ECB wonders if egalitarian approach is ill-conceived

Throughout the economic crises of the past few years, the European Central Bank has boasted how its generous system for providing liquidity to eurozone banks has withstood all storms.

But as attention has shifted from rescuing the region’s financial system to concern over public finances – especially in Greece – a possible significant flaw has been exposed: might ECB rules have contributed to fiscal indiscipline by not differentiating more between the eurozone government bonds put up as collateral?

Worse, in the light of events, it is dawning on some ECB policymakers that the procedures in place for when a government loses control over its public finances and its credit ratings plummet, could prove dangerously crude.

At present, the ECB has just one option – banning the use of its bonds when their rating falls below a certain level (currently BBB-minus).

For a country such as Greece that could have catastrophic consequences, raising a big question of whether the ECB, guardian of Europe’s monetary union, would ever allow it to happen.

“The nuclear option is the ultimate protection if you are willing to use it – but it is not really credible,” says Erik Nielsen, European economist at Goldman Sachs.

François Puget, head of euro fixed income flow trading at BNP Paribas, adds: “Have you ever seen a central bank not accept the collateral of its own country, even if in the case of the ECB it is 16 countries?”

Faced with such questions, a debate has begun at the Frankfurt-based institution the effects of which will ripple across financial markets: roughly €1,600bn of assets were put forward as collateral on average in 2008.

At the heart of the debate is the ECB’s “haircut” system – the discount applied to the market value of an asset put up as collateral to decide how much liquidity can be drawn. Although the ECB would argue that the market value reflected the risks involved, government bonds with the same maturity incur the same “haircut” – regardless of whether they are issued by Greece or more fiscally prudent countries.

For the first decade of Europe’s monetary union, that system, which reflected the politics of the eurozone, created few problems. Other central banks around the world operate with similar thresholds.

But as a monetary union without a fiscal union, the eurozone and ECB face different challenges to other economic blocs.

With hindsight, Greece’s example showed how ineffective financial markets were in punishing eurozone countries that let their public finances deficits spin out of control or had lost economic competitiveness. One reason for the relatively small spreads between the interest rate on, say, Greek and German bonds, may have been their apparently equal treatment in the eyes of the ECB.

The global financial crisis that intensified after the collapse of Lehman Brothers in September 2008 changed all that. Spreads widened as financial markets fretted about the possibility of governments defaulting. As finance ministries struggled to present credible plans for reducing public sector deficits, ratings agencies gained enormous influence.

If the ECB sticks to plans to revert to an A-minus minimum requirement at the end of this year, and Moody’s follows others in issuing a further downgrade, Greek assets could become ineligible for use. That is because Moody’s is the only agency still giving Greece the required single A rating.

”We have never advocated regulatory use of independent credit ratings by any authority, as it risks encouraging excessive dependency on ratings, often for purposes they are not intended for,” says a Standard & Poor’s spokesman. “If authorities are to continue using ratings, they should use other measures or benchmarks as well.”

But as Ewald Nowotny, Austria’s central bank governor, noted in exasperation this month: “The fate of Greece and, if you are going to be more dramatic, the fate of Europe, depends on the judgement of one rating agency. That is an unacceptable situation.”

The option of the ECB issuing its own ratings appears unrealistic – not least because its judgements would bring it into conflict with governments that were downgraded publicly.

An alternative put forward last week by Axel Weber, Germany’s Bundesbank president and possible future head of the ECB, would be a “sliding scale” system for treating government bonds.

”You could take higher haircuts for lower ratings, we could have a more continuous collateral framework. I think that’s something that needs to be discussed,” Mr Weber suggested.

Discussions are at an early stage. A sliding scale approach need not necessarily distinguish between all countries, but could penalise obvious fiscal sinners; after all, the ECB has said it will impose a “haircut add-on” if a government’s bonds fall to the current BBB- lower limit.

The risk would be that such a move forced up Greek bond yields, exacerbating Athens’ deficit problems, as banks and investors might demand a higher premium to buy bonds that require bigger haircuts to exchange as collateral.

Another drawback of a “sliding scale” would be the risk of the ECB’s decisions becoming politicised if governments felt they were being treated unfairly or the solidarity that binds the eurozone were threatened.

“It would suggest eurozone government bonds are not equal,” said Gary Jenkins, head of fixed income research at Evolution. “This could lead to resentment among those countries that have to pay more in haircuts for their bonds.”

It would also have negative consequences for banks in the stronger countries. French and German banks, for example, hold more Greek bonds than those of other eurozone members.

But those following the discussions suggest the rules could be made clear in advance – allowing the ECB to act impartially while improving the functioning of the eurozone.