Markets Insight
November 23, 2011 11:42 am
Time for sovereigns to swallow their medicine
In Europe we are transfixed by the sight of bond spreads above the German Bund. Just as structured investment products such as collateralised debt obligations were tainted post-Lehman, so too is sovereign debt. There are other parallels too – just as regulatory reliance on ratings contributed to sleeping on the job over complex products, so too have regulatory exemptions and zero risk weightings removed the brakes from the sovereign debt wagon.
On markets and banks, the constant refrain of European Union legislators is that “things cannot go on as before” and the European Commission boasts 29 measures on financial services in its work programme. Some of the same medicine needs to be applied to sovereign debt.
“Business as usual” for sovereign debt in financial legislation is no longer acceptable. The cosy and dangerous interconnection between banks and sovereigns has not stood us in good stead in this crisis. Balancing budgets and better economic governance are necessary but not sufficient.
We already have two opportunities before us to start this fix, but governments are nervous and want to stop changes. This is foolish on two counts. First, it is not a helpful signal to the markets. As Mario Draghi, governor of the European Central Bank, has reminded us, it takes longer to regain confidence than to lose it. Second, the legislation now before us has implementation dates stretching towards the end of the decade. So is that how long governments intend to keep it swept under the carpet?
What are these fixes? One is the abandonment of the zero risk weight currently allocated to all sovereign debt for all eurozone members. It has already been noted that such zero risk is a fallacy, even for the US as it risks further downgrades if it does not get its debt under control. Just as triple A structured products led investors up the garden path, so too has zero risk. The foolishness of having Greek and German debt treated similarly just because they are both in euros needs little explanation.
The European Parliament has already voted several times to address this problem, while recognising phasing-in would need care. It would be inconsistent with both the zeal for reforming the private sector and for better governance if there is no signal of change about zero risk weighting.
Less obvious, but more recently noticed, is the legislation on derivatives. The European Markets Infrastructure Regulation is the instrument that brings in the G20 agreement for central clearing and reporting of over-the-counter derivatives. This business created a complex web of interconnectedness about which little was known. So centralised clearing to get a handle on risk and centralised reporting to get an understanding of the big picture is the solution we all signed up to.
The draft Emir regulation gave central banks a complete exemption. This is a standard type of exemption that gets slipped in to all kinds of legislation so that central bank dealings can remain mysterious, and claim zero risk, but it deserves close attention.
Sovereign countries conduct substantial derivative operations including exchange rate and interest rate swaps. There is some logic in exempting central banks from clearing: having them in a default fund of the clearing houses does not look like a good idea, as this poses contagion risks to central banks in the event of a major default.
Sovereign derivative dealings, however, have banks on the other side and some astonishing numbers have come to light from the bank stress tests. In December 2010, derivative exposures to EU banks of the German and Italian sovereigns were each over €5bn. It is clear sovereigns play a large part in the big picture that reporting aims to capture, so their exemption does not seem at all sensible.
Further, these are all OTC contracts and, with a full sovereign exemption from regulation, they would not be required to post collateral with banks. Are we sure that the sovereigns are all so safe as to make this reasonable? Portugal and Ireland are now posting collateral, and if we want to extricate our banks and sovereigns from their unhealthy, systemic relationship this should be the norm. Ironically, it might also be cheaper because banks pass on in fees the extra costs they must bear from a non-collateralised deal. The point is: collateralisation addresses systemic risk in a way that fees do not.
The European Parliament already envisages addressing these systemic effects: it intends to limit the exemption of sovereigns to central clearing only, still requiring reporting and collateralisation. Such is the fear of greater transparency that objections are already coming in from European countries and elsewhere.
But governments must recognise that they have broken sovereign bond markets through excessive debt. As with banks, saying sorry and promising better behaviour is not enough.
.
Sharon Bowles is chair of the European Parliament’s Economic and Monetary Affairs committee
.
Copyright The Financial Times Limited 2011.
0 comments:
Publicar un comentario