A Euro Zone Basket as Stabiliser for the Euro Area?

The causes of the European debt crisis—as seemingly diverse as the member states of the European Union (EU) itself—had one thing in common. Regulators and policymakers alike did not anticipate the degree to which liberties in sovereign debt management could become an existential threat to the entire EU financial system. Indeed, as subsequent analysis and debate has revealed, regulatory systems even acted as enablers. The 2015 European Systemic Risk Board (ESRB) report on the regulatory treatment of sovereign exposures, for example, noted that, despite numerous historic examples of sovereign defaults, regulatory treatment routinely ignored the possibility of sovereign default and risk (Note 1). The cost of such negligence on the European body politic is more than financial. As recent elections across the EU have shown, the management of the European debt crisis became a strong factor in spreading political instability.

Understanding and challenging (poor) sovereign debt practices—and their enabling regulatory frameworks—are imperative to strengthening the European Union against threats, both fiscal and political. The Euro Zone Basket (EZB) proposal—which we first detailed in a white paper entitled "Breaking the Doom Loop (Note 2)" —aims to achieve this. It acknowledges the critical impact that the sovereign-bank nexus has in national and European financial (in)stability. It offers a simple formula for regulating sovereign debt that embraces already tried-and-true private-sector approaches to risk management via capital and liquidity assessments.

Among the critical flaws revealed in the post-crisis scrutiny of the eurozone's financial infrastructure and processes was the sovereign-bank nexus, the dominant financial relationship between domestic commercial banks and their sovereigns. The nexus is grounded in two major phenomena.

First, as hinted at above, regulatory frameworks privilege sovereign debt over others, granting zero capital requirements. Commercial banks are assumed to otherwise practice their due diligence in assessing and covering the risks of their assets and investments, and thusly regulated. Similar levels of scrutiny are wholly absent in the sovereign-banking nexus. That is, where regulators require commercial banks to mitigate their risks, purchases of sovereign bonds carry no such requirements. As the 2015 ESRB report noted, regulators in the EU as elsewhere routinely categorise government bonds as high-quality and highly liquid assets. This zero-risk assumption flies in the face of years of historic examples, analysis, theory, and best practices in financial risk management—effectively a loophole for sovereigns in the regulatory treatment of debt.

Second, while foreign lenders and credit rating agencies may reject sovereign debt holdings based on their own risk assessments, research has shown that domestic banks have a sovereign debt home bias. While partly the perception of domestic banks and their sovereigns as ‘natural allies,’ analysis published by the Centre for Economic Policy Research, for example, points to other voluntary and involuntary choices (Note 3). These can be driven by the regulatory advantages described above, on the one hand, or government pressure on domestic banks to hold sovereign debt, on the other, among others.

As a 2017 Bloomberg article succinctly described, these two phenomena are both part of the sovereign debt doom loop, "whereby weak banks can destabilise governments that support them and over-indebted governments can push banks holding their bonds over the precipice (Note 4)." Despite the evidence of its critical role in the European debt crisis, the sovereign-bank nexus has yet to be sufficiently challenged at either national or EU levels. In fact, according to a recent brief published by the Economic Governance Support Unit (EGOV) of the European Parliament, commercial banks throughout the European Union and the European Economic Area continue to hold significant ratios of domestic sovereign debt (Note 5). While the report acknowledges the ideal that this represents—an ideal in which sovereign debt is truly safe and highly liquid—the reality, according to the report's authors, is that inattentiveness to these ratios can also result in costly bank bailouts, vulnerability to rating downgrades, and overall financial economic instability.

As economists and policymakers have increasingly (and critically) noted, the debt-driven ties that exist between sovereigns and their domestic banks have been shown to make sovereigns uniquely vulnerable to financial crises and—in the case of the European Union—deeply threatening to a stable monetary union. However, whether due to regulatory privilege or home bias, sovereigns and their domestic banks have seen little incentive to change. Regulatory reform proposals that include cross-border asset pooling and tranching of government debt securities—and that continue to promote those debts as ‘low-risk and high-rated assets’—may not foster efforts to stimulate higher levels of cross-border investment by banks.

Here is where the Euro Zone Basket (EZB) aims to offer a solution.

The EZB method starts with the acknowledgement that any approach that increases regulatory complexity or imposes inflexible limits—especially for the most-likely-affected sovereigns and their domestic banks—would face resistance from private players and contribute to the political pressures and instability results previously described. In the case of proposals that include pooling or tranching, for example, anything that requires commercial banks to commit to risks not of their own choosing (e.g., by being offered sovereign debt assets ‘en bloc’ only) may be perceived as threats to their independence. That is, the regulatory path ahead must be illuminated by a commitment to simplicity, transparency, and cooperation.

The EZB offers a far simpler approach. It is a straight-forward mathematical formula to reduce the privilege of/bias for domestic sovereign debt by requiring appropriate, grade-rated capital provisions for domestically concentrated sovereign debt holdings (based on a rating-grade-based calculation akin to the Basel II internal ratings-based (IRB) formula). Simultaneously, it reduces capital provision requirements on foreign sovereign debt holdings—again, compared to risk-based capital requirement computation. Thereby the EZB stimulates interest in cross-border sovereign debt investment by commercial banks and hence leads to more diversified sovereign debt portfolios and better-integrated European capital markets.

Best, the EZB method does not require the formation of another EU agency, does not prescribe asset portfolios, nor does it overestimate the willingness of sovereigns to institute limitations for themselves. Not only is it manageable, it truly supports the ideals of a functioning and fully integrated monetary union.

National central banks (NCBs) each have shares in the European Central Bank (ECB). These are weighted equally by the EU member state's share of the EU's gross domestic product (GDP) and total population. The country's share—its capital key—is expressed by a percentage that is adjusted every five years and with the entry of every new country into the Union.

For the purposes of the EZB calculation, the member state is i and its capital key is CK_i and it would determine what percentage of a bank's total sovereign bonds would be permissible without requiring capital provisions. This capitalisation-free amount is expressed in the EZB calculation as a sum (s_i).

Of course, any commercial bank remains free to determine for itself what its total position of sovereign debt is, with respect to corresponding supervisory bodies. It is that total amount (expressed as S in the EZB calculation) from which the capitalisation-free amount would be calculated.

That is, a capitalisation-free sum (s_i) equals the bank's total available sovereign debt sum (S) multiplied by the capital key percentage (CK_i) or

s_i = S * CK_i

Any commercial bank that wishes to hold an excess of sovereign bonds—that is, any sovereign debt, domestic or foreign, above the corresponding, capital-key-determined amount available for that country—would require capital provision corresponding to standard formulas for associated risk weights, such as those provided by the Bank for International Settlements (i.e., as per the Basel II IRB formulae).

That is, what is to be capitalised (c_i) equals the larger amount of total sovereign debt of country i (a_i) less the capitalisation-free sum (s_i), or

c_i = a_i - s_i

There are, of course, some caveats. One, this would apply only to those sovereign debts that have investment grade ratings. Where this is not the case, those sovereign debts would be subject to appropriate risk-based capitalisation requirements regardless of whether concentrated or not in the portfolio of any commercial bank. Secondly, limitations on capitalisation-free (s_i) and capitalised (c_i) concentrations of sovereign debt may also have to be applied.

The sovereign-bank nexus—which has been supported by this regulatory privilege in risk assessment and a sovereign debt home bias—contributed mightily to the European debt crisis and subsequent political instability throughout the European Union. Economic and political experts have increasingly agreed that the doom loop of crises between weak banks and over-indebted governments can only be broken by regulatory reform that appropriately assesses sovereign debt risks and directly challenges the sovereign-bank home bias by incentivising cross-border sovereign debt holdings by banks.

Unlike pooling, tranching, and other reform proposals, the proposal of a Euro Zone Basket (EZB) avoids the tendency toward institutional complexity by embracing conceptual consistency and mathematical simplicity. By leveraging the capital keys of the European Central Bank, regulators can use the EZB's simple, transparent, and fair formula for calculating a capitalisation-free sum that any commercial bank can hold of a sovereign debt and reinsert standard risk assessment and capital requirements for additional holdings. Moreover, the EZB offers a model for financial reform that is also reflected in the ideals of the European Union itself—encouraging investment and cooperation for the mutual benefit of all its member states.

Originally published as a chapter in Towards a More Resilient Euro Area: Ideas from the ‘Future Europe’ forum (2018). The ebook is freely available to the public at https://www.ceps.eu/publications/towards-more-resilient-euro-area. Excerpted with permission of the authors.