What can increase the default risk in local governments?
| Author | Salvador Rayo-Cantón,Juan Lara-Rubio,Andrés Navarro-Galera,Dionisio Buendía-Carrillo |
| Published date | 01 June 2017 |
| Date | 01 June 2017 |
| DOI | http://doi.org/10.1177/0020852315586308 |
| Subject Matter | Articles |
International Review of
Administrative Sciences
2017, Vol. 83(2) 397–419
!The Author(s) 2015
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DOI: 10.1177/0020852315586308
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International
Review of
Administrative
Sciences
Article
What can increase the default risk
in local governments?
Andre
´s Navarro-Galera,
Juan Lara-Rubio, Dionisio Buendı
´a-
Carrillo and Salvador Rayo-Canto
´n
University of Granada, Spain
Abstract
Concern has been expressed by international organisations and in previous studies
about the financial situation of local governments, and the question of debt has been
identified as a crucial element in efforts to overcome the current financial crisis.
However, the variables that can affect the financial soundness of these governments
have not been sufficiently studied, despite their direct relation to the credit risk pre-
mium. In this article, we aim to identify risk factors for default by local governments, and
provide useful information to municipal financial managers. We conducted an empirical
study of 148 Spanish municipalities and analysed data from four years, applying a random
effects logistic regression model. Our findings reveal that a lower population density,
less dependent population, falling levels of per capita income and the presence of pro-
gressive local government are all risk factors for default by local governments.
Furthermore, our findings indicate that the general financing structure variable and
debt composition and maturity variable do influence the risk of default by local
governments.
Points for practitioners
The findings of this article can provide useful information for managers and politicians
responsible for the financial management of local governments, in particular, by enabling
them to better understand the risk premiums assigned by banks. Specifically, by iden-
tifying the risk factors for default, this article highlights the warning signs of this risk, so
that suitable arguments may be expressed in negotiating loan repayment schedules and
interest rates, and in designing financial viability and restructuring plans.
Keywords
default risk, financial factors, local government, population factors, socio-economic
factors
Corresponding author:
Juan Lara-Rubio, Department of Financial Economics and Accounting, Faculty of Economics and Business
Studies, University of Granada, Campus Universitario de Cartuja, s/n, Postcode 18071 Granada, Spain.
Email: juanlara@ugr.es
Introduction
In recent years, various authors (Cohen et al., 2012; Guillamo
´n et al., 2011; Inceu
et al., 2011) have concluded that the global financial crisis has had a very negative
impact on public sector finances, and this has raised concerns about the viability
and financial position of governments, especially local administrations. In conse-
quence, a growing body of academic research has addressed the question of the
financial condition of local governments (Carr and Karuppusamy, 2010; Wang
et al., 2007; Zafra-Go
´mez et al., 2009), the fiscal stress that they face (Benito
et al., 2010; Cohen et al., 2012) or their financial health (Cabaleiro et al., 2013;
Carmeli, 2007).
More specifically, local government borrowing has been identified as a key issue
to be addressed in order to overcome the present financial crisis, and for this
reason, studies have been undertaken to determine the factors that influence the
level of municipal debt (Guillamo
´n et al., 2011; Lago-Pen
˜as, 2008). Among their
conclusions, these studies have identified several variables that affect local govern-
ment debt, including population density, immigration, economic level and the pol-
itical orientation of the governing party.
However, none of these previous studies have specifically examined the factors
that may influence the risk of default on the debt incurred by local governments,
despite the fact that leading international bodies (EC, 2011; EU, 2012; World Bank
Group, 2010) have expressed concerns about government insolvency, since, in their
opinion, this question is of crucial importance for financial sustainability in view of
the often high levels of bank borrowing by public entities. Thus, the International
Federation of Accountants (IFAC, 2013) has identified borrowing as one of the key
dimensions of the financial sustainability of governments.
Therefore, in view of many local governments’ currently high levels of bank
debt, we believe that it would be interesting and useful to analyse the factors
that may influence the possibility of default by local governments, identifying vari-
ables that may limit their ability to meet loan repayment schedules and which,
consequently, would increase their risk premium.
According to international pronouncements (EU, 2012; IFAC, 2013; US
Department of the Treasury, 2013), knowledge of these risk factors could be
very useful for local government managers and policymakers by enabling them
to predict the risk premium that banks will assign them. Moreover, by identifying
these factors, local officials may be better equipped to take decisions in their nego-
tiations with banks regarding loan amounts, interest rates and maturities, and to
take preventive measures against situations of default by designing viability and
restructuring plans and taking measures to strengthen local finance, among other
actions.
According to organisations like the World Bank Group (2010) and the US
Department of the Treasury (2013), the New Basel Capital Accord (better
known as Basel II) represented a groundbreaking advance for the international
financial system. The Basel II model helped ensure the solvency and stability of
credit institutions by assessing the financial risks faced by loan recipients, including
398 International Review of Administrative Sciences 83(2)
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