Hiona Balfoussia
Bank of Greece

Harris Dellas
University of Bern, CEPR

Dimitris Papageorgiou
Bank of Greece


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- classification: E3, E44, G01, G21, O52. 

Acknowledgements: We want to thank Heather Gibson, Nobu Kiyotaki and Alexandros Vardoulakis for helpful discussions. We would also like to thank the participants of the 2019 joint SUERF/Narodowy Bank Polski Conference on “Challenges of Interactions between Macroprudential and other Policies”, the 2018 Annual Meeting of the Association of Southern-European Economic Theorists (ASSET) and the Athens University of Economics and Business seminar series for valuable comments. The views expressed in this paper are those of the authors and not necessarily those of the Bank of Greece, the ECB or the Eurosystem.

Hiona Balfoussia
Bank of Greece
Economic Analysis and Research Department
Bank of Greece
21 E. Venizelos Ave, Athens 10250
email: hbalfoussia@bankofgreece.gr

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