Financial and real sector interactions: enter the sovereign "ex machina"
Speech by Mr Jaime Caruana, General Manager of the BIS, at the CAFRAL/BIS conference on "Financial sector regulation for growth, equity and stability in the post-crisis world", Mumbai, 15 November 2011.
Recent events underscore the lesson that financial stability depends not only on the links between banks and the corporate and household sectors, but also on those between banks and the sovereign. The sovereign must be prepared to act as ultimate backstop for the financial system. But this requires that fiscal buffers be built up in good times. Otherwise, the sovereign can itself become a source of financial instability, as its credit risk interacts in a malign way with bank and other private sector credit risks. Sovereigns must now earn back their reputation as borrowers that are practically risk-free. Ultimately, the sovereign's solvency is a precondition for the central bank's success in dealing with threats to monetary and financial stability.