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Overview

On 4 December 2019, the Eurogroup agreed in principle, subject to national procedures, on the elements related to the ESM reform. These include the further development of ESM instruments, enhancing the ESM’s role and setting up a common backstop for the Single Resolution Fund (SRF). This Explainer covers the ESM reform and the revisions to the ESM Treaty and its supporting documents.

Explainer

The ESM Treaty was revised to provide a legal basis for a set of new tasks assigned to the ESM. These tasks were part of a wider package of measures approved the by Heads of State or Government in December 2018 to complete the Banking Union and to strengthen further the Economic and Monetary Union (EMU) and the ESM. This included the introduction of the common backstop for the Single Resolution Fund (SRF), to be provided by the ESM on behalf of the euro area, as well as the further development of the financial assistance instruments and the role of the ESM.

The signature of the revised Treaty early next year will pave the way for the ratification process of the revised Treaty in the 19 ESM Member States.

The Single Resolution Fund (SRF) is a fund established by the EU for resolving failing banks in the context of the Banking Union. It is financed by contributions from the banking sector, not by taxpayer money. In the event that the SRF is depleted, the ESM can act as a backstop and lend the necessary funds to the SRF to finance a resolution. To this end, the ESM will provide a revolving credit line.

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 by 1 January 2024. The nominal cap for ESM loans to the SRF is set at €68 billion. This figure is expected to be above the target level of the SRF in 2024 to which the size of the backstop is aligned, which is 1% of covered deposits in the Banking Union (currently estimated at around €55 billion). 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 so that the total maturity is up to five years. As a result, it will be fiscally neutral over the medium term.

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

The ESM common backstop will be used only as a last resort, in the situation that the SRF is depleted, and the Single Resolution Board (SRB) is not able to raise sufficient contributions or borrow funds from other sources at acceptable rates.

Decisions on loans and disbursements will be taken by the ESM Board of Directors (consisting of high-level officials from the 19 euro area finance ministries) by mutual agreement and on a case-by-case basis, guided by certain criteria. Such decisions should be taken within 12 hours of the SRB’s request, but in the case of a particularly complex resolution operation, the ESM Managing Director may agree to lengthen the deadline to up to 24 hours.

The Board of Directors may take a decision under an emergency voting procedure (qualified majority of 85% of the votes cast) if the European Commission and the ECB conclude that a failure to urgently adopt a decision would threaten the economic and financial sustainability of the euro area. A similar emergency voting procedure exists since 2012 for ESM’s financial assistance instruments.

No. After the establishment of the ESM common backstop, the Direct Recapitalisation Instrument for banks will be removed from the ESM’s toolkit of financial assistance instruments.

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 the precautionary credit lines more effective.

Precautionary credit lines are available for euro area Member States with sound economic fundamentals, which could be affected by an adverse shock beyond their control. In other words, precautionary credit lines intend to prevent potential small crises from turning into more serious ones that may make it necessary for the Member State to request 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 in recent years. 

Access to a PCCL will be based on eligibility criteria and limited to ESM Members where the economic and financial situation is fundamentally strong. As a rule, ESM Members need to meet quantitative benchmarks and comply with qualitative conditions related to EU surveillance. The eligibility criteria include a track record of two years preceding the request for a PCCL with a general government deficit not exceeding 3% of GDP, a general government structural budget balance at or above the country specific minimum benchmark, a debt/GDP ratio below 60% or a reduction in the differential with respect to 60% over the previous two years at an average rate of 1/20 per year. In addition, the requesting country should have access to international capital markets on reasonable terms and a sustainable external position. It should also not be experiencing excessive imbalances or severe financial sector vulnerabilities.

In the case of PCCL, there will be no need for the requesting country to sign a Memorandum of Understanding (MoU). Instead, the country will specify its policy intentions in a Letter of Intent (LoI), committing to continuous compliance with the eligibility criteria. Continuous respect of the eligibility criteria will be assessed at least every six months. The ESM Member has the right to request funds at any time during the availability period according to the agreed terms.

If an ESM Member no longer complies with the eligibility criteria for the PCCL, access to the credit line will be discontinued, unless the Board of Directors decides by mutual agreement to maintain the credit line. If the country has drawn funds before the non-compliance is established, an additional margin will be charged.

Access to an ECCL is open to ESM Members that do not comply with some of the eligibility criteria required for accessing a PCCL but whose general economic and financial situation remains sound. The requesting country has to sign a Memorandum of Understanding (MoU) detailing policy conditionality, aimed at addressing the remaining weaknesses, and requiring a continuous respect of the eligibility criteria which were considered met when the credit line was granted.  Compliance with conditionality will be assessed on the basis of quarterly compliance reports submitted to the ESM Board of Directors. The ESM Member has the right to request funds at any time during the availability period according to the agreed terms.

The ESM Treaty has since the ESM’s inception in 2012 included the requirement that the ESM should only provide stability support to countries whose debt is considered sustainable. The revised ESM Treaty will also require the confirmation of a country’s repayment capacity. The assessments on debt sustainability and repayment capacity will be conducted by the European Commission, in liaison with the ECB, and the ESM, on a transparent and predictable basis, while allowing at the same time a sufficient margin of judgement.

No changes are made regarding private sector involvement. The current ESM Treaty already addresses the point of an adequate and proportionate private sector involvement in accordance with long established IMF practice only in exceptional cases. Neither the current ESM Treaty, nor the revised Treaty make debt restructuring automatic.

In the future the ESM may, if so requested by the relevant ESM Member, facilitate the dialogue between that ESM Member and its private investors on a voluntary, informal, non-binding, temporary, and confidential basis. 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.

Collective action clauses are clauses in the documentation of a bond that allow changes to the terms of bonds that are subject to a vote by their holders. If a qualified majority approves the change, it becomes effective for all those bonds. Unlike for companies, there is no bankruptcy or restructuring procedure for sovereign issuers. Therefore, collective action clauses in sovereign bonds help make sovereign debt restructuring more orderly and predictable. A sovereign state’s bonds are typically divided into a number of different issuances, or “series” (with different maturities, interest amounts, etc.). Single-limb CACs allow the majority vote to take place at the level of all these “series” combined, without the need for a majority at the level of the holders of each individual “series”.

The introduction of the single-limb CACs does not change the current possibility for countries to use so-called sub-aggregation, which is to hold separate votes for different groups of bond issuances, opening the door to offer different conditions to each group.

Single-limb CACs are meant to address the problem of so-called holdout investors. Holdout investors in bonds can act strategically to take advantage of the problem a country faces and therefore deepen the crisis. In the past, certain firms have specialised in distressed sovereign debt by purchasing sovereign bonds at steep discounts. They then resisted any change of the terms of the bonds with the intent of subsequently litigating to get paid back in full, most of the time at the expense of the other bondholders. This strategy is feasible if the holdout investor can buy enough bonds to form a blocking minority in a restructuring vote. This is much easier if the voting system requires a majority within each “series”.

Single limb CACs address the described problem in the current voting system.

Research suggests that the change will not have a meaningful market impact on sovereign bonds.

Since 1 January 2013, bonds issued by euro area governments must include CACs. However, these are currently “double-limb CACs”, which require two separate majorities to approve a change in bond terms: one at the level of each “series” and one at the level of all “series” combined. This means that it is currently easier for holdout investors to block a restructuring by concentrating their investment in a single “series”, compared to a single-limb CAC, where this strategy is not sufficient, as described above.

When the ESM and its 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 programmes for Cyprus and 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. The joint position on future cooperation was incorporated in a memorandum of cooperation, which will enter into force at the same time as the amendments to the ESM Treaty.

The ESM will have a stronger role in the design, negotiation and monitoring of conditionality in future financial assistance programmes.

When an ESM Member requests support, the Commission in liaison with the ECB, and the ESM will work closely together to prepare the assessments supporting the decision to grant a loan. These include the assessment of a Member’s debt sustainability and repayment capacity, the assessment of financial stability risks, and the financing needs of the Member requesting support. The ESM will perform its analysis and assessment from the perspective of a lender.

The ESM will be involved in the design of policy conditionality and any future Memorandum of Understanding (MoU) detailing the conditionality attached to the financial assistance facility will be signed by both the Commission and the ESM Managing Director.

The ESM will also monitor compliance with the conditionality attached to the financial assistance facility together with the Commission in liaison with the ECB.

The assessment of debt sustainability and repayment capacity, for the member state requesting financial assistance, will be carried out on a transparent and predictable basis. Assessments for financial assistance programmes will be carried out by the Commission in liaison with the ECB, and the ESM.

For the preparation of the debt sustainability analysis (“DSA”), the Commission will work on the basis of its growth forecasts and estimates, existing stocks and stock-flow adjustments, net borrowings and fiscal path, incorporating also the Commission’s assessment of compliance with Stability and Growth Pact requirements.  The ESM will contribute to the DSA with the analysis of the Member’s financing plans and cost of funding, which entails the assessment of the liquidity position, sovereign bond market and potential risks stemming from the size and structure of outstanding debt, debt issuance plans, interest rate developments, refinancing capacity and market access.

The repayment capacity assessment builds upon and complements the debt sustainability analysis and shifts the focus to the beneficiary Member State’s ability to manage its overall payment obligations, or liabilities, in a way ensuring the repayment to the ESM over the entire horizon of the lending relationship.

The general expectation is that institutions will come to a common view and present the debt sustainability and the repayment capacity assessments to the ESM decision-making bodies. In case the collaboration does not yield a common view, the Commission makes the overall assessment of the sustainability of the public debt, while the ESM assesses the capacity of the Member concerned to repay ESM loans.

As until now, the ESM will participate in post-programme monitoring to safeguard its balance sheet by assessing the ability of a beneficiary Member to repay. In accordance with the Early Warning System (“EWS”) Procedure established pursuant to Article 13 (6) of the ESM Treaty, the EWS starts with the first disbursement and continues until all financial assistance is fully repaid.

In principle, post-programme surveillance missions by the Commission and EWS missions are combined, to prevent unnecessary duplication of analysis by the Commission and the ESM and to avoid unnecessary burden on the relevant Member.

The Commission and the ESM will meet informally to share assessments and analysis pertaining to their respective competences as well as to discuss and assess macro-financial risks. The Commission, in agreement with the Member State concerned, may also invite ESM staff to join its missions related to economic policy coordination and budgetary monitoring.

The Members of the Commission responsible for Financial Stability and Economic and Financial Affairs and the ESM Managing Director meet at least twice a year, also in non-crisis times, to discuss issues of common interest, including the main findings of the macro-financial risk analysis.

The revised ESM Treaty will come into force once it has been ratified by all 19 ESM Member States. This involves approval in parliaments in all Member States. The ratification process will start following the signature of the agreement amending the ESM Treaty.

The ESM reform is part of a comprehensive package of measures to deepen Economic and Monetary Union (EMU), including work on completing banking union and the introduction of a new budgetary instrument for the euro area, to make it more robust.

Discussions will therefore continue on the creation of a European deposit insurance, which is the missing third pillar of banking union. More technical work will be needed to define the possible ways forward.

Progress is being made on the creation of a capital markets union (CMU) in Europe. Since the project was launched, most of the Commission’s 13 legislative proposals have now been agreed. A new strategy for the CMU is among the top priorities of the newly-appointed Commission.

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