1. Charles Augustine Abuka MACRO-FINANCIAL LINKAGES AND FINANCIAL SECTOR STABILITY

2. Outline of the Presentation The Rational for the Analysis of Macro Financial Linkages Assessing Risks and Vulnerabilities in the Financial System Using FSIs to Evaluate Financial Stability Macro Financial Stress Testing 1

3. Rationale for analysis of Macro Financial Linkages 2

4. 1. Rationale for analysis of Macro Financial Linkages Policy makers and analysts should be familiar with the issues, techniques, and challenges related to financial sector analysis. There are two main reasons the interest in the financial sector:  Stable and growing financial sector is critical to the expansion of the macro economy.  Macroeconomic stability is intricately related to financial sector soundness. 3

5. 1. Rationale for analysis of Macro Financial Linkages The theoretical literature points to several roles for financial factors:  Negative macro shocks lower the amount of “internal” funds that households and firms can use in investment projects. This increases their demand for and the costs of “external” funding [Bernanke and Gertler(1989)].  Macro shocks tend to lower the value of collateral. This increases the cost of external financing [Kiyotaki and Moore(1997)]. 4

6. 1. Rationale for analysis of Macro Financial Linkages  Adverse shocks to goods prices shift purchasing power from debtors to creditors. This tends to contract aggregate demand further [Fisher(1933)].  Exchange rate shocks tend to change the net worth of households and firms if their foreign-currency assets are not equal to their foreign currency liabilities [Krugman (1999)].  The deterioration in balance sheets can increase the likelihood that debtors will be unable to meet their loan obligations. 5

7. 1. Rationale for analysis of Macro Financial Linkages Elements of analysis: – Identify key macroeconomic developments, – Define the significance of financial sector developments and its importance in the economy, – Ascertain various linkages between the real and financial sectors, – Evaluate financial sector stability, 6

8. 1. Rationale for analysis of Macro Financial Linkages Assessing Macro-Financial Linkages – Identify macroeconomic or financial market “trigger events”, – Construct a macroeconomic scenario that is likely to develop in response to the trigger events, – Assess the stage of development of the financial system, – Discuss potential risks that may arise in the financial sector as a result of the macro scenario. 7

9. Assessing Risks and Vulnerabilities in the Financial System 8

10. 4. Assessing Vulnerabilities in the financial system Construct sectoral balance sheets. Note their potential limitations for analysis of direct and indirect risks within various sectors, Identify balance sheet mismatches. Note how the imbalances might imply risks for other sectors, Identify possible vulnerabilities that are associated with balance sheet mismatches, Identify other sectors of the economy that may be indirectly exposed to mismatches because of intersectoral linkages, Discuss strategies for deeper analysis of macro and financial stability. How is the stability of the real and financial sectors are inter-related. 9

11. 2. Assessing Vulnerabilities in the Financial System The answers depend on several factors:  The magnitude of the macro shocks,  The vulnerability of the financial system to macro shocks,  The extent to which the macroeconomy and the financial system are inter-linked. At the minimum the following risks should be investigated – interest rate risk, – exchange rate risk, – credit risk, – rollover risk, – liquidity risk, – capital requirement risk, and solvency risk. 10

12. 2. Assessing Vulnerabilities in the Financial System Financial institutions tend to have mismatches associated with their balance sheet positions which create increased exposures to particular types of financial risk such as:  maturity,  currency,  capital structure. 11

13. 2. Assessing Vulnerabilities in the Financial System Mechanisms to identify potential vulnerabilities in the financial system including:  Examining financial soundness indicators (FSIs).  These are accounting ratios that are correlated with the financial health of households, firms, banks, and NBFI’s.  Examining detailed aspects of the balances sheets of households, firms, banks, and non-bank financial institutions.  This helps to identify elevated balance-sheet mismatches. 12

14. 2. Assessing Vulnerabilities in the Financial System Maturity Mismatches – Maturity mismatches occur when the average maturity of assets does not match that of liabilities. – Maturity mismatches can arise in either domestic or foreign currency. – Maturity mismatches can expose financial institutions to several types of risk.  interest rate risk  rollover risk and  liquidity risk 13

15. 2.Assessing Vulnerabilities in the Financial System Currency Mismatches – Currency mismatches occur when foreign- denominated assets are greater or less than foreign-denominated liabilities and create exposures to exchange rate risk. 14

16. 2. Assessing Vulnerabilities in the Financial System Capital Structure Mismatches – Capital structure mismatches result from relying too much on debt financing rather than equity. Why is this a problem? Equity values tend to be volatile in times of uncertainty. Payments from equity are contingent on profits and dividends which tend to fall in bad times. 15

17. 2. Assessing Vulnerabilities in the Financial System Indirect Exposures and Financial Risks – Indirect exposures result from the fact that every economic sector has claims and liabilities on other sectors. – The banking sector and currency mismatches: Banks may reduce their direct exposure to foreign exchange risk by borrowing in foreign currency and on-lending to domestic agents in foreign currency. Since households mostly have assets and income in domestic currency, banks may have elevated credit risk to the extent that households could become unable to meet their obligations due a currency depreciation. 16

18. 2. Assessing Vulnerabilities in the Financial System Balance Sheet Concepts The consolidated balance sheet of a country relates: – External assets and liabilities of: The government sector (including the central bank) The private financial sector (banks) The non financial sector (corporates and households) – Versus non resident foreigners The BSA differs from the more traditional approach that looks at economic and financial flows – aggregate demand and supply, – the fiscal balance, – the current account balance, and capital flows. 17

19. 2. Assessing Vulnerabilities in the Financial System Balance Sheet Concepts – Each sector of the economy has claims on and liabilities to other sectors of the economy. – Loans from banks to households will show up both as a claim of the financial sector on the nonfinancial sector, and as a liability of the nonfinancial sector to the financial sector. – Government borrowing abroad shows up as a liability to non- residents, and there is a corresponding asset on the balance sheet of non-residents that reflects external claims on the government. Why emphasize these interlinkages? Weaknesses in a given economic sector may have spillover effects to other sectors. 18

20. 2. Assessing Vulnerabilities in the Financial System Sources of Data for the BSA compilation: – Monetary and financial sector data for the breakdown by currency and maturity for assets and liabilities. – External Debt Statistics – Country International Investment Positions (IIP) – Portfolio Investment Survey data 19

21. 20 2. Assessing Vulnerabilities in the Financial System Sectoral Balance Sheets and Some Important Linkages

22. 2. Assessing Vulnerabilities in the Financial System Why the balance sheet approach for risk analysis? – Traditional analysis focused on flows and prices. After the Asian financial crisis, the focus is on flows and balance sheets (types of debt, illiquid assets etc). Capital account crises arise from portfolio adjustments to shocks, Vulnerability is driven by balance sheet weaknesses, A drop in the demand for assets of any one sector could spill over into other sectors including the government sector, It is adjustments in the stocks that drive flows. – The composition and size of liabilities and assets is an important source of vulnerability. 21

23. 2. Assessing Vulnerabilities in the Financial System Why the balance sheet approach for risk analysis? – Creditors may lose confidence in: A country's ability to earn foreign currency to meet its debt obligations, The governments ability to service its debt, The banking systems ability to meet deposit outflows, other outflows and capital requirements, The corporate sectors capacity to service its debt. An economy consists of interlinked sectoral balance sheets. The recent vulnerabilities arose from a variety of sources: The public sector Private sector Interactions between the public and banking sectors 22

24. 2. Assessing Vulnerabilities in the Financial System Why the balance sheet approach for risk analysis? – The underlying structure of the balance sheet can help in understanding the impact of a sharp adjustment in the demand for a country’s financial assets, – It helps in understanding the impact of the resulting adjustment in key asset prices such as the exchange rate. – Capital account crises occur when there are balance sheet vulnerabilities and trigger events. 23

25. 2. Assessing Vulnerabilities in the Financial System Why the balance sheet approach – Focuses on policies that could reduce sectoral vulnerabilities paying particular attention to: Sound debt management by the public sector to minimise the risk of weaknesses in the public sectors balance sheet being the source of difficulty. Incentives that make the private sector to limit its exposure to various balance sheet risks: – Currency and maturity risks created by short term foreign currency denominated debt. Maintenance of a sufficient cushion of foreign exchange reserves. 24

26. 2. Assessing Vulnerabilities in the Financial System The Balance Sheet Approach: risks are related – The different types of risks may lead to credit risk – the risk that a debt or will not be able to repay his debt. – Solvency risk to the debtor is credit risk to its creditors. – The banking system is prone to credit risk which in turn can trigger a bank ran. – Payment difficulties in one sector have the potential of quickly spreading to the economy as a whole if the sectors difficulties trigger a bank run. – Sectoral balance sheets are linked: One sectors balance sheet is typically another's asset, An unwinding of vulnerabilities in one sector typically has spill over effects on other sectors. 25

27. 2. Assessing Vulnerabilities in the Financial System The Balance Sheet Approach: risks are related – Should all balance sheet vulnerabilities be eliminated? No. Most vulnerabilities are a natural part of the business of an efficient economy, Vulnerabilities need to be managed. – Transmission of vulnerabilities: Banking sector is often a critical transmission channel of vulnerabilities, Weaknesses in both the private sector as well as private sector can be shifted to the banking system, The public sector is often the ultimate holder of risks as a result of implicit or explicit guarantees for the banking system. The BSA has weaknesses too! 26

28. Using FSIs to Evaluate Financial Stability 27

29. 3. Using FSIs to Evaluate Financial Stability 28 In evaluating financial stability we also need to:  Compile the FSIs for your financial system,  Understand the drawbacks of FSIs, The core set of FSI’s closely follows the CAMELS framework: – Capital adequacy – Asset quality, earnings and profitability – Liquidity – Sensitivity to market risk

30. Macro Financial Stress Testing 29

31. 4. Macro Financial Stress Testing This involves assessing the sensitivity of financial or nonfinancial corporations, households or economic sectors to a set of extreme but plausible shocks. Elements of a macro-financial stress test are: – The scenario of trigger events – a set of macroeconomic shocks (changes in GDP, inflation rate, interest rates, the exchange rate, real estate prices or unemployment). – The macro model that translates the initial shocks into changes in key macro variables. – The financial risks that are the focus of the stress test and which macro variables are best associated with assessing the level of those risks. 30

32. 4. Macro Financial Stress Testing Macro scenario design should focus on these issues: Identification of structural weaknesses in the economy, specific structural issues of the financial system that pose threat to stability in the near to medium term horizon, Identification of global market trends that could affect financial system. How the regime shifts might affect economy and financial system? Identification of weak individual institutions (banks, insurance companies, pension funds, micro financial institutions) that can be at risk due to their risk management policies and exposures to specific borrowers. 31

33. 4. Macro Financial Stress Testing Limitations for Macro Stress Testing – Data limitations – Staff analytical skills in some countries – Most economic models are linear, but extreme shocks tend to be non-linear – Economic relationships that were estimated during normal times may change during stressed times – The treatment of key financial interactions and feedback effects is still rudimentary. – Financial system behaviour under stressed conditions is difficult to model (networks; contagion) 32

34. References 33

35. References Allen, Mark, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini, 2002, Bunn, P., Cunningham, A. and M. Drehmann, 2005, “Stress Testing as a Tool for Assessing Systemic Risks,” Financial Stability Review (June) (Bank of England)www.bankofengland.co.uk/publications/fsr/topic/surveillanc e/index.htm “A Balance Sheet Approach to Financial Crisis,” IMF Working Paper #210, Washington: International Monetary Fund. Bernanke, Ben, and Mark Gertler, 1989, “Agency Costs, Net Worth, and Business Cycle Fluctuations,” American Economic Review, Volume 79, pgs 14-31. 34

36. References Cihak, Martin, 2007, “Introduction to Applied Stress Testing,” IMF Working Paper #59, Washington: International Monetary Fund. Cihak, Martin, and Klaus Schaeck, 2007, “How Well Do Aggregate Bank Ratios Identify Banking Problems?” IMF Working Paper #275, Washington: International Monetary Fund. Fisher, Irving, 1933, “The Debt-Deflation Theory of Great Depressions,” Econometrica,Volume 1 (October), pgs. 337-57. International Monetary Fund, 2003, “Financial Sector Soundness Indicators—Background Paper,” Washington: International Monetary Fund. 35

37. References Deutsche Bundesbank, 2007, “Stress Tests: Methods and Areas of Application,” Financial Stability Review (November) www.bundesbank.de/finanzsystemstabilitaet/fs_dokumentation.en.ph p Haldane, A., Hall, S. and S. Pezzini, 2007, “A New Approach to Assessing Financial Stability,” Bank of England Financial Stability Paper No. 2. www.bankofengland.co.uk/publications/fsr/papers.htm IMF, 2008, Austria: Financial Sector Assessment Program Technical Note -Stress Testing and Short-Term Vulnerabilities (April) www.imf.org/external/pubs/cat/longres.cfm?sk=22116.0 36

38. References IMF and World Bank, 2005, “Stress Testing,” Appendix D, in Financial Sector Assessment—A Handbook, pp. 379–407 http://www.imf.org/external/pubs/ft/fsa/eng/index.htm Haldane, Andrew, 2009, “Why Banks Failed the Stress Test” http://www.bankofengland.co.uk/publications/speeches/2009/speec h374.pdf Ong, L. L. and M. Cihak, 2010, “Of Runes and Sagas: Perspectives on Liquidity Stress Testing Using an Icelandic Example,” IMF WP 10/156www.imf.org/external/pubs/cat/longres.cfm?sk=24019.0 Singh, M. and K. Youssef, 2010, “Price of Risk—Recent Evidence from Large Financials,” IMF WP 10/190 www.imf.org/external/pubs/ft/wp/2010/wp10190.pdf 37