Study Examines Banking Vulnerabilities’ Impact On Public Debt

Bank vulnerabilities can foreshadow big costs for government budgets

Pre-crisis bank characteristics, crisis management policies matter

Better information, fiscal policy, tax policy can limit banking stress effects

While the 2008 global financial crisis highlighted the far-reaching implications of the linkages between banks and the central government for public debt sustainability, these linkages are not new, a new study notes.

Over the past three decades, banking crises have contributed to large increases in public debt (see Chart 1). The median cost of direct government intervention in banking crises was 7 percent of GDP. Including indirect fiscal costs from post-crisis recessions, the median increase in public debt four years after the beginning of a crisis was 12 percentage points of GDP. And in many countries, public debt increased by more than 20 percentage points of GDP.

“While sound regulatory and macroprudential policies are the first line of defense, governments should be prepared for risks that inevitably remain,” noted Said Bakhache of the IMF’s Strategy, Policy, and Review Department, one of the report’s authors.

Fiscal cost of bank vulnerabilities

“Banking recessions,” or recessions preceded by a rapid increase in bank credit to the private sector, tend to exhibit deeper contractions in GDP and longer recovery times than other recessions (see Chart 2). And while banking expansions boost fiscal balances during an economic boom, once the boom turns to bust, fiscal pressures are significantly worse in banking recessions compared to recessions associated with more normal credit cycles. This leads to greater deteriorations in the fiscal outcomes and public debt.

When large banking expansions unravel in systemic banking crises, public finances tend to take a significant hit. The high direct fiscal costs of crisis management policies, particularly bank bailouts, are amplified by the overall economic impact of the banking crisis: risk premia rise, consumption and investment fall, and asset values suffer.

These effects compound to reduce government revenues and create public spending needs, potentially leading to rapid buildup of public debt. The impact on public debt is lessened somewhat by asset recovery, which has been high in some countries.

Factors that affect the bank-sovereign link

Several features amplify the effects of banks’ vulnerabilities, the study says.

• Banks’ balance sheet expansion, leverage, and reliance on...