Letter by the Managing Director
on the Annual Report of the
Board of Auditors
Dear Chairperson of the Board of Auditors,
I would like to thank you for the Board of
Auditors’ Annual Report to the Board of
Governors (“the Report”) for the period ended
31 December 2013.
In 2013 the ESM management continued its
intensive relationship with you, the Board of
Auditors. Following the resignation of Mr Harald
Noack, we welcomed the appointment of Mr
Igors Ludboržs as a new member of the Board of
Auditors nominated by the European Court of
Auditors, and the election of Ms Katarína
Kaszasová as Chairperson. A number of key staff
members, including the ESM management,
devoted a considerable amount of time to
discuss with you relevant issues and
developments, to submit written notes in
response to your questions, and to provide
cooperation and assistance during two Board of
Auditors’ audits. We have also provided
administrative support for 11 meetings of the
Board of Auditors in 2013 and four meetings in
2014 to date.
Since your first Annual Report to the Board of
Governors in May 2013, the ESM has advanced
further the development of its organisational
policies and procedures and has achieved a
marked improvement in its internal control and
accounting environment. This substantial
progress is acknowledged also in the
Management Letter for the year ended 31
December 2013 by the independent external
auditor PricewaterhouseCoopers, Luxembourg
(PwC), who issued an unqualified auditor’s report
in respect to the ESM Financial Statements as
of 31 December 2013.
In 2014 we will continue the efforts to build our
risk management and control framework with

the aim of meeting the best practice established
by the international financial institutions, while
taking into account also the unique mandate of
the ESM as the permanent crisis resolution
mechanism for the countries of the euro area.
During this period of maturing, the
recommendations noted in your Report are
particularly useful as they provide us with
valuable guidance and help us set the priorities in
the process.
I now turn to the detailed recommendations
noted in the Report, on which the ESM
management would like to provide the following
comments:

Follow Up of 2012 Board of Auditors
Annual Report to the Board of Governors
•

EU regulatory framework

It is noted that the Board of Auditors reiterated
“its strong recommendation that the ESM
adopts the EU regulatory framework as its own”.
The ESM management will seek further
clarification from the Board of Auditors
regarding the meaning of the term “EU
regulatory framework” as it is rather broad and
does not reconcile directly with the ESM’s status
as an intergovernmental international financial
institution which is not part of the EU Treaties.
The ESM regulatory frame of reference is the
Treaty Establishing the European Stability
Mechanism ratified by the 18 euro area Member
States, and the By-Laws adopted by the Board of
Governors. The ESM is currently in the process
of finalising its internal policies and procedures
with the aim of developing an internally-cohesive
framework aligned with the ESM Treaty and
By-Laws.

ESM
2013

2

•

”Three lines of defence” concept

The re-organisation of the ESM Risk department
in April 2014 completed the design of the ESM
three lines of defence governance model and
achieved a clear separation between the first
and second lines of defence. The re-organisation
was endorsed by the Board Risk Committee and
implemented the Board of Auditors’
recommendation noted in your Risk Management
Audit Report dated 7 April 2014.
The embedded Operational Risk and
Counterparty Risk functions were centralised in
the Risk department and the first line of defence
roles for the Asset and Liability Management
(ALM) and Middle Office teams were further
defined. The Head of Risk covers all risks faced
by the organisation and hence operates as a
Chief Risk Officer.
The staffing of the second line of defence will be
completed during the upcoming months with the
recruitment of several additional risk officers
who will support the established senior risk
management team.
•

“ Fit for purpose” assessment of the
accounting framework

In May 2014 the ESM management completed
the first periodic “fit for purpose” analysis of the
adopted ESM accounting framework, as
recommended by the Board of Auditors. The
assessment was performed using internal
resources as well as accounting expertise of
Deloitte, Luxembourg. We concluded that the
approved ESM accounting framework (EU
Accounting Directive with the Banking Directive)
fits the specific purpose of the ESM, its political
mandate and long term financial assistance
strategy, while providing all the relevant
information to the addressees of the Financial
Statements. The above assessment was
presented to the Board of Auditors on 13 May
2014.
•

ESM Procurement Policy

As discussed last year, the EU Directive on Public
Procurement specifically sets forth that it is not
applicable to international organisations or
international financing institutions, where the
public contracts concerned are fully financed by
that organisation or institution.
Therefore the ESM designed a procurement
framework that fits its legal status as
international organisation. In the implementation
of the ESM Procurement Policy, we aimed to
meet the best practice of corporate
procurement in the international financial

institutions. As part of this effort, the ESM is a
member of the Network on Procurement in
International Organizations (NPIO) and the
organisation of EU Agency and Institution
Procurement Officers and Assistants.
One of the practical implications of the ESM’s
role as a crisis resolution mechanism is the
requirement for the ESM to operate efficiently
and effectively, including in the area of corporate
procurement. The timely procurement of
services, supplies and works required for the
ESM operations is not consistent with the
lengthy procurement procedures pursuant to
the EU Directive. The ESM Procurement Policy
observes the fundamental principles of the EU
Directive for fair treatment, transparency,
mutual recognition and proportionality, while
reflecting also the specific context of the ESM.

Findings
•

 oard of Auditors’ Report on the 2013
B
Financial Statements

The ESM management recognises the
importance of effective internal controls which
provide the foundation for the safe and sound
operation of the organisation. Significant
improvements were achieved in 2013. In 2014
and in future years, the ESM will continue to
mature its entity-level and process-level controls.
During the extensive tests of controls performed
by the independent external auditor as part of
the 2013 statutory audit, there were no
exceptions to note. The PwC Management
Letter for the year ended 31 December 2013
also does not contain any new findings/
recommendations and all three issues noted in
2012 are now considered partially closed.
In this context, we do not share the Board of
Auditors’ assessment that the organisation
“continues to face challenges in reaching
standard practice”.
•

E xternal audit – procurement process for
the external auditor

In 2013 the ESM management performed a
detailed assessment of the performance of the
external auditor following the 2012 statutory
audit. Based on the satisfactory outcome of the
assessment and after taking into account the
considerable time and resources required for a
new procurement process and the subsequent
transition to a new external auditor, the ESM
recommended to the Board of Governors that
the PwC engagement should be automatically
renewed for the 2013 statutory audit.

ESM
2013

3

In response to the Board of Auditors’ request,
the PwC audit team for the 2013 statutory audit
was reinforced with leading specialists from the
PwC practices in Germany, UK and Luxembourg.
Over the next couple of months, the ESM will
perform a procurement process for the
selection of an external auditor for the 2014
statutory audit and will submit to the Board of
Governors a proposal for appointment of the
auditor. The ESM will invite the Board of Auditors
as observer in order to ensure full transparency
and quality of the process.
•

E xternal audit – Board of Auditors’ access
to audit documentation

Despite the legal complications related to
granting access to the Board of Auditors to the
working papers of the external auditor, PwC
reported to the Board of Auditors in detail on its
audit plan, audit procedures and the results of
its work. We understand that during the meeting
at the PwC premises on 1 April 2014, PwC
addressed all questions raised by the Board of
Auditors and provided the requested electronic
files with audit evidence.
The ESM management will specifically reflect the
Board of Auditors’ requirement for access to the
working papers of the external auditor in the
upcoming procurement process and as an
element of the engagement for the 2014
statutory audit and onwards.
However, we would like to alert the Board of
Auditors that this requirement is not a standard
industry practice and may potentially impede the
appointment of an external auditor of good
international repute.
•

E xternal audit – Board of Auditors’
recommendation for long form report

Regarding the Board of Auditors’ recommen­
dation for the external auditor to issue a long
form report, we recall that this topic was
discussed during the joint Board of Directors
and Board of Auditors meeting in Rome on 13
June 2013. The Board of Directors supported
the view that a long form report would not be
suitable for the ESM as an international financial
institution. Furthermore, such long form report
and related additional audit procedures may not
be within the scope of the external auditor’s
mandate pursuant to the ESM By-Laws.
Long form reports are generally required by
national bank supervisors for banking
institutions. In 2013 the external auditor
complemented the ESM’s statutory audit report
with an additional “special topic report” on an

area relevant to the financial reporting process
as noted in the PwC Management Letter.
•

 udit access to services provided by third
A
parties

We take note of the Board of Auditors
recommendation to ensure unlimited audit
access regarding services provided by third
parties. The ESM has developed a standard
“right to audit” legal clause and has been
successful in gradually introducing the clause in
contracts with key suppliers. Our ability to
impose this clause on independent
counterparties, however, may not always be
successful despite the ESM’s efforts in this
regard.
For example, the ESM was not in a position to
influence the decision of the European
Investment Bank (EIB) to decline the ESM’s “right
to audit clause”. We believe that this decision
was dictated by the status of the institution and
its relevant protection and immunity.
Nevertheless, in practical terms the work of EIB
Third Party Accounting Services which provide
outsourced accounting services to the ESM is
reviewed by the ESM external auditor as part of
the annual statutory audits.
•

Staffing of the internal audit function

The internal audit function of the ESM was in
place since the inauguration of the organisation
on 8 October 2012. Following the departure of
the initial internal auditor in February 2013, we
have swiftly arranged for Ernst & Young,
Luxembourg, to provide interim internal audit
services until the new internal auditor joined the
organisation at the beginning of July 2013.
In 2013, the ESM internal auditor had the
mandate and budget to engage external parties
to support the audit work. As of the beginning of
June 2014, the internal audit function is staffed
with two experienced auditors who continue to
have the option and allocated resources to use
external experts in order to complete the annual
internal audit plan agreed with the Board of
Auditors. This combined sourcing model allows
for increasing the resources and using the
necessary technical skills for specialised audits,
if needed. One of the practical implications of the
ESM’s role as a crisis resolution mechanism is
the requirement for the ESM to operate
efficiently and effectively, including in the area of
corporate procurement. The timely procurement
of services, supplies and works required for the
ESM operations is not consistent with the
lengthy procurement procedures pursuant to
the EU Directive. The ESM Procurement Policy

ESM
2013

4

observes the fundamental principles of the EU
Directive for fair treatment, transparency,
mutual recognition and proportionality, while
reflecting also the specific context of the ESM.
•

 isk Management audit – reorganisation of
R
the risk function

As noted above, the proposed reorganisation of
the ESM risk function was endorsed by the
Board Risk Committee in April 2014. All
embedded risk functions were centralised in the
Risk department, first and second line of defence
teams were clearly delineated, and a revised
organisational chart of the risk function has been
submitted to the Board of Auditors.
•

ESM Transitional Investment Portfolio

The Transitional Investment Portfolio (“TIP”),
together with the investment guidelines applicable
to it, was approved by the Board of Directors on
29 November 2012 and complies with the
requirements on prudent investment put forward
in Article 22 of the ESM Treaty. The TIP was
described in detail in the ESM Diversified Funding
Strategy dated November 2012. Details of the TIP
holdings and their accounting treatment appear
also in the 2013 Financial Statements.
The TIP was designed to address the transitional
aspects related to the emergence of the ESM as a
new issuer in financial markets and the continued
activity of the EFSF. The TIP is a one-off initiative
related to establishing the ESM as a new issuing
entity and will be closed in December 2014.
•

 ecommendation for specific policy on
R
reputational risk

The ESM Communication’s team undertakes a
number of activities to monitor and mitigate the
ESM’s reputational risk, including permanent
media monitoring, regular contacts and face-toface meetings with journalists covering the ESM
and related issues in a European and international
context. The Chief Spokesperson regularly
attends all Internal Risk Committee meetings and
when necessary, there is an escalation of
reputational risk issues to the Board Risk
Committee.
In 2014 we will implement the Board of Auditors’
recommendation to align the reporting and
follow-up on reputational risk incidents with the
already established process for reporting of
internal operational risk events. Furthermore,
draft amendments to the High Level Principles
for Risk Management have been prepared to
include a definition of reputational risk and will be
submitted to the Board of Directors for approval
later in 2014.

•

 isk management vacancies, risk manageR
ment elements and policies under
development

We consider the items noted by the Board of
Auditors to reflect a natural further development
of the ESM risk management framework as
would be expected in any organisation. Strict
prioritisation has focused attention to date on
the key risks. The list of developments in
progress shows that we continue to improve.
We expect that the available risk management
vacancies will be filled before the end of 2014.
•

Standard “right to audit” clause

As noted above, the ESM will strive to include its
standard “right to audit” clause as a prerequisite
for all future outsourcing arrangements.
However, we recognise that we may not be able
to obtain agreement from other international
financial institutions, such as the EIB, which
provide services to us.
I hope that the above comments are helpful as
they provide the ESM management’s perspective
to the issues raised, illustrate the progress the
ESM has made on many of the Board of Auditors’
recommen­
dations, and confirm our strong
commitment to continue the maturing of the
ESM. I would like to thank you again for your
valuable recommendations and I am looking
forward to continuing our good working
relationship in 2014 and beyond.

Klaus Regling
Managing Director
European Stability Mechanism