Government Debt Expansion and Bank Capitalization: The Conditioning Role of Institutional Quality

This study explores how banks’ capital ratios respond to government debt-to-GDP shocks and how this response varies with regulatory quality. Using local projections for a large panel of advanced and non-advanced economies, we document that on average, increases in public debt are followed by declines in banks’ capital-to-assets ratios. However, this aggregate trend conceals important heterogeneity. When regulatory quality is introduced as a conditioning variable, capital adjustment becomes state dependent. Banks operating in weaker regulatory environments incorporate fiscal pressure more slowly and may raise capital ratios in the medium term, whereas those in stronger systems record losses earlier and experience an immediate decline in capital, followed by a recovery in advanced economies as conditions stabilize. These results show that institutional quality shapes the transmission of fiscal shocks to bank balance sheets and that simple capital measures capture this adjustment more reliably than risk-weighted ratios. The findings highlight the need to account for fiscal conditions in macroprudential assessments and underscore the importance of supervisory capacity for maintaining bank resilience when public debt increases.