Abstract
Concerns about fiscal sustainability and worsening balance sheet conditions of major banks triggered a doom loop between banks and sovereigns during the European sovereign debt crisis. Despite closer financial integration and additional institutional safeguards, the home bias, i.e. bank holdings of domestic sovereign debt, is still high in most EU countries. Sovereign debt accumulation by the domestic financial sector may happen under the pressure of moral suasion, but the impact on consolidation by the sovereign is ambiguous. We therefore examine the non-linear effects of home bias on fiscal sustainability using panel smooth transition regression models on a fiscal rule for EU countries. We find that debt consolidation is a concern for governments, even when the home bias is high. Potential financial instability constrains governments’ deficit bias, without endangering economic stabilisation, at least in countries with developed financial markets. Countries with shallow markets face constraints in stabilisation of economic shocks and must run procyclical policies to avoid debt problems. Foreign entry in the banking system disciplines sovereigns, yet state-owned banks soften budget constraints.
