Sovereign bond-backed securities: a feasibility study January 2018

Volume II: technical analysis by ESRB High-Level Task Force on Safe Assets

Sovereign bond-backed securities: a feasibility study Volume II: technical analysis January 2018 Contents 1

Executive summary 3

1 Risk measurement 6

1.1 Historical price volatility 9

1.2 Stress tests of model-based simulation of losses 12

1.3 Stress tests of model-based simulations of unexpected losses 26

1.4 Estimating yields on SBBS 41

1.5 Dynamic risk assessment 53

1.6 Assessing effects on interconnectedness 63

2 Contractual features and debt restructuring events 66

2.1 Contractual features 66

2.2 Debt restructuring events 68

3 Market intelligence 84

3.1 Industry workshop at the Banque de France 84

3.2 Meetings with market participants 90

3.3 Survey 95

3.4 Input from representatives of debt management offices (DMOs) 111

4 Market design and liquidity 117

4.1 Issuance of SBBS 117

4.2 Microstructure of the SBBS market 134

4.3 Development of the SBBS market 147

4.4 Impact on sovereign bond markets 158

5 Regulatory policy 177

5.1 Treatment of SBBS under the existing regulatory framework 177

Contents

Sovereign bond-backed securities: a feasibility study Volume II: technical analysis January 2018 Contents 2

5.2 Treatment of sovereign exposures and securitisations under Pillar 2 and bank stress tests 184

5.3 Drivers of demand for SBBS relative to sovereign bonds under current regulation 190

5.4 Enabling product regulation for SBBS 193

5.5 Implications of the treatment of sovereign exposures 196

5.6 Drivers of demand for SBBS relative to sovereign bonds under broader regulatory reforms 213

References 216

Members of the ESRB High-Level Task Force 221

Imprint and acknowledgements 222

Sovereign bond-backed securities: a feasibility study Volume II: technical analysis January 2018 Executive summary 3

This second volume published by the ESRB High-Level Task Force presents technical analysis on aspects of sovereign bond-backed securities (SBBS) related to risk measurement, contractual features, market intelligence, market design and regulation. It is based on analysis conducted by the Task Force, its three workstreams and its liquidity and legal expert teams, in addition to intelligence gathered from interactions with market participants. This second volume of the Task Forces report therefore complements the first by providing a more technical analysis, which is warranted to shed light on the unique properties of SBBS. Together, the two volumes assess whether SBBS could achieve their policy objectives, the side-effects and risks that could ensue from their issuance, and the conditions under which a market for SBBS could feasibly develop.

Section 1 measures the risk properties of senior, mezzanine and junior SBBS. To that end, it subjects the securities to a series of stress tests to examine their robustness to the euro area sovereign debt crisis as well as even more severe hypothetical events. As such, the analysis abstracts from recent improvements to the euro area financial architecture and the fiscal positions of EU Member States and should therefore be interpreted as being much more conservative than typical supervisory stress tests. In simulations of hypothetical defaults, senior SBBS perform at least as well as the lowest-risk sovereign bonds in terms of their expected loss, value-at-risk, expected shortfall and expected loss conditional on tail events. By contrast, the performance of non-senior SBBS is more sensitive to measurement: both the mezzanine and junior securities perform relatively well in terms of expected loss and expected loss conditional on tail events, but appear riskier when measured by probability of default, value-at-risk, expected shortfall or sensitivity to systematic events. In the worst case, following defaults by multiple large sovereigns, junior SBBS could be completely wiped out, depending on recovery rates. The section then estimates yields on the three securities between 2000 and 2016 by implementing a pricing tool using historical market data. At the end of October 2016, the estimated yield on a 10-year 70%-thick senior SBBS is estimated to have been 0.13%, that of a 20%-thick mezzanine security 1.4% and that of a 10%-thick junior security 4.9%. These point estimates do not change significantly under different assumptions about key parameters (e.g. default correlation or LGD). The relative positions of mezzanine and junior SBBS compared to national sovereign bonds are stable historically. During 2011-12, for example, when sovereign risk was elevated, the risk of these securities relative to national sovereign bonds was similar to long-term averages.

Section 2 describes the contractual features of SBBS, focusing on a hypothetical sovereign debt restructuring event. The analysis conveys three main messages. First, contracts and the broader legal framework should be designed so that sovereign bonds in SBBS cover pools are treated in the same way as those held by investors directly. Equal treatment should also be ensured during any sovereign debt restructuring event. The treatment of bonds by a defaulting sovereign must therefore not discriminate according to whether investors hold sovereign bonds directly or through SBBS. Second, in a sovereign debt restructuring process, SBBS issuers would vote on the restructuring proposal based on instructions from a third-party trustee, which would have a fiduciary duty to act in the interests of all SBBS investors by maximising the value of their claim. Alternatively, issuers could aggregate votes submitted by SBBS holders. Third, in the case of a nominal haircut to principal or a reduction in coupon payments on sovereign bonds in a

Executive summary

Sovereign bond-backed securities: a feasibility study Volume II: technical analysis January 2018 Executive summary 4

hypothetical restructuring event, the modified bonds would replace the old bonds in the SBBS cover pool, thereby providing for equal treatment of investors in sovereign bonds and SBBS.

Section 3 summarises insights gained from market participants through three channels: discussions at a workshop at the Banque de France on 9 December 2016, responses to a survey posted on the ESRB website, and a series of meetings with market participants. The Task Force engaged through these channels with institutions that play a variety of roles in the financial system, including debt management offices, investment banks, commercial banks, asset managers, central counterparties and credit rating agencies. This engagement provided valuable feedback, with market participants conveying a range of views concerning the scarcity of safe assets, market microstructure, issuance, security design and investor demand, including both positive and sceptical assessments of SBBS. Overall, the feedback helped to shape the findings of the Task Forces feasibility study.

Section 4 discusses the design of an SBBS market, its liquidity and its interaction with sovereign debt markets. The key steps for the issuance of SBBS include: filling SBBS order books; assembling the underlying portfolio; establishing the issuer; and placing senior, mezzanine and junior SBBS with investors. The use of the order book ensures that SBBS-arranging entities only buy sovereign bonds to the extent that they receive orders for the securities. An arranger would also need to engage in other administrative tasks, including drafting prospectuses, liaising with credit rating agencies and conducting investor roadshows. In terms of institutional arrangements, SBBS arranger(s) could be multiple private sector entities or a single public institution (or a combination of both). Different considerations apply in each case. Competing private sector arrangers could generate efficiency gains, but would require regulation and supervision to ensure coordination and homogeneity of SBBS. In terms of a public sector arranger, the institutional setting would need to be designed to preserve market discipline and credibly preclude mutualisation of sovereign risks, which is a key tenet of SBBS. In either case, SBBS issuers would be bankruptcy-remote from arranger(s), and neither Member States nor European institutions would provide guarantees or paid-in capital for SBBS issuers or payment flows. Section 4 also outlines illustrative sizes of an SBBS market. The size of the market would be demand-led, with maximum limits set by policy, guided by liquidity in secondary markets for sovereign debt. In the early years of market development, one possible scenario would be to cap initial issuances at levels similar to debt securities issued by the European Stability Mechanism (ESM), which issued 10 billion of bonds in its first year. To achieve its policy objectives, however, the SBBS market would ultimately need to be large enough to facilitate portfolio diversification and de-risking by financial institutions. Achieving critical mass would depend on investor demand for the securities. In the medium-run, maximum market size could be guided by investor requirements in terms of portfolio diversification and de-risking, within constraints given by the impact of SBBS on sovereign debt market liquidity. A 33% issuer limit somewhat analogous to the Eurosystems public sector purchase programme (PSPP) would imply a medium-run SBBS market size limit of approximately 1.5 trillion.

Section 5 evaluates the regulatory framework. Under existing regulation, SBBS would receive an unfavourable treatment compared with a portfolio of the underlying sovereign bonds. This unfavourable treatment