Peter Praet gave an interview to the Financial Times this morning where he made a very important point about sovereign debt holdings (full transcript without the paywall courtesy of the ECB here):
The worst case, to say it very bluntly, is of a central bank providing liquidity to banks just to buy or carry legacy assets, and the banking sector doesn’t restructure. This was typically the Japanese situation in the early 2000s.
Perhaps paradoxically, a rigorous AQR and stress test helps monetary policy. Appropriately treating banks’ holdings of sovereign debt according to the risk that they pose to banks’ capital makes it unlikely that the banks will use central bank liquidity to excessively increase their exposure to sovereign debt. This is because banks will be wary of the constraints placed on sovereign debt by the stress tests to which they are subject at the same time.
The ECB had expressed dissatisfaction about the fact that the previous round of LTRO had been used to buy sovereign bonds and offered banks with an easy carry trade which in turn contributed to increase financial fragmentation and the sovereign-banks nexus as banks hoarded domestic government bonds. This is now described as an unintended consequence that needs to be addressed. This was a critical point made by Jens Weidmann in a recent OpEd in the FT and it is also something that has been at the heart of discussions in the context of the AQR and the ESRB.
There are two very different problems here that should be distinguished:
The first is the increase in sovereign debt holdings in aggregate and this is hardly an unintended consequences, this was actually precisely the point of the LTRO. Get banks to hold assets because their liquidity risks were taken care of. The LTRO were designed both to stabilize sovereign debt markets and loosen monetary conditions, in that sense they have worked pretty well, driving government funding pressures and affected yields across the credit spectrum.
The second is the concentration of domestic debt, (ie. the renationalisation of debt holdings). This is the real unintended consequence. The ECB probably didn’t anticipated so much national hoarding. But this can easily be controlled by diversification/concentration caps on sovereign debt holdings. This is actually something the ECB could impose as a single supervisor, via the European Systemic Risk Board or in the context of the AQR but this is very different from imposing capital surcharges or haircuts on sovereign debt in repo operations.
It is critical that the ECB differentiates the problem of large holdings of sovereign debt (quite normal in high risk aversion environment) from high domestic concentration of sovereign debt holdings. These are two different issues. Confusing both will lead the ECB to:
- tighten monetary condition at the worse possible moment
- weaken the transmission channels via the refinancing operations of government debt
- destabilise government debt markets by exacerbating already challenging funding conditions for sovereigns
- weaken banks’ profitability and increase risks to financial stability