Fiscal Deficits, Bank Credit Risk, and Loan Loss Provisions

Abstract

Fiscal deficits represent an important variable for banks’ aggregate credit risk, revealing governments' ability to curb banks’ losses in bad states, either with direct cash infusions or with macroeconomic stabilization policies. Deteriorating deficits are associated with increasing financial distress of the banking sector and higher levels of loan loss provisions. The effect is more pronounced for banks with strong aversion to under-provisioning, and is robust to a battery of tests and to the identification of fiscal shocks using military spending data. This association represents an additional source of negative co-movement between provisions and economic conditions, with implications for financial stability.

Keywords: Banking; Credit Risk; Fiscal Deficits; Business Cycles; Loan Loss Provisions

JEL Classification: E62; G21; G32