ECB could fix euro zone flaw with risk-free bond: think tank

ECB could fix euro zone flaw with risk-free bond: think tank
The new European Central Bank (ECB) headquarters are pictured behind partially dismantled Sudfass brothel club in Frankfurt, November 22, 2014.

LONDON - 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.

The two professors say the need for the ECB to pump money into the euro zone economy could be an opportunity for the market itself to create a euro bond - which the ECB would then buy - that does not lead to debt mutualization.

"The ECB would merely announce the features of the synthetic bonds it will purchase," they write in a policy proposal.

Regulations would have to be changed to turn the special bond into a zero-risk asset by forcing banks to set aside cash for holding bonds as currently issued by individual countries, while not requiring any provision for holding the new product.

The new bond would include debt issued by euro zone members in proportion to the size of their economies and the ECB would buy only its senior tranches.

The ECB has looked at similar instruments before and they could still feature in future policy, sources with knowledge of ECB thinking said.

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