Quite a lot of people (including ftalphaville in numerous occasions) have pointed out lately that the Euro crisis is largely a loss of confidence on periphery ‘safe assets’ (safe assets defined as per Gorton 2012). That is something i ‘ve already tried to touch as well in an earlier post.

The loss of safe asset status for an asset class (such as long-term Spanish sovereign debt) has a number of (well known by now) consequences:

  • Local banks usually carry a large portfolio of such assets in their balance sheets, especially compared to their capital base. As a result, their credit status/rating is lowered and their access to sufficient and cheap international funding impaired.
  • The loss is associated with larger haircuts and/or drop in price for the corresponding debt instruments. Consequently, secured loans made with these assets as collateral face large margin calls and the credit multiplier is lowered (since rehypothecation is reduced due to large haircuts). In general, interbank credit volumes face immediate and strong declines.

The approach taken by the ECB to cope with this problem so far has been mainly to provide long-term liquidity, with the central bank reserves performing the function of safe assets. Collateral rules in the 3Y-LTROs have been relaxed considerably, allowing banks to post average quality credit claims (non-securitized loans) in order to obtain funds. This has the significant advantage that, since credit claims are not assets traded in a secondary market, no daily mark-to-market valuation is performed and liquidity provided is kept stable with no price shocks reinforcing the liquidity issue (through margin calls). Still, (1) the ECB takes the role of ‘market maker’, (2) since unsecured lending is limited in the current environment bank reserves are not rehypothecated (reducing the interbank credit multiplier and forcing a large ECB balance sheet expansion to compensate for it) and (3) unsecured bank debt holders are effectively subordinated by the central bank increasing its holdings of European bank assets.

During the 2008 financial crisis, the Fed implemented the Term Securities Lending Facility as a way to ‘upgrade’ assets pledged by credit institutions and keep interbank markets functioning. The general idea was that banks would post low quality paper as collateral and receive high quality (US Treasuries) assets as a short-term loan which they could use in the interbank repo market. As a result, the Fed managed to keep the repo market going, avoiding further drops in loan activity as well as remove a large part of low quality collateral from the active market (by taking it temporarily on its balance sheet).

Since 2010, the ECB has created a large (around €200bn) SMP portfolio of sovereign debt. Unfortunately, the Greek PSI experience showed that it considers its holdings as senior to other bondholders which makes any future purchases more of an exit strategy for existing bondholders, than a stabilizing mechanism. I ‘d like to propose a way for the ECB to take advantage of the fact that its portfolio is considered ‘safe’ (although consisting of periphery sovereign debt) while supporting the Euro repo market.

Debt Certificate

The ECB should create a ‘short-term debt certificate’ (stdc) backed by the face value of the SMP portfolio. The debt certificate should have a low maturity of  one month and pay an annualized interest rate equal to the ECB deposit rate. One of the reasons for keeping the maturity short is for the ECB to avoid disclosing the details of its holdings (something that it seems to be reluctant to do).

The other reason is that the proposed loan will have a tenor of one month. Banks would provide sovereign debt securities of the same type as the ones held in the SMP portfolio as collateral on a monthly debt certificate auction with a maximum size equal to the available amount of debt certificates. The auction would determine the interest rate paid by all banks to the ECB for holding the stdc (it is probably better for banks to be able to place multiple bids). Risk management by the ECB would be the same as always, with daily mark-to-market valuation of posted collateral and margin calls if needed. Settlement of the loan will be done before the debt certificate so that, as long as there is no default on the loan, the certificates do not mature in the hands of the public.

As the semi-annual European repo survey shows, roughly 50% of total repo activity is concentrated in maturities up to one month. I think it is quite reasonable to assume that troubled banks face even shorter tenors and mainly borrow overnight or weekly. As a result, the stdc would provide a handy ‘risk-free’ instrument to use in the majority of repo trades, lowering volatility, haircuts and ECB market making. An expansion of the SMP portfolio would become a stabilizing factor since it would allow for even more safe lending in the repo markets while also moving risky assets in the ECB balance sheet.

In case of a bank default, the ECB would end up with sovereign debt while the bank repo counterparty with the stdc. On maturity (of the stdc) the ECB would credit the holder with an equal amount of bank reserves and would place the sovereign securities in its SMP portfolio, making the default functionally equivalent to an expansion of the SMP.

Given that a bank always has the alternative of using the ECB refinancing operations to acquire funds, the ECB MRO rate should act as a maximum rate in the debt certificate auctions (technically the MRO – Eurepo GC rate). The debt certificate facility should lower (or even eliminate) periphery liquidity premium spreads since any sovereign debt instrument can be posted to the ECB auction. On the other hand, the facility cannot be of real help for credit spreads and sovereign solvency.

SMP management

Another (a bit more far fetched) proposal is for the ECB to start managing its SMP portfolio in the same manner as the SOMA account of the Fed. In other words it should consider its holdings permanent and be allowed to bid with non-competitive bids on sovereign debt auctions (of the same issuer as maturing securities) in order to be able to maintain its portfolio size. That would immediately make the SMP a stabilizing factor since on maturity the ECB would not expect to get paid but would rather rollover its holdings. The fact that something like that would probably be considered as monetary financing is a limiting factor for acceptance.

Since we are on the subject of ‘science fiction’, another proposal is for the ECB to immediately remit all profits produced by its SMP holdings (interest paid by securities held minus cost of SMP weekly term deposits) to the corresponding countries Treasury accounts. Depending on institutional arrangements, this could happen quarterly or annualy and peg the cost of SMP for sovereigns to the average of the ECB SMP term deposits rate.

Advertisements