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INTERNATIONAL FINANCIAL PROGRAMS

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Title: INTERNATIONAL FINANCIAL PROGRAMS


1
INTERNATIONAL FINANCIAL PROGRAMS
  • Overview of Financial Issues and Analysis
  • May 31, 2002

2
OUTLINE
  • Financial Sector Assessment Program
  • Money laundering and terrorist financing
  • Stress testing

3
IMPLICIT THEMES
  • Crisis prevention
  • Risk assessment
  • Sound practices
  • Risk management
  • At policy level
  • At level of private institutions (financial and
    nonfinancial)

4
FINANCIAL SECTOR ASSESSMENT PROGRAM
5
BACKGROUND
  • Mexico (1994-95) and Asia (1997-98) highlighted
    importance of
  • strong financial sectors,
  • enhanced supervision and regulation,
  • crisis prevention.
  • Assessment of strength and capacity of financial
    sectors is element of new international financial
    architecture.

6
INTERNATIONAL INITIATIVESBodies
  • G-7 Economic Summits
  • G-22 Working Groups
  • Financial Stability Forum
  • Joint IMF/World Bank Financial Sector Liaison
    Committee (FSLC)

7
INTERNATIONAL INITIATIVESInstruments
  • Financial Sector Assessment Program (FSAP)
  • Reviews of Standards and Codes (ROSC)
  • Technical assistance and country follow-up

8
WHAT IS THE FSAP?
  • A joint product of the IMF and the World Bank
    (the Financial Sector Liaison Committee) -- to
    enhance coordination between the Bank and the
    Fund
  • An international cooperative effort using experts
    from cooperating official institutions
  • A program, begun in 1999, to generate
    comprehensive assessments of national financial
    systems

9
WHAT ARE ITS OBJECTIVES?
  • Identify strengths, vulnerabilities and risks
  • Ascertain development and technical assistance
    needs
  • Assess observance and implementation of relevant
    international standards and codes
  • Help design appropriate policy responses

10
HOW DO THE BANK AND FUND USE THE FSAP FINDINGS?
  • FSAP provides the basis for
  • -- A policy dialogue
  • -- The formulation of financial sector
    development strategies and
  • -- Lending and non-lending services (TA)
  • Financial Sector Assessments (FSAs) are given to
    Bank Board for information.
  • Financial System Stability Assessments (FSSAs)
    are discussed by Fund Board.

11
WHAT ARE THE FSAP OUTPUTS?
  • Main Report
  • Overall assessment
  • Stability issues
  • Development priorities
  • Key recommendations
  • Selected Financial Sector Issues
  • Detailed Assessments of Standards and Codes

12
WHICH STANDARDS ARE ASSESSED?
  • Core Principles for Effective Banking
    Supervision, 1997
  • IAIS Insurance Core Principles, 2000
  • IOSCO Objectives and Principles for Securities
    Regulation, 1998
  • IMF Code of Good Practices on Transparency in
    Monetary and Financial Policies (MFP Code), 2000
  • CPSS Core Principles for Systemically Important
    Payment Systems, 2001
  • AML/CFT

13
OTHER KEY STANDARDS
  • Accounting
  • Auditing
  • Insolvency and creditor rights
  • Corporate governance
  • Data dissemination (IMF)
  • Fiscal transparency (IMF)

14
TECHNICAL ASSISTANCEandCOUNTRY FOLLOW-UP
These are critical.
15
MONEY LAUNDERINGandTERRORIST FINANCING
16
WB IMF BOARDS AGREE
  • Money laundering is a global concern
  • It affects financial systems has development
    costs
  • To intensify global efforts in anti-money
    laundering (AML) and in countering the financing
    of terrorism (CFT) within respective development
    mandates

17
MONEY LAUNDERING
  • any transaction involving funds derived from
    criminal activity
  • TERRORIST FINANCING
  • Fundraising or supporting organizations engaged
    in terrorism.

18
GOALS
  • Money Launderers
  • Inject transfer dirty money so funds from
    criminal activities appear to have come from
    legal sources
  • Ensure underlying criminal activity remains
    invisible
  • Terrorists
  • Fund raising
  • Criminal act doesnt always precede transfers

19
COMMON PREDICATE OFFENCES
  • Terrorism/terrorist financing
  • Drug trafficking
  • Bribery
  • Smuggling (arms, people, goods)
  • Theft
  • Embezzlement
  • Racketeering
  • Tax evasion
  • Gambling
  • Prostitution

20
CONSEQUENCES OF MONEY LAUNDERING
  • Makes crime a profitable enterprise
  • Damages market integrity
  • Deters (honest) foreign investment
  • Perpetuates corruption - undermines good
    governance
  • Contamination/contagion B.C.C.I.

21
CONSEQUENCES OF MONEY LAUNDERING (continued)
  • Uneven playing field for honest businesses
  • Laundered funds often untaxed income
  • Risks for Financial Institutions
  • Regulatory Risk
  • Credit Operational Risks
  • Market risk

22
GOOD AML/CFT FRAMEWORK
  • Enhances efficiency capacity in
  • Detection of corruption financial fraud
  • Preventing bribery of public officials
  • Discourages
  • tax evasion/avoidance
  • growth of underground economy
  • Promotes legitimate private business sector
  • Enhances financial sector supervision
  • Avoid name shame process.

23
GOALS OF AML/CFTLAWS POLICIES
  • Know-Your-Customer (KYC)
  • Report Suspicious Transactions
  • Financial Intelligence Unit (FIU)
  • A central, national agency responsible for
    receiving, requesting, analyzing and
    disseminating to the competent authorities,
    disclosures of financial information in order to
    counter money laundering.

24
Basic FIU Concept (one example)
Foreign FIU
Financial Institution
3
Financial Institution
1
FIU
Financial Institution
Prosecutorial Authorities
4
Financial Institution
2
Law Enforcement
25
AML/CFT METHODOLOGY
  • Money laundering properly criminalized?
  • KYC policies/procedures required?
  • Compliance officers staff training required?
  • Financial Intelligence Unit (FIU) operational?
  • Sectors entities are covered?
  • Financial institutions
  • Securities, insurance, leasing companies,
  • Casinos, other entities, professions
  • Cooperation permitted (domestic international)?
  • Penalties sufficient?

26
ORGANIZATIONS REFERENCES
  • United Nations www.un.org
  • UN Global Program Against Money Laundering
    (Vienna)
  • UN Security Council Counter-Terrorism Committee
    (NYC)
  • Model laws regulations www.imolin.org
  • Fin. Action Task Force Ag. Money Laundering
    FATF www1.oecd.org/fatf
  • 40 AML Recommendations 8 new CFT
    Recommendations
  • Regional FATF organizations
  • NCCT List www1.oecd.org/fatf/NCCT_en.htm
  • Egmont Group see FATF website
  • Quick ref Country summaries by U.S. State Dept.
  • www.state.gov/documents/organization/8703.pdf

27
STRESS TESTING
  • A Review of the Issues
  • and Methodologies

28
What Are Stress Tests?
  • Range of techniques used to assess the
    vulnerability of a portfolio to major changes in
    the macroeconomic environment or to exceptional
    events.
  • In the case of banks, stress test are conducted
    to evaluate vulnerability to credit (or default),
    interest rate, foreign exchange, and liquidity
    risks.
  • Techniques were developed for individual
    portfolio applications, but can be applied to
    aggregate portfolios.

29
Why Conduct Stress Tests?
  • Reasons for banks
  • Make risks more transparent by estimating
    potential losses on a portfolio in abnormal
    markets.
  • Complement statistical models with information
    about losses under extreme events.
  • To comply with Basle recommendations.
  • Basle states that banks that use internal models
    to measure market risk must conduct stress tests.
  • Reasons for supervisors
  • To measure systemic risks.
  • To understand tests undertaken by banks and
    ensure adequate risk management.

30
Stress Tests Limitations
  • They rely on judgment
  • What risk factors to stress
  • How to combine factors stressed
  • Range of values to consider
  • Time frame to analyze
  • They have no probabilities attached to them.
  • Help answer how much could be lost but not how
    much is likely to be lost.
  • Generally, these tests do not integrate different
    types of risks.

31
Stress Testing Decision Sequence
32
Aggregate Stress Testing of
Financial Systems
  • Measure of the risk exposure of a group of
    reporting firms (i.e., banks) to a specified
    stress scenario.
  • Objectives
  • Offer forward-looking rather than historical
    information on aggregate risk-taking behavior.
  • Help regulators identify structural
    vulnerabilities and risk exposures that could
    lead to a disruption of financial markets.
  • Emphasis on potential externalities and market
    failures (e.g., evaporation of liquidity).

33
Aggregate Stress Testing of
Financial Systems
  • Challenges
  • Determine the scope (i.e., which institutions to
    include?)
  • How best to aggregate?
  • Compile results of individual tests, report
    distribution of results, dispersion?
  • Test aggregate portfolio and report average?
  • Limitations
  • There are no probabilities attached to the
    outcomes.

34
Data Requirements for the Conduct of Banking
Sector Stress Tests
  • Balance sheet and income statement data (ideally
    at high frequencies) covering at least 5 years.
  • Information on banks (on and off-balance sheet)
    exposure to exchange rate changes, specific
    economic sectors, etc.
  • Market indicators of bank performance if
    available.
  • Bank ratings by regulators or external auditors.
  • Macro-indicators affecting the financial system
    (e.g., GDP growth, real interest rates, stock
    prices, exchange rates, etc.)

35
Credit Risk
  • Risk that a counter-party or obligor will default
    on their contractual obligations.
  • Objective of stress tests assess the extent to
    which bank solvency is impacted by
  • (a) Better provisioning of existing bad loans
    (i.e., either reflecting an adjustment in
    provisions to cover true NPLs or a rise in
    provisions to more adequate levels).
  • (b) Future losses arising from the impact of
    micro or macro conditions on banks stock of bad
    loans.
  • Given (a) and (b), the new capital-asset ratio
    will be

36
Implementing Credit Risk Stress Tests
  • How to estimate future losses
  • Examine default transition matrices.
  • Examine past trends of NPLs and assume that past
    losses recur.
  • Use regression analysis to estimate response of
    non-performing loans to macroeconomic shocks like
    changes in interest rates, changes in real GDP,
    changes in terms of trade, etc.
  • Commercial products such as JP Morgans
    Creditmetrics, Credit Suisses Creditrisk,
    McKinseys Credit Portfolio View, and KMVs
    Creditor Monitor have been developed to help
    banks estimate the distribution of potential
    future losses.
  • What to do when data is limited
  • When no precise information exists on the extent
    of underprovisioning or the behavior of NPLs, it
    might be useful to at least calculate the maximum
    loss that banks could bear if capital is to
    remain above the required level.

37
Interest Rate Risk
  • Risk incurred by a financial institution when the
    interest rate sensitivity of its assets and
    liabilities are mismatched.
  • Interest rate changes can affect
  • (a) the income of financial institutions
  • (b) the market value of assets and liabilities
  • Common approaches to analyze interest rate risk
  • Repricing gap model
  • Duration model
  • In both cases we need to identify interest rate
    sensitive assets (e.g. loans, government bonds,
    etc.) and liabilities (deposits, loans received,
    etc.).

38
Gap analysis
  • Objective examine the change in the banks net
    interest income resulting from a change in
    interest rates.
  • NII interest income - interest expenses
  • It follows that ?NII?rcumulative gap
  • If gap is gt0, then NII increases as r increases.
  • If gap is lt0, then NII drops as r increases.

39
Duration analysis
  • Objective Examine the impact of interest rate
    changes on bank solvency measured at market
    values.
  • Conceptual underpinnings
  • Market value of an asset or liability is the
    present value of its cash flows. As interest
    rates rise, the market value drops.
  • Market value of a bank is the difference between
    the market value of its assets minus its
    liabilities.
  • Duration
  • Weighted average time to maturity, using the
    present values of the cash flows as weights.
  • Measure of the interest rate sensitivity or
    elasticity of an asset or liability to interest
    rate changes.
  • Duration analysis consists of evaluating the
    dollar weighted duration of assets vis-a-vis that
    for liabilities. The market value of a bank will
    drop as interest rates rise, if the former is
    larger than the latter.

40
Duration Analysis
  • Given that
  • and since
  • then,
  • E as R if DAA lt DLL

41
Implementing Interest Rate Risk Stress Tests
  • Type and size of shocks
  • Simplest type of shocks (a) parallel shift in
    yield curve, (b) change in slope of yield curve,
    and (c) change in the spread between interest
    rates with the same time horizon.
  • Commercial bank examination manual of the U.S.
    Federal Reserve recommends a 200 basis point
    parallel shift in the yield curve as a plausible
    scenario.
  • Alternatively, examine the impact of large
    interest rate changes observed in the past either
    in the country in question or in neighboring
    countries.
  • Time horizon
  • A longer time horizon allows for a greater
    variation and possibility of larger shocks.
    Scenarios with shorter time horizons tend to be
    applied to institutions with large trading
    portfolios subject to risk on a daily basis.
  • What to do when data limitations exist
  • Make educated guesses of the duration of assets
    and liabilities to get upper and lower bound
    estimates of changes in equity following changes
    in interest rates.

42
Exchange Rate Risk
  • Risk that exchange rate changes can affect the
    value of an institutions assets and liabilities.
  • Exchange rate risk can be direct or indirect
  • Direct where a financial institution takes or
    holds a position in foreign currency
  • Indirect foreign exchange exposure of financial
    institutions borrowers affect their
    creditworthiness
  • Stress test objective calculate the impact of a
    devaluation on the solvency of banks.
  • Net foreign exchange exposure (NFE) foreign
    assets - foreign liabilities
  • If NFElt0 bank loses from a devaluation.

43
Implementing Exchange Rate Stress Tests
  • Type of shock
  • Depending on their relevance, one or more
    exchange rates can be shocked either separately
    or simultaneously.
  • Type of scenario
  • If the exchange rate has suffered from sharp
    depreciations in the past, historical scenarios
    could be used.
  • Currency crises in other countries could be used
    as a yardstick.
  • Hypothetical yet plausible scenarios can also be
    used.
  • Recommended size of shocks
  • Derivatives Policy Group (1995) recommends shocks
    between 6-20. Commission of the European
    Communities (2000) suggests 10 change.
  • What to do when data limitations exist
  • If supervisors have defined hard limits on the
    net open foreign exchange position of financial
    institutions, these could be used to conduct
    stress tests.

44
Liquidity Risk
  • Banks face constant liquidity pressures because
    of the nature of their business.
  • Banks fund longer-term loans with short-term
    liabilities.
  • Imbalances between the maturity of assets and
    liabilities of banks may imply that incoming cash
    flows from assets may not match the cash outflows
    to cover liabilities.
  • Liquidity problems may result from assets
    unexpectedly becoming illiquid during period of
    stress.
  • E.g., banks holding government bonds as liquid
    assets may find that the market may disappear
    during times of crisis.

45
Liquidity Stress Tests
  • Objective examine the impact of changes in bank
    liquid assets on the ability of banks to meet
    their liquid liabilities. In particular, analyze
  • (1) What size deposit run could a bank endure,
    given its liquid assets?
  • (2) What if certain assets considered liquid
    become illiquid at times of stress?
  • Type and size of shocks
  • Use historical data.
  • At the minimum, banks should be able to withstand
    shocks of a similar magnitude to those observed
    in the past.
  • Examine deposit withdrawals observed in other
    peer group countries.

46
Market risk and Value-at-risk
  • Market risk refers to the likelihood of losses on
    a portfolio arising from movements in market
    prices (commodity prices, exchange rates,
    interest rates, stock prices, etc.).
  • The value-at-risk (VAR) of a portfolio is a
    statistical measure that summarizes the largest
    expected loss that the portfolio is likely to
    suffer over a specified time period for a given
    level of confidence.
  • E.g. a portfolio may have a ten-day VAR of 100
    million at a 99 confidence. This implies that
    over the next ten days there is less than 1
    chance that the portfolio will lose more than
    100 million.

47
Drawbacks from Using VARs
  • Not useful in providing information about
    unlikely events.
  • The accuracy of the loss threshold depends on the
    specification and estimation of the underlying
    statistical model of portfolio returns.
  • If the true distribution of returns has fatter
    tails than the assumed distribution, then the VAR
    may underestimate the losses.
  • If the estimation technique is inaccurate (e.g.,
    because of linear approximation) the model may
    under-predict losses.

48
Stress Testing in the Context of the FSAPs
  • Mostly univariate tests have been conducted.
  • Scenarios tend to be historical or hypothetical.
  • Size of shocks varies by country.
  • Methodologies discussed above have been
    implemented with the exception of VAR, which has
    only been used in a few cases.
  • Areas for improvements
  • Develop multivariate tests that account for
    changes in correlations.
  • Determine likely feedback of banking sector
    problems to the macroeconomy and other areas of
    the financial sector.

49
References
  • - Bank for International Settlements (2000),
    Stress Testing by
  • Large Financial Institutions Current Practice
    and Aggregation
  • Issues, Committee on the Global Financial
    System.
  • - Bank for International Settlements (2001), A
    Survey of Stress
  • Tests and Current Practice at Major Financial
    Institutions
  • Committee on the Global Financial System.
  • - Blaschke, Winfrid, Matthew Jones, Giovanni
    Majnoni and
  • Maria Soledad Martinez Peria (2001), Stress
    Testing of
  • Financial Systems A Review of the Issues,
    Methodologies, and
  • FSAP Experiences, IMF Working Paper, WP/01/88.
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