Sovereign bond-backed securities: weakening the doom loop?

Introduction

Could the European Commission’s proposal to weaken the debt “doom loop” be itself doomed?

On November 12, 2018, the European Parliament Committee on Economic and Monetary Affairs (ECON) expressed serious reservations about the Commission’s proposed framework to enable the development of a market for sovereign bond backed securities (SBBS). The proposed framework reflected a demand driven policy aimed at helping banks diversify their sovereign debt and tackle the “doom loop” where a bank’s and a Member State’s deteriorating finances put pressure on each other.

What are SBBS?

SBBS are debt securities backed by a diversified portfolio of government debt issued by Member States in the euro area. The composition of the underlying portfolio is determined by the proportion of capital held by each Member State in the European Central Bank (ECB), otherwise known as the “ECB capital key”. The ECB capital key, according to the Commission, represents a proxy for each Member State’s economic size and its stake in the stability of the European financial system.

Under the proposed framework, Member States would not issue new debt to form an SBBS portfolio. Instead, existing sovereign debt would be bought by special purpose vehicles (SPVs), that would repackage such debt into new SBBS, collect coupons, and pass coupon payments to investors. In its report, the Commission anticipates that this would avoid mutualisation of losses among euro area Member States as only private investors would be exposed to the collective losses of the euro area Member States and, under the proposed framework, Member States are not required to coordinate debt issuance plans.

The Commission aims to break the “doom loop” between Member States and banks. Many banks in the EU hold large quantities of their home Member State’s sovereign debt due to favourable capital adequacy treatment, a relatively low risk profile and familiarity with the product. The doom loop is a negative feedback loop created by perceived weakness of the Member State or the relevant bank that may result in adverse economic consequences. If a Member State is facing significant economic distress the market price of its debt will be affected. Given that domestic banks tend to hold a large amount of this debt on their balance sheets, a significant market fluctuation or downgrade of that Member State’s sovereign debt will impact their financial strength as well.

A recalibration of regulatory capital requirements is necessary to make SBBS products appealing to banks, as currently SBBS issued by an SPV would be treated less favourably than the sovereign debt it holds. The proposed framework is intended to remedy this. SBBS will be split into two tranches: the junior 30 per cent will be structurally subordinated to the most senior 70 per cent. Under the proposed framework, senior tranche would be afforded the same capital treatment as the sovereign debt. The intention is to incentivise banks to replace the sovereign debt currently on their balance sheets with senior SBBS with a view to weakening the link between banks and individual Member States.

Issues with the proposed framework

Using the ECB capital key to determine the underlying portfolio of the SBBS presents several issues. Each Member State’s contribution to the ECB varies from year to year according to their relative GDP and various agreements. As a result, the underlying portfolio would also need to vary from year to year. This would result in annual variances to the different risk profile and underlying portfolio. Unless highly complex mechanics are put in place, 2018 SBBS and 2019 SBBS (for example) would not be fungible, significantly limiting their liquidity. In addition, the ECB capital key is politically sensitive in each of the Member States, may be considered too politicised to aggregate into an underlying portfolio.

Why would banks choose SBBS if they are treated no more favourably than sovereign debt? If banks decide to diversify away from domestic sovereign debt, they could simply purchase a basket of Member States’ debt according to the relative GDPs of each Member State. This has the benefit of being more liquid than SBBS. Furthermore, in order for banks to hold the senior tranche, there must be sufficient buyers of junior tranche SBBS for a transaction to be viable.

Industry responses

Industry responses to the proposed SBBS framework were also mixed. Responses from German stakeholders were particularly critical. The German Banking Industry Association questioned whether there would be adequate supply of securitisations upon which the SBBS portfolios would be based, and warned that SBBS could result in the fragmentation of the market for sovereign bonds. The Society of Investment Professionals in Germany (the DVFA) cautions that the yield might not be commensurate for the risk profile of a junior SBBS position. Lack of demand for junior tranches would limit the amount of senior tranche SBBS that can be issued and, by extension, the effectiveness of the framework.

The German Debt Association and the Association for Financial Markets in Europe have expressed their doubts with the proposed framework, in that SBBS may fail to appeal to investors. On the supply side, there are concerns that German government bonds would be effectively devalued if they are aggregated with those issued by less favourably rated Member States.

The Italian Banking Association similarly highlighted barriers to SBBS becoming liquid and low risk assets based on the proposed framework. Anonymous feedback was supplied by a stakeholder from Malta, identifying that the proposed framework may actually hinder smaller Members States from utilising SBBS and thus limiting their access to debt markets. This stakeholder also emphasised that the proposed framework could create financial stability risks for smaller Member States who, for strategic reasons, source funds overwhelmingly from the domestic market, and may also result in reputational risk for Member States who instruments are put in the subordinated tranche.

In October 2018, ECON published a draft report on the proposed framework. ECON’s amendments to the proposal cover three broad areas

• Amendments to the proposal regulatory treatment of SBBS as a risk-free asset to discourage banks from amassing concentrated holdings of the risky junior tranches. In order to receive beneficial regulatory treatment, banks will need to hold either only the senior tranche of SBBS or a fully diversified holding. However, this goes no way to answering the key question as to who will hold the junior tranches, especially if banks cannot.
• Assigning ESMA regulatory and supervisory responsibility for SBBS issues, in order to ensure a uniform supervisory practice and enhance product quality. This would include SBBS issuers having to apply to ESMA for certification that an issuance meets the criteria for being an SBBS, and also implies ongoing monitoring by ESMA and the power to strip issuances of their SBBS certification if it no longer meets the criteria.
• Provisions for an orderly process to alter the SBBS portfolio composition in the event that a Member State were to lose market access (thus making SBBS responsive to the economic context as this changes over time), and increasing the minimum size of the junior tranche of an SBBS from 2 per cent. to 5 per cent. in order to enhance loss absorption capacity of the junior tranche.

However, the above amendments are by no means agreed. In the latest ECON meeting on 12 November 2018, ECON members expressed scepticism about the usefulness of the proposal, whether there is a suitable market for the product and the negative impact the instruments may have in times of crisis.

Conclusion

The SBBS proposal faces significant issues regarding its feasibility and effectiveness. While it may appeal to certain EU stakeholders, the plan has yet to appeal to euro-area market participants and industry associations. Their support will be critical in rolling out the SBBS. Depending on investor demand, the SBBS market could develop incrementally at first. We are still waiting for signs of progress of the legislative process – as it stands a vote on the ECON report is scheduled for early 2019. The proposal is also listed as a priority pending proposal in the Commission Work Programme 2019. However, with a lack of consensus among the EU institutions and competing issues such as Capital Markets Union and Brexit, this proposal potentially could stop in its tracks before European elections in May 2019.