Edited by Matthias Haentjens and Bob Wessels
Chapter 3: A fiscal backstop to the banking system
The strength of a banking system ultimately depends on the strength of the sovereign behind it. This principle was reinforced during the 2007–09 Global Financial Crisis and the subsequent 2010–12 European Sovereign Debt Crisis. Well-known examples of a weak sovereign, which could not back-up its troubled banking system, are Iceland, Ireland, Portugal and Cyprus. Governments – assembled in the Financial Stability Board – aim to reduce their potential exposure to the banking system through several reforms. The major reform proposals to strengthen financial stability are twofold:1 (i) Reduce the probability of failure by increasing capital substantially; (ii) Reduce the impact of failure by imposing resolution plans, bail-in arrangements, as well as adopting structural reforms of the banking system. A key structural reform is the requirement to separate commercial and investment banking, as suggested by Volcker for the United States (US), Vickers for the United Kingdom (UK) and Liikanen for the European Union (EU). However, it can be questioned whether such separation will really limit the government’s potential exposure. Remember that the US government had to rescue several (lightly regulated) investment banks during the Global Financial Crisis. Another reform is the planned application of bail-in of (junior) creditors to reduce the need for taxpayers’ money. While bail-in can work very well in the case of idiosyncratic failures, it remains to be seen whether authorities dare to apply it during a severe banking crisis. Bail-in spreads the losses through the system and can thus cause contagion.
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