22 February 2018

VOX: The feasibility of sovereign bond-backed securities for the euro area

Drawing on a recent feasibility study published by a High-Level Task Force of the European Systemic Risk Board, it outlines how to pave the way for market development by removing regulatory obstacles.

One source of shock amplification in the euro area is that banks tend to hold large amounts of domestic sovereign debt. This home bias ties the stability of banks to the fortunes of governments – and vice versa. In 2012, governments committed to cutting this Gordian knot, which was responsible for worsening the financial crisis from which Europe is still recovering. Since then, progress towards a full banking union – in which country-level circumstances do not determine bank-level risks – has been substantial. But progress has nevertheless been insufficient. New ideas are needed to move Europe forward by completing banking union.

In this context, a High-Level Task Force of the European Systemic Risk Board (ESRB) has investigated one promising way to cut the knot. The idea under investigation is to bundle sovereign bonds – assembled from countries able to issue debt to private investors – and use it to back the issuance of new securities with different levels of seniority. The most senior component would be protected by mid-tier (‘mezzanine’) and first-loss (‘junior’) securities. The existence of these sovereign bond-backed securities (SBBS) would allow banks to reduce their domestic sovereign risk exposure (by gradually swapping their holdings into senior SBBS) without needing to reduce their overall holdings of sovereign debt-related instruments or engineer sudden and asymmetric adjustments in the composition of those holdings. They therefore offer a gentle path to the completion of banking union that respects the principle of national responsibility for fiscal policy.

SBBS are a promising tool to weaken the nexus between bank risk and sovereign risk. By providing a truly euro area-wide benchmark asset, a well-functioning market for senior SBBS could also help to complete other aspects of monetary union. The report of the ESRB High-Level Task Force on Safe Assets (2018) sets the foundation for an informed policy discussion on the feasibility of paving the way for SBBS in the euro area.

The Task Force’s main finding is that a gradual development of a demand-led market for SBBS might be feasible under certain conditions. One necessary condition is for an SBBS-specific enabling regulation to provide the conditions for a sufficiently large investor base, including both banks and non-banks. To enhance financial stability, this regulation would need to treat SBBS according to their unique design and risk properties. For banks, regulating senior SBBS no more severely than sovereign bonds could incentivise them to hold these low-risk securities. The regulatory treatment of mezzanine and junior SBBS should reflect their greater riskiness. In this way, SBBS could contribute to enhancing financial stability and the completion of monetary union.

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