Financial Soundness

8/6/2019 Financial Soundness

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Financial Soundness Indicators

Paul J.van SluijsPaul J.van Sluijs

World BankWorld BankNairobi, May 15Nairobi, May 15 17, 200617, 2006


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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


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Financial system stability:

Principal components* of the system are jointly capable ofabsorbing adverse disturbances

Financial system facilitates a smooth and efficient reallocationof financial resources from savers to investors

Financial risks are priced and assessed reasonably adequate

Risks are efficiently managed

* financial institutions, markets and infrastructure


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Tools a.o:

Macro prudential surveillance

Financial stability indicators

Stress testing

Supervision and surveillance

Analysis of macro-financial linkages


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Overview





Links between FSIs




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FSIs are indicators used to

Monitor thesoundness of a financial system

Assesssystemic 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)

What are FSIs?


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What are FSIs?

Basic surveillance data used to construct FSIsBasic surveillance data used to construct FSIs

Balance sheets & income statements of differentBalance sheets & income statements of different

banksbanks

Information on ownership structure of financialInformation on ownership structure of financial

institutionsinstitutions

Information on interlinkages among banksInformation on interlinkages among banks


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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


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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


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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


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FSIs for non-financial

sector Macroeconomic

conditions and shocks

FSIs monitoringvulnerabilities

FSIs of capacity to

absorb losses

Institutional factors

Macro conditions

Debt sustainability

Macro policies

Cost of capital

External shocks

Macro-prudential analysis using FSIs


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What are FSIs?Two types ofFSIs

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


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What are FSIs?Core FSIsCore FSIs

Capital adequacyCapital adequacy

Regulatory capital/rw assetsRegulatory capital/rw assetsRegulatory tier I capital/rw assetsRegulatory tier I capital/rw assets

Asset qualityAsset quality

Non perf. loans/total gross loansNon perf. loans/total gross loans

Non perf. loans net of provisions/capitalNon perf. loans net of provisions/capital

Sectoral distribution of loans/total loansSectoral distribution of loans/total loans

Large exposures/capitalLarge exposures/capital


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What are FSIs? Earnings and profitability

ROA, ROE

Interest margin/gross incomeNon-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


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What are FSIs?Encouraged FSIsEncouraged FSIs

Other banking sector FSIsOther banking sector FSIs

Capital/total assetsCapital/total assets

Geographical distribution of loans/total loansGeographical distribution of loans/total loans

Gross asset position in fin. derivatives/capitalGross asset position in fin. derivatives/capital

Trading income/total incomeTrading income/total income

Personnel expenses/non interest expensesPersonnel expenses/non interest expenses

Spread lending and deposit rateSpread lending and deposit rate

Spread highest and lowest interbank rateSpread highest and lowest interbank rate

Customer deposits/total loansCustomer deposits/total loans Fx loans/total loansFx loans/total loans

Fx liabilities/total liabilitiesFx liabilities/total liabilities

Net open position equities/capitalNet open position equities/capital


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What are FSIs? Securities market liquiditySecurities market liquidity

Average bidAverage bid--ask spreadask spread

Average daily turnoverAverage daily turnover

Non bank financial institutionsNon bank financial institutions

Assets/financial system assetsAssets/financial system assets

Assets/GDPAssets/GDP

Corporate sectorCorporate sector

Total debt/equityTotal debt/equity

Return on equityReturn on equity

Earnings/interest and principal expensesEarnings/interest and principal expenses

Corporate net fx exposure/equityCorporate net fx exposure/equity

Number of applications for protection from creditorsNumber of applications for protection from creditors


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What are FSIs?

HouseholdsHouseholds

Household debt/GDPHousehold debt/GDP

Debt service and principal payments/incomeDebt service and principal payments/income

Real estate marketsReal estate markets

Real estate pricesReal estate prices

Residential loans/total loansResidential loans/total loans

Commercial loans/total loansCommercial loans/total loans


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What are with FSIs?What to do with FSIsWhat 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


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What are FSIs?Selecting FSIs

FSIs that need to be monitored depends on a countrys

financial structureSystemic 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


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Availability ofFSIs

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

What are FSIs?


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Data limitationsData limitations Ways to address themWays to address them

Available data gives poorAvailable data gives poor

coverage of some risks (e.g assetcoverage of some risks (e.g asset

quality, contagion risk)quality, contagion risk)

Complement FSIs with otherComplement FSIs with other

information (from stress tests &information (from stress tests &

CPs and codes & standardsCPs and codes & standards

assessments)assessments)

Inconsistent data definitions andInconsistent data definitions and

reporting across countriesreporting across countries

Use FSAPs, TA andUse FSAPs, TA and CompilationCompilation

GuideGuide to improve datato improve data

comparabilitycomparability

Strategies to address data limitations

What are FSIs?


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Overview





Links between FSIs




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FSIs and peer groups

Peer groups: based on features relevant toPeer groups: based on features relevant to

financial stability, including whether:financial stability, including whether:

Domestic or foreign is lender of last resort/paysDomestic or foreign is lender of last resort/pays

for closing insolvent banksfor closing insolvent banks

Government guarantee, e.g. state banksGovernment guarantee, e.g. state banks

Banks play key payments or intermediation roleBanks play key payments or intermediation role

Financial strength of foreign parent banksFinancial strength of foreign parent banks


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FSIs and peer groupsExample of possible FSI per groupsExample of possible FSI per groups

Grouping by different form of risk to financial systemGrouping by different form of risk to financial system

Domestically controlled banksDomestically controlled banks State owned banksState owned banks

Large banksLarge banks

Complex groupsComplex groups

Foreign owned banksForeign owned banks Subsidiaries and branches of large global banksSubsidiaries and branches of large global banks

Subsidiaries and branches of smaller foreign banks


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Overview





Links between FSIs




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PrudentialPrudential

ratiosratios

Regulatory andRegulatory and

supervisory frameworksupervisory framework

IndividualIndividual

institutionsinstitutions

Peer groupsPeer groups BankingBanking

systemsystem


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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, unrealisedcapital gains) give less protection to creditors

Valuation problems can cause overestimation of capital


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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



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FSIs monitoring asset quality

Loan concentration by sector/total loans

Indicates a possible vulnerability when banking sector as a whole has aconcentrated 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



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Banking sector earnings and profitability FSIs:

From reporting/calculate:

Return on equity and assets

Interest margin

Level of non interest expenses



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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 sellingassets at fire sale prices

Liquid assets/short term liabilities

Assesses potential scale of bank run & assets available to cover loss



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Market riskFSIs

Limitations of existing measures

Probabilities of movements in exchanges rates & interest rates ignored

No allowance for correlation effects among balance sheet items

Value-at-Riskmeasures help to overcome these limitations

Key-rate duration overcomes problems with maturity bucket approach

VaR provides a comprehensive measure of exposure to all sources ofmarket risk undernormalmarket conditions

However,

Stress tests needed to assess market risk in abnormalmarket environments



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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 bysupervisors



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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 corporatesector (e.g. FX shock raises default risk)

Real estate sector FSIs

Real estate price FSI may detect potential bubble in the realestate market that has contributed to many banking crises



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FSIs for Insurance Capital adequacyCapital adequacy

Additional focus on liability risk (function ofAdditional focus on liability risk (function of

social and demographic development)social and demographic development) Asset qualityAsset quality

Duration match assets/liabilitiesDuration match assets/liabilities

ReinsuranceReinsurance

Earnings and ProfitabilityEarnings and Profitability LiquidityLiquidity

Sensitivity to Market RiskSensitivity to Market Risk


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FSIs for securities marketsMarket 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


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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


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FSIs for household sector

Household debt to GDPHousehold debt to GDP

Household debt burden to incomeHousehold debt burden to income


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Overview What is financial system stability?




Links between FSIs




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Non-financial sector FSIsEstimate credit links of impact

of corporate FSIs on assetsquality FSIs

FSIs of financial

sector vulnerabilities

Accounting links show how afall in asset quality reduces

capital ratiosFSIs of financial

sector capital

adequacy

Links between FSIs


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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 ofasset quality FSI on capital ratio

Use info on rules & definitions from BCP assessments andcountry sources

Links between FSIs


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Links between asset quality & corporate leverage

Objectives of the analysis

Identify risks to banking sector from credit linkagesHelp 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 relationshipfor a country

Links between FSIs


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Links between FSIs

Links between FSIs and other surveillance tools

Financial stability review: example ECB



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FSIs & stress testsFSIs 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 linksbetween FSIs

Links between FSIs and other

surveillance tools


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Linking FSIs & core principles assessments

Indicates how effectively banks & supervisors respond to risksrevealed by FSIs

Assesses how compliance with criteria reduces specific risk

monitored by an FSI

Analysis shows where improving compliance reduces risks to financialstability

FSIs helps focus assessments on gaps in compliance posing a risk to

financial stability


surveillance tools


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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 onlymeasure current liquidity conditions


surveillance tools


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Links between FSIs





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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


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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


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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


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Links between FSIs





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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



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Key challenges in using FSIsFurther 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

Documents

Financial Soundness