Task force urges eurozone rule change for common securities

A central bank task force has said the eurozone’s financial rules need to change if a mooted and politically charged “safe asset” to strengthen the single currency area’s banking system is to work.

The group led by Philip Lane, the Central Bank of Ireland governor, said investors would only want a safe asset — a common eurozone security, backed by all member states — if it qualified for the same regulatory treatment as nationally-issued sovereign debt.

“We think that this market could develop [but] a necessary condition is that the EU has an enabling regulation that reflects the unique design and risk properties of sovereign-backed securities,” said Mr Lane on Monday. The task force called on EU lawmakers to act.

The lack of a eurozone “safe asset” akin to US Treasuries emerged as a serious problem for the single currency area during the financial crisis. Weaker eurozone governments such as Greece and Ireland found investors less willing to hold their debt because of the assumed cost of bailing out their banks. But because many of those banks were heavily invested in their own governments’ debt, the whole financial system came under pressure.

A eurozone safe asset would be an attempt to break this cycle because it would be backed by all 19 member states.

“We think that if this market succeeded it would contribute to financial stability by completing banking union . . . and capital markets union,” said Mr Lane in Frankfurt.

However, the idea is politically contentious at a time when several rival plans for strengthening the eurozone are circulating, and no decision on creating such an asset has been taken. Germany — seen as the strongest eurozone member state with the lowest borrowing costs — opposes the idea of being seen to, in effect, bail out weaker members.

One issue identified by the task force is how regulators treat a eurozone safe asset.

Because sovereign debt is considered almost risk-free, banks can buy it without having to set aside capital as insurance against a default. Mr Lane said the task force’s talks with investors showed that the safest tranche of a eurozone safe asset would also need this so-called zero risk weight to be an attractive purchase.

The task force suggested that any eurozone safe asset could be divided into tranches carrying different risks for investors. It said about 70 per cent of the security would be a low-risk, “safe” asset, with holders of riskier tranches more exposed to default.

Holders of the safest tranche would only be bailed in if Greece, Cyprus, Portugal, Italy and Spain all defaulted completely on their obligations, the task force suggested.

Brussels has yet to confirm whether it would give the safe assets the same treatment as government debt. At present, government debt has zero-capital treatment. Academics who have worked on the idea are privately confident that a solution can be found.

Mr Lane said a safe asset would help avoid the “doom loop” between sovereigns and their banks and capital flight from the eurozone’s periphery to its core. “If there is a flight to safety, it would be from the junior to the senior [tranches],” Mr Lane said in a briefing in Frankfurt on Monday.

The assets backing the bond would reflect the contribution each member state makes to the eurozone’s economic output, with German debt accounting for just short of 30 per cent of all the debt.

Mr Lane said the task force had “no particular calendar” in mind for the creation of the asset, but recommended a gradual approach to expanding the market to avoid liquidity problems in sovereign debt markets.

The task force has taken 18 months to come up with its recommendations. A group of academics first proposed the idea of a eurozone safe asset backed by sovereign bonds in 2011.

Letter in response to this article:

There will be no demand for this super-safe asset / From Jean Dermine, Insead, Singapore