Writing an MSA and the road towards a score card approach to assess financial system’s risks Writing an MSA and the road towards a score card approach to assess financial system’s risks Arturo J. Galindo

Agenda Writing the Financial Sector Chapter for MSA 2011 An Example – CAN’s Banking System Report Beyond 2012

Agenda Writing the Financial Sector Chapter for MSA 2011 An Example – CAN’s Banking System Report Beyond 2012

Writing the MSA 2011 – Financial Sector Stability Section The MSA will include an analysis of the stability of the banking and non banking financial sector aimed at assessing whether there is a strong likelihood that in the next two years, financial institutions may be in need of rescue operations that may threaten fiscal sustainability or the functioning of the payment system.

MSA 2011 – Content (i) Analysis of bank and the non bank financial sector if relevant (systematically important). A small set of graphs and tables are included with key information and the text reflect a description of that data drawing the implications for financial stability. If quantitative analyses are available (stress tests, etc) they would be welcome (not required). If the central bank produces a financial stability report, this could be used as the leading input for the production of this section of the MSA.

MSA 2011 – Content (ii) Banking sector: descriptive analysis of trends and risks (if possible by groups: private, public, foreign): –Quantity and the cost of credit (by type) and deposits. –Quality of credit (npl) –Solvency ratios (provisions, capital ratios) –Profitability (ROA/ROE) –Liquidity –Regulations

MSA 2011 – Content (iii) Non-bank financial sector will vary depending on the systemic importance of institutions such as pension funds, insurance companies, investment banks, stock brokers (or security dealers or other similar institutions), mutual funds, etc. Descriptive analysis. Where possible supported by analytical exercises (not be specifically required). The MSA may include a description of the regulatory structure for significant non-bank activities highlighting any deficiencies where relevant.

MSA 2011 – Content (iv) Focus: attempt to capture the major sources of risks, including potential risks associated with the interrelation of financial activities and institutions. In general there will not be a unique format for this section of the MSA. The analysis will depend on country specific characteristics including the availability of information.

Agenda Writing the Financial Sector Chapter for MSA 2011 An Example – CAN’s Banking System Report Beyond 2012

CAN’s Banking System Report

Report’s Content Monitor –Financial depth and structure (compare banking to non banking, foreign/public/domestic, concentration) –Balance sheet growth –Asset quality –Capital adequacy –Liquidity –Profitability –Costs and interest rates

Details

Sources & others Banking superintendencies. Frequency: Monthly Data: by bank We present aggregates by: –Total –Public –Private Domestic Foreign

1. Financial depth and credit growth Financial development in CAN is low Except for Venezuela credit has been growing rapidly in CAN. –Credit from public banks in Ecuador and Venezuela grows at rates exceeding 30%. Activos y Créditos Bancarios: Diciembre 2010 (% GDP)

1. Financial Development Banks are the most relevant players in CAN’s financial systems.

2. Structure of the Banking System Peru has the highest concentration of banks in the region Venezuela and Ecuador have a very high participacion of public banks In Ecuador a public bank (Banco del Pacífico) is one of the largest players Peru has the highest share of foreign banking in CAN. Concentración del Sector Bancario: Diciembre 2010

3. Asset quality NPLs are relatively low in CAN compared to G7 countries. NPL in public banks in Venezuela (more than 1/3 of the system’s assets) are high and growing at the same time that credit from these banks grows at 36% per year. Provisions are relatively high, but provisioning rules are not homogeneous across countries.

4. Capital adequacy Capital/Asset ratios are around13%. But beware of capital measurements. The K/A ratio is higher than in many advanced economies. Patrimonio/Activos Ponderados por Riesgo

5. Liquidity and Management Liquidity Has remained relatively stable in CAN Peru and Bolivia have very liquid banking systems. In Peú this is driven by high reserve requirements. Activos Líquidos (% Obligaciones de Corto Plazo) Gastos Operativos (% Activos) Management  Operational costs have been stable or falling in most countries except in Venezuela (private banks).

6. Profitability In 2010 ROA was on average 1.9% and ROE17.3%. The highest has been in fast growing Peru and the lowest in Ecuador. Non interest income plays an important role in Ecuadorian and Bolivian banks.

Agenda Writing the Financial Sector Chapter for MSA 2011 An Example – CAN’s Banking System Report Beyond 2012

A methodology to assess banking fragility Based on S&P’s framework that we are in the process of LAC-inizing. Main idea: –Methodology to assess the risk profile of a country’s financial –Allows us to determine the relative risk of a country’s financial system relative to the region

Proposed methodology (i) Analyzes country and industry risks and categorizes risks according to levels (high risks receive greater weights). Country risks include: –Economic stability –Economic imbalances –Credit risk Banking sector risks –Institutional framework –Competition –System wide funding

Proposed methodology (ii) Each of the six factors has indicators that help classify each factor and assign a score. ClassificationScore Very low risk1 Low risk2 Intermediate risk3 High risk5 Very high risk7 Extremely high risk10

Proposed methodology (iii) The sum of the six scores leads to an index that then maps into the following scale: Sum of points1-10 Scale

Proposed methodology (iv) For an individual country, the scale doesn’t tell us much, but it provides a ranking of banking sector risks for the 26 countries of the bank. The key assumption is that the rankings will be comparable across countries. In order to do so, Galindo, Powell and others are defining the components of each factor, and certain thresholds to classify risks.

Roadmap MSA 2011 – Financial sector discussion should following the narrative described in the guidelines –Simultaneously economists should work on the score card approach and will receive guidelines soon to start working on them. MSA 2012 – Financial sector section should include the narrative + the score card approach.