Are sovereign bond-backed securities the key to financial stability within the Eurozone?

Creating a Eurozone-wide safe asset and thus diversifying sovereign risk within the currency union without the need for sovereign debt mutualisation – sounds like having your cake and eating it, doesn’t it? Well, according to the European Systemic Risk Board (ESRB), sovereign bond-backed securities (SBBS) might do the trick. SBBS are merely an idea, discussed in ESRB working papers, and feasibility studies, but one day they might become reality.

How would SBBS work?

Just like more traditional asset-backed securities, SBBS would combine two key features: pooling of assets and tranching of risk. The SBBS-issuing entity keeps a cover pool of government bonds as assets on its balance sheet. For the sake of simplicity and transparency, it might be beneficial to only include EUR-denominated central government bonds of Eurozone member states in the pool, using the ECB capital key to determine the portfolio weights. Minor deviations could however be made in order to account for member states with small amounts of outstanding debt or to allow for the inclusion of bonds from non-Eurozone EU member states, which would enhance diversification.

The cover pool is used to back on the liability side the issuance of SBBS, which are claims on the underlying sovereign bond portfolio. Financial engineering is applied to create a contractual seniority structure consisting of three distinct tranches: senior, mezzanine and junior. A cash flow waterfall defines the priority of payments so that any non-payment on bonds in the cover pool is first borne by junior SBBS holders. Only after the junior tranche is exhausted, further losses would be imposed on mezzanine SBBS holders and so on. Senior SBBS, sometimes referred to as European Safe Bonds (ESBies), are thus protected by the loss-absorbing nature of the subordinated tranches. According to the ESRB feasibility study, a 70% thick senior SBBS would have risk characteristics at least as strong as lower-risk Eurozone government bonds. A 20% thick mezzanine SBBS would behave similarly to lower investment grade sovereign bonds, whereas a 10% thick junior SBBS would be much riskier and comparable to higher-risk Eurozone government bonds.

Importantly, the SBBS-issuing entity is simply a pass-through vehicle, i.e., cash flows accruing from the cover pool are merely passed on to SBBS investors. Claims of investors are limited to the assets secured in their favour. The SBBS-issuing entity itself is bankruptcy-remote.

What would be the advantages of SBBS?

The emergence of senior SBBS as a Eurozone-wide low-risk asset would have two main advantages.

• Stability and cohesion within the European bank sector: One of the biggest macroprudential concerns for European banks is the “home bias” with regards to their sovereign bond exposures. This can create a vicious circle: A political or economic crisis in a certain Eurozone member state might lead to a sell-off in its government bonds, which would reduce the net worth of local banks holding large amounts of their home country’s sovereign debt. The banks would then be likely to reduce their lending, deepening the country’s crisis. Holding senior SBBS instead of local government bonds would break this feedback loop by diversifying and de-risking European banks’ sovereign bond exposures.
• Uniform European low-risk asset: Compared to the “commoditised” US Treasury market, the decentralised market for Eurozone government bonds is heavily fragmented since all countries issue their own debt instruments individually. This heterogeneity, and the inefficiency that goes along with it, might be overcome by senior SBBS as a standardised Eurozone-wide low-risk asset, which could be used as a uniform pricing benchmark or to collateralise repo and derivatives transactions.

Are SBBS going to be implemented anytime soon?

No, I wouldn’t expect an implementation in the near future. There are considerable hurdles that would need to be cleared first, in particular the following two.

• Regulatory treatment: Under existing bank regulation SBBS would receive significantly less favourable treatment than sovereign bonds. SBBS would essentially be considered securitised products, leading to higher capital requirements for banks. Only if this regulation is amended could there be a realistic chance of a demand-led emergence of SBBS.
• Compositional drift of cover pools: External factors – recalculations of the ECB capital key, a scarcity of Bunds, etc. – might lead to compositional changes in cover pools over time. This would reduce the fungibility of different SBBS series, as they would be imperfect substitutes for one another, and might thus negatively impact the overall liquidity of the SBBS market. In order to improve liquidity, existing SBBS series could be re-opened (“tap issues”), as long as changes in the cover pool remain relatively small.

Conclusions and outlook

SBBS would certainly offer a number of desirable features – both from an investor’s view point and with regards to financial stability within the Eurozone. They might have the potential to ultimately become a mainstream asset class. The ESRB reckons that over time the SBBS market could reach volumes of €1.5 trillion or more. It’s not going to be a quick win, though.