Financial Stability in Europe

Cosimo Pacciani

GLC Risk Management Conference

Vienna, 10-11th September 2015

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Disclaimer

IMPORTANT: YOU ARE ADVISED TO READ THE FOLLOWING CAREFULLY BEFORE READING, ACCESSING OR MAKING ANY OTHER USE OF THE MATERIALS THAT FOLLOW.

This presentation (the “Presentation”) has been prepared by and is the sole responsibility of the author and it does not represent the views of the European Financial Stability Facility (the “EFSF”) & the European Stability Mechanism (the "ESM"), and has not been verified, approved or endorsed by any lead auditor, manager, bookrunner or underwriter retained by EFSF or ESM.

The Presentation is provided for information purposes only and does not constitute, or form part of, any offer or invitation to underwrite, subscribe for or otherwise acquire or dispose of, or any solicitation of any offer to underwrite, subscribe for or otherwise acquire or dispose of, any debt or other securities of EFSF or ESM (the “Securities”) and is not intended to provide the basis for any credit or any other third party evaluation of Securities. If any such offer or invitation is made, it will be done so pursuant to separate and distinct offering materials (the "Offering Materials") and any decision to purchase or subscribe for any Securities pursuant to such offer or invitation should be made solely on the basis of such Offering Materials and not on the basis of the Presentation.

The Presentation should not be considered as a recommendation that any investor should subscribe for or purchase any Securities. Any person who subsequently acquires Securities must rely solely on the final Offering Materials published by EFSF or ESM in connection with such Securities, on the basis of which alone purchases of or subscription for such Securities should be made. In particular, investors should pay special attention to any sections of the final Offering Materials describing any risk factors. The merits or suitability of any Securities or any transaction described in the Presentation to a particular person’s situation should be independently determined by such person. Any such determination should involve, inter alia, an assessment of the legal, tax, accounting, regulatory, financial, credit and other related aspects of the Securities or such transaction.

The Presentation may contain projections and forward-looking statements. Any such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause EFSF’s or ESM’s actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Any such forward-looking statements will be based on numerous assumptions regarding EFSF’s and ESM’s present and future strategies and the environment in which the EFSF or ESM will operate in the future. Further, any forward-looking statements will be based upon assumptions of future events which may not prove to be accurate. Any such forward-looking statements in the Presentation will speak only as at the date of the Presentation and EFSF and ESM assume no obligation to update or provide any additional information in relation to such forward-looking statements.

The Presentation must not be reproduced, redistributed or passed on to any other person or published, in whole or in part, for any purpose without the prior written consent of the author.

The Presentation is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.

Financial Stability: A Definition

“A financial system is in a range of stability whenever it is capable of

facilitating (rather than impeding) the performance of an economy, and of

dissipating financial imbalances that arise endogenously or as a result of

significant adverse and unanticipated events”

Garry J. Schinasi – Defining Financial Stability (IMF, 2004)

Three conditions for Financial Stability can be defined:

1. Support to economic transformation – ‘Range of Stability’

2. Facilitation of the performance of an economy

3. Adverse OR unanticipated events to be assessed

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2007-2012: a history of imbalances

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2008 2009 2010 2011 2012 2013 2014 2007

Cost of Crisis

NORTHERN

ROCK

BEAR STERNS

LEHMAN BROS

UK AND US BANKS

GERMAN BANKS

SPANISH BANKS

IRELAND PORTUGAL CYPRUS GREECE

SPAIN

IRISH BANKS

The 2007/12 crisis has impacted the financial stability of advanced

economies, due to:

Financial sector’s bubbles inflating economic parameters

Corrections to the system made difficult by growing connections among

financial players

Contingent liabilities and accumulation of losses posed a threat to

sovereign credit worthiness of some European countries

Series of one-off events in different key economies

The three steps of the crisis

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Banking Crisis Sovereign Crisis Path to Recovery

Ad-hoc intervention

M&A

Regulatory Intervention

Guarantee Schemes

Equity Injection

Valuation vs. Stress Test

Direct public intervention

Nationalisation of banks

Industry-wide schemes

Change to regulatory requirements

Risk Vs. Compliance

Systemic solutions

Supranational Schemes

Euro-wide solution

Industry-driven support

Macroprudential intervention

Growth vs. Stability

Asset Protection Scheme (UK)

TARP (US)

FMS (Germany)

NAMA

SAREB

ECB OMT

FED QE

EFSF

AQR

Banking Union (SRB/SSM)

Juncker Plan

ESM

ECB QE

2008 2009 2010 2011 2012 2013 2014 2007 2015

What we learned

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Financial institutions had to build capacity in different forms to reduce the

impact of systemic events – e.g. capital buffer, resolution mechanisms

Financial conditions need to be tested and stressed on an ongoing basis

Correlation between financial crises and sovereign crises need to be

mitigated

Social impact of crises need to be addressed (risk of bank panics/runs)

Regulation needs to provide a sustainable playing field for agents

The financial system has to keep financing the real economy

New challenges require contingency planning of higher proportions than

in the past

Focus on EFSF and ESM

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The EFSF and ESM are the first resolution mechanisms of large

magnitude created in the world since Bretton Woods

In June 2010, The European Financial Stability Facility (EFSF) was

created as a temporary crisis resolution mechanism by the euro area

Member States

Between 2010 and 2012, the EFSF has provided financial assistance to

Ireland, Portugal and Greece. The assistance was financed by the EFSF

through the issuance of bonds and other debt instruments on capital

markets

In October 2012, the ESM was created, as sole and permanent

mechanism for responding to new requests for financial assistance by

euro area member states. It has provided loans to Spain and Cyprus and

more recently (2015) it has provided financial support to Greece

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Financial Backstops – EFSF and ESM Timeline

7 June European Financial Stability Facility (EFSF) was created

28 November Agreement of financial assistance programme for Ireland (€85bn)

17 May Agreement of financial assistance programme for Portugal (€78bn)

20 June Agreement by euro zone and EU finance ministers to increase EFSF effective lending capacity to €440bn (and

guarantee commitments to €780 bn), widen scope of mandate and finalise terms of permanent stability

mechanism, European Stability Mechanism

21 July Euro zone summit, second support package for Greece and increased scope for EFSF/ESM

2 February ESM Treaty signed

14 March Second Greek programme formally approved by Euro Working Group

20 July Eurogroup grants financial assistance to Spain’s banking sector

8 October ESM inaugurated

29 November Financial Assistance Facility Agreement with Spain (€100bn)

2010

2011

2012

2013 1 January All staff now ESM (but also work for EFSF)

8 January ESM launches its short term programme with its 1st bill auction

25 March Eurogroup agrees to grant financial assistance to Cyprus

8 May Financial Assistance Facility Agreement with Cyprus (€9bn)

1 July EFSF may no longer finance new programmes nor enter into new loan facility agreements

8 October ESM launched its long-term funding programme with a €7 billion 5-year benchmark bond

8 December Ireland successfully exits EFSF financial assistance programme

31 December Spain successfully exits ESM financial assistance programme

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Financial Backstops – EFSF and ESM Timeline (cont)

13 March Latvia becomes 18th Member of ESM

30 April ESM reaches target level of €80 billion in paid-in capital

18 May Portugal successfully exits EFSF financial assistance programme

7 July ESM BoD approves Spain’s request to make an early repayment of €1.3bn

19 December Technical extension of EFSF financial assistance programme for Greece until 28/02/2015

2014

2015 3 February Lithuania becomes 19th Member of ESM

27 February EFSF Board of Directors extends MFFA for Greece until 30/06/2015

10 March ESM BoD approves Spain’s second request for make any early repayment (€1.5bn)

10 March ESM issues first every negative yield for syndicated euro SSA benchmark

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EFSF & ESM: overview

* The initial subscribed capital of €700 bn has increased since the accession of Latvia in March 2014 and Lithuania in February 2015

** For the financial assistance for recapitalisation of the Spanish banking sector, pari passu will apply

*** Regulation (EU) no. 575/2013 (Capital Requirements Regulation), Article 118. Following a decision published by the Basel Committee on Banking Supervision on 18 March 2014, EFSF &

ESM securities will be included in the list of entities receiving a 0% risk weighting under Basel II, as well as received HQLA categorisation for Liquidity Coverage Ratio computation under Basel III

Legal Structure

Duration

Private company under Luxembourg law

Maximum

Lending capacity

Creditor status Pari passu

June 2010-June 2013

No new programmes from 1 July 2013

€192bn committed for

Ireland, Portugal & Greece

Inter-governmental institution under

international law

Permanent institution

€500bn

Preferred creditor status (after IMF) **

Capital structure Backed by guarantees of euro area

Member States

Subscribed capital of €704.8bn*

€80.55bn in paid-in capital

€624.3bn in committed callable capital

Credit Rating AA (negative) / Aa1 (stable) / AA (stable) - / Aa1 (stable) / AAA (stable)

Risk Weighting /

HQLA designation 0% Risk Weighted / High Quality Liquid Asset for LCR***

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ESM Robust Capital Structure: backed by €704.8* bn subscribed capital

Paid-in Capital

€80.55 bn*

• Not available for on-lending but to protect bondholders

• Prudent and conservative investment policy

high quality liquid assets

a short-term and a medium-term tranche

Committed Callable Capital

€624.3 bn*

• Emergency capital call

ESM MD can make emergency capital call to

avoid default on any ESM payment obligation

(to be paid within 7 days of receipt)

• Capital call to restore level of paid-in capital

ESM Board of Directors can make a capital call to

restore level of paid-in capital if reduced due to

loss absorption

• General capital call

ESM Board of Governors may call in capital at any

time

ESM’s subscribed capital exceeds maximum lending capacity by 40%

Minimum 15% ratio of paid-in capital/amount of ESM indebtedness

Paid-in Capital / Subscribed Capital = 11.4%

* The initial subscribed capital of €700 bn has increased since the accession of Latvia in March 2014 and Lithuania in February 2015

Eu

r b

n

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EFSF and ESM: mission and scope of activity

Mission : to safeguard financial stability in Europe by

providing financial assistance to euro area Member States

Instruments

Loans Primary Market

Purchases

Secondary Market

Purchases

Precautionary

Programme

Bank recapitalisations

through loans to governments

All assistance is linked to appropriate conditionality

EFSF and ESM finance their activity by issuing bonds or other debt instruments

Direct bank

recapitalisation

only

EFSF & ESM instruments

■Loans

– Objective: assist MS that have significant financing needs but have lost access to market financing

– MoU (negotiated by EC, in liaison with ECB and where possible IMF) details conditionality

■Primary market purchases

– Objective: allow MS to maintain or restore market access

– For use by MS under macro-economic adjustment programme or under precautionary programme

– Limit: no more than 50% of final issued amount. ESM can hold / sell back to country / resell on

market / use for repos

■Secondary market purchases

– Objective: support functioning of debt markets and appropriate price formation in government bonds

– For use by programme and non-programme countries, with conditionality. Subject to ECB report

identifying risk to euro area and assessing need for intervention

■Precautionary programme

– Objective: prevent crisis situations by assistance before MS face difficulties in raising funds and

avoid negative connotation of being a programme country

– Precautionary conditioned credit line (PCCL) and Enhanced conditions credit line (ECCL). Country

placed under enhanced surveillance by EC during availability period

■Bank recapitalisation through loans to governments

– Objective: help remove the risk of contagion from the financial sector to the sovereign

– Instrument of last resort when other instruments, including the bail-in mechanism, are not sufficient

– For countries not under a macro-economic adjustment programme. Eligible if 1) lack of alternatives

via private sector 2) inability of country to recapitalise banks without experiencing adverse

effects on its financial stability and 3) ability to reimburse the loan. Conditionality applies.

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ESM instrument: direct bank recapitalisation

On 8 December 2014, ESM Board of Governors adopted the ESM direct recapitalisation

instrument for euro area financial institutions.

■Due diligence and thorough economic valuation are pre-requisites

■Limit: €60 billion is the max. amount for direct recapitalisation by the ESM

■ Conditionality: bank-specific rules and policy conditions for the requesting Member State

■ Potential retroactive application: Decided on a case-by-case basis under unanimity rule

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Member State

• Unable to rescue without adverse effects on fiscal

sustainability and market access

• Assistance must be indispensable to protect financial

stability of euro area or its Member States

Bank

• Is or likely to be in breach of capital requirements

• Viability depends on capital injection & restructuring

• Unable to attract sufficient capital from private sources

• Systemic or pose threat to financial stability

Requisites for Eligibility

Direct recapitalisation of banks by ESM: main features

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Private Capital

Appropriate level of write-down/ conversion of debt

in line with EU state aid rules and BRRD*

* A bail-in equivalent to at least 8% of a bank’s total liabilities

and own funds must be imposed before any resolution fund is tapped.

Single Resolution Mechanism

From January 2015 onwards

Up to 5% of a bank’s total liabilities

Bail/in and resolution / restructuring

Member State Reach 4.5% Tier 1

Requesting Member State injects capital to reach

a minimum threshold of 4.5% CET 1

ESM

Reach adequate capital level

ESM injects capital once 4.5% CET1 is reached

Requesting Member State still contributes: 20% in

first 2 years and 10% afterwards

Direct Bank Recapitalisation Instrument

Managing Risk at ESM – Key Objectives

Given the institutional mission, Risk Management at ESM is focused on:

• Monitoring the lending activities

• Managing the investment portfolio to ensure that required credit quality and liquidity are maintained

• Keep monitoring market risk trends, to provide adequate input to decision makers

• Support capital preservation

• Reduce potential risks from operations and compliance

EFSF and ESM are ‘first of their kind’ organisations, therefore the risk function had to be built following best governance practices

ESM and EFSF are non regulated but market-open and highly monitored

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Managing Risk at ESM - Outline of function

ESM risk framework has been established at outset:

• “High Level Principles for Risk Management” (Oct 2012)

» taxonomy of risk types – impact, mitigants

» three lines of defence (business, risk management

and internal audit)

» governance (Internal & Board Risk Committees)

» role of Head of Risk / CRO and Risk Department

• Risk Appetite statement – translation of ESM mandate to risk parameters

• Risk Policy – expands on HLPRM; hierarchy of risk policies and procedures

Chief Risk Officer reports directly to Managing Director, role covers all

risks (financial and non-financial)

Risk culture important – responsible and qualified staff, segregation of

duties, high ethical standards, careful review

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Managing Risk at the ESM – A three pronged defence

The Three Lines of Defence framework allows to share risk management

responsibility across the ESM/EFSF;

The Risk function remains independent and able to intervene when required.

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Managing Director

CRO

Head of Risk & Compliance

General Counsel

1st line of defence 2nd line of defence

Chief Spokesperson

Internal Audit

3rd line of defence

Deputy MD, CFO

Credit Risk

Risk & Compliance

Department

Strategy and Institutional

Relations

Internal Risk Committee

Lending

Head of Investment and

Treasury

Funding

Middle/Back Office

ALM

ALM

Economic and

Market Analysis

MD, Head of Economics,

Policy Strategy and Banking

Corporate

Governance

Finance and

Control

Secretary General

HR and

Organisation

IT and Operations

Operational Risk

Banking

Market Risk

Compliance

Managing risk at ESM - Exposure types

Overview of ESM risk exposure types:

Developing capability to issue / invest in wider spread of activities, risk manage interest rate exposure

Risk is managed through ad-hoc monitoring, limits and reporting – with emphasis on capital preservation and liquidity

Direct Recapitalisation Instrument (DRI) will add equity risk 18

Managing risk at ESM – An example: Early Warning System

• ESM Treaty, Art. 13: “The ESM shall establish an appropriate warning system to ensure that it

receives any repayments due by the ESM Member under the stability support in a timely manner”.

• ESM Terms and Conditions on Capital Calls (under Article 9.2 and 9.3 of the ESM Treaty) require

the Internal Risk Committee to form a view on the financial situation of a borrower and to assess

the planned repayment schedule against likely scenarios.

• In order to address this requirement, the ESM has developed an Early Warning System, with ad-

hoc reporting, decision making and escalation processes:

» Reporting

Five months before a payment date, the borrower provides the ESM with a cash flow overview for

the period up to the payment date, including the ESM payment, which is subject to analysis.

» Internal Risk Committee decision

The Internal Risk Committee receives a full report including the loan exposure, the summary of

the liquidity situation of the borrower and any additional information with a recommendation for

action. The Internal Risk Committee forms a view on the financial situation of the borrower and

likelihood of payment of the amount due in three months. If the Internal Risk Committee

concludes that there is a risk of default the process is escalated.

» Escalation process

The Managing Director immediately informs the Board of Directors, the observers in the Board as

well as EWG and propose possible actions.

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Conclusion

How to avoid a Minsky moment to become a Minsky Cycle

• Financial stability in Europe requires multi-layering of institutions

• Additional capacity will need to be framed through regulation and prudent credit growth

• Resolution mechanisms offer a flexible tool, which can be adjusted to specific purposes or expanded according to requirement

• Political and social impact of crises requires a robust governance with checks and balances

• Risk managing a resolution mechanism involves a new combination of tasks and roles

• Communication channels between different institutions in Europe are pivotal for monitoring and action

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Thank you!

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Contact

Name: Cosimo Pacciani

Position: Chief Risk Officer

Phone: +35 2 260962255

Email: C.Pacciani@esm.europa.eu

Follow ESM on Twitter:

@ESM_Press (www.twitter.com/ESM_Press)

This presentation must not be reproduced, redistributed or passed on

to any other person or published, in whole or in part, for any purpose

without the prior written consent of the European Stability Mechanism