DP14003 Fiscal distress and banking performance: The role of macroprudential regulation

Author(s): Hiona Balfoussia, Harris Dellas, Dimitris Papageorgiou
Publication Date: September 2019
Keyword(s): bank performance, Banking Union, Fiscal distress, Greece, optimal macroprudential policy
JEL(s): E3, E44, G01, G21, O52
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14003

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.