State Contingent Debt as Insurance for Euro Area Sovereigns

Abstract

The authors provide a novel angle to the ongoing discussions by the G20 on sovereign contingent debt and argue that contingent debt could provide market-based insurance to protect the euro area from future debt crises. Risk-sharing with the markets is a practical way forward in the context of the Franco-German debate on risk-sharing among EU member states vs system-wide risk reduction. The financial innovation of contingent debt is a feasible euro area reform that would not introduce risk-sharing between states or require institutional reforms or Treaty changes. However, coordination would be needed. The authors’ suggestion fills a gap in the proposals on the completion of the banking union and the possible establishment of a European Monetary Fund (EMF). These proposals offer institutions-based solutions to crises, with the banking union providing safety regulations that will make banking institutions more resilient, while the EMF will be a ‘fire brigade’ to be called on in emergencies. What has not been tapped are the markets, whose tolerant behaviour to sovereign demands encouraged the build up of debt, while their finicky response exacerbated the crisis.