The European Commission has published a proposed Regulation designed to facilitate the development of an EU market for securities backed by the sovereign bonds of the Eurozone Member States. If adopted, the proposal would mean, in particular, that so called Sovereign Bond-Backed Securities, or “SBBSs” would no longer be subject to securitisation-specific regulatory charges.
The Commission sees SBBSs as a potential solution to two significant problems in the EU’s banking sector, namely, the need to resolve the “doom loop” and the lack of euro-area safe assets.
The Doom Loop
Banks have a tendency to concentrate their sovereign bond portfolios in their own sovereign. Consequently, an increase in the risk of bank insolvency raises the risk of government default, which further damages the banking sector and so on, creating the so-called doom loop. According to the Commission, SBBSs would help break the doom loop by encouraging banks to diversify exposures to all euro-zone issued bonds thus weakening the link between euro-area sovereigns and their domestic banks.
The supply of high-rated euro-denominated sovereign bonds, which act as “safe assets” in the financial system, has declined in recent years. This is despite an increase in overall public debt and an increased demand for such products on the part of banks and other financial institutions, partially because of new regulatory requirements. In the Commission’s view, SBBSs could help increase the supply of euro-area safe assets, by providing the possibility for pooling and tranching. However, SBBSs do not involve any mutualisation of risks and losses among Member States as these do not mutually guarantee their respective liabilities within the portfolio of sovereign bonds underlying SBBSs.
Overview of the proposed Regulation
The Commission published the proposal towards the end of May 2018. Among other things, it provides:
- the underlying portfolio of an SBBS must be composed of sovereign bonds of all EU Member States whose currency is the euro. The relative weight of each Member State’s sovereign bonds should be very close to the relative weight of the respective Member State’s participation in the ECB capital key;
- SBBSs tranches that are part of the same issue must have a single original maturity date;
- an SBBS should be composed of a senior tranche corresponding to 70 per cent of the nominal value of the SBBS issue and one or more subordinated tranches, which provide protection to the senior tranche;
- an SBBS can only be issued by a special purpose entity (“SPE”) that is exclusively devoted to the issuance and management of SBBSs and that does not undertake any other activities, other than holding qualifying sovereign bonds, such as providing credit;
- an SPE must notify ESMA if a product complies with the SSBS product requirements and the notifying SPE is liable for any loss or damage resulting from incorrect or misleading notifications;
- investors may place appropriate reliance on the SBBSs notification and the information disclosed by SPEs concerning compliance with specific SBBSs product requirement. However, they must still perform appropriate due diligence.
The proposed Regulation also modifies the UCITS Directive, the Solvency II Directive and the Capital Requirements Regulation in order to ensure that SBBSs receive a regulatory treatment equivalent to their underlying assets.
The proposed Regulation is proving to be politically controversial. On the one hand, its proponents claim that treating SBBSs in the same way as euro-area sovereign bonds denominated in euro would remove regulatory barriers to the gradual emergence of an SBBS market, thus helping to break the doom loop and increasing the supply of euro-safe assets.
On the other, its opponents doubt that the proposal would realise its objectives and claim that it is a distraction from what should be the real goal, namely making all euro-area sovereign bonds safe again. In addition, some of the richer Member States are opposed to the proposal on the basis that it would mean that they would be required to support some of the more indebted Member States.
Significantly, the French German roadmap for the Euro Area, published on 19 June 2018 states that the proposal “has significantly more disadvantages than potential benefits and should not be pursued”.
The Commission is seeking feedback on its proposal until 24 August 2018 (here).