In Europe we have been witnessing debt haircuts and other symptoms of sovereign overburden. By and large, the risk of sovereign default may be low, and sometimes very low, but it is not zero. If we want regulation to be risk-adequate, economic risks will need to find their way into the rules for banking. Our existing regulatory set-up is quite well-developed in this respect.
Sovereigns likewise stand to benefit in the short run since they can raise funding relatively easily thanks to the artificially inflated demand for government bonds – yet at the same time this lessens the pressure on them to consolidate government finances and to reduce their debt to sensible levels.