Question

Has the doom loop between indebted banks and indebted sovereigns in Europe been broken? and What further steps should be taken to ensure that all bank failures in Europe can be handled at a bearable cost to society?

Answer 1

Yes, the doom loop between indebted banks and indebted sovereigns in Europe has indeed been broken. The doom loop is the relationship between the default risk of banks and sovereigns. This loop was prominent during the period 2008 to 2014. The loop completely disappeared after the year 2016 after the implementation of the new recovery and resolution regulatory framework in Europe.

The further steps that should be taken to ensure that all bank failures in Europe can be handled at a bearable cost to society should be that there should be extensive use of Eurobonds as and when the needs emerge. Use of Eurobonds will weaken the link between government and bank risk and hence bank failures and their consequent bailouts will weaken the risk exposure between sovereigns and banks. Secondly central banks collateral policy should be changed. There should be the use of a risk weighted system in the operations of the central bank and this will lead to diversification of bank portfolios. Lastly and most importantly to ensure that all bank failures in Europe can be handled at a bearable cost to society there should be a supranational resolution mechanism that should be put in place. This will weaken the feedback process between the banks and the government and hence will eventually reduce the potential cost of a bank bailout.