Bank capital adjustment to public debt shocks: The role of institutions in emerging markets

This paper examines how banks' capital ratios respond to shocks to government debt-to-GDP and how these responses differ across regulatory environments. Using local projections on a broad cross-country panel, we find that increases in public debt are usually followed by declines in banks' capital-to-assets ratios. This average pattern, however, masks important heterogeneity. In countries with weaker regulatory frameworks, banks tend to adjust more slowly and may even raise capital ratios in the medium term. In contrast, stronger regulatory systems are associated with earlier capital losses and faster balance-sheet contraction, followed by a recovery in advanced economies. These findings suggest that regulatory quality plays a central role in shaping the transmission of fiscal shocks to the banking sector and that simple capital measures provide a useful lens for tracking this adjustment.