“How to reconcile risk sharing and market discipline in the euro area”: Some observations on the new Vox paper

17 January 2018

In this fallow period for policy-making while Europe waits for a new German Government, it is welcome that an illustrious group of Franco-German thinkers should publish a Vox paper that outlines a complete, coherent strategy for the Eurozone.

http://voxeu.org/article/how-reconcile-risk-sharing-and-market-discipline-euro-area

The authors set out three sound reasons for believing the binary choice between more risk sharing/better incentives is false. The authors specify six areas for reform and this blog reflects on three of them.

The observations below are from the perspective of a market participant who has published a plan for a Temporary Eurobill Fund (details at end).

·         The focus on the need to change the risk weightings (and large exposure limits) for banks holding sovereign debt is absolutely correct. This author started writing about the risks from this policy error nearly thirty years ago. Action is long, long overdue and the current period of low interest rates and falling public debt ratios offers the best chance to correct this for decades. However, the combination of still very high public debt and a still-fragile banking system argues for cautious moves. The European Banking Authority (EBA) recently updated its quantitative analysis of the banking system’s progress on meeting its Minimum Requirement of Eligible Liabilities (MREL) to meet the Bank Recovery and Resolution Directive’s (BRRD) requirement for bail-inable liabilities. Most of the progress has come from reducing the balance sheet rather than raising capital so increasing the cost of holding sovereign debt risks prompting another, and unwelcome, round of credit squeeze on the EU economy

·          Linked to this fragility of the banking system and whatever the intellectual merits, the proposals for sovereign debt re-structuring need to be considered with extreme caution when public debt is still about 90% of GDP. This massive stock of debt is mainly held by a financial system that is subject to asset/liability matching regulations. So a sudden, and probably major, reduction in some of its assets may have to be matched by some reduction in its liabilities to citizens e.g. deposits, pensions, insurance policies etc. if capital is insufficient. However, the authors are clearly aware of the risk of precipitating a `run’ out of sovereign debt by such leveraged financial institutions.

·         The call to create “safe assets” for “investors” is welcome but there is no reason to stop at assets for financial institutions and companies. Europe should be able to provide all citizens with a safe, simple and cheap asset for the liquid part of their savings. The paper implicitly calls for the introduction of Sovereign-Backed Bond (SBBs). As his swan song, former German Finance Minister Schauble gave a “non-paper for paving the way towards a Stability Union” to his last meeting of Eurogroup. Notably, the paper described “debt mutualisation” in the form of SBBs as “complex and expensive financial engineering”. Even the Commission’s Reflection Paper was somewhat ambiguous and cautious about these proposals, so the chances of further progress on them now seem low.

In any case, the proposal does not seem to go far enough to create a European asset that is of a global scale and where its governance can buttress the EU’s overall economic governance system by introducing a flexible and progressive `market discipline’. This author has published a series of papers[1] proposing a Temporary Eurobill Fund (TEF) that was examined by the Expert Group[2] on Debt Redemption Funds and Eurobills set up by European Commissions President Barroso. (The Expert Group included this author as well as two of the Vox paper’s authors.) 

The TEF is a simple “plainest of plain vanilla” plan:

• For a common institution to purchase the under-two year debt issuance of participating states.
• The institution would finance such purchases by issuing its own bills - matching its assets in overall volume and maturity.
• The TEF’s legal structure would replicate the ESM and would not require a change to EU Treaties so could be set up very quickly.
• If it did not prove effective, then it would cease to issue new bills and would have run off entirely within two years.

The author proposes that the TEF plan should be added to the comprehensive strategic thinking.

*****

© Graham Bishop