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ECB rules do not rule out risk-sharing

by Frank Westermann

ECB rules do not rule out risk-sharing

An important element in the European Central Bank quantitative easing programme starting next month is the limit on risk-sharing, with risks from asset purchases residing largely with national central banks carrying out the operations.

Individual euro members, or the euro system as a whole, really cannot avoid being exposed to risks from individual national central bank’s (NCB) bond purchases. But the technical practices and accounting rules of the euro system have been framed in such a way that the issue of possible central bank losses arising from purchase of government securities can be successfully hidden for many years. The timing of the crystallisation of losses, and the definition of who will bear them, will remain extremely opaque.

Through NCB asset purchases, new money can flow freely across borders, reshaping frameworks of assets and liabilities in a way that renders ineffective the ECB’s risk-limitation arrangements. Consider the position of a euro area government that anticipates imminent difficulty repaying bond issues purchased by a NCB under the QE programme. As long as these bonds are eligible collateral, and the ECB maintains its full allotment policy, the government concerned should be able to find a private bank that will buy newly issued bonds. The private bank can use these bonds as collateral to obtain refinancing loans from the central bank. And the government can use the revenues to repay the maturing bonds held by the NCB.

From the central banks’ perspective, collateralised loans would replace the purchases of the now-maturing bonds – but unlike bonds, these loans are subject to loss sharing. Also, the government does not need to default, as – indirectly, via the private banks – it will continue to have access to central bank financing. Furthermore, a fall in prices will not immediately lead to losses; there is no ‘fair value’ accounting for bonds purchased under QE, as they are classified as ‘held to maturity’.

The International Accounting Standards Board has recently introduced the IFRS9, which ensures a more conservative approach by applying the ‘expected loss model’. As long as the euro area does not implement this, however, and countries do not explicitly default, sudden write-offs of losses – individual or shared – are unlikely to happen in the near future. The issue of central bank losses from QE will preoccupy us for many years. But, if and when they are crystallised, the losses are likely to be borne by the euro system as a whole.