ESBies no all-round antidote

Ever since the financial crisis, different options are being discussed as to how the emphatic governments-banks nexus in Euroland can be unravelled. This linkage is regarded as the main source of the risk that crises in the financial sector could potentially spill over onto government financing and the entire economy of a country and vice versa.

One idea for how to severe the linkage that arose in 2011 is now currently back in stronger focus: the European Safe Bonds (ESBies). These are structured bonds that can be floated by a private or a public issuer or even by a Special Purpose Vehicle (SPV). The issuer buys EMU government bonds in the secondary market according to a defined key and uses them to create an assets pool. The purchase is financed by issuing at least two different tranches of bonds: the “secure” senior paper (ESBies) and the “less secure” junior tranches (EJBies). The advocates of the ESBies hope that by means of the ESBies they can create a new segment of secure bonds that were hitherto limited mainly to Bunds. In order to help the ESBies establish themselves, banks will be incentivized to buy ESBies by a term that says the afore-mentioned bonds need not be covered by equity. On the other hand, the privilege of a risk weighting of in principle 0% for EMU government bonds would be eliminated.

The concern is that ESBies will presumably not fulfil the expectations that their champions associate with them. Firstly, it can be doubted whether ESBies would really be as safe as their inventors, Brunnermeier et al., assume in their working paper entitled “ESBies: Safety in the tranches”. Above all in times of crisis, when government bonds that have lower credit ratings feel the pressure, confidence in ESBies and their security pool could dwindle. Banks, in particular those in the core EMU member states, would thus presumably not consider ESBies as equal substitutes for Bunds. Moreover, the interest among south European banks in ESBies could also be limited if the costs of their own refinancing were to be higher than the yield on ESBies.

The fiscal incentivization ESBies trigger could likewise point in the wrong direction. If government bonds were to be purchased according to a fixed key for the pool for ESBies, in the long term the market would be stripped of its emphatic control function – a trend already discernible to a certain extent today in the framework of the PSPP at least for the duration of that programme. In our view, ESBies would therefore simply constitute another step in the direction of having government risks borne by the Euroland community. The assistance for countries that have poor credit ratings afforded by making more favourable refinancing available to them would then indirectly be bought at the cost of squeezing the countries that enjoy higher ratings. These adverse effects would thus fly in the face of incentives to initiate structural reforms and reduce debt.

ESBies are in the final instance one model among many that are geared to create a more pronounced pan-EMU responsibility for EMU-member-state refinancing in order to counteract the problems of heterogeneity and the fragmentation of the European government bond market. Most proposals cannot exclude the problem of the risk of the wrong political and fiscal incentives, meaning that the path via reforms and fiscal consolidation remains the most promising of all.

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