On 24 May 2018, the European Commission proposed new rules that will help further reduce risks in the EU banking sector and increase financial stability. The rules set out the criteria for sovereign bond-backed securities (SBBS), which are a new type of standardised financial instrument. They also clarify how these securities are to be treated, from a regulatory perspective. The proposal is expected to help banks diversify their balance sheets and further weaken the so-called bank-sovereign nexus. This is the two-way link whereby a country's rating deteriorates due to weak or failing banks – in turn weakening further the financial position of banks holding their own country's government bonds. This 'doom loop' between banks' financial positions and their home country's public finances was at play during the financial crisis. The proposal is also expected to help other financial institutions diversify their balance sheets.

New financial instrument

Sovereign bond-backed securities are a new financial instrument. They are claims – which investors can buy – on the proceeds of a portfolio of euro-area government bonds. These claims have a varying seniority: any losses would first hit subordinate tranches (in their order of subordination) and only after all the subordinate tranches have been wiped out, would they hit the senior tranche.

As these claims are backed by a diversified portfolio, their riskiness is tied to a pool of sovereign bonds, rather than the sovereign bonds of any one individual euro-area Member State. This means banks and other potential buyers can diversify their sovereign bond holdings.

Furthermore, these securities help facilitate risk-sharing among private-sector participants. This is because SBBS allow for a different way to 'splice' euro area sovereign risk, and for investors to choose one or the other tranche based on their risk-return preferences. As subordinate tranches are expected to be more risky, for example, they are also expected to carry a higher return.

These securities will be market-driven. The proposal does not require that public institutions launch such instruments. Furthermore, SBBS will not require mutualisation of debt among euro area Member States.  This is when a Member State (and its taxpayers) is liable for the unpaid obligations of another Member State.  Nor will sovereign bond-backed securities necessitate changing the regulatory treatment of sovereign bonds – for example, that banks are not required to hold capital to cover the risk of sovereign bonds losing value. This is unaffected by the proposed new rules.

The new rules lay down the criteria defining what can be labelled as a sovereign bond-backed security. Basically, the underlying portfolio must be a pool of government bonds from all euro area Member States, composed in line with the Member States' relative contribution to the capital of the European Central Bank (i.e., their weights in the ECB's so-called 'capital key'). The interest payments and the principal repayments from this portfolio must be assigned to at least two tranches – a senior one, with a size of 70%, and a sub-senior one for the remaining 30%. In particular the senior tranche will constitute a low-risk pan-European asset. The sub-senior tranche can be divided into multiple tranches if the entity issuing the securities deems it necessary. Finally, SBBS have to be issued in euro. This creates a product that should be appealing to potential investors, as it is standardised and transparent as well as liquid, i.e. it can easily be traded in the market.

Which rules apply?

From a regulatory perspective, under current rules sovereign bond-backed securities would be treated as securitisation products. This means they would be treated less favourably than the euro-area sovereign bonds that make up their underlying portfolio. But sovereign bond-backed securities are considerably less risky than traditional securitisation products. This is due in part to the nature of their underlying assets – which are tradeable and well-known euro-area sovereign bonds. It is also because the portfolio composition is pre-determined. This means that the issuers of these securities have limited leeway to structure the underlying portfolio to their own benefit – and to the detriment of uninformed investors (the so-called 'adverse selection' problem). So by treating these securities in the same way as euro-area sovereign bonds, this proposal should help eliminate regulatory obstacles to the development of a market for sovereign bond-backed securities.

The concept of sovereign bond-backed securities was originally put forward by a group of academics in a publication entitled ''ESBies: Safety in the Tranches''.  In 2016, the European Systemic Risk Board (ESRB) set up a high-level task force to carry out a feasibility study assessing the risks and benefits of these securities. The Commission's proposal builds to a large extent on the work of the task force and the report it produced. 

Now, the proposed rules need to be agreed by the European Parliament and Council before they become EU law.

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