Breaking the Bank-Sovereign Nexus

By Viral Acharya, C.V. Starr Professor of Economics

Ownership of sovereign debt by non-banking financial institutions and retail investors will provide a broad base that will weaken the bank-government nexus and reduce the severity of future crises, banking or sovereign.

The unique feature of the global financial crisis that began in 2007 is that it is an amalgam of a financial markets crisis, a banking crisis and a sovereign debt crisis. The crisis began as a credit and financial problem in most countries but soon snowballed into a banking and sovereign crisis. In some cases, such as Ireland, governments took on excess debt and risks while rescuing failed banks or stimulating the economy. And in yet others, such as Spain, private debt and a growth slowdown engulfed governments too. And in yet others, such as Greece and Italy, governments took on excess debt and ran up deficits. These crises indicate the existence of a strong two-way relationship between banking crises and sovereign debt crises.

It is equally clear from these events that myopic governments are keen to expand fiscally to subsidize consumption rather than invest in stable growth, which requires undertaking tough structural reforms; worse, they are reluctant to reduce fiscal deficits even in the wake of unsustainably large debts on their balance sheets. And very often, banking systems of their countries hold a substantial part of the public debt. Indeed, a captive and repressed financial system is the least cost option for myopic governments for funding deficits.
This, in turn, creates a reluctance on the part of such governments to develop alternative channels to market public debt to non-banking financial institutions and retail investors.

While India has not experienced a crisis recently, the ownership structure of government debt seems problematic from the view of financial and economic stability. More than 80% of government debt in India is held by banks and state-owned insurance companies. This ownership structure, coupled with substantial public ownership of banks and financial institutions, implies a strong nexus between banks and governments.

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