Sovereign Bond-Backed Securities (SBBS), a new class of safe financial assets, could be gradually developed to strengthen the euro area against future financial shocks, an influential task force chaired by the central bank governor concluded. from Ireland, Philip Lane.
The guarantee would consolidate the public debt of different countries into a single asset that could withstand the default of one or more countries without causing contagion.
Asset-backed securities are guarantees of income payments from a specified pool of assets, which in this case are sovereign bonds. Securities help institutions such as governments and banks sell debt in the public markets.
The feasibility study conducted by Mr Lane suggests that the design of the SBBS could facilitate action to make sovereign bond portfolios less risky without “pooling sovereign risks in Europe”.
Sovereign bond investors are aware of country risks when investing, including economic risks and political risks. What the risk of pooling means is that the risk of all sovereign securities would be pooled. Since the SBBS would be created through private contracts, each government would be responsible for servicing its own debt obligations, thus not pooling risk.
This is important because if one country were to default on the obligation, the other countries in the title would not necessarily be responsible for taking over. The report took longer than expected due to German reservations that in the event of a country defaulting it could be suspended, although the task force’s recommendation suggests that would not be the case.
The European Systemic Risk Council’s high-level working group on safe assets suggested that SBBS could be progressively developed under certain conditions, including regulation to provide the conditions for a “sufficiently large investor base”.
“For banks, regulating senior SBBSs no more severely than sovereign bonds could encourage them to hold these lower risk securities,” Lane wrote.
The way the SBBS would work is that, like sovereign bonds, the cash flow to the securities would come exclusively from the underlying bonds. However, the securities would be issued by a dedicated and independent entity, without prior negotiation or indebtedness. The aim is to protect the entity against insolvency or other legal proceedings so that in the event of bankruptcy it is not affected.
The SBBS would also require issuers to never default on the contract, which is possible with simple sovereign bonds, even if the underlying bonds were in default.
Mr Lane’s panel wanted to publish its findings last March, but was held up by technical hurdles. The European Systemic Risk Board – created in 2010 to prevent financial crises in the European Union, and currently chaired by European Central Bank President Mario Draghi – “took note” of the work in December but did not want to approve them.