A feasibility study into sovereign bond-backed securities (SBSS), published by the European Systemic Risk Board (ESRB) has been slammed by Markus Ferber, German conservative MEP and first Vice-Chairman of the European Parliament’s Economic and Monetary Affairs Committee (ECON).
“Once you begin the process of creating packages of sovereign bonds, the next step will inevitably be for someone to ask for joint liability for those packages,” he said. “This would be the starting point for Eurobonds [not ‘eurobonds’ see below] and thus for a permanent breach of the treaties.”
Philip Lane, chair of the ESRB High-Level Task Force on Safe Assets noted in the report that in principle, the design of SBBS could “facilitate the diversification and de-risking of sovereign bond portfolios without mutualising sovereign risks in Europe.”
From a financial stability perspective an SBBS could potentially help to facilitate the diversification and de-risking of banks’ sovereign bond portfolios, according to the ESRB, as diversification could reduce the exposures of banks to domestic sovereign risk. De-risking would mitigate the system-wide contagion that might otherwise result from common risk exposures.
The report notes that “by holding more diversified and lower-risk sovereign bond portfolios, the banking sector could be a source of risk reduction, rather than amplification, during adverse conditions. In addition, a well-developed area-wide low-risk asset could be used as collateral, as a store of value, and as a pricing benchmark.”
It also proposes that the cover pool of sovereign bonds be weighted based on participating Member States’ contributions to the European Central Bank (ECB) capital key with euro-denominated sovereign bonds eligible for inclusion in this cover pool if they have “a competitive price in well-functioning markets.”
It argues that the senior layer be 70% thick to support the policy objective of creating a low-risk security, based on analysis indicating that a 70%-thick senior security would perform as well as lower-risk sovereign bonds in terms of “expected loss, value-at-risk, expected shortfall, and expected loss conditional on tail events.” The 30% of subordinated securities would then be divided into a 20%-thick mezzanine security and a 10%-thick junior security which would offer higher returns and embed higher risks.
In order to balance out the risk, any non-payment on bonds in the cover pool would be borne by holders of the most subordinate security according to a contractually-defined automatic cash flow waterfall.
Ferber wrote, “Securitised government bonds are by no means the silver bullet the European Systemic Risk Board would like us to think, The proposals aim at levelling the interest rate differentials between Member States and by doing so suffocating the disciplining power of the market. If you believe in national fiscal responsibility and accountability, this is exactly the wrong way to go.”
While ‘Eurobonds’ in Ferber’s reference are bonds that represent the debt of multiple European currencies in a single security, ‘eurobonds’ are securities denominated in a currency beyond that of the jurisdiction in which they are issued.