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23 November 2017

No safe­ty with “Eu­ro­pean Safe Bonds”

Dr. Ludger Schuknecht, former Chief Economist at the German Finance Ministry
Ludger Schuknecht, former chief economist at the German Finance Ministry

By Ludger Schuknecht and Levin Holle

For a long time, we have been arguing for stability and safety in European financial and debt markets. Therefore, one might be surprised that we are not enthusiastic about the idea of “European Safe Bonds” (ESBies).

The ESBies concept, also known as Sovereign Bond-Backed Securities, aims to manage financial risk via pooling and tranching of sovereign bonds from euro area member states. A special purpose vehicle would buy national government bonds and issue two types of securities. The junior tranche would bear the risk of individual sovereigns defaulting on their debt, while the senior tranche, called ESBies, would be virtually risk-free.

We do have much sympathy for the two overarching objectives the ESBies concept is trying to achieve:

We fully subscribe to the view that the sovereign-bank-nexus is still a problem. If banks fail, we should avoid as much as possible that losses end up on the public balance sheet, i.e. with the taxpayer. Conversely, if a government gets into trouble, banks overburdened with public sector bonds are poorly equipped to deal with a restructuring need. We urgently have to reduce this nexus to preserve stability and get incentives right.

It is also true that financial markets need safe assets - for liquidity service, for storage of value or as a benchmark for the riskiness of other assets. Securities issued by sound debtors, including highly-rated governments, but also synthetic products or derivatives such as covered bonds and swap arrangements can be useful in this regard.

So, the goals are right. But unfortunately, ESBies don’t bring us there. On the contrary, they drive us in the wrong direction, potentially increasing financial risks further. From a number of flaws that the ESBies concept has, we would like to highlight the three most severe ones:

ESBies are a fair-weather concept. In times of crisis, they would not serve as a safe haven instrument, but add fuel to the fire. The country with the weakest fiscal performance will likely determine the rating of the whole pool. When market uncertainty grows, a flight into safety sets in and the demand for the risk-bearing junior tranche will dry up. Without demand for the junior tranche, the senior “safe” bonds can no longer be generated. More government bonds will be sold individually on the markets at a time when financial markets are under stress anyway. Political pressure to rescue the concept with “market making” or guarantees at the European level will mount – Eurobonds through the back door!

ESBies would also not increase the available volume of safe bonds. Either the tranching is done with just a small share of junior bonds, say 20-30 percent. In this case, the safety of senior ESBies wouldn’t be beyond doubt. Alternatively, the junior share is larger, making the resulting senior ESBies safer but fewer. Both options will probably end up with the contrary to what is intended: fewer safe assets in the financial system than we currently have with a decent amount of sovereign bonds from highly-rated individual countries.

Last but not least, a cautious note on risk management. Securitisation brings a lot of advantages to financial markets, as long as structures and risks are well-understood. But we painfully learnt in the US subprime crisis what happens when assets become opaque. Having an additional counterparty, i.e. the special purpose vehicle that pools and tranches the bond portfolio, adds further complexity, risks, and costs to debt markets. In order to fly, ESBies would probably need to receive regulatory privileges over regular government bonds. This cannot be the intention.

There are better ways than financial engineering to reduce the sovereign-bank-nexus and ensure safe government bonds. Two things are key:

First, we need adequate risk pricing in financial markets. To this end we should move to an adequate regulatory treatment, especially on concentration risks for government bonds on bank balance sheets. Only with truly risk-adjusted capital requirements, will banks be in a position to handle possible losses without resorting to public sector bailouts.

Second and most importantly, national governments are responsible for sound public finances that ensure the safety of their issued bonds. Only less risk will make the system safer. For many governments, that means reducing the debt overhang that has been built up over the past decades.

These two elements sound almost trivial. At least they look much less exciting and innovative than new ideas for financial engineering. But they are the only effective way to achieve true stability and safety in European financial and debt markets.

This  article appeared first in the German daily newspaper Frankfurter Allgemeine Zeitung on 23 November 2017.