29 June 2012

ECB/Coeuré: The euro area sovereign debt market - lessons from the crisis

Mr Coeuré tackled the following questions: What has characterised the pricing of sovereign credit risk over the last two decades; what is the relevance of the sovereign debt market tensions for monetary policy; and what lessons have we learnt.

Looking at the sovereign debt markets of the euro area over the past two decades, it is possible to clearly distinguish three main periods. First, there was the run-up to Economic and Monetary Union (EMU), that is especially the period of about five years before 1999, when the euro was introduced. During this time, sovereign bond yields quickly converged towards those of German Bunds. Much of this convergence is explained by the elimination of exchange rate and inflation risks. In the second period, ranging from the introduction of the euro in 1999 to the collapse of Lehman Brothers in September 2008, government bond yields remained at moderate levels and did not differ much from country to country. In the third phase, since autumn 2008, a sudden and disruptive re-pricing of sovereign credit risk has taken place. Government bond yields started to diverge, sometimes reaching levels that matched and exceeded those of the early 1990s. There were fundamental reasons for such a re-pricing of risk. Fiscal expansion due to the need to fight the crisis came on top of already high levels of public debt. Governments’ commitment to support systemically important financial institutions added to their contingent liabilities. Lower potential growth rates raised concerns for public finance sustainability. In addition to these fundamental causes, sovereign bond markets in some jurisdictions have been characterised by poor liquidity and high volatility.

There is a strong link between the stability of sovereign debt markets and the smooth functioning of monetary policy. This becomes very clear once we consider the prominent role of government bonds in the monetary policy transmission mechanism. I would like to identify four channels through which the functioning of government bond markets can interfere with the transmission of monetary policy. Let me call them the interest rate channel, the wealth channel, the collateral channel, and the bank balance sheet channel.

• First, government bonds play a key role in transmitting the monetary policy stance to the real economy via the so-called interest rate channel. In times when government bonds are considered as essentially risk-free and liquid instruments, a change in current and expected policy rates is a central factor in shifting the government bond yield curve.
• Second, faced with threatening direct and indirect losses from strong price declines of sovereign bonds, consumers may opt for precautionary savings, which would counteract a desired stimulus to consumption from monetary policy easing.
• Third, government debt securities have been a key source of collateral for banks to use in secured lending with other banks and the ECB. With the sharp decline in sovereign bond prices – often associated with a rating downgrade of the respective sovereign issuer – government bonds were made subject to significant haircuts and their refinancing power declined. This has eroded the volume of collateral available in the form of government bonds and stressed the re-financing possibilities of banks.
• Fourth, the re-pricing of government debt also had a direct negative impact on the asset side of banks and therefore on their own perceived riskiness. In fact, since 2009, we can see a close relationship between measures of bank and sovereign credit risk.

There are a number of ways to mitigate exaggerated pro-cyclicality of government bond markets. One way is to reduce the reliance of the financial, regulatory and supervisory framework on credit ratings. The European Commission has put forward a number of proposals to this end. Similarly, it is worth considering ways to delink the risk assessment of credit institutions from the credit rating of the sovereign. In addition, risk management by central clearing counterparties or CCPs is of particular importance, as an increasing number of financial transactions is expected to migrate to them. The CPSS-IOSCO principles for financial market infrastructures expect CCPs to adopt forward-looking and conservative margin and haircut policies to limit the risk of destabilising responses to changes in credit ratings.

But to address the root causes of the current instability, fundamental policies will have to be adopted. The adverse feedback loop between banks and sovereigns, that I mentioned before, can be broken by establishing a true financial union: in my view this includes the creation of a pan-euro area deposit insurance fund and a pan-euro area bank resolution framework, supported by a single supervisory system with centralised decision-making. If the European Stability Mechanism – an institution that can provide financial assistance to euro area Member States in order to safeguard the stability of the euro area as a whole – could inject capital directly into banks, this would also help to break the bank-sovereign loop. Of course, such support must come with strong conditionality and control. Let me note that depending on its design, the financial union could introduce additional elements of risk-sharing among euro area countries, and as such, it should be subject to strong democratic accountability and control at national and European level.

Full speech

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