Sovereign bank link? Bank sovereign link? Or linking banks to sovereigns?

The sovereign bank link and the imperative to break it is fairly ubiquitiuous in today's discussion how to improve the financial system. Like with so many overused and underthought buzz words, the sovereign bank link embeds several aspects which circumscribe different problems and solicit different solutions:

• Banks' preference for public over private lending: Public sector loans and sovereign bonds often enjoy privileged treatment, such as zero risk weight among other. This is often thought to bias banks towards lending to the public sector. However, competition will cause this benefit to accrue to the debtor, not the creditor: all else equal, the cost of funds for the public debtor becomes cheaper than for private debtors, resulting in a lower hurdle rate for public than for private investments. This can lead to an unhealthy allocation of savings indeed. As regulatory risk weights are of relevance for banks but not other investors, this privilege has in particular distorted banks' credit allocation, and deserves to be phased out as Der Spiegel reports the ESRB had been proposed. Moreover, privileged treatment should be phased out altogether, including in pension fund regulations and tax exemption of coupons. Conversely, penalizing banks' public lending for the sake of curtailing the sovereign bank link would create new distortions.

• Banks' exposure to the sovereign: Large exposures to the sovereign tie banks and governments together although they would better be independent. Banks' health generally depends on the business cycle, as does the public sector's which ought to smooth the cycle. If a shock adversely affects the sovereigns' creditworthiness, large sovereign exposures would drag down the banks, whose health is crucial for economic growth. In case of public overindebtedness, a situation coined as fiscal dominance could arise, in which independent monetary policy becomes an impossible preposition because banks' health hinges on the sovereign sector's, and monetary policy succumbs to the situation, e.g. by initiating inflationary policies.

• Sovereigns' exposure to banks: As a result of bank bailouts, the public sector also holds large claims on banks. The banking crisis can thus spill into a public debt crisis, and from there spread further through the financial system, including through other banks' exposure to the sovereign as described above. Such situation can arise even before a bank intervention, when ailing banks are large and expected to receive government support. This adverse feedback loop, which previously entangled Cyprus, Greece, and Ireland, could be curtailed by a large third party backstop.

In conclusion, the discussion about curtailing the bank sovereign loop has many facettes. Ending priviliges such as zero risk weights would reduce distorted lending decisions, but need to be phased carefully. A third party backstop, such as the ESM, would strengthen the credibility of the bailout mechanisms discussed, yet ECOFIN's proposed pecking order of support mechanisms may in practice prove unworkable.