1

Systemic Surveillance and the Use of Macro Prudential Indicators

Mariano Cortés

IMF

Monetary and Capital Markets Department

World Bank/International Monetary Fund/Federal Reserve SystemSeminar for Senior Bank Supervisors from Emerging Economies

October 23, 2008

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Agenda I. What is macro-financial system surveillance

(MFSS) and why should we care?

II. The building blocks of MFSS

III. Financial Soundness Indicators and MFSS

IV. The crisis and the analysis of FSIs

Liquidity

Capital

V. Combining FSIs and market indicators

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Agenda

I. What is macro-financial system surveillance (MFSS) and why should we care?

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What is macro-financial system surveillance?

It is the process of identifying strengths and vulnerabilities in countries’ financial systems so that, if necessary, actions could be taken in a timely and informed manner to prevent crises from occurring.

In other words, it is a methodology that aims to preserve systemic financial stability.

Note that the focus is the system and therefore the contained failure of individual institutions are not ruled out; it is a “top-down” approach.

The health of individual institutions is the focus of micro-prudential surveillance (e.g., supervision); it is a “bottoms-up” approach.

The environment (e.g., macroeconomic, regulatory, legal) in which financial systems operate is key for assessing sources of risks and incentives

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Why we should care about macro-financial system surveillance

The macroeconomic impact of financial sector weaknesses, and most certainly crises, include…

Negative effects on growth

through credit and capital misallocation

More pronounced business cycles—

reluctance to lend

prone to disorderly de-leveraging in downturns (i.e., credit crunch and contagion to other financial institutions)

Possible cross-border contagion

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Why we should care about macro-financial system surveillance (continued)

Monetary policy implementation is made more difficult

bank responses to interest rate policy changes are less predictable,

concerns over the health of banks may limit the scope for policyaction

Negative fiscal consequences

potentially large build-up of debt to support/resolve banks and to recapitalize the central bank

build-up of contingent liabilities in the form of guarantees of deposits and credits

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Why we should care about macro-financial system surveillance (final)

Large fiscal costs of financial system crises

222001-3Argentina

CostYearCountryCostYearCountryCrisis cost in percent of GDPCrisis cost in percent of GDP

1294-95Venezuela2397-2000Korea

312000-03Turkey5297-2002Indonesia287-91U.S.A 1191-93Finland

3597-2000Thailand2298-2001Ecuador1994-95Mexico3381-83Chile

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Agenda

II. The building blocks of MFSS

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The building blocks of macro-financial system surveillance

Assessment of macroeconomic developments with a potential bearing on the soundness of the financial system

e.g., risk of sudden stop triggering an exchange rate correction with adverse impact on banks, households, and corporations with large un-hedged liabilities

Assessment of the strength and vulnerabilities of financial institutions and the system

Assessment of financial sector linkages back to the real economy

e.g., following an adverse shock, weak banks become de-capitalized and trigger a credit-crunch with serious adverse consequences on economic activity

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Financial Systems—Strengths and Vulnerabilities: Assessments Tools

A range of tools is deployed, including:

Review of FSIs and other balance sheet, income, and expenditure aggregates; review of market indicators

Stress testing and scenario analysis

Assessment of regulatory and supervisory frameworks (e.g., compliance with prudential standards--BCPs)

Assessment of financial system safety nets (e.g., deposit insurance, LOLR facilities)

Assessment of markets (e.g., money and T-bills) and their infrastructure (e.g., payment and securities settlement systems)

Crisis management arrangements (e.g., bank resolution framework)

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Tools—Stress Testing and Scenario AnalysisStress testing is a range of techniques used to assess the vulnerability of the financial system to exceptional but plausible shocks.

Stress tests impose a coherent structure in which to discuss risks and can add rigor to systemic analyses.

Stress test were originally developed for use at the level of portfolios and for individual institutions.

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Tools—Stress Testing and Scenario Analysis (continue)

Stress tests attempt to

combine a forward-looking macroeconomic perspective

with an assessment of the sensitivity of financial institutions to major shocks in the economic and financial environment.

The system-wide nature does not imply that the tests should be performed only on aggregate data

Aggregate data can disguise substantial exposures and risk concentrations at the institutional level that would be netted out through aggregation

It is therefore important to perform stress tests on an institution-by-institution basis as much as possible

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Tools—Stress Testing (continue)Stress tests should be tailored to:

country-specific circumstances

complexity of the financial system

data availability.

Stress testing balance-sheet positions only can be misleading because:

off-balance-sheet positions can quantitatively and qualitatively alter on-balance-sheet exposures.

it may not be clear where market and credit risks ultimately reside—credit risk derivatives or contingent liabilities.

off-balance-sheet funding vehicles (conduits and SIVs) can also be sources of vulnerabilities.

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Tools—Stress Testing (final)

Three main types of stress tests:

Single-factor sensitivity analysis—to identify how portfolios respond to changes in relevant economic variables such as interest rates, exchange rates, and equity prices;

Scenario analysis (model-based simultaneous moves in a group of risk factors)—to assess the resilience of financial institutions and the financial system to exceptional events;

Contagion analysis—to take account of the transmission of shocks from individual institutions to the financial system as awhole.

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MFS and the FSAPThe IMF and the World Bank undertake comprehensive assessments of member countries financial systems through the jointly run FSAP program

The program was launched in 1999 as part of the international community’s efforts to strengthen the global financial architecture

Today, some 126 countries/currency unions have undergone initialassessments, of which 46 have already undertaken at least one update assessment

Going forward, the Fund is likely to step up its financial stability assessment work

Focus on implementation of FSF recommendations

Should the FSAP be mandatory?

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Agenda

III. Financial Soundness Indicators and MFSS

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What are financial soundness indicators (FSIs)?

• FSIs mainly aggregate bank-level supervisory data

Needed to assess risks to the financial system as a whole

• FSIs complement supervisory indicators for a bank

The later help assess risks at the individual bank level (e.g. CAMEL)

• Aggregation reveals risks missed at micro level

• FSIs are a subset of the much broader group macro-prudential indicators (e.g., debt/GDP, international reserves)

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FSIs must be used with other indicators

Financial market data, early warning indicators, macro forecasts & data

REER, wages, EMBI spreads, macro policiesMacroeconomic conditionsMacro

surveillance

Interest rates and spreadsCredit growthMonetary data & policySector balance sheets

Financing role of banksMonetary transmission

Debt sustainability

Analysis of macro-financial linkages

FSIs (e.g.• Corporate leverage• Liquidity and FX risk • NPLs/loans • Capital ratio)Supervisory and financial infrastructure information

Bank sector vulnerabilitiesCapital adequacy

Macro-prudential surveillance

Types of Indicators/dataFinancial shocksBusiness cycle shocks

External shocks

Financial market surveillance

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What FSIs can and cannot tell you• FSIs reveal current condition of financial sector

Show vulnerabilities and capacity to absorb losses

Some FSIs (e.g., corporate leverage, housing prices) contain potentially leading information on bank balance sheet developments

• They cannot tell you probability of shocks or a crisis

So use FSIs with crisis prediction indicators (e.g. FM data)

• Stress testing gives FSIs forward-looking perspective

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Goal is crisis prevention • Focus on identifying vulnerabilities

• What are the lessons of the current crisis

Stages of a financial crisis (“Manias, Panics and Crashes” by Kindleberger)

1. Shock (risk monitored with market indicators)

2. Vulnerabilities → capital & liquidity problems

3. Propagation mechanism: financial weaknesses →systemic liquidity problems & credit crunch

4. Feedback mechanism: from financial sector to the real economy, which could portend more problems for the financial sector from a deeper macro downturn (2nd

round effects on the FS balance sheets)

5. crisis

Focus ofsurveillance using FSIs

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Types of FSIs• Core FSIs (12)

• FSIs essential to surveillance

• Covers banking sector which is important in every country

• Can be compiled by many countries with existing data

• Encouraged FSIs (28)

• Are relevant to some countries depending on need

• May require additional analytic work

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Core FSIs—bank sectorRegulatory capital ratios• Regulatory capital/RWAs• Tier 1 capital/RWAs• (NPLs-provisions)/capitalAsset quality• NPLs/total loans• Sector exposure concentrationsEarnings and profitability• ROE, ROA, Expense ratio• Interest margin/gross incomeLiquidity• Liquid asset ratio• Liquid assets/short term liabilitiesMarket risk• FX net open position/capital

Some encouraged FSIsOther banking sector FSIs• Capital/total assets • Gross derivatives

positions/capital• Trading income/incomeLiquidity in securities market • Bid-ask spread• Average daily turnoverNon-financial sectors• Corporate leverage ratio• Corporate ROE• Corporate FX exposure• Real estate prices

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Major progress in use of FSIs• FSI Compilation Guide

Guide is a reference so seminar can focus on interpretation

Web link http://www.imf.org/external/np/sta/fsi/eng/2004/guide/index.htm

• Coordinated Compilation Exercise

62 countries were requested to provide the 12 core FSIs (and encouraged to compile some of the 28 encouraged FSIs) as of end-2005

• FSIs widely available in Country FSRs, FSSAs, and AIVs, though often not yet very comparable cross-country or in accordance to the Guide.

Most countries of seminar participants produce FSIs: you know the statistical issues – lets focus on analysis but…

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Core concept is source of control • For domestic-controlled banks

Banks must rely on domestic resources in a crisis & country bares cost

Supervision and policy options based on domestic control

however …

• Consolidation must be cross-border to capture risk abroad

Thus, domestic banks’ subsidiaries and branches abroad are captured in home country FSIs

Failure to do this leads to miss-measurement of exposure and capital

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FSIs and foreign-owned banks• Compile FSIs for subsidiaries of foreign-owned banks separately

Gives coverage of all domestically incorporated banks

• Risk depends on extent of parent bank support—two cases

Weak parents that may not give support, so subsidiaries treated as locals

Strong parent typically support subsidiaries in a crisis

Reflects concern about reputation risk by large global banks

Consolidate branches and subsidiaries with foreign parent by country

Use those banks’ home country FSIs to assess risk

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Foreign banks pose capital account risk• Risks different when strong foreign banks dominate system

Parent almost always supports subsidiary to protect reputation

• Risks to financial stability come from impact on capital flows

Banks provide external financing to fund credit growth

When risks materialize, banks could stop financing and repatriate funds

Risk depends on exchange rate regime—fixed or managed

Risk of contagion if banks follow same strategy in region

Focus on share of CAB financing due to bank-intermediated flows

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FSIs and stress testing• Stress testing gives forward-looking perspective, combining

potential macro shocks (large but plausible)

vulnerabilities identified using FSIs to assess risk

• Shocks are applied to individual bank balance sheets and P&L accounts

bank-by-bank results aggregated by peer group

aggregation is identical to that used to compile FSIs peer groups

• Baseline of stress test is existing FSIs

• Output of stress test is changes in FSIs due to shock

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Other Ratios needed FSIs needed

0.013

earning /assets (ROA)

0.5520.4940.0330.0690.1160.065

RWA/ assets

Loans/ assets

Provisions/ loans

Capital/ assets

Regulatory capital/RWA

NPL/ loans

Italian banking system ratios

Mapping FSIs into stress test

0.087-0.00960.0975

Regulatory capital/RWA

earning /assets (ROA)

NPL/ loans

Italy: Impact of a 50% increase in NPL ratio on

FSIs

Calculations (back of envelope)

∆NPL/L = New provisions/L

New provisions/L = ∆Earnings/L

∆Earnings/L = ∆Capital/L

∆Capital/L • L/A • A/RWA= ∆Capital/RWA

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Agenda

IV. Lessons from the crisis for the analysis of FSIs

• Liquidity

• Capital

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More focus on liquidity risk

Liquidity shortages were a key feature of financial crises

“A remarkable feature of the last 40 years is the degree to which attention… has swung from concerns about liquidity to a concentration on capital requirement. In my view this pendulum has swung too far.”

Charles Goodhart, Per Jacobsson Lecture, BIS

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Liquidity risk Originates in maturity transformation: a core bank function

Banks are opaque, creating counterparty risk

In crisis, refinancing risk not bankruptcy was key concern

Interbank market is a channel of contagion

Uncertainty that repayment failure could trigger others

• Banks face liquidity risk in securities market

Crisis highlighted role of mark-to-market pricing in these markets

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Liquidity FSIs show vulnerability to a liquidity crisis

• Liquidity ratio (liquid assets/total assets)

Indicates balance sheet shrinkage the system can absorb

Identifies the point when illiquid assets must start to be sold (at a loss)

Broad or narrow measures reflect liquidity in different securities markets,

but it could overstate liquidity in a crisis.

• Liquid assets/short term liabilities

Liquid assets relative to liabilities that can be withdrawn quickly

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Analysis to complement liquidity FSIs

• Size of interbank credit exposures

FSI: (bank gross interbank deposit + loans)/total loans

• Crisis highlighted need for deeper analysis of banks’ funding

Securities markets—long term but need ST for liquidity management

Interbank market—unsecured so more risk of rationing

Repo market—collateral failed to limit counterparty risk as expected

Derivative/CDS exposures to a few big counterparty

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Securities market liquidly• Two encouraged FSIs

Bid-ask spread

Average daily turnover

• Markets for government securities banks hold as liquid assets

• Indicates liquidity that can be raised without fall in price

but ….

• Crisis showed low reliance on this market for liquidity

• Focus on other markets that became illiquid in a crisis

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Central banks and liquidity riskCrisis showed that extant CB liquidity facilities failed to eliminate liquidity risk

Banks often lack sufficient acceptable collateral – so range increased

Crisis showed much liquidity risk from cross border funding

CBs can create liquidity in own currency (and must use FX reserves)

Shows need for central bank FX swaps (as FX swap market fails)

Money market can fail to distribute liquidity so central banks must provide LOLR directly to banks

Often must provide liquidity against relatively poor collateral--haircuts

Can’t distinguish illiquid from insolvent banks, and so may incur losses

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Liquidity risk high in emerging marketsDollarization increases liquidity risk

CBs can’t create liquidity in foreign currencies

Must use scarce FX reserves for liquidity support, raising crisis risk

Bank liquidity crises can trigger capital account crises

FX reserves used to cover FX deposit loss can’t protect currency

Local currency deposits converted into FX cash drains FX reserves

• Use indicators of liquidity risk in dollarized systems

(FX reserves + liquid bank FX assets)/liquid FX liabilities

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FSIs for Capital--Focus on Bank Solvency

A. Leverage ratio

An encouraged Indicator

Capital to assets

Crisis highlighted importance

B. Regulatory capital

Core Indicators:

Regulatory capital to risk-weighted assets (RWAs)

Regulatory Tier I capital to risk-weighted assets

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A. Leverage ratio capital measuresMarket valuation/ capitalization

book value of equity or tier 1 (mostly equity)

– defines who absorbs losses in capital structure

Market value of equity

– Should be NPV of earnings but very volatile; gives cost of new capital

Net Worth –

Accounting equation: NW = A - L

relevant in insolvency: buffer available to absorb losses

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B. Regulatory Bank “Capital”Structure

Tiers of “capital” to absorb losses based on seniority in capital structure

Risk-weighting of assets

Inclusion of off-balance-sheet items (in principle at least)

Crisis showed two limitation of CAR – RWA and tier II

Markets only look at equity to assess adequacy of capitalization

Risk-weighting of assets proved unreliable owing to failure of ratings/weightings

Prior to crisis CAR looked strong but leverage ratio fell

CAR misleading due to capital arbitrage with banks rapidly expanding assets with low-risk weight (funded with credit repo)

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Banks Tier 1 to assets and RWAs

4

5

6

7

8

9

10

Y2002 Y2003 Y2004 Y2005 Y2006 Q2Y20073

4

5

6

7

8

Tier1/RWA (B) Tier1/RWA Tier1/TA (B) Tier1/TA

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Banks Tier 1 to assets and RWAs Ratio of Bank Securities Holdings and

Deposits to Assets

20

25

30

35

40

45

50

55

60

65

70

Y2002 Y2003 Y2004 Y2005 Y2006 Q2Y2007

perc

ent

Securites/assets10 global banks

Deposits/assets10 global banks

Deposits/assetsother banks above $100 bn

Securities/assetsother banks above $100 bn

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Global banks total asset and RWAs

0

2

4

6

8

10

12

14

16

18

Y2002 Y2003 Y2004 Y2005 Y2006 Q2Y2007

Trill

ions

RWA (1~10) TA (1~10)

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Global banks total asset and RWAs

30

35

40

45

50

55

Y2004 Y2005 Y2006 Q2Y2007

RWA/TA (B w/o 10) RWA/TA

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RWAs also misleading in stresssituation as writedowns boosts CAR

12.5%5.56%FSI – Reg. Cap. to RWA

100100Total

3%3%FSI – Capital to assets

2020Others

9595Deposits2070Loans

22Subordinated debt

555Government bonds

33Capital55Cash

After a Crisis

Before a Crisis

After a Crisis

Before a Crisis

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Agenda

V. Combining FSIs and market indicators

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Combining FSIs with other Indicators

• Use market indicators to assess risk of shock separately from vulnerabilities

Estimating risk of shock a separate, parallel exercise

• Use BOP, fiscal and corporate indicators to assess other vulnerabilities in parallel

End result is an estimate of crisis risk

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Combining FSIs with other Indicators

• The IMF uses an internal “Vulnerabilities Exercise” (VE)

VE a screening tool to detect vulnerable countries; follow up needed

Sector vulnerabilities aggregated for overall country rating

thresholds determine if indicators signal High, M, or L vulnerability

weights used to aggregate sector indicators for country VE rating

Other sectors:

Balance of payments

Fiscal

corporate

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Vulnerability Exercise indicators

Price/earnings ratio∆credit - ∆NGDPFX debt/total debtExternal debt

ROAFX loans/loansST debt/total debtExchange rate regime

Leverage ratioROAPublic debt/ NGDPRER overvaluation

Interest coverage ratioNPLs/loansPrimary gap/ NGDPCurrent account bal.

Default prob. (DtoD)Capital adequacy ratioBudget deficit/ NGDPReserve coverage

Corporate SectorFinancial SectorFiscal SectorExternal Sector

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Illustrative Thresholds for VE

80%5%

-0.5%7.5%8%

HighMedium

40%Dollarization ratio: FX loans/loans2.5%∆private sector credit/∆nominal GDP

0ROA4%NPL/Loans10%Capital adequacy ratio

Threshold for ratings FSI/Indicator

• These are illustrative, have changed and may differ by region/country

• Thresholds for credit growth from econometric crisis prediction model

• Accounting rules affect threshold from supervisors (e.g. NPLs, CARs)

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IMF: uses 6 types of market indicators

Monetary and financial conditions

Risk appetite

Macroeconomic risks

Emerging market risks

Credit risk

Market risk

Conditions and Risks Changes since April 2008 GFSR

Monetary and Financial Conditions ↓G-7 real short rates ↔G-3 excess liquidity ↓Financial conditions index ↓Growth in custodial reserve holdings ↑G-3 lending conditions ↓

Risk Appetite ↓Investor survey of risk appetite ↓Investor confidence index ↔Emerging market fund flows ↓Risk aversion index ↓

Macroeconomic Risks ↑World Economic Outlook global growth risks ↔G-3 confidence indices ↑Economic surprise index ↓OECD leading indicator ↑Implied global trade growth ↑Global breakeven inflation rates ↓

Emerging Market Risks ↑Fundamental EMBIG spread ↔Sovereign credit quality ↑Credit growth ↓Median inflation volatility ↑Corporate spreads ↔

Credit Risks ↑Global corporate bond index spread ↑Credit quality composition of corporate bond index ↑Speculative-grade corporate default rate forecast ↑Banking stability index ↔Loan delinquencies ↑

Market Risks ↑↑Hedge fund estimated leverage ↓Net non-commercial positions in futures markets ↔Common component of asset returns ↑World implied equity risk premia ↓Composite volatility measure ↑Financial market liquidity index ↑

Source: IMF staff estimates.

Table 1.6. Changes in Risks and Conditions Since the April 2008 Global Financial Stability Report

Note: Changes are defined for each risk/condition such that ↑ signifies higher risk, easier monetary and financial condition, or greater risk appetite, and ↓ signifies the converse; ↔ indicates no appreciable change. The number of arrows for the six overall conditions and risks correspond to moves on the global financial stability map.

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April 2008 GFSROctober 2008 GFSRApril 2008 GFSROctober 2008 GFSR

Credit risksEmerging market risks

Market andliquidity risks

Macroeconomic risks

Monetary and financial Risk appetite

Conditions

Risks

Figure 1.1. Global Financial Stability Map

Source: IMF staff estimates.Note: Closer to center signifies less risk, tighter monetary and financial conditions, or reduced risk appetite.

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Monetary and financial indicators

-2

0

2

4

6

8

10

12

1991 1993 1995 1997 1999 2001 2003 2005 2007

G-7 Real Short-Term Interest Rate1

(In percent, GDP-weighted average)

Sources: Bloomberg L.P.; and IMF staff estimates. 1Canada and the United Kingdom are included in the compsoite but not shown separately.

Euro area

Japan

United StatesComposite

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Monetary and financial indicators

-20

-10

0

10

20

30

40

50

60

70

80

1991 1993 1995 1997 1999 2001 2003 2005 2007-90

-80

-70

-60

-50

-40

-30

-20

-10

0G-3 Bank Lending Conditions1

(Net percentage of domestic respondents tightening standards for loans)

Tighter lending conditions

Sources: Lending surveys by Bank of Japan, European Central Bank, and Federal Reserve Board for households and corporates; and IMF staff estimates.1Monthly-interpolated GDP-weighted average. Euro area 1999:Q1 to 2002:Q4 based on values implied by credit growth.

Japan(right scale)

Euro area

United States

Composite

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Risk appetite indicatorsMerrill Lynch Fund Manager Survey(Net percent of investors reporting higher risk-taking than benchmark)

-50

-40

-30

-20

-10

0

10

20

30

May-01 May-02 May-03 May-04 May-05 May-06 May-07 May-08

Sources: Merrill Lynch.

Increasedrisk-taking

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Risk appetite indicators

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08

Sources: Emerging Portfolio Fund Research, Inc.; and IMF staff estimates.

Total Net Inflows to Emerging Market Bond and Equity Funds(In percent of assets under management, 13-week moving average)

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Macroeconomic risk indicators

-60

-40

-20

0

20

40

60

Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06

G-3 Confidence Indicator(GDP-weighted average of deviations from the average)

Sources: Bloomberg L.P; and IMF staff estimates.

United States

Japan

Germany

Composite

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Emerging market indicators

5

10

15

20

25

30

35

Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08

Sources: International Monetary Fund, International Financial Statistics; and IMF staff estimates. 1 44 countries.

Emerging Market Private Sector Credit Growth1

(GDP-weighted average, in percent)

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Emerging market indicators

Sovereign(left scale)

0

200

400

600

800

1000

Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-080.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

Sources: Credit Suisse; JPMorgan Chase & Co;, and IMF staff estimates.Note: JPMorgan Emerging Market Bond Index Global and Credit Suisse Emerging Market Corporate Bond Index.

Emerging Market Corporate Credit Spreads(In basis points)

Corporate(left scale)

Corporate-to-sovereign ratio(right scale)

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Credit risk indicators

3.5

4.5

5.5

6.5

7.5

Jan-91 Jan-95 Jan-99 Jan-03 Jan-07

Delinquency Rate on Consumer and Mortgage Loans1

(In percent)

Sources: Federal Reserve; Mortgage Bankers Association; and IMF staff estimates.130-, 60-, and 90-day delinquencies for residential and commercial mortgages, and credit card loans in the United States.

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Credit risk indicators

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

Expected Number of Bank Defaults Given At Least One Bank Default(Among 15 selected banks)

Sources: Bloomberg L.P.; and IMF staff estimates.

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Credit risk indicators

0

2

4

6

8

10

12

14

Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08

Actual default rate

Forecast default rate

Source: Moody's.

Moody's Speculative Grade Default Rates: Actual and 12-Month Forecast (In percent)

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Market risk indicators

0

100

200

300

400

500

600

Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08

Funding and Market Liquidity Index(January 1996 = 100)

Sources: Bloomberg L.P.; and IMF staff estimates.Note: Based on the spread between yields on government securities and interbank rates, spread between term and overnight interbank rates, currency bid-ask spreads, and daily return-to-volume ratios of equity markets. A higher value indicates tighter market liquidity conditions.

63

Market risk indicators

0.35

0.40

0.45

0.50

0.55

0.60

0.65

0.70

Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07

Sources: Bloomberg L.P.; JPMorgan Chase & Co.; and IMF staff estimates.

Estimated Common Component in Asset Class Returns(Share of variation in returns, 90-day moving average)

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Market risk indicatorsComposite Volatility Index(In standard deviations from the period average)

-2.0

-1.0

0.0

1.0

2.0

3.0

Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08Sources: Bloomberg L.P.; and IMF staff estimates.Note: Representing an average z-score of the implied volatility derived from options from stock market indices, interest, and exchange rates. A value of 0 indicates the average implied volatility across asset classes is in line with the period average (from 12/31/98 where data is available). Values of +/-1 indicate average implied volatility is one standard deviation above or below the period average.

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Concluding Thoughts• Use FSIs flexibly in combination with other indicators

• Obtaining FSIs is now easy relatively easy, the challenge is interpretation

• Assess data quality (incentives to misreport high in crisis)

• Use accounting linkages to consider simple stress scenarios

• Follow up with analysis of macro-financial linkages