Does the euro area need a safe or a diversified asset?
Author: Daniel Gros
Key points for policy-makers
The banking system of the euro area can be stabilised even without creating a new ‘safe’ asset. The real problem is the concentration of risk on bank’s balance sheets in the form of large holdings of bonds of the home sovereign. Diversification should be the first priority. But the current regulatory framework hinders diversification of sovereign risk because existing investment funds of euro area government bonds are treated as if they were much less safe and liquid than the individual government bonds themselves.
On May 24th, the Commission proposed ‘enabling’ legislation for the creation of sovereign bond-backed securities (SBBS). Enabling SBBS is useful, but they require a new framework for the tranching involved, with no track record in markets. It is thus highly uncertain whether SBBS will be widely adopted. By contrast, the approach proposed in this contribution would rely on an existing globally recognised framework (e.g. the Luxembourg or Irish UCITS or electronic-traded funds – ETF), widely used by market participants today.
Regulators should treat regulated funds that invest only in euro-area government securities in the same way they treat the underlying government bonds. This applies in particular to two key issues: capital and liquidity requirements. As long as government bonds have a zero-risk weight (under the standard Basel approach), euro area banks should not have to hold any additional capital on funds based only on euro area government securities.
The same treatment should apply to the liquidity cover ratio (LCR), which obliges banks to hold a buffer of cash or liquid high-quality securities. Diversified funds of euro area government bonds should be put into the same liquidity category as government bonds themselves. Diversified funds of the debt of many countries have a more stable market value than even the safest individual country bond. They should thus become the preferred instrument to satisfy liquidity needs.
Funds that contain euro area government bonds in proportion to the capital key in the ECB should be recognised as ‘diversified’ and should be exempted from the large exposure limits.