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On Guard! Protecting the UK’s financial system 

As the world’s economies take steps to rebuild after Covid, the UK should beware of dealing with the Eurozone on EU terms in any future deal, says Bob Lyddon. He explains the ECB’s Pandemic Emergency Purchase Programme could undermine the Eurozone as a free financial market, giving the European Central Bank de facto control over Eurozone member states.

The European Central Bank has responded to the to the pandemic through another programme of bond buying. This, as I explain in The ECB’s Pandemic Emergency Purchase Programme, has taken up hundreds of billions of euros of Eurozone member state government bonds into the ECB’s Pandemic Emergency Purchase Programme, the ‘PEPP’.

The PEPP bought the majority of new debt issued in 2020 by countries like Spain, Italy and Portugal. The result has been to concentrate 50 per cent of Eurozone public sector debt in the hands of Eurozone financial mechanisms. The proportion could be much higher if the original balances held on accounts in the TARGET2 (the system used for settling payments) payment system were revealed.

ECB operations have driven bond yields down to around 0 per cent, saving Eurozone public sector borrowers billions of euros in interest payments. The ECB has driven both speculators and private investors out of the market: activity is concentrated between Eurozone financial mechanisms and investment banks.

Statistics on trading in bonds and related derivatives show a marked decline in liquidity. So the ECB’s operations have eliminated yield and diminished liquidity: the investments should then at least be safe.

However, investors are likely to be disappointed. They are unlikely to want to accept most of the ECB’s asset base at nominal value, if the ECB to wishes to offload these bonds at any point. For although 25,000+ of the bond issues appear on the ECB’s list of collateral eligible for payment and market operations, by no means all class as ‘central bank money’ – and only such an asset is free of credit risk. Considerable numbers of these bonds are rated by the public credit rating agencies at the lower end of Investment Grade. Indeed the PEPP is permitted to hold bonds that have fallen down into Speculative Grade, and to buy new bonds of issuers who are rated Speculative Grade as long as the issuer was rated Investment Grade in April 2020.

As a result, through its interventions and distortions the ECB has compromised and undermined a fundamental equation of a free financial market: that any instrument admitted for trading in its system should offer a transparent blend of Safety, Yield and Liquidity, benchmarked to independent standards.

The euro was supposed to usher in broad and liquid capital markets based on these principles. The PEPP holds this promise below the waterline.

Last year, in 2020, a group of German academics and lawyers took a case to the German Constitutional Court to attempt to rein in the ECB’s pre-existing programme which invested in public sector securities – the Public Sector Purchase Programme, or PSPP. They obtained an equivocal judgement in which the court placed reliance on certain safeguards built into the PSPP which meant that the ECB could be seen as acting within its powers. The ECB has written its mandate for the PEPP to bypass these safeguards and to make itself inviolate to challenge: the PEPP mandate permits the ECB to adapt the ways and means as it sees fit.[1] The ECB has therefore ensured that the German Constitutional Court cannot challenge it again, and has put itself beyond democratic controls from either the Member State level or other organs of the EU. In doing so the ECB has, through the PEPP, taken on a sovereign life of its own, supplanting member state sovereignty.

Whilst the ECB has undermined one of the promises of the euro (broad and liquid capital markets), it has morphed itself into a type of market actor that ironically fulfils another promise of the euro but not in the intended way: the ECB has become a pan-European commercial bank. Through the PEPP and other programmes, the ECB is buying – and accepting as collateral – all manner of asset classes that expose it to credit risk on corporate and retail customers right across the Eurozone, but without having its own credit department to assess the credit risk it is taking on. Instead it relies on public credit ratings and banks’ self-assessment of those risks which the banks transfer to the ECB. Those banks are of course conflicted in coming up with a risks assessment for that which they want to offload onto the ECB. The self-assessment mechanism is known as Internal Ratings-Based or ‘IRB’, and it is the common methodology used by banks in Greece, Italy, Cyprus, Spain, Portugal and Ireland to assess credit risk – the methodology that has resulted in such high levels of bad debts.

By this scheme, the ECB has not only undermined the Eurozone financial market through the PEPP: it has fundamentally undermined itself.

This begs the question as to what sort of Brexit deal should be agreed for financial services. There is intense lobbying for the kind of porous arrangements that pertained while the UK was an EU member. The key term, often used on both sides of the channel is ‘equivalence’ , but the UK must insist that UK law only should govern the UK’s financial sector and businesses operating in or out of the UK or involved in EU trade.

A free market must be free to take whatever steps are needed to prevent systemic risk and the UK in any future deal must retain its freedom under UK law to protect the country, its businesses and its consumers, from the dangers posed by any controlled and debased financial system. If the two are connected merely in some porous, automated way, the state interference, self-interest and subsidy that underpin the controlled market will infect and undermine the free one. The only deal the UK could do should be based on enhancements to, i.e. strengthening, current ‘equivalence’ arrangements in the UK’s favour, with the UK dictating the terms so as to manage Eurozone risk from afar on behalf of its own markets and those trading with it in the world’s markets.


[1] Decision (EU) 2020/440 of the European Central Bank of 24 March 2020 on a temporary pandemic emergency purchase programme (ECB/2020/17)

Robert Lyddon

Robert Lyddon is a bank accounting and financial analyst with specialist knowledge of banking and payments systems. He works as a management consultant in international banking both privately and with PwC. His new paper The ECB’s Pandemic Emergency Purchase Programme is published by the Bruges group and for Politeia he has co-authored with Barnabas Reynolds and David Blake Managing Euro Risk: Saving Investors from Systemic Risk (2020).

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