Financial stability indicators and public debt developments

• We examine the inter-linkages between financial stability and fiscal policy.
• Weak profitability and low asset quality signal future fiscal troubles.
• A weak capital base raises the probability of future sovereign debt problems.
• Increases in the regulatory capital adequacy ratio can reduce future fiscal risks.

This paper investigates the inter-linkages between financial stability and fiscal policy. It analyzes the effect of selected financial stability indicators on the probability of future debt deterioration, controlling for several macroeconomic variables. We find significant evidence that a fragile banking system can put at risk public finances. Weak bank profitability, low asset quality and a weak capital base increase the fragility of the banking system, thus, raising the probability of future fiscal troubles.