Banks, Governments and Debt Crises
Foreign Policy Association Great Decisions 2011
Posted: 8 Jan 2011
Date Written: January 6, 2011
Financial institutions and governments the world over have been locked in mutual dependence since long before the crisis that began in 2007. Postcrisis reforms will not rid banks and governments of one another; at best, they may renegotiate the terms of engagement. This essay uses case studies from the Europe and the Americas to explore the implications of two enduring links between financial institutions and governments: first, the formal and informal public insurance that banks and a growing number of other firms enjoy in exchange for providing critical public services; second, the powerful economic, political and regulatory incentives for financial firms to hold government debt. As a result, an increase in government debt is a common by-product of large-scale bank failure, and large-scale bank failure is a common by-product of government debt default. Such links complicate loss allocation and crisis response. The essay concludes that no sovereign bankruptcy or financial resolution regime can be effective without accounting for the links between governments and financial firms.
Keywords: financial crisis, bank resolution, sovereign debt
JEL Classification: E58, E53, F33, F34, F36, K20, K33
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