Opinion

The ECB is compromising the attractiveness of euro-area sovereign bonds

The ECB should refine its collateral framework in order to continue protecting its balance sheet without putting at risk the safe-asset status of sovereign bonds of the euro area.

By: and Date: August 29, 2018 Topic: Finance & Financial Regulation

This op-ed was also published by:

público logo

The decision of the ECB to revoke, upon the conclusion of Greece’s EU financial aid programme on August 20th, the waiver that allowed Greek bonds to be accepted as collateral in the ECB’s refinancing operations – despite the bonds’ low rating – is bringing the institution’s collateral framework back into the spotlight.

Indeed, while sound public finances are a prerequisite for sovereign bonds to be considered safe, the central bank’s power to decide whether or not to accept an asset as collateral in its refinancing operations, and how to value it, gives the bank a crucial role in defining the safety of an asset.

In these monetary operations, haircuts – i.e. the difference between the market value of an asset, and the value ascribed to that asset when used as collateral – are vital in forging financial markets’ perceptions of the safety of a debt security. Indeed, haircut levels determine whether financial institutions will be able to exchange these assets easily and almost at par against the ultimate safe asset: money issued by the central bank.

Currently, eligibility and haircuts applied by the ECB in its refinancing operations depend on four elements: the type of asset, the type of issuer, the residual maturity of the asset, and the rating of the issuer of the asset.

This means that the current approach relies heavily on the ratings made by private credit rating agencies. In fact, to determine its own rating of a particular sovereign bond, the ECB takes the best rating out of four accepted credit rating agencies (Moody’s, Fitch, S&P and DBRS) and then maps it to the three “credit quality steps” of the ECB rating scale.

This is clearly dangerous for two reasons. First, relying on pro-cyclical ratings from external credit rating agencies can lead to abrupt swings in haircuts. Before the crisis, this approach resulted in applying the same haircut to every euro-area sovereign bond with the same maturity, signalling to markets that all bonds were of the same quality. During the crisis – and despite the ECB’s adjustments to its collateral framework – the quick downgrades of some sovereigns led to significant changes in applied haircuts. That is why haircuts on one-year Portuguese bonds increased from 1.5% to 6.5% in 2011, thus reducing their attractiveness for investors in the midst of the European sovereign debt crisis.

Second, differences in haircuts between the different ECB credit quality steps are not gradual enough to adequately reflect the different increases in risk levels. For instance, the current haircut for a sovereign bond with a residual maturity of one-year rated A-minus is equal to 1%, while it is 7% for a similar bond rated BBB+, just one grade below (in the S&P and Fitch scale). This is what happened to Italian bonds in February 2017.

It is important for the ECB to properly value haircuts, in order to protect its balance sheet and to avoid providing bad incentives for governments as well as for financial institutions holding these assets. However, the current valuation method is inadequate, as it leads to large changes in haircuts that could influence, among other things, the way financial institutions perceive the safety of these assets.

If it is not fully satisfactory to use ratings from credit rating agencies in central banks’ collateral framework, what else can be done? A first possibility would be for the ECB to use its own criteria to value haircuts, as the Bank of England (BoE) and many other central banks do around the world. That being said, given the multi-country nature of the euro area and the potential distributional consequences that significant ECB losses could induce between countries – through a reduction of future profits distributed to member states or even higher inflation – the ECB is in a much more complex situation than a central bank like the BoE, which only has to deal with one treasury.

In this context, to avoid the risk of the ECB appearing politicised (as in February 2015 when it decided to withdraw the waiver that was making Greek bonds eligible as collateral despite their low rating), it might be preferable for the ECB to still rely on an external risk assessment. In that case, a possible alternative to private ratings could be the use of a debt sustainability analysis that would be done, for instance, by the European Stability Mechanism (ESM).

This situation would not be perfect either, as it could lead to heated political debates between countries at the ESM. Nonetheless, it would still be better than delegating these decisions to private rating agencies, which cannot be held accountable for their potential mistakes and for the pro-cyclicality of their ratings. For lack of a better institution (e.g. a euro-area treasury, or any other form of executive body), and despite its flaws in terms of governance, the ESM board (formed by the finance ministers of the euro zone) is currently the only political executive body able to take this type of decision at the euro-area level.

Second, the ECB’s rating scale and the corresponding haircut valuation should be made more gradual. There are currently only three steps in the ECB scale (and the first two share the same haircut valuation), while there are 10 different grades a bond can receive from rating agencies that make it eligible as collateral. Having a more granular scale would make haircut changes smoother and provide better incentives to governments and financial participants.

Despite their fundamental differences, the comparison between the frameworks of the ECB and the BoE is enlightening. As the BoE explains, “haircuts are set so as to be broadly stable in the light of changing market conditions” in order to 1) provide the central bank “with adequate protection of its balance sheet”, but also 2) provide “greater certainty to counterparties”. Indeed, relying on its own criteria and not on external ratings allowed the BoE to keep haircuts applied to eligible sovereign bonds – including Italian and Portuguese bonds – stable in recent years, while the ECB mechanistically revised its haircuts when ratings were downgraded.

The institutional setup of the euro area is, in its essence, much more challenging than the relationship between the BoE and the UK government. However, it does not mean that the ECB framework cannot evolve to balance these two essential objectives better in order to continue protecting its balance sheet without putting at risk the safe-asset status of sovereign bonds of the euro area.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to communication@bruegel.org.

View comments
Read article More on this topic More by this author

Blog Post

Big Macs in big countries: an update on euro area adjustment

Have prices moved in the direction of correcting real exchange rate misalignments everywhere in the euro area in recent years? Not between the largest euro-area economies, i.e. France, Germany and Italy, says evidence from the Big Mac index. However, latest trends may be working in the right direction in these countries too.

By: Konstantinos Efstathiou Topic: Global Economics & Governance Date: September 20, 2018
Read article More on this topic

Blog Post

The economic case for an expenditure rule in Europe

Proposals for reforming the euro area back on the agenda. An overhaul of the European fiscal rules should be on high on this agenda, because the current fiscal framework has not worked well. This column proposes substituting the numerous and complex present rules with a new, simple rule focused on limiting annual growth rate of expenditures.

By: Zsolt Darvas, Philippe Martin and Xavier Ragot Topic: European Macroeconomics & Governance Date: September 13, 2018
Read article More on this topic More by this author

Opinion

Should central European EU members join the euro zone?

Eurozone membership (or the use of a fixed exchange rate) was not a factor determining economic success in Central Europe. There were both good and bad macroeconomic performances in both the flexible and the fixed exchange rate regimes of Central European countries. The implication is that Central European “outs” could be economically successful both with and without the euro, yet the EU is not only about economic benefits.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: September 11, 2018
Read article More on this topic

Blog Post

The higher yield on Italian government securities could soon be a burden for the real economy

The increase in the spread between Italian (BTP) and German (Bund) government securities is directly an additional burden for Italy public finance, and thus for tax payers. But it could soon also become a burden for the real economy, as the increased yield on Italian government securities could pull up the cost of bank loans for Italian firms, thus imparting a deflationary impact onto the economy.

By: Francesco Papadia and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: September 10, 2018
Read article Download PDF More on this topic More by this author

Policy Contribution

High public debt in euro-area countries: comparing Belgium and Italy

This Policy Contribution looks at the evolution of public debt in Belgium and Italy since 1990 and uses the debt dynamics equation to explain the contrasting evolution in the two countries in the run-up to the introduction of the euro, during the early years of the euro and since the beginning of the crisis, arguing that the euro could have been used also by Italy to undertake sufficiently large fiscal adjustment.

By: André Sapir Topic: European Macroeconomics & Governance Date: September 6, 2018
Read article More on this topic More by this author

Opinion

Overcoming the hurdles to Italian Growth

Is the time for refining recommendations and for a serious political debate on how best to overcome bottlenecks and improve the economic prospects of Italians.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: September 4, 2018
Read article More on this topic More by this author

Blog Post

Fighting fear with factfulness – and engagement

Margrethe Vestager, European Commissioner for Competition, delivered the keynote speech at Bruegel's Annual Dinner 2018, held on 3 September 2018.

By: Margrethe Vestager Topic: European Macroeconomics & Governance Date: September 3, 2018
Read article Download PDF More on this topic

Policy Contribution

Should we care about central bank profits?

The authors investigate the ECB’s profit-making activity of the last 20 years, assessing how this was achieved and the reasons why we should care more broadly about central banks generating profits.

By: Francesco Chiacchio, Grégory Claeys and Francesco Papadia Topic: European Macroeconomics & Governance Date: August 30, 2018
Read article More on this topic More by this author

Blog Post

Criteria for entry into the ERMII and the banking union: the precedent from Bulgaria

In its bid to join the single currency Bulgaria has made commitments on financial supervision but also wider structural reform which set a precedent for future applicants for participation in the exchange rate mechanism ERMII. Most conditions, though not all, are justified by the additional demands of the banking union. But the envisaged timeline seems ambitious, and verification will not be straightforward.

By: Alexander Lehmann Topic: European Macroeconomics & Governance Date: August 29, 2018
Read article More on this topic

Opinion

Integrity of official statistics under threat

Andreas Georgiou has unwittingly become an international icon for statistical integrity. His continuing politically-motivated persecution is highly damaging for Greece, and more broadly for the credibility and reputation of the euro area.

By: Edwin M. Truman and Nicolas Véron Topic: European Macroeconomics & Governance Date: August 10, 2018
Read article More on this topic More by this author

Opinion

Griechenland braucht einen Neuanfang

This was first published by Die Zeit. Acht Jahre nach Beginn des ersten Hilfsprogramms für Griechenland ist es soweit – Griechenland soll wieder auf eigenen Füßen stehen. Die Eurogruppe soll heute das Ende des dritten Hilfsprogramms beschließen und die Modalitäten für die Zeit danach definieren. Ziel sollte es jetzt sein, einen tragfähigen Ausstieg aus dieser für alle Seiten […]

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 3, 2018
Read article More on this topic More by this author

Blog Post

The European Union must defend Andreas Georgiou

Andreas Georgiou’s case raises disturbing questions about the integrity of European statistical processes. Forceful action by EU authorities on Mr Georgiou’s case is long overdue. The European Union also needs to consider reforming its statistical framework to ensure a similar scandal cannot recur.

By: Nicolas Véron Topic: European Macroeconomics & Governance Date: June 26, 2018
Load more posts