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Long Road Ahead for Creating Safe European Asset

The EC is looking at how the banks can have a more diversified portfolio of public debt securities.The EC is looking at how the banks can have a more diversified portfolio of public debt securities.
The European Commission is studying how to obtain a safe European asset without having to establish a tax union to back the issue of the said asset

The economic recovery is starting to consolidate in Europe. Now, after many years of intense debate and some important reforms, like the progress towards banking union,  the world runs the risk of thinking that the eurozone’s institutional network is robust enough to face the challenges of the future with guarantees, a Spanish financial services company CaixaBank Research says.

However some of the weaknesses that the crisis showed up have still not been corrected. One of these is the so-called doom loop, or the negative relationship which can develop between a country’s public sector and the banking sector during a recession, The Corner reported.

One of the specific reasons contributing to the doom loop is that the sovereign bond portfolios of each country’s banks are biased towards their country’s public debt. So in the context of a crisis, if there is an increase in the risk premium of the sovereign bonds, that has a repercussion on the risk premium of the banks.

It limits their lending capacity and ends up negatively affecting the country’s economy. In the end, a vicious circle may be created between a country’s public sector and its banking sector.

To break this circle, the European Commission is looking at how the banks can have a more diversified portfolio of public debt securities. Obviously, the most sensible thing would be to reduce the barriers which still make it difficult to create pan-European banks and advance towards a bona fide tax union. This would envisage, amongst other things, the issue of European public debt backed by a European budget.

That said, advances on those two fronts seem very difficult, at least in the short-term. So the commission is studying how to obtain a safe European asset without having to establish a tax union to back the issue of the said asset.

The specific proposal which is being studied envisages that an entity (public or private) acquires, using a transparent and predictable weighting scheme, a diversified portfolio of eurozone sovereign bonds in the secondary market.

Then it issues securities backed by these same sovereign bond-backed securities. The institution would issue two kinds of securities: senior bonds and subordinated bonds. Although the underlying portfolio for both securities would be the same, the subordinated tranche would be the first to absorb any eventual losses and, in line with this greater risk, would offer a larger return.

  Subordinated Bonds

So in practice, if for example the subordinated bonds represented a total of 30% of the portfolio, the senior tranche would only suffer losses in the event the defaults in the portfolio exceeded 30% of its value.

Therefore the senior tranche of the SBBS would be formed by extremely safe assets thanks to the principles of diversification and subordination. On the one hand, the holder of the asset’s exposure to the risk of default of any particular sovereign bond would be very limited, as it is backed by a portfolio of diversified sovereign bonds. And, the subordinated tranche would protect the senior one from potential losses in the portfolio.

This asset could help to reduce the link between the banking and the sovereign risk as it would facilitate the lenders diversifying their portfolio of sovereign bonds.

That said, for the banks to be willing to buy the afore-mentioned asset, it would be necessary for the treatment which the regulator gives the SBBS to be on a par with that given to sovereign bonds.

Furthermore, the SBBS has other desirable qualities. In the first place, obviously, they would allow for an increase in the supply of risk-free assets. At the same time, a safe European asset could attract greater demand on a global level. This, in the end, would lower the financing costs for the countries in the eurozone.

And finally, another positive aspect of the SBBS is that its implementation would not distort the fiscal discipline mechanism imposed by markets on governments. That is because the issuer of the securities would only buy a fraction of the bonds in circulation in a country (at market price) and the governments would still have the ultimate responsibility for financing in the market.

However, the proposal also presents problems. One of the main ones is that it’s not clear the SBBS would function as expected during a period of crisis, just when they would be really needed. In times of great uncertainty, it’s likely that the subordinated tranche would be significantly reduced, limiting the amount of safe securities which could be issued.

In fact, the severest critics are afraid that in this context there would be increased political pressure on states to guarantee the issue of the subordinated assets to some extent, in order to be able to continue to issue senior securities.

A mutualization of the fiscal risk would slip in through the back door without any of the benefits associated with the traditional mechanisms for a sovereign bailout.

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