Bank–Sovereign Doom Loop
Term: Bank–Sovereign Doom Loop | Book: Lipstick on a Pig (financial bailouts): book profile and conceptual summary
Definition and core idea
The bank–sovereign loop, or the link between banks and the sovereign, refers to a negative feedback in which weakness in banks can weaken the government’s finances, and a decline in the government’s credit puts pressure in turn on banks’ balance sheets, funding and stability.
Explanation and elaboration
If the government takes on a large financial commitment to support banks, concern about the state of public debt can rise. On the other hand, banks that hold a large amount of government bonds may be hurt by a fall in the value of those bonds or a rise in the government’s funding cost. Weakness in banks and in the government intensify each other in such a situation.
The IMF describes this link as a mechanism for transmitting and amplifying financial shocks. Even so, the loop does not work the same way in every country and every crisis; the level of debt, the structure of banks’ assets, the currency of debt, monetary policy, market confidence and the government’s fiscal capacity all matter.
Notes and limits of interpretation
Separating claim from fact
The bank–sovereign loop is not solely the result of bailouts; balance-sheet links, holdings of government bonds, guarantees and the effect of a banking crisis on the economy and tax revenue also play a part.
Relations to other concepts
Review questions
- What problem does this concept clarify?
- Who benefits and who is harmed?
- What evidence is needed to test this claim in a real case?
- Which part is the author’s position and which part needs independent evidence?