3 Chapter 3 Assessing Financial Stability Financial system stability in a broad sense means both the avoidance of financial institu tions failing in large numbers and the avoidance of serious disruptions to the interme diation fun ions of the financial sy nesfacilitescediraoea and liquidity services. Within thi broad definitio terms of a cial systems can operating inside or outside the stable corridor (instability). Financial stability analysis is intended to help identify threats to financial system stability and to design appropriate policy responses.It focuses on exposures,buffers,and linkages to assess the soundness and vulnerabilities of the financial system.as well as the economic,regulatory,and institutional determinants of financial soundness and stabil- ity.It considers whether the financial sector exhibits vulnerabilities that could trigger a liquidity or solvency crisis,amplify macroeconomic shocks,or impede policy responses to shocks.The monitoring and analysis of financial stability involve :an a ent of mac of fi ncial institution nd markets,financial sy nd the the vul ow they are the extent of th ng managed.Depending on thi system's stability,policy prescriptions m continu ing prevention (when the financial system is inside th e stable corridor),remedia action (when it is approaching instability),and resolution(when it is experiencing instability) 3.1 Overall Framework for Stability Analysis and Assessment The analytic framework to monitor financial stability is centered around macropruden. tial surveillance and is complemented by surveillance of financial markets,analysis of 子
35 3 Financial system stability in a broad sense means both the avoidance of financial institutions failing in large numbers and the avoidance of serious disruptions to the intermediation functions of the financial system: payments, savings facilities, credit allocation, efforts to monitor users of funds, and risk mitigation and liquidity services. Within this broad definition, financial stability can be seen in terms of a continuum on which financial systems can be operating inside a stable corridor, near the boundary with instability, or outside the stable corridor (instability).1 Financial stability analysis is intended to help identify threats to financial system stability and to design appropriate policy responses.2 It focuses on exposures, buffers, and linkages to assess the soundness and vulnerabilities of the financial system, as well as the economic, regulatory, and institutional determinants of financial soundness and stability. It considers whether the financial sector exhibits vulnerabilities that could trigger a liquidity or solvency crisis, amplify macroeconomic shocks, or impede policy responses to shocks.3 The monitoring and analysis of financial stability involves an assessment of macroeconomic conditions, soundness of financial institutions and markets, financial system supervision, and the financial infrastructure to determine what the vulnerabilities are in the financial system and how they are being managed. Depending on this assessment of the extent of the financial system’s stability, policy prescriptions may include continuing prevention (when the financial system is inside the stable corridor), remedial action (when it is approaching instability), and resolution (when it is experiencing instability). 3.1 Overall Framework for Stability Analysis and Assessment The analytic framework to monitor financial stability is centered around macroprudential surveillance and is complemented by surveillance of financial markets, analysis of Chapter 3 Assessing Financial Stability
Financial Sector Assessment:A Handbook macrofinancial linkages,and surveillance of macroeconomic conditions.These four key elements play distinct roles in financial stability analysis. .Surveillance of financial markets helps to assess the risk that a particular shock or a combination of shocks will hit the financial sector.Models used in this area of 3 surveillance include early warning systems(EWSs).Indicators used in the analysis include financial market data and macro-data,as well as other variables that can be used for constructing early warning indicators (see section 3.2). Mac ess the health of the financial system and used fo macroprudential surveillance are the monitoring of financial soundness indicator (FSIs)and the conducting of stress tests.Those tools are used to map the condi tions of non-financial sectors into financial sector vulnerabilities.The analysis alsc draws on qualitative data such as the results of assessments of quality of supervision and the robustness of financial infrastructure (see section 3.3). Analysis of macrofinancial linkages attempts to understand the exposures that can cause shocks to be transmitted through the financial system to the macroeconomy. ()balance of the varou sectors in the economy and(b)indic eators of access to fi inanc 6 private sect or (to asse the extent t privat owners would be ab e to inject l to cove the potential losses identified through macroprudential surveillance)(see section 3.4). Surveillance of macroeconomic conditions then monitors the effect of the finan- cial system on macroeconomic conditions in general and on debt sustainability in particular(see section 3.4). Assessing financial stability is a complex process.In practice,the assessment requires eral ite ons.For example,the effects of the fin cial system on ma duce feedback effects on the fin ancial system no sdinou pu an qualitative assessments of effectiveness of supervision,and those effects,in turn,might influence the analysis of vulnerabilities and overall assessment of financial stability. 3.2 Macroeconomic and Financial Market Developments An analysis of macroeconomic and financial developments provides an important con- text for the analysis of financial sector vulnerabilities.The goal of the surveillance of macroeconomic developments and of financial markets is to provide a forward-looking sment of the likelihood of ex The literature on EWS aus pro vides useful guidance for this mo le of analysis .EWSs try-in a statistically optimal way (ie.,ina way that minimizes"false alarms"and missed crises)to combine a number of indicators into a single measure of the risk of a crisis.EWSs do not have perfect forecast. ing accuracy,but they offer a systematic method to predict crises.Two approaches to constructing EWS models have become common:the indicators approach(Kaminsky
36 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 macrofinancial linkages, and surveillance of macroeconomic conditions. These four key elements play distinct roles in financial stability analysis. • Surveillance of financial markets helps to assess the risk that a particular shock or a combination of shocks will hit the financial sector. Models used in this area of surveillance include early warning systems (EWSs). Indicators used in the analysis include financial market data and macro-data, as well as other variables that can be used for constructing early warning indicators (see section 3.2). • Macroprudential surveillance tries to assess the health of the financial system and its vulnerability to potential shocks. The key quantitative analytical tools used for macroprudential surveillance are the monitoring of financial soundness indicators (FSIs) and the conducting of stress tests. Those tools are used to map the conditions of non-financial sectors into financial sector vulnerabilities. The analysis also draws on qualitative data such as the results of assessments of quality of supervision and the robustness of financial infrastructure (see section 3.3). • Analysis of macrofinancial linkages attempts to understand the exposures that can cause shocks to be transmitted through the financial system to the macroeconomy. This analysis looks at data such as (a) balance sheets of the various sectors in the economy and (b) indicators of access to financing by the private sector (to assess the extent to which private owners would be able to inject new capital to cover the potential losses identified through macroprudential surveillance) (see section 3.4). • Surveillance of macroeconomic conditions then monitors the effect of the financial system on macroeconomic conditions in general and on debt sustainability in particular (see section 3.4). Assessing financial stability is a complex process. In practice, the assessment requires several iterations. For example, the effects of the financial system on macroeconomic conditions may produce feedback effects on the financial system. The profile of risks and vulnerabilities (ascertained through macroprudential surveillance) could feed into qualitative assessments of effectiveness of supervision, and those effects, in turn, might influence the analysis of vulnerabilities and overall assessment of financial stability. 3.2 Macroeconomic and Financial Market Developments An analysis of macroeconomic and financial developments provides an important context for the analysis of financial sector vulnerabilities. The goal of the surveillance of macroeconomic developments and of financial markets is to provide a forward-looking assessment of the likelihood of extreme shocks that can hit the financial system. The literature on EWSs—which deals with factors that cause financial crises—provides useful guidance for this mode of analysis. EWSs try—in a statistically optimal way (i.e., in a way that minimizes “false alarms” and missed crises)—to combine a number of indicators into a single measure of the risk of a crisis. EWSs do not have perfect forecasting accuracy, but they offer a systematic method to predict crises. Two approaches to constructing EWS models have become common: the indicators approach (Kaminsky
Chapter 3:Assessing Financial Stability Lizondo,and Reinhart 1998,and Kaminsky 1999)and limited dependent variable probit- logit models(B those modelsand find that they such as bond spreads and credit ratings.However,although those models can anticipate some crises,they also generate many false alarms. ews models are seen as one of a number of inputs into the imfs surveillance pro 3 cess,which encompasses a comprehensive and intensive policy dialogue.The IMF puts significant efforts into developing EWS models for emerging market economies,which esulted am other thing ers by Kar nsky.Lizondo,and Reinhart ()and by gand (19).The MF uses a com ion of EWS approach in particular,the Devel ping Country Studies Division model and a modification of the Kaminsky,Lizondo,and Reinhart model,both of which use macro-based indicators of cur rency crises (IMF 2002b).It also makes use of market-based models that rely on implied probability of default and balance-sheet-based vulnerability indicators (e.g.,see Gapen and others 2004). In recent yea s,other institutions and individuals have also developed EWS models T ncluded EWS models developed or studied by staff mem hers at the IS Federal Rese e (Ka Schindle and s el2001), E Central Bank (Bussiere and Fratzscher 200),and the Bundesbank(Schnatz1998) Academics and various private sector institutions also developed a range of EWS models.The private sector EWS models include Goldman Sachs's GS-watch (Ades,Masih,and Tenengauzer 1998),Credit Suisse First Boston's(CSFB's)Emerging Markets Risk Indicator (EMRI) (Roy 2001),Deutsche Bank's Alarm Clock (Garber,Lumsdaine,and Longato 2001),and Moody's Macro Risk model (e.g.,Gray,Merton,and Bodie 2003). The EWS lite of crises crises (sudden sizable depreciation of th e rate and loss of reserves),debt crises (default or re ing on exteral debt),and banking crises (rundown of bank deposits and widesprea failures of financial institutions).One can distinguish three "generations"of crises mod. els,depending on what determinants the models take into account.The first generation focuses on macroeconomic imbalances (e.g.,Krugman 1979).The second generation focuses on self-fulfilling speculative attacks,contagion,and weakness in domestic finan- cial markets (eg..Obstfeld 1996).The third ge eration of models introduces the role l he caus sset price ca eful leading indicator of crises (e.g..Chang and Velasco 2001).In general,empiri studies (e.g.,Berg and others 2000)suggest that currency crises occur more often tha debt crises (roughly 6:1)and that a large portion of the debt crises happened along with or close to the currency crises.Banking crises are hard to identify.tend to be protracted. and,thus,have a larger macroeconomic effect.Banking crises also tend to occur with or shortly after a currency crisis. Forecasting banking crises is based on three approaches .The macroeconomic approach is based on the idea that macroeconomic policies ause cris nd it tries to predi anking cris onomic variables For example,Demirgus-Kunt and Detragiache(1998)study the factors of sys banking crises in a large sample of countries using a multivariate logit model anc 37
37 Chapter 3: Assessing Financial Stability 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Lizondo, and Reinhart 1998, and Kaminsky 1999) and limited dependent variable probit– logit models (Berg and Pattillo 1999). Berg and others (2000) assess the performance of those models and find that they have outperformed alternative measures of vulnerability, such as bond spreads and credit ratings. However, although those models can anticipate some crises, they also generate many false alarms.4 EWS models are seen as one of a number of inputs into the IMF’s surveillance process, which encompasses a comprehensive and intensive policy dialogue. The IMF puts significant efforts into developing EWS models for emerging market economies, which resulted, among other things, in influential papers by Kaminsky, Lizondo, and Reinhart (1998) and by Berg and Pattillo (1999). The IMF uses a combination of EWS approaches, in particular, the Developing Country Studies Division model and a modification of the Kaminsky, Lizondo, and Reinhart model, both of which use macro-based indicators of currency crises (IMF 2002b). It also makes use of market-based models that rely on implied probability of default and balance-sheet-based vulnerability indicators (e.g., see Gapen and others 2004). In recent years, other institutions and individuals have also developed EWS models. Those efforts included EWS models developed or studied by staff members at the U.S. Federal Reserve (Kamin, Schindler, and Samuel 2001), the European Central Bank (Bussiere and Fratzscher 2002), and the Bundesbank (Schnatz 1998). Academics and various private sector institutions also developed a range of EWS models. The private sector EWS models include Goldman Sachs’s GS-watch (Ades, Masih, and Tenengauzer 1998), Credit Suisse First Boston’s (CSFB’s) Emerging Markets Risk Indicator (EMRI) (Roy 2001), Deutsche Bank’s Alarm Clock (Garber, Lumsdaine, and Longato 2001), and Moody’s Macro Risk model (e.g., Gray, Merton, and Bodie 2003). The EWS literature covers three main types of crises: currency crises (sudden, sizable depreciation of the exchange rate and loss of reserves), debt crises (default or restructuring on external debt), and banking crises (rundown of bank deposits and widespread failures of financial institutions). One can distinguish three “generations” of crises models, depending on what determinants the models take into account. The first generation focuses on macroeconomic imbalances (e.g., Krugman 1979). The second generation focuses on self-fulfilling speculative attacks, contagion, and weakness in domestic financial markets (e.g., Obstfeld 1996). The third generation of models introduces the role of moral hazard as a cause of excessive borrowing and suggests that asset prices can be a useful leading indicator of crises (e.g., Chang and Velasco 2001). In general, empirical studies (e.g., Berg and others 2000) suggest that currency crises occur more often than debt crises (roughly 6:1) and that a large portion of the debt crises happened along with or close to the currency crises. Banking crises are hard to identify, tend to be protracted, and, thus, have a larger macroeconomic effect. Banking crises also tend to occur with or shortly after a currency crisis. Forecasting banking crises is based on three approaches: • The macroeconomic approach is based on the idea that macroeconomic policies cause crisis, and it tries to predict banking crises using macroeconomic variables. For example, Demirgüç-Kunt and Detragiache (1998) study the factors of systemic banking crises in a large sample of countries using a multivariate logit model and
Financial Sector Assessment:A Handbook real interest rates,the vulnerability to balance of payments crises,the existence of an explicit deposit insurance scheme,and weak law enforcement,on the other hand. 3 The bank balance-sheet approach assumes that poor banking practices cause crises and that bank failures can be predicted by balance-sheet data (e.g..sahaiwala and Van den Berg 2000:Jagtiani and others 2003). The market indicators approach assumes that equity and debt prices contain infor. ond that of bala sheet data.Market-based EWS that fin cial beliefs about th t prices contain info ure.I n particular,opt prices of the underlying assets.Thi n prices refle ect market belief is information can e used to extract a probability distribution,namely,the probability of default.The advan tage of equity and debt data is that they can be available in high frequency and that they should provide a forward-looking assessment (e.g.,Bongini,Laeven,and Majnoni 2002;Gropp,Vesala,and Vulpes 2002).3 3.3 Macroprudential Surveillance Framework Surveillance of the soundness of the financial sector as a whole-which is macropruden tial surveillance- -complements the surveillance of individual financial institutions by supervisors-which is microprudential surveillance.Macroprudential surveillance derive from the need to identify risks to the stability of the system asa whole.resulting from the of the a ies of man Mac clos and other monitoring vulnera abilities and focus on vulnerabilities in the extemal position while using macroec nomic indicators as key explanatory variables.Macroprudential analysis (analysis of FSIs and stress test ing)focuses on vulnerabilities in domestic financial systems arising from macroeconomic shocks,whose likelihood and severity can be judged from EWSs.At the same time,infor mation from macroprudential analysis can provide input into assessing macroeconomic vulnerabilities.Analysis of FSIs for individual banks,along with other supervisory infor- mation,serves as a form of EWS for the financial condition of individual banks in many supervisory assessment systems(Sahajwala and Van den Berg 2000). combination of qualit nd ntitative meth ve m ethods fo ality of the le al iudicial,and nce p actices in the fir pervision. important part of the qualitati e into a ten gathered through the internationally accepted standards and The quantitative methods include a combination of statistical indicators and techniques designed to summarize the soundness and resilience of the financial system. The two key quantitative tools of macroprudential surveillance are the analysis of FSIs and stress testing.The analysis of FSIs includes assessing their variation over time
38 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 find that crises tend to erupt when growth is low and inflation is high. They also find some association between banking sector problems, on the one hand, and high real interest rates, the vulnerability to balance of payments crises, the existence of an explicit deposit insurance scheme, and weak law enforcement, on the other hand. • The bank balance-sheet approach assumes that poor banking practices cause crises and that bank failures can be predicted by balance-sheet data (e.g., Sahajwala and Van den Berg 2000; Jagtiani and others 2003). v The market indicators approach assumes that equity and debt prices contain information on bank conditions beyond that of balance-sheet data. Market-based EWS models are based on the premise that financial asset prices contain information on market beliefs about the future. In particular, option prices reflect market beliefs about the future prices of the underlying assets. This information can be used to extract a probability distribution, namely, the probability of default. The advantage of equity and debt data is that they can be available in high frequency and that they should provide a forward-looking assessment (e.g., Bongini, Laeven, and Majnoni 2002; Gropp, Vesala, and Vulpes 2002).5 3.3 Macroprudential Surveillance Framework Surveillance of the soundness of the financial sector as a whole—which is macroprudential surveillance—complements the surveillance of individual financial institutions by supervisors—which is microprudential surveillance. Macroprudential surveillance derives from the need to identify risks to the stability of the system as a whole, resulting from the collective effect of the activities of many institutions. Macroprudential analysis also closely complements and reinforces EWSs and other analytical tools for monitoring vulnerabilities and preventing crises. EWSs traditionally focus on vulnerabilities in the external position while using macroeconomic indicators as key explanatory variables. Macroprudential analysis (analysis of FSIs and stress testing) focuses on vulnerabilities in domestic financial systems arising from macroeconomic shocks, whose likelihood and severity can be judged from EWSs. At the same time, information from macroprudential analysis can provide input into assessing macroeconomic vulnerabilities. Analysis of FSIs for individual banks, along with other supervisory information, serves as a form of EWS for the financial condition of individual banks in many supervisory assessment systems (Sahajwala and Van den Berg 2000). Macroprudential surveillance uses a combination of qualitative and quantitative methods. The key qualitative methods focus on the quality of the legal, judicial, and regulatory framework, as well as governance practices in the financial sector and its supervision. An important part of the qualitative information is often gathered through the assessments of internationally accepted standards and codes of best practice. The quantitative methods include a combination of statistical indicators and techniques designed to summarize the soundness and resilience of the financial system. The two key quantitative tools of macroprudential surveillance are the analysis of FSIs and stress testing. The analysis of FSIs includes assessing their variation over time
Chapter 3:Assessing Financial Stability and amon assess the shocks.Stress testing viding an estimate of how th value of each financial institution's portfolio will change when there are large changes to some of its risk factors (such as asset prices). 3 3.3.1 Analysis of Financial Soundness Indicators FSIs are used to monitor the financial system's vulnerability to shocks and its capacity to absorb the resulting losses.Work on FSIs has produced a set of core FSIs and a set of encouraged FSIs (see chapter 2). .The core set of FSIs covers only the banking sector,thereby reflecting its central role.Those FSIs are considered ess otial for ru fin ia ystem and,thus, small co across co ies.Also. ta to compi are gene encouraged set of FSIs covers add y availabl for key non-financia l sectors because balance-sheet weaknesses in those sectors are a source of credit risk for banks and,thus,help detect banking sector vulnerabilities at an earlier stage.The encouraged set of FSIs are relevant in many,but not all, countries. The choice of FSIs depends on the structure of a country's financial system and data availability.Although the be limited d to this et.In bo ore set provides n initial prioritiztion,the choice shouldo minated ystems,the vant equate. or other type f financial institutions may b need tions are systemically important. Of course,some countre s may have othe relevant indicators that are not included in the core or encouraged sets that may need to be monitored.In countries with well-developed markets,with information on key prices spreads,and price volatility,other market information,including ratings,can be used as market-based indicators to monitor risks in individual sectors and institutions and to help assess the evolution of relative risks.thereby facilitating supervision and macroprudential surveillance (see box 3.1). The of FSIs typically involves amination of trends,comparison betweer relevant peer gro ups of countries and institut ons,and disaggregation into vari ings.Control is often an important criterion for dis aggregation because it can indicate the sources of outside support that are potentially available to institutions in distress and thus can influence their vulnerability to bank runs,as well as their exposure to cross-border contagion. Domestically controlled banks are overseen by a country's central bank and supervisor and,in a crisis,would be recapitalized by the banks'domestic owners or otherwise by the state.Within this peer gro distinguished from pri public banks,which have a state guarantee,are typically which may fail if los mini vel of ital and onsequently may be more pr one to ba hin the group of domesti llywed k intoactive ed peer group because they are exposed to cross-border contagion.Those banks could entail
39 Chapter 3: Assessing Financial Stability 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 and among peer groups, as well as assessing their determinants. FSIs help to assess the vulnerability of the financial sector to shocks. Stress testing assesses the vulnerability of a financial system to exceptional but plausible events by providing an estimate of how the value of each financial institution’s portfolio will change when there are large changes to some of its risk factors (such as asset prices). 3.3.1 Analysis of Financial Soundness Indicators FSIs are used to monitor the financial system’s vulnerability to shocks and its capacity to absorb the resulting losses. Work on FSIs has produced a set of core FSIs and a set of encouraged FSIs (see chapter 2).6 • The core set of FSIs covers only the banking sector, thereby reflecting its central role. Those FSIs are considered essential for surveillance in virtually every financial system and, thus, serve as a small common set of FSIs across countries. Also, the data to compile those FSIs are generally available. • The encouraged set of FSIs covers additional FSIs for the banking system and FSIs for key non-financial sectors because balance-sheet weaknesses in those sectors are a source of credit risk for banks and, thus, help detect banking sector vulnerabilities at an earlier stage. The encouraged set of FSIs are relevant in many, but not all, countries. The choice of FSIs depends on the structure of a country’s financial system and data availability. Although the core set provides an initial prioritization, the choice should not be limited to this set. In bank-dominated systems, the core and some relevant encouraged FSIs may be adequate. FSIs for other types of financial institutions may be needed if those institutions are systemically important. Of course, some countries may have other relevant indicators that are not included in the core or encouraged sets that may need to be monitored. In countries with well-developed markets, with information on key prices, spreads, and price volatility, other market information, including ratings, can be used as market-based indicators to monitor risks in individual sectors and institutions and to help assess the evolution of relative risks, thereby facilitating supervision and macroprudential surveillance (see box 3.1). The analysis of FSIs typically involves examination of trends, comparison between relevant peer groups of countries and institutions, and disaggregation into various groupings. Control is often an important criterion for disaggregation because it can indicate the sources of outside support that are potentially available to institutions in distress and thus can influence their vulnerability to bank runs, as well as their exposure to cross-border contagion. Domestically controlled banks are overseen by a country’s central bank and supervisor and, in a crisis, would be recapitalized by the banks’ domestic owners or otherwise by the state. Within this peer group, public banks, which have a state guarantee, are typically distinguished from private banks, which may fail if losses exceed some minimum level of capital and consequently may be more prone to bank runs. Within the group of domestically owned, private banks, internationally active banks may be grouped into a separate peer group because they are exposed to cross-border contagion. Those banks could entail
Financial Sector Assessment:A Handbook Box 3.1 Market-Based Indicators of Financial Soundness Market-based indicators are among the key data sets p.Vesala.and Vulpes 2002) In additi n,c lly not an issu 3 independent ana ts to obtain input dat aand for the rket pr rume ts to d spread cial t market- dicators h ve a wide array o t that the ket be s and their c may be commonly watched indic of country risk adition,thee indicat institutions'securities re not nublic of shock the fina I secto or if the ir trading is limited (as may the market informa financi an ot pub (e.g.,loan c data can of the od ind ments analysis of ver,mark t-basdindic ators can premise tha arket pric titution nancial marke nd that of balan e-she ata and other dat cent studie sugest that su off and Wal tha the ).d d M h,in turn.c bout the futur narket informa including the pro and B ti(04)find that n adv using market prices rathe rating,and surveys ilable at high requency.The advanta acce They find is th ch a ng sy and Also although the based me ures of vu tings.I heir st market price da should provide ence ab the market indicators'efficiency in ing assessment te.g
40 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Box 3.1 Market-Based Indicators of Financial Soundness Market-based indicators are among the key data sets used by macroprudential analysis, along with aggregated prudential data, macroeconomic data, stress tests, structural data, and qualitative information. They include market prices of financial instruments, indicators of excess yields, market volatility, credit ratings, and sovereign yield spreads. The market-based indicators have a wide array of uses. In particular, market prices of financial instruments issued by financial institutions and their corporate counterparts can be used to assess financial soundness of the issuers. Sovereign yield spreads are commonly watched indicators of country risk. Market price data from the stock, bond, derivatives, real estate, and other financial markets can be used to monitor sources of shocks to the financial sector. Indicators of market price volatility can help assess the market risk environment. Finally, sovereign ratings and ratings of financial institutions and other firms (as well as the accompanying analysis by the rating companies) are important sources of information to any analysis of vulnerabilities.a Analysis of the market-based indicators complements the analysis of aggregated microprudential data. The use of market-based indicators to monitor financial institutions’ soundness is based on the premise that market prices of financial institutions’ securities could reveal information about their conditions beyond that of balance-sheet data and other aggregated microprudential data. If this premise is true, then the market-based indicators can usefully complement the FSIs, a majority of which—including all core FSIs—are based on aggregating financial institutions’ microprudential data. The key premise is that the asset prices contain information on market beliefs, which, in turn, contain information about the future. In particular, option prices reflect market beliefs about the future prices of the underlying assets. This information can be used to extract a probability distribution, including the probability of default. An advantage of using market prices rather than prudential data is that the price data are generally available at high frequency. The advantage of equity and debt data is that they are frequent, which allows for more sophisticated analysis, such as the analysis of volatility and covariance. Also, although the accounting measures of risk (such as nonperforming loans [NPLs] and loan loss reserves) are essentially backward looking, market price data should provide a forward-looking assessment (e.g., Bongini, Laeven, and Majnoni 2002; Gropp, Vesala, and Vulpes 2002). In addition, confidentiality is generally not an issue with market data, which should make it easier for independent analysts to obtain input data and for the results to be publicly shared and verified. The quality of the market-based indicators depends on the extent and quality of the financial markets. For asset prices to contain useful information, it is important that the market be robust and transparent. If it is not, then asset prices may be substantially affected by factors other than the financial health of the issuer or the underlying quality of the asset. In addition, the usefulness of market-based indicators to assess financial sector soundness may be limited if some financial institutions’ securities are not publicly traded or if their trading is limited (as may be the case, for instance, for government-owned banks or family-owned banks). Finally, if relevant information is not publicly disclosed (e.g., loan classification data that are not disclosed in some countries), but if that type of information is collected by supervisors, then prudential data can be superior to market-based indicators in measuring financial sector soundness. However, market-based indicators can still be useful in assessing the potential shocks to the financial institutions arising from or transmitted through financial markets. Empirical studies show that market prices can be helpful in forecasting bank distress. For example, recent studies for the United States suggest that subordinated yields explain not only bank rating changes but also regulatory capital ratios (Evanoff and Wall 2001), that equity prices provide useful information on bank failure (Gunther, Levonian, and Moore 2001), and that both equity prices and bond yields explain ratings (Krainer and Lopez 2003). However, early warning systems that combine market information with other data tend to perform better than the nonmodel market-based indicators. Berg and Borensztein (2004) find that “market views,” as expressed in spreads, ratings, and surveys, are not reliable crisis predictors, important as they may be in determining market access. They find that early warning system models, which combine a range of indicators, have outperformed purely market-based measures of vulnerability such as bond spreads and credit ratings. Their study was focused on predicting currency crises, but there is even less evidence about the market indicators’ efficiency in predicting banking sector crises. a. When assigning ratings, rating companies typically use a range of analytical approaches and data, including available prudential indicators. Nonetheless, ratings are classified as market-based indicators, thus recognizing that they are produced mainly for use by market participants
Chapter 3:Assessing Financial Stability significant risk ex incude the activiti of those foreig ranches and subsidi ries,even are not part of the because they area soure of isk tothe banking system. For the domestic branches and subsidiaries of foreign-controlled banks,support in a crisis can be expected to come in the first instance from their foreign owners.This type of 3 support may be based (a)on the foreign bank's legal obligation,which generally extends to branches but not to subsidiaries abroad;(b)on broader reputation or operating con- cerns,which may lead the foreign bank to support its subsidiaries abroad in a crisis:or nt banks may also A心， ation because e parent bank nce issubsidiarie also the risk o agion.Those FSI oreign-controlle deposit-takers play a significant role in the financial system,separate FSIs may need to be compiled for the local subsidiaries of those deposit-takers. Quantitative information on the structure,ownership,and degree of concentration of the financial system helps to set priorities for analyzing FSIs while also providing a basis for the identification of structural issues and developmental needs.This information indicates the relative importance of differe ent type s of fin ncial institutions (e.g..banks ecuritiescompanies,ins nce compa n funds);the relativ mp ce of dif. p(pr vate,pu blic,foreign);and the ownership provides a b understanding of the main components of the sector and it degred diversification (see chapters 2 and 4 for a further discussion of financial structure and its determinants). 3.3.1.1 Analysis of FSIs for Banking In most countries,banks form the core of the financial system and,thus,warrant close monitoring for indications of potential vulnerabilities.A range of quantitative indicators can be used to analyze the health and stability of the banking system,including financial soundness indicato narket-based indicators of financial co nditions. ral indica rs describing and tems,andm onomic indic range of tive informa on is als 1。 S. s the banking system inclu ry framework (w P0g阳即 payment system,accounting and auditing standards,the legal infrastructure,the liquidity support arrangements,and the financial sector safety nets. Banking sector FSIs discussed in chapter 2 cover capital adequacy,asset quality,man- agement soundness,eamnings and profitability,liquidity,and sensitivity to market risk.An analysis of inter-linkage s am ong those fsls and their mac onomic and institutional minants.togethe with a nt of thei shocks thre t analysis. The ages not only an t also to her variable hips within the financial sec tor and with other non-financial sectors.They also reflect institutional determinants,such as the key 41
41 Chapter 3: Assessing Financial Stability 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 significant risk exposure through their foreign branches and subsidiaries. FSIs should include the activities of those foreign branches and subsidiaries, even though the latter are not part of the domestic activity, because they are a source of risk to the banking system. For the domestic branches and subsidiaries of foreign-controlled banks, support in a crisis can be expected to come in the first instance from their foreign owners. This type of support may be based (a) on the foreign bank’s legal obligation, which generally extends to branches but not to subsidiaries abroad; (b) on broader reputation or operating concerns, which may lead the foreign bank to support its subsidiaries abroad in a crisis; or (c) both of those elements. At the same time, FSIs of the foreign parent banks may also deserve examination because the soundness of the parent bank would influence not only the potential for support to its subsidiaries but also the risk of contagion. Those FSIs are typically produced by the home country of the parent bank. When foreign-controlled deposit-takers play a significant role in the financial system, separate FSIs may need to be compiled for the local subsidiaries of those deposit-takers. Quantitative information on the structure, ownership, and degree of concentration of the financial system helps to set priorities for analyzing FSIs while also providing a basis for the identification of structural issues and developmental needs. This information indicates the relative importance of different types of financial institutions (e.g., banks, securities companies, insurance companies, pension funds); the relative importance of different types of ownership (private, public, foreign); and the concentration of ownership. It provides a basic understanding of the main components of the sector and its degree of diversification (see chapters 2 and 4 for a further discussion of financial structure and its determinants). 3.3.1.1 Analysis of FSIs for Banking7 In most countries, banks form the core of the financial system and, thus, warrant close monitoring for indications of potential vulnerabilities. A range of quantitative indicators can be used to analyze the health and stability of the banking system, including financial soundness indicators (aggregated microprudential indicators), market-based indicators of financial conditions, structural indicators describing ownership and concentration patterns, and macroeconomic indicators. A range of qualitative information is also needed to assess the banking system, including the strength of the regulatory framework (which is based on assessments of the Basel Core Principles, or BCP), the functioning of the payment system, accounting and auditing standards, the legal infrastructure, the liquidity support arrangements, and the financial sector safety nets. Banking sector FSIs discussed in chapter 2 cover capital adequacy, asset quality, management soundness, earnings and profitability, liquidity, and sensitivity to market risk. An analysis of inter-linkages among those FSIs and their macroeconomic and institutional determinants, together with an assessment of their sensitivity to various shocks through stress tests, provide the basic building blocks of financial stability analysis.8 The linkages not only among the various groups of FSIs but also to other variables are derived from accounting and lending relationships within the financial sector and with other non-financial sectors. They also reflect institutional determinants, such as the key
Financial Sector Assessment:A Handbook parameters of the prudential framework.Topics studied in this area include,for example determinants of asset quality,links between asset quality changes and capital,and deter minants of profitability,all of which are discussed below. One important topic of study involves determinants of asset quality.Asset quality is affected by the state of the business cycle,the corporate financial structure,and the level 3 of real interest rates,which,together,influence the capacity for debt servicing.Therefore, in empirical work.FSIs of asset quality are typically ssed on various explanator variables,such as co age,macr mic onditions,and interes rates.In ose types regr based el data for in a country;in othe rcases,time s a wer example o cro -country time series n,the IMF(00 )estimated the tionship betweer corporate sector FSIs and banking sector asset quality FSIs on panel data compiled from large private databases for 47 countries over 10 years.It found that a 10 percentage point increase in corporate leverage was generally associated with a 1.8 percentage point rise in NPLs relative to total loans after one year.Also,a 1 percentage point rise in GDP growth resulted in a 2.6 percentage point decline in the NPLs-to-loans ratio,reflecting the fact that fewer corporations are likely to experience problems repaying loans during rapid growth. Links bet asset chan and ris pital are also studied.A deterioration ts capital additional reserves ks ne d to hold against the litional ba assets.I the rules in the country involving loan loss provisioning and the application of those rules in banking practice.Therefore,to model this link,one needs to understand well the pruden tial and supervisory framework in the country in question,which is where the findings of the BCP assessments can be of great help.The link between asset quality (and other risk factors)and capital is typically studied in the context of stress tests (see appendix D on stress testing for references on this issue). Another important topic of study involves the determi large the etical and ants of profitability.Thereis rical lit on the bank-le el and ntry-level factor e mining bank ef This is ntitative anal sis of FS can be complemente with informa on fre m assessment of the effectiveness of financial sector supervision.BCP assessmentsprovide a vast array of contextual information that can be useful in interpreting FSIs.First,they can clarify the definition of data being used to compile FSIs by,for example,indicating the quality of capital.Second,they can help establish the underlying cause of observed movements in FSIs when there are competing explanations,such as whether a fall in the capital ratio might be supervisory action rather than rapid balance-sheet expansion.Third,they isks.such as ESI E rth the ride info on how 1 management d,thus. ective system is likel ly to respond to the risk associated with particular values for FSI the supervisory system to emerging financial sector problems,which reveals how quickly Finally,t vulnerabilities identified by FSIs are likely to be corrected.A lack of compliance with many of the BCP would suggest that the banking sector vulnerabilities detected using FSIs may be more serious than in a financial system with good compliance.Assessments
42 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 parameters of the prudential framework. Topics studied in this area include, for example, determinants of asset quality, links between asset quality changes and capital, and determinants of profitability, all of which are discussed below. One important topic of study involves determinants of asset quality. Asset quality is affected by the state of the business cycle, the corporate financial structure, and the level of real interest rates, which, together, influence the capacity for debt servicing. Therefore, in empirical work, FSIs of asset quality are typically regressed on various explanatory variables, such as corporate leverage, macroeconomic conditions, and interest rates. In some assessments, those types of regression estimates were based on panel data for banks in a country; in other cases, time series of aggregate data were used. As an example of cross-country time series regression, the IMF (2003c) estimated the relationship between corporate sector FSIs and banking sector asset quality FSIs on panel data compiled from large private databases for 47 countries over 10 years. It found that a 10 percentage point increase in corporate leverage was generally associated with a 1.8 percentage point rise in NPLs relative to total loans after one year. Also, a 1 percentage point rise in GDP growth resulted in a 2.6 percentage point decline in the NPLs-to-loans ratio, reflecting the fact that fewer corporations are likely to experience problems repaying loans during rapid growth. Links between asset quality changes and capital are also studied. A deterioration in asset quality affects capital (and risk-weighted assets) through additional reserves that banks need to hold against the additional bad assets. The additional reserves reflect the rules in the country involving loan loss provisioning and the application of those rules in banking practice. Therefore, to model this link, one needs to understand well the prudential and supervisory framework in the country in question, which is where the findings of the BCP assessments can be of great help. The link between asset quality (and other risk factors) and capital is typically studied in the context of stress tests (see appendix D on stress testing for references on this issue). Another important topic of study involves the determinants of profitability. There is a large theoretical and empirical literature on the bank-level and country-level factors determining bank efficiency. This issue is further discussed in chapter 4. Quantitative analysis of FSIs can be complemented with information from assessments of the effectiveness of financial sector supervision. BCP assessments9 provide a vast array of contextual information that can be useful in interpreting FSIs. First, they can clarify the definition of data being used to compile FSIs by, for example, indicating the quality of capital. Second, they can help establish the underlying cause of observed movements in FSIs when there are competing explanations, such as whether a fall in the capital ratio might be supervisory action rather than rapid balance-sheet expansion. Third, they provide information on risks, such as operational and legal risk that cannot be captured adequately using FSIs. Fourth, they provide information on how effective the banks’ risk management is and, thus, how effectively the banking system is likely to respond to the risk associated with particular values for FSIs. Finally, they indicate the responsiveness of the supervisory system to emerging financial sector problems, which reveals how quickly vulnerabilities identified by FSIs are likely to be corrected. A lack of compliance with many of the BCP would suggest that the banking sector vulnerabilities detected using FSIs may be more serious than in a financial system with good compliance. Assessments
Chapter 3:Assessing Financial Stability of financial infrastructu rporate gov ce,accounting and auditing,insolvene egimes, the liquidity and 3.3.1.2 Analysis of FSIs for Insurance 3 Insurance is an important and growing part of the financial sector in virtually all devel oped and in many emerging economies;consequently,insurance sector soundness is important.Insurers help to allocate risks and to mobilize long-term savings (especially retirement savings)by spreading financial losses across the economy.Insurance compa- nies facilitate economic activity in sectors,such as shipping,aviation,and the profession- al services that are particularly reliant on insurance.The insurance companies can help to pro ote risk-mitigating activities through their incentives to as e and monito the risks hey are exp ed.Finally,in mpanies he elp pro to entities better able to evaluate,monitor,and mitigare those risk through specialization. The risk profiles of insurers and banks differ.Insurance companies generally are exposed to greater volatility in asset prices and face the potential for rapid deterioration in their capital base.Insurance companies typically have liabilities with longer maturities and assets with greater liquidity than banks have,thus enabling the insurance companies to play a larger role in long-term capital markets.Life insurers often have significantly exposure to equities and real estate and lower exposure to direct lending than do banks.I ries insurers offer products swith guaranteed retus,furthe r ex bat nsurance sector for financial stability has increased recentl because of intensified links between insurers and banks,thereby increasing the risk of contagion.Those links can include cross-ownership,credit-risk transfers,and financial reinsurance.Financial deregulation has caused insurers to diversify into banking and asset management products,thus exposing them to additional risk by making their liabilities more liquid.Insurers have also increased their exposure to equities and complex risk manager and declining yields on fixed-interest Assessing the soundness of the insurance sector requires ood understanding of link ages among,and determinants of, the various financial soundn sindicators for the i ance sector di supplemented by information on the quality of risk management in the insurance indus try.which will draw on the assessment of observance of relevant supervisory standards(see discussion that follows).Capital adequacy can be viewed as the key indicator of insurance sector soundness.However,analysis of capital adequacy depends on realistic valuation of both assets and liabilities of the insurance sector.Com pared with banking,asset side risks for the ins are similar.but liability side risks de nd on diffe ent factors,such should ak aphic and secto ral developments. ng the stability of the insurance e into account the size and grow of the sector, e im portance of type and asset-management-type product the of the indusry (inding th relative importance of the life sector),and the strength of linkages to the banking sector 43
43 Chapter 3: Assessing Financial Stability 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 of financial infrastructure––corporate governance, accounting and auditing, insolvency and creditor rights regimes, and systemic liquidity arrangements––can also help interpret the liquidity and solvency indicators. 3.3.1.2 Analysis of FSIs for Insurance Insurance is an important and growing part of the financial sector in virtually all developed and in many emerging economies; consequently, insurance sector soundness is important.10 Insurers help to allocate risks and to mobilize long-term savings (especially retirement savings) by spreading financial losses across the economy. Insurance companies facilitate economic activity in sectors, such as shipping, aviation, and the professional services that are particularly reliant on insurance. The insurance companies can help to promote risk-mitigating activities through their incentives to measure and monitor the risks to which they are exposed. Finally, insurance companies help promote stability by transferring risk to entities better able to evaluate, monitor, and mitigate those risks through specialization. The risk profiles of insurers and banks differ. Insurance companies generally are exposed to greater volatility in asset prices and face the potential for rapid deterioration in their capital base. Insurance companies typically have liabilities with longer maturities and assets with greater liquidity than banks have, thus enabling the insurance companies to play a larger role in long-term capital markets. Life insurers often have significantly higher exposure to equities and real estate and lower exposure to direct lending than do banks. In some countries, insurers offer products with guaranteed returns, further exacerbating risks for life insurers. The importance of the insurance sector for financial stability has increased recently because of intensified links between insurers and banks, thereby increasing the risk of contagion. Those links can include cross-ownership, credit-risk transfers, and financial reinsurance. Financial deregulation has caused insurers to diversify into banking and asset management products, thus exposing them to additional risk by making their liabilities more liquid. Insurers have also increased their exposure to equities and complex risk management products in response to deregulation and declining yields on fixed-interest products. Assessing the soundness of the insurance sector requires good understanding of linkages among, and determinants of, the various financial soundness indicators for the insurance sector discussed in chapter 2. In addition, the analysis of those indicators should be supplemented by information on the quality of risk management in the insurance industry, which will draw on the assessment of observance of relevant supervisory standards (see discussion that follows). Capital adequacy can be viewed as the key indicator of insurance sector soundness. However, analysis of capital adequacy depends on realistic valuation of both assets and liabilities of the insurance sector. Compared with banking, asset side risks for the insurance sector are similar, but liability side risks depend on different factors, such as demographic and sectoral developments. Assessing the stability of the insurance sector should take into account the size and growth of the sector, the importance of bankingtype and asset-management-type products, the structure of the industry (including the relative importance of the life sector), and the strength of linkages to the banking sector
Financial Sector Assessment:A Handbook Dara quality may be an issue because many countries lack the actuarial expertise,super- visory authority,or capacity to collect sufficient information The analysis and interpretation of soundness indicators should draw on an evaluation of the observance of Insurance Core Principles issued by the International Association of Insurance Supervisors (IAIS 2003)(see also chapter 5).This set of principles provides 3 information on the effectiveness of supervision,the structure and characteristics of com- panies in the sector,and other useful qualitative information that is not always captured by financial ratios.In particular.the cifics of supe affect asset c ompositi well s mix ulatory environme aken into account in interpreting insurance FSIs 3.3.1.3 Analysis of FSIs for Securities Markets Securities markets are a major component of the financial sector in many countries.The capitalization of equity and bond markets in many industrialized countries,with savings in securities investments now exceeding savings in deposits,dwarfs the aggregate assets of the banking system.Exposures of households.corporations.and financial institutions to securities markets have increased substantially through investments in primary and secondary markets and through trading of risk in financial markets. Well-developed securities markets offer an alternative source of intermediation,thus in the 6 tition.Well-fun ctioning markets providea mechanism for the efficien of assets of risks,create liquidity in financial claims,and efficiently all locate risks Those market help reduce the cost of capital,thereby raising economy-wide savings and investment They also foster market discipline by providing incentives to corporations and financial institutions to use sound management and governance practices The stability of securities markets can be monitored using a range of quantitative indicators measuring depth,tightness,and resilience of markets.Most quantitative indi cators focus on market liquidity because of the impor rtant role that liquid securities play in the balance sh ial institutions Ch usses the FSIs that me red by gross ave ily value of securities tra d relative to the stock) e analysis o securities markets FSIs focuses on trends in those key variables and their determinants,including institu tional factors and market structure (for an example of this type of analysis,see Wong and Fung 2002).The analysis also tries to assess resiliency of the market,which refers eithe to the speed with which price fluctuations resulting from trades are dissipated or to the speed with which imbalances in order flows are adjusted.Although there is no consensus yet on the appropriate measure for resiliency,one app roach is to examine the speed of the al market conditions (such as the bid-ask read and orde volume) after large tra For more on n the ss of ma y conditions in appendix D. For an alt e approach to measuring soundness using market volatility as a financial soundness indicator,see Morales and Schumacher (2003). Qualitative information drawn from standards assessments and other sources can also help assess stability of securities markets and can help interpret FSIs.The financial market
44 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Data quality may be an issue because many countries lack the actuarial expertise, supervisory authority, or capacity to collect sufficient information. The analysis and interpretation of soundness indicators should draw on an evaluation of the observance of Insurance Core Principles issued by the International Association of Insurance Supervisors (IAIS 2003) (see also chapter 5). This set of principles provides information on the effectiveness of supervision, the structure and characteristics of companies in the sector, and other useful qualitative information that is not always captured by financial ratios.11 In particular, the specifics of supervisory and regulatory environment affect asset composition, as well as the mix of risks, and should be taken into account in interpreting insurance FSIs. 3.3.1.3 Analysis of FSIs for Securities Markets12 Securities markets are a major component of the financial sector in many countries. The capitalization of equity and bond markets in many industrialized countries, with savings in securities investments now exceeding savings in deposits, dwarfs the aggregate assets of the banking system. Exposures of households, corporations, and financial institutions to securities markets have increased substantially through investments in primary and secondary markets and through trading of risk in financial markets. Well-developed securities markets offer an alternative source of intermediation, thus enhancing efficiency in the financial sector through competition. Well-functioning securities markets provide a mechanism for the efficient valuation of assets and diversification of risks, create liquidity in financial claims, and efficiently allocate risks. Those markets help reduce the cost of capital, thereby raising economy-wide savings and investment. They also foster market discipline by providing incentives to corporations and financial institutions to use sound management and governance practices. The stability of securities markets can be monitored using a range of quantitative indicators measuring depth, tightness, and resilience of markets.13 Most quantitative indicators focus on market liquidity because of the important role that liquid securities play in the balance sheets of financial institutions. Chapter 2 discusses the FSIs that measure market tightness (bid–ask spreads) and depth (market turnover, measured by gross average daily value of securities traded relative to the stock). The analysis of securities markets’ FSIs focuses on trends in those key variables and their determinants, including institutional factors and market structure (for an example of this type of analysis, see Wong and Fung 2002). The analysis also tries to assess resiliency of the market, which refers either to the speed with which price fluctuations resulting from trades are dissipated or to the speed with which imbalances in order flows are adjusted. Although there is no consensus yet on the appropriate measure for resiliency, one approach is to examine the speed of the restoration of normal market conditions (such as the bid–ask spread and order volume) after large trades. For more on the robustness of market liquidity under conditions of stress, see the discussion in section 3.3.2 and in appendix D. For an alternative approach to measuring soundness using market volatility as a financial soundness indicator, see Morales and Schumacher (2003). Qualitative information drawn from standards assessments and other sources can also help assess stability of securities markets and can help interpret FSIs. The financial market