Europe Needs More Than a Bundle of Bonds
The European Commission has been thinking about ways to strengthen the euro zone, and is proposing a plan for a new “sovereign bond-backed security.” Give the commission credit for putting its finger on an important defect of the euro-zone system. Unfortunately, its remedy falls far short.
The defect is the so-called “doom loop” between governments and banks. Banks in Europe have preferred to buy bonds issued by their own national governments. As a result, alarm over government finances (typically caused by earlier overborrowing) can infect national banking systems. The new security takes aim at this dangerous concentration of risk by bundling sovereign bonds from different euro-zone countries into a single instrument. The idea is to encourage banks to diversify their bond holdings, so that a fiscal crisis won’t automatically turn into a banking crisis.
Crucially, however, the proposed new securities wouldn’t be jointly guaranteed by the euro-zone governments. That’s a step too far for members such as Germany: They’re reluctant to stand behind the borrowing of their less-fastidious partners. Without the joint guarantee, the new instrument is largely pointless. It wouldn’t help banks do anything they can’t already do. There’s currently nothing to stop them buying a portfolio of bonds issued by different governments. The new security would be no safer than a bundle structured the same way.
True, the regulatory system could be tilted to make the new bonds more appealing, but that isn’t part of the plan. The commission proposes to treat them as riskless for the purpose of calculating the capital that banks have to raise -- but ordinary sovereign bonds are already treated that way, so the bundle confers no advantage.
What if in future the bonds of some heavily indebted countries were treated as risky for capital-adequacy purposes, as indeed they should be? In that case, there’d be an incentive to buy the new, officially “safe” security -- but without the joint guarantee, that zero risk-weight for the bundle would be questionable, to put it mildly, because the new security would include bonds the regulators elsewhere deem risky.
The innovation would have symbolic value, always much prized in EU affairs. And it could serve as a prelude to deeper forms of integration. But the point is, those deeper forms of integration are what’s really needed. Without a fully fledged banking union and at least some elements of a fiscal union -- including jointly guaranteed euro-bonds -- the euro zone is bound to relapse into another crisis. One hopes the commission’s proposal is indeed a prelude, and not an excuse for going no further.
--Editors: Ferdinando Giugliano, Clive Crook
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