I develop a model where governments have an incentive to keep their financial sectors undercapitalized during crises. Protected by limited liability, highly levered banks buy domestic bonds that are correlated with their other sources of revenue. In anticipation, governments set milder capital requirements to increase their future debt capacities when they most need to borrow. Myopic governments are more likely to induce high private sector debt, triggering a "race to the bottom" in capital regulation among countries. Using a general equilibrium model, I can rationalize, in the context of the Euro crisis, the increasing demand for domestic government bonds in the periphery, the crowding-out effect in private lending, and the reluctance to recapitalize the banking sector.