The European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM)

Structure, Objectives and Principles of Operation

Seminar Paper, 2012

41 Pages, Grade: 1,0


Table of Content:

I. Abstract

II. The European Financial Stability Facility (EFSF)
1. Emergence of the EFSF
2. Structure
2.2. Capital Structure
3. Principles of Operation
3.1. Process of Support Requests
3.2. Funding Strategy
4. Structures and Objectives of Financial Support Instruments
4.1. Bank Recapitalisation
4.2. Precautionary Programme
4.3. Primary Market Intervention
4.4. Secondary Market Intervention
5. Lending Operations
5.1. The Programme for Ireland
5.2. The Programmes for Portugal, Greece, Spain, and Cyprus

III. The European Stability Mechanism (ESM)
1. Introduction
2. History
2.1 Generic
2.2 Treaty Basis and Ratification
3. Structure
3.1 Governance Structure
3.2 Capital Structure and Contribution
4. Funding Objectives and Principles
4.1 Procedure
4.2 Instruments

IV. Conclusion

V. Questions

Separation of Chapters

Marcus Stallech:

I. Abstract
II. The European Financial Stability Facility (EFSF
V. Questions

Daniel Kolb:

III. The European Stability Mechanism
IV. Conclusion
V. Questions

I. Abstract

The following paper by Marcus Stallechner and Daniel Kolb deals with the structure, objectives and principles of operation of the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM). The focus is on the way from the emergence of those two companies, their company and capital structure, as well as on their financial support instruments and lending operations. The topicality and effects on the economy as well as the great public interest make this to an interesting article, which approaches the details and facts of the EFSF and ESM.

II. The European Financial Stability Facility (EFSF)

1. Emergence of the EFSF

In May 2010 Greece started to get into financial trouble. Because the effects of a national bankruptcy of Greece were unpredictable, the International Monetary Fund (IMF) and the other euro area member states accommodated a bilateral credit of €110 billion for Greece. A few days later it became clear, that Greece hasn´t been the only country that was in trouble. Portugal and Ireland also headed towards national bankruptcy. Therefore on 9 May the heads of state and government decided to create a temporary bailout fund until 2013 for the whole euro zone. The bailout fund started its operation on 7 June and exists of the European Financial Stability Facility (EFSF) with a capacity of €440 billion guaranteed by the euro area member states together with the European Financial Stability Mechanism (EFSM) with a capacity of €60 billion and the IMF with a capacity of €250 billion. After Ireland in November 2010 and Portugal in May 2011 drew on a credit, the EFSF got into trouble because it was not able to take out all €440 billion from the capital market while keeping its AAA rating. The reason was that only 6 euro area member states had an AAA rating (Germany, Finland, France, Luxembourg, Netherland, and Austria). If the EFSF wanted to keep its AAA rating, only the guarantees of the so rated countries could be used as collateral for a credit on the capital market. As a result the guaranteed lending volume of the AAA rated countries had to be extended to overall €440 billion and even if it was without effect on the solvency of the EFSF, also the guarantees of the worse rated countries were increased. This led to a total capacity of the EFSF of €780 billion. As in July 2011 it became clear that Greece needed another €109 billion, the EFSF also got new competences (see chapter 4). All countries that borrowed money from the EFSF also had to fulfil high demands for budget cuts controlled by a troika of the European Union (EU), the ECB(European Central Bank) and the IMF (see chapter 4). Because of the EFSF being a temporary bailout fund it will be concluded on the earliest point of time after 30 June 2013 once there are no further loan payments to be disbursed and all other financial support actions are paid back. The last two countries, which asked for financial assistance of the EFSF, were Cyprus in June 2012 and Spain in July 2012.

(Nikolas Busse, FAZ, 2011 | Prof. Dr. Lüder Gerken, 2011 |, 2012)

Figure 1 |, 2011

illustration not visible in this excerpt

2. Structure

2.1. Company Structure

The EFSF is a “société anonyme” headquartered in Luxembourg City and its shareholders are the 17 euro area member countries. In contrast to the ESM it runs under Luxembourgian law and is also a very lean organisation with a staff of around 20 people, which is possible due to the help of the German Debt Management Office (DMO) and the European Investment Bank (EIB). The German DMO provides front and back office support, debt issuance as well as cash and risk management. The EIB is responsible for IT, infrastructure, documentation and accounting. The CEO of the EFSF is the German native Klaus Regling, who former worked at the European Commission (EC), the IMF and the German Ministry of Finance.

Figure 2 |, 2011

illustration not visible in this excerpt

The EFSF is observed by the board of directors that consists of one representative (deputy ministers, secretaries of state or general directors of national treasuries) of every euro area member state. In addition to the state representatives there are also observers of the ECB and the EC in the board of directors who can present their ideas without having a right to vote. The head of the board of the EFSF is the chairman of the Economic and Financial Committee (EFC) of the EU, Thomas Wieser. (, 2012 |, 2010 |, 2012)

2.2. Capital Structure

As already mentioned in chapter 1, the capacity of the EFSF had to be increased to maintain its AAA rating. In the bar diagram below the amount of capital in € billion per euro area member state is depicted.

Figure3 |, 2012

illustration not visible in this excerpt

The guaranteed capital, which backs up the issues of the EFSF, is distributed according to the percentage of the paid-in capital of the euro area member states at the ECB. In the chart it is stated that Germany backs up highest amount of guarantees with a share of €211 billion. This corresponds to about 27% of the total guarantees of €780 billion. Altogether, the three biggest economies in the euro zone, Germany, France and Italy back up an amount of €508.8 billion, which represents about 65% of the whole amount of the EFSF. Therefore, the EFSF probably could not compensate a bailout of one of theses countries. (, 2012)

3. Principles of Operation

3.1. Process of Support Requests

Before the EFSF could act and support a country, there were a few steps that had to be done. First of all, to make a support request at the EFSF, a euro area member state country was not allowed to be able to fund itself under acceptable interest rates on the capital market. After a country made a support request, it had to negotiate a cost-cutting and reformation programme with the EC and the IMF. Therefore, experts from the EC, the IMF and the ECB were sent to the requesting country to work out such a programme. After the euro area member states ministers of finance, who later on also had to decide about the maximum amount of the loan, the margin, maturity and the number of instalments, accepted this scheme, a so-called Memorandum of Understanding (MoU) had to be signed between the country in need and the European Commission. As financial assistance of the EFSF was closely linked to strict policy conditions, all these were stranded in the MoU. In case a country fails the conditions, the loan disbursements can be set out and the MoU would be renegotiated. On condition that all these requirements were fulfilled, the EFSF could raise the funds and disburse the loan to the country in need. (, 2012)

3.2. Funding Strategy

To provide financial support to euro area member states, the EFSF had to raise funds on the capital market. As explained before, the guarantees for the funds are backed up by the shareholders of the EFSF, which are the euro area member countries.

The overall funding strategy of the EFSF could be stated as SSA

(Sovereign, Supranational and Agency) with benchmark issuing and focus on a high liquidity. A Sovereign is somebody with power and authority on somebody else, that were in case of the EFSF the euro area member states. Supranational means that an institution operates across national boarders and is governed by representatives and shareholders from different countries. Other examples for supranational institutions besides the EFSF are the International Finance Corporation (IFC) and the EIB. An agency is an institution, which acts on behalf of someone else. Related to the EFSF the German DMO is the agency as it is responsible for issuing bonds, syndications, auctions, private placements, and tap issues which all belong to a long-term funding programme. (, 2012, |, 2012)

A closer look on the details of the funding strategy points out, that at the beginning the EFSF applied a simple strategy that is called back-to-back strategy. In November 2011 the EFSF started applying a modified strategy that used a cash buffer as an essential component. This strategy also included a short-term bill programme, which consisted of regular auctions of three month and six month bills. An improvement of the modified strategy was also, that the raised funds were not anymore related to a certain country; instead they were taken together and disbursed to the countries in need. The advantage of this was, that the lending rate stayed the same for every country. For the remaining quarter of 2012 the EFSF plans to keep it current strategy consisting of issuing benchmark bond as well as a short-term bill program. Until the end of 2012 the EFSF plans to raise €11 billion in long-term funding and €8.5 billion in short-term bills. For 2013 the EFSF expects issuing bonds of €40 billion in the long-term programme and €12 billion in the short-term bill programme. Like before, it is expected that the main investors of EFSF bonds are institutions like bank, pension funds, central bank and asset managers from all around the world. (, 2012)

4. Structures and Objectives of Financial Support Instruments

To support euro area member state countries in financial difficulties, the EFSF has several instruments, which are also used by the ESM since its start in September 2012. When it was founded in 2010, the EFSF originally was just allowed to issue bonds or other debt instruments within an economic adjustment programme to finance itself. This was necessary to provide loans to countries in need. Combined with the

increase of its lending capacity in competences, which were

- Bank recapitalisations
- Precautionary programmes
- Primary market intervention
- Secondary market intervention

(, 2012)

4.1. Bank 2011 the EFSF also got new

Bank recapitalisations usually concern small countries with a large financial sector problem. The main goal of such a programme is to limit the effects of financial stress on the economy and other financial institutions within the euro zone. The EFSF was not allowed to make loans directly to the banks, instead it made sure that the government had enough money to recapitalise the financial institutions by borrowing money to the government at a acceptable interest rate. Bank recapitalisations work only in countries, which did not apply for an economic adjustment programme, because in this a bank recapitalisation is already included (€35 for Ireland and €12 for Portugal).

As time is a factor during bank recapitalisations in terms of increasing speed of financing and reflecting the sectorial usage of the loan, the process of requesting and controlling has to be more simply. The initial request for a bank recapitalisation programme has to be made by the government of the euro area member state to the chairman of the

Eurogroup, Jean-Claude Junker. Afterwards, there will be an assessment by the European Commission together with the ECB and if necessary also with the EBA (European Banking Authority), the ESMA (European Sales and Marketing Association) and the EIOPA (European Insurance and Occupational Pensions Authority).

Of course there are also conditions attached to this type of assistance. First of all, the shareholders of distressed financial institutions are enquired to provide additional capital, afterwards the national governments are expected to find a solution and only if those two steps fail, the EFSF would have intervened. As the EFSF did just borrow the money to the government and not directly to the financial institutions, it was considered as state aid. Therefore it had to be conforming to the EU state aid rules.

(, 2012 | Klaus Regling, 2012 |, 2012)

4.2. Precautionary Programme

In the precautionary programme euro area member states who are not in any other financial support programme and whose economy is still healthy could apply for a credit line at the EFSF to prevent a crisis. There are three different types of credit lines:

- Precautionary Conditioned Credit Line (PCCL)
- Enhanced Conditions Credit Line (ECCL)
- Enhanced Conditions Credit Cine with sovereign partial risk protection (ECCL+)

If a euro area member state would like to apply for a PCCL, its economic and financial situation has to be generally healthy. This is determined through criteria like observing the SGP (Stability and Growth Pact) and EIP (Excessive Imbalance Procedure) obligations as well as the sustainable public debt. A PCCL can be a loan or a primary market purchase.

The ECCL can be used for all euro area member states whose economic and financial situation is still healthy, but already shows temperate vulnerabilities, which exclude access to the PCCL. The criteria for an ECCL are, that the euro area member countries correct their economic and financial weaknesses after consulting the EC and ECB.

An ECCL+ is basically an ECCL with a sovereign partial risk protection to primary bonds. This means that a holder of a PPC (Partial Protection Certificate) gets a concrete amount of credit protection, which is a certain percentage of the nominal value of the amount of the government bond. The criteria for an ECCL+ are equal to those for an ECCL, except that certain circumstances require a PCC.

Usually the conditions of a PCCL, an ECCL, and an ECCL+ in terms of size of the credit line vary between 2% and 10% of the GDP (Gross Domestic Product). The duration is usually 1 year, but the credit line can be extended for 6 month twice.

(, dpa, 2011 |, 2012 |, 2011)

4.3. Primary Market Intervention

The main objective of a primary market intervention is to recreate a euro area member state´s trust and relationship with the investors. Therefore the government bonds can be purchased to a limit of 50% of the total amount of issued bonds. This reduces the risk of failed government bond auctions. The primary market intervention mainly affects countries, which are already under a macroeconomic adjustment programme and can be applied either in additions of a regular loan or at the end of such a programme to facilitated a euro area state member´s come back on the market. The conditions of a primary market intervention are equal to those on of a macroeconomic adjustment programme or of a precautionary programme.


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The European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM)
Structure, Objectives and Principles of Operation
University of Applied Sciences Augsburg
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ESM, EFSF, Rettungsschirm
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Marcus Stallechner (Author)Daniel Kolb (Author), 2012, The European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), Munich, GRIN Verlag,


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