Summary:
Concerns about fiscal sustainability and worsening balance sheet conditions of major banks triggered a doom loop between banks and sovereigns during the 2010-2013 sovereign debt crisis. Despite closer financial integration and additional institutional safeguards, the home bias, i.e. domestic bank holdings of domestic sovereign debt, is still high in most EU countries and raises concerns on the incentive of governments to consolidate debt. We examine the effects of home bias on fiscal sustainability in EU countries. Using an extension of an IMF database on sovereign debt holdings by Asonuma et al. (2015) and a novel methodology, we find that a higher home bias does not necessarily reduce the reaction of governments to public debt. The reason is that a developed banking system allows sovereigns to raise more public debt domestically at acceptable conditions to support economic stabilisation. An increased presence of foreign banks has a benign effect on sustainability by reducing governments’ debt bias, but state-owned banks reduce it. Developing financial markets further through the completion of the Banking and Capital Markets Unions in the EU could help countries in the trade-off between economic stabilisation and debt sustainability, while bringing in more foreign banks might enforce stronger fiscal discipline.
Keywords: fiscal policy, government debt, home bias, financial development, banking, doom loop
Publication date: 01-04-2025
IIT-25-099I
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