ECB working paper finds fiscal consolidation improves bank balance sheets

A new working paper from the European Central Bank has found, using a "very large data set of individual banks' balance sheets", that standard capital adequacy ratios such as the Tier I ratio tend to improve following episodes of fiscal consolidation.

The paper analyses the effects of fiscal consolidations on the portfolio choices of banks and on banking sector stability. The authors, Jacopo Cimadomo, Sebastian Hauptmeier and Tom Zimmermann, see two channels through which fiscal adjustments could affect bank balance sheets.

First, they say, a direct effect of fiscal consolidation runs through the portfolio choice of banks. If a fiscal adjustment is perceived to reduce the credit risk of a sovereign borrower, a bank's demand for the bonds of this issuer should increase relative to other assets, thereby changing the bank's portfolio in the direction of a lower risk composition.

A second, indirect, channel runs through the macroeconomic effects of fiscal contractions. Based on the standard Keynesian view, a fiscal tightening would exert a negative impact on GDP in the short run, which tends to reduce banks' capital bases, due to loan losses for example, and therefore weaken standard measures of capital adequacy.

Therefore, the improvement in capital adequacy ratios results from a portfolio re-balancing from private to public debt securities, which reduces the risk-weighted value of assets. In fact, the authors say, if fiscal adjustment efforts are perceived as structural policy changes that improve the sustainability of public finances and, therefore, reduces credit risk, the banks' demand for government securities should increase relative to other assets.

To read the paper in full, click here.