Explainer on ESM reform and revisions to the ESM Treaty
On 21 June 2019, the Euro Summit welcomed the progress made in the Eurogroup on the strengthening of the Economic and Monetary Union (EMU). The Summit took note of the broad agreement reached by the Eurogroup on the revision of the ESM Treaty and expects the Eurogroup to continue its work so as to allow for an agreement on the full package in December 2019. This Explainer covers the ESM reform and the revisions to the ESM Treaty.
Why will the ESM Treaty be revised?
The ESM Treaty will be 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 revisions to the ESM Treaty were broadly agreed by the Eurogroup in June 2019. A final decision by the euro area Heads of State or Government is expected in December 2019, which would pave the way for starting the ratification process of the revised Treaty.
Common backstop to the Single Resolution Fund
What is the common backstop?
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.
When will the common backstop be in place?
The common backstop will be in place at the latest by 1 January 2024. The size of the credit line(s) will be aligned with the target level of the SRF, 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 by up to another two years. As a result, it will be fiscally neutral over the medium term.
Can the common backstop be introduced before 2024?
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. 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).
In what situations can the SRF draw loans under the common backstop?
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 ex-post contributions or borrow funds from other sources at acceptable rates.
Who will decide whether to grant a credit line and disburse loans from the ESM to the SRF?
On the basis of a request by the SRB and of a proposal by the ESM Managing Director, the ESM Board of Governors (composed of the 19 euro area finance ministers) may decide to grant the credit line to the SRB covering all possible uses of the SRF.
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 the criteria listed in the Terms of Reference of the Common Backstop. 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 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 financial assistance instruments.
Will the ESM’s Direct Recapitalisation Instrument for banks remain part of the ESM’s financial assistance toolkit?
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.
ESM precautionary credit lines
What precautionary credit lines are available?
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.
Why are precautionary credit lines needed?
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. A precautionary credit line works like an insurance policy. 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 potential small crises from turning into more serious ones that would 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 recently.
How will the PCCL work under the revised ESM Treaty?
Access to a PCCL will be based on eligibility criteria and limited to ESM Members where the economic and financial situation is fundamentally strong and whose government debt is sustainable. 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) and to implement reforms. Instead, the country will sign a Letter of Intent (LoI) committing to continue to comply with all eligibility criteria. Continuous respect of the eligibility criteria will be assessed at least every six months.
What happens if a country does not comply with the PCCL eligibility criteria?
If an ESM Member no longer complies with the eligibility criteria for the PCCL or with the attached eligibility criteria, access to the credit line will be stopped, 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 assessed, an additional margin will be charged. If the credit line is not maintained, the country can request another form of financial assistance from the ESM.
What are the requirements for requesting an ECCL?
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) committing to comply with the conditionality defined for it. The country commits to adopt corrective measures addressing such weaknesses and avoiding future problems in respect of access to market financing.
The ESM Member has the flexibility to request funds at any time during the availability period. When an ECCL is granted or a PCCL drawn, the ESM Member is subject to enhanced surveillance by the EC. Surveillance covers the country’s financial condition and its financial system. These rules have been in place since the ESM was set up in 2012 and remain unchanged in the revised ESM Treaty.
What are single-limb collective action clauses (CACs)?
Collective action clauses are clauses in bond terms that allow changes to the terms of those bonds to be made subject to a vote by the holders of those bonds. If a majority approves the change, it becomes effective for all the 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 multiple 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”. This reduces “holdout” risk, i.e., that a small group of bondholders decides 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 a debt crisis.
In the revised ESM Treaty, ESM Members will commit to introducing single-limb CACs into new euro area sovereign bonds issued starting from 1 January 2022.
What is the current situation regarding the use of CACs?
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 more difficult to achieve a majority that would make it possible to restructure a country’s sovereign debt, compared to a single-limb CAC.
What role can the ESM have in debt restructuring?
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, informal, non-binding, temporary and confidential basis.
The ESM’s cooperation with the European Commission
Why was it necessary to lay down the principles of the ESM’s cooperation with the EC?
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 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.
What will be the ESM’s new tasks in future financial assistance programmes?
The ESM will have a stronger say in the preparation and monitoring of conditionality in future financial assistance programmes. The ESM will be more involved in the design of policy conditionality and any future MoU will be signed by both the Commission and the ESM Managing Director. The Commission and ESM would jointly prepare the financial stability risk, 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.
To enable the ESM to perform these tasks, it may follow and assess the macroeconomic and financial situation of its Members including the sustainability of their public debt and carry out analysis of relevant information and data. The European 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.
How ESM and EMU reform will continue
What has to happen to complete this ESM reform?
The ESM Treaty will come into force when 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 an agreement amending the ESM Treaty and when key documents related to the ESM reform are politically agreed by all ESM Members. This is expected to happen in December 2019.
What are the next steps in the EMU reform?
The June 2019 Euro Summit took note of the main features of a budgetary instrument for convergence and competitiveness for the euro area. Political discussions will continue regarding the size, governance and sources of financing for the instrument.
Discussions will also continue on creation of a European deposit insurance scheme (EDIS), which is the missing third pillar of banking union. More technical work will be needed to define the possible ways forward, which would open up the way to a roadmap for political negotiations on EDIS.
Progress is being made on the creation of a capital markets union (CMU) in Europe. Since the project was launched, most of the European Commission’s 13 legislative proposals have now been agreed. It will take several years before their full impact of these measures is felt. It is up to the next Commission to decide on future policies that will complete the work on the CMU.
Draft revised text of ESM Treaty as agreed by the Eurogroup on 14 June 2019
New annexes (III and IV) to draft revised ESM Treaty (on precautionary credit lines and backstop facility)
Statement of the Euro Summit, 21 June 2019
Letter by President Centeno to President Tusk on the deepening of EMU (15 June 2019)
Term sheet on the Budgetary Instrument for Convergence and Competitiveness