Banking Regulation and Sovereign Default Risk: How Regulation Undermines Rules

Abstract The global financial crisis exposed the sovereign-bank nexus as a driver of financial instability and an impediment to economic growth. Little attention has been paid to the interaction of banking regulation and public finance. This study analyzes the interaction between the prudential regulation of banks’ capital requirements and constitutional fiscal rules. We hypothesise that a conflict occurs between the regulatory privileged treatment of sovereign bonds held by banks and the market exposure logic enshrined in constitutional fiscal rules. This is particularly problematic in currency unions such as the US and the euro area. Our legal analysis builds on an empirical econometric assessment showing that peripheral euro area governments increase their debt following a tightening in macroprudential capital regulation, laying bare the undesired interaction between banking regulation and constitutional rules.