European policymakers rarely feel the need to emulate the US. But if euro government bonds were more like Treasuries, any eurozone member would enjoy a seemingly limitless investor base for its debt and the derivatives market could access a vast pool of high-quality euro collateral.

On January 29, a task force convened by the European Systemic Risk Board unveiled a 300-page report on how to build this kind of pan-European safe-haven asset, dubbed sovereign bond-backed securities (SBBS). The idea involves tranching a pool of sovereign bonds in a securitisation structure: 70% senior, 20% mezzanine and 10% equity. The European Commission will consider the proposal and potentially adopt draft legislation to enable it at a meeting scheduled for May 23.

Philip Lane, governor of the Central Bank of Ireland and chair of the ESRB task force, envisages issuance growing gradually after a test period – potentially to a substantial €1.5 trillion ($1.85 trillion), meaning even a 10% equity tranche would need to be about €150 billion in size. The senior tranche is intended to provide more of the high-quality assets banks crave for collateral and treasury management. It would also reduce the risk of another doom loop such as the one suffered by Greece between 2011 and 2012, when banks were laden with debt issued by their home government, which in turn implicitly underwrote the banks.

But regulatory experts warn the current European Union regime for sovereign debt exposures will need to change to make a success of SBBS as a new safe asset. Market participants fear that with all the focus on the senior tranche, the first-loss piece has been treated as something of an afterthought, and yet the whole structure depends on it. The higher the yield on the junior tranche, the more yield must be given up by senior-tranche investors to ensure the pricing across the whole structure is consistent with the underlying bond yields.

“In terms of securitised assets of low credit quality, the pricing is prohibitive, I would think, and the capacity of the investor base to hold that junior tranche is questionable. The first stumbling point is how you place that junior tranche into an investor who has deep pockets to be able to hold it more or less to maturity,” says a senior public-sector debt capital markets (DCM) banker at a European bank.

The first stumbling point is how you place that junior tranche into an investor who has deep pockets to be able to hold it more or less to maturity

Senior public-sector DCM banker at a European bank

“Maybe you can find a moderately sized group of investors who might want to hold it on a short- to medium-term basis and trade it around among themselves, but that doesn’t sound like a €100 billion market to me,” he adds.

One credit investor who ought to be a potential buyer of the equity tranche in theory is doubtful about the concept in practice. David Riley, head of credit strategy at $60 billion fixed-income fund manager BlueBay Asset Management, compares it with a traditional collateralised debt obligation and finds the comparison unfavourable.

“The problem is you don’t get that much diversification because you are looking at a relatively small number of credits, and the effective number is even smaller because you have such a disparity in terms of economic size,” he says.

Junior doom

The task force report proposes weighting the pool of bonds by size of economy, rather than amount of debt outstanding, to avoid skewing the pool towards heavily indebted sovereigns. Of the 19 eurozone members, Germany, France, Italy and Spain dominate in terms of economic size. Estonia has no sovereign debt outstanding, and other countries such as Malta could only contribute tiny amounts.

“As we saw with the eurozone crisis, there was contagion [across the periphery], so the level of diversification credit you would incorporate in terms of risk profile is actually going to be relatively low,” says Riley.

Two other sources also point out that buyers of the SBBS tranches cannot choose which sovereigns they are exposed to, potentially leaving them with unwanted risks in periods of market stress. This could make the junior tranche less appealing than simply holding a basket of peripheral eurozone sovereign bonds selected freely by the investor, and in need of expensive hedging.

“Investors who hold the junior tranches are forced holders of a group of countries, rather than managing the different credits within there,” says the senior DCM banker. “They may well end up hedging that by saying ‘I am happy with 90% of this, but I am going to have to sell one of the country’s bonds or buy CDS [credit default swaps] to hedge my position’.”

Moreover, by design, the junior tranche is not intended for use as a high-quality asset and is therefore unlikely to qualify as standard collateral or for the liquidity coverage ratio. That makes it intentionally less appealing to banks, increasing the importance of finding a stable non-bank investor base.

“It is not obvious ex ante which other players you would be appealing to by trying to look unappealing to the banking sector,” says Gianluca Salford, European rates strategist at JP Morgan. “For instance, the [softer regulatory] treatment for insurance companies or pension funds would be interesting as an alternative. To rely only on hedge funds, in my personal view, would make the [junior tranche] asset class too volatile.”

BlueBay’s Riley compares the proposal to the development of the bank-contingent convertible (CoCo) bond market. Those instruments were effectively mandated by regulators to provide banks with debt that could be bailed in easily during a resolution to reduce the risk of government bailouts. The CoCo market started small and has now achieved critical mass, but it has done so thanks to legal clarity regarding the triggers for converting the bonds into equity or writing off principal.

“It was an evolution tapping into the existing asset class and investor base of bank subordinated debt, which was reasonably well established. Could you have something like that for sovereigns? Yes, but you would need to have a credible bail-in mechanism [for the junior tranche] and triggers that wouldn’t be subject to political manipulation in some manner,” says Riley.

The ESRB task force report acknowledges as much: “In the event of a debt crisis, the government may be tempted to default selectively on the bonds held in the SBBS structure – or settle on better terms with resident bondholders [of underlying bonds] – to the detriment of the SBBS holders.”

To avoid this risk, the task force proposes either introducing new clauses into eurozone sovereign bonds or including a rule in the SBBS enabling legislation that would specifically outlaw such discrimination between creditors. The report recommends the latter solution, because it would immediately cover all existing bonds, not just new issuance.

At his press conference, the ESRB’s Lane argued the existence of outstanding SBBS bonds in a crisis could act as a market-stabilising factor, even if new issuance stalled due to problems finding buyers for the junior tranche. Potential losses from any sovereign restructuring would be spread among a more diversified group of investors in the stock of SBBS that had already been issued, instead of hitting domestic banks disproportionately.

Regulatory incentives

Encouraging banks to diversify into the SBBS senior tranche, however, will require changes to bank prudential regulation for exposures to securitisations. In the EU, securitisations currently receive a much less favourable capital treatment than vanilla sovereign bonds, including a 5% risk-retention requirement intended to align the incentives of the issuing bank with end-investors. This would deter banks from holding large inventories and defeat the purpose of creating SBBS as a safe asset for treasury and collateral management.

The European Commission is already aware of this and on January 23 it called for industry responses to the idea of easing bank regulatory capital requirements for exposures to the mooted SBBS. The consultation mentioned applying a new softer treatment to at least the senior tranche, while leaving open the question of how the other tranches should be treated.

But, even if the treatment of SBBS senior tranches is equalised with that for home-currency sovereign bonds – which currently enjoy a zero risk weight under the standardised approach to credit risk in the EU – it may not be enough, according to prudential experts. This ties the fate of SBBS firmly to the very sensitive question of whether to end the zero risk weight for home-currency vanilla sovereign exposures on bank balance sheets in Europe.

We are not making a call as a task force on whether [this] reform is desirable, because different jurisdictions have different views on that question

Philip Lane, Central Bank of Ireland

The zero risk weight is part of the reason for home sovereign concentration risk, together with treasurers’ inherent tendency to invest in the market they know best. But eliminating it could disrupt the market for national sovereign bonds because domestic banks would be forced to migrate their holdings.

In his press conference on January 29, Lane said: “We are making a conditional statement: if there were such reforms that incentivised banks to diversify their holdings of sovereign debt and to de-risk, then the scale of demand for the senior tranche would be substantially enhanced. We are not making a call as a task force on whether [this] reform is desirable, because different jurisdictions have different views on that question.”

Market participants tend to feel a stronger stance will be necessary.

“Why would an Italian bank hold the SBBS rather than the Italian bond?” asks Moritz Kraemer, head of sovereign ratings at S&P Global Ratings. “They can hold the equivalent of an SBBS today – they can hold a mix of Italian, German, Spanish and French paper – but they choose not to; they choose to hold mainly Italian bonds. Why would those incentives change if you have the SBBS, which might also be less liquid than Italian bonds?”

Markus Demary, a senior financial markets economist at Cologne Institute for Economic Research in Germany, conducted a survey among German banks on SBBS. It showed a marked reluctance to switch out of Bunds, which have well-known and long-established default and liquidity risks.

“It would be necessary to create a very liquid market for these euro area bonds, and this is difficult because the banks are holding German government bonds for liquidity management and they do not see these euro area safe bonds as a close substitute. The banks told us they expect low demand for these euro area safe bonds,” says Demary.

At his press conference, Lane emphasised that research by the task force showed eurozone banks hold only 17% of eurozone sovereign bonds (figure 1) and just 11% of the area’s supranational issuance. Supranationals are favoured heavily by non-eurozone investors, who do not necessarily have the expertise to analyse individual sovereign creditworthiness, and they might be attracted to SBBS for similar reasons. Hence, he concluded, overall demand for the senior tranche did not depend on prudential reform.

However, Lane acknowledged it is “an open question” as to whether SBBS alone could prompt banks to diversify away from their home sovereigns, absent changes in prudential rules. “It depends not just on current regulations, but also what banks predict about the future. If they anticipate there is some likelihood at some point of some reform that incentivises diversification and de-risking, then this product could be taken up, even in advance of regulatory changes,” he said.

Concentration charges

Amid difficulties in agreeing a way forward, European policymakers decided in mid-2016 to wait until the Basel Committee on Banking Supervision concluded its own review on the treatment of sovereign risk on the banking book. However, in December 2017, in discussing a giant package of reforms to complete the Basel III rules, the Basel Committee was unable to agree even to consult formally on updating the framework for sovereign credit risk.

Nicolas Veron, a senior fellow at think-tanks Bruegel in Brussels and the Peterson Institute in Washington, DC, advised the European Parliament at a hearing in November to push ahead with prudential reform regardless, by adopting concentration risk charges for sovereign exposures in the eurozone. The parliament’s economic and monetary affairs committee took up the idea on January 24, in a resolution that urged European lawmakers to safeguard European financial stability through measures such as reducing the sovereign concentration risk.

Veron’s stance is that the eurozone faces a unique situation because its member states no longer have an independent monetary policy in their home currency. While the European Central Bank (ECB) has a responsibility to maintain the integrity of the euro as a whole, it does not have the legal mandate to finance the government debt of an individual country. Even if the eurozone as a whole is solvent, this situation raises sovereign default risks for single members – risks that do not exist in countries that control their own currencies.

Veron’s plan would impose a risk charge once a bank’s exposure to a single – most likely home – sovereign exceeds a given threshold.

…if policymakers create demand for these assets and banks hold them without having sufficient capital to cover potential losses, then these sovereign-backed bonds have to be real safe assets

Markus Demary, Cologne Institute

“Single-country sovereign debt would be subject to those charges if concentrated, but it would completely make sense to exempt a tranched bundle of sovereign debt from many different countries – you could have as much as you want without having a problem with concentration. It is actually one of the components of what has to be put in place for safe assets to be effective and viable,” Veron tells Risk.net.

Concentration charges would also avoid the competitive implications that would result if Europe introduced risk weights on sovereign bonds but other Basel jurisdictions allowed their banks to maintain zero risk weights on eurozone sovereign bonds. Provided eurozone banks kept their holdings diversified, they would face no extra capital charge compared with their non-European peers.

However, exempting SBBS from concentration charges to stimulate the market could create moral hazard, says Demary. It would, in his view, increase the likelihood of the ECB or some other multilateral institution stepping in as a buyer of last resort if problems with the junior tranche cast doubt on the viability of the senior tranche.

“The problem is, if policymakers create demand for these assets and banks hold them without having sufficient capital to cover potential losses, then these sovereign-backed bonds have to be real safe assets. If there were any disturbance in the market for these safe bonds, banks would refrain from holding them – perhaps forever,” says Demary.

Truly, deeply safe

This shines a light on the most important challenge facing safe bonds: how to ensure they really are safe, in terms of not just default risk, but also liquidity risk. The ESRB task force explicitly ruled out any kind of multilateral guarantee that might have been used to reassure market participants. The report states: “SBBS do not provide for any joint liability among member states; therefore, mutualisation of sovereign risks or potential losses is excluded by design.”

All underlying bonds would be shared across all tranches, and the senior DCM banker questions whether even the senior tranche would actually be as safe as a single, highly rated sovereign exposure such as Bunds.

“Because of the way the securitisation is set up, you’d have to lend the junior tranche a little bit of the AAA quality so it wasn’t completely unappetising to investors. So you might end up diluting the one best-quality safe asset we have,” says the banker.

Research by the task force bears this out: the report includes a table of yields and risk simulations – using value-at-risk (VaR) and expected shortfall outputs with a 99% confidence level – prepared by the task force.

The role of SBBS is not to step in and provide governments with a backstop financing source

ESRB policy expert Sam Langfield

These figures suggest the senior tranche of an SBBS would have had the same characteristics as a Bund on average across the whole period between 2000 and 2016, but would be less resilient in a stress scenario, with higher yields and higher VaR and expected shortfall risk numbers than Bunds during the crisis period of 2011–12.

Ratings agencies are also sceptical about the creditworthiness of the senior tranche and its ability to attract the highest ratings. This is precisely because of the concentration and correlation risks among the underlying sovereign bonds, which could make the senior tranche highly correlated with the first-loss piece.

“With an underlying asset that is very lumpy and highly correlated, tranching gives you very little, unless you tranched it to separate [out] the core eurozone countries in the safe tranche, but that would defeat the whole purpose,” says Kraemer.

In one sense, the task force does indeed want a kind of firewall to prevent problems in one sovereign affecting the whole structure. The report proposes a market access criterion, whereby bonds that do not have a secondary market clearing price would be denied inclusion in future issuance of SBBS.

This approach is particularly worrying for the DCM banker, who questions how national debt-management offices would react (see box: Whither the national sovereign debt?). He paints a scenario where SBBS have taken off and some sovereigns are auctioning most of their bonds into the securitisation structure rather than to end-investors.

“At the point when one of those countries gets into trouble, what happens then? Do they go back to their old way of selling bonds to investors they don’t have any contact with any more, who haven’t actually been able to buy so many government bonds because they have been buying so many securitisations?” he asks.

At the task force press conference on January 29, ESRB policy expert Sam Langfield emphasised the SBBS is “not intended as a new financing tool for governments”.

“If it transpires a government is unable to finance itself in open markets, that is the unfortunate situation we are in. The role of SBBS is not to step in and provide governments with a backstop financing source,” he said.

Lane recognised the exclusion from SBBS is “a type of cliff edge”, which would officially confirm the sovereign’s loss of market access, but then, so is the loss of national sovereign market access today. “The question ultimately is: does [SBBS] make cliff effects worse? I have yet to see good examples where that is true.”

Whither the national sovereign debt?

When eurozone finance ministers begin to consider the proposal for SBBS, the first people they are likely to approach for advice are their own debt-management offices (DMOs), which manage national sovereign debt issuance. Market participants familiar with the DMOs say they guard their independence jealously.

Perhaps too jealously sometimes. On January 9, Italy and Portugal announced sovereign bond syndications within hours of each other, potentially competing for pools of investors who overlap substantially. This would suggest more co-ordination is a good idea and SBBS issuance might be one way to achieve it.

But, for DMOs, the market’s confidence in their ability to issue and refinance whenever needed is everything. They might well become alarmed if the SBBS project forced them to swap a highly liquid domestic yield curve for a less liquid pan-eurozone instrument.

“In securitisation, you are taking an illiquid product and trying to create liquidity. Here you start with the crème de la crème and you are trying to make something even better – that is difficult,” says Gianluca Salford at JP Morgan.

DMOs have been involved with the task force chaired by the Central Bank of Ireland’s Philip Lane from the beginning. In his presentation on January 29, Lane emphasised any SBBS issuance would start gradually, on a demand-led basis, and its eventual build-up would be “conditional on smooth market functioning”.

This test period will be crucial, says the senior public-sector DCM banker at the European bank. On the one hand, the SBBS-issuing vehicle could be a new buyer for national sovereign debt, helping the long-term management of the yield curve.

On the other hand, many senior DMO officials have worked in the role for decades and know their existing investor base in minute detail. Their due diligence on the impact of the SBBS on the liquidity and home market of their national sovereign bonds will be intense, especially as the market for those bonds has held up well in most eurozone countries, even at the height of the Greek crisis.

“Because of the hugely important role they play and [the fact that] governments rest on their success, that scrutiny would be very high,” says the banker.