BRUSSELS: The European Commission plans to give preferential treatment to a new class of state bond-backed securities to encourage use of the instrument, which is aimed at diversifying banks' holdings of euro zone bonds, a draft plan showed.

The plan, expected to be announced next week, is meant to address a weakness in the currency bloc that came to light in the 2010-2012 euro zone debt crisis, when banks' high exposure to their sovereigns' own debt exacerbated the problems facing banks and euro zone authorities alike.

The draft proposal, seen by Reuters, is aimed at enabling the uptake of so-called Sovereign Bond-Backed Securities (SBBS), a new low-risk asset which would be composed of bonds from all 19 countries that use the euro.

The security, which has a potential market worth 1.5 trillion euros ($1.7 trillion) according to the European Systemic Risk Board, would not involve any sharing of risks among euro zone countries – which may overcome any German resistance to the plan.

But it already faces criticism that it may ultimately be ineffective.

“These novel securities can help to enhance banks' sovereign bond diversification (thus alleviating the sovereign-bank nexus) and to expand the supply of euro-denominated low-risk assets," the commission said in its draft proposal.

But national debt agencies cited by the commission in its document said the SBBS “would neither be conducive to break the bank-sovereign nexus nor to create a euro area low-risk asset."

The new asset would have a senior, more secure tranche, corresponding to 70 percent of the nominal value of the issuance, with the rest being allocated to one or more subordinated, riskier tranches.

Issuances would be composed of a fixed amount of national bonds from euro zone countries, “equal to the relative weight of the respective Member State's participation in the European Central Bank capital key," the proposal said.

The fixed blend of national bonds and the high contagion risks between the bloc's countries without risk-sharing measures are likely to make the securities of little help in a crisis, critics say.

“Trust in SBBS will be lowest when they are most needed in times of crisis, making it a ‘fair weather' instrument rather than a safe asset," said a paper from the Association for Financial Markets in Europe (AFME), a trade body for large financial firms.

In a bid to make the new asset more attractive, the commission is proposing lower capital requirements for banks that hold these securities, which would not be treated as other securitised products which require lenders to offset their risks with capital buffers.

“Securitisation-specific regulatory charges are not justified for SBBS," the commission said, arguing that these new securities would be backed by risk-free sovereign bonds.

The draft document also stresses that the regulatory treatment of sovereign exposures would not be changed to avoid risks to financial stability – a clarification likely to be welcomed by Italy and other high-debt euro zone states who could see their borrowing costs spike if sovereigns were no longer treated as super-safe assets.

EU states and lawmakers will have to agree on the plan once it is formally proposed by the EU commission.

Copyright Reuters, 2018