Fiscal risk and financial fragility

We propose a new methodology to evaluate the importance of fiscal risk to financial stability. We first develop 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. While in our model the evolution of public entities' revenues is stochastic and heavily depends on expectations about macroeconomic risk factors, the evolution of their personnel expenses and debt is rather deterministic due to the stickiness of the regulation. We then estimate the resilience of the financial sector to the public sector by simulating bank credit defaults in a multilayer network with interacting agents comprising banks, firms, and the public entities. Using Brazilian data at the state level, we establish a statistical link between states' probability of non-compliance and probability of default, enabling us to estimate the expected impact of the public sector in terms of financial losses on the economy. We find that, while most Brazilian states are struggling to comply with budget legal constraints on personnel expenses, the richest states are more likely to not comply with limits on their consolidated debts. We show that financial contagion is small mostly because banks that are more exposed to the public sector are highly capitalized.