The Fiscal-Financial Stability Nexus: Rethinking the Role of Public Debt
For decades, public finance and financial stability were regarded as two relatively distinct fields. The sustainability of public finance was discussed by finance ministries, fiscal councils and budget analysts, while the stability of financial markets and banks belonged to the domain of central banks, regulators and supervisory authorities.
In recent years, however, it has become increasingly clear that this distinction no longer reflects reality. In its 2026 Annual Economic Report, the Bank for International Settlements (BIS) highlights a phenomenon known as the fiscal-financial stability nexus. It describes a situation in which the state of public finances and the stability of the financial system influence each other and can no longer be analysed in isolation.
The BIS's central message is that fiscal discipline is becoming a prerequisite for financial stability, while financial stability is, in turn, becoming a prerequisite for fiscal sustainability. The two can no longer be viewed separately.
From the Bank–Sovereign Nexus to a Broader System
Discussions have traditionally focused on the so-called bank–sovereign nexus - the mutual interdependence between banks and the state. The European sovereign debt crisis demonstrated that problems in public finances can weaken the banking sector, while banking-sector problems can subsequently place an additional burden on public finance.
The BIS argues, however, that today's system is considerably more complex. In addition to banks, it encompasses large non-bank financial institutions, hedge funds, insurance companies, pension funds, repo markets and derivatives markets. In this environment, stress can spread rapidly across sectors and national borders. Sovereign bond markets may appear stable for years, yet a shift in market sentiment can cause liquidity to evaporate rapidly and funding costs to rise sharply. The BIS therefore warns that fiscal space may narrow long before a country reaches conventionally defined limits of debt sustainability.
According to the BIS, what characterises the emerging fiscal-financial stability nexus?
- high levels of public debt,
- the growing role of non-bank financial institutions in holding and trading sovereign debt,
- greater sensitivity of financial markets to fiscal risks,
- more frequent central bank interventions to stabilise markets,
- stronger interdependence between fiscal, monetary and regulatory policies.
In other words, public debt is no longer solely a matter of budgetary policy. It is becoming part of the architecture of the financial system.
Notably, the academic literature describes this relationship through the concept of "two-way propagation channels". The interaction between public finances and the financial system does not operate in only one direction. High public debt can increase the vulnerability of the financial sector, while financial crises can significantly weaken public finances through the costs of stabilising banks, declining tax revenues and weaker economic growth.
Public debt can therefore no longer be regarded merely as a budgetary category. In the modern financial system, it has become part of the infrastructure of financial markets and a source of interdependence among governments, banks, investors and central banks.
The State and Finance: A Relationship of Mutual Dependence
Ad van Riet offers a particularly interesting perspective on this issue in his paper on European financial law and the "state-finance nexus". He points out that modern financial systems are built around sovereign bonds as a core safe asset. The state relies on the financial sector to finance its debt, while the financial sector relies on sovereign bonds as collateral, liquid assets and investments receiving preferential regulatory treatment.
European financial regulation therefore contains numerous provisions that create what are known as "sovereign privileges". Sovereign bonds receive preferential treatment under several regulatory frameworks, including favourable capital treatment, exemptions from risk-concentration limits and recognition as high-quality liquid assets.
This creates an interesting paradox. The more the financial system relies on public debt as a core safe asset, the stronger the interdependencies between the financial sector and public finances may become. The BIS refers to this mutually reinforcing risk mechanism as the "sovereign-bank doom loop". It describes a situation in which banking-sector problems weaken public finances, increasing sovereign risk. The resulting decline in the value of sovereign bonds then further weakens the banks holding them in their portfolios. This creates a vicious cycle in which fiscal and financial risks reinforce each other.
On the one hand, regulation seeks to strengthen financial stability by encouraging the holding of assets considered safe. On the other hand, it creates additional demand for public debt and weakens the market discipline intended to encourage governments to pursue responsible fiscal policies. According to van Riet, the European model therefore contains an inherent dilemma: financial regulation encourages the holding of public debt while simultaneously weakening the mechanisms intended to ensure its long-term safety. The author also makes an important observation: the safety of sovereign bonds is not simply an economic fact. To a considerable extent, it is an institutional construct resting on a combination of confidence, regulation, monetary policy and the functioning of the financial system.
What the Ethiopian Example Reveals
Although this may appear to be a problem primarily associated with advanced economies, relevant insights also emerge from very different settings. One interesting example is a study of fiscal decentralisation in Ethiopia, which examines the relationship between fiscal federalism and macroeconomic stability at the level of regional governments.
The authors use the misery index - the sum of inflation and unemployment - as an indicator of stability. The higher the index, the worse the state of the economy in terms of both economic stability and social welfare.
The findings are particularly instructive. Revenue decentralisation - whereby regions generate their own revenue and assume responsibility for it - contributes to greater stability. By contrast, expenditure decentralisation and regional dependence on transfers from the central government undermine stability.
Key findings of the Ethiopian study:
- expenditure decentralisation does not, by itself, guarantee stability,
- dependence on transfers may weaken fiscal discipline,
- revenue autonomy strengthens accountability for regions' own decisions,
- the alignment of decision-making powers and responsibility is crucial to the stability of the system.
The underlying logic is universal. If a regional government makes expenditure decisions without bearing full responsibility for raising the necessary revenue, it has an incentive to shift the costs of its decisions to another level of government. The authors therefore emphasise the importance of hard budget constraints and accountability for one's own decisions.
In a sense, this is the same problem highlighted by the BIS. When decision-making powers are separated from responsibility for their consequences, fiscal vulnerabilities emerge and may gradually spread to the financial system.
The Common Denominator
Despite their different geographical and institutional contexts, the academic sources discussed here share a common line of reasoning. The Ethiopian study shows that expenditure decentralisation without adequate revenue responsibility may contribute to macroeconomic instability. Van Riet points out that financial regulation supporting demand for public debt strengthens the interdependence between the state and the financial sector. The BIS then describes the broader implications of these processes through the emerging fiscal-financial stability nexus, in which fiscal problems become financial problems and financial problems, in turn, affect public finances.
Although these perspectives differ, they all point to the same conclusion: modern public finances and the modern financial system are now considerably more interconnected than they were in the past.
To conclude, it is worth recalling the succinct observation made by the BIS authors: "Prudent regulation cannot substitute for fiscal prudence." Even the most sophisticated financial regulation cannot compensate for irresponsible fiscal policy. Regulation can strengthen the resilience of the financial system, but credible and sustainable public finances remain its solid foundation.
Public debt can therefore no longer be regarded solely as a budgetary category. It is becoming an integral part of the broader debate on the stability of modern economies, the functioning of financial markets and the resilience of the institutional frameworks on which they are built.
Sources:
- Bank for International Settlements (2026): Annual Economic Report
- Borio, C., Farag, M., & Zampolli, F. (2023): Tackling the fiscal policy-financial stability nexus. (BIS Working Papers No. 1090)
- Bushashe & Bayiley (2023): Fiscal decentralization and macroeconomics stability nexus: Evidence from the Sub-national governments context of Ethiopia
- Van Riet, A. (2023): European financial law and the state-finance nexus: Sovereign privileges or market discipline for safe public debt?
Images: Knowledge at Wharton, BIS AER 2026, ChatGPT