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Fiscal distress and banking performance: the role of macroprudential regulation

Hiona Balfoussia, Harris Dellas () and Dimitris Papageorgiou
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Dimitris Papageorgiou: Bank of Greece

No 276, Working Papers from Bank of Greece

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 (search for similar items in EconPapers)
JEL-codes: E3 E44 G01 G21 O52 (search for similar items in EconPapers)
Pages: 33
Date: 2019-12
New Economics Papers: this item is included in nep-ban and nep-mac
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