Tackling the fiscal policy-financial stability nexus is essential to ensure financial and hence macroeconomic stability. In this paper, we review the literature on this topic and suggest how policy could best tackle the link. Doing so involves action on two fronts. First, incorporating financial stability considerations in the design of fiscal policy. This means, in particular, considering the risk of financial crises when assessing fiscal space, recognising the flattering effects of financial booms on fiscal positions and removing or reducing fiscal incentives to private debt accumulation. Second, acknowledging that domestic currencydenominated public debt is not fully risk-free in the design of the prudential regulation of financial institutions. This calls for carefully balanced risk-sensitive capital charges or other measures to limit banks’ sovereign exposures with due regard to the special role of government bonds in the financial system and country-specific characteristics. That said, prudent regulation cannot substitute for fiscal prudence.

Keywords: financial crises; doom loops; sovereign exposures; prudential policy; fiscal policy.