By Marius Zaharia
LONDON (Reuters) - As the European Central Bank comes closer to buying sovereign bonds, one London-based think tank says an opportunity has arisen to fix one of the euro zone's birth defects -- the absence of a credible "risk-free" asset.
Regulators deem domestic sovereign bonds risk-free -- so-called although no asset is entirely without risk -- and push financial firms to buy them as a safety buffer, exempting them from a rule that requires setting aside capital for holding other assets.
However, when they assess how strong a bank needs to be, regulators consider both German bonds -- the only state debt in the bloc rated triple-A by all three major agencies -- and bonds issued by Greece, which defaulted two years ago, risk-free.
As a result, euro zone banks are loaded with low-rated government debt, creating a potential "doom loop", in which troubles at a bank can drag in governments and vice-versa.
The most commonly discussed proposal for a new risk-free asset is a joint euro bond that transfers debt risk from weaker countries to stronger ones. However, that idea has faced resistance from the latter who fear they could end up on the hook for less prudent borrowers' profligacy.
Luis Garicano and Lucrezia Reichlin at the Centre for Economic Policy Research have come up with an idea that they say counters that objection and breaks the toxic link between banks and sovereigns.
The two professors say the need for the ECB to pump money into the euro zone economy could be an opportunity for the market itself to create a euro bond -- which the ECB would then buy -- that does not lead to debt mutualization.
"The ECB would merely announce the features of the synthetic bonds it will purchase," they write in a policy proposal.
Regulations would have to be changed to turn the special bond into a zero-risk asset by forcing banks to set aside cash for holding bonds as currently issued by individual countries, while not requiring any provision for holding the new product.
The new bond would include debt issued by euro zone members in proportion to the size of their economies and the ECB would buy only its senior tranches.
The ECB has looked at similar instruments before and they could still feature in future policy, sources with knowledge of ECB thinking said.
Steven Major, global head of fixed income research at HSBC, says the proposal has "potential", especially as he sees legal and practical issues with the ECB buying government bonds.
But he says it could hurt banks in southern Europe, which own large amounts of their own countries' high-yielding debt. The creation of the new product would require them to buy expensive top-rated bonds while setting aside cash for their current debt holdings.
"If the proposal only works for core banks it would defeat the purpose," Major said, referring to lenders in northern Europe. "To get the benefit across the euro zone you need participation from the peripheral banks."
Large holders of bonds issued by weaker, peripheral euro zone states warn that changing the regulatory treatment of existing government debt could destabilize those markets.
"Next day everyone will be selling Italian bonds and you end up with potential self-fulfilling processes in the market where there's no buyers and only sellers and it becomes very disorderly," said Myles Bradshaw, European strategist at PIMCO, the world's biggest bond investor.
Garicano, who calls the bank-sovereign symbiosis "diabolic", countered this by pointing to the ECB's promise to do "whatever it takes to save the euro".
"I don't think it would happen for the same reason it doesn't happen now -- the ECB," the professor of economics and strategy at the London School of Economics told Reuters.
Philip Brown, a Citi banker who organizes debt sales for governments, said the low liquidity of the instrument would make it "somewhat impractical".
Wrapping bits of highly liquid government bond markets into a hybrid bond in which initial trading volumes would be tiny means any buyer would demand a liquidity premium.
Investors like liquid products because they can buy and sell them without significantly altering the market price. Therefore for this particular bond the buyer is likely to offer the seller a lower price than what was spent to create the product to compensate for the low liquidity, some in the market say.
Garicano is not worried.
"Given the large demand for safe assets, the exclusive use of these euro safe assets for liquidity purposes at banks ... and their role as the main instrument of monetary policy, this will be a highly liquid market," he said, adding that the ECB could help out in the early stages with a special facility to finance creation of the product.
(Additional reporting by John Geddie and Emelia Sithole-Matarise; Editing by Giles Elgood)