The Bank for International Settlements published a working paper by Fabrizio Zampolli proposing a debt sustainability framework that explicitly links sovereign borrowing costs to financial intermediaries’ balance-sheet capacity and market dynamics. The paper argues that financial stability constraints can materially limit fiscal space and undermine debt stability even when conventional indicators such as the interest rate-growth differential appear favourable, making r minus g an insufficient guide to sustainability. The framework highlights four amplification mechanisms that can tighten an economy’s effective debt limit through procyclical liquidity and risk: the bank-sovereign nexus, “original sin redux” via foreign investors’ local-currency bond holdings, duration matching by pension funds and insurers, and deleveraging in repo markets by leveraged investors. Across these channels, the paper finds that financial amplification can generate an endogenous debt limit even without default risk or fiscal fatigue, that fiscal space increases with deeper markets and stronger risk-bearing capacity (including more intermediary equity, faster recapitalisation, less binding Value-at-Risk constraints, lower volatility and shorter duration exposure) and with a stronger fiscal reaction, and that fiscal space is state-contingent, with adverse yield shocks compressing it more sharply when the economy is closer to the debt limit. The paper also points to further research needs, including integrating the balance-sheet driven fiscal limit with models that feature explicit default and self-fulfilling liquidity crises, and analysing the role and limits of central bank interventions in restoring market functioning during liquidity stress.
Bank for International Settlements 2026-03-26
Bank for International Settlements publishes framework showing financial stability constraints can tighten fiscal space and create endogenous debt limits
The Bank for International Settlements released a working paper by Fabrizio Zampolli proposing a debt sustainability framework linking sovereign borrowing costs to financial intermediaries’ balance-sheet capacity and market dynamics. It identifies four amplification mechanisms that can tighten an economy’s effective debt limit, highlighting the insufficiency of conventional indicators like the interest rate-growth differential. The paper suggests fiscal space is state-contingent and influenced by market depth, risk-bearing capacity, and fiscal reactions, with further research needed on central bank interventions during liquidity stress.