Claudia Buch: The bank-sovereign nexus - securing progress by completing the banking union

Almost two decades after the global financial crisis, the bank-sovereign nexus has weakened, and it is not currently a source of prudential concern. The reforms implemented after the crisis have clearly paid off. But as the European Commission is currently reviewing the state of the EU banking sector, it is time to assess and secure the progress made.

Historically, banking crises have shown us time and again how closely bank and sovereign balance sheets may be interwoven. Weak and fragile banks can make the financial system more crisis prone and weigh on growth, bringing high social and fiscal costs. Weak and highly indebted sovereigns, in turn, can negatively affect the banking system through higher risk premia and heightened macroeconomic uncertainty.

Breaking the bank-sovereign nexus has therefore been one of the main objectives of post-crisis financial sector reforms. In the euro area, where there is national responsibility for fiscal policy but a common monetary policy, the need to weaken the bank-sovereign nexus was a major reason for the creation of the banking union.

Two main factors have weakened the bank-sovereign nexus.

First, strong regulation, supervision and resolution powers have reduced the probability of banks failing and improved the ability to deal with failure. In Europe and globally, significant progress has been made to move from bailout to bail-in by establishing resolution regimes and filling up industry-financed resolution funds. Should losses occur, they should now be borne by banks' shareholders and creditors and, where needed, industry funds – not taxpayers.

Second, bank balance sheets have strengthened over the past decade, asset quality has improved, and banks have become better capitalised. This reduces the probability and severity of potential future crises, which would carry high economic costs.