In this paper the focus will be on the interrelations between bank and government balance sheets. The apparent interrelations between weak financial institutions and public fiscal imbalances would imply that in addition to the assessment of fiscal variables, possible liquidity needs or defaults of financial institutions and their predicted impact on government debt should be taken into account when judging about the sustainability of the latter.
To start, a brief theoretical explanation of how bank performance can be linked to public debt build-up will be given, including a short reference to some empirical studies concerning this issue. Secondly, an overview of the debt build-up will be given both of countries which have asked for EFSF support, Greece; Ireland; and Portugal, as well as of Spain, and of countries which have experienced a substantial increase in government debt during the recent crisis due to financial sector rescue packages, e.g. Germany and The Netherlands . At first the change in debt will be divided into three components: the change in primary deficit, the contribution of the snowball effect: interest rate payments and nominal GDP growth, and stock-flow adjustments. Thereafter, each component showing a relatively large contribution will be assessed into more detail. Thirdly, a model will be used to discuss the implications for sovereign debt sustainability, taking into account the interrelations between banking sector weakness and sovereign debt build-up. The model used in this context will be based on the model of Mody and Sandri (2011). Finally, empirical research will provide an insight in how and whether the market incorporates financial sector performance in its analysis of sovereigns’ credibility, since in the end it is the market which determines if debt remains sustainable or not: If the market no longer beliefs a government is able to serve its debt, it will no longer be willing to provide liquidity to that government. In the empirical study a panel framework will be used to regress government bond yield spreads of euro area countries on several financial variables, such as the value of financial sector equity; financial sector rescue packages; and guarantees granted to financial institutions during the crisis, in addition to fiscal and other macro-economic control variables. Furthermore, special attention will be given to the impact (if any) of the ECB’s Securities Markets Program (SMP) and Long Term Refinancing Operations (LTRO). It is expected that financial variables do influence bond yield spreads, and that also the ECB’s programs have led to, at least temporary, alterations in yield spreads.