The European Central Bank is moving towards a policy of risk-sharing in future government bond purchases, helping forge a crucial ‘missing link’ in euro area financial architecture.
The ECB and its shareholder central banks appear to be on the brink of a change of doctrine that could help further lower yield spreads between traditionally stronger and weaker members of economic and monetary union. In future ‘steady-state’ bond market operations, national central banks could acquire securities issued by other member governments. This would reverse a key feature of the landmark January 2015 decision on quantitative easing under which NCB bond purchases were limited to own-country issuance.
The shift in thinking, which has not been formally decided, could have widespread repercussions, even though it is not likely to come into effect for some time. Opening a potential route for cross-border bond purchases by EMU central banks in coming years would help create a more unified environment for banking and capital markets. It could indirectly boost the European Union’s faltering promotion of capital markets union.
However, some hurdles need to be surmounted. The amounts of government bonds in a future ‘structural’ bond portfolio on the ECB’s consolidated balance sheet will be relatively small compared with the high point of €4.9tn of public and private sector bonds built under the ECB’s exceptional QE programmes of recent years.
But steps by the German Bundesbank and the Dutch Nederlandsche Bank to purchase Italian and Spanish government bonds as part of ‘normal’ monetary operations might run into legal and political obstacles. This reflects general concerns about monetary financing – illegal under the European treaties – and especially German constitutional court rulings that QE should take place only in exceptional cases and be unwound as soon as possible.
Another reason for caution surrounds prospects for fiscal policy in Italy, the euro area member with the highest public debt. If policies in Italy diverged from European rules in coming years, that would significantly mitigate against other central banks’ Italian bond purchases.
Change in mindset partly reflects the large losses by northern NCBs
The change in mindset now underway partly reflects the large losses registered by northern central banks as a result of purchases of their own governments’ low- (sometime negatively) yielding securities since the euro area started across-the-board QE nine years ago.
The view that asset purchases will become a more regular part of monetary operations in future has gained ground. Additionally, the significant expansion of Target-2 imbalances among member NCBs – reflecting disparities in distribution of central bank money around the Eurosystem – has persuaded even conservative central banks that monetary union already embodies large elements of risk-sharing.
The Bundesbank’s Target-2 claims on other NCBs through the ECB are now around €1.1tn, against €460bn at end-2014. Over that period the negative balances of Italy, Spain and France have risen to €520bn, €390bn and €120bn respectively, against €210bn, €190bn and €40bn at end-2014. Reassuringly, over the last year of ECB balance sheet decline, these imbalances have been falling in most cases.
Central banks in more indebted countries, by contrast with the low-debt northerners, have benefitted from higher yields on their own governments’ securities. This has mitigated their losses during the last few years of growing strains on central banks’ balance sheets caused by a widening interest rate mismatch between their assets and liabilities.
The unexpected distribution of losses among EMU members – diametrically opposite to what many expected in 2015 – has led to some polite Schadenfreude among southern European central bankers. The 2015 decision against full risk-sharing reflected the view of the German Bundesbank and other northern central banks that purchasing securities issued by highly indebted members countries could expose individual NCBs to unjustifiable credit risks. These would cause losses for governments and ultimately for taxpayers.
The published ECB account of the crucial January 2015 governing council meeting that decided QE records that some central bankers favoured full risk-sharing ‘to counter perceptions of a lack of unity … [and] underline the singleness of monetary policy.’ Others voiced concerns about ‘moral hazard’ and said partial loss-sharing would be more commensurate with EMU’s decentralised architecture. This led to a compromise limiting risk-sharing to 20% of total purchases – representing the securities purchased in a centralised manner by the ECB rather than NCBs, as well as overall Eurosystem buying of supranational agency bonds.
Interest rate risk on bond-buying was deemed lower than infringing ‘no bail-out’ rule
Senior Bundesbank figures were aware nine years ago of the potential for losses from purchasing expensive German government bonds, especially in view of the collapse in yields to negative levels for some maturities. However, the interest rate risk on such operations was deemed lower than that of being perceived to infringe the euro area’s ‘no bail-out’ rule by partaking in generalised buying of highly indebted countries’ securities.
The Eurosystem stopped net bond purchases at end-June 2022. The ECB’s QE portfolio is declining gradually, reflecting curtailed reinvestments of maturing bonds. The ECB’s overall balance sheet has fallen more quickly to €6.9tn from the June 2022 high of €8.8tn as a result of banks repaying earlier crisis-fighting targeted loan programmes. ECB officials have spoken about the Eurosystem building a ‘structural’ bond portfolio in coming years as part of measures to maintain well-functioning money markets in non-crisis periods.
This would necessitate a ‘steady state’ balance sheet possibly three times the size of the €1tn-€2tn in the years before the 2007-08 financial upsets. The deliberations form part of planning on the ECB’s future balance sheet structure after dissipation of the immediate effects of the last 15 years of financial and political turbulence. The ECB’s much-heralded review of its operational framework, originally due to be completed at the end of last year, has run into unexpected challenges. It is now scheduled to finish ‘by the end of spring’, according to Christine Lagarde, ECB president.
In view of the complexity, the work is unlikely to lead to clear-cut conclusions. The review involves a convoluted array of judgments about the need for euro area bank reserves, influenced by regional and structural disparities and the effects of banking regulation requiring much greater liquidity coverage than two decades ago.
The ECB has given few hints of the likely outcome. The future system underpinning distribution of Eurosystem commercial bank reserves looks likely to be a hybrid of the Federal Reserve’s ‘supply-driven’ framework and that more demand-orientated set-up run by the Bank of England. There is consensus that, in line with other big central banks, the ECB’s balance sheet will be sizeably bigger. In a report in October the Amundi asset management group estimated that a Eurosystem government bond portfolio could total €800bn in 2033 out of a consolidated balance sheet of €4tn.
David Marsh is Chairman of OMFIF.