Downgraded Bonds Get A Backstop

The ECB announced that it will accept bonds below investment grade as collateral for its bank financing facility.

Exceptional times call for exceptional measures. This appears to be the conclusion of the European Central Bank.

In mid-April, the ECB announced that it will accept bonds below investment grade as collateral for its bank financing facility—a step that would be considered unthinkable in more normal times. Since the overall goal is to keep the economic crisis from spreading to banks, making credit unobtainable for businesses, the bank is restricting support to recently downgraded bonds.

“The economic shock from the Covid-19 crisis is amplified through its adverse effect on the value of banks’ collateral,” Luis de Guindos, vice president of the ECB, and Isabel Schnabel, Executive Board member, said in a blog post. “As asset valuations drop and ratings are downgraded across economic sectors, the resulting drop in eligible collateral may cause banks to further tighten their credit supply to the real economy.” By acting swiftly, the ECB hopes to prevent any such “procyclical feedback loops.”  However, they warn that the new program, which is set to expire in September 2021, “comes at the cost of additional risk on the Eurosystem’s balance sheet.”

The spread between the German Bund and the Italian BTPs (government bonds)—a measure of the risk attached to Italian debt—went down after the ECB’s announcement.

The move by the central banks comes at an especially opportune time for Italian banks. Italy has a large amount of government debt that make it vulnerable to a sovereign downgrade. If these instruments were declared unusable as collateral, many Italian banks would find themselves unable to obtain liquidity from the ECB. By backstopping downgraded bonds, the ECB ensures that this will not happen.