Sovereign Regulatory Risk-Weight Privilege and Constitutional Fiscal Rules

Abstract

The global financial crisis exposed the sovereign-bank nexus as a driver of financial instability and an impediment to economic growth. Less attention has been paid to fiscal effects. Accordingly, this study analyzes the interaction between the macroprudential regulation of banks' capital requirements and fiscal rules. We hypothesize that a conflict occurs between the regulatory privileged treatment of sovereign bonds held by banks and the market exposure logic enshrined in constitutional fiscal rules. This is particularly problematic in currency unions such as the US and the euro area. We estimate local projections to examine the reaction of sovereign fiscal positions in euro area member states to a restrictive macroprudential capital regulation shock. We find that peripheral euro area governments increase their debt following an unanticipated tightening in macroprudential capital regulation. This result indicates that the macroprudential treatment is at odds with constitutional fiscal rules.

Keywords: Fiscal rules, macroprudential capital regulation, fiscal balance, zero-risk weights, sovereign-bank nexus

JEL Classification: C33, G28, H63, K33