Under the headline ‘Safe Assets Concepts and Market Discipline in the Euro Area: Fiction or Vision for Curing Banks States Circular Dependencies?’ industry experts, an economist and a civil institution expert discussed the issues of a safe asset, it’s feasibility, the political obstacles for introducing or phasing-in, and the closely interrelated bank-state-nexus.
Financial Stability Conference 2018
31 October 2018
Panel II – Discussion
Safe Assets Concepts and Market Discipline in the Euro Area: Fiction or Vision for Curing Banks States Circular Dependencies?
with Lee C. Buchheit, Partner, Cleary Gottlieb; Dr. Dietmar Hornung, Associate Managing Director, Moody‘s; Dr. Reza Moghadam, Vice Chairman for Sovereigns and the Official Institutions, Morgan Stanley; Thierry Philipponnat, Director, Institut Friedland; Dr. Leopold von Thadden, Monetary Policy Strategy Division, European Central Bank; moderated by Prof. Jörg Rocholl, President, ESMT Berlin
Panel II – Discussion
First off, Jörg Rocholl highlighted the poignancy of the panel‘s topic by characterising the bank-state nexus as one of the greatest contemporary challenges for the EU and introduced the panel speakers.
First off, Leopold von Thadden opened with some initial remarks on the empirical and practical considerations of sovereign bond-backed securities (SBBS). As described in the ESRB report of January 2018 on safe assets, SBBS are a policy instrument to mitigate the bank-sovereign nexus. Unlike Eurobonds, SBBS combine a diversification and tranching of national debt issued by member states, with the intention to make portfolios of banks less risky. The idea is that non-senior tranches would be held outside banks, Leopold von Thadden illustrated. While diversification by itself empirically proves to be a source of contagion, tranching at a national level may have little stabilising effect in already strongly segmented markets. Secondly, SBBS create a common low-risk security in order to reduce cross-border safe haven flows, such that flight to safe assets could occur between tranches instead of borders. The third objective is to have a common as well as tradable low-risk security in order to improve financial integration.
Differing from the ESRB recommendation, the proposal of the European Commission on SBBS regulation entails an exclusively private issuance of SBBS, greater flexibility due to less uniform tranching points and a prudentially equal treatment of senior and non-senior tranches, whereas the ESRB report proposes that the treatment of non-senior tranches should reflect their greater riskiness. Common features between both proposals include the removal of unfavourable SBBS treatment resulting from securitization in order to enable SBBS to compete with normal sovereign bond, Leopold von Thadden explained. In addition, embedded diversification will be achieved via financial engineering, and overall SBBS are conceived as a pass-through vehicle to avoid any form of mutualisation. Moreover, SBBS would be fiscally neutral, in the sense that SBBS issuances have no seniority. While the draft report from the European Parliament on SBBS offered compromise lines, SBBS were not part of the agenda of the June 2018 Euro summit. Possible alternatives to SBBS encompass E-bonds, which, however, entail seniority of issuer and hence fiscal discipline effects. The option of national tranching might be ineffective to reduce the risk of fragmentation, unless accompanied by appropriate regulation. Finally, there are Eurobonds, against which, however, SBBS were explicitly designed as an alternative, Leopold von Thadden concluded.
On the overall topic of the bank-sovereign nexus, Thierry Philipponnat elaborated on the circular reference of this doom loop being, in part, beneficial for banks as sovereign bonds are considered risk-free and yield an infinite return on capital in the current EU environment. Moreover, it ensures the option to be bailed out by their domestic government. In turn, this nexus ensures the issuing sovereigns easy funding for debt financing. “However, we all know that risk-free sovereign bonds are a phantasy”, he highlighted. A proposal for risk weights on sovereign holdings was already presented by the European Parliament in 2012, but strongly opposed by Member States, even though they were well aware of the associated problems. Putting even higher risk weights for banks that buy debt from their domestic government would, however, effectively reduce the bank-state nexus. Thierry Philipponnat then raised the objection that SBBS use financial engineering to make up for a lack of political will to cut this nexus. “We do not need window dressing, but to address the fundamental economic issues”, he stressed.
Reza Moghadam critically remarked that if SBBS are already impractical, then so are risk-weighted tranches of SBBS, and observed an overall lack of political will for sovereign bond rating. From a market perspective, he explained that SBBS appear as an elegant creation to simultaneously address risk sharing and risk reduction. However, it may not be impossible but very difficult to put SBBS in a market and for them to be practical, which first of all requires regulation and a public institution behind it. At present, the market would attach a very high risk premium to these instruments and treat them like securitised assets on the basis of mortgages and not nearly like government bonds, he outlined. Moreover, markets for trading government bonds are extremely liquid, and making SBBS liquid is difficult by comparison, as it takes high volumes as well as a schedule for issuing future bonds for the market to feel comfortable with liquidity increasing over time. Given the liquidity provisions, risk weights and capital needs, it constitutes an overly enormous investment for the private sector to put together and issue this instrument, which is why it requires a public body. Reza Moghadam concluded that the rating and therefore the associated pricing of SBBS to be above and thus more expensive than the underlying bonds, simply because it will be illiquid, new and have its own rating.
Subsequently, Jörg Rocholl asked Dietmar Hornung about the possibilities and limits of rating SBBS. Contrary to the expressed scepticism surrounding SBBS, Dietmar Hornung noted that other EU institutions created in the wake of the crisis, namely EFSF and ESM, proved quite successful. Similarities to the SBBS proposal include the use of structured finance technology to come up with an issuance. SBBS related differences are exemplified by its notion on financial engineering and its weakness evoked by a lack of political commitment, he said. On the SBBS objectives, rating agencies evaluate its capability to effectively cut the nexus as rather limited, since both sovereign and bank issuers are exposed to the same macroeconomic environment and associated risks. In terms of reducing the safe haven cross-border capital flight in a crisis scenario, SBBS do not appear to be sufficiently stress-resilient, especially as its demand for junior tranches will evaporate during a crisis, he said. Regarding the third SBBS objective to increase safe assets in Europe, there are unlikely rating prospects for sovereigns to take the lead given that there are no elements of debt mutualisation. According to experiences with the EFSF, rating agencies would assume a rather high correlation of defaults across Europe for SBBS particularly in a stress scenario. Dietmar Hornung summarised that without the full sovereigns‘ commitment the SBBS proposal does not seem to be a great step forward.
In the light of a prospective episode of distress in Europe, Lee Buchheit replied that Italian banks have a long tradition of rolling over their exposure of Italian government debt securities. This enables the sovereign to have a stable and predictable market for its securities that is insulated against financing risks by foreign investors. On the downside, in a deteriorated situation that requires a sharp reduction of the sovereign debt stock, and given that the domestic financial industry holds such a large percentage of the papers, the room for manoeuvre for debt restructuring is severely limited. An extreme distress scenario would merely allow for a reprofiling of Italian debt with a simple extension of maturities having the benefit of obviating the need to refinance the government’s maturing debt in the market with intolerably high coupons. This would have to be inevitably tied to some form of fiscal adjustment programme. Any principal haircut of government bonds as done in Greece 2012 would not be feasible, Lee Bucheit underlined.
Resonating with the panel’s assessment of SBBS, Leopold von Thadden noted that nevertheless SBBS should be seen as a compromise which can improve upon the status quo. Addressing the critical issue, namely the bank-sovereign nexus, only over primary channels may be even harder since such approach would touch even more strongly on the controversies surrounding regulation. Regarding financial engineering one should be aware that the underlying portfolio would not consistent of subprime mortgages but of plain vanilla government bonds of member states. As for crisis management he highlighted that SBBS represent just one part of a broader reform package. SBBS should be seen as a complement – and not as a substitute – to ESM and other reform dossiers. “The question is whether other alternative proposals have a better chance of bringing the European core and periphery together”, he said.
On the question of what alternative solution would effectively cut the severe bank-sovereign doom loop such as in Italy, Thierry Philipponnat noted that with the current Italian crisis Europe pays for its indecision and inaction on risk weights of about six years ago. Investors do not seek completely risk-free assets, but rather need to know about the involved risk and its price, and with sufficient early notice the market would be able to adjust. Reza Moghadam agreed that markets can embrace regulation, risk weights and additionally introduced instruments and price them accordingly, but the bar on preconditions for SBBS to work remain high. Thierry Philipponnat went on saying that even without these technical issues behind SBBS he was unconvinced that any significant share of investors would be interested in buying.
Turning to Reza Moghadam, Jörg Rocholl was interested in a global perspective on removing the privileges of sovereign debt. Resistance against risk weights is no solely European phenomenon, but prevails in many emerging markets and countries such as Japan as well, Reza Moghadam replied. Exposure limits over a long period of up to 15 years in order for banks to adjust or a greater fiscal backstop present possible alternatives, which must be accompanied by other measures to increase solidarity within Europe. “If you simply force the reduction of risk without some form of risk sharing then the price would be quite high.”
On the question of how to manage contagion effects reflected by similar ratings between banks and sovereigns due to heavy exposures, Dietmar Hornung conceded that in such cases part of the sovereign assessment constitutes the basis for the bank assessment. Currently, the peripheral countries, namely Greece, Cyprus, Portugal, Spain and Ireland, experience a rebound after a significant transition towards lower ratings. Especially Portugal represents a great success story as it improved its credit profile over time through tough fiscal and structural reforms. On the downside, Italy constitutes the exception displaying the lowest ratings ever. “Typically with those countries the interaction of economic and fiscal weakness is of great concern”, Dietmar Hornung said. Lee Buchheit characterized the current crisis as politically driven with a relatively inexperienced Italian administration that creates risks due to a lack of predictability. On SBBS he shared the motivation behind it, but agreed with Thierry Philipponnat that the underlying problem is the illusion that regulators have been forced to embrace that all European sovereigns are of an identical AAA credit risk. Adopting SBBS would create another illusion, if regulators were obliged to treat all tranches with AAA rating, which rating agencies realistically would never impart. As the only practical solution Lee Buchheit considered concentration limits phased in over time as mentioned by Reza Moghadam. Leopold von Thadden suggested that concentration-based measures could ideally be combined with SBBS, as these are inherently exempted from charges due to their embedded diversification. Without such embedded features, even more regulation may be needed to overcome the risk of getting stuck in segmented national markets.
Regarding other possibilities to cutt the bank-state nexus, Thierry Philipponnat proposed to force EU sovereigns to systematically issue junior bonds for a sufficient buffer of junior bail-inables, which then could be priced accordingly by the market. In case of a good credit rating, junior and senior debt would display more or less the same price, whereas with low credit rating the differences would grow. Lee Buchheit pointed out that a similar proposal has already been made with so-called red and blue bonds. Reza Moghadam intervened on this proposal and warned about the potentially devastating effect for the Italian government to pay its debt, since then half would be of junior tranche being priced considerably more. At last, Leopold von Thadden reiterated the great importance of phasing in new instruments over time as put forward by Lee Buchheit and Reza Moghadam. “With all the political will and commitment we need to find over time solutions working through new issuances.” In contrast, legacy assets should not be touched upon, as this would make it all the more demanding for the Italian banking system, Leopold von Thadden noted.
The first question from the floor elaborated on an alternative bail-in concept. In the short-term bank managers have incentives to excessively take on sovereign debt. In a distress scenario the balance sheets’ asset side shrinks and the liability side needs fixing. Besides recapitalisation there is the option of bailing in liabilities. In view of investors and then capital this would counterbalance the incentive to buy these bonds in the first place as they have to foot the bill in the end. If the resolution works in the long-run there might be natural incentive from debt governance that these excessive amounts of sovereign debt are no longer on the asset side of the balance sheets. Lee Buchheit echoed that indeed if one believed the resolution directive to practically work, then recapitalisation could be fully or partially avoided during a crisis. However, if the market had considered the resolution directive to work appropriately and they saw a sovereign getting into financial distress, the market would raise cost of capital for those institutions and one would wind up recapitalising before the crisis hits.
Another question referred to whether the current regulatory framework with the SSM could already help to cut the bank-sovereign nexus by examining individual banks‘ balance sheets and if necessary instruct them to restructure and diversify their portfolio. Thierry Philipponnat strongly agreed with this proposal while Reza Moghadam replied that with the Pillar 2 review process a respective framework that examines bank by bank is already in place. To some extent the SSM already looks at the individual level as to assess whether one bank is subject to greater risks compared to others. One design imperfection despite the SSM is that it requires the cooperation of national supervisors as they play a big role for stress tests, and yet national supervisors do not want to put their domestic banks at a competitive disadvantage. Hence, a mixture of the Pillar 2 with some central direction would be ideal, he said.
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