Financial sector weakness and public debt build-up in the Euro areaFinancial sector weakness and public debt build-up in the Euro area
Faculty of Applied Economics
Revue bancaire et financière. - Bruxelles, 2003, currens
(2012):8, p. 508-516
University of Antwerp
The financial crisis has renewed the interest in the relationship between financial sector weakness and sovereign debt sustainability. To assess the direct effect of financial sector weakness on sovereign debt during the recent crisis we decompose the debt build-up of the euro area countries between 2008 and 2011 into the primary deficit, a snowball effect, and stock-flow adjustments. It appears that in some countries the sovereign debt increase was mainly attributable to financial sector bail-outs, but that overall, the indirect effects of the financial crisis have prevailed. Besides explicit liabilities governments also widely assumed contingent liabilities. To assess the implications of linkages between weak financial institutions and sovereign debt sustainability we show the results of a simulation exercise based on a simple model. One insight is that the existence of an adverse feedback loop between banking and sovereign risk is problematic both with and without recapitalization of financial institutions by governments. This asks for policies to be taken to break the strong linkages in order to prevent ailing financial institutions and sovereigns to end up in a vicious circle.