Call it the Holy Grail of the euro zone. Ever since the financial crisis, economists have been seeking ways to create a safe financial instrument, which banks in the single currency area can buy without having to load up on domestic sovereign bonds. Many placed their hopes in the proposal of a bundle of sovereign bonds called “European Safe Bonds” (ESBies); but that looks set to disappoint.
The purpose of a European “safe asset” is to dismantle the so-called doom loop between lenders and governments. Many euro zone banks hold large portfolios of domestic government bonds. When a sovereign gets into trouble, as happened to Greece and -to a lesser extent -Italy during the euro zone crisis, investors start doubting the value of these holdings. As a result, a sovereign debt crisis can quickly produce a banking crisis too. In fact, the sovereign debt crisis may be exacerbated, since investors may fear that the government will need to bail out its banks.
Of course, banks do need sovereign bonds: They are liquid assets, which can be sold quickly when needed. They can also be used as collateral by a central bank to obtain liquidity. So economists are seeking ways to design a financial instrument which is not tied to an individual euro zone country. The constraint here is that the new security should involve no sharing of debt, or debt mutualization, an idea which Germany and other low-debt countries are vehemently opposed to. They fear that they would be responsible for standing by weaker member states such as Italy or Portugal, were they to default.
A group of economists working together with the European Systemic Risk Board, the body looking after the overall financial stability of the EU, seemed to have been successful in this quest. The “European Safe Bonds”, presented in January after a long academic gestation, would combine all euro-zone sovereign bonds into one asset. They have the attractive feature of allowing investors to diversify risk. But, on closer scrutiny, they aren’t as safe as they seem: ESBies could end up inducing the very crises they seek to avoid.
The ESRB proposal suggests that government bonds would be packaged together according to weights dictated by the ECB’s capital key. This determines how much capital each country should contribute towards the ECB. They would then be filleted in three parts: A supposedly safe one (the ESBies) — which would be bought by the likes of pension funds — and then a mezzanine and a junior tranche, which could be acquired by hedge funds. Were a country to default, the junior tranche would be the first one to suffer losses. If this were not enough, safer portions would also be affected.
The design of this instrument is clever. Its adoption, however, depends crucially on the way regulators treat it. At the moment, ESBies would be treated for risk purposes like a securitized product, the murky financial instruments such as mortgage-backed securities which contributed to the financial crisis. Banks find these securities costly, because of the amount of capital needed to hold against them. Supporters of ESBies would like regulators to be less stringent, arguing that sovereign bonds are a lot safer than, say, auto loans or mortgages.