Tackling the fiscal policy-financial stability nexus

Summary

Focus

Despite the great strides made by policy reforms following the Great Financial Crisis, the link between fiscal policy and financial stability has attracted less attention. We review the channels through which fiscal and financial risks propagate and mutually reinforce each other and suggest how policy could best tackle these links.

Contribution

We provide a holistic perspective on the fiscal policy-financial stability nexus, also involving monetary and prudential policies. In doing so, we highlight the importance of both protecting the financial system from the sovereign and protecting the sovereign from the financial system.

Findings

We make a number of policy recommendations. First, policymakers need to consider the risks of financial instability when deciding on the size of fiscal buffers and measuring cyclically adjusted fiscal positions. Second, policymakers should continue to make progress towards reducing the favourable treatment of debt versus equity. Finally, in prudential regulation, more could be done to ensure that capital and liquidity requirements better reflect banks' sovereign exposures. Similarly, it will be important to recognise the role of non-bank financial intermediation in the broader nexus between fiscal policy and financial stability.

Abstract

Tackling the fiscal policy-financial stability nexus is essential to ensure financial and hence macroeconomic stability. In this paper, we review the literature on this topic and suggest how policy could best tackle the link. Doing so involves action on two fronts. First, incorporating financial stability considerations in the design of fiscal policy. This means, in particular, considering the risk of financial crises when assessing fiscal space, recognising the flattering effects of financial booms on fiscal positions and removing or reducing fiscal incentives to private debt accumulation. Second, acknowledging that domestic currency-denominated public debt is not fully risk-free in the design of the prudential regulation of financial institutions. This calls for carefully balanced risk-sensitive capital charges or other measures to limit banks' sovereign exposures with due regard to the special role of government bonds in the financial system and country-specific characteristics. That said, prudent regulation cannot substitute for fiscal prudence. 

JEL classification: E6, G2, G3, H1, H3, H6, H8

Keywords: financial crises; doom loops; sovereign exposures; prudential policy; fiscal policy