3.8 Concluding remarks
The model we have developed enables quantification of the Crown's exposure to risk. It could be used in regular reporting, for example, as part of the suite of other fiscal indicators and in risk management (for example, by applying it to real policy questions).
To be incorporated in regular reporting, the model will require further refinement, particularly with respect to parameter estimation. In any case, it is important to keep the limitations of the model in mind. Judgement is required in interpreting the results of the model. And some policy issues with implications for balance-sheet risk will be too fine grained for this model to be able to shed useful light on the desirable course of action (for example, an SOE increasing its gearing). Value-at-risk models tend to be better at measuring risk under ‘normal' conditions than under extreme conditions.
The modeling could be improved with more detailed analysis of some parts of the balance sheet. Moreover, off-balance sheet risks, such as contingent liabilities, could also be added to the model so long as a probability distribution of possible outcomes can be specified.
This model is not the only approach to quantifying the Crown's exposure to risk. It might also be worth exploring other complementary approaches. One is to develop a ‘factor' model in which the central issue is the sensitivity of the Crown's assets and liabilities to a small set of underlying factors, such as interest rates, exchange rates, equity prices, and the strength of the economy. Another is to make the long-term fiscal model stochastic; that is, to allow projected revenues and spending to evolve with random elements as well as the existing trends. A third is to integrate analysis of the Crown's finances with those of other sectors of the economy (for example, Gray, Merton, and Bodie, 2008). This approach is attractive because the Crown's financial position depends closely on the financial position of households and businesses and because the chance of a very bad fiscal outcome is closely linked in particular to the health of the banking sector.
