A European plan to pool debt from countries like Greece with bonds sold by governments with stronger finances will aim at banishing the "doom loop" between sovereign and bank liabilities that almost broke the eurozone in 2012, but the complexion of Germany's next ruling coalition is key to its chances of going ahead.
Sovereign bond-backed securities, known as SBBS or ESBIes, would repackage national debt from across the eurozone into a new security, providing a pool of safe assets that banks would be able to buy instead of loading up with their own governments' debt. It was the tendency for European banks to hold large stockpiles of their local bonds which caused a downward spiral in the prices of the debt of both lenders and sovereigns in countries such as Greece and Spain so severe that it led some investors to question the survival of the single currency area itself.
"ESBies lower — potentially hugely — the exposure of banks to their own sovereign and so break the vicious euro area sovereign-bank doom loop," Ciaran O'Hagan, head of euro area rates research at Société Générale in Paris, said in an interview. "As result, ESBies hold the promise of making euro area structures and [European government bonds] much more resilient."
While the recipe for creating safe bonds bears similarities to that of some of the complex instruments at the heart of the last financial crisis, issuers would still be responsible for paying back their own liabilities, and the synthetic securities would be comprised of tranches paying different interest according to the likelihood of default.
The European Systemic Risk Board, or ESRB, based at the Frankfurt headquarters of the European Central Bank, became the latest EU institution to voice approval of the idea at the beginning of 2018, and the European Commission is set to issue a legislative proposal in coming months.While the recipe for creating safe bonds bears similarities to that of some of the complex instruments at the heart of the last financial crisis, issuers would still be responsible for paying back their own liabilities, and the synthetic securities would be comprised of tranches paying different interest according to the likelihood of default.
"In principle, the design of SBBS could facilitate the diversification and de-risking of sovereign bond portfolios without mutualizing sovereign risks in Europe," wrote Philip Lane, chair of the ESRB's high-level task force on safe assets, in a recent report.
The ESRB's support has made the project much more likely to come to fruition, said O'Hagan, although this process could still take years. Fundamental to its prospects will be attracting the support of the more powerful EU countries, he noted. With Italy and France publicly declaring support, the only notable absentee is now the most critical: Germany.
Until last September's inconclusive elections, this looked a potentially insurmountable barrier, particularly given the opposition of former Finance Minister Wolfgang Schäuble, whose staunch advocacy of robust government finances went hand in hand with an acute suspicion of paying other countries' bills. But Schäuble has now left the post to become speaker of parliament, and looks set to be replaced by the center-left Olaf Scholz, if Chancellor Angela Merkel clinches a new coalition with the social democratic SPD.
An initial deal between Merkel's CDU and the SPD in in February indicated a willingness to make greater contributions to the EU budget, and Schulz has made remarks which were interpreted in German media as foreshadowing a greater generosity towards the bloc, including its weaker members.
While this bodes well for safe bonds, the coalition deal may yet be junked by an internal SPD vote on March 4, amid reports of widespread discontent among members of the party, whose support has hit the lowest levels since the end of the Second World War. The SPD did not return several requests to comment.
Even if the necessary political support can be mustered, regulatory hurdles remain to be overcome. The securities could not be counted as liquid bank assets under current regulation, meaning that the liquidity coverage ratio, which has to be equivalent to at least 100% of all liabilities for 30 days, will not include them.
Rules also prevent the ECB from accepting SBBS as collateral, and lenders would have to hold capital against them, something which they do not have to do for sovereign bonds. The European Commission is due to issue new guidance smoothing out these wrinkles in the coming weeks.
Once all this is out of the way, authorities will still have to tread carefully before introducing the bonds, said O'Hagan, particularly as this would likely involve selling of sovereign debt as banks recalibrate their portfolios to make room for the new securities. Potential financial upheaval "would be immense," he said, "akin to all the preparations we had for the introduction of the euro."
Perhaps fortunately, the biggest holder of eurozone sovereign bonds would be well placed to help mitigate any such disruption: the ECB itself. Since the inception of its quantitative easing program, it has amassed €2.4 trillion of securities as of mid-February, concentrated in sovereign bonds. Soon it might be in a position to kick off the SBBS program by securitizing its holdings.
A plan for the bonds' creation, which might eventually including moves to first compel banks to lowering their exposures to single sovereigns, could emerge in the next few months, according to Tom Kinmonth, fixed-income strategist at ABN Amro in Amsterdam.
"In the end a securitization of sovereign debt is likely to go hand in hand with some form of agreement to reduce sovereign holdings of the banking sector," he said.
"The SBBS program is a hot topic and particularly this year as the European Commission wishes to complete all remaining impediments to complete the European Banking Union in 2018."
Vanya Damyanova contributed to this article.
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