Conversely, weak public finances can destabilise banks – directly through their exposure to sovereign bonds or indirectly through worsening macroeconomic conditions. What are the implications of these insights? It follows from them that loosening the links between banks and sovereigns is vital if the euro area is to be made more stable. But how do we get there?
First, pinpointing excessive risk concentrations is essential. A European banking supervisor can weaken the nexus between sovereigns and banks by monitoring and putting a brake on the build-up of excessive risks, whether in specific economic sectors or in government financing – even if this can only be done in medium term.