This paper analyzes the interactions between government's indebtedness, sovereign default risk and the size of the informal sector. We test an underlying theory that suggests that in societies with limited tax enforcement, the presence of informality constrains the set of pledgeable fiscal policy alternatives, increases public debt and the implied probability of sovereign debt restructuring. The hypotheses that we test in our empirical analysis are: a larger size of the informal sector is associated with (1) higher public indebtedness, (2) higher interest rates paid on sovereign debt, (3) a higher level of financial instability and (4) a higher probability of sovereign default. The empirical results from cross-country panel regressions show that after controlling for previously highlighted variables in the literature that could explain the variation in financial instability, sovereign default risk and public indebtedness, the size of informality remains as a significant determinant of these variables.

We study whether central bank independence (CBI) and monetary policy arrangements can jointly influence the likelihood of policymakers assigning banking supervision to central banks. Our empirical analysis shows that, assuming a benevolent government, a higher degree of central bank operational (economic) independence is associated with a lower probability of supervisory powers being entrusted to the monetary authority. We interpret this result as deriving from governments’ fear of the risk of excessively discretionary monetary policy. However, there is evidence that – conditional on operational independence – central banks are more involved in supervision when they pursue tighter monetary policy goals (a specific aspect of political independence). Our interpretation is that the latter may represent a commitment to mitigate central banks’ discretion in the monetization of financial distress. Our study suggests that CBI can be relevant, not only for its alleged effects on macroeconomic variables, but also in influencing policymakers’ decisions on the allocation of banking supervisory powers.