The unique feature of the global financial crisis that began in 2007 is that it is an amalgam of a financial markets crisis, a banking crisis and a sovereign debt crisis. The crisis began as a credit and financial problem in most countries but soon snowballed into a banking and sovereign crisis. In some cases, such as Ireland, governments took on excess debt and risks while rescuing failed banks or stimulating the economy. And in yet others, such as Spain, private debt and a growth slowdown engulfed governments too. And in yet others, such as Greece and Italy, governments took on excess debt and ran up deficits. These crises indicate the existence of a strong two-way relationship between banking crises and sovereign debt crises.
It is equally clear from these events that myopic governments are keen to expand fiscally to subsidize consumption rather than invest in stable growth, which requires undertaking tough structural reforms; worse, they are reluctant to reduce fiscal deficits even in the wake of unsustainably large debts on their balance sheets. And very often, banking systems of their countries hold a substantial part of the public debt. Indeed, a captive and repressed financial system is the least cost option for myopic governments for funding deficits. This, in turn, creates a reluctance on the part of such governments to develop alternative channels to market public debt to non-banking financial institutions and retail investors.
While India has not experienced a crisis recently, the ownership structure of government debt seems problematic from the view of financial and economic stability. More than 80% of government debt in India is held by banks and state-owned insurance companies. This ownership structure, coupled with substantial public ownership of banks and financial institutions, implies a strong nexus between banks and governments.
The dangers of this nexus cannot be overstated. First, having easy access to banks for funding deficits will reduce market discipline on governments and allow them to over-borrow with few immediate consequences. Second, instead of government debt markets being an antidote for a banking crisis, and banks being an antidote to a sovereign crisis, the two will amplify each other. A domestic banking crisis can adversely affect the fiscal situation and the country’s sovereign rating and make any future issuance of debt more difficult. Similarly, sovereign credit deterioration can cause collateral damage to the banking system and disrupt and increase the costs of financial intermediation for the rest of the economy.
What are the alternatives? An obvious way to avoid the emergence of reinforcing banking sovereign crises is to implement a prudent, substantially counter-cyclical, fiscal policy. But it may not be realistic to expect governments to discipline themselves when election-cycle lengths are not longer than economic-cycle lengths.
A second-best alternative is to diversify the ownership of the government debt outside the banking system. Ownership of sovereign debt by non-banking financial institutions and retail investors will provide a broad base that will weaken the bank-government nexus and reduce the severity of future crises, banking or sovereign.
With wider ownership of government debt, a banking crisis in itself will not disrupt the government bond market as investors will allocate funds away from banks to government bonds. Indeed, the government may experience a flight to safety and can engage in a fiscal stimulus if necessary. Investors will also be better off in having access to an additional asset class that will reduce the clamour for gold and real estate.
Conversely, in the presence of a well-functioning bond market, a credit deterioration of the government need not impair banks substantially as its debt is not all held by banks, but is also owned by other financial institutions and retail investors. Diversified ownership of sovereign debt also creates a direct channel of monetary transmission. This is because any changes affecting interest rates could concern consumption and portfolio decisions of the entire system via their effect on the market values of the debt holdings. With dominant bank holdings, the transmission mechanism will operate only through the indirect bank channel, which itself will be severely impaired in the midst of a banking crisis.
An essential requirement for diversifying the ownership of sovereign debt is to create a liquid secondary market. Such liquidity is essential for non-banking institutions and retail investors to hold substantial portions of debt as they may need to transact in government debt at a relatively high frequency for trading and portfolio rebalancing purposes.
Government bond liquidity has been found to be self-fulfilling in that diverse market participants with heterogeneous views, attracted to a liquid market, further enhance liquidity of the secondary market.
There is thus a chicken and egg problem for breaking the bank-government nexus in the Indian context. Liquid secondary markets in government debt are required to attract non-bank investors and the presence of a wider investor base is required for creating a liquid government bond market. A first step in solving this problem could be to reduce the statutory liquidity ratio (SLR) requiring banks to hold government bonds and encourage them to market the securities to non-banking financial institutions and retail investors. Creation of liquid benchmark securities, in which there is regular issuance and secondary trading, is an important second step for the development of a credible government yield curve, essential for trading and valuation of government debt. As the experiences of other developed financial markets indicate, creation of such benchmark securities will facilitate the development of interest rate derivatives and corporate bond markets.
Viral V. Acharya is C.V. Starr Professor of Economics at the Stern School of Business, New York University and Gangadhar Darbha is executive director at Nomura Structured Finance, Mumbai.