THESE are bright days in the euro area. Preliminary figures say that the currency zone’s GDP grew by 2.5% last year, the fastest since 2007. But many of the faultlines in the zone’s financial system, as revealed by the financial crisis, remain. A proposal published on January 29th by a group reporting to the European Systemic Risk Board, a prudential supervisor, may mend one of the more troubling flaws.
Euro-area banks favour their home countries’ debt. A sample of 76 lenders examined by supervisors last year had exposures of €1.7trn ($1.9trn) to euro-area governments, of which €1.1trn was lent to their home states. That exceeded the banks’ common equity tier-1 capital, their cushion against losses, of €1trn. The fortunes of states and banks are thus bound in a “doom loop”. Suppose an economic shock raises the risk of a sovereign default. Banks’ balance-sheets start to crumble. They need propping up by the already wobbly state. And as they cut lending, the real economy weakens, worsening the fiscal woe. That, more or less, is what happened in the zone’s sovereign-debt crisis.
One way of breaking the loop is for euro-area governments to issue or guarantee bonds jointly. But that runs the risk that the prudent pay for the profligate. This week’s proposal—for a new asset, sovereign-bond-backed securities (SBBS)—both leaves states responsible for their own debts and encourages banks to diversify sovereign risk. Issuers of SBBS, which could be public- or private-sector entities, would buy euro-area government bonds at market prices, and repackage them. Buyers of SBBS would be paid interest and principal (and be exposed to default) as if they owned the underlying bonds.
SBBS would be divided into three tranches. Buyers of the lowest slice, making up 10% of the total value, would suffer the first loss in a default. The top layer, accounting for 70%, would be about as safe as German government bonds, says the group’s report. In senior SBBS banks would thus have a low-risk asset that would diversify their exposure across the whole zone. The doom loop would be broken.
To get SBBS going, regulation would have to change. Capital rules treat government bonds as risk-free, so that banks need hold no equity against them, but senior SBBS would incur a charge, though in fact they are no riskier. And as things stand, the European Central Bank (ECB) could not accept SBBS as collateral. The European Commission is due to propose helpful changes in the law in the first quarter of this year.
One possible worry is that, if successful, SBBS may cause liquidity for some sovereign bonds to dry up. Bonds bought by SBBS issuers would in effect be “frozen” on their balance-sheets. On the other hand, SBBS could actually make sovereign-bond markets more liquid by providing alternative means of collateral, hedging and arbitrage. Judging by the ECB’s quantitative-easing programme, under which the central bank has amassed €1.7trn of national debt, the report reckons that any freezing effects would be limited, at least for an SBBS market of similar size.
SBBS are an ingenious way of strengthening the euro area’s financial structure. But more needs doing. Another recent report, by a team of French and German economists, lists six proposals to stabilise the system and encourage macroeconomic prudence. A new safe asset is just one, alongside common deposit-insurance, revised fiscal rules, and more. There is lots to do. Best to start before trouble returns.