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Financial Soundness Indicators

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Title: Financial Soundness Indicators


1
Financial Soundness Indicators
  • Paul J.van Sluijs
  • World Bank
  • Nairobi, May 15 17, 2006

2
Overview
  • What is financial system stability?
  • What are financial soundness indicators?
  • Practical issue Choosing FSI peer groups
  • Risks assessed with FSIs
  • Links between FSIs
  • Links between FSIs and other surveillance tools
  • Financial stability review example ECB
  • Key challenges in using FSIs

3
What is financial system stability?
  • Financial system stability
  • Principal components of the system are jointly
    capable of absorbing adverse disturbances
  • Financial system facilitates a smooth and
    efficient reallocation of financial resources
    from savers to investors
  • Financial risks are priced and assessed
    reasonably adequate
  • Risks are efficiently managed
  • financial institutions, markets and
    infrastructure

4
What is financial system stability?
  • Tools a.o
  • Macro prudential surveillance
  • Financial stability indicators
  • Stress testing
  • Supervision and surveillance
  • Analysis of macro-financial linkages

5
Overview
  • What is financial system stability?
  • What are financial soundness indicators?
  • Practical issue Choosing FSI peer groups
  • Risks assessed with FSIs
  • Links between FSIs
  • Links between FSIs and other surveillance tools
  • Financial stability review example ECB
  • Key challenges in using FSIs

6
What are FSIs?
  • FSIs are indicators used to
  • Monitor the soundness of a financial system
  • Assess systemic risk
  • FSIs aggregate micro-prudential indicators used
    by supervisors to assess soundness of a financial
    institution
  • FSIs include indicators representing markets in
    which institutions operate
  • FSIs can detect risks to the financial system as
    a whole that might be missed by micro-prudential
    indicators
  • Macro-prudential indicators FSIs other
    indicators (mainly macro economic)

7
What are FSIs?
  • Basic surveillance data used to construct FSIs
  • Balance sheets income statements of different
    banks
  • Information on ownership structure of financial
    institutions
  • Information on interlinkages among banks

8
What are FSIs?
  • Users of FSIs
  • Central banks monitor risk to monetary policy
    from financial stability
  • Supervisors assess risks to individual banks
    from financial stability
  • Private sector assess risks to investments from
    financial stability
  • IMF member surveillance (e.g. Art IV and FSAP)
    and global surveillance

9
What are FSIs?
  • How FSIs are used
  • FSAPs
  • Identify main financial sector vulnerabilities
  • Assess capacity of the system to absorb losses
  • Target assessments and baseline for stress testing

10
What are FSIs?
  • How FSIs are used (continued)
  • Ongoing financial sector surveillance
  • Monitor imbalances as balance sheets evolve
  • Complement monitoring of financial and
    macroeconomic developments
  • Track evolution of financial system
    vulnerabilities identified in an FSAP

11
Macro-prudential analysis using FSIs
12
What are FSIs?
  • Two types of FSIs
  • Core FSIs
  • FSIs essential to banking sector
  • Cover only the banking sector due to its central
    role in financial stability
  • Can be compiled by many countries with existing
    data
  • Encouraged FSIs
  • Additional banking indicators
  • Data on other financial institutions and markets
    relevant to assess financial stability (non bank
    f.i., corporate sector, real estate sector,
    markets)
  • May require additional analytic work
  • FSAPs show corporate FSIs most important
  • Other indicators based on surveillance needs

13
What are FSIs?
  • Core FSIs
  • Capital adequacy
  • Regulatory capital/rw assets
  • Regulatory tier I capital/rw assets
  • Asset quality
  • Non perf. loans/total gross loans
  • Non perf. loans net of provisions/capital
  • Sectoral distribution of loans/total loans
  • Large exposures/capital

14
What are FSIs?
  • Earnings and profitability
  • ROA, ROE
  • Interest margin/gross income
  • Non-interest expenses/gross income
  • Liquidity
  • Liquid assets/total assets
  • Liquid assets/short term liabilities
  • Sensitivity to market risk
  • maturity mismatch duration assets vs.
    liabilities
  • FX net open position/capital

15
What are FSIs?
  • Encouraged FSIs
  • Other banking sector FSIs
  • Capital/total assets
  • Geographical distribution of loans/total loans
  • Gross asset position in fin. derivatives/capital
  • Trading income/total income
  • Personnel expenses/non interest expenses
  • Spread lending and deposit rate
  • Spread highest and lowest interbank rate
  • Customer deposits/total loans
  • Fx loans/total loans
  • Fx liabilities/total liabilities
  • Net open position equities/capital

16
What are FSIs?
  • Securities market liquidity
  • Average bid-ask spread
  • Average daily turnover
  • Non bank financial institutions
  • Assets/financial system assets
  • Assets/GDP
  • Corporate sector
  • Total debt/equity
  • Return on equity
  • Earnings/interest and principal expenses
  • Corporate net fx exposure/equity
  • Number of applications for protection from
    creditors

17
What are FSIs?
  • Households
  • Household debt/GDP
  • Debt service and principal payments/income
  • Real estate markets
  • Real estate prices
  • Residential loans/total loans
  • Commercial loans/total loans

18
What are with FSIs?
  • What to do with FSIs
  • Trends over time
  • Build-up of vulnerabilities
  • Comparison with peer groups of countries
  • Caution concerning cross-country comparability
  • Disaggregation within countries
  • Identify specific source of vulnerability

19

What are FSIs?
  • Selecting FSIs
  • FSIs that need to be monitored depends on a
    countrys financial structure
  • Systemic importance of insurance or securities
    firms
  • Size and intermediation role of foreign state
    banks
  • In most countries core FSIs are needed
  • Provides a common set of FSIs across countries
  • Core and encouraged FSIs will evolve over time to
    reflect surveillance priorities

20
What are FSIs?
  • Availability of FSIs
  • Individual bank data usually availablee.g. from
    supervisors
  • Quality of data can be good if
  • Based on supervisory reporting requirements
  • Cross-border operations consolidated to capture
    risks abroad
  • Cross-country comparability of data is poor
  • Few countries compile and disseminate FSIs
  • Not sure about data to use and interpretation
  • Confidentialityalthough aggregation protects it

21
What are FSIs?
Strategies to address data limitations
22
Overview
  • What is financial system stability?
  • What are financial soundness indicators?
  • Practical issue Choosing FSI peer groups
  • Risks assessed with FSIs
  • Links between FSIs
  • Links between FSIs and other surveillance tools
  • Financial stability review example ECB
  • Key challenges in using FSIs

23
FSIs and peer groups
  • Peer groups based on features relevant to
    financial stability, including whether
  • Domestic or foreign is lender of last resort/pays
    for closing insolvent banks
  • Government guarantee, e.g. state banks
  • Banks play key payments or intermediation role
  • Financial strength of foreign parent banks

24
FSIs and peer groups
  • Example of possible FSI per groups
  • Grouping by different form of risk to financial
    system
  • Domestically controlled banks
  • State owned banks
  • Large banks
  • Complex groups
  • Foreign owned banks
  • Subsidiaries and branches of large global banks
  • Subsidiaries and branches of smaller foreign banks

25
Overview
  • What is financial system stability?
  • What are financial soundness indicators?
  • Practical issue Choosing FSI peer groups
  • Risks assessed with FSIs
  • Links between FSIs
  • Links between FSIs and other surveillance tools
  • Financial stability review example ECB
  • Key challenges in using FSIs

26
Risks assessed with FSIs
27
Risks assessed with FSIs
  • Capital adequacy FSIs
  • Indicate capacity to absorb losses
  • Definition and quality vary across countries
  • Tier 1 capital (equity) provides most protection
  • Tier 2 capital (e.g. Tier 1 subordinated debt,
    unrealised capital gains) give less protection to
    creditors
  • Valuation problems can cause overestimation of
    capital

28
Risks assessed with FSIs
  • FSIs monitoring asset quality
  • NPLs/Loans an imperfect measure
  • May differ from banks ex-ante internal
    assessment
  • Tend to be a lagging indicator
  • NPLs - provisions/capital
  • Indicates additional provisions that may need to
    be taken

29
Risks assessed with FSIs
  • FSIs monitoring asset quality
  • Loan concentration by sector/total loans
  • Indicates a possible vulnerability when banking
    sector as a whole has a concentrated exposure to
    a sector
  • However,
  • Nominal values of exposures do not reflect
    variations in asset quality
  • Asset quality reflects probabilities of default
    or downgradei.e. highly dependent on asset
    credit rating
  • Credit Value-at-Risk models needed to translate
    nominal exposures into credit risk equivalents

30
Risks assessed with FSIs
  • Banking sector earnings and profitability FSIs
  • From reporting/calculate
  • Return on equity and assets
  • Interest margin
  • Level of non interest expenses

31
Risks assessed with FSIs
  • Banking sector liquidity FSIs
  • Liquidity is a key source of systemic risk
  • Liquidity ratio (liquid assets/total assets)
  • Assesses the balance sheet shrinkage the system
    can absorb before selling assets at fire sale
    prices
  • Liquid assets/short term liabilities
  • Assesses potential scale of bank run assets
    available to cover loss

32
Risks assessed with FSIs
  • Market risk FSIs
  • Limitations of existing measures
  • Probabilities of movements in exchanges rates
    interest rates ignored
  • No allowance for correlation effects among
    balance sheet items
  • Value-at-Risk measures help to overcome these
    limitations
  • Key-rate duration overcomes problems with
    maturity bucket approach
  • VaR provides a comprehensive measure of exposure
    to all sources of market risk under normal market
    conditions
  • However,
  • Stress tests needed to assess market risk in
    abnormal market environments

33
Risks assessed with FSIs
  • Other FSIs for the banking sector
  • Net open position in foreign exchange
  • Indicates potential loss from exchange rate
    change
  • Measure from 1996 amendment to Basel Accord
  • Should incorporate futures and forward hedges
  • For more complex derivatives use stress testing
  • Duration to measure maturity mismatch
  • Limitation duration is technically hard to
    compute
  • Partial solution approximate using maturity
    bucket data collected by supervisors

34
Risks assessed with FSIs
  • FSIs for the non-bank financial sector
  • An early warning indicator of potential banking
    sector problems
  • Corporate sector FSIs
  • Corporate leverage return on equity indicates
    risk of default
  • Detect indirect credit risk arising from shocks
    to the corporate sector (e.g. FX shock raises
    default risk)
  • Real estate sector FSIs
  • Real estate price FSI may detect potential bubble
    in the real estate market that has contributed to
    many banking crises

35
FSIs for Insurance
  • Capital adequacy
  • Additional focus on liability risk (function of
    social and demographic development)
  • Asset quality
  • Duration match assets/liabilities
  • Reinsurance
  • Earnings and Profitability
  • Liquidity
  • Sensitivity to Market Risk

36
FSIs for securities markets
  • Market liquidity
  • Bid-ask spread
  • Average daily turnover
  • Indicates liquidity of markets in which bank
    assets are traded
  • Indicate banks capacity to obtain liquidity by
    liquidating assets
  • Limitation monitors current conditions but does
    not indicate robustness of liquidity in a crisis
  • Solution additional information on market
    micro-structure

37
FSIs for corporate sector
  • Debt-to-equity ratio (Leverage)
  • Ability to withstand shock, repayment capacity
  • Return on equity
  • Profitability
  • Important to look at trend over time (leading
    indicator of distress)
  • Liquidity
  • short-term assets relative to short-term
    liabilities
  • Important to have sectoral decomposition

38
FSIs for household sector
  • Household debt to GDP
  • Household debt burden to income

39
Overview
  • What is financial system stability?
  • What are financial soundness indicators?
  • Practical issue Choosing FSI peer groups
  • Risks assessed with FSIs
  • Links between FSIs
  • Links between FSIs and other surveillance tools
  • Financial stability review example ECB
  • Key challenges in using FSIs

40
Links between FSIs
41
Links between FSIs
  • Links between asset quality FSIs capital
    adequacy
  • Linkages vary by county depending on
  • Provisioning and loan classification rules
  • Definition of capital
  • These are analysed for each country to assess the
    impact of asset quality FSI on capital ratio
  • Use info on rules definitions from BCP
    assessments and country sources

42

Links between FSIs
  • Links between asset quality corporate leverage
  • Objectives of the analysis
  • Identify risks to banking sector from credit
    linkages
  • Help anticipate deterioration in asset quality
  • Currently, in-depth empirical analysis for each
    country is used to assess links (i.e. on FSAPs)
  • Multi-country analysis using panel database can
    be used to estimate relationship for a country

43
Overview
  • What is financial system stability?
  • What are financial soundness indicators?
  • Practical issue Choosing FSI peer groups
  • Risks assessed with FSIs
  • Links between FSIs
  • Links between FSIs and other surveillance tools
  • Financial stability review example ECB
  • Key challenges in using FSIs

44

Links between FSIs and other surveillance tools
  • FSIs stress tests
  • FSIs are the baseline for stress test shocks
  • Stress test shock applied to bank balance sheets
    aggregatedso is bottom-up
  • Output of stress test is on capital ratio FSI
  • Stress test impact reflected in FSIs and so helps
    benchmark links between FSIs

45
Links between FSIs and other surveillance tools
  • Linking FSIs core principles assessments
  • Indicates how effectively banks supervisors
    respond to risks revealed by FSIs
  • Assesses how compliance with criteria reduces
    specific risk monitored by an FSI
  • Analysis shows where improving compliance reduces
    risks to financial stability
  • FSIs helps focus assessments on gaps in
    compliance posing a risk to financial stability

46
Links between FSIs and other surveillance tools
  • Complementing FSIs with financial infrastructure
    assessments
  • Robustness of financial infrastructure revealed
    by codes standards assessments helps assess
  • Bank capacity to access liquidity under stress
  • Robustness of market liquidity under stress
  • This aspect of liquidity risk not well captured
    as FSIs only measure current liquidity conditions

47
Overview
  • What is financial system stability?
  • What are financial soundness indicators?
  • Practical issue Choosing FSI peer groups
  • Risks assessed with FSIs
  • Links between FSIs
  • Links between FSIs and other surveillance tools
  • Financial stability review example ECB
  • Key challenges in using FSIs

48
Financial Stability review ECB
  • Overview overall risks to financial stability
  • Risks from global financial imbalances
  • Risks in global capital markets
  • Exposures to euro area non-financial sector
  • Performance of the euro area banking sector
  • Performance of the euro area insurance sector
  • Overall assessment
  • Analysis macro-financial environment
  • External
  • Euro area

49
Financial stability review ECB
  • Euro area financial system
  • Financial markets
  • Banking sector
  • Other financial institutions
  • Financial systems infrastructure
  • Payment systems
  • Securities clearings and settlement systems

50
Financial stability review ECB
  • Data in charts and in statistical annex
  • Banking sector
  • Non-bank financial sector
  • Markets
  • Large value payments (TARGET)
  • www.ecb.int

51
Overview
  • What is financial system stability?
  • What are financial soundness indicators?
  • Practical issue Choosing FSI peer groups
  • Risks assessed with FSIs
  • Links between FSIs
  • Links between FSIs and other surveillance tools
  • Financial stability review example ECB
  • Key challenges in using FSIs

52
Key challenges in using FSIs
  • Assessing the level of risk associated an FSI
    value (Benchmarking)
  • Detecting vulnerabilities at an early stage
  • Identifying appropriate peer groups for which to
    compile FSIs
  • Improving data quality and comparability

53
Key challenges in using FSIs
  • Further work to be done
  • Development of
  • definitional guidelines for indicators
    (compilation guide)
  • indicators for non-bank financial sector
  • indicators for households and real estate sectors
  • Analytical tools and stress testing
  • Benchmarks
  • Data availability corporate sector
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