Europe is back on track. The economic recovery is robust. Growth is higher than it has been for a decade. But we cannot be complacent. While the single currency has been successful, the framework has flaws. Monetary union remains incomplete.
Europe does not yet have a truly common market for banking services, making it vulnerable to economic shocks. When they hit, financial markets fragment along national lines. Shocks therefore get amplified by local fragilities, rather than mitigated by a broad-shouldered common market in which private investors share risks.
One source of shock amplification is that banks tend to hold domestic government bonds in excess. This home bias ties the stability of banks to the fortunes of governments — and vice versa.
More than five years ago governments committed to cutting this Gordian knot, which was responsible for worsening the financial crisis from which Europe is still recovering. But progress has been limited. New ideas are needed to move Europe forward.
Over the past 18 months I have chaired a task force of the European Systemic Risk Board. We have explored a promising way to cut the knot by creating a new type of asset: sovereign bond-backed securities. They would repackage bundles of national sovereign bonds into securities with different levels of risk. These securities would benefit from cross-country diversification. Moreover, the senior component would be protected by the more junior securities, which stand first in line to absorb losses. These riskier securities would be held by non-bank investors eager for higher return. All of this is achieved by simple contract design, not alchemy.
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Creating these securities would not require countries to share fiscal risks. Each government would remain responsible for servicing its debt. Instead, the securities would facilitate private and voluntary risk-sharing, enhancing the efficiency of financial markets.
To see how it works, imagine you’re a merchant wanting to stock the best young wines. The provincial approach would be to deal with your nearest vineyard. But the local weather sometimes disappoints. You would do better by asking vineyards from different areas to club together and provide you with their best wines. Your customers will be well served, regardless of local weather.
Banks are like your wine shop. At present, they buy the local stuff. But they would serve their customers better by obtaining the new securities, which protect banks against local disappointments. At the same time, governments — like vineyards — maintain their independence.
Today, the task force publishes its feasibility study. The two-volume, 300-page report provides a technical foundation for an informed public debate. The core finding is that the securities do not yet exist because regulation would treat them more harshly than government debt. To get the market started, regulators need to acknowledge that the senior security would be at least as safe as low-risk government debt, and treat it accordingly. At the same time, regulation of the junior securities should reflect their greater risk. With this in mind, the European Commission is considering a proposal to remove existing regulatory barriers.
Going further, it is clear that demand for the senior securities would be enhanced by more extensive reforms that encourage banks to adjust their holdings of government debt. Still, opinions differ on whether such reforms are needed for success.
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After the necessary regulatory adjustments, investor demand could lead to the gradual development of a deep and liquid market. The senior security could become a benchmark low-risk asset, which the euro area as a whole currently lacks.
Banks could be then be safer and capital markets more efficient. This would support long-term growth without weakening market discipline or moving towards fiscal risk-sharing. They are a pragmatic step forward, helping Europe to tap its unfulfilled potential. After all, Europe has strong fundamentals — and world-class wines.