1 Bachelor Thesis
Jules Nusteling 10763546 Jan Fichtner
Second reader: Philip Schleifer Word count: 8446
Political Science
E-mail: Jules-nusteling@live.nl 25-06-2018
2 Introduction
In the wake of the financial crisis and the Euro zone crisis the European Union has been looking for ways to make the Euro zone more resilient to financial crises and asymmetric shocks. Experiencing the ‘diabolical doom loop’ created awareness of the weaknesses of the current European institutions. The European Union struggles to find regulation regarding the doom loop because most of the regulation proposals involve joint liability between different countries. Due to political circumstances, the increase in Eurosceptic parties inside the European member states for example, it becomes much more difficult to implement regulation that further European integration. However, it is necessary for the Eurozone as a whole to find solutions towards diabolic cycles that engulf governments into a downwards fiscal and economic spiral. The banking union created a critical notion on European integration, and with the progress halted, the focus shifted on a less political solution that would also strengthen the Eurozone. The plan provided is to create Sovereign Bond-Backed Securities (SBBS), formerly known as European Safety Bonds (ESBies) (ESRB 2018: 11-12).
In 2011 the European Systemic Risk Board proposed the European Safety Bonds (Brunnermeier et al. 2011). One of the more recent proposals of the ESRB to the European Union in January 2018 calls the policy the Sovereign Bond-Backed Securities, instead of European Safety Bonds (ESRB 2018). There is no distinct difference between the ESBies and the SBBS. The SBBS proposal will be discussed with the discussion on the ESBies in mind because the SBBS is based upon the ESBies proposal. The ESBies are bonds that consist of different financial packages of different national bonds. This way of tranching ensures that the bonds are safe (ibid). The bonds come in two versions, the senior version and the junior version. The senior versions are a safe investment for long term investors, while the junior versions of the bond holds more risk, therefore more yield which should attract the attention of the likes of hedge fund investors (ibid).
While the SBBS can substitute the institutional development of a lender of last resort, it is not entirely risk free. The spreading of risk in financial packages makes them safer, but in the way in which the EU is set up, there can be a contagion of economic instability (Giugliano 2018). If multiple countries are hit by the same asymmetric shock, the SBBS drop and the outcome would still be problematic. This is why it is important to focus on the negative sides of the SBBS (CEPR 2018). To look at this problem, the research will be done on domestic preference differences between the northern and southern countries (Epstein & Rhodes 2016).
3 This paper tries to shed light on the discussion surrounding a new proposal on preventing heavy hits to more vulnerable countries in the Eurozone due to asymmetric shocks. In order to analyse the different interests of different member states of the European this paper will first focus on how the Euro crisis of 2009-2010 developed, and how the diabolic doom loop works. This is needed in order to understand how these problems are to be solved. Elaboration of the problem helps in understanding how different proposals can help strengthen the European Union in a way that prevents a possible next Eurozone crisis. Next, this paper will discuss two former proposals that were dismissed due to the members of the Eurozone giving much opposition towards these proposals as they generated a joint liability for the member states. In order to understand the resistance against the ESBies, it is necessary to look at the other options, and why they were not implemented in the European Union.
This paper will discuss the proposal on denominated Eurobonds and the Blue Bond Proposal. Insights in these proposal offer a greater understanding of the problem at hand, and what is needed to protect the Union against these problems. In the next section this paper will discuss the ESB proposal and the SBBS proposal, looking into what the policies exactly are and the benefits and downsides of the policies. This paper makes the distinction between the two proposals in the way that critique on the ESBies proposal will also apply to the more recent SBBS proposal, but references to the ESBies critique if it is directed towards the ESBies proposal.
These parts of the paper are necessary to answer the main research question of this paper. In order to understand the different positions on the implementation of the ESBies proposal, it is important to understand the interests and economic position of different important member states in the European Union. This paper tries to answer the question : “How are the domestic preferences considering the European Safety Bonds of the north and the south different when implementation at the European Union level should be beneficial for all?”. This takes on the discussion on ESBies, but tends to focus on domestic preferences, and why they differ from the strengthening of the Eurozone as a whole. It is important to note that the benefits and downsides of the ESBies proposal and the SBBS proposal are the same. With the recent changes to the name of the proposal, the arguments for implementation as well as the arguments against the implementations do not change. As the arguments are the same, answering the research question on the stances on ESBies will help in understanding the development of the new SBBS proposal.
This paper will focus mainly on Germany as a ‘Northern country’, as Germany is one of the most influential actors in the Eurozone. Not only is Germany the most political influential
4 actor, but it also functions as one of the triple A rated bonds in the Eurozone, with a booming economy. In contrast it is important to compare the stance of Germany on the implementation with ‘southern’ countries. For this this paper chooses Italy as it can be seen as ‘more vulnerable’. The comparison will be done with Italy because Italy has a huge national debt at the time of writing. For Italy the implementation of the proposal might have other domestic benefits than for Germany. This is why the comparison will be interesting for the development for the policy as it could possibly strengthen the Union as a whole, but therefore giving in to certain domestic preferences.
Financial Crisis
In 2008 the international financial crisis shook up the world. The biggest financial crisis since the Great Depression in the 1930s showed the world that financial institutions and banks can not take huge risks. The burst of the mortgage bubble in the United States created an awareness on the limit of risks banks could take, and that there needs to be more supervision on creating financial constructions to prevent another downwards spiral. The interconnectedness of the global financial market ensured that not only the situation in the United States spiralled out of control, but everywhere else in the world too. The European Union got into great financial trouble because of the shock from the United States. The crisis exposed unsustainable fiscal policies of countries inside the European Union (Kenny 2018). High budgets deficits in certain countries in the European Union showed that they were not able to pay of their debts, so the risk of defaults were high. For example, Greece had a national debt larger than their entire economy, which means that the bond yields went up drastically (ibid). The reason for the bonds to rise, is that the yields are connected to the risk of the investments. In other words, investors noticed that the countries were less likely to return the investment on the bonds, and therefore they demanded higher yields. The higher yields on the bonds means that the borrowing costs increase for the country. This creates a downwards spiral were as the demanded yield keeps getting higher, the country will find much more difficulty in keeping up with the ever increasing borrowing costs of money. This will keep increasing the debt of the country. This vicious circle is called a ‘doom loop’.
Diabolic loop
When the country gets financially in trouble, the banking sector of the country also finds itself in a peculiar place. Most banks are biased towards investing in domestic bonds. With domestic bonds on their balance sheets a domestic default would mean failure of most banks in the country. Furthermore, when the bonds get riskier in times of crisis, the value of the bonds drop because there is no insurance of the country holding up their side of the bargain.
5 This is called the sovereign debt risk (Brunnermeier 2016a: 1-2). If the sovereign debt risk rises, the banks lose value on their domestic bonds. This ensures that there are less loans to the domestic economy of the country, lowering economic growth and therefore lowering tax revenue. Also the equity value of the banks drop, which means that the total value of the banks drop. Therefore they are less attractive for investments, and become less stable in the financial markets. In other words, when the risk of these banks defaulting becomes higher, the probability of a default of the bank increases. These development therefore increases the bail out costs of the bank because of the larger deficit (idem: 3-4). This is important in understanding how the doom loop works. With the decline of tax revenue and economic growth the sovereign debt risk gets bigger. Logically more banks start getting in trouble. When the first bank fails, and needs a bail out from the state, the state solvency reduces. The state has to bail out the bank with money they currently possess. This further increases the sovereign debt risk, putting more domestic banks in danger. Their bail out cost increases, and when the next bank fails the country finds itself in a downwards spiral. This downwards spiral is what is considered the diabolic loop or doom loop.
This doom loop is based upon three factors. The first factor is the bias of banks to hold on to sovereign debt portfolios of the domestic countries (ibid). This makes that the banks are dependent on swings in the market, focused on the domestic governments debt. When the state where the bank resides gets into trouble, the bias towards domestic bonds only influences a downwards spiral. The bias for domestic bonds is a prerequisite for the diabolic loop.
The second factor is the problem that governments cannot not bail out banks (Nolan et al. 2016:2). Banks simply hold a too important position in society to fail. The victims of the financial downfall of a bank would be too high for society to carry. This is the reason why bailout is optimal once banks are distressed (Brunnermeier et al. 2016a: 2). The government is not able to let banks fail. Banks enjoy a systemic advantage in the equity market when it comes to needing help of the government in troubled times (Nolan et al. 2016: 2). This advantage also gives the bank the knowledge that there will be a bail out when the bank takes too much risk (Farhi & Tirole 2016: 12). This creates a wrong incentive for banks to take risks that they cannot take on (idem: 3). This factor is embedded in the financial system that exists throughout the world.
The third factor is the free capital mobility (Brunnermeier et al. 2016a: 2). Free capital movement means that capital can quickly move from a vulnerable country to a non-vulnerable country (Lane 2013). The market value of the domestic debt of a government can influence the choice of international investors in what the future of the governments solvency
6 might hold (ibid). These possibility of free capital movement influences the perception of international investors on the financial markets. They can always move their capital to ‘safe’ countries when there is an increase of risk in certain countries. This is called the “flight to safety” syndrome (Grauwe and Moesen 2009: 1). This further enforces the doom loop. The vulnerable countries become less and less stable as investors move out of the less stable countries, towards safety in the more stable countries.
The Eurozone Crisis
The reason the doom loop was even more prevalent in the European Union was due to the free capital mobility inside the European Union. During the economical good times between 2003 and 2007, capital flowed from the non-vulnerable countries towards the more risky, vulnerable countries (Brunnermeier 2016a: 2). Because the European Union was experiencing an economic boom during that time, investors were interested in the more vulnerable countries because of a perceived high notion of investment opportunities in the more unstable states in the European Union. While having many investment opportunities, the European Union also has no foreign exchange risk. The European Union handles the same currency, so for investors it seemed like there was not much backlash on investing in different member states (De Grauwe 2016: 63-64). The elimination of exchange risks had lead to an increase in economic growth, and therefore created a safe notion on the eurozone (idem: 61). The absence of foreign exchange risk had an impact on the sovereign bond spreads of the different countries, they converted towards each other. This made it more convincing for investors to treat every country in the euro area as a safe investment. The trust given by the absence of foreign exchange risks generated the notion that all euro area members had safe national bonds (ibid).
After the financial crisis of 2009, the solvency of some member states inside the euro area became questionable. The bonds of these member states were at risk to be redenominated with a devalued exchange rate (Brunnermeier et al. 2016a: 2-4). This meant that short term investors made the short term capital flow from the vulnerable member states to the more stable members of the euro zone. Without a proper solution for the flow of capital, the investors flocked towards the more safe member states, in order to ensure their investments. This demand for safety was met by the more stable member states and their sovereign’s’ debts. This capital flow from the vulnerable members towards the non-vulnerable countries reduced the cost of borrowing for the non-vulnerable countries as there is less risk involved because they are backed by the investors (ibid). For these member states this is a positive development. This is the reason why countries like Germany were not that heavily hit by the euro zone crisis.
7 The stability for some of the non-vulnerable member states meant that the investors had to pull out of the domestic bond market of the vulnerable member states (ibid). When the investors pull out of the domestic bond market the prices of the specific domestic bonds decline (De Grauwe 2016: 113). This becomes a problem as stated before, the banks in the country start to show significant losses on their balance sheets (ibid). The second problem with this is that the domestic liquidity depresses. This means that when the domestic liquidity reduces in a great way and this will make it improvingly difficult for banks to keep up their deposits. There is a way to prevent this, but then the domestic banks have to pay prohibitive interest rates (ibid). In this way the sovereign debt crisis spills over towards the domestic banks.
Next to the spill over to the domestic banking sector, the sovereign debt crisis is also enhanced in the more vulnerable countries. As their domestic bonds devalue the cost of borrowing money increases for the country (Brunnermeier et al. 2016a: 2). With the risk of defaults in the domestic banking sector rising, the government struggles more and more to ensure a bail out in the banking sector. This further enhances the sovereign’s debt crisis and the domestic banking crisis, creating a ‘deadly embrace’ between the two. This is the European example of the diabolic loop. It is stated that vulnerable member states of the euro zone get hit by the overall crisis, and develop problematic stances on the problem. The question that rises here is how this can affect the whole euro zone, accepting that some countries get hit harder by the crisis then others (ibid). The problem inside an union like the European Union, is that it is susceptible to economic and financial contagion.
When the risk of investing in certain national domestic bonds rises, the yield on the bonds goes up. Investors require more yield on investments if the risk is higher. This is simple supply and demand. The demand for the higher yields, demands the country to have higher borrowing costs, as stated above. This cycle becomes problematic as investors view these countries as high risk countries, and this stimulates the loss of confidence for investors in this country (Kenny 2018). This loss of confidence boosts the selling of the bonds of the country that is getting riskier. Typically, this loss of confidence in one country means that investors also lose trust in countries with the same economical and financial weaknesses (ibid). This is what is called contagion (Allen & Gale 2000: 1-2). The trust in countries with the same flaws also drops, devaluing their bonds as well. In a union like the European Union, this means the vulnerable countries get more vulnerable. The investors flock towards the stable, or non-vulnerable, countries. This leaves the vulnerable countries of the union in the downwards spiral described above. This is why the European Crisis is an asymmetric crisis. The different member states in the euro zone were affected differently, depending on them being stable or not. Either the capital flowed out the country and their domestic bonds, or it flowed towards
8 the bonds. In this way it either increased the borrowing cost of money or decreased the cost, depending on the financial and economic health of the country (ibid). This is important in understanding why certain members of the European Union accept or deny certain solutions to the doom loop problem.
Former proposed policies
The last chapter discussed the problems revolving around the development of financial crisis and the diabolic doom loop that can accompany financial crisis. This chapter will focus on the problem solving of the doom loop problem of the European Union. There are solutions to the problem, as one of the three factors of the doom loop has to be negated in order to prevent the doom loop from happening. This chapter will explain the different proposals and elaborate why these implementations were halted or were slowed heavily in their development. It is important to understand the road to the European Safety Bonds as a solution, as it creates context on why the SBBS are a positive or negative development for individual member states of the European Union. To counter one of the three factors of the doom loop, the European Union first came up with the European bonds plan.
In 2009 Paul de Grauwe and Wim Moesen proposed a policy plan for the European by introducing common European bonds. They suggested to issue out euro denominated bonds. The idea behind these bonds would be that they would be collectively guaranteed by the members of the eurozone (De Grauwe and Moesen 2009: 3-4). The issue of bonds would be done through the European Investment Bank (EIB). This proposal focuses on finding a solution for the ‘flight of safety’ of investors. With the guarantee of the member states with more taxing power than others make these bonds safe (idem: 3). Countries with a high spread on their bonds would have an easier time recovering from financial troubled times, and give them an easier time providing for economic stimulus programs (ibid).
The problem this brings around, is that this policy is susceptible to the ‘free riding’ problem. It is likely that the member states with more stable economies would end up paying for the fiscal and economic problems in other member states. The vulnerable member states would have no more incentive to generate a stable fiscal policy, as they would be bailed out by the non-vulnerable countries if there are any problems (idem: 4). To terminate the freeriding problem, the proposal of De Grauwe and Moesen considered that each country has to pay their yearly interest rate on the bonds, using the same rate as the national government bonds (ibid). This would mean that the non-vulnerable countries would not be penalized with higher
9 interest rates than their own, and the vulnerable countries still have an incentive to have an upkeep on their economy. This creates an atmosphere where there can be no free-riding in borrowing rates (Eijffinger 2011: 7). However, this proposal does not solve the collective problem of having the chance of the non-vulnerable countries having to bail out the more vulnerable countries. The collective ambiguity of this proposal was the reason countries as Germany decided to vote against the implementation of this proposal. Although the proposal did not increase interest rates for Germany, the collective responsibility it introduced was not wanted by several members of the euro zone (Frankel 2012).
In 2010 Jacques Delpla and Jakob von Weiszäcker proposed another policy on Eurobonds, the Blue Bond Proposal (Delpla and Weiszäcker 2010). The proposal was brought up to return to financial stability in a period with huge debt levels, trying to turn back the sovereign debt crisis. They offer a policy that solves the problem of creating huge debt pools without running the risk of the solidarity of the European Union creating the wrong incentives for the more vulnerable countries (idem: 1). The main goal is to keep the vulnerable countries from the free riding problem, and keep up their need to try to achieve stable fiscal and economic policies without taking too much risk (ibid). The proposal consist of the pooling of the GDP of the debt of all member states.
Sixty percent of the GDP of the governments debts would be pooled up in a common European bond, called a ‘Blue Bond’. These Blue bonds are 60 percent of the GDP of the pooled governments debts. If the debt exceeds 60% of the GDP, they will be pooled in a bond that is called ‘Red Debt’ (ibid). The idea behind this proposal is the tranching of the debt into the two different bonds, blue and red. The first 60% of the GDP is tranched in the blue bond. This debt is pooled by all participating members of the euro zone (Eijffinger 2011: 6). If the debt exceeds the 60 percent mark of the GDP, this debt will be tranched into the red bond. The blue bonds will act as senior bonds, with a lower yield as the risk is lower than with the junior red bonds. When the government needs to partially default, the red bonds are the first bonds to get defaulted on (idem: 3). The junior bonds ensure that the senior bonds are not hit that hard or even be hit at all by the partial default (ibid).
This brings up the question what kind of investors would choose for the junior red bonds. Hedge funds and private investors often look for short bonds with high yield in order to maximize their profits (Fichtner 2013: 10). The junior bonds hold more risk, as they are the first victim of a default. This is why banks are not stimulated to invest in the junior bonds, but rather in the senior blue bonds (Ewing 2011). Logically, more risk demands more yield on the junior bonds. This is also the incentive for governments to keep their debts below the 60 percent threshold. The requirement to pay more yield on the junior bonds makes the
10 borrowing cost of countries higher when the debt is not in check. However, this proposal does need all members of the eurozone to participate in the scheme (Eijffinger 2011: 8). Participation is not voluntary for members, and therefor it becomes a mandatory policy from the European Union. The European Union will force a credible commitment on all members of the euro zone, which can cause an strong anti-European movement (Ewing 2011). This aversion of integration in the European Union is the problem with the policy proposals, the proposal of de Grauwe and Moesen struggled with the collective problem of which governments have to pay when the Euro zone hits a crisis (Eijffinger 2011: 7). The same goes for the blue bond proposal.
The minister of Finance of Germany, Wolfgang Schäuble, stated in an interview with Der Spiegel in 2011 that the option of Eurobonds would be too simple (Schäuble 2011). He stated that there ‘is no collectivization of debt and there is no unlimited support’ (ibid). There need to be strict conditions to supporting the weaker countries. The weaker countries that need solidarity from the stronger economic countries must reduce their deficits by reforming their economies (ibid). This is needed for countries like Germany, they do not want the Eurobonds to make the Euro zone go into a ‘transfer union’. It should not be the case for the rich and solvent countries to subsidize the poor countries (Ewing 2011). This notion about the Eurobonds is shared among the other ‘northern’ countries, who are seen as the stronger, non-vulnerable members of the eurozone.
In Germany, Merkel’s opposition towards the Eurobonds and her vision on the overall economy policy regarding the euro crisis gave her the largest share of votes for the CDU since the 1950’s in the elections of 2013 (Matthijs and McNamara 2015: 242-243). The public opposition towards the further integration of the European Union, with Euro bonds, is shown in this example. The political discourse on the prevention of crisis in the Union, and what solutions would be viable for individual member states as well as the union as a whole came under a frame of neoliberalism (idem: 243). In this way, Germany proved to have an influential structural position in the Eurozone decision making process, as the proposals on Eurobonds were not implemented in the Eurozone (idem: 242). The integration of the Eurobonds in the Union had too little benefit for the stronger economic member states individually.
The neoliberal discourse on the implementation gave way to thinking about the financial and economic problems in the European Union on domestic level. Germany refuses to adopt debts created by a single Euro country (idem: 240). For Germany, it would be a strange development for the European Union if other euro countries could make debts and have the stronger ones carry the burden of the debt (ibid). The discourse went on to whoever made
11 the debt, should pay the debt (ibid). This shows how the domestic preferences are laid out in the political hemisphere of the Euro zone, and why the proposals on Eurobonds were not implemented. As it turns out, Germany has a powerful position when it comes to the governance on financial integration of the European Union.
This is important to note, as the implementation of the banking union in the eurozone is being increasingly slowed down by the European Union. The banking union should serve as a way in making the Eurozone more resilient to asymmetric financial shocks, but the attempt to finalizing the banking union is slowed down heavily. The first proposals on implementing the full-fledged banking union was set out to be finished in 2019 (Juncker 2017). This banking union consist of three different pillars, and while the first and second pillar are (partially) in place, the third pillar is scheduled to be finalized in 2025 at the time of writing. Member states differ on opinion on the implementation of the third pillar, as a dispute between the northern (Germany, the Netherlands and Finland) and southern countries of Europe (Spain, France and Greece) (Epstein& Rhodes 2016). The north is afraid that with the implementation of the third pillar they become financially responsible for defaults of banks in other countries in the Eurozone (Jones et al. 2016).
This thesis does not have the scope to include an in depth analysis of the situation regarding the banking union and the fiscal and economical implications a banking union has for the eurozone. However it is important to note that in order for the banking union to function as it is meant all three pillars need to be implemented. The implementation of the third pillar is struggling with heavy political resistance in the European Union, as it moves further towards fiscal and economic integration (Epstein& Rhodes 2016). The implementation of the third pillar takes much more time than anticipated and it is expected that the implementation of the third pillar will be halted overall as it still holds the collective responsibility problem (Jones et al. 2016). The implementation focuses heavily on the cooperation of the member states of the eurozone, which tend to act on domestic economic preferences instead of the collective interests of the whole European Union (Lombardi and Moschella 2016: 475-476). The European Union is in need of another solution to strengthen the eurozone on financial crisis. European Safety Bonds
In 2016 the European Systemic Risk Board offered a proposal from 2011 to the European Union. They proposed the policy of European Safety Bonds (ESBies) or Sovereign Bond-Backed Securities (SBBS). The ESBies proposal focusses on solving the problem of the flight to safety dynamic of asymmetric financial shocks, while also reducing bail out costs for governments as the banks would be less exposed to sovereign risk (idem: 6). While the former two Eurobond proposals were shot down and not implemented, this proposal
12 formulates synthetic Eurobonds. The European Safety Bonds (ESBies) are no bonds issues by an European institution but are rather financial products build up out of multiple different bonds from different European member states (Brunnermeier et al. 2016a: 1-4). The ESBies are tranched into two different bonds. There is the junior bond and the senior bond. The senior bond (the European safety bond) holds up for 70 percent of the bonds from all 19 members of the Eurozone, the other 30 % is tranched into the European Junior Bonds (EJB) (ibid). The idea behind this synthetic bond is not to ensure that governments have an incentive to try to lower their deficits like the Blue Bond proposal or create a shared responsibility for default like the proposal de Grauwe made. This proposal focuses more on reducing the other part of the doom loop cycle, it offers a solution on the problem of weak sovereigns influence domestic banks by trying to diversify the assets of domestic banks (Kraemer 2017: 3).
The interesting development over the first half of 2018 is the shift of the ESBies proposal towards the SBBS proposal. While both proposals have the same core content, meaning the tranching of the sovereign bonds, the name changing of the proposal seems like an appeal towards the more euro sceptic parties. The name Sovereign Bond-Backed Securities is less affiliated with the European Union than European Safety Bonds. Another difference between both proposals is the difference in the implementation of the policies. The ESBies proposal had a clear institutional setting on how to implement the policy, while the SBBS proposal leaves more room for discussion on how to implement the proposal (ESRB 2018). However, both proposals have the same core, as they focus on preventing the doom loop dynamic. While strengthening against one factor in the doom loop dynamic, the banks bias towards domestic bonds, the ESBies solution also reduces the third factor of the doom loop cycle. It prevents the flight to safety dynamic by encouraging banks to invest in the senior ESBies (Brunnermeier 2016a: 36). In this way it can also prevent the happening of the doom loop and therefore help build resistance against the downwards spiral that can happen in a financial crisis. This encouragement is done via the pooling of all the government bonds in the ESBies and EJBies (ibid). The senior tranche eliminates the cross-border flight to safety as they provide one pooled bond that is relatively safe (ibid). The banks are hereby provided with a ‘safe and liquid store of value’ (ibid). With the pooling of all bonds of governments into these financial tranched products, the proposal also promises to double the supply of AAA- rated euro-denominated financial bonds (ibid).
The doubling of the pool of triple A rated bonds is due to the nature of how the tranching of financial products work. The tranching of the pooled bonds works similar to how a Collateralized Debt Obligation (CDO) works. The pooled government bonds are
13 collateralized in a security derivative, the junior bond or the senior bond. In this way both derivatives cover the whole of the underlying face value of the national government bonds sold. Losses created by sovereign defaults would then first hit the holders of the EJBies. When the default losses exceed the 30 percent mark only then will the ESBies be hit by the default (idem: 7). The benchmark of 30 and 70 percent are set by the European Systemic Risk Board in the 2011 proposal, with the calculation that the exceeding of the 30 percent mark will be extremely unlikely (ibid). The European Union can however choose to change the percentages.
As stated before, there is another principle that is up for discussion in the European Union, the way of implementing the securities. With the SBBS proposal, there is room for discussion on the parameters of the covered tranched pool and how the senior tranche is structured in order for the proposal to improve financial stability in the Eurozone (ESRB 2018: 11). The proposal for the SBBS states that there should be two requirements for the bonds that are tranched in the securities. It is important to note that the bonds are purchased by an institutionalized arranger of the securities (ESRB 2018: 13). This institutional arranger can purchase bonds from sovereigns that have primary market access (ibid). For the bonds that have secondary market access, the arranger should buy secondary market bonds which have existing competitive market prices (ibid). This is necessary to keep the junior bonds interesting enough for investors, as the yield on the security bonds keeps the same as the yield on the sovereign bonds. These institutional rules are important in generating the securities, as they would otherwise be less interesting than the normal sovereign bonds (ibid). In using these rules for the arrangers of the securities, the securities will keep their value in addition to the sovereign domestic bonds (ibid).
As a note on the SBBS, the comparison with CDO’s might seem worrying, because the CDO’s are practically what caused the global financial crisis of 2008 in the first place. The main difference with the CDO’s is that government bonds are historically seen much more safe then for example the mortgages that caused the financial downfall in 2008. In addition to that note, while the banking union is not yet fully implemented, the first two pillars are already in place. This reinforces the safety of the government bonds, in order to prevent a huge financial crisis due to defaults on the SBBS.
The way the different financial products work, is that the higher rated 70 percent of the bonds get tranched in the SBBS senior bonds. This makes these bonds more attractive to banks, as they are safety backed due to the fact that the risk is spread across multiple national bonds. In this way, the banks domestic bias for their own governments bonds is decreased. In the SBBS proposal, this measurement on the choice if the bond will be a senior or a junior bond
14 will rely on the ECB capital key (ESRB 2018: 13). The ECB capital key is a well-defined and institutionalized way of weighing the economic weight of a country in the European Union (ibid). In this way it can be analysed which bonds are considered to be triple A or fairly risky. With the junior tranched bonds being more risky they have a higher yield. This raises the question on what kind of investors will invest in the junior bonds. As mentioned earlier, hedge funds often try to find quick, high yields from their investments (Fichtner 2013: 10). These investors will most likely still invest in the more riskier bonds. This implicates that the flight to safety dynamic will be highly reduced by the implementation of the SBBS proposal. In this way, the proposal tries to reduces two of the danger factors of the doom loop, without achieving joint liability inside the eurozone. This is why these synthetic Eurobonds have a bigger chance to be politically accepted, opposed to the proposals on the ‘real’ Eurobonds. The argument that the more solvent, richer countries should pay off the debts of the poorer countries is not a valid argument with the SBBS proposal.
The North versus the South
While the argument for not wanting joint liability is no longer viable on the SBBS proposal, the lack of joint liability brings up a new problem. With the synthetic bonds proposal, the borrowing costs risk of the countries is not backed up by the implementation of the SBBS. In other words, the more vulnerable countries still have to worry about the yields on their bonds rising as they might become more riskier as an investment. This generates the question if the investors that look for a higher yield than the senior bonds will flock towards the junior bonds. When there are little to no investors in the junior tranche, there will be no security for the senior bonds. When a possible default occurs, the pooled junior bonds will not hold up enough for the senior bonds to be safe. The assumption in the proposal from Brunnermeier is that hedge funds and other private speculators will flock towards the junior bonds, but there is no way that this can be stated for certain (Brunnermeier et al 2016a: 2-4). However, it is a necessity for the mechanic to work out, and generate a safe environment for the synthetic Eurobonds.
This is one of the first criticism of the German government on the ESB proposal. The chief economist at the ministery of Finance of Germany, Ludger Schuknecht, stated in 2017 that ESBies are a ‘fair weather proposal’ (Schuknecht 2017). He stated that the ESBies were not the right solution to the doom loop cycle, but that it rather enforces the problems with financial instability. When there is a financial crisis, the ESBies would not secure the rating of the bonds. Schuknecht instead argues that the countries with the weakest fiscal performance will be crucial in determining the ratings of the whole pool their in (ibid). This implicates that the synthetic bonds will only be as strong as their weakest link. Another point Schuknecht
15 makes, is that it is unlikely that the implementation of the ESBies will double the pool of triple A rated bonds in the eurozone.
Germany argues that the tranching of the junior bonds in 30 percent is too small for the senior bonds to be entirely safe (ibid). The solution to this might seem simple, increase the percentage rates of the junior bonds, but that will mean that there will be less safe senior bonds (ibid). Germany argues that both solutions will lessen the amount of ‘safe’ bonds, instead of the increase the proposal promises to withhold. In addition to the ‘fair weather’ arguments of the German government, the German official Olaf Scholz argued that the implementation of the SBBS would generate new complexity to the market, as the ‘differences in the interest rates are not large enough for the pooling to make sense’ (Chrysoloras & Weber 2018). Germany works towards the discourse of the proposal not being beneficial and still risky (BMF 2017: 3-4). The German Advisory Board for the ministery of Finance doubted the implementation of the SBBS because the board stated that banks would be less interested in securitized bonds than government bonds (ibid). This also adds to the discourse on the uncertainty of how the policy is going to work out for the market. With these arguments, Germany tends to focus more on the worst case scenario of what could happen with the implementation of the SBBS. Germany does not tend to focus on the factor of breaking the bias of banks on domestic bonds. In the way the critique is formulated, it focuses on the fact that the pooling of the bonds would make the A rated bonds less safe, and not the notion that the pooling of government bonds could strengthen the higher risk bonds of the peripheral countries (Brunnermeier et al 2016a: 6). This is also the concern of the Dutch government, as stated by the minister of foreign affairs Stef Blok (Blok 2018). Blok wrote an assessment of the SBBS proposal to the Dutch parliament, which states that the Dutch government does not see the SBBS proposal as necessary for the European Union (ibid). One of the arguments the Dutch government states, is that securitization does not create risk free assets (ibid). This focus is justified, but it does not look into the possibilities of the proposal in order to strengthen the euro zone as a whole. This shows that the Northern countries focus more on the possible weaknesses of the proposal, instead of looking at what the proposal could mean in breaking the doom loop for the whole of the euro zone.
As an actor with lots of influence the German government seems to direct the discussion into the weaknesses instead of the strengths of the proposal. The Dutch government seems to move to this direction as well. After all, it is important to note that the German bonds are the ‘safe haven’ in times of financial distress. This generates an incentive not to change the way the bonds operate, as the German government will not be hit massively by financial crisis. However, the implementation will reduces the risk of a financial crisis happening, and in that
16 way negating the necessity of being a ‘safe haven’ in the Eurozone (Brunnermeier et al 2016a: 6). Germany also has to take note that being the ‘safe haven’ in the Eurozone comes at the expense of the less solvent countries inside the same Eurozone (ibid).
The fear of the senior tranche replacing the safety insurance of the German bonds is a realistic one, but it does open up the opportunity of the strengthening of the Eurozone as a whole. At the time of writing the only triple A rated bonds come from Luxembourg, the Netherlands and of course Germany (idem: 3). When more bonds are rated safe, that is if they are pooled together, the spread of investors will be higher differentiated across the Eurozone. Logically, this development does not benefit these three countries. However, what is left out from the discourse set out by the German government is the expectation of the lowered risk of financial crisis itself. With the chance of the Eurozone being affected by a global crisis lowered, the need of being a ‘safe haven’ becomes less prominent. Reducing the weight of asymmetric shocks to the Eurozone has benefits for the whole region, instead of having a policy were the solvent and rich countries benefit of these asymmetric shocks. The difference in country preferences becomes clear when we compare the Germany case to the case of a country as Italy. Italy deals with a debt of 132 percent of its GDP (Trading Economics 2018). As to compare this to Germany, their national debt is 64,1 percent of its GDP (ibid). With the ESBies in place, it is prospected that 55 percent of the public debt of the Italian government has to be bought by private investors (Minenna 2017). While this is still a large percentage of the public debt of Italy, it would relieve the government by toning down stress on the development of the economy and public spending. The need for the whole public debt to be financed by private investors through the regular domestic bonds would be relieved of 45 percent of its pressure, which could help Italy improve the economic and financial position they are in.
The upheaval of the Italian economy, and thereby focusing on lowering the debt of the government would mean that the bonds of the Italian government will be less risky. Therefore, the argument of the ESBies depending on the ‘weakest link in the chain’ will diminish (Brunnermeier 2016a: 5-7). The strengthening of the domestic economies of the more vulnerable countries in the Eurozone could mean that the pooled securitization would develop a positive spiral upwards. If the SBBS would influence economic growth in a positive way, the 55 percent of the public debt would be easier to finance for the Italian government (Minenna 2017). When the risk of a default on their bonds lowers, the borrowing costs of money to financing public spending lowers. In this case, the SBBS would help develop a more sustainable financial and economic environment in the Eurozone, as the more vulnerable countries could develop as more resilient towards crisis (Brunnermeier 2016a:
5-17 7). With this scenario in mind, it is important to take note of what happens when there is a financial crisis. The flight of capital would be reduces by the spreading of the risk and the liquidity of the ESBies.
When the risk of flight of capital is reduced, an asymmetric shock would make less of an impact in the Eurozone, as countries as Italy would not have the burden of needing to bail out the banks. Without the implementation of ESBies the factor of capital flight can have a huge negative impact on the financial stability of a country. This is the main reason for the necessity of the implementation of the safety bonds. The ESBies take on the problem of the doom loop circle from another angle than the other proposals on bonds. The political environment in the Eurozone is making regulation with joint liabilities practically impossible due to different domestic preferences (Matthijs & McNamara 2015: 242-243). The ESB proposal is not meant to be a perfect solution. It is however a decent alternative for halted developments like creating the full-fledged banking union in the European Union. Governments have their reasons to look into the possible risks of implementing the ESB proposal, but the Northern countries tend to neglect the potential positive effects it could have on the strengthening of the Eurozone as a whole (Blok 2018; BMF 2017). Without the joint liability that the other proposals require, it might be the only viable solution at the time of writing this essay in furthering European integration.
Conclusion
With the doom loop being an circle, it does not matter where the changes are implemented to prevent the cycle from escalating into a downwards spiral. This is why the SBBS proposal serves as a good placeholder for better regulations, like the implementation of the full fledged banking union. However, due to the fear of European integration and the Eurosceptic sounds from different countries in the eurozone, it becomes politically difficult to implement changes where the richer, solvent countries are responsible for the vulnerable countries when there is a financial dip (Schuknecht 2017). The reasoning for Germany to resist the implementation of the ESBies generates a notion of the German government longing to uphold their position in the Eurozone as a safe haven. This keeps Germany economically strong, and gives them even benefits from an asymmetric shock that hits the more vulnerable countries in the Eurozone. However, Germany is dependent on the long run of the rest of the Eurozone if further European integration is coming up. The European Union as a whole could reinforce each of the different members in economic sense, creating opportunity to bolster the more vulnerable countries on the back of the more solvent countries. This is not an increase in risk for Germany, as they still hold their bonds at a triple A rating. The addition is that the other governments could profit from these stable, risk free bonds through the pooling of SBBS. In
18 the example of Italy, it shows how risk aversion through the pooling could mean a positive development for the Italian national debt and thereby for the growth of the economy.
With no joint liability, there should be enough incentive for the different member states to acknowledge the benefits of implementing the SBBS. Instead the leading actor in the European Union, Germany, tries to shift the discourse about the implementation towards the possible negative consequences. While the negative are problematic towards the problems the European Union is facing, it is unknown how the implementation will work out. However it does stand out, that the German government focuses only on the negative aspects of the policy. Bringing up the argument of the ‘weakest link in the chain’ is counterproductive when the effects are not negative but positive. The fact that the German state would need to remain a safe haven is a set back for the European Union as a whole, as there needs to be consensus about progression and integration.
Having member states with domestic interests is an inevitable outcome of things as the European Union, but these kind of preferences need to be tracked in order to understand the direction the European Union is heading for. The more solvent states with safe ratings on their bonds are not as eager to jump into the SBBS. While it seems Germany influences the debate on it by directing the discussion towards the possible problems the policy has. Domestic preferences will always be present in an institution as the European Union, but the discourse forgets to mention the political benefits of this particular proposal, in opposition to the former ones that were dismissed by the European Union due to heavy political resistance. The European Union needs to build resilience against financial crisis, and the plans for it can not always be perfect. Solutions like the SBBS proposal should be properly analysed before jumping to conclusion. One actor inside the European Union should not lead the discourse on whether or not the policy is viable for the Union as a whole.
Recommendations
It was beyond the scope of this thesis to look into the preferences for all member states of the eurozone on the topic of ESBies/SBBS. It is recommended that further research builds on the notions that member states have their own preferences and that economic and financials positions matter when shaping these preferences. Another recommendations for further research is the development of the SBBS. At the time of writing the SBBS proposal is very recent, and multiple governments have not responded officially to the proposal yet. It could also be relevant to analyse why the name is changed, in order to understand the political and economical environment of the European Union.
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