On 24th May 2018 the European Commission issued a proposal of Regulation on sovereign bond-backed securities.
The euro-area banking sector continues to be vulnerable to the sovereign-bank nexus, i.e. the strong link between the creditworthiness of a government and that of the banks in its jurisdiction. This is partly caused by the banks' concentrating their sovereign bond portfolios in their own sovereign (so-called "home bias"). Deteriorating creditworthiness of a sovereign leads to balance sheet strains for banks in its jurisdiction and in turn, banks' difficulties put pressure on the government budget directly ("bailout") or indirectly (lower tax revenues). Beyond these links, banks also remain strongly exposed to economic developments in their home country.
In the wake of the global financial crisis the supply of high-rated euro-denominated sovereign bonds decreased but demand for safe assets has increased. The demand is bolstered by the strong prudential requirements. Therefore, this legislative proposal aims to enable the development of Sovereign Bond-Backed Securities (SBBS) and to support further integration and diversification within Europe's financial sector.
SBBSs will be created by the private sector. A private entity would assemble an underlying portfolio of sovereign bonds from the market and would subsequently transfer them to a legally separate entity, specifically set up for the purpose of issuing to investors a series of securities representing claims on the proceeds from this underlying portfolio. SBBS should represent a diversified pool of euro-area sovereign bonds which include sovereign bonds from all euro area Member States according to their economic weight. SBBS will not involve mutualisation of risks and losses among euro area Member States but private investors would share risk and possible losses. The various securities issued would bear any losses in a certain sequence. Investors can choose to buy the higher or the lower risk securities. Investing in these instruments may help investors (investment funds, insurance companies, or banks) to diversify their sovereign portfolios. It would also contribute to weakening the link between banks and their home countries.
The viability of SBBS can ultimately be ascertained only by the market. Under the current regulatory framework, SBBS would be defined as securitisation products. However, due to the nature of the underlying assets and standardised and simple nature, SBBS carry risks that are comparable to the underlying sovereign bonds. Therefore, the proposal adapts the regulatory framework and SBBS will be granted the same regulatory treatment as national euro-area sovereign bonds denominated in euro (e.g. for the capital requirements purposes).
The proposal will now be discussed by the European Parliament and the Council.