2012-06-27 – London
The Bank for International Settlements (BIS) reported that sovereign debt instruments issues by various governments have been losing their risk-free status at an alarming rate.
Fiscal balances in many developed economies were already on an unsustainable path well before the financial crisis. The crisis led to a significant further deterioration in fiscal sustainability by increasing annual fiscal deficits adding to over-all sovereign debt. In addition, the fiscal position of many governments is even worse if unfunded and so-called off-balance sheet liabilities are taken into account. As a result, financial markets and credit rating agencies are taking a more critical view of sovereign credit risk, which poses a major threat to macroeconomic and financial stability.
Sovereign debt issues are generally considered the least risky asset class, and they also play a key role in the financial system’s technical foundations, infrastructure and regulation.
Credit risk and quantitative easing
Risk-free sovereign bonds are held by investors globally and further credit risk increases may create very large losses. However, despite the fact that the credit risk has been escalating on western sovereign issues, as is shown by the evolution of CDSs and by rating downgrades, prices have been rising strongly due to intervention by central banks and sluggish economic improvement. However, intervention by central banks cannot last indefinitely.
Quantitative easing is suitable for solving a temporary liquidity crisis but cannot solve underlying solvency problems. Conversely, a prolonged aggressive monetary policy may create risks for global financial stability. In addition, several widely recognised investors are arguing that the current activism by central banks without fiscal consolidation would only alter the functioning of markets, contaminate price discovery and distort capital allocation. As a result, intervention by central banks may be reduced sooner or later and investors may suffer significant losses if credit risk is not reduced.
Widely used financial theory
The existence of a risk-free asset is a key assumption in modern portfolio theory and a main parameter in strategic asset allocation. Portfolio managers use strategic asset allocation in order to pursue a desired level of systematic risk, which, according to several studies, explains more that 90% of total portfolio returns. According to these strategies, a portfolio’s systematic risk is increased or decreased by borrowing or lending risk-free assets, respectively. The consequences of an absence of a risk-free asset in strategic asset allocation are unknown, but will certainly cause a dramatic increase in the financial market’s volatility and cost of capital.
Monetary design
Central banks buy and sell government securities to carry out open market operations, which are their main tool for monetary policy implementation. The usual aim of open market operations is to control the short term interest rates and the supply of base money in an economy, and thus indirectly control the total money supply. Consequently, the whole monetary system will have to be redesigned if sovereign bonds lose their risk-free nature. Moreover, a significant increase in the credit risk of sovereign bonds will negatively impact on the solvency of central banks, which may undermine their operational autonomy and ultimately challenge their credibility. In the worst-case scenario, this may lead to the collapse of the fiduciary monetary system.
Widely used collateral
Fourth, risk-free sovereign bonds are also used as collateral in a wide range of secured lending transactions between different financial players: retail banks, investment banks, insurance companies, hedge funds, etc. The repo market is a fundamental pillar in payment systems as it connects liquidity suppliers and consumers and an increase in the yield of collateral instruments will increase the cost of these transactions. This will have major implications for the financial system as the repo market has been gaining weight in inter-bank operations due to the credit crisis.
Furthermore, risk-free sovereign bonds are also widely used as collateral in the derivatives cleared through Central Counter Parties (CCP). The CCP demand further collateral in order to balance any significant increase in the credit risk of collateral instruments, which increases the cost of these transactions and may trigger a sell-off of collateral instruments. For example, Greece, Ireland and Portugal’s bailouts were triggered by an increase in collateral demanded by LCH.Clearnet due to the growing credit risk of these previous sovereigns.
Regulatory capital requirements
Finally, risk-free sovereign bond yields are used by regulators as a key input in capital requirement valuations. In addition, most of OECD sovereign issues are considered risk-free by regulators and do not have any capital charge. Consequently, any increase in credit risk will boost the volatility of capital requirements.
All in all, maintaining the risk-free nature of key sovereign borrowers has wider implications than merely having lower funding costs. In the worst-case scenario, it may even threaten the current monetary system. And, as we have previously reported, there is not a clear risk-free replacement for risk-free sovereign issues. Consequently, governments have to boost their efforts on fiscal consolidation in order to solidify and regain their risk-free status.
