Transcript Financial Soundness Indicators Paul J.van Sluijs World Bank

Financial Soundness Indicators
Paul J.van Sluijs
World Bank
Nairobi, May 15 – 17, 2006
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Overview
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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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What is financial system stability?
Financial system stability:
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Principal components* of the system are jointly capable of
absorbing adverse disturbances
Financial system facilitates a smooth and efficient reallocation
of 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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What is financial system stability?
Tools a.o:
 Macro prudential surveillance
 Financial stability indicators
 Stress testing
 Supervision and surveillance
 Analysis of macro-financial linkages
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Overview
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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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What are FSIs?
FSIs are indicators used to
 Monitor the soundness of a financial system
 Assess systemic 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)
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What are FSIs?
Basic surveillance data used to construct FSIs
 Balance sheets & income statements of different
banks
 Information on ownership structure of financial
institutions
 Information 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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Macro-prudential analysis using FSIs
FSIs for non-financial
sector
FSIs monitoring
vulnerabilities
FSIs of capacity to
absorb losses
Macro conditions
Debt sustainability
Macroeconomic
conditions and shocks
Institutional factors
Macro policies
Cost of capital
External shocks
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What are FSIs?
Two types of FSIs
 Core FSIs
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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
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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 FSIs
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Capital adequacy
 Regulatory capital/rw assets
 Regulatory tier I capital/rw assets
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Asset quality
 Non perf. loans/total gross loans
 Non perf. loans net of provisions/capital
 Sectoral distribution of loans/total loans
 Large exposures/capital
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What are FSIs?
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Earnings and profitability
 ROA, ROE
 Interest margin/gross income
 Non-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 FSIs
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Other banking sector FSIs
 Capital/total assets
 Geographical distribution of loans/total loans
 Gross asset position in fin. derivatives/capital
 Trading income/total income
 Personnel expenses/non interest expenses
 Spread lending and deposit rate
 Spread highest and lowest interbank rate
 Customer deposits/total loans
 Fx loans/total loans
 Fx liabilities/total liabilities
 Net open position equities/capital
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What are FSIs?
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Securities market liquidity
 Average bid-ask spread
 Average daily turnover
Non bank financial institutions
 Assets/financial system assets
 Assets/GDP
Corporate sector
 Total debt/equity
 Return on equity
 Earnings/interest and principal expenses
 Corporate net fx exposure/equity
 Number of applications for protection from creditors
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What are FSIs?
Households
 Household debt/GDP
 Debt service and principal payments/income
 Real estate markets
 Real estate prices
 Residential loans/total loans
 Commercial loans/total loans
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What are with FSIs?
What to do with FSIs
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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 country’s
financial structure
Systemic importance of insurance or securities firms
Size and intermediation role of foreign & state banks
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most countries core FSIs are needed
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Provides a common set of FSIs across countries
Core
and encouraged FSIs will evolve over time to
reflect surveillance priorities
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What are FSIs?
Availability of FSIs
Individual bank data usually available—e.g. from supervisors
Quality of data can be good if
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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
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Not sure about data to use and interpretation
Confidentiality—although aggregation protects it
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What are FSIs?
Strategies to address data limitations
Data limitations
Ways to address them
Available data gives poor
coverage of some risks (e.g asset
quality, contagion risk)
Complement FSIs with other
information (from stress tests &
CPs and codes & standards
assessments)
Inconsistent data definitions and
reporting across countries
Use FSAPs, TA and Compilation
Guide to improve data
comparability
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Overview
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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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FSIs and peer groups
Peer groups: based on features relevant to
financial stability, including whether:
 Domestic or foreign is lender of last resort/pays
for closing insolvent banks
 Government guarantee, e.g. state banks
 Banks play key payments or intermediation role
 Financial strength of foreign parent banks
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FSIs and peer groups
Example of possible FSI per groups
 Grouping by different form of risk to financial system
 Domestically controlled banks
 State owned banks
 Large banks
 Complex groups
 Foreign owned banks
 Subsidiaries and branches of large global banks
 Subsidiaries and branches of smaller foreign banks
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Overview
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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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Risks assessed with FSIs
Prudential
ratios
Individual
institutions
Regulatory and
supervisory framework
Peer groups
Banking
system
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Risks assessed with FSIs
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, unrealised
capital gains) give less protection to creditors
 Valuation problems can cause overestimation of capital
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Risks assessed with FSIs
FSIs monitoring asset quality
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NPLs/Loans: an imperfect measure
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May differ from banks’ ex-ante internal assessment
Tend to be a lagging indicator
{NPLs - provisions}/capital
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Indicates additional provisions that may need to be taken
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Risks assessed with FSIs
FSIs monitoring asset quality
 Loan concentration by sector/total loans
 Indicates a possible vulnerability when banking sector as a whole has a
concentrated exposure to a sector
However,
 Nominal values of exposures do not reflect variations in asset quality
 Asset quality reflects probabilities of default or downgrade—i.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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Risks assessed with FSIs
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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Risks assessed with FSIs
Banking sector liquidity FSIs
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Liquidity is a key source of systemic risk
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Liquidity ratio (liquid assets/total assets)
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Assesses the balance sheet shrinkage the system can absorb before selling
assets at fire sale prices
Liquid assets/short term liabilities
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Assesses potential scale of bank run & assets available to cover loss
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Risks assessed with FSIs
Market risk FSIs
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Limitations of existing measures
 Probabilities of movements in exchanges rates & interest rates ignored
 No allowance for correlation effects among balance sheet items
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Value-at-Risk measures help to overcome these limitations
 Key-rate duration overcomes problems with maturity bucket approach
 VaR provides a comprehensive measure of exposure to all sources of
market risk under normal market conditions
However,
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Stress tests needed to assess market risk in abnormal market environments
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Risks assessed with FSIs
Other FSIs for the banking sector
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Net open position in foreign exchange
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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
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Limitation: duration is technically hard to compute
Partial solution: approximate using maturity bucket data collected by
supervisors
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Risks assessed with FSIs
FSIs for the non-bank financial sector
 An early warning indicator of potential banking sector problems
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Corporate sector FSIs
 Corporate leverage & return on equity indicates risk of
default
 Detect indirect credit risk arising from shocks to the corporate
sector (e.g. FX shock raises default risk)
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Real estate sector FSIs
 Real estate price FSI may detect potential bubble in the real
estate market that has contributed to many banking crises
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FSIs for Insurance
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Capital adequacy
 Additional focus on liability risk (function of
social and demographic development)
Asset quality
Duration match assets/liabilities
Reinsurance
Earnings and Profitability
Liquidity
Sensitivity to Market Risk
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FSIs for securities markets
Market liquidity
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Bid-ask spread
Average daily turnover
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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
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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 GDP
 Household debt burden to income
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Overview
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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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Links between FSIs
Non-financial sector FSIs
Estimate credit links of impact
of corporate FSIs on assets
quality FSIs
FSIs of financial
sector vulnerabilities
FSIs of financial
sector capital
adequacy
Accounting links show how a
fall in asset quality reduces
capital ratios
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Links between FSIs
Links between asset quality FSIs & capital adequacy
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Linkages vary by county depending on
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Provisioning and loan classification rules
Definition of capital
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These are analysed for each country to assess the impact of
asset quality FSI on capital ratio
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Use info on rules & definitions from BCP assessments and
country sources
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Links between FSIs
Links between asset quality & corporate leverage
Objectives
of the analysis
Identify risks to banking sector from credit linkages
Help anticipate deterioration in asset quality
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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 relationship
for a country
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Overview
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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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Links between FSIs and other
surveillance tools
FSIs & stress tests
FSIs
are the “baseline” for stress test shocks
Stress
test shock applied to bank balance sheets & aggregated—so
is bottom-up
Output
of stress test is on capital ratio FSI
Stress
test impact reflected in FSIs and so helps benchmark links
between FSIs
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Links between FSIs and other
surveillance tools
Linking FSIs & core principles assessments
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Indicates how effectively banks & supervisors respond to risks
revealed by FSIs
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Assesses how compliance with criteria reduces specific risk
monitored by an FSI
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Analysis shows where improving compliance reduces risks to financial
stability
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FSIs helps focus assessments on gaps in compliance posing a risk to
financial stability
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Links between FSIs and other
surveillance tools
Complementing FSIs with financial infrastructure assessments
Robustness of financial infrastructure revealed by codes &
standards assessments helps assess
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Bank capacity to access liquidity under stress
Robustness of market liquidity under stress
This aspect of liquidity risk not well captured as FSIs only
measure current liquidity conditions
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Overview
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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 Stability review: ECB
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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
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External
Euro area
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Financial stability review: ECB
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Euro area financial system
Financial markets
 Banking sector
 Other financial institutions
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Financial systems infrastructure
Payment systems
 Securities clearings and settlement systems
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Financial stability review: ECB
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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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Overview
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
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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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Key challenges in using FSIs
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Assessing the level of risk associated an FSI value
(Benchmarking)
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Detecting vulnerabilities at an early stage
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Identifying appropriate peer groups for which to compile FSIs
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Improving data quality and comparability
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Key challenges in using FSIs
Further 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
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