Financial Soundness Indicators Paul J.van Sluijs World Bank Nairobi, May 15 – 17, 2006
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
What is 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
What is financial system stability? Tools a.o: Macro prudential surveillance Financial stability indicators Stress testing Supervision and surveillance Analysis of macro-financial linkages
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
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) FSI—name reflects the function of the indicators MPI indicate how the indicators are constructed
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
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
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
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
Macro-prudential analysis using FSIs 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
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
What are FSIs? Core FSIs Capital adequacy Regulatory capital/rw assets Regulatory tier I capital/rw assets Asset quality Non perf. loans/total gross loans Non perf. loans net of provisions/capital Sectoral distribution of loans/total loans Large exposures/capital
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
What are FSIs? Encouraged FSIs 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
What are FSIs? 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
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
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
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 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
What are FSIs? Availability of FSIs Individual bank data usually available—e.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 Confidentiality—although aggregation protects it
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
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
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
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
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
Risks assessed with FSIs Prudential ratios Regulatory and supervisory framework Individual institutions Peer groups Banking system
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
Risks assessed with FSIs 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 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
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
Risks assessed with FSIs 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 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 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 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
FSIs for Insurance 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
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
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
FSIs for household sector Household debt to GDP Household debt burden to income
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
Links between FSIs 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 sector capital adequacy
Links between FSIs 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 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
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
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
Links between FSIs and other surveillance tools 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 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
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
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
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
Financial stability review: ECB Data in charts and in statistical annex Banking sector Non-bank financial sector Markets Large value payments (TARGET) www.ecb.int
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
Key challenges in using FSIs 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 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