The EFSF, European Financial Stability fund was founded in May 2010 with the objective to act as a bank (although EFSF does not operate as a bank) to provide financial assistance to the Eurozone member countries that use the Euro as their currency.
The purpose of the EFSF was to safeguard the financial stability in the Eurozone and does this by offering financial aid to the Eurozone member states. Set up as a rescue fund, the EFSF is used to combat the regional sovereign debt crisis.
The EFSF was set up after a unanimous agreement by 27 member states which authorizes the EFSF to borrow up to €440 billion, which was later increased to €780 billion in July 2011. The EFSF is operates from Luxembourg and has its own CEO, Klaus Regling, a board of directors comprising of high level executives from the 17 eurozone member states and an operational staff of 12 employees with administrative help offered by the European Investment Bank.
How does the EFSF provide financial assistance
The EFSF issues bonds and other debt instruments in order to raise the cash and provide loans to countries that need the aid. While primarily the cash is raised in Euros, upon the request of the country in crisis, other currencies can also be used. The debt instruments are sold via specific banks to investors who wish to purchase them, mostly institutional investors and other foreign countries as well.
The loans given out to the countries are backed or guaranteed by other Eurozone members. To get a loan from the EFSF, other financial institutions such as the European Commission, International Monetary Fund also also involved.
When applying for a loan, the country seeking aid must prove that it is unable to borrow money from the international debt markets. After many rounds of negotiation with the IMF, EU Commission and the EFSF committee, the country’s financial books are looked into and a decision is made. While approving the loan, the EFSF requires other member states to accept granting of the loan to the beligeaured country.
Defaulting on the EFSF Loans
The EFSF’s primary purpose is to disburse the loans, therefore the institution does not directly deal with the loan itself. Countries receiving the financial aid must pay back the funds received along with a specified interest rate. When a country that receives the EFSF loan default, the guarantors are on the hook. However, in order to limit the liability of the guarantors, each of the participating member states are limited in the amount of loan guarantee that they can offer. For example, Germany can guarantee a loan of up to 27%, France can guarantee up to 20% and so on. In a bigger perspective, Eurozone member states that enjoy a stable financial credit rating status usually have a larger stake in the loan guarantees. In total, the aggregate of all loan guarantors usually amounts to 100% of the loan that is being disbursed.
Initially, the EFSF was slated to be shut down by June 2013 in the event of no financial activity. However this has changed as the EFSF granted loans to countries such as Portugal, Ireland and thus will remain active until the loan obligations by these countries are fully met.
In order to make it easy for the EFSF to raise money, credit ratings agencies such as Moody’s, Standard and Poors and Fitch Ratings, initially awarded the EFSF a rating of Triple A. However in early 2012, the investment ratings for the EFSF was downgraded to AA+ which sparked worries for the EFSF to raise more funds easily.
The EFSF will be eventually replaced by the European Stability Mechanism or ESM with €500 billion of firepower. The EFSF has lent money to countries such as Greece, Ireland, Portugal.