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1 Financial Soundness Indicators Paul J.van Sluijs World Bank Nairobi, May 15 – 17, 2006.

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Presentation on theme: "1 Financial Soundness Indicators Paul J.van Sluijs World Bank Nairobi, May 15 – 17, 2006."— Presentation transcript:

1 1 Financial Soundness Indicators Paul J.van Sluijs World Bank Nairobi, May 15 – 17, 2006

2 2 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

3 3 What is financial system stability? Financial system stability: 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

4 4 What is financial system stability? Tools a.o: Macro prudential surveillance Financial stability indicators Stress testing Supervision and surveillance Analysis of macro-financial linkages

5 5 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

6 6 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) What are FSIs?

7 7 Basic surveillance data used to construct FSIs Balance sheets & income statements of different banks Balance sheets & income statements of different banks Information on ownership structure of financial institutions Information on ownership structure of financial institutions Information on interlinkages among banks Information on interlinkages among banks

8 8 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

9 9 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

10 10 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

11 11 FSIs for non-financial sector Macroeconomic conditions and shocks FSIs monitoring vulnerabilities FSIs of capacity to absorb losses Institutional factors Macro conditions Debt sustainability Macro policies Cost of capital External shocks Macro-prudential analysis using FSIs

12 12 What are FSIs? Two types of FSIs 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

13 13 What are FSIs? Core FSIs Capital adequacy Capital adequacy Regulatory capital/rw assets Regulatory capital/rw assets Regulatory tier I capital/rw assets Regulatory tier I capital/rw assets Asset quality Asset quality Non perf. loans/total gross loans Non perf. loans/total gross loans Non perf. loans net of provisions/capital Non perf. loans net of provisions/capital Sectoral distribution of loans/total loans Sectoral distribution of loans/total loans Large exposures/capital Large exposures/capital

14 14 What are FSIs? 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

15 15 What are FSIs? Encouraged FSIs Other banking sector FSIs Other banking sector FSIs Capital/total assets Capital/total assets Geographical distribution of loans/total loans Geographical distribution of loans/total loans Gross asset position in fin. derivatives/capital Gross asset position in fin. derivatives/capital Trading income/total income Trading income/total income Personnel expenses/non interest expenses Personnel expenses/non interest expenses Spread lending and deposit rate Spread lending and deposit rate Spread highest and lowest interbank rate Spread highest and lowest interbank rate Customer deposits/total loans Customer deposits/total loans Fx loans/total loans Fx loans/total loans Fx liabilities/total liabilities Fx liabilities/total liabilities Net open position equities/capital Net open position equities/capital

16 16 What are FSIs? Securities market liquidity Securities market liquidity Average bid-ask spread Average bid-ask spread Average daily turnover Average daily turnover Non bank financial institutions Non bank financial institutions Assets/financial system assets Assets/financial system assets Assets/GDP Assets/GDP Corporate sector Corporate sector Total debt/equity Total debt/equity Return on equity Return on equity Earnings/interest and principal expenses Earnings/interest and principal expenses Corporate net fx exposure/equity Corporate net fx exposure/equity Number of applications for protection from creditors Number of applications for protection from creditors

17 17 What are FSIs? Households Households Household debt/GDP Household debt/GDP Debt service and principal payments/income Debt service and principal payments/income Real estate markets Real estate markets Real estate prices Real estate prices Residential loans/total loans Residential loans/total loans Commercial loans/total loans Commercial loans/total loans

18 18 What are with FSIs? What 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

19 19 What are FSIs? Selecting FSIs FSIs that need to be monitored depends on a countrys financial structure Systemic 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

20 20 Availability of FSIs 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?

21 21 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 Strategies to address data limitations What are FSIs?

22 22 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

23 23 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 Domestic or foreign is lender of last resort/pays for closing insolvent banks Government guarantee, e.g. state banks Government guarantee, e.g. state banks Banks play key payments or intermediation role Banks play key payments or intermediation role Financial strength of foreign parent banks Financial strength of foreign parent banks

24 24 FSIs and peer groups Example of possible FSI per groups Grouping by different form of risk to financial system Grouping by different form of risk to financial system Domestically controlled banks Domestically controlled banks State owned banks State owned banks Large banks Large banks Complex groups Complex groups Foreign owned banks Foreign owned banks Subsidiaries and branches of large global banks Subsidiaries and branches of large global banks Subsidiaries and branches of smaller foreign banks

25 25 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

26 26 Risks assessed with FSIs Prudential ratios Regulatory and supervisory framework Individual institutions Peer groups Banking system

27 27 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

28 28 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 Risks assessed with FSIs

29 29 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 downgradei.e. highly dependent on asset credit rating Credit Value-at-Risk models needed to translate nominal exposures into credit risk equivalents Risks assessed with FSIs

30 30 Banking sector earnings and profitability FSIs: From reporting/calculate: Return on equity and assets Interest margin Level of non interest expenses Risks assessed with FSIs

31 31 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 selling assets at fire sale prices Liquid assets/short term liabilities Assesses potential scale of bank run & assets available to cover loss Risks assessed with FSIs

32 32 Market risk FSIs Limitations of existing measures Probabilities of movements in exchanges rates & interest rates ignored No allowance for correlation effects among balance sheet items 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, Stress tests needed to assess market risk in abnormal market environments Risks assessed with FSIs

33 33 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 by supervisors Risks assessed with FSIs

34 34 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 corporate sector (e.g. FX shock raises default risk) Real estate sector FSIs Real estate price FSI may detect potential bubble in the real estate market that has contributed to many banking crises Risks assessed with FSIs

35 35 FSIs for Insurance Capital adequacy Capital adequacy Additional focus on liability risk (function of social and demographic development) Additional focus on liability risk (function of social and demographic development) Asset quality Asset quality Duration match assets/liabilities Duration match assets/liabilities Reinsurance Reinsurance Earnings and Profitability Earnings and Profitability Liquidity Liquidity Sensitivity to Market Risk Sensitivity to Market Risk

36 36 FSIs for securities markets Market 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

37 37 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

38 38 FSIs for household sector Household debt to GDP Household debt to GDP Household debt burden to income Household debt burden to income

39 39 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

40 40 Non-financial sector FSIs Estimate credit links of impact of corporate FSIs on assets quality FSIs FSIs of financial sector vulnerabilities Accounting links show how a fall in asset quality reduces capital ratios FSIs of financial sector capital adequacy Links between FSIs

41 41 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 of asset quality FSI on capital ratio Use info on rules & definitions from BCP assessments and country sources Links between FSIs

42 42 Links between asset quality & corporate leverage Objectives of the analysis Identify risks to banking sector from credit linkages Help 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 relationship for a country Links between FSIs

43 43 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

44 44 FSIs & stress tests FSIs 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 links between FSIs Links between FSIs and other surveillance tools

45 45 Linking FSIs & core principles assessments Indicates how effectively banks & supervisors respond to risks revealed by FSIs Assesses how compliance with criteria reduces specific risk monitored by an FSI Analysis shows where improving compliance reduces risks to financial stability FSIs helps focus assessments on gaps in compliance posing a risk to financial stability Links between FSIs and other surveillance tools

46 46 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 only measure current liquidity conditions Links between FSIs and other surveillance tools

47 47 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

48 48 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

49 49 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

50 50 Financial stability review: ECB Data in charts and in statistical annex Banking sector Non-bank financial sector Markets Large value payments (TARGET)

51 51 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

52 52 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 Key challenges in using FSIs

53 53 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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