The co-dependence of governments and the financial sector

The link between the financial sector and governments was apparent in 2008

Subdued growth in some emerging markets and low commodity prices have led to renewed interest in the link between governments and the financial sector. Recent financial crises have shown how strong this link has been, for example:

  • In 2008, the banking crisis in Ireland morphed into a financial crisis after the authorities’ decision to recapitalise banks directly and guarantee their liabilities. This helped push public debt levels from 24% of GDP in 2007 to 120% of GDP in 2012.
  • On the other hand, private sector government debt holders had to accept losses during the second round of Greek bailout talks in 2012. This placed pressure on the banks who held over €30bn in domestic government bonds at the time.

For businesses this is relevant for two main reasons. First, banks remain a key source of credit, particularly in emerging markets. Second, economic research shows that financial crises can also amplify the depth and length of subsequent recessions, thus having a direct impact on business revenues. 

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?

But the G7 have led the way on bank reforms

Figure 5 shows that the G7 have made significant progress in insulating public finances from future banking failures. First, banks have raised capital: compared to 2010, banks’ ratio of regulatory tier 1 capital to risk-weighted assets has increased in all of the G7 economies with the exception of Canada. Also, across the European Union (EU) for example, a common Banking Recovery and Resolution Directive (BRRD) was enforced at the beginning of this year. Unlike in the past, this now ensures that banks’ shareholders and creditors pay their share of the costs of a bank failure through a bail-in mechanism. This has been complimented by other regulatory tools like stress tests which aim to forecast banks’ balance sheets at times of severe but plausible events.


In contrast the E7 are lagging behind

For the E7, the pace of reform has been slower, partly because of the relatively smaller impact of the 2008 crisis. However, with emerging market risks rising (see our March 2016 edition) and GDP growth slowing down in large economies like China, Brazil and Russia, insulating governments from banking failures remains an unresolved issue.

This is particularly relevant now as there are some tentative signs that financial sector risks are rising. According to the International Institute of Finance (IIF), nonperforming loans are on the rise in most emerging markets.1 If these trends continue, then they could at an extreme trigger bank failures which, in the absence of resolution mechanisms, could have an impact on public finances.

Other sources of finance are growing in popularity

One possible implication of tighter banking regulation is that if banks become more prudent with their lending, financial activity may end up being shifted away from traditional banks. There are signs that this could already be underway as alternative financial channels have been growing in size. For example, the Financial Stability Board estimates that the assets of other financial intermediaries, a measure of the size of the shadow banking sector, in 20 economies and the Eurozone was around $80 trillion in 2014, up from $68 trillion in 2010.² In the UK for example, peer-to-peer lending has increased from £73 million in 2010 to £4.4 billion at the end of 2015 (see Figure 6) which represents a compound annual growth rate of 108%.


Less focus has been placed on the reverse channel

However, progress on insulating banks from weaknesses arising in government finances remains limited. Figure 7 shows that banks’ exposure to home government debt was broadly similar in the middle of last year to what it was at the end of 2013. As well as this, the exposure 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.

The next challenge is for policymakers around the globe to put in place measures that reduce banks’ exposure to financially stressed governments. The Eurozone is at the forefront of this thinking with the European Systemic Risk Board having conducted some preliminary research into policy options. 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.



1"EM Bank Lending Conditions Survey- 2015Q4”, International Institute of Finance

²”Global Shadow Banking Monitoring Report 2015”, Financial Stability Board