Fiscal Risk and Financial Fragility
Thiago Silva (),
Solange Guerra and
Benjamin Tabak ()
No 495, Working Papers Series from Central Bank of Brazil, Research Department
This paper proposes a new methodology to evaluate the importance of fiscal risk to financial stability. We first develop a novel method to estimate the probability of default of public entities, which takes into account a strict legal framework is mandatory for governments. Using options theory, we model the volatile public revenues using country macroeconomic expectations while allowing expenses, which cannot be easily reduced, to grow with inflation. Next, we compute the expected losses due to fiscal risk using a combination of the probability of default with potential losses that the public sector would impose on the economy using a complex network model. Motivated by the crisis on Brazilian states after 2015, we use Brazil to illustrate the usefulness of our model. We estimate the probability of default of states using legal restrictions on consolidated debt and personnel expenses. While most states are struggling to comply with limits on personnel expenses, the richest states have trouble to comply with limits on the consolidated debt. Using a network model that embeds counterparty and funding risks to estimate losses, we find state-owned banks are most likely to be affected if states default on bank credit. Financial contagion is small mostly because the banks that are more exposed to the public sector are highly capitalized.
New Economics Papers: this item is included in nep-ban and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: Track citations by RSS feed
Downloads: (external link)
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
Persistent link: https://EconPapers.repec.org/RePEc:bcb:wpaper:495
Access Statistics for this paper
More papers in Working Papers Series from Central Bank of Brazil, Research Department
Bibliographic data for series maintained by Francisco Marcos Rodrigues Figueiredo ().