Working Paper: CEPR ID: DP14003
Authors: Harris Dellas; Hiona Balfoussia; Dimitris Papageorgiou
Abstract: Fiscal fragility can undermine a government’s ability to honor its bank deposit insurance pledge and induces a positive correlation between sovereign default risk and financial (bank) default risk. We show that this positive relation is reversed if bank capital requirements in fiscally weak countries are allowed to adjust optimally. The resulting higher requirements buttress the banking system and support higher output and welfare relative to the case where macroprudential policy does not vary with the degree of fiscal stress. Fiscal tenuousness also exacerbates the effects of other risk shocks. Nonetheless, the economy’s response can be mitigated if macroprudential policy is adjusted optimally. Our analysis implies that, on the basis of fiscal strength, fiscally weak countries would favor and fiscally strong countries would object to banking union.
Keywords: Fiscal distress; Bank performance; Optimal macroprudential policy; Greece; Banking union
JEL Codes: E3; E44; G01; G21; O52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fiscal fragility (E62) | Positive correlation between sovereign default risk and bank default risk (F65) |
| Optimal adjustment of bank capital requirements (G21) | Reversal of positive correlation between sovereign default risk and bank default risk (F65) |
| Optimal adjustment of bank capital requirements (G21) | Strengthening of the banking system (G28) |
| Strengthening of the banking system (G28) | Higher output and welfare (D69) |
| Fiscal tenuousness (E62) | Exacerbation of the effects of risk shocks (E71) |
| Optimal macroprudential policy adjustments (E61) | Mitigation of adverse impacts of fiscal tenuousness (E63) |
| Higher capital requirements (G28) | Improvement of welfare and support for greater financial intermediation (E69) |
| Fiscal strength (E62) | Preferences regarding banking regulation (G28) |