Comment: Unresolved collateral issues remain

The news that the ECB will only accept sovereign debt with an A- rating or higher as collateral for repurchase agreements and other collateral financing trades with commercial banks will help to instil fiscal discipline on member countries in the long-run. But Jean-Claude Trichet's clarification on ECB policy on collateral still leaves a number of questions unanswered.
The news that the ECB will only accept sovereign debt with an A- rating or higher as collateral for repurchase agreements and other collateral financing trades with commercial banks will help to instil fiscal discipline on member countries in the long-run. But Jean-Claude Trichet's clarification on ECB policy on collateral still leaves a number of questions unanswered.

A recent paper by Willem Buiter and Anne Sibert argues that current Eurosystem operational practices send "signals to the market that cause the market prices of debt instruments to incorporate negligible and excessively small credit risk differentials". The result is that the interest rates on all euro-denominated sovereign debt instruments are very similar, despite differences in "fundamental criteria such as public debt burdens and capacity to generate primary surpluses" a cross the eurozone.

According to the authors, the fact that credit risk differentials are essentially zero for the short maturity instruments accepted as collateral by the ECB, "represents a subsidy to the use of inferior sovereign collateral".

Moreover, current ECB policies directly contribute to this subsidy. The assignment of all euro-denominated sovereign debt to the same liquidity category is their biggest concern. It means that all euro-dominated government debt securities issued by eurozone countries, regardless of their underlying risks, receive the same haircut - or discount on market value - from the ECB.

The ECB already employs a system of differential haircuts on other forms of collateral, but what the authors suggest is that credit ratings be used to assign eurozone governments' debt instruments into different "liquidity categories". AAA-rated debt would be in the highest category and would "be subject to a zero valuation haircut at all maturities". Next, AA-rated securities would be in a lower liquidity category and subject to a higher valuation discount. In essence each rating category should be placed in a unique liquidity category, the valuation haircut rising as the credit rating decreases.

As all 12 eurozone countries' debt instruments are currently still rated above A-, which is the ECB's threshold for collateral, the problem identified by Buiter and Sibert remain relevant. Greece's debt instrument will continue to receive the same haircut as that of Germany and France, and prices will still not reflect differences in credit and default risk. The authors' suggestions would remove the unfair subsidising and free-riding of weaker fiscal governments, and provide further incentives for keeping deficits under control.

However, it remains unlikely that the ECB will be willing to place so much emphasis on the evaluations of the credit rating agencies, and that it will be prepared to adopt such politically sensitive role.

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