Actions by banks and the official sector can mitigate these effects.

Banks should adjust both sides of their balance sheets. On the asset side, they can further diversify their government debt portfolios to reduce overexposure to the home sovereign. On the liabilities side, banks can protect themselves against risk aversion by holding additional capital, making greater use of stable funding sources, diversifying the timing and jurisdiction of their debt issuance and avoiding clusters of maturing debt.

These strategies all have associated trade-offs. For some banking systems, diversifying away from the domestic sovereign would reduce sovereign risk but increase liquidity risk, as foreign sovereign debt may not be eligible under liquidity standards or as collateral in central bank and private repurchase agreements. Moreover, greater use of stable funding sources may entail higher funding costs.

Overall, it is clear that banks themselves can mitigate but not eliminate the impact of sovereign debt problems. This impact can, however, be further minimised by prudent official action.

Governments must acknowledge that because it is not possible to protect the banking system from a distressed domestic sovereign, sound and transparent public finances are essential. Moreover, increasing financial integration means that international financial stability depends on the solidity of fiscal conditions in individual countries.

Beyond ensuring that banks have strong capital bases, bank supervisors must also monitor the interaction of sovereign risk against regulatory policies that encourage banks to hold large quantities of public debt. In addition, they should ensure maximum transparency regarding banks’ sovereign exposures, possibly through the use of coordinated, ad hoc disclosures. This would reduce uncertainty about an individual bank’s assets, avoid the build-up of funding pressures for all banks, and limit contagion.

Central banks should have flexible operational frameworks that, during severe crises, allow them to ease liquidity pressures by supplying funding against a broad range of collateral. Given this is not costless as it shifts credit risk to the central bank, it should be used sparingly and with appropriate safeguards.

Finally, regulatory reforms that target “too big to fail” institutions can reduce investors’ expectations of government support for banks, thereby weakening the link between sovereigns and banks.

The bottom line is that deteriorating fiscal conditions have an adverse impact on the stability of banking systems at home and abroad. Fiscal authorities need to step up efforts to return public finances to more solid long-term paths. Banks, their supervisors and central banks should act now to prepare for a sustained period of more volatile sovereign risk premiums. Recent history has proved that it is impossible to insulate the banking system fully from a distressed domestic sovereign. However, everyone has a role in minimising the impact.

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