Dear Mr. Draghi, Here Is A Way To Break The Bank-Sovereign Negative Feedback Loop

by: Martin Lowy


The negative feedback loop between banks and their sovereigns needs to be eliminated.

To do that, banks need a riskless asset to replace their sovereigns' bonds.

The ECB can create such assets by offering banks reverse repos.

The reverse repos will be liquid, will earn income, and will make it seamless for the ECB to supply liquidity when it is needed.

This is an open letter to Mario Draghi. I write it for Seeking Alpha because among my early articles for Seeking Alpha were articles on Mr. Draghi's first press conferences after becoming president of the ECB. My report on the first press conference in November 2011 boldly said that Mario Draghi "will do whatever it takes." That was seven months before you said it publicly, Mr. Draghi. No, I was not eavesdropping on your personal soliloquies. It just stuck out all over you. You were there to succeed. I followed up with posts like this one, supporting your efforts even when you seemed to disappoint others.

Therefore, Mr. Draghi, please listen to me, I am your friend and admirer, and I am a friend of the European project.

It is now an official goal to sever the negative feedback loop of mutual dependence between banks and their sovereigns in Europe. But how to cut the cord is less clear. And without cutting that cord, it is difficult to see how even the new banking design can succeed.

Joint bank supervision and resolution, both of which are being implemented, are two steps in the right direction. Joint chartering and a single set of banking laws would be two more such steps, and a joint deposit insurance system would be a very good third step. However, these steps do not solve two basic problems.

The most basic of the two remaining problems is that banks need a riskless asset that they can use for liquidity, a modicum of income, and a counterbalance to the riskiness of loan portfolios. And that asset should not be linked to the cyclical fortunes of any one nation.

Historically, sovereign debt has been viewed and used as that riskless asset. Such use works in the U.S. and U.K. where the sovereign has the power to print currency and therefore need never default (though voluntary default - unthinkable - is possible). In the euro zone, however, nations do not have the power to print to repay. That makes their sovereign debt risky in some cases. And it makes the linkage between the nation and its banks dangerously circular. The failure of one almost automatically leads to the failure, default or need for a bailout of the other.

The second remaining issue is that in many countries, the market for local sovereign debt relies heavily on local banks for support. If that support is withdrawn too quickly, the price of the debt will plummet and interest rates will rise.

There is a solution. It is based on the already-groundbreaking QE program being conducted by the ECB.

As everyone now knows, QE involves buying government (and perhaps other) debt as a part of monetary policy operations. And it results in a build-up of such securities on the central bank's balance sheet.

Suppose the ECB took an additional page out of the Federal Reserve's playbook and used the assets purchased through QE to offer reverse repos to banks, at various maturities, as the Federal Reserve Bank of New York now is doing in a pilot program. (My thanks to John Cochrane, who has pointed out the potential uses of reverse repos offered by the Fed). The banks then would have their access to riskless assets and the nations still would have their sovereign debt markets supported through QE, with market support gradually decreasing until the credit markets adjust to the new reality.

Bank capital requirements could also reflect the potential differences between sovereign debt of a single nation and ECB reverse repos.

Some I am sure would complain that although QE may be legal and reverse repos for banks may be legal, in the case of the ECB, the combination is not legal. I am not an expert on European law. I invite those who are to comment.

From a monetary policy point of view, the ability to offer reverse repos is a plus. It gives the central bank another way to manage interest rates and liquidity. From a bank liquidity point of view, it separates the bank from its sovereign and it enables the central bank to seamlessly provide liquidity by closing out a repo. From a bank solvency point of view, it separates the bank from its sovereign. It also would reduce the risks inherent in Target2 imbalances.

My suggestion would not make the design of the euro perfect. But it would remove one of the principal dangers of a currency that its member nations cannot expand.

With goodwill in Europe, Mr. Draghi, I believe you will succeed. I hope my little idea helps.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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