(How) could European safe assets be constructed?

Video & Audio recordings

Presentations

Presentation by Sam Langfield

Presentation by Anne Leclercq

Summary

As a response to the financial turmoil, amplified by the sovereign and bank risk nexus, the ESRB formed a high-level taskforce on safe assets. In the first report, the group analyzed the feasibility of sovereign bond-backed securities (SBBS) that pools and tranches sovereign bonds - see the presentation for details. So far, financial regulation prohibits the launch of a financial instrument that securitizes sovereign bonds in the EU.

SBBS benefits

• Creation of safe asset (senior tranche may be triple A?) which would diversify bank’s balance sheet
• Reduces risk of moral hazard because portfolio is based on ECB capital key
• No formal debt mutualization, but contract-based instrument
• Investors could use instrument to hedge movements in sovereign bonds market

SBBS risks

• Decreases liquidity and distorts prices of sovereign bonds that are not securitized
• Requires demand for junior tranche which has same default risk as ‘weakest link’ of all sovereign bonds in the portfolio
• Lack of portfolio diversification possibilities (due to ECB capital structure)
• Fluctuations in price (also across tranches) due to correlation of sovereign’s default risk
• Cost of issuance would lead to mark-up over safe rate, especially when liquidity is low
• Coordination of national debt issuance is required to optimize securitization process
• Supply needs to be sufficiently large to provide commercial banks with substitutes for sovereign bonds

It is worth noting that while some argue that dynamics following ECB’s Quantitative Easing program serve as a good indication (e.g. ‘freezing’ large stock of sovereign bonds) of market reactions towards a potential launch of SBBS, others were questioning the external validity and refer to the specific circumstances during that period.

Event notes by David Pichler, Research Assistant.