Fiscal risk and financial fragility

TLDR: In this article, the authors proposed a new methodology to evaluate the importance of fiscal risk to financial stability and developed a method to estimate the probability of non-compliance of public entities, which takes into account the strict legal framework that is mandatory for governments.

About: This article is published in Emerging Markets Review.The article was published on 2020-06-20 and is currently open access. It has received 8 citations till now. The article focuses on the topics: Financial fragility & Financial contagion.

Figures

Figure 4: Fiscal situation of Brazilian states regarding the legal restriction of personnel expenses to net current revenue. According to the FRL, the Executive branch of states must maintain this personnel expenses index lower than 49%.

Table 5: Proportion of losses that banks are subject to, in view of credit default from states. Losses are evaluated in December 2015 and 2016 and are broken down by bank control: state-owned and domestic/foreign private banks. We only report results for the five states that are struggling the most with fiscal problems by the end of the sample period: Goiás , Minas Gerais, Rio de Janeiro, Rio Grande do Sul, and São Paulo. We depict in bold the type of bank that suffers the most at each time point and state.

Table 2: Funding portfolio of Brazilian states broken down by creditor type: federal government and banks. The amounts are reported for two dates: December 2015 and June 2016. We show the four states with the largest bank debt to the financial system, as well as the state of Rio Grande do Sul, which is experiencing fiscal problems.

Table 3: Proportion of outstanding bank credit that Brazilian states took from the Brazilian financial system in December 2015 and June 2016. We discriminate these amounts by state-owned and private (domestic and foreign) banks. We list the four states with the largest bank debts in the Brazilian banking system, as well as the state of Rio Grande do Sul, which is experiencing fiscal problems. For each state and date, we depict in bold the prevailing portion of bank credit to the corresponding state.

Figure 1: (a) Consolidated debt of states as a percentage of the Brazilian GDP from 2002 to 2017 broken down by credit from banks and from the federal government, and other debts. (b) Outstanding bank debt of five Brazilian states that are facing fiscal difficulties. The curve in (b) is constructed using 5 states out of the 27 that compose the total credit from banks shown in (a). We only report data from 2012 onwards because such cutoff point represents the beginning of rising bank debt of Brazilian states.

Figure 7: Trajectory of the probability of non-compliance with the legal expenses limit PE/NCR ≤ 49% (Executive branch) in the following relative year for Brazilian states. For each point in the curves, we evaluate the probability of non-compliance in the upcoming year in an independent manner. For instance, with regard to the point referring to April 2014 for the state of São Paulo, we evaluate its probability of non-compliance until April 2015. The list of states classified as moderate or low is given in footnote 19.

Frequently asked questions

Q1. What have the authors contributed in "Fiscal risk and financial fragility" ?

In this paper, the authors use options theory to model volatile public revenues that depend on country macroeconomic expectations while allowing expenses, which are hard to reduce, to grow with inflation. 

Q2. What future works have the authors mentioned in the paper "Fiscal risk and financial fragility" ?

The authors innovate in the sense that the methodology not only uses historical data but also embodies expectations or prospects for real GDP in the future. May B il li o n B R L Goiás Minas Gerais Rio de Janeiro Rio Grande do Sul São Paulo ( a ) Potential losses 20 % 30 % 40 % 50 % 60 % 70 % 80 % 90 % 100 % 110 % Jan 2012 May Sep Jan 2013 May Sep Jan 2014 May Sep Jan 2015 May Sep Jan 2016 May Sep Jan 2017 May Goiás Minas Gerais Rio de Janeiro Rio Grande do Sul São Paulo ( b ) Lower bound for the probability of default 20 % 30 % 40 % 50 % 60 % 70 % 80 % 90 % 100 % 110 % Jan 2012 May Sep Jan 2013 May Sep Jan 2014 May Sep Jan 2015 May Sep Jan 2016 May Sep Jan 2017 May Goiás Minas Gerais Rio de Janeiro Rio Grande do Sul São Paulo ( c ) Upper bound for the probability of default 0 5 10 15 20 25 Jan 2012 May Sep Jan 2013 May Sep Jan 2014 May Sep Jan 2015 May Sep Jan 2016 May Sep Jan 2017 May B il li o n B R L Goiás Minas Gerais Rio de Janeiro Rio Grande do Sul São Paulo ( e ) Upper bound for expected losses Figure 9: ( a ) Potential losses to the financial system if the authors assume idiosyncratic state defaults. 

Q3. What is the effect of government indebtedness on the financial system?

In addition, government indebtedness can force a reduction of investments and therefore affect private firms in the form of reduced demand and incentives, which in turn could again hit the financial sector through further loan defaults. 

Q4. What are the prohibited actions that would cause state indebtedness?

Among the forbidden actions that would cause state indebtedness, the FRL prohibited new credit operations of public entities with controlled companies. 

Q5. How critical are the 27 federated entities in achieving the legal expenditure limit?

Of the 27 federated entities, 5 (18.5%) are more critical in complying with the CD/NCR index, while 22 (81.5%) are more critical with the PE/NCR index. 

Q6. What is the importance of monitoring the sustainability of the public sector when dealing with financial stability?

The crisis in the Euro area highlighted the importance of monitoring the sustainability of the public sector when dealing with financial stability. 

Q7. Why is the Brazilian financial system more vulnerable to external shocks?

This fact ispartly because their creditor banks are relatively less capitalized, which increases the vulnerability and likelihood that shocks will get amplified inside the financial network. 

Q8. What is the impact of the credit crunch on the Brazilian financial system?

In addition to this direct hit, the authors evaluate the negative spillover effects due to successive credit deterioration and credit crunches, which can be seen as sources of financial contagion. 

Q9. How do the authors evaluate the probability of default?

the authors evaluate the probability of default in terms of the fiscal sustainability of the public entity by looking at the balance of revenues and expenses. 

Q10. What is the FRL’s legal restriction on the reduction of personnel costs?

In addition, the FRL prohibited the further in-10The reduction of personnel costs by public entities faces a number of obstacles, since they cannot reduce salaries and civil servants can be fired or dismissed only in exceptional cases that are listed in the law.