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Economics 04 Jun 2018

Low-risk euro-zone asset sees the light of day

The European Commission has presented its proposal on developing a new class of low-risk assets in the form of sovereign bond-backed securities (SBBS). The new security, whose goal is to enhance diversification and reduce sovereign bond risk in the euro zone, was included in the European Commission’s roadmap. The plan unveiled in December 2017 aims to deepen European Economic and Monetary Union.

How will it work?

According to the Commission, the plan will eliminate current regulatory obstacles by granting SBBS the same regulatory treatment as euro-zone sovereign bonds. Banks and other financial institutions acquiring these instruments will make their sovereign bond portfolios more diversified and lower risk, which will have a positive impact on the stability of the European financial system as a whole. Only private investors will share the risk and possible losses on these securities. The new financial instrument also aims to weaken the sovereign-bond link between banks and their home countries.

BBVA Research explains in a report on financial regulations that new securities will come under the umbrella the ECB’s capital subscription key. The EC proposal includes a senior tranche amounting to 70% of total SBBS issued. The tranche will be low risk and geared mainly toward institutions such as banks. Although the EC report prior to the proposal of the European Systemic Risk Board (ESRB) established that these instruments would comprise of different tranches with different risks and characteristics, no details of this were given in the EC’s proposal. The ESRB estimated that within in a structure in which SBBS would have different tranches with different levels of risk, the senior tranche would have a loss ratio similar to the German bund.

Those opposed to any form of mutualization of euro-zone sovereign debt might view this new tool with skepticism. But both the European Commission and the ESRB took pains to explain and underscore that SBBS would not mean euro-zone members sharing any type of risk as they would remain responsible for their own sovereign bonds as BBVA Research explains in its report.

Previous studies by the ESRB held that this new instrument would facilitate the diversification and reduction of risks of sovereign bonds and help break the vicious cycle between banking systems and state debt, thus allowing banks to reduce their sovereign bond holdings.

The European Systemic Risk Board also believes that if the market works in the right way, SBBS will act as automatic stabilizers during crises and help create a more level playing field between countries.  However, it warned that SBBS won’t eliminate individual sovereign risk although it will reconfigure sovereign bonds into low and high risk.

According to BBVA Research, the Commission’s proposal will help reduce systemic risk and financial fragmentation in the euro zone.  However, in its report it recognizes that the new instrument will bring with it certain risks and will not be lacking in drawbacks, none the least the issue of political support for the proposal. Some euro-zone member states have previously expressed their opposition to any novelty that smacks of debt mutualization and are, therefore, loathe to the arrival of this type of asset because of the impact it could have on the sovereign debt markets.

A step closer to banking union?

The proposal by the European Commission leaves aside, at least for the moment, the idea of eurobonds, which would mean a mutualization of risk. Hence, the EU executive arm’s choice of SBBS which, while not implying any substantial change to the structure of European Economic and Monetary Union, constitutes a step forward that lends itself more readily to approval. The Commission’s proposal now moves on to the Council and the European Parliament, which can amend it or throw it out.

The Commission’s proposal might not be the only economic novelty in Europe this year. Some of the measures put on the table by the EC at the end of 2017 will be taken up again by the European Council at the end of June when heads of state and government will debate the issue. According to Miguel Jiménez, BBVA Research chief economist for Europe, the summit will debate important reforms such as the creation of a European Monetary Fund and a European anticyclical stabilization fund.

Miguel Jiménez believes the anticyclical fund would help deal with scenarios of asymmetric shocks that have a varied impact on member states. It would help countries struggling the most in times of recession not to see their burden of having to tackle economic and budgetary problems added to by having to fulfil EU fiscal rules. However, we will have to wait to see the concrete proposals up for debate at the European summit for European Economic and Monetary Union to continue to advance.

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