Tools for Assessing Financial System Soundness
Tools for
Assessing Financial System Soundness
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Financial
Sector Assessment Program
Financial Sector Assessment Program
(FSAP), introduced in May 1999. Many other national and international
institutions have also initiated or intensified monitoring work.
The ability to monitor financial sector soundness
presupposes the existence of valid indicators of the health and stability of
financial systems. These macro prudential indicators (MPIs) matter for several
reasons. They allow for assessments to be based on objective measures of
financial soundness. If MPIs are made publicly available, they enhance
disclosure of key financial information to the markets. In addition, if the
indicators are comparable across countries —which is possible if countries
adhere to internationally agreed prudential, accounting, and statistical
standards—they facilitate monitoring of the financial system, not only at the
national but also at the global level. The latter is crucial in view of the
magnitude and mobility of international capital, and the risk of contagion of
financial crises from one country to another.
The IMF has been building up experience with MPIs for
some time as part of its surveillance and research, and more recently in the
context of the FSAP. A consultative meeting on MPIs was held at IMF
headquarters in September 1999. High-level experts from central banks,
supervisory agencies, international institutions, academia, and the private
sector discussed their experiences in using, measuring, and disseminating MPIs.
The state of knowledge in these areas and proposals for further work were also
discussed at a meeting of the IMF's Executive Board in January 2000.
What are they?
MPIs comprise both aggregated micro prudential indicators
of the health of individual financial institutions and macroeconomic variables
associated with financial system soundness (see table). Financial crises often
occur when both types of indicators point to vulnerabilities—that is, when
financial institutions are weak and face macroeconomic shocks.
CAMELS framework. Indicators of the current health of the
financial system are derived primarily by aggregating data on the soundness of
individual financial institutions. One commonly used framework for analyzing
the health of individual institutions is the CAMELS framework, which looks at
six major aspects of a financial institution: capital adequacy, asset quality,
management soundness, earnings, liquidity, and sensitivity to market risk.
·
Capital. Capital adequacy ultimately
determines how well financial institutions can cope with shocks to their balance
sheets. Thus, it is useful to track capital-adequacy ratios that take into
account the most important financial risks—foreign exchange, credit, and
interest rate risks—by assigning risk weightings to the institution's assets.
·
Assets. The solvency of financial
institutions typically is at risk when their assets become impaired, so it is
important to monitor indicators of the quality of their assets in terms of
overexposure to specific risks, trends in nonperforming loans, and the health
and profitability of bank borrowers—especially the corporate sector.
·
Management. Sound management is key to
bank performance but is difficult to measure. It is primarily a qualitative
factor applicable to individual institutions. Several indicators, however, can
jointly serve—as, for instance, efficiency measures do—as an indicator of
management soundness.
·
Earnings. Chronically
unprofitable financial institutions risk insolvency. Compared with most other
indicators, trends in profitability can be more difficult to interpret—for
instance, unusually high profitability can reflect excessive risk taking.
·
Liquidity. Initially solvent financial
institutions may be driven toward closure by poor management of short-term
liquidity. Indicators should cover funding sources and capture large maturity
mismatches.
·
Sensitivity
to market risk. Banks
are increasingly involved in diversified operations, all of which are subject
to market risk, particularly in the setting of interest rates and the carrying
out of foreign exchange transactions. In countries that allow banks to make
trades in stock markets or commodity exchanges, there is also a need to monitor
indicators of equity and commodity price risk.
Indicators of market perceptions—such as the
prices/yields of financial instruments and the creditworthiness ratings of
financial institutions—are often used to supplement the information obtained
through the CAMELS framework.
Macroeconomic indicators.
The operation of a financial system depends on overall
economic activity, and financial institutions are significantly affected by
macroeconomic changes. Recent analysis has shown that certain macroeconomic
trends have often preceded banking crises. Assessments of financial soundness,
therefore, need to incorporate the broad picture—particularly an economy's
vulnerability to capital flow reversals and currency crises.
Among the relevant macroeconomic indicators are data on
aggregate and sectoral growth, trends in the balance of payments, the level and
volatility of inflation, interest and exchange rates, the growth of credit, and
changes in asset prices, especially stock and real estate prices. Indicators
should also cover variables affecting the vulnerability of financial systems to
the transmission of crises across countries, including correlations between
financial markets, similar macroeconomic characteristics, trade spillovers, and
contagion from investor behavior.
How should they be used?
MPIs are quantitative variables. But the assessment of
financial system soundness also requires an ability to couple the analysis of
MPIs with informed judgments on the adequacy of the institutional and
regulatory frameworks. These frameworks include the structure of the financial
system and markets; accounting standards and disclosure requirements; loan-classification,
provisioning, and income-recognition rules, and other prudential regulations;
the quality of supervision of financial institutions; the legal infrastructure
(including those parts of it covering bankruptcy and foreclosure); incentive
structures and safety nets; and liberalization and deregulation. The
interpretation of MPIs is contingent on these institutional circumstances, and
the monitoring of such indicators can only complement, not substitute for,
institutional judgment.
Stress tests.
Macro prudential analysis often uses a variety of
stress-testing techniques to gauge financial systems' resilience to shocks.
Selected macroeconomic indicators can be used to test quantitatively the impact
of changes in those variables on financial institutions' portfolios and on the
aggregate solvency of the financial system. Stress testing can also help
analysts project likely future developments in MPIs using macroeconomic
forecasts and observations on past relationships between macroeconomic and
prudential indicators.
More
generally, because the relevance of individual indicators may vary from country
to country, MPIs cannot be used mechanically. Assessments need to be based on a
comprehensive set of indicators, taking into account the overall structure and
economic situation of a country and its financial system. Similarly, the
complex reality of financial markets will be hard to capture in a composite
indicator of financial system soundness. MPIs should be monitored to assess the
soundness not only of the banking system but also—if they are systemically
relevant—of nonbank financial institutions and securities markets
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