Sovereign bond-backed securities (SBBS), a new class of safe financial asset, could be gradually developed to strengthen the euro area against future financial shocks, an influential taskforce chaired by Central Bank of Ireland governor Philip Lane has concluded.
The security would bundle government debt from different countries into a single asset that could withstand default by one or more countries without sparking contagion.
Asset-backed securities are guarantees of income payments derived from a specified pool of assets, which are, in this case, sovereign bonds. The securities help institutions such as governments and banks sell debt to public markets.
The feasibility study conducted by Mr Lane suggests the design of SBBS could facilitate the taking of steps to make sovereign bond portfolios less risky without “mutualising sovereign risks in Europe”.
Investors in sovereign bonds are aware of country risks when they invest, including economic risks and political risks. What mutualising risk means is that risk from all of the sovereigns in the securities would be pooled together. Because the SBBS would be created through private contracts, each government would be responsible for servicing its own debt obligations thus not mutualising the risk.
This is important because if one country were to default on the bond, the other countries in the security wouldn’t necessarily be responsible for picking up the slack. The report has taken longer than expected due to German reservations that, in the event of one country defaulting, it could be on the hook, although, the taskforce recommendation suggests this would not be the case.
The European Systemic Risk Board High-Level Task Force on Safe Assets suggested that SBBS could be gradually developed under certain conditions, including regulation to provide the conditions for a “sufficiently large investor base”.
“For banks, regulating senior SBBS no more severely than sovereign bonds could incentivise them to hold these low-risk securities,” Mr Lane wrote.
The way the SBBS would work is that, like sovereign bonds the cash flows that accrue to the securities would derive exclusively from the underlying bonds. However, the securities would be issued by a dedicated, independently established entity with no previous trading or indebtedness. The purpose of that is to protect the entity from insolvency or other legal proceedings so that, in the event of bankruptcy, it is not affected.
The SBBS would also require issuers never to default on the contract, which is possible under straightforward sovereign bonds, even if the underlying bonds were in default.
Mr Lane’s panel wanted to publish its findings last March, but was delayed by technical hurdles. The European Systemic Risk Board – created in 2010 to prevent financial crises in the European Union, and currently chaired by European Central Bank president Mario Draghi – “took note” of the work in December but stopped short of endorsing it.Tags: Bonds, Business, Central Bank, Europe, European Central Bank, European Union, Mario Draghi, Markets, Philip Lane