The ECB is compromising the attractiveness of euro-area sovereign bonds

The decision of the ECB to revoke, upon the conclusion of Greece’s EU financial aid programme on August 20th, the waiver that allowed Greek bonds to be accepted as collateral in the ECB’s refinancing operations – despite the bonds’ low rating – is bringing the institution’s collateral framework back into the spotlight.

Indeed, while sound public finances are a prerequisite for sovereign bonds to be considered safe, the central bank’s power to decide whether or not to accept an asset as collateral in its refinancing operations, and how to value it, gives the bank a crucial role in defining the safety of an asset.

In these monetary operations, haircuts – i.e. the difference between the market value of an asset, and the value ascribed to that asset when used as collateral – are vital in forging financial markets’ perceptions of the safety of a debt security. Indeed, haircut levels determine whether financial institutions will be able to exchange these assets easily and almost at par against the ultimate safe asset: money issued by the central bank.

Currently, eligibility and haircuts applied by the ECB in its refinancing operations depend on four elements: the type of asset, the type of issuer, the residual maturity of the asset, and the rating of the issuer of the asset.

This means that the current approach relies heavily on the ratings made by private credit rating agencies. In fact, to determine its own rating of a particular sovereign bond, the ECB takes the best rating out of four accepted credit rating agencies (Moody’s, Fitch, S&P and DBRS) and then maps it to the three “credit quality steps” of the ECB rating scale.

This is clearly dangerous for two reasons. First, relying on pro-cyclical ratings from external credit rating agencies can lead to abrupt swings in haircuts. Before the crisis, this approach resulted in applying the same haircut to every euro-area sovereign bond with the same maturity, signalling to markets that all bonds were of the same quality. During the crisis – and despite the ECB’s adjustments to its collateral framework – the quick downgrades of some sovereigns led to significant changes in applied haircuts. That is why haircuts on one-year Portuguese bonds increased from 1.5% to 6.5% in 2011, thus reducing their attractiveness for investors in the midst of the European sovereign debt crisis.

Second, differences in haircuts between the different ECB credit quality steps are not gradual enough to adequately reflect the different increases in risk levels. For instance, the current haircut for a sovereign bond with a residual maturity of one-year rated A-minus is equal to 1%, while it is 7% for a similar bond rated BBB+, just one grade below (in the S&P and Fitch scale). This is what happened to Italian bonds in February 2017.

It is important for the ECB to properly value haircuts, in order to protect its balance sheet and to avoid providing bad incentives for governments as well as for financial institutions holding these assets. However, the current valuation method is inadequate, as it leads to large changes in haircuts that could influence, among other things, the way financial institutions perceive the safety of these assets.

If it is not fully satisfactory to use ratings from credit rating agencies in central banks’ collateral framework, what else can be done? A first possibility would be for the ECB to use its own criteria to value haircuts, as the Bank of England (BoE) and many other central banks do around the world. That being said, given the multi-country nature of the euro area and the potential distributional consequences that significant ECB losses could induce between countries – through a reduction of future profits distributed to member states or even higher inflation – the ECB is in a much more complex situation than a central bank like the BoE, which only has to deal with one treasury.

In this context, to avoid the risk of the ECB appearing politicised (as in February 2015 when it decided to withdraw the waiver that was making Greek bonds eligible as collateral despite their low rating), it might be preferable for the ECB to still rely on an external risk assessment. In that case, a possible alternative to private ratings could be the use of a debt sustainability analysis that would be done, for instance, by the European Stability Mechanism (ESM).

This situation would not be perfect either, as it could lead to heated political debates between countries at the ESM. Nonetheless, it would still be better than delegating these decisions to private rating agencies, which cannot be held accountable for their potential mistakes and for the pro-cyclicality of their ratings. For lack of a better institution (e.g. a euro-area treasury, or any other form of executive body), and despite its flaws in terms of governance, the ESM board (formed by the finance ministers of the euro zone) is currently the only political executive body able to take this type of decision at the euro-area level.

Second, the ECB’s rating scale and the corresponding haircut valuation should be made more gradual. There are currently only three steps in the ECB scale (and the first two share the same haircut valuation), while there are 10 different grades a bond can receive from rating agencies that make it eligible as collateral. Having a more granular scale would make haircut changes smoother and provide better incentives to governments and financial participants.

Despite their fundamental differences, the comparison between the frameworks of the ECB and the BoE is enlightening. As the BoE explains, “haircuts are set so as to be broadly stable in the light of changing market conditions” in order to 1) provide the central bank “with adequate protection of its balance sheet”, but also 2) provide “greater certainty to counterparties”. Indeed, relying on its own criteria and not on external ratings allowed the BoE to keep haircuts applied to eligible sovereign bonds – including Italian and Portuguese bonds – stable in recent years, while the ECB mechanistically revised its haircuts when ratings were downgraded.

The institutional setup of the euro area is, in its essence, much more challenging than the relationship between the BoE and the UK government. However, it does not mean that the ECB framework cannot evolve to balance these two essential objectives better in order to continue protecting its balance sheet without putting at risk the safe-asset status of sovereign bonds of the euro area.