Blog Post

Is the ECB collateral framework compromising the safe-asset status of euro-area sovereign bonds?

Central banks’ collateral frameworks play an important role in defining what is considered as a safe asset. However, the ECB’s framework is unsatisfactory because it is overly reliant on pro-cyclical ratings from credit rating agencies, and because the differences in haircuts between the different ECB credit quality steps are not sufficiently gradual. In this note, the authors propose how the ECB could solve these problems and improve its collateral framework to protect its balance sheet without putting at risk the safe status of sovereign bonds of the euro area.

By: and Date: June 8, 2018 Topic: European Macroeconomics & Governance

While sound public finances are a prerequisite for sovereign bonds to be considered safe, the central bank plays a crucial role in defining asset safety given its position as a protector of the currency’s value and as a potential backstop in a liquidity crisis (as argued in a previous blog post). However, in practice, the central bank also matters because of what assets it accepts as collateral in its refinancing operations and how it values them.

Haircuts applied in these monetary operations are utterly relevant in forging financial markets’ perceptions of the safety of a debt security, as haircuts’ levels determine whether financial institutions will be able to exchange these assets easily and almost at par against the ultimate safe asset: central bank reserves.

Currently, eligibility and haircuts applied by the ECB in its refinancing operations depend on four elements: 1) the type of asset, 2) the type of issuer, 3) the residual maturity and 4) the rating of the issuer of the asset.

This means that the current approach to valuing haircuts in refinancing operations relies heavily on the ratings made by private credit rating agencies. In fact, to determine its own rating of a particular sovereign bond, the ECB takes the best rating out of four accepted credit rating agencies (Moody’s, Fitch, S&P and DBRS) and maps it to the three “credit quality steps” of the Eurosystem harmonised rating scale (Figure 1).

How have haircuts on sovereign bonds evolved since the creation of the monetary union, and in particular during the crisis? To our knowledge, the resulting ECB ratings (and thus the haircuts applied) are not directly available, but it is easy to replicate them using the long-term ratings of the four credit rating agencies for each euro-area sovereign.

Taking into account the various changes in the ECB’s collateral framework that have taken place since 2008 (see details for instance in Wolff, 2014), this allows us to determine the eligibility and haircuts applied to euro-area countries debt securities.

Figure 1. Sovereign ratings and ECB credit quality steps

Source: Bruegel based on Bloomberg and the ECB.

Note: The ratings on the vertical axis are computed as the first best rule between the four external credit ratings translated into numerical grades from 1 to 20. Ratings from 1 to 4 correspond to the ECB credit quality step (CQS) 1, ratings from 5 to 7 to CQS 2 and ratings from 8 to 10 to CSQ 3 (which did not exist before October 2008).

 

As an example, Figure 2 shows the evolution of haircuts applied to one-year fixed coupon government bonds of all euro-area countries (changes in haircuts of bonds of other maturity would be very similar, even though levels would differ).

Figure 2. ECB haircuts for one-year government bonds with fixed coupons (in %)

   Panel A. Euro-area 15, Italy and Portugal

Panel B. Greece

Panel C. Cyprus

Source: Bruegel based on Bloomberg and the ECB.

Note: The events leading to changes in haircuts valuation are signalled by red dots (a description is available by hovering over them). EA-15 includes all euro-area countries other than Portugal, Italy, Greece and Cyprus, each from the respective date of accession. In 2010, the ECB announced the continued eligibility of Greek debt despite its downgrade below BBB- until February 2012 but did not disclose the haircuts applied. From March to July 2012, it communicated the acceptance of debt instruments issued by the government of Greece subject to a buy-back scheme, but again did not disclose the haircuts applied. That is why haircuts are labelled as “unknown” in the chart.

 

 In our view, Figure 2 highlights the two main issues of the current framework:

  • First, relying on pro-cyclical ratings from external credit rating agencies (visible in Figure 1) can lead to abrupt swings in haircuts. Before the crisis, this approach resulted in applying the same haircut to every euro-area sovereign bond with the same maturity, signalling to markets that all bonds were of the same quality. During the crisis – and despite the ECB’s adjustments to its collateral framework – the quick downgrades of some sovereigns led to significant changes in applied haircuts.
  • Second, differences in haircuts between the different ECB credit quality steps are not gradual enough to adequately reflect the different increases in risk levels. For instance, the current haircut for a sovereign bond with a residual maturity of one-year rated A- is equal to 1%, while it is 7% for a similar bond rated BBB+, just one grade below (in the S&P and Fitch scale). This is what happened to Italian bonds in February 2017.

It is important for the ECB to properly value haircuts to protect its balance sheet and to avoid bad incentives for governments as well as for financial institutions holding these assets. However, the current way to value haircuts is inadequate as it leads to large changes in haircuts that could influence, among other things, the way financial institutions perceive the safety of these assets.

We make some suggestions to solve these issues:

  • First, if using ratings from credit rating agencies in central banks’ collateral framework is not fully satisfactory (as also suggested by the Financial Stability Board in 2010), what else can be done? A first possibility would be for the ECB to use its own criteria to value haircuts, as the Bank of England (BoE) and many other central banks around the world do. However, given the multi-country nature of the euro area and the potential distributional consequences that significant ECB losses could induce between countries – through a reduction of future seigniorage profits, or possibly through higher inflation – the ECB is in a much more complex situation than a central bank like the BoE, which only has to deal with one treasury. In this context, to avoid the risk of the ECB appearing politicised (as in February 2015 when it decided to withdraw the waiver that was making Greek bonds eligible as collateral despite their low rating), it might be preferable for the ECB to still rely on an external risk assessment. In that case, a possible alternative to private ratings could be to use a debt sustainability analysis that would be done, for instance, by the European Stability Mechanism (ESM). This situation would not be perfect either, as it could lead to heated political debates between countries at the ESM. But, in our view, it would still be better than delegating these decisions to private rating agencies which cannot be held accountable for their potential mistakes and for the pro-cyclicality of their ratings. For lack of a better institution (e.g. a euro-area Treasury or any other form of executive body) and despite its flaws in terms of governance, the ESM board (formed by Eurogroup finance ministers) is currently the only political body able to take this type of decision at the euro-area level. Alternatively, haircuts could also be based on past performances of countries regarding their respect of European fiscal rules. These would first need to be improved to avoid mistaken recommendations.
  • Second, the ECB’s rating scale and the corresponding haircut valuation should be made more gradual. There are currently only three steps in the ECB scale (and the first two share the same haircut valuation), while there are 10 different grades from rating agencies that are eligible as collateral. Having a more granular scale would make haircut changes smoother and provide better incentives to governments and financial participants.

Despite their fundamental differences, the comparison between the frameworks of the ECB and the BoE is enlightening. As the BoE explains, “haircuts are set so as to be broadly stable in the light of changing market conditions” in order to 1) provide the central bank “with adequate protection of its balance sheet”, but also 2)  provide “greater certainty to counterparties”. Indeed, relying on its own criteria and not on external ratings allowed the BoE to keep haircuts applied to eligible sovereign bonds – including Italian and Portuguese bonds – stable in recent years, while the ECB mechanistically revised its haircuts when ratings were downgraded.

The institutional setup of the euro area is, in its essence, much more challenging than the relationship between the BoE and the UK government. However, it does not mean that the ECB framework cannot evolve to balance these two essential objectives better in order to continue protecting its balance sheet without putting at risk the safe status of sovereign bonds of the euro area.

The authors would like to thank Francesco Chiacchio for his help with the data visualisation.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article Download PDF
 

External Publication

How Can the European Parliament Better Oversee the European Central Bank?

This paper, written at the request of the Committee on Economic and Monetary Affairs, assesses how the European Parliament holds the European Central Bank accountable. The same exercise is done for the Bank of Japan, in order to identify possible lessons for the ECB and the European Parliament.

By: Grégory Claeys and Marta Domínguez-Jiménez Topic: European Macroeconomics & Governance, Global Economics & Governance Date: September 23, 2020
Read about event
 

Past Event

Past Event

The Sound of Economics Live: The State of the Union going forward

In the first Sound of Economics Live episode after summer we look at the State of the Union address delivered by Ursula von der Leyen.

Speakers: Giuseppe Porcaro, André Sapir, Guntram B. Wolff and Alicia García-Herrero Topic: Energy & Climate, European Macroeconomics & Governance, Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: September 16, 2020
Read article More on this topic More by this author
 

Opinion

Without good governance, the EU borrowing mechanism to boost the recovery could fail

The European Union recovery fund could greatly increase the stability of the bloc and its monetary union. But the fund needs clearer objectives, sustainable growth criteria and close monitoring so that spending achieves its goals and is free of corruption. In finalising the fund, the EU should take the time to design a strong governance mechanism.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: September 15, 2020
Read article Download PDF
 

Policy Contribution

Is the COVID-19 crisis an opportunity to boost the euro as a global currency?

The euro never challenged the US dollar, and its international status declined with the euro crisis. Faced with a US administration willing to use its hegemonic currency to extend its domestic policies beyond its borders, Europe is reflecting on how to promote it currency on the global stage to ensure its autonomy. But promoting a more prominent role for the euro is difficult and involves far-reaching changes to the fabric of the monetary union.

By: Grégory Claeys and Guntram B. Wolff Topic: European Macroeconomics & Governance, Global Economics & Governance Date: June 5, 2020
Read article More on this topic
 

Opinion

The Independence of the Central Bank at Risk

The ruling of the German Federal Constitutional Court (GFCC) of May 5 on the ECB’s monetary policy affects not only the relation of Germany to the European Central Bank (ECB) and the Court of Justice of the European Union (ECJ) but also the constitutional foundations of monetary policy.

By: Peter Bofinger, Martin Hellwig, Michael Hüther, Monika Schnitzer, Moritz Schularick and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: June 2, 2020
Read article Download PDF
 

Policy Contribution

COVID-19’s reality shock for external-funding dependent emerging economies

COVID-19 is by far the biggest challenge policymakers in emerging economies have had to deal with in recent history. Beyond the potentially large negative impact on these countries’ fiscal accounts, and the related solvency issues, worsening conditions for these countries’ external funding are a major challenge.

By: Alicia García-Herrero and Elina Ribakova Topic: Finance & Financial Regulation, Global Economics & Governance Date: May 28, 2020
Read article Download PDF More by this author
 

Policy Contribution

European Parliament

The European Central Bank in the COVID-19 crisis: whatever it takes, within its mandate

To keep the euro-area economy afloat, the European Central Bank has put in place a large number of measures since the beginning of the COVID-19 crisis. This response has triggered fears of a future increase in inflation. However, the ECB's new measures and the resulting increase in the size of its balance sheet, even if it were to be permanent, should not restrict its ability to achieve its price-stability mandate, within its legal obligations.

By: Grégory Claeys Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: May 20, 2020
Read article Download PDF
 

Policy Brief

Rebooting Europe: a framework for a post COVID-19 economic recovery

COVID-19 has triggered a severe recession and policymakers in European Union countries are providing generous, largely indiscriminate, support to companies. As the recession gets deeper, a more comprehensive strategy is needed. This should be based on four principles: viability of supported entities, fairness, achieving societal goals, and giving society a share in future profits. The effort should be structured around equity and recovery funds with borrowing at EU level.

By: Julia Anderson, Simone Tagliapietra and Guntram B. Wolff Topic: Energy & Climate, European Macroeconomics & Governance Date: May 13, 2020
Read article More on this topic More by this author
 

Opinion

The message in the ruling

The German Constitutional Court's ruling on the ECB's asset purchase programme is open to much criticism but it can hardly be blamed for raising an important question.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: May 12, 2020
Read article More on this topic More by this author
 

Podcast

Podcast

An analysis of the German Constitutional Court's ruling on the ECB QE programme

The German Constitutional called today on the ECB to justify its bond-buying program. What does today's ruling of the German Constitutional Court mean for the ECB's QE program? Could such a decision open a precedent when it comes to contesting EU law? Today, Giuseppe Porcaro and Guntram Wolff are joined by Franz Mayer, chair of Public Law at the University of Belefield, to analyse the German Constitutional Court's ruling.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: May 5, 2020
Read about event More on this topic
 

Past Event

Past Event

The Sound of Economics Live: An analysis of the German Constitutional Court ruling on the ECB QE programme

What does today's ruling of the German Constitutional Court mean for the ECB's Quantitative Easing programmme

Speakers: Franz Mayer, Giuseppe Porcaro and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 5, 2020
Read article More on this topic
 

Opinion

Monetisation: do not panic

The extraordinary operations that are under way in most countries in response to the COVID-19 shock have raised fears that large-scale monetisation will result in a major inflation episode. This column argues that so far, there is no evidence that central banks have given up, or are preparing to give up, on their price stability mandate. While there are obviously some reasons to worry, central banks are doing the right thing and the authors see no reason to panic.

By: Olivier Blanchard and Jean Pisani-Ferry Topic: Finance & Financial Regulation Date: April 14, 2020
Load more posts