ESM Management Comments on Board of Auditors’
Annual Report to the Board of Governors
for the period ended 31 December 2014
Dear Chairperson,
I would like to thank you for the opportunity to provide
management comments on the Board of Auditors’
Annual Report to the Board of Governors for the
period ended 31 December 2014.
During the past year, the ESM management continued
its collaborative relationship with the Board of Auditors.
In 2014, the Board of Auditors held nine meetings and
met once with the Board of Directors. Furthermore,
the Chairperson of the Board of Auditors met with the
Chairperson of the Board of Governors and attended
the annual meeting of the Board of Governors. To date
in 2015, the Board of Auditors has held four meetings.
During these meetings, the Board of Auditors was
regularly updated on ESM activities, the work of the
ESM governing bodies, and other relevant issues and
developments. Key staff members, including the ESM
management, devoted considerable time and effort
to discuss relevant issues, to submit written notes in
response to questions raised, and to provide any other
cooperation and assistance needed for the successful
discharge of the mandate of the Board of Auditors.
Furthermore, the Board of Auditors met regularly
with the internal audit function and monitored and

reviewed the work of the external auditor. In response
to the previously issued Board of Auditors’ recommen‑
dation, the ESM performed a competitive procure‑
ment procedure for the selection of an independent
external auditor for the financial years 2014–2016.
To ensure full transparency and process quality, the
ESM invited members of the Board of Auditors to
serve as independent observers. The ESM manage‑
ment also specifically reflected the Board of Auditors’
access to the working papers of the external auditor
as a mandatory requirement for the engagement.
PricewaterhouseCoopers, Luxembourg (“PwC”) obtained
the highest score in the procurement procedure
and was subsequently appointed by the Board of
Governors as the independent external auditor for
a three‑year term.
The Board of Auditors, as part of its duties, also
reviewed the ESM financial statements as of
31 December 2014 (the “Financial Statements”) as
well as the working papers of the external auditor
on the statutory audit of the Financial Statements.
Subsequently, the Board of Auditors prepared
a report in respect of the Financial Statements
which is included in the ESM 2014 Annual Report
along with the Financial Statements and the external
auditor’s opinion.

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Audit Procedures Conducted in 2014

AUDIT PROCEDURES CONDUCTED
BY THE BOARD OF AUDITORS
The ESM is subject to significant independent audit
review throughout the year, as well as at year‑end.
In addition to the annual external audit, the Board
of Auditors carried out several independent audits in
accordance with Article 30 (3) of the ESM Treaty. In
January 2014 the Board of Auditors carried out an audit
of the ESM Risk Management, and in November 2014,
an audit of the ESM Lending Operations. Furthermore,
in February 2015, a follow‑up audit of the ESM Risk
Management was conducted.
In line with Article 24 (5) of the ESM By‑Laws, the
Board of Auditors appointed two subject matter
experts from the German Supreme Audit Institution
(Bundesrechnungshof) to support its audit work. The
ESM dedicated significant time and effort to providing
all the necessary cooperation and support required
for the successful completion of these audits.

AUDIT PROCEDURES CONDUCTED
BY THE INTERNAL AUDIT FUNCTION
The Internal Audit function reported that the 2014
Audit Plan approved by the ESM management and
presented to the Board of Auditors, had been accom‑
plished and that the ESM had made sustained efforts
in the clearance of outstanding internal audit recom‑
mendations. During the past year, the Internal Audit
function performed eight audits, on matters such as
business continuity, asset and liability management,
outsourcing controlling, funding, as well as investment
and treasury. No high‑risk recommendations were
outstanding at the end of March 2015. The ESM
management agreed that, going forward, greater
emphasis would be placed upon the timely closure
of internal audit recommendations, including those
classified as medium and low risk.

The Internal Audit function had full, free and unre‑
stricted access to the Board of Auditors throughout
the year. There have been seven meetings between
the Internal Audit function and the Board of Auditors
in 2014 and three further meetings to date in 2015.
The Internal Audit function reported to the Board
of Auditors on: the results of the internal audits
conducted, the progress in implementing the Annual
Audit Plan; and, on a quarterly basis, the implementa‑
tion status of the internal audit recommendations as
well as the recommendations issued by the Board of
Auditors and the independent external auditor.

AUDIT PROCEDURES CONDUCTED BY
THE INDEPENDENT EXTERNAL AUDITOR
The independent external auditor PwC carried out
the statutory audit and issued an unqualified audi‑
tor’s report confirming that based on the audit, the
Financial Statements give a true and fair view of the
ESM financial position, financial performance and
cash flow as of 31 December 2014. The statutory
audit consisted of a preliminary audit conducted from
November through December 2014, and a final
audit review of the Financial Statements conducted
from January through March 2015. As part of its
annual audit, PwC also reviewed the principal internal
control procedures in place in order to ensure the
accuracy and reliability of ESM accounting records
and the safekeeping of assets. The independent exter‑
nal auditor conducted the audit in accordance with
the International Standards on Auditing as adopted
for Luxembourg by the “Commission de Surveillance
du Secteur Financier”. During the extensive tests of
controls performed as part of the statutory audit, no
exceptions were noted. Furthermore, PwC confirmed
that unlimited access to documents and staff had
been granted and noted very good cooperation by the
ESM management.

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ESM Internal Control Framework
Since the last Board of Auditors’ Annual Report to
the Board of Governors in June 2014, the ESM has
progressed significantly in consolidating and finalising
processes, procedures and internal controls across
all areas of the institution.
The ESM recognises the importance of effective
internal controls which provide the foundation for the
safe and sound operation of the institution. In October
2013, as part of the maturing of the institution, the
Board Risk Committee supported the implementation
of the principles of the Basel Committee’s Framework
for Internal Control Systems in Banking Organisations.
Since then, the ESM has made important strides
in further developing its internal controls with the
objective of completing a comprehensive and effective
internal control system aligned with best practices
by the end of 2015. During the past year, the ESM
developed an Internal Control Roadmap which iden‑
tified the remaining elements outstanding and the
steps required to achieve this objective. To address
these, the ESM rolled out a major institution‑wide
project and dedicated significant internal and external
resources during 2014 and 2015 to finalise the ESM
internal control framework. The project is currently
75 percent complete and all outstanding elements will
be fully in place as of year‑end 2015.

With the completion of the Internal Control Roadmap,
the ESM will translate the Basel Committee’s internal
control principles into relevant entity level, process
level, and information technology controls, consistent
with the nature, complexity and risks inherent in ESM
activities. The internal control framework will thus
complement the three lines of defence governance
model which the Board of Directors established with
the ESM Risk Policy.
The independent external auditor acknowledged these
efforts, noting good progress on the recommenda‑
tions issued in last year’s Management Letter. PwC
confirmed that the internal control environment had
significantly improved compared to the previous year
in terms of staff allocated to the second and third
line of defence as well as the organisational effort
dedicated to the strengthening of internal controls.
I now turn to the detailed recommendations issued
in the Board of Auditors’ Annual Report to the Board
of Governors. In line with Article 24 (8) of the ESM
By‑Laws, the ESM management would like to provide
the following comments in this regard:

4 | EUROPEAN STABILITY MECHANISM

1.	Follow‑up to the 2013 Board of Auditors’ Annual Report
to the Board of Governors

- ESM Internal Control Framework
As noted earlier, the ESM substantially enhanced
its internal control framework over the past year in
order to meet best practice standards. As such, the
ESM rolled out a major institution‑wide project and
deployed significant resources to the strengthening of
the internal control system in order to fully align with
the Basel Committee’s Framework for Internal Control
Systems in Banking Organisations. The ESM made this
alignment one of its institutional priorities and these
efforts will allow the ESM management to confirm the
adequacy and effectiveness of ESM internal controls
as of 31 December 2015.

- ESM Financial Controls and
Financial Reporting
As part of the ongoing internal control initiative, the
ESM strengthened the Finance & Control function
and its underlying controls. As such, procedures
and controls over the completeness and accuracy of
accounting entries were enhanced.
To address fully the recommendations issued by the
Board of Auditors and the independent external
auditor, the ESM also implemented an IT accounting
module for its financial system in May 2015. The
module automates the generation of accounting
entries for all financial transactions and reduces the
number of manual interventions required. The ESM
expects that these efforts should fully address the
recommendations issued in this regard.

- “Fit for purpose” Analysis of the ESM
accounting framework
On 13 December 2012, the Board of Directors
adopted a resolution implementing the EU Accounting
Directive (Fourth Council Directive 78/660/
EEC of 25 July 1978, as amended) and the EU
Banking Directive (Council Directive 86/635/EEC of
8 December 1986, as amended) as the applicable
ESM accounting framework. The Board of Auditors
approved this decision on 16 January 2013 subject
to the subsequent completion of a “fit for purpose”
analysis of the adopted ESM accounting framework.
Accordingly, the ESM performed its first “fit for pur‑
pose” analysis in May 2014, after completion of the

first full financial year of activity. This in‑depth analysis
was performed by internal resources with external
expertise provided by Deloitte, Luxembourg.
The “fit for purpose” analysis concluded that the
approved ESM accounting framework fits the spe‑
cific purpose of the ESM, its political mandate and
long‑term financial assistance strategy, while providing
all relevant information to the addressees of the
Financial Statements.
The analysis was extensively discussed with the Board
of Auditors and updated to reflect the comments
provided. Following these discussions, the Board of
Auditors agreed to conclude its deliberations on the
matter, subject to the ESM performing a continuous
review and assessment of the suitability of the ESM
accounting framework in case of changes in ESM
activities or the accounting landscape.
Accordingly, the ESM is monitoring the accounting
environment with view to any upcoming changes and
developments:
On 29 June 2013, the new EU Accounting Directive
(Directive 2013/34/EU of the European Parliament
and of the Council of 26 June 2013) was published in
the Official Journal of the European Union. This new
Directive repeals the current EU Accounting Directive.
The ESM will adhere to the same transposition period
applicable to the Member States and will therefore
implement the Directive for the financial year com‑
mencing on 1 January 2016 and onwards.
The new EU Accounting Directive re‑casts the cur‑
rent EU Accounting Directive and Council Directive
83/349/EEC of 13 June 1983 on consolidated
accounts. Consequently, many of the provisions in
the new EU Accounting Directive have been carried
over from earlier directives. The ESM is currently
assessing the implications for the financial reporting
process and will finalise a comprehensive gap anal‑
ysis in preparation of the application of the new EU
Accounting Directive in 2016.
In addition to the applied ESM Accounting Framework,
the ESM is continuing to closely follow the devel‑
opments in relation to the International Financial
Reporting Standards (“IFRS”), including the IFRS 9
Financial Instruments, which will become effective no
earlier than 2018.

| 5

The ESM is assessing the implications of the new EU
Accounting Directive as well as any developments
regarding the IFRS in consultation with external
accounting experts. In addition, the ESM seeks reg‑
ular information exchanges with peer institutions on
these matters.
As such, based on the continuous assessment
performed by the ESM, neither ESM activities and
operations, nor current legislation have changed sig‑
nificantly since the approval of the applied accounting
framework by the Board of Directors in December
2012 and the Board of Auditors in January 2013.
Therefore no revision of the applied accounting frame‑
work is currently required.

- Adoption of the “EU Regulatory
Framework” and ESM Procurement Policy
The ESM has noted that the Board of Auditors reiter‑
ated its recommendation that “the ESM adopts the EU
regulatory framework as its own”. As already outlined
in previous years, this frame of reference does not rec‑
oncile directly with the ESM status as an international
financial institution outside the EU framework. The
ESM regulatory frame of reference is the ESM Treaty
ratified by the 19 euro area Member States, and the
ESM By‑Laws, as adopted by the Board of Governors.

This rationale also applies to the ESM procurement
policy. Taking this into account and similar to other
international financial institutions, the ESM had initially
implemented a procurement framework corresponding
to its legal status as an international financial institution.
While such procurement policy observes the fundamen‑
tal principles of the EU Directive on Public Procurement
of fair treatment, transparency, non‑discrimination,
mutual recognition and proportionality, it also reflects
the specific context and operating model of the ESM.
In response to the recommendation of the Board of
Auditors, the ESM extensively reviewed various alter‑
natives for the further development of its procurement
framework as well as the associated costs and bene‑
fits linked to these alternatives. Following a technical
consultation with experts from the ESM Members and
a subsequent discussion with the Board of Directors
in May 2015, the ESM is currently in the process of
implementing the thresholds and key elements of the
EU Directive on Public Procurement while preserving
a certain degree of efficiency and flexibility in the
procurement procedures and timeframes.
The ESM will thus address the Board of Auditors’
recommendation later in 2015 by implementing
a “substance over form” approach to its alignment with
the EU public procurement rules, commensurate with
its special mandate, relative size and operating model.

6 | EUROPEAN STABILITY MECHANISM

2.	Findings and Recommendations of the 2014 Board
of Auditors’ Annual Report to the Board of Governors

EXTERNAL AUDIT
- Procurement procedure for the
external auditor and Board of
Auditors’ access to the working
papers of the external auditor
The ESM performed a competitive procurement pro‑
cedure for the selection of the independent external
auditor for the 2014 - 2016 ESM statutory audits.
To ensure full transparency and process quality,
the ESM invited members of the Board of Auditors
to serve as independent observers. PwC obtained
the highest score amongst all candidates for the
engagement and was subsequently appointed by
the Board of Governors for a three‑year term.
The audit engagement letter reflected the Board of
Auditors’ requirements on the terms of the external
audit engagement, including the Board of Auditors’
access to the working papers of the independent
external auditor.

- Long‑form audit report
Regarding the Board of Auditors’ recommendation
for the issuance of a long form report by the
independent external auditor, the ESM would like to
recall that this topic was discussed during the joint
Board of Directors and Board of Auditors meetings
on 13 June 2013 in Rome and on 13 June 2014
in Lisbon. The Board of Directors repeatedly
supported the view that a long form report would
not be suitable for the ESM as an international
financial institution. Long form reports are generally
a requirement that national bank supervisors issue
for banking institutions. Furthermore, such a long
form report and the related additional audit proce‑
dures may not fall within the scope of the external
auditor’s mandate pursuant to the ESM By‑Laws.
Since 2013, the external auditor has been comple‑
menting the Management Letter with an additional
“Special Topic Report” on a matter relevant to the
financial reporting process selected in consultation
with the Board of Auditors. As such, the 2014
Special Topic Report assessed the ESM manage‑
ment reporting system and its linkages to the
Financial Statements.

Furthermore, for 2015 and onwards the ESM is
planning to look into the preparation of an additional
report in line with Article 11 of the recently issued
Regulation (EU) No 537/2014 on specific require‑
ments regarding statutory audits of public‑interest
entities. Such an additional report could replace
the 2015 Special Topic Report if it is found to be
better suited to addressing the Board of Auditors’
recommendation in this regard.

- Management Letter recommendations
The independent external auditor confirmed overall
good progress in addressing the recommendations
issued in the 2013 Management Letter. Out
of three recommendations the external auditor
included in last year’s Management Letter, one has
been completed and closed and no new findings or
recommendations have been issued for this year.
As outlined above, the ESM made significant
progress on the two remaining recommendations
which relate to the strengthening of the internal
control environment, and the accounting system and
organisation. With the completion of the Internal
Control Roadmap and the automated accounting
module, both of these recommendations should be
fully addressed as of year‑end 2015.

INTERNAL AUDIT
- Staffing of the internal audit function
In accordance with the Board of Auditors’ recom‑
mendation, the ESM recruited a second internal
auditor as of the beginning of June 2014. Two
experienced auditors now staff the Internal Audit
function. They will continue to have access to
external experts for the completion of the Annual
Audit Plan agreed with the Board of Auditors and
the ESM management. This combined sourcing
model reflects the overall ESM operating model
and ensures additional internal audit resources
and specialised technical skill that specific audits
may require.
The ESM management will continue its efforts to
proactively support and strengthen the internal audit

| 7

function as a third line of defence and to address
any outstanding internal audit recommendations in
a timely manner.

- “Right to audit” clause for external
service providers
The ESM has developed a “right to audit” clause and
has been successful in gradually introducing this
legal clause into contracts with key suppliers, as
noted by the Board of Auditors. The ESM has also
progressed considerably in its negotiations on such
a clause with the remaining existing suppliers and
will strive to include the “right to audit” clause in all
future outsourcing arrangements. The ESM’s ability
to incorporate the clause depends however on the
counterparty’s agreement, which may not always be
forthcoming despite sustained ESM efforts.

procedures for managing reputational and legal
risks have been drawn up with clearly assigned
roles and responsibilities within these processes.

- Further development of the risk
management elements and policies
The ESM Risk Policy, which the Board of Directors
approved in September 2013, envisages several
sub‑policies with further implementation detail to be
approved by the Internal Risk Committee and the
ESM Managing Director. These remaining sub‑poli‑
cies, as listed, are currently being finalised. The pri‑
orities in this process have been identified in the Risk
Management Self‑Assessment exercise presented
to the Board Risk Committee on 30 June 2014.
The ESM will conduct a second Risk Management
Self‑Assessment exercise in 2015.

ESM RISK MANAGEMENT AUDIT

AUDIT OF ESM LENDING OPERATIONS

- Distinction between first and second lines
of defence

- Early Warning System

In April 2014, the ESM centralised all embedded
risk functions in the Risk department. The first
and second line of defence teams were clearly
delineated, and a revised organisational chart of the
Risk function has been issued and submitted to the
Board of Auditors.
This re‑organisation completed the design of the
ESM three lines of defence governance model
achieving a clear separation between the first and
second lines of defence. It was endorsed by the
Board Risk Committee and effectively implemented
the Board of Auditors’ recommendation.
In addition, the ESM completed the staffing of the
second line of defence with the recruitment of
additional risk officers who support the established
senior risk management team.
With regard to the recommendation on legal
and reputational risks, the ESM Communications
and Legal teams already undertake a number of
activities to actively monitor and manage these
risks. Furthermore, the Internal Risk Committee
exercises effective oversight over these risks. The
Chief Spokesperson and the General Counsel attend
all Internal Risk Committee meetings and when nec‑
essary, the ESM escalates any reputational or legal
risk issues to the Board Risk Committee. As part
of the Internal Control Roadmap, written operating

An Early Warning System for the ESM lending portfolio
is a requirement of the ESM Treaty and is reflected in
the ESM High Level Principles for Risk Management
and the ESM Risk Policy.
The ESM designed the current Early Warning System
in 2013. The system was subsequently discussed with
the Board Risk Committee and approved by the Board
of Directors in 2014. It aims to capture the ability of
a country to cover upcoming payments to the ESM,
and thus to prevent a situation where a repayment
default could trigger a surprise capital call for ESM
Members.
The Early Warning System was designed to be
a streamlined process that operates with a high
degree of reliability and accuracy, and is supported by
all ESM Members based on the legal right of the ESM
to demand information from a beneficiary Member
as part of contractual information undertakings.
Extending the data to a somewhat longer horizon
could be beneficial to the ESM in compiling its liquidity
assessment, taking into account that the margin of
uncertainty increases with the projection horizon.
Such a change can, however, only be implemented
with the support of the ESM Members. The ESM
will therefore approach the Board Risk Committee
to understand its view on the provision of further
information. In this context, the ESM will also review
whether the Early Warning System reporting could be
done on a quarterly basis.

8 | EUROPEAN STABILITY MECHANISM

In closing, I hope that the above comments are helpful
as they provide the ESM management’s perspective
on the matters raised, and illustrate the considerable
progress and effort the ESM has made in addressing
the Board of Auditors’ recommendations.
The ESM is appreciative of the constructive feedback
and support that the Board of Auditors has provided
over the past year. Going forward, the ESM will
continue to foster the mutually constructive, yet
appropriately independent relationships among the
ESM management, the Board of Auditors, as well as
the internal and external auditors.

The ESM management continues to be confident
that its policies, procedures and staff will succeed in
delivering the ESM mandate and in ensuring effective
control mechanisms.
I look forward to continuing our good working relation‑
ship in 2015 and beyond.

Luxembourg, 4 June 2015,
Klaus Regling
Managing Director