Think Tank: ECB Could Fix EZ Flaw with Risk-Free Bond

As the European Central Bank comes closer to buying sovereign bonds, one London-based think tank says an opportunity has arisen to fix one of the euro zone’s birth defects — the absence of a credible “risk-free” asset.  Regulators deem domestic sovereign bonds risk-free — so-called although no asset is entirely without risk — and push financial firms to buy them as a safety buffer, exempting them from a rule that requires setting aside capital for holding other assets.

However, when they assess how strong a bank needs to be, regulators consider both German bonds — the only state debt in the bloc rated triple-A by all three major agencies — and bonds issued by Greece, which defaulted two years ago, risk-free.  As a result, euro zone banks are loaded with low-rated government debt, creating a potential “doom loop”, in which troubles at a bank can drag in governments and vice-versa.

The most commonly discussed proposal for a new risk-free asset is a joint euro bond that transfers debt risk from weaker countries to stronger ones. However, that idea has faced resistance from the latter who fear they could end up on the hook for less prudent borrowers’ profligacy.  Luis Garicano and Lucrezia Reichlin at the Centre for Economic Policy Research have come up with an idea that they say counters that objection and breaks the toxic link between banks and sovereigns.


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