TIME TO SEVER THE SOVEREIGN-BANK NEXUS
As governments in emerging markets and low-income countries increasingly turn to sovereign borrowing to bridge financing gaps, a complex and self-reinforcing cycle emerges, linking the financial health of the sovereign to its creditors, especially domestic banks.
In times of prosperity, this relationship can lower government borrowing costs, boost economic growth, and strengthen financial stability. However, during economic downturns, it can also heighten financial stress, raising borrowing costs and leading to potential capital losses for banks. This pro-cyclical dynamic, known as the sovereign-bank nexus, highlights the delicate balance of the financial linkages between government and the financial sector.
This paper analyses the feedback loops and financial linkages that define the sovereign-bank nexus and explores how they shape both the financial sector and the broader economy. Key recommendations identified by the paper to sever this nexus are:
In times of negative sovereign bank cycles (or crises), authorities should act decisively to identify capital shortfalls in the banking system and ensure banks have robust capital and funding plans to remediate and develop frameworks that support speedy bank recovery (including banking legislation reform, financial stability funds, etc.).
In better times, authorities should focus on preventative measures that weaken the sovereign bank nexus and reduce vulnerabilities. In the short term this means better disclosure, steps to limit accounting and regulatory arbitrage and imposing risk weights on credit risk and large concentrations of sovereign debt holdings by banks.
In the long term, it is critical to develop bank resolution frameworks, privatise state-owned banks and deepen domestic financial markets. Alongside this, authorities should direct their policy decisions towards reducing moral hazard – financial institutions should not become ‘too big to fail’.
