Banks, moral hazard, and public debts

In financial crises, private debts typically turn into public debt. In the case of private bank debt, a risk is that sovereign debt may balloon out of control because of actions taken to prevent the collapse of banking systems. This paper discusses some issues related to this interaction between bank debt and sovereign debt. Specifically, it recalls well-identifi ed stylised facts about the loop between banks and sovereigns. It suggests that, beyond positive reasons, some normative considerations explain the nature and intensity of this loop. From a policy perspective, it assesses the implications of some recent developments in regulation and public policies, points out what could be done to reduce the chances of a negative bank-sovereign feedback loop, and evaluates whether the options to better allocate the costs of crises are mutually consistent. Clearly, the crisis requires a fundamental rethink of previously commonly accepted views. One was that risky private debt could easily be morphed into high quality and liquid assets. Another was there are intrinsically riskless financial assets. Efforts by policy-makers are underway to create a new normal, where all risks are properly measured and understood, are fully priced in and their quantity better controlled. Moving to a new normal also requires that fi scal rules and discipline are better entrenched through robust and time consistent policy frameworks.