FINDING A COMMON
EUROPEAN SAFE ASSET
Addressing the “Eurozone’s Three Problems”
Abel van Wechem
asvanwechem@icloud.com
Abstract
The current economic structure of the Eurozone is still lacking one thing: a Eurozone wide safe asset. Having such an asset could be of great benefit for the countries participating in the scheme, especially in a time of crisis such as the Covid-19 pandemic we are currently facing. This thesis takes a practical approach in assessing four proposals for such a Common European Safe Asset; Eurobonds, Eurobills, ESBies/EJBies and Red/Blue bonds. This thesis makes a comparison of the effectiveness of each of the proposals in addressing three of the Eurozone’s financial-economic issues or the “Eurozone’s Three Problems”; The sovereign-bank doom-loop, the flight-to-safety and the overall scarcity of financial safe assets. Doing so, it aims to identify the proposal that is most suited for adoption by the countries of the
Eurozone. The thesis concludes that the tranched sovereign bond-backed securities in the form of ESBies and EJBies constitute the proposal that would be best equipped to counteract the three aforementioned issues.
Inhoudsopgave
Introduction ... 2
I- Current Eurozone System and the Eurozone’s Three Problems ... 5
1. Sovereign-bank doom-loop ... 7
2. Flight-to-Safety ... 9
3. Scarcity of fitting assets for transmission of monetary policy and collateral ... 11
II- Safe Assets ... 11
1. Characteristics and uses of safe assets ... 12
2. Particular benefits of a European Safe Asset ... 13
2.1 Disentangling the sovereign-bank doom-loop ... 13
2.2 Containing the flight-to-safety ... 14
2.3 Helping with monetary transmission and financial market functioning ... 14
III- Only Pooling ... 14
1. Eurobonds ... 15
Design and benefits ... 15
Political and legal infeasibility due to moral hazard ... 16
2. Eurobills ... 17
Design and benefits ... 17
Lack of effectiveness ... 19
IV- Pooling and Tranching ... 19
1. European Safe Bonds (ESBies) ... 19
Design ... 19
2. Bonds and Red Debt [not finished] ... 22
Design ... 22
3. What problems they solve ... 24
3.1 Diversifying banks’ sovereign-bond portfolios ... 24
3.2 Transforming the flight-to-safety ... 25
3.3 Providing a transmission tool and collateral for financial transactions ... 25
V- Comparison ... 26
1. Total Volume ... 26
2. Liquidity ... 28
3. Attractiveness to banks and investors ... 28
4. Feasibility ... 29
5. Final comparison ... 30
VI- Conclusion ... 31
Introduction
Almost 30 years after the signing of the Maastricht Treaty, the Eurozone is still lacking an essential building block: a Common European Safe Asset. The idea is almost as old as the euro itself and has gotten more and more attention since the Great Financial Crisis in 2008. With a global pandemic and recession beating down on us, the need for a collective effort has hardly been greater.
The past decade has been less than kind for the Eurozone and its members. The bankruptcy of the Lehmann Brothers in 2008 and the subsequent Great Financial Crisis led to economic hardship the likes of which had not yet been experienced for a long time. The overall trust in the banking sector fell, with commercial banks across Europe, like the Dutch ABN Amro bank, going under or having to resort to government bailouts [NBC news article, 2009]. The self-perpetuating trend of decreasing output and a liquidity-shortage-related rationing of credit saw the economies of Europe deteriorate further and further.
The subsequent sovereign-debt crisis of 2011 quickly became the Eurozone’s next big hurdle. As the government of Greece became increasingly at risk of defaulting on its sovereign debt, previously default-remote government bonds saw their spreads rise at alarming rates. Fiscal tensions combined with economic strains created a fear amongst investors for the breaking-up of the European Monetary Union itself. A redenomination risk was calculated into bond-yield for Eurozone sovereigns [Bayer et. al., p. 3 (2018)].
However, faced with these issues the entities of Europe did not stand by idly. Mario Draghi, then president of the ECB, made it loud and clear in his famous “whatever it takes” speech that the Euro would be preserved [Mario Draghi, Global Investment Conference, (2012)]. Desperate times called for desperate measures as the mandate of the ECB was significantly expanded. The ECB made use of several means of unconventional monetary policy to bring stability back to the fragile Eurozone landscape. Trillions of euros worth of sovereign bonds were bought on the secondary market as a form of quantitative easing through the Public Sector Purchase Program [ECB, Decision 2015/774, (2015); Bundverfassungsgericht,
05-05-2020, Facts of the Case; Belke and Gros, CEPS, p. 1 (2019)]. In addition, the European
Stability Mechanism was erected to function as an emergency lending facility, being able to provide countries in their direst of needs with liquidity, albeit under strict conditions [ESM
While these measures were effective to the extent that they allayed the most pressing fears and panics concerning the continuing existence of the Eurozone, several issues still remain, three of which will be addressed in this thesis and which will be referred to as the
“Eurozone’s Three Problems”.
Firstly, while the Eurozone currently seems stable, a large source of systemic risk is still found in the “sovereign-bank doom-loop”. This well-known phenomenon, which will be discussed more elaborately later on, is essentially a self-fulfilling contagion loop between commercial banks on the one hand and their domestic sovereigns on the other. The deterioration of the state leads to a deterioration of its major commercial banks and vice-versa. While unaddressed, this loop leaves countries’ financial stability vulnerable and prone to disruptions.
Secondly, the European capital market is still heavily fragmented. During the crises this became all too apparent. In times of market panic, investors quickly move their capital out of countries they at that time see as risky (i.e. Greece and Cyprus) and into countries they deem safe (mostly Germany). This “flight-to-safety” leads to an abrupt capital shift, causing rapid changes in interest rates and liquidity problems for banks in the periphery of the Eurozone.
Thirdly, as the current crisis has investors scramble for safety, the demand for safe assets quickly outgrows the supply. The ECB has a job to transmit monetary policy to the Eurozone countries. The transmission of monetary policy means that the ECB sets out certain
conditions, like interest rates for banks, or uses unconventional means like quantitative easing in the PSPP, and through these actions aims to influence the aggregate demand, interest rates, and amounts of money and credit in order to positively affect overall economic performance and the price level in particular. The ECB buys vast amounts of sovereign bonds in its
quantitative easing programs such as the aforementioned PSPP.Through the purchase of said bonds it aims at evenly transmitting monetary policy throughout all Eurozone countries, or in other words “ that the monetary conditions set by the ECB would pass smoothly and
consistently on to enterprises' and households' borrowing costs and ultimately on to aggregate demand [throughout all the countries of the Eurozone]*” (*comment added by
author) [Expert Group, European Commission, Final Report, para. 149 (2014)]. However, the national nature of each sovereign bond makes it difficult for the ECB to transmit monetary policy evenly across all Eurozone countries and not asymmetrically affect countries vis-à-vis each other. In addition, the private sector needs large quantities of highly liquid safe assets to
be posted as credible collateral in various types of financial transactions, such as repos. A shortage of safe assets therefore poses hinder to the smooth function of the financial system and hinders the ECB in transmitting its policy.
For years there has been vivid debate on the creation of a European Safe Asset. This new-to-be issued asset would address some, or all of the aforementioned issues currently plaguing the Eurozone. There is a broad consensus that a safe asset which is both ultra-liquid and default-remote would bring the countries participating in the scheme significant benefits. Such an asset could contribute to overall financial stability and ease refinancing conditions.
The fact that such an asset would represent all Eurozone countries rather than represent a single country in the way a national sovereign bond does, would contribute greatly to the disentanglement of the sovereign-bank nexus. The concentration of domestic sovereign bonds on commercial banks’ balance sheet would – to a certain extent, depending on the proposal - be replaced by a debt-instrument representing a multitude of sovereigns. This would
transform a large portion of cross-border capital traffic into cross-instrument capital traffic and therefore stabilize capital flows between Eurozone countries in times of crisis. Finally, a homogeneous asset that represents all Eurozone countries poses the ideal tool for the ECB to transmit its monetary policy evenly across the Eurozone, without asymmetrically affecting one country vis-à-vis the other.
While the consensus on its potential benefits exist, there is no agreement on the scheme through which such a safe asset should be realized. Some parties voice the need for grand debt-instruments, mutually guaranteed by all Eurozone countries. Others state that the Eurozone’s Three Problems can be equally well addressed with less intrusive and more precise instruments, leaving more accountability with each of the participating parties. Essentially the discussion is marked by a trade-off between effectiveness in solving the Eurozone’s Three Problems on the one hand, and on the other hand maintaining political feasibility.
This paper will discuss four proposals, of which two will be discussed more thoroughly.
First, two proposals primarily employing pooling:
• The Eurobond
• The Eurobills, proposed by Phillippon and Helwig
• The ESBies, proposed by Brunnermeier et. al.
• The Red/Blue Bonds, proposed by Delpla and Weizsacker
The question is whether any of the current proposals is fit to solve the Eurozone’s Three Problems, and if so, which ones and to what extent. This thesis will delve into a number of proposals, comparing their respective aspects and drawing factual conclusions as to their fitness of addressing the Eurozone’s Three Problems.
The discussion and review of safe asset proposals has been conducted by other authors and institutions before. A review of several proposals has been conducted by Claessens et. al. in 2012 for the IMF, the European public-law dimension of some proposals has been discussed by Jorgen Axel Kammerer in 2016, and a comparison of yet another set of proposals with regard to their level of investor protection and representation has been published by Sebastian Grund as recent as 2020. This paper – while not claiming to be exhaustive – takes on a
different scope and focuses primarily on the extent to which these four assets address the Eurozone’s Three Problems.
Section I will first sketch the layout of the Eurozone and explain the Eurozone’s Three Problems in more depth. Section II will discuss the benefits of safe assets in general, which functions as a background against which each proposal can be compared. Section III will go into the design aspects of the first two proposals to create an overview of the variety that exists within Safe Asset proposals. Section IV will address two more proposals: the ESBies and the Red/Blue Bonds. These two proposals specifically will be thoroughly assessed on their merits, inspecting whether they are capable of addressing all of the Eurozone’s Three Problems. Section V will consist of a written and graphical comparison between all proposals. Section VI will conclude.
I-
Current Eurozone System and the Eurozone’s Three Problems
Presently there are 28 countries part of the European Union of which a total of 19 countries have adopted the Euro as their sole currency. These 19 countries are referred to as the Eurozone, they reinforced their union in 1992 when they became party to the Maastricht treaty. This treaty, which constitutes the birth of both the European Union and of the Euro as our sole currency, marked the start of a monetary union within Europe.
Source: Author
The design of the EMU is rather unique in the sense that it puts the control of the Eurozone’s monetary policy solely under control of the ECB while leaving economic and financial policy in the hands of the participating Eurozone countries themselves [Ad van Riet, ESRB, p. 2
(2017); ESRB HLTF Volume. 1, p. 8 (2018)]. Joining a monetary union and a single currency
has some evident benefits. For example, the exchange rate of a larger currency is less prone to heavy fluctuations and more robust against speculation. Secondly, it eliminates costs related to conversion of currency between Eurozone countries.
However, these benefits come at the costs of decreased autonomy. Joining the monetary union and handing the control over monetary policy over to the ECB means that countries can no longer tailor-make monetary policy to their own economic circumstances at all times. In addition they can no longer print extra money, artificially alter their exchange rate to boost foreign exports or issue bonds in a currency under their own monetary control [Ad van Riet,
ESRB, p. 2 (2017)].
Moreover, the fact that there is a monetary union in place without a fiscal union being in place has led to tensions in the past. Since the countries of the European Monetary Union rely on each other and one country’s fiscal health affects another, imprudent or reckless fiscal policy of one country can aggravate the others. Such issues were witnessed in the sovereign debt crisis where Greece’s fiscal policy started to affect all other Eurozone countries [Ad van Riet,
ESRB, p. 4 (2017)], whilst the other Eurozone countries were unable to effectively impose
changes or meaningful sanctions on the (de)faulting Greek government.
The following subsections will discuss the ‘Eurozone’s Three Problems’, and their bearing on the Eurozone as such.
1. Sovereign-bank doom-loop
A large issue is the often discussed source of systemic financial risk in the Eurozone called the “sovereign-bank doom-loop”. The effects of this loop were a major factor in the sovereign debt crisis [Brunnermeier et. al., p. 181 (2017)]. To understand how the introduction of any new European Safe Asset could counteract the negative effects of this loop, it is important to understand how it works.
In the current financial system banks and sovereigns have developed a worrying level of interdependency. This mainly follows from the fact that banks hold excessive amounts of sovereign bonds on the asset side of their balance sheet.
According to the Basel III requirements as well as the Capital Requirements Regulation (CRR) banks are obligated to hold assets on their balance sheet as a buffer for the risk on their liabilities. The riskier the liabilities that they hold are, the higher the “risk-weight” of those liabilities, the more assets they are consequently obligated to hold as a buffer.
For example, for secured real-estate loans banks are required to hold 35% of the value of this loan in assets. This means that there will be a buffer of 35% of the loans’ value to absorb losses following from non-performance. For non-secured real-estate loans, the assigned risk-weight is 100%. The riskier nature of the non-secured loan vis-à-vis the secured loan is reflected in a higher capital-reserve requirement.
However, where Member States’ sovereign bonds are concerned, this does not apply. By virtue of article 114(4) CRR “Exposures to Member States' central governments, and central
banks denominated and funded in the domestic currency of that central government and central bank shall be assigned a risk weight of 0 %”. This means that for lending money to
Eurozone countries through the buying of sovereign bonds, commercial banks are not obligated to hold any buffer-capital on their asset side [Brunnermeier et. al., p. 180 (2017);
Claessens et. al., IMF Working Paper, p. 7 (2012); Phillippon and Helwig, (2011)].
Compared to other types of loans, this frees up their capital significantly, making it available to be invested elsewhere. Moreover banks have a tendency to over-concentrate their
multiple sovereigns [Brunnermeier et. al., p. 180 (2017); Claessens et. al., IMF Working
Paper, p. 7 (2012)].
While it is true that sovereign bonds are generally default remote assets, assigning a 0% risk weight to all sovereigns bonds regardless of their respective risks creates a perverse incentive to over-stock on these bonds, and the riskier ones even more so. Even in the height of the sovereign debt crisis the sovereign bonds issued by the solid German government still had the same CRR risk weight as the fragile Greek bonds: 0%.
The risk this excessive exposure poses becomes apparent in times of crisis. A problem faced by either the state ór the commercial banks quickly has one contaminating the other. A worsening of the state’s fiscal situation increases the risk on its sovereign bonds. This causes the book and market equity value of the banks to fall [Brunnermeier et. al., p. 180 (2017);
Claessens et. al., IMF Working Paper, p. 7 (2012)]. Consequently, the worsening state of
commercial banks will cause the banks to sell off assets. This means a decrease in the amount of loans given to the real economy. This ‘credit crunch’ lowers overall output and growth, and further increases sovereign risk [Brunnermeier et. al., p. 180 (2017); Claessens et. al., IMF
Working Paper, p. 7 (2012)]. In addition, with growing bank leverage a risk for a government
bailout of banks will start to factor into this vicious downward spiral [Brunnermeier et. al., p.
180 (2017); Claessens et. al., IMF Working Paper, p. 7 (2012)]. The cycle is illustrated in the
image below.
While this problem seems to be a mostly domestic one, this is not the case in a monetary union. Failing banks and states in one county carry a contagion risk. This was seen in the sovereign debt crisis of 2012 where the worrying state of the Greek government had severe effects on the other governments of the Eurozone.
The problem is essentially one of over-concentration. An excess amount of domestic
sovereign bonds held by banks creates a symbiotic relationship between the wellbeing of the banks and of the sovereign. This is undesirable since it makes the whole economy more prone to failure and more vulnerable against both exogenous as well as endogenous shocks.
Source: Brunnermeier et. al., Figure 1 (2017)
2. Flight-to-Safety
A second issue is found in the large-scale uncontrolled capital movements between Eurozone countries in times of crisis. When investors sense danger, they quickly move their capital out of the riskier Eurozone countries and into the countries they perceive as safer. This “flight-to-safety” has adverse effects on the countries in the periphery of the Eurozone and on the Eurozone’s financial system as a whole [De Grauwe and Moesen, p. 1 (2009); Claessens et.
al., IMF Working Paper, p. 7 (2012)]. This became particularly apparent after the Great
Financial Crisis.
In the period between 2003 and 2007, large amounts of capital flowed from the safe to less-safe countries of the Eurozone [Brunnermeier et. al., p. 181 (2017); De Grauwe and Moesen,
p. 1 (2009)]. Investors saw these less safe countries as offering many investment opportunities
and were optimistic about their risks. This influx of capital led to an asset-price inflation and credit boom [Brunnermeier et. al., p. 181 (2017); Ad van Riet, ESRB, p. 3 (2017)]. Whilst the economies of the Eurozone were doing well, there were little problems and investors saw no need to compare countries economic fundamentals [Ad van Riet, ESRB, p. 3 (2017)].
After the Great Financial Crisis, it became all too clear that some countries were, in fact, safer than others. A long period of excess credit had allowed for capital to seep into less-productive sectors (such as real estate), and the recession now exposed the fiscal imprudence, vulnerable banking sectors and “structural rigidity” of several Eurozone countries [Brunnermeier et. al.,
p. 181 (2017); Ad van Riet, ESRB, p. 3 (2017)]. Investors started to put a higher value on
safety, and moved their capital to safer regions accordingly.
Two-thirds of the top-rated euro-denominated sovereign bonds come from Germany, and so Germany saw a vast inflow of capital. [Brunnermeier et. al., p. 181 (2017)]. Conversely, countries like Greece and Cyprus quickly saw their newfound capital evaporate into the safer countries of the Eurozone. Germany saw its borrowing costs decrease, even below the level justified by its fundamentals, while periphery countries saw their borrowing costs soar [Brunnermeier et. al., p. 181 (2017); Claessens et. al., IMF Working Paper, p. 7 (2012)].
Source: Author
Such a rapid cross-border shift of capital has destabilizing effects. It contributes to a volatile bond market and creates problems in the banking sector. In addition, the depletion of credit availability leads to large output losses in the countries left behind by the capital flow [Brunnermeier et. al., p. 180 (2017); Ad van Riet, ESRB, p. 3 (2017); De Grauwe and
Moesen, p. 1 (2009); Claessens et. al., IMF Working Paper, p. 7 (2012)]. These output losses
consequently affect all other Eurozone countries, the strongly export-oriented economy of Germany possibly even more so. Lastly, the flight-to-safety can have a self-perpetuating effect. Countries in the Eurozone’s periphery facing high interest rates will see an increased incentive to halt any current efforts to stabilize their economies [De Grauwe and Moesen, p. 3
even more with higher interest rates, this could discourage governments to undertake effective countermeasures. These same excessive spreads can also create an expectation of future default crises, which will counteract the effectiveness of governments’ budgetary policies [De
Grauwe and Moesen, p. 3 (2009)].
3. Scarcity of fitting assets for transmission of monetary policy and collateral
The ECB attempts to maintain price stability within the Eurozone, meaning that a euro buys roughly the same amount of goods in each country [Gelpern and Gerding, p. 403 (2016)]. In unstable times, where one country is booming and another is dealing with a recession this is no easy task. Absence of a country-neutral safe asset that can be bought and sold in large quantities without disproportionately affecting a single country hampers the ECB’s ability to evenly transmit its monetary policy throughout the Eurozone [Claessens et. al., IMF Working
Paper, p. 8 (2012); Ad van Riet, ESRB, p. 3 (2017)]. In addition, an overall lack of safe assets
like we are currently facing [Gelpern and Gerding, p. 366 (2016)] can result in a scarcity of adequate collateral used for other financial transactions. This, combined with the credit-rationing from the sovereign-bank doom-loop, can result in economic contraction and put further strain on a struggling economy [Gelpern and Gerding, p. 403 (2016)].
While left unaddressed, each of the Eurozone’s Three Problems continues to be a source of systemic risk for the Eurozone. The nexus between banks and their sovereigns will need to be disentangled in order to stop the sovereign-bank doom-loop from endangering both
sovereigns and commercial banks. In addition, the Eurozone will need a way to stop the excessive capital flows from peripheral regions into safer regions that occur in times of crises. Lastly, to better enable the ECB to conduct and transmit monetary policy evenly across the Eurozone, and to enable a smooth functioning of the financial sector, a steady supply of fitting assets will need to be readily available. If the Eurozone’s aim is to maintain a durable union and sustainable currency, all of the Eurozone’s Three Problems will need to be
addressed.
II-
Safe Assets
The introduction of a European Safe Asset could make a significant contribution to addressing the aforementioned Eurozone’s Three Problems. The following chapter will elaborate on the properties of such safe assets. In section one, the characteristics and general uses of safe assets will be explained. Section two will discuss the benefits that the
introduction of a Common European Safe Asset could bring in addressing the Eurozone’s Three Problems.
1. Characteristics and uses of safe assets
The term “safe asset” is a general term for financial contracts which economic actors treat as if they were risk-free [Gelpern and Gerding, p. 365 (2016)]. Some of these types of assets are government debt, bank deposits, AAA-rated corporate debt, asset backed securities, short-term tradeable debt (commercial paper) and repo’s, however, this list is not exhaustive
[Gelpern and Gerding, p. 365 (2016)]. In 2012 the IMF published a landmark paper regarding safe assets where it estimated the aggregate value of global safe assets at USD 114 trillion, this number at the time exceeded global economic output [Gelpern and Gerding, p. 365
(2016); IMF GFSR, 17-19, (2012)].
The availability of a safe asset is essential for the proper functioning of modern financial systems [Brunnermeier et. al., p. 179 (2017); Ad van Riet, ESRB, p. 2, 9 (2017)]. The IMF report and literature identify several functions of safe assets:
1. They serve as a store of value. Large funds and (institutional) investors worldwide have trillions of euro’s and dollars which they need to invest. To at least make up for the passing of time, simply sticking all of these trillions of euro’s under billions of mattresses will not do. Safe assets provide a way for these investors to house their money without being exposed to large credit risks.
2. The safe assets function as a pricing benchmark. Simply put: when there is an x amount of interest paid for a “risk-free” asset, any added amount of risk can then be quantified and compared to this safe-asset benchmark. The price, compared to the safe assets will then be an indication of former asset’s riskiness.
3. Safe assets also work as an effective form of lubrication for financial transactions. In repurchase and derivatives markets it is common that contracts require collateral. Safe assets function as credible and easy collateral in these transactions, streamlining those processes.
4. Their safe nature, high volume and high liquidity make safe assets ideal tools for the transmission of monetary policy by central banks, which relies heavily on the
exchanging of money for quasi-money in the form of safe assets. For example, the buying of highly liquid sovereign debt or commercial paper that has money-like qualities.
5. They are widely used by banks to meet prudential liquidity and capital requirements. [sources for pointer 1 through 5: Gelpern and Gerding, p. 372, (2016); IMF GFSR,
88-90 (2012); Brunnermeier et. al., p. 179 (2017); Ad van Riet, ESRB, p. 7, 12 (2017)]
If an assets is treated as safe, this conveniently allows investors to use the assets on a ‘no questions asked’ basis. This convenience translates into a lower interest rate having to be paid on such an asset. For an asset to enjoy a safe status - and the accompanying lower yield - it will need to bear certain properties in regard to its liquidity, its capability to be used as money and its remoteness from default-risk. The asset will therefore need to have a large volume and be marketed in a highly liquid market, will need to accrue money or have money-like qualities and will need to bear (almost) no default risk [Ad van Riet, ESRB, p. 6, 14 (2017)].
Even with vast amounts of safe assets being in circulation, global demand still outreaches global supply [Brunnermeier et. al., p. 179 (2017); Philiippon and Hellwig, (2011); Gelpern
and Gerding, p. 366 (2016)]. Times of crisis, like the GFC, European Sovereign Debt Crisis
and now the Covid-19 pandemic make investors scramble for perceived safety, increasing demand for safe assets even further [Ad van Riet, ESRB, p. 6, 9 (2017)].
A centrally issued and guaranteed Eurobond, a security collateralized by a large pool of sovereign bonds (the ESBie) [Brunnermeier et. al. (2017)], a jointly-and severally guaranteed 60% debt-to-GDP amount of Blue Bonds [Delpla and Weizsackeer, (2011)], a
market-replacing short term instrument as the Eurobill [Phillippon and Helwig, (2011)] all – to some extent – possess the necessary qualities to be deemed a safe asset. All of these proposals will be discussed in more depth later.
2. Particular benefits of a European Safe Asset
The availability of a major safe asset will bring several benefits to the Eurozone countries that participate in the scheme. Primarily, a safe asset would contribute to addressing the
Eurozone’s Three Problems.
2.1 Disentangling the sovereign-bank doom-loop
To the extent where a safe asset leads to diversification of banks’ holding of domestic sovereign debt, a European Safe Asset can also weaken or in some proposals even break the sovereign-bank doom loop [Claessens et. al., IMF Working Paper, p. 7 (2012); ESRB HLTF,
Volume 1, p. 7, 14 (2018); Brunnermeier et. al. p. 181 (2017); Ad van Riet, ESRB, p. 43 (2017)]. The safe asset would to some extent take the place now filled by sovereign bonds.
portfolio consisting largely of Common European Safe Assets is relatively insulated from any countries’ idiosyncratic risks [Claessens et. al., IMF Working Paper, p. 7 (2012)]. This defragmentation of the European public debt market will decrease the contagion risks stemming from sovereign bond concentrations on large banks’ balance sheets. Banks would no longer be too heavily exposed to the default of one sovereign.
2.2 Containing the flight-to-safety
A central pool of safe assets will limit issues caused by a “flight-to-safety” in times of market panic. When shocks occur, risk averse investors tend to move their assets away from the risky periphery of the Eurozone and into the core countries leading to large cross-border capital flows [Claessens et. al., IMF Working Paper, p. 7 (2012)]. These shifts create funding challenges for banks and destabilizing changes in yields [Claessens et. al., IMF Working
Paper, p. 7 (2012)]. When the different low- and high risk sovereign bonds would be pooled,
this transfer of capital would be averted to a significant extent. A shift might remain between higher- and lower risk tranches of certain assets, where their designs provide for such
diversification. This would, however, not cause the same problems [Claessens et. al., IMF
Working Paper, Table 1 (2012)].
2.3 Helping with monetary transmission and financial market functioning
Safe assets, and government bonds especially, are an import tool for the transmission of monetary policy. The borrowing cost for other economic actors is in part dependent on the interest rates on government bonds [Gelpern and Gerding, p. 403 (2016)]. A high-volume commonly issued debt-instrument on Eurozone level would aid the ECB in evenly
transmitting monetary policy. The asset could be bought by the ECB in quantitative easing programs such as the Public Sector Purchase Programme without the ECB having to worry about distributional effects between Eurozone countries [Claessens et. al., IMF Working
Paper, p. 8 (2012)]. In addition, the availability of large volumes of credible safe assets would
aid the flow of financial transactions as they can easily be used as collateral in financial transactions on a “no questions asked” basis. This could result in an increased overall economic output [Gelpern and Gerding, p. 403 (2016)].
III- Only Pooling
The next section will discuss two proposals for a Common European Safe Asset: the
Eurobonds, for which the idea has been around for more than two decades, and the Eurobills scheme which was proposed by Phillippon and Helwig. Both of these proposals employ the pooling of debt of Eurozone countries as well as joint-and-several guarantees in order to make
for a diversified and safe asset. In respective order, the next section will discuss both proposals’ strengths and shortcomings.
1. Eurobonds Design and benefits
One of the oldest proposals is the issuance of common euro debt, or the Eurobond. The first recommendations for such an instrument were made by the Giovanni Group back in the year 2000 [Giovanni Group Report, 2000], and then again by the European Primary Dealers Association and De Grauwe and Moesen in 2009 [Claessens et. al., IMF Working Paper, p. 7
(2012); De Grauwe and Moesen, (2009)]. The idea is very simple in the sense that it does not
rely on any novel financial instrument, new institutions or synthetic issuance. Essentially, Eurobonds would be bonds issued conjunctly by the Eurozone member states for which all issuing states would be jointly-and-severally liable. The benefits of such a scheme, especially for financially unstable states, would be large.
Firstly, they would to a large extent dissolve the doom-loop between banks and sovereigns [Claessens et. al., IMF Working Paper, p. 29 (2012)]. Banks would hold these Eurobonds on their asset sheets rather than (mostly domestic) sovereign bonds. The sovereign-bank doom-loop, which follows from the banks’ excessive exposures to their domestic sovereigns and vice-versa would almost seize to exist as the Eurobonds will have banks exposed to all Eurozone sovereigns at the same time. The weakening condition of one sovereign will not affect the marked-to-market value of a Eurobond significantly and would not have either the bank or the sovereign spiralling downward when facing an economic shock.
Secondly, the ‘flight-to-safety’ phenomenon where risky market conditions trigger unwanted cross-border capital flows will similarly be lessened. With investors’ exposure effectively spread out across all Eurozone sovereigns, there will be less of a need to move capital across borders in search of safety when a crisis hits. Since every sovereign is a valid liable creditor for the repayment of the debt, there is no benefit in moving capital from Greece to Germany. If Greece starts defaulting on its payments, bondholders could simple hold more stable countries liable for repayment. Capital would not see any major geographical shifts [Claessens et. al., IMF Working Paper, p. 34 (2012)].
Thirdly, a high-volume highly liquid safe asset could readily be used by both the ECB and economic actors in their course of transmitting monetary policy or conduction financial
transactions. Having a vastly available asset such as the Eurobonds would potentially solve the scarcity of safe assets entirely.
Political and legal infeasibility due to moral hazard
However, only looking at the potential benefits of the Eurobond does not give a just picture. The Eurobonds would rely on almost maximized risk-sharing and debt mutualization. Currently, these concepts are highly infeasible along both the political and the legal dimension. This infeasibility comes largely from the moral hazard it would bring. Moral hazard is understood as one party being able to make certain risk decisions, where another party is (partly) liable for the situation where these risks materialize [Expert Group, European
Commission, Conclusions, para. 24 (2014)]. Stronger countries would want to see the
common issuance of debt create an incentive for fiscal prudence, not diminish these incentives [Claessens et. al., IMF Working Paper, p. 5 (2012)].
In the system of joint-and-several liability, two possibilities of transfer arise. Firstly ex ante, through the lowering of spreads of sovereigns, which will asymmetrically benefit the more unstable sovereigns. Secondly ex post, as states can effectively rely on other states to pay the common debt if they are unable to do so themselves [Kammerer, p. 392, (2016); Expert
Group, European Commission, Conclusions, para. 24 (2014); Claessens et. al., IMF Working Paper, p. 5, 6 (2012)]. Transfers of an almost permanent nature between countries have been
observed in federal systems. This would happen when asymmetric shocks affecting less fiscally sound state had a cyclical nature. Every point in the cycle where the shock would affect the less fiscally sound state would see a more fiscally sound state picking up the costs, leading to a repeated process of transfers between more and less fiscally sound states
[Claessens et. al., IMF Working Paper, p. 5, (2012)]. The possibility of resolving fiscal issues through transfers by better-off countries does not incentivize weaker countries to prudently manage their budget. In fact, sound fiscal policy would make the fiscally prudent countries a more likely target for the repayment of the common debt, as their stronger resulting position would make them more able to repay any loans [Kammerer, p. 392, (2016)]. This risk of weaker countries “free-riding” on the system of common debt leaves stronger countries fearful to end up having to bail weaker countries out [Claessens et. al., IMF Working Paper,
p. 6 (2012)].
In addition, but surely not of less importance, such an instrument will in all likelihood infringe on the no-bailout clause of Article 125 TFEU [Kammerer, p. 389, 392, (2016); ECJ,
countries are subject to Treaty Law. And as was decided in the Pringle case, an action between member states (or in this case: Eurozone countries) - such as the joint issuance of Eurobonds - may only be allowed if it does not negatively affect each countries’ incentive to conduct sound budgetary policy [Kammerer, p. 391, (2016); ECJ, Case C-370/12 (Pringle),
para. 137 (2012)]. A situation where the Eurobond creates reasons for countries to piggyback
of off more stable member states cannot be said to effectively contain moral hazard.
The moral hazard that is inherent to the Eurobonds makes this type of safe asset currently infeasible. On the political aspect of the debate they are infeasible because there is little chance that opponents of risk mutualization (like Germany and The Netherlands) will agree to partake in the scheme. On the legal aspect of the debate they are infeasible because the
existence of this moral hazard will in all likelihood infringe on the ruling of the ECJ in the Pringle case that an action between Eurozone countries like this cannot diminish each countries’ incentive to conduct sound budgetary policy.
2. Eurobills Design and benefits
Another proposal is that of the Eurobill by Philippon and Helwig. This short-maturity
mutualized debt instrument relies on both its capped size and time-horizon in order to contain moral hazard. First, the Eurozone countries would erect a new entity: the Debt Management Office (hereafter: DMO). The DMO conducts auctions for the issuance of the Eurobills, as does it manage the allotments and redemptions. The Eurobills are a short term debt instrument for which Eurozone countries would be jointly-and-severally liable. Within the Eurobills scheme, countries would submit their issuance schedule for all their national debt with a maturity of up to one year at the beginning of each quarter, to the DMO. On the dates that Eurozone countries would normally hold the auctions for the sale of their national short-term debt, all of the debt is bought directly by the DMO instead [Phillippon and Helwig, (2011)]. The Eurobills auction is used to fulfil every Eurozone country’s short-term debt needs, with the constraint that no country can have more than 10% of its GDP worth outstanding in Eurobill debt [Phillippon and Helwig, (2011)].
Eurozone countries would forfeit their right to issue short-term debt (of up to one year) outside of the Eurobills scheme [Phillippon and Helwig, (2011); Expert Group, European
Commission, Final Report, para. 128, (2014)]. The fact that Eurobills would then constitute
the only sovereign short-term debt would give them credible seniority over all other liabilities [Phillippon and Helwig, (2011)].
The joint-and-several liability resting on all participating Eurozone countries poses a potential risk for all countries involved when, for example, one country defaults on its Eurobills
payment obligations. The structure of the Eurobills which makes them credibly senior to all other liabilities will decrease risk for the countries involved [Phillippon and Helwig, (2011)] as it will be more difficult for one country to redeem other junior liabilities rather than redeeming the senior Eurobills liabilities.
In addition, the Eurobills counteract moral hazard by making access to the scheme conditional on sound long-term fiscal policy [Phillippon and Helwig, (2011)]. This entails that, if a
country does not meet the requirements, this country could see its Eurobill debt not be rolled over at the end of the term. Through this risk of losing access, countries are continuously exposed to a certain degree of market discipline, strengthening the existing framework for economic governance and market discipline [Phillippon and Helwig, (2011); Claessens et.
al., IMF Working Paper, p. 26, (2012)].
It is the seniority that makes the debt less risky for more stable countries involved. Rather than creating an open-ended commitment for all participating states, the shared liability can be reviewed each year as the debt could potentially be rolled off after each term [Phillippon
and Helwig, (2011); Claessens et. al., IMF Working Paper, p. 26, (2012)]. It counteracts the
moral hazard that is inherent to the concept of debt-mutualization [Phillippon and Helwig,
(2011)] as the Eurobills’ seniority will keep countries continually exposed to market
discipline.
Eurobills could be a helpful tool in addressing the Eurozone’s Three Problems. [Expert
Group, European Commission, Final Report, para. 9, 148, 149 (2014); Ad van Riet, ESRP, p. 7 (2017)]. With a status as safe asset, which follows from the joint-and-several guarantees by
the Eurozone countries, Eurobills could “help to ensure that the monetary conditions set by
the ECB would pass smoothly and consistently on to enterprises' and households' borrowing costs and ultimately on to aggregate demand” [Expert Group, European Commission, Final Report, para. 149, (2014)]. In addition the Eurobills could help contribute to the proper
working of the financial system and the disentanglement of the sovereign bank doom loop by decreasing exposure of banks to domestic government debt [Expert Group, European
Commission, Final Report, para. 121, 149, 151, (2014); Claessens et. al., IMF Working Paper, p. 25-26, (2012)]. In this respect it addresses two of the Eurozone’s Three Problems.
further integrate the Eurozone, and reduce market fragmentation [Expert Group, European
Commission, Final Report, para. 152, (2014)]. A lower degree of fragmentation will help to
limit the flight-to-safety, alleviating the last of the Eurozone’s Three Problems.
Lack of effectiveness
However, the very aspects that help this particular proposal contain moral hazard are, in the view of the author, also the aspects that make the proposal inadequate to solve the Eurozone’s Three Problems. Only a Eurobill pool that is large will be able to adequately address the Eurozone’s Three Problems [Expert Group, European Commission, Conclusions, para. 18,
(2014)]. The total volume of the Eurobills, being capped at 10% GDP, is relatively small
compared to the other proposal which are for example capped at 60% GDP in case of the Blue Bond proposal and estimated to be several times larger in volume than the Eurobills in case of the ESBies proposal (roughly 3 trillion for the ESBies compared to 500 billion in Eurobills) [Brunnermeier et. al., p. 191 (2017); Expert Group, European Commission, Conclusions,
para. 124, (2014)] . While they would help to disentangle the sovereign-bank doom-loop and
limit the flight-to-safety, they would by definition do this to a smaller extent than the other proposals. For this reason the Eurobills lack (comparative) effectiveness and are not the most suited European Safe Asset option to address the Eurozone’s Three Problems.
IV- Pooling and Tranching
The next section will dive into two more proposals; the European Safe Bonds and the
Red/Blue bonds. Due to their large volumes and high degree of diversification, both of these proposals are fit to address the Eurozone’s Three Problems to a far reaching extent.
The first of the two is the “European Safe Bond” which is essentially a sovereign-bond
backed security, using a large quantity of Eurozone sovereign debt as collateral. The second is the “Red/Blue Bond” proposal by Delpla and Weizsacker which, in addition to the ESBies diversifying and traching, also employs joint-and-several liability as a mechanism to make the asset safe. The following subsections will address each proposals.
1. European Safe Bonds (ESBies) Design
The first of the two proposals is that of the European Safe Bonds by Brunnermeier et. al. As opposed to the Eurobonds or Blue Bonds, the ESBies do not require any form of risk-sharing among the participating countries.
The ESBies are a form of sovereign bond-backed securities. Like any security, the instrument makes use of both pooling of risk as well as tranching. In case of the ESBies, this makes the asset effectively safe. The asset-pool for the ESBies would consist of sovereign bonds issued by Eurozone countries. The tranching would be into two layers; the European Senior Bonds (ESBies), which due to the design of the scheme would be deemed a safe asset, and the European Junior Bonds (EJBies), which would be the first tranche to take losses in case of default. The following passage will show how this would work in practice.
A public entity, the Debt Management Office (DMO) would buy large quantities of sovereign debt of all participating Eurozone countries. It would do so in accordance with a
pre-determined ratio as not to create perverse incentives for countries to enact policies that would see more of their national debt bought up for the ESBies pool. The creator of the proposal, Brunnermeier, suggests relying on a moving average of either euro area countries’ GDP’s or their contributions to the ECB’s capital [Brunnermeier et. al. (2017)].
Source: European Parliament Briefing, p.2, (2018), edited by author
The cover pool would contain bonds from both safer and riskier sovereigns of the Eurozone. This means that this pool, which holds safe and less safe bonds, would by definition be less safe than a pool consisting of only the safer bonds. In order to make the ESBies become safe enough to be deemed a safe asset, not only the diversification but also the tranching is a necessary component [ESRB HLTF, Volume 1, p. 14, (2018)]. Therefore, with the pool of diversified sovereign debt as collateral, a special purpose vehicle will issue two layers of bonds; the European Senior Bonds and the European Junior Bonds.
Setting the divide of senior versus junior bonds to a 70/30 split would make the senior bonds at least as safe as the German Bund, with their expected five-year loss rates at 0.09%
on their payment obligations would then first be borne by holders of the EJBies. Only when the entire 30% fraction of EJBies would be wiped out would the ESBies begin to suffer any losses at all. This is what renders them very default remote. A portfolio consisting of only ESBies would be less risky than the least risky bank sovereign bond portfolio [ESRB HLTF,
Volume 1, p. 15 (2018)].
Source: European Parliament Briefing, p.2, (2018), edited by author
The sovereign debt would have to be bought under strict conditions and only at market prices, anything else would hinder the price formation of the bond-pool [ESRB HLTF, Volume 1,
p. 13 (2018)]. The sovereign debt should only be bought on the primary market if that
particular country has primary market access. If countries that have lost primary market access would still see their debt purchased by the DMO, the scheme would essentially become a crisis management tool that helps illiquid Eurozone countries to return to capital markets [ESRB HLTF, Volume 1, p. 13 (2018)]. This is not the purpose for which the ESBies were intended [ESRB HLTF, Volume 1, p. 13 (2018)].
In addition, the bonds on the secondary market should only be bought for a competitive price [ESRB HLTF, Volume 1, p. 13 (2018)]. If not, this could see the ESBies-scheme misused in two ways. Firstly, the acquiring of sovereign debt could become an illegitimate means of funding illiquid governments [ESRB HLTF, Volume 1, p. 13 (2018)]. Secondly, buying the sovereign debt that goes into the ESBies cover pool at competitive prices is necessary to ensure that the ESBies themselves will also have market-clearing prices [ESRB HLTF,
Volume 1, p. 13 (2018)]. Say, for example, that the sovereign debt going into the ESBies
than the market price of the sovereign debt its cover pool consists of. This in turn would have a negative effect on the willingness of investors to invest in ESBies rather than investing in a portfolio of sovereign debt themselves.
Holding to these requirements – only buying on the primary market when there is market access and only buying on the secondary market at competitive prices - ensures that the DMO can maintain a neutral position as pass-through vehicle and in addition ensure that the payoff structure of the ESBies and EJBies can remain the same as the payoff structure of the
underlying sovereign bonds in the cover pool [ESRB HLTF, Volume 1, p. 13, 14 (2018)].
The vast quantity and liquidity that the ESBies could have, combined with their high level of safety would make the ESBies a true safe asset. This asset would be attractive for commercial banks to hold on their balance sheet in order to meet their capital requirements or to use in their repo facilities [Brunnermeier et. al. (2017)]. The EJBies on the other hand would be riskier and bear more interest. This would make them interesting instrument for hedge funds, speculators and other interest-seeking investors [Brunnermeier et. al. (2017)].
Currently, the only safe assets in the Eurozone are the bonds issued by Germany, the
Netherlands, Finland Luxembourg and Austria. Together these amounted to EUR 2.9 trillion worth of triple-A rated assets [Eurostat, quarterly government debt, (2020); Brunnermeier et.
al., p. 179 (2017); Ad van Riet, ESRB, p. 42 (2017)]. The ESBies proposal does not rely on
any guaranteed or mandatory purchases, rather the entire process is demand-led [European
Parliament Briefing, p. 10, 11 (2018)]. While some authors question whether there will be
adequate demand for the ESBies [European Parliament Briefing, p. 10, 11 (2018)], others expect that the issuance of the ESBies will result in a doubling of the Eurozone’s total safe asset supply, creating a substantial float of safe assets [Brunnermeier et. al., p. 214 (2017); Ad
van Riet, ESRB, p. 42 (2017); Pekanov, p. 17 (2019)]. 2. Bonds and Red Debt
Design
The Red/Blue Bond proposal by Delpla and Weizsacker relies on debt mutualization as well as debt-layering to create a safe asset and contain moral hazard.
The proposal suggest that all debt of participating sovereigns should be pooled and divided into two assets; Blue Bonds and Red Debt. For the Blue Bond all states will be jointly-and-severally liable, for the remaining Red debt all responsibility will continue to fall on the issuing state itself.
In most cases the bulk of debt would qualify as “blue debt” as each country is allowed to pool up to 60% of their GDP’s worth of debt into the collective guarantee system. Even in the unforgiving economic landscape of 2020, this number would still amount to roughly EUR 6.1 trillion [Eurostat, 2020]. The joint-and-several liability resting on all participating states together would render the bond extremely safe [Delpla and Weizsacker, p. 2 (2011)].
Participating in the Blue Bond programme is not meant to be a right, or an entitlement. Rather it is a privilege, earned by proper fiscal policies and budgetary austerity [Delpla and
Weizsacker, p. 3 (2011)]. The hard cap of 60% is also just that, a hard cap. Countries not
meeting their fiscal responsibility could see their Blue Bond appropriation downgraded to a lower debt-to-GDP percentage.
The allocation of the bonds would happen annually. The “independent stability council” would propose the allocation of blue bonds for that vintage on a take it or leave it basis. The national parliament of each country would then have to vote on this proposal. It is only on their authority that bonds can be issued in the state’s name, and that mutual guarantees can be given [Delpla and Weizsacker, p. 3 (2011)].
All debt exceeding a nation’s allocation of Blue Bond issuance would fall into the second asset-type: Red Debt. As its ominous name suggests, this type if debt is not preferred for issuers. With a substantially lower total-volume and absence of mutual guarantees, this type of debt will be more expensive for the issuer. As the repayment responsibility for this debt falls solely still on the issuing state, it exposes the issuer to severe market discipline. Failure to impose adequate fiscal reforms and policies will be penalized by the market, resulting in higher yields and difficult refinancing conditions. It is by virtue of this increased exposure to market discipline that, according to its designers, the overall budgetary efficiency of the total debt will increase [Delpla and Weizsacker, p. 3 (2011)]. It will not merely be a re-packaging of risk but also create new incentives for countries to better their ways.
3. What problems they solve
The creation of the ESBies or Blue Bonds would help to treat, [Brunnermeier et. al. p. 181
(2017); Pekanov, p. 16 (2019)] or effectively solve [Ad van Riet, ESRB, p. 42, 43 (2017)] the
Eurozone’s Three Problems. This subchapter will first address the ESBies’ and Blue Bonds’ effects on the sovereign-bank doom-loop. Second, it will address their effects on the “flight-to-safety” phenomenon. Lastly, it will discuss the ESBies’ and Blue Bonds’ value to
monetary policy and to the smooth functioning of financial transactions.
3.1 Diversifying banks’ sovereign-bond portfolios
As was previously explained, the existence of the sovereign-bank doom-loop and the excessive home bias of Eurozone banks is a pressing issue on the current financial system [ESRB HLTF, Volume 1, p. 7 (2018); Brunnermeier et. al. p. 181 (2017); ]. With the large-scale issuance of the ESBies or Blue Bonds, a low-risk and diversified asset, this loop could be effectively counteracted.
The systemic risk primarily comes from two sources; the overall amount of risk associated with banks’ portfolios and the fact that these portfolio’s suffer from excessive (domestic) concentration risks. The ESBies and Blue Bonds address both [ESRB HLTF, Volume 1, p. 7,
14 (2018); Brunnermeier et. al. p. 181 (2017); Ad van Riet, ESRB, p. 43 (2017); Claessens et. al., IMF Working Paper, Table 1, (2012)].
The tranching of the sovereign-bond backed securities into European Senior Bonds and European Junior Bonds, or the delineation of government debt into Blue Blonds and Red debt addresses the overall risk in banks’ portfolios. It provides banks with a low-risk substitute for the banks’ sovereign bonds in the form of the ESBie/Blue Bond. Changing out banks’ current sovereign bond portfolios for a portfolio consisting of low-risk bonds would in itself decrease the amount of risk to which these banks are exposed.
However, this de-risking of banks’ portfolios is not enough. It leaves the issue of excessive domestic concentration on the table. To properly address this, diversification is also necessary [ESRB HLTF, Volume 1, p. 14, (2018)]. The design of ESBies and Blue Bonds makes it so that also this issue is adequately tackled. Currently banks hold large amount of sovereign bonds on their balance sheet, an excessively large portion of which comes from their domestic sovereign [ESRB HLTF, Volume 1, p. 7, (2018)]. The ESBies and Blue Bonds however, do not link directly to any particular sovereign. Rather, due to their designs are they exposed to a multitude of sovereigns at the same time. Swapping out the excessive amounts of domestic sovereign bonds for ESBies or Blue Bonds will therefore shift the banks’ exposure from their
domestic sovereign to an exposure to all of the participating sovereigns. A system-wide insertion of the ESBies or Blue Bonds would hence counteract contagion of idiosyncratic sovereign risk and lower the overall riskiness of banks’ portfolios [ESRB HLTF, Volume 1, p.
7, (2018)].
3.2 Transforming the flight-to-safety
In addition to the sovereign-bank doom-loop, the large scale flight-to-safety of capital in times of crisis is also still one of the channels through which economic shocks are propagated. A seemingly solid country, rattled by an economic shock would quickly see its access to credit evaporate as investors move their capital into the regions they deem safer. These uncontrolled flows have a destabilizing effect as their asymmetric nature negatively affects countries in the Eurozone’s periphery while disproportionately depressing safer countries’ borrowing costs [Brunnermeier et. al., p. 180, (2017)].
Because of the tranching employed by both the ESBies and Blue Blonds, such a cross-border capital flow would be significantly decreased. The essence of the problem, which lies in the geographical nature of the capital movement, is counteracted by the large scale availability of both safe and risky assets within each national border. In times of crisis, when investors forego on risky assets and scramble for a safe haven, rather than moving their money away from Greece and into Germany they would move their money away from the EJBies and Red Bonds and into the ESBies and Blue Bonds [Brunnermeier et. al., p. 181, (2017); Ad van Riet,
ESRB, p. 42, (2017)]. Such a cross-instrument flight would not have the same destabilizing
effects as a cross-border capital flight.
3.3 Providing a transmission tool and collateral for financial transactions
Both the ESBies and Blue Bonds would provide the Eurozone with a vast pool of country-neutral safe assets. The Blue Bonds with their projected 60% Eurozone GDP amount would in 2020 result in a pool size of roughly EUR 6.1 trillion. The size of the ESBies remains
speculative as the scheme is demand-led. Several authors project that the ESBies will significantly increase the Eurozone’s total supply of safe assets, or even double them. [Brunnermeier et. al., p. 214 (2017); Ad van Riet, ESRB, p. 42 (2017); Pekanov, p. 17,
(2019)]. The estimates range from a pool between EUR 1.5 trillion and EUR 3.7 Trillion.
Currently, the supply of safe assets is scarce [Brunnermeier et. al., p. 179 (2017); Ad van Riet,
ESRB, p. 42 (2017); Gelpern and Gerding, p. 366 (2016)]. The influx of these assets would
benefit the ECB and financial actors alike. The creation of the Blue Bond or the ESBies would present a large pool of safe assets which could readily be used by the ECB for the
transmission of its monetary policy, or by economic actors as credible collateral in financial transactions.
V-
Comparison
All discussed proposals differ from each other. Where size is concerned, ESBies and Blue Bonds and Eurobonds are expected to have massive volumes compared to the Eurobills, which is capped at 10% GDP. Required guarantees and likeliness to be repaid in full differ as well, Eurobonds, Eurobills and Blue Bonds, for example, employ joint-and-several liability for all participants, where ESBies do not.
While all four proposals constitute a Common European Safe Asset, each proposal has certain characteristics that distinguishes it from the rest. To get a good view as to which proposal is most suited to address the Eurozone’s Three Problems, the next chapter will aim to compare the four proposals vis-à-vis each other looking at four relevant dimensions. Subsection one will discuss the total potential volume of each of the proposals. Subsection two will assess the liquidity of each proposal. Subsection three will look at to what extent each asset is attractive to investors and banks. Subsection four will go into each of the proposals’ feasibility.
Subsection five will make a final comparison and give a verdict on which proposal is most suited to address the Eurozone’s Three Problems.
1. Total Volume
When addressing the Eurozone’s Three Problems, an important factor in the effectiveness of each proposal is their anticipated total volumes. [European Commission, Impact Assessment,
p.48, (2018)]. Firstly, in order for the European Safe Asset to disentangle the sovereign-bank
doom-loop, the asset should have enough volume to sufficiently rebalance Eurozone banks’ balance sheet so that these banks are no longer excessively exposed to their domestic
sovereign or any particular single sovereign. Banks tend to hold large quantities of sovereign debt on their balance sheets. For Italian banks in 2015 for example, 60% of their total
portfolio of securities consisted of public sector securities [Affinito et. al, p. 7 (2016)]. So in order to rebalance all Eurozone banks’ portfolios, a significant volume of assets would be necessary. Secondly, to limit the flight-to-safety, similarly a high volume would be beneficial. The European Safe Asset limits the cross-border capital flight by offering a safe haven
alternative that does not require capital to cross borders. In order to do so, the volume will need be sufficient to cater to as many investors looking for safety as possible. Lastly, where suitable assets for the ECB’s smooth transmission of monetary policy and credible collateral
for financial transactions are concerned; more is better. Also for this problem of the Eurozone a high volume could make a contribution.
The total (expected) volume of each proposal is as follows:
• The Eurobonds idea, because of its underdeveloped state, gives little absolute data as to its exact intended size. However, for the remainder of this section it is assumed that the Eurobonds would be phased in on a large scale, and would at some point replace the entire existing national sovereign bond market. It would be illogical for countries to issue sovereign debt for which only they are wholly liable if that country at the same time had the option to issue Eurobonds for which all Eurozone countries would be jointly liable and which would in all likelihood have more favourable interest rates. Replacing the current sovereign debt market would put the total volume of the
Eurobonds at EUR 10.8 trillion and make it the largest proposal of the four [Eurostat,
2020].
• The Blue Bonds have a clear pre-set volume, at 60% GDP. With the current GDP of the Eurozone this would result in a volume of EUR 6.1 trillion
• The ESBies are a demand-led instrument, and its actual volume is therefore difficult to gauge. Various authors and institutions have given varying estimates, putting the steady state volume of the ESBies somewhere between EUR 1.5 trillion and EUR 3.7 trillion
• Eurobills have hard cap at 10% GDP and would currently result in a total volume of EUR 1.08 trillion 10.8 6.1 3.7 1.08 1.5 0 2 4 6 8 10 12
Eurobonds Blue Bonds ESBies Eurobills
TOT A L V OL U M E X E U R 1 TRIL LIO N
Comparative Volumes
2. Liquidity
Aside from volume, when limiting the flight-to-safety and when providing suitable assets for monetary policy transmission and credible posting of collateral, liquidity is also an important aspect. In times of crisis, when investors actively seek safety, in order for them to do so within-borders rather than cross-borders, the European Safe Asset should be readily available for trade and therefore liquid. In a stakeholder survey on sovereign bond-backed securities (SBBS) conducted by the European Commission, 13 out of 15 participant submitted that liquidity would be very important [European Commission, Impact Assessment, p. 51, (2018)]. Likewise for the ECB and economic actors using the safe assets, the assets should be easily tradeable so as to ensure smooth functioning of financial transactions and the ECB’s
unconventional forms of monetary policy transmission such as the PSPP quantitative easing program which involves the trading of sovereign debt as well.
Liquidity of such an asset seems to depend on two main factors: 1) its total volume, as was discussed before and 2) the level of standardization each product has, 70% of the stakeholders indicated that a high degree of standardization would be important [European Commission,
Impact Assessment, p. 50, (2018)]. Whereas the average number submitted was lower, around
EUR 500 billion, 22% of the stakeholders submitted that the safe assets would need a total volume of over EUR 1.5 trillion to be adequately liquid [European Commission, Impact
Assessment, p. 51, (2018)]. All proposals meet this threshold, except for the Eurobills which
might fall short in the view of some stakeholders. Where standardization is concerned, all proposals are likely to employ a high degree of standardization. Comparing the proposals along this line will yield no useful conclusion.
3. Attractiveness to banks and investors
It is not enough that there is a sufficient amount available of each asset tot satisfy the portfolio diversification needs of the Eurozone’s banking sector and the investment sector’s need for safe assets in times crisis. Banks and investors should also have an incentive to actively alter their current portfolios and prefer the European Safe Asset over other asset types.
One factor that both banks and investors might look at is whether the assets are safe enough. Banks use sovereign bonds as a store of value and a way to meet prudential capital and
liquidity requirements and investors in crisis would buy the assets as a safe haven. Eurobonds, Blue Bonds and Eurobills all entail joint-and-several liability for all Eurozone countries. This makes the defaulting on the assets very unlikely as any Eurozone sovereign could be held liable. The ESBies do not entail such shared liability and are, therefore, more prone to adverse
shocks and risk of default. In addition, as the 70/30 spit between senior and junior bonds is pre-defined in order to safeguard the senior tranche’s likelihood of repayment, the demand-led issuance of the ESBies could in practice also be limited by the market’s (insufficient) appetite for this junior tranche as well.
Source: Ad van Riet, 2017, edited by author
Whether or not it will be attractive for banks to replace sovereign bonds in there current portfolios with any one of these four assets depends mainly on the regulatory treatment of the assets. Currently, sovereign bonds hold a 0% risk weight with regard to prudential regulation. This is one of the main benefits and reasons for banks to hold such large quantities of
government debt. While it is likely that a jointly-and-severally guaranteed sovereign debt instrument would get the same treatment, the same cannot be said as strongly for a securitized instrument with a cover pool consisting of government debt such as the ESBies. Currently, proposed legislation for a favourable change in regulatory treatment for Sovereign Bond-Backed Securities (SBBS) such as the ESBies is being discussed by the European Parliament and the European Commission. Whether the ESBies will get the same regulatory treatment as national sovereign debt remains to be seen.
4. Feasibility
Outside of the three objective factors discussed in Section, one bottleneck has yet to be discussed: the feasibility of the proposals. For the Eurobonds and the Blue Bonds this poses a particular issue. Both the Eurobonds and Blue Bonds rely on joint-and-several liability resting on all participating Eurozone countries. This form of ‘risk mutualization’ has faced a strong
opposition from the outset of the debate. Especially Germany has taken a firm stance against risk sharing in such a way with Angela Merkel going as far as stating that there will be no full debt sharing “as long as I live” [Merkel Speech, (2012)]. The moral hazard that is inherent to schemes involving risk mutualization might prove to be the halting factor for the Eurobonds and Blue Bonds.
Taking into account that each scheme would fare best with the participation of all Eurozone members and would most likely not work properly without the Eurozone’s biggest member – Germany- , Eurobonds and Blue Bonds are not currently a feasible proposal to address the Eurozone’s Three Problems. While it is true that Eurobills also employ joint-and-several guarantees, according to the authors of the proposal the strongly capped size and time horizon provide adequate protection for the jointly liable Eurozone countries, something that could keep Eurobills as a viably feasible option. The ESBies do not employ joint-and-several liability and therefore do not make Eurozone countries liable for the debt of others. Consequently this scheme would not meet the same political resistance
5. Final comparison
Eurobills, while potentially politically feasible and sufficiently diversified do not seem to be the most suited proposal to address the Eurozone’s Three Problems simply for the reason that their volume would be too low, and with that, their perceived liquidity as well. The European Safe Asset in the form of the Eurobills would not suffice to rebalance the Eurozone’s banks’ portfolios or sufficiently deter the flight-to-safety.
Looking at volume, liquidity and attractiveness it is the Eurobonds and Blue Bonds that are the most suited proposals to address the Eurozone’s Three Problems. Their massive volumes estimated at EUR 10.8 trillion and EUR 6.1 trillion respectively would be sufficient to allow banks to rebalance their portfolios that are currently overly exposed to their domestic
sovereigns. In addition would the joint-and-several liability inherent to the proposal make the assets sufficiently safe to work as a safe haven for investors so as to counteract the cross-border capital flows that now occur in times of crisis. However, this same risk sharing
property is what makes both proposals (politically) infeasible. With some prominent members of the Eurozone (Germany, Austria, The Netherlands) being fierce opponents, the proposals are not likely to become reality in the near future.
The golden mean between proposals that reach too far from some Eurozone countries and a proposal that would not bear enough impact to resolve the Eurozone’s Three Problems is the
