Need to break the link between the financial sector and governments

Subdued growth in some emerging markets and low commodity prices have led to renewed interest in the link between governments and the financial sector. This has also been an important issue on the global policy agenda as policymakers have tried to loosen these ties. But, how successful have they been?

The G7 have made significant progress in insulating public finances from future banking failures. Unlike in the past, regulation now ensures that banks’ shareholders and creditors pay their share of the costs of a bank failure through a bail-in mechanism. Other regulatory tools like stress tests, which aim to forecast banks’ balance sheets at times of severe but plausible events, have complemented this.

For the E7, the pace of reform has been slower, partly because of the relatively smaller impact of the 2008 crisis. With emerging market risks rising and GDP growth slowing down in large economies like China, Brazil and Russia, insulating governments from banking failures remains an unresolved issue.

However, less focus has been placed on insulating banks from weaknesses arising in government finances. The exposure to domestic sovereign bonds of banks in Germany, Spain, Portugal and Italy is similar to the levels held by Greek banks during the bailout.

This is not surprising as in Europe home government debt is treated as a risk-free asset from a regulatory perspective, despite events during the Eurozone debt crisis showing that this is not always the case.

Richard Boxshall, Senior Economist, PwC, says: “The next challenge is for policymakers around the globe to put in place measures that reduce banks’ exposure to financially stressed governments. If this can be achieved, then the two-way link between governments and the financial sector will be weakened further. This would have positive impacts on financial stability at an individual economy and at a global level.”

For more details, please see this month’s Global Economy Watch at www.pwc.com/gew

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