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While sound public finances are a prerequisite for sovereign bonds to be considered safe, the central bank plays a crucial role in defining asset safety given its position as a protector of the currency’s value and as a potential backstop in a liquidity crisis. However, in practice, the central bank also matters because of what assets it accepts as collateral in its refinancing operations and how it values them.
Haircuts applied in these monetary operations are utterly relevant in forging financial markets’ perceptions of the safety of a debt security, as haircuts’ levels determine whether financial institutions will be able to exchange these assets easily and almost at par against the ultimate safe asset: central bank reserves.
Currently, eligibility and haircuts applied by the ECB in its refinancing operations depend on four elements: 1) the type of asset, 2) the type of issuer, 3) the residual maturity and 4) the rating of the issuer of the asset.
This means that the current approach to valuing haircuts in refinancing operations relies heavily on the ratings made by private credit rating agencies. In fact, to determine its own rating of a particular sovereign bond, the ECB takes the best rating out of four accepted credit rating agencies (Moody’s, Fitch, S&P and DBRS) and maps it to the three “credit quality steps” of the Eurosystem harmonised rating scale.
How have haircuts on sovereign bonds evolved since the creation of the monetary union, and in particular during the crisis? To our knowledge, the resulting ECB ratings (and thus the haircuts applied) are not directly available, but it is easy to replicate them using the long-term ratings of the four credit rating agencies for each euro-area sovereign.
Taking into account the various changes in the ECB’s collateral framework that have taken place since 2008 (see details for instance in Wolff, 2014), this allows us to determine the eligibility and haircuts applied to euro-area countries debt securities. [...]