechanism reform” (p.2, footnote 1).

The common backstop will cover all possible uses of the SRF. Further work is needed to find solutions for cases when a resolved bank may need funds to continue operating the next day. This "liquidity provision in resolution” issue will be discussed further in 2019. There should be reporting by June next year.

Disbursements under the common backstop will be approved by the ESM Board of Directors, consisting of high-level officials from the 19 euro area finance ministries, by mutual agreement. Procedures will be in place so that such approval can be made swiftly and efficiently (in as little as 12 hours), in strict confidentiality because of the sensitive data. ESM Members’ national constitutional requirements, including the involvement of parliaments in some ESM Members, will be fully respected while ensuring due confidentiality.

Two types of credit lines are available in the ESM toolkit: a Precautionary Conditioned Credit Line (PCCL) and an Enhanced Conditions Credit Line (ECCL). The agreed reforms are meant to make them more efficient.

A precautionary credit line works like an insurance policy. A credit line is made available to a euro area Member State. The baseline assumption is that the availability of the money alone will be sufficient to calm market worries and that no disbursement will be needed. In other words, precautionary credit lines intend to prevent small crises from turning into big crises that would make it necessary for the Member State to ask the ESM for an ESM loan with a full economic adjustment programme. The International Monetary Fund (IMF) also has precautionary credit lines and several countries have used them successfully recently.

The eligibility process will be made more transparent and predictable. The PCCL is available to an ESM Member whose economic and financial situation is fundamentally sound but which could be affected by an adverse shock beyond its control. The requesting country has to meet a number of criteria to be able to access the credit line and needs to sign a Letter of Intent committing to continue to meet the criteria. Compliance with the criteria is assessed at least every six months. As a rule, Member States need to comply with the EU fiscal rules. That includes having a deficit below 3% of gross domestic product and meeting the debt benchmark (having a debt to GDP ratio below 60% or a reduction in this ratio of 1/20th per year). They cannot have excessive imbalances or be subject to the Excessive Deficit Procedure, and government debt needs to be considered sustainable.

If a country does not comply with all the stricter PCCL criteria then it can apply for an ECCL under certain policy conditions, which are wider-ranging. The requesting country has to sign a Memorandum of Understanding (MoU) committing to comply with the eligibility criteria, which it met at the time of the request, and in addition to the required reforms. The Member State also faces “enhanced surveillance” under the EU framework. Under a PCCL, “enhanced surveillance” would only apply if the country actually draws on the credit line. 

They are legal rules for sovereign bonds that make debt restructuring more orderly and predictable. They reduce the creditor holdout problem, which can emerge if a small group of bondholders decide not to take part in the restructuring, forming a minority to block it, in the hope of getting a better deal for themselves. These “holdouts” can result in delays in resolving the crisis. With the single limb CACs this will be less likely to happen – if enough bondholders vote in favour, the proposal is approved and applies to all bonds. The finance ministers of the euro area want to introduce these rules by 2022 and to include this commitment in the ESM Treaty.

When appropriate and if requested by the Member State, the ESM may facilitate the dialogue between the country and private investors. The constant contact the ESM already has with key players in the euro area sovereign debt markets makes the ESM well placed for this role. The ESM’s involvement would take place on a voluntary and informal basis.

When the ESM and its temporary predecessor, the EFSF, were set up their main task was to raise and disburse the money necessary for the rescue loans by issuing bills and bonds on the financial markets. Over time, the ESM has taken on additional responsibilities. With the ESM programme for Greece, the ESM has become involved in policy related issues and has worked closely in particular with the Commission, but also with the European Central Bank (ECB) and the IMF. The current cooperation with the Commission has been reflected in a joint MoU signed in April 2018.
 
In November 2018, the Commission and the ESM agreed on a joint position with regard to their future cooperation.

Going forward, the ESM will have a stronger say in the preparation and monitoring of future adjustment programmes. The ESM will be more involved in the design of policy conditionality as any future MoU will be signed by both, the Commission and the ESM. The Commission and ESM would jointly prepare the financial stability, financing needs, and debt sustainability assessments required to agree on new programmes. In cases where the ESM and the Commission do not agree on the debt sustainability analysis (DSA), the Commission would be responsible for the overall DSA assessment, while the ESM could assess the country’s ability to repay the ESM loan.

The euro area finance ministers will prepare the necessary amendments to the ESM Treaty by June 2019. After that, the revised ESM Treaty will have to be ratified by all 19 ESM Members, which will require involvement of national parliaments.

By spring 2019, progress should be made on the Capital Markets Union.  Also, a high-level working group will work on the next steps toward a European deposit insurance scheme and report on progress by June 2019.

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