The EFSF and ESM lending rates aim to fully cover their funding and operational costs and reflect the varying risk profiles of each funding instrument.
For this purpose, the ESM and EFSF have used different funding and lending approaches over time:
- Early on, in 2011, the EFSF matched the funds raised from bill and bond sales to a particular programme country’s disbursement schedule, called a back-to-back funding or lending strategy.
- Later on, to ensure greater funding efficiency and regular market access, both the EFSF and ESM adopted a diversified funding strategy. Under this strategy, the cash raised was no longer attributed to a particular country; instead, these funds were pooled and disbursed to programme countries. Under this strategy, the rescue funds can use a greater variety of funding instruments across different maturities. This cost of funding is passed on fully to the programme countries, and makes up part of their lending rates. Besides this rate, the ESM and EFSF also charge fees to cover operational costs and margins to cover credit risk.
- To recapitalise banks and finance potential resolution costs, the rescue funds deliver loans in the form of ESM- or EFSF-issued notes, termed ‘in kind’, as opposed to ‘in cash’, disbursements.
Cost of funding rates:
The ESM and EFSF cost of funding rate is a daily per annum rate. This rate reflects the cost that one of the two rescue funds is liable to pay on a given day to investors who hold ESM- or EFSF-issued instruments. The cost of funding rate is derived from a daily computation of the actual interest accrued on either all ESM- or all EFSF-issued debt. Each rescue fund, therefore, has its own funding rate. The ESM and EFSF cost of funding rates are input into the calculation of the blended lending rates.
To compute the cost of funding, the same rules apply for both ESM and EFSF rates. The cost of funding rate is computed as a weighted average using four key parameters for each rescue fund. Two parameters are average interest rates on the short- and long-term pools, the other two are so-called ‘coverage’ ratios, which refer to the share of an ESM or EFSF loan that is covered by the issuance within the short- and long-term pools. The four key parameters therefore are: long-term pool coverage, short-term pool coverage, average interest rate on the long-term pool, and average interest rate on the short-term pool.
Blended lending rates:
The rescue funds calculate the overall cost of lending to the programme countries, the ‘blended lending rate,’ for both the EFSF and the ESM. Each is calculated as a weighted average interest rate including the lending costs of all the loans to the programme countries expressed in one single rate. The rate covers the cost of funding for cash disbursements, the back-to-back funding rates, the disbursements in kind, and the fees and margins charged for the assistance. As the structure of disbursements differs across the individual countries, the lending rates may vary as well. The rates shown on the ESM website are calculated as an average of country-specific lending rates, weighted by the respective loans outstanding.
Additional information on the evolution of the blended lending rates by country can be found below.
Ireland and Portugal (EFSF)
When the EFSF started up activity, it financed loans to Ireland and Portugal through fixed-rate bond issuances on a back-to-back basis. These loans were more expensive at the outset, given a higher interest rate environment at the time, the need for collateralisation, substantially higher margins charged to borrowers, and the fact that the EFSF was a new issuer in the market. From December 2011, after the approval of the diversified funding strategy, the EFSF progressively moved to pool-funded loans, which were initially financed by short-term bills, therefore the rates were lower. Later on, the funding of the loans progressed towards long-term funding instruments, which generated a gradual increase in the cost of funding in 2012. From the beginning of 2013, the rates decreased slightly due to a low-rate environment and have remained moderately stable.
For the EFSF Greek programme, the dynamics were different. Initially, Greece was mainly financed by disbursements in kind, with 87% of the initial disbursements indexed on the six-month Euribor rate. Therefore, the rates started relatively low and gradually moved upwards through November 2012. This occurred as the loans related to the private sector involvement, initially disbursed in kind, were rolled into the pool, and new pool-funded loans were disbursed. The Eurogroup decided in late 2012 to lighten Greece’s repayment burden. It deferred Greece’s interest payment until December 2022 and cancelled the initial guarantee commission fees of 10 basis points. The rates also remained significantly lower than those of Ireland and Portugal, mostly due to the funding structure: some loans for bank recapitalisation to Greece continued to be financed in kind whereas loans to Ireland and Portugal were only pool funded through longer duration fixed-rate funding instruments. Starting from January 2013, the upward rate movement stems from the rollover of the back-to-back loans to the pool. In 2014 and 2015, the lending rates for Greece remained relatively stable, in line with minor movements in the cost of the EFSF funding rate.
Initially, when it started operations, the ESM absorbed the EFSF bills programme and only provided financing on a short-term basis. The ESM thus granted the first loans through disbursements using short-term maturities designed to boost banks’ capital and cover resolution costs. This explains why Spain obtained such low rates at the beginning of its programme. From the end of 2013, the ESM started issuing longer-term funding instruments, which, together with the rollover to the pool of loans initially disbursed in kind, explains the increase in the Spanish lending rate. After this increase, the rate remained constant in 2014 and 2015, with only minor movements in the cost of funding due to ESM funding activity.
Until September 2013, the ESM relied principally on pool-funded loans to finance the programme for Cyprus. For the same period, all Spanish loans were provided instead as in kind loans of ESM-issued notes. Thus, for the period before September 2013, there was a gap in funding rates between Cyprus and Spain because the pool-funded rates (cost of funding) were higher than the in-kind rates. After the disbursement in kind of the bank recapitalisation loan, Cypriot rates responded to the lower cost by falling 20 basis points. In 2014 and 2015, the lending rates of the two countries started converging. They also both increased as the ESM issued longer-term funding instruments, more pool-funded Cypriot loans were disbursed, and a large amount of Spanish and Cypriot loans disbursed in kind gradually shifted to the higher rate pool-funded loans.
In August 2015, a new ESM-financed assistance programme for Greece began. Most of the new disbursements to Greece were made in cash; these were therefore pool funded and are priced on the basis of ESM’s cost of funding rates. Other disbursements were made in kind, i.e. through issuance of ESM notes to recapitalise Greek banks. These in-kind debt instruments, whose price is based on the cheaper Euribor 6-month rate, can more swiftly be deployed to reinforce banks’ capital.