The first item regards banks’ capital. Under the current regime, banks do not need to hold capital against the risks of loans to sovereigns – unlike other loans. The thinking here was that sovereign borrowers could not default and that loans to governments were therefore risk-free. And, if no losses could develop, it wasn’t necessary to establish capital buffers.
This has the potential to enhance the credibility of the framework and strengthen market discipline. At the same time, as the reforms consider changes to well-established deposit insurance schemes, it is important to avoid unwanted side effects. Let me recap: Recent events have highlighted weaknesses in the banking sector during periods of monetary policy tightening.