The sovereign-bank nexus

The Global Financial Crisis (GFC) and, even more, the following Euro sovereign debt crisis have highlighted the close interplay between sovereigns and domestic banks. In the most acute phases of crises, the risk of the sovereign sector and the domestic banking sector has increased considerably, with a high degree of correlation. This interconnectedness of banks and sovereigns is often referred to as the sovereign-bank “nexus”, whereby problems originating in one of the two sectors may cause a negative “feedback loop” that further amplifies the effects in each sector (BIS, 2017). This evidence has stimulated an extensive debate. On the one hand, some scholars argue that the link between sovereign and banks is very dangerous for financial stability and therefore must be “broken”. On the other hand, other pundits claim that government exposures are very important for banks and, more generally, for the proper functioning of the financial system; thus, breaking the nexus could cause many problems. The second section of this chapter analyses the risks and the benefits of the sovereign-bank nexus. The third section reviews the regulatory treatment of sovereign exposures. The fourth section illustrates recent proposals to alleviate the negative effects of the nexus. The fifth section offers a discussion of the COVID-19 impact on this topic. Finally, the sixth section concludes.