According to the proceedings of a seminar held at the Bank for International Settlements (BIS) in January 2013, Mr. Alberto Giovannini argues that investors should wonder whether we can conceive of a financial system without a risk-free asset. The financial crisis has uncovered weaknesses in the financial system able to crack assumptions deemed fundamental to financial markets. In fact, investors price securities according to a base reference when discounting cash flows: the risk-free interest rate. Until only a few years ago government bonds functioned as a safe haven as a broad category which market participants, and among them financial intermediaries, used as a plug to allocate their investments according to their attitude towards risk. Financial intermediaries play an important role in making possible that cash strained households and corporates be funded by cash rich ones which don’t have to weigh banks’s liabilities credit risk. But when sovereign default risk creeps in, market participants must take into account the likelihood of default by discriminating issuers according to their bankruptcy risk. At this point, as the late developments in the financial system have demonstrated, sovereign risk may undermine bank assets’s creditworthiness creating the adverse feedback loops at the origin of investors’s dilemma about the euro break-up headache, for example.
Securitization through special purpose vehicles has provided, by means of its cash-flow tranching from underlying assets, an imperfect alternative source of risk-free assets. The financial system has the creative resources to design alternative avenues to create safe collateral in financial and integrated operations as we have come to know them recently. But the financial system can get shaken by the excesses brought by exuberance (e.g. erroneous design in the securitization processes). Banks are the primary purchaser of government issued debt for market-making reasons and for the mitigated impact it has on their balance sheet capital requirement ratios. Thus financial stability needs short-term government securities as a sound and reliable means of capital allocation whereby investors can gain and adjust their risk exposures to markets. Mr. Giovannini argues that the once intimidating prospect of the disappearance of government debt as a risk-free asset, because of the easing of public balance financing needs, has now been replaced by the even more horrifying possibility of a shortage of sovereigns as true risk-less issuers. Another question remains unanswered: How would security market prices and portfolio allocations change if investors had no risk-free assets to invest in?