This study analyzes the impact of fiscal instability on the soundness of financial institutions. The IMF's long-term fiscal outlook (2021) forecasts Korea's public finances to weaken over the medium to long term. Deteriorating fiscal stability may undermine the soundness of the financial sector by way of the financing channels of government bonds and guarantees. Through an empirical analysis, this study finds that the higher the risk of sovereign default, as measured by credit default swap (CDS) premiums on government bonds, the higher the risk of bank default, as measured by bank bonds CDS premiums. Moreover, this study looks at other countries sharing similar fiscal and financial features as Korea―without reserve currencies, greater banking sector size relative to national revenue, and huge private sector credit that is rapidly expanding― and finds that for such countries, bank default risk is further amplified when sovereign default risk increases.

The analysis results may have two policy implications. Firstly, it is necessary to build up fiscal soundness, and this is an indispensable policy agenda item for the Korean economy to pursue over the longer term. Secondly, the banking sector needs to become less reliant on public finances and more self-sufficient. In case of a bank failure in contingencies, it is desirable to adopt a bail-in system that requires creditors to share the losses to rescue the defaulted financial institutions rather than bail-out, which provides relief at the expense of government revenue.

Preface
Executive Summary

Chapter 1 Introduction

Chapter 2 Channels Through Which Fiscal Instability Triggers Financial Instability
　Section 1 Guarantee-Related Channels
　Section 2 Government Bond-Related Channels
　Section 3 Other Channels
　Section 4 (Supplement) Channels Through Which Financial Instability Triggers Fiscal Instability

Chapter 3 Current Situation in Korea and Hypothesis Development
　Section 1 Classification of Advanced and Non-Reserve Currency Countries
　Section 2 Status of Fiscal Soundness
　Section 3 Status of Financial Soundness
　Section 4 Status of Fiscal-Financial Linkages
　Section 5 Status of External Debt
　Section 6 Hypothesis Development

Chapter 4 Analysis of the Impact of Fiscal Soundness on Financial Soundness
　Section 1 Data
　Section 2 Impact of Sovereign Default Risk on Bank Default Risk
　Section 3 Factors Influencing the Strength of Fiscal-Financial Linkages
　Section 4 Comparison with Acharya et al. (2014)

Chapter 5 Conclusion and Policy Implications

References
Appendix
ABSTRACT