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Rating agencies: Eurozone 'safe' bond won't break 'doom loop' for banks

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Rating agencies: Eurozone 'safe' bond won't break 'doom loop' for banks

A recent proposal by the European Commission for the issuance of sovereign bond-backed securities, as a type of new 'safe asset' in the eurozone, will likely help banks diversify exposure to their sovereigns but will not significantly alter banks' national debt holdings, according to credit rating analysts.

"SBBS [sovereign bond-backed securities] would provide an additional tool for banks to diversify their holdings of sovereign debt. However, we doubt the emergence of SBBS would trigger a quick rebalancing of eurozone banks' sovereign exposures," S&P Global Ratings analysts said in a research note June 7.

The EC proposed May 24 that all bonds issued by eurozone member states be pooled in a portfolio to serve as collateral for the SBBS, which will be issued by privately held special purpose vehicles. Since the new securities will be created through private contracts, only private investors will share the risks and potential losses while the government issuers will have to serve just their own debt obligations in case of stress.

As investors in SBBS, eurozone banks will be able to diversify their sovereign debt portfolios, which is essential as they are still heavily exposed to national debt, Scope Ratings said in a June 7 note. "Domestic banks hold around 50% of the total national debt held by banks worldwide, ensuring that rising yields have a significant impact on their portfolios. Domestic institutions then face greater pressures to cut lending, thereby slowing economic growth, hence the vicious cycle," the rating agency said.

The existence of this cycle, often referred to as the "doom loop," means that each time the state runs into trouble there is a risk of a banking sector crisis and vice versa — a shock to domestic banks weakens the sovereign. EU policymakers have been trying to break that doom loop since the global financial crisis. European banks' large exposure to government debt exacerbated the eurozone's sovereign debt crisis and almost led to the end of the single currency area in 2012.

Not a "genuine eurozone common bond"

While SBBS are a step in the right direction, these instruments in their currently proposed form are not fit for the purposes intended by the EC, namely, to reduce the doom loop and raise the amount of 'safe,' AAA-rated assets, the S&P Global Ratings' analysts said. "Conceptually, the creation of a eurozone safe asset class could ... reduce the risk of asymmetric fiscal crises among member states and help cement the euro's status as a reserve currency. In particular, a common eurozone instrument backed by a joint ... guarantee from all member states could match U.S. Treasuries as a safe-super liquid asset, which the ECB has stressed the eurozone needs," the S&P Global Ratings analysts said.

However, they argue SBBS are not the "genuine eurozone common bond" they are intended to be but "bunch[ed] together single-country exposures of all member states, without any element of direct risk sharing." To create a security that is really comparable to U.S. Treasuries is going to require "a level of political willingness among all member states that does not exist today," the analysts added.

Scope is more positive in its assessment of the SBBS, saying that they have the potential "to gradually reduce [domestic bank] exposures to their respective sovereigns by 50% on average". However, the rating agency also said there are significant "political and practical obstacles" to creating marketable SBBS. "One catch is that SBBS won't find takers without regulatory change. Banks don't have to set aside capital to hold sovereign debt, which is considered risk free, but would have to do so, counterintuitively, for SBBS, unless the EC convinces EU members to adjust the rules on preferential regulatory treatment," Scope's analysts Bernhard Bartels and Giacomo Barisone wrote.

This S&P Global Market Intelligence news article may contain information about research by S&P Global Ratings, a separately managed division of S&P Global. Descriptions in this news article were not prepared by S&P Global Ratings. The original S&P Global Ratings documents referred to in this news brief can be found here. S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.