Europe’s Sovereign Bond-Backed Securities

new european union

The European Commission is proposing that the private sector create asset-backed securities around sovereign bonds that match the capital key.  These derivatives could allow banks (and other investors) to easily break from the home bias and diversify from their sovereign.    Opposition was immediate and it is not clear if the private sector will take up the call enthusiastically.  

It has been discussed for several weeks, and today the European Commission unveiled a proposal for a new asset-backed security.  The backing would be sovereign bonds weighted by the size of the economy.

This may sound like mutualization of risk, but it is no such thing.  These new securities are not Eurobonds. The EC is calling on the private sector to bundle existing sovereign bonds, an issue asset-backed securities with different tranches to provide gradations of risk.  The sovereign bond-backed securities (SBBS) will not be available any time soon.  National governments need to approve appropriate legislation, but the signal from the EC is that the SBBS should be treated in the same way as national sovereign bonds, rather than securitized products.

The EC is proposing what the private sector should do.   It is taking no risk itself.  The success depends on the take up by investors and banks.  Fitch is skeptical.  It does not see how re-packaging sovereign bonds reduces risk.  It also does not see the SBBS supplanting German Bunds as the benchmark.

Many investors may not like these new instruments.  There are no state guarantees.  They will likely be assigned lower credit-ratings than the highest rated members and have less liquidity.  Germany has come out in opposition, claiming it creates new risks.

The best fit may be for European banks.  The SBBS may help loosen the relationship (doom-loop) between banks than their sovereign.   In the recent past, a banking crisis became often morphed into a sovereign crisis, public funds were drawn upon.  In Europe, this is more difficult since the Bank Recovery and Resolution Directive (BRRD, approved 2014).

The causation arrow also can go the other way. Domestic banks are often substantial holders of their sovereign bonds.  A sell-off of those sovereign bonds could weaken the health of the banks. The SBBS would help would the link by facilitating the diversification of sovereign bond holdings.  It could help break the overwhelming element of home bias.

ECB member Lane from Ireland, who is tipped to possibly succeed Praet as the central bank’s economist, headed a commission at the European Systemic Risk Board that led to the SBBS proposal.  He suggested that the senior tranches of the SBBS could potentially be accepted by the ECB as collateral, but the central bank technically cannot take on credit risk.

Some observers (like European Professor Claeys who shared his critic on Vox) argue that the SBBS are unnecessary and a distraction.  The SBBS does not bring the EMU closer to completing monetary union or banking union.   There are no shortcuts to the necessary national and institutional reforms.  In the best of worlds, the criticism seems valid, but in the second or third best world that we occupy, there may be a legitimate use for SBBS.  It need not be much of a distraction from reforms, which ECB President Draghi frequently complains are insufficient.