On the Hook for Impaired Bank Lending: Do Sovereign-Bank Interlinkages Affect the Net Cost of a Fiscal Stimulus?

Recently, some notable contributions suggest that discretionary fiscal policy can be an effective and self-financing policy option in the presence of extreme macroeconomic conditions. Given the special relationship between the Irish sovereign and its main financial institutions, this paper assesses the implications for the Irish fiscal accounts of certain macroeconomic policy responses. Using a comprehensive empirical framework, the paper examines the relationship between house prices, unemployment, and mortgage arrears. Loan loss forecasts over the period 2012–14 are then generated for the mortgage book of the main Irish financial institutions under two different scenarios. It is shown that macroeconomic policies, which alleviate levels of mortgage distress, improve the solvency position of the guaranteed Irish institutions, thereby reducing the sovereign’s future capital obligations. Thus, the unique situation the sovereign finds itself in vis-´a-vis its main financial institutions may have significant implications for the net cost of a fiscal stimulus.