Bank-Sovereign Doom Loop Requires Fiscal Response, BIS Says

  • Bank regulation isn’t enough to stop contagion, BIS says
  • Budgets belie boom-bust risks; tax codes egg on excess debt

Policy makers have to take tougher action to sever the link between banks and sovereigns that wreaked so much havoc during the last financial crisis, according to the Bank for International Settlements.

The current regulatory treatment of government debt on banks’ balance sheets is “no longer tenable,” the Basel, Switzerland-based lender said in its annual report released on Sunday. Assigning a capital charge to sovereign bonds is being studied by the Basel Committee on Banking Supervision.

Stefan Ingves, chairman of the Basel Committee, has said policy makers will examine options to tighten capital rules around banks’ holdings of sovereign debt in a “careful” and “gradual manner.”

But that’s not enough to solve the problem, according to the BIS. Treasuries worldwide need to change their fiscal policies to prevent bubbles, create room to intervene when necessary and remove incentives that cause financial fragility in the first place, most importantly the tax preference for debt.

“A more active and targeted fiscal policy could be used to safeguard the sovereign from from private sector financial excess,” the BIS said in the report.

Bretton Woods

Financial crises are an immense cost to taxpayers, the BIS said, based on data for such crises since the end of the Bretton Woods era.

In advanced economies, the median increase in public debt was equivalent to 15 percent of economic output in the three years after the crisis. After the 2008 crisis, that debt increase was even bigger: In advanced economies, the median rise was 30 percent of output, and debt now stands at nearly 100 percent.

To protect sovereigns against that risk, the starting point is to recognize the “flattering effect” financial booms have on public finances in the run-up to a bust, according to the BIS. Budget balances would have been worse by nearly 1 percent of gross domestic product in Spain, or almost 0.7 percent in the U.S., if adjusted for those effects.

Using those adjusted budget numbers, and adding a buffer for possible spending on financial stability risks, would have created more space to deal with the fallout later, the BIS said. However, the more important goal would be to removing the structural incentives that help inflate risks.

‘Fiscal Incentives’

“At present, fiscal incentives often do more to encourage greater leverage than they do to support financial stability,” the BIS said. “Examples include underpriced government guarantees of debt liabilities and tax systems that favor debt over equity.”

For all the regulatory efforts toward removing implicit promises by government to bail out banks, guarantees are still a huge factor in banking all over the world, according to the BIS. In the U.S., a third of financial sector liabilities have an explicit guarantee, and a further 26 percent implicitly -- a total of more than 60 percent.

Those guarantees still help subsidize global banks’ own lending, which is about 30 basis points cheaper than it would be without the implicit guarantee, though that’s down from as much as 200 basis points five years earlier.

The tax preference for debt shows in two main ways: mortgages and corporate debt. Tax relief that translates into mortgages that cost more that a percentage point less than they would otherwise have pushed household debt in countries like the Netherlands, Denmark or Norway to more than twice disposable income.

“The broad benefits from eliminating the debt bias appear substantial,” according to the BIS. “Evidence suggests that removing, or at least reducing, the debt bias in taxation could be a key ingredient of a macro-financial stability framework.”

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