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1
Financial Soundness Indicators
Paul J.van SluijsPaul J.van Sluijs
World Bank World Bank
Nairobi, May 15 – 17, 2006 Nairobi, May 15 – 17, 2006
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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
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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
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What is financial system stability?
Tools a.o: Macro prudential surveillance
Financial stability indicatorsStress testing
Supervision and surveillance Analysis of macro-financial linkages
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
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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?
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What are FSIs?
Basic surveillance data used to construct FSIsBasic surveillance data used to construct FSIs Balance sheets & income statements of Balance sheets & income statements of
different banksdifferent banks Information on ownership structure of financial Information on ownership structure of financial
institutionsinstitutions Information on interlinkages among banksInformation 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 vulnerabilitiesAssess capacity of the system to absorb
lossesTarget 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 evolveComplement monitoring of financial and
macroeconomic developmentsTrack evolution of financial system
vulnerabilities identified in an FSAP
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FSIs for non-financial sector Macroeconomic
conditions and shocksFSIs monitoring vulnerabilities
FSIs of capacity to absorb losses
Institutional factors
Macro conditions Debt sustainability
Macro policiesCost of capitalExternal shocks
Macro-prudential analysis using FSIs
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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
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What are FSIs?
Core FSIsCore FSIs Capital adequacyCapital adequacy
Regulatory capital/rw assetsRegulatory capital/rw assets Regulatory tier I capital/rw assetsRegulatory tier I capital/rw assets
Asset qualityAsset quality Non perf. loans/total gross loansNon perf. loans/total gross loans Non perf. loans net of provisions/capitalNon perf. loans net of provisions/capital Sectoral distribution of loans/total loansSectoral distribution of loans/total loans Large exposures/capitalLarge exposures/capital
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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
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What are FSIs?Encouraged FSIsEncouraged FSIs
Other banking sector FSIsOther banking sector FSIs Capital/total assets Capital/total assets Geographical distribution of loans/total loansGeographical distribution of loans/total loans Gross asset position in fin. derivatives/capitalGross asset position in fin. derivatives/capital Trading income/total incomeTrading income/total income Personnel expenses/non interest expensesPersonnel expenses/non interest expenses Spread lending and deposit rateSpread lending and deposit rate Spread highest and lowest interbank rateSpread highest and lowest interbank rate Customer deposits/total loansCustomer deposits/total loans Fx loans/total loansFx loans/total loans Fx liabilities/total liabilitiesFx liabilities/total liabilities Net open position equities/capital Net open position equities/capital
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What are FSIs? Securities market liquiditySecurities market liquidity
Average bid-ask spread Average bid-ask spread Average daily turnoverAverage daily turnover
Non bank financial institutionsNon bank financial institutions Assets/financial system assetsAssets/financial system assets Assets/GDPAssets/GDP
Corporate sectorCorporate sector Total debt/equityTotal debt/equity Return on equityReturn on equity Earnings/interest and principal expensesEarnings/interest and principal expenses Corporate net fx exposure/equityCorporate net fx exposure/equity Number of applications for protection from creditors Number of applications for protection from creditors
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What are FSIs?
HouseholdsHouseholds Household debt/GDPHousehold debt/GDP Debt service and principal payments/incomeDebt service and principal payments/income
Real estate marketsReal estate markets Real estate pricesReal estate prices Residential loans/total loansResidential loans/total loans Commercial loans/total loansCommercial loans/total loans
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What are with FSIs?
What to do with FSIsWhat 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
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What are FSIs?Selecting FSIsFSIs that need to be monitored depends on a country’s financial structure
Systemic importance of insurance or securities firmsSize and intermediation role of foreign & state banks
In most countries core FSIs are neededProvides a common set of FSIs across countries
Core and encouraged FSIs will evolve over time to reflect surveillance priorities
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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?
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Data limitationsData limitations Ways to address themWays to address them
Available data gives poor Available data gives poor coverage of some risks (e.g asset coverage of some risks (e.g asset
quality, contagion risk)quality, contagion risk)
Complement FSIs with other Complement FSIs with other information (from stress tests & information (from stress tests &
CPs and codes & standards CPs and codes & standards assessments)assessments)
Inconsistent data definitions and Inconsistent data definitions and reporting across countriesreporting across countries
Use FSAPs, TA and Use FSAPs, TA and Compilation Compilation GuideGuide to improve data to improve data
comparability comparability
Strategies to address data limitations
What are FSIs?
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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
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FSIs and peer groups
Peer groups: based on features relevant to Peer groups: based on features relevant to financial stability, including whether:financial stability, including whether:
Domestic or foreign is lender of last resort/pays Domestic or foreign is lender of last resort/pays for closing insolvent banksfor closing insolvent banks
Government guarantee, e.g. state banksGovernment guarantee, e.g. state banks Banks play key payments or intermediation roleBanks play key payments or intermediation role Financial strength of foreign parent banksFinancial strength of foreign parent banks
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FSIs and peer groups
Example of possible FSI per groupsExample of possible FSI per groups Grouping by different form of risk to financial systemGrouping by different form of risk to financial system
Domestically controlled banksDomestically controlled banks State owned banksState owned banks Large banksLarge banks Complex groupsComplex groups
Foreign owned banksForeign owned banks Subsidiaries and branches of large global banksSubsidiaries and branches of large global banks Subsidiaries and branches of smaller foreign banks
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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
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Risks assessed with FSIs
Prudential Prudential ratiosratios
Regulatory and Regulatory and supervisory frameworksupervisory framework
Individual Individual institutionsinstitutions
Peer groupsPeer groups Banking Banking systemsystem
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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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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
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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
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Banking sector earnings and profitability FSIs:
From reporting/calculate:Return on equity and assetsInterest marginLevel of non interest expenses
Risks assessed with FSIs
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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
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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
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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
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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
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FSIs for Insurance
Capital adequacyCapital adequacy Additional focus on liability risk (function of Additional focus on liability risk (function of
social and demographic development)social and demographic development) Asset qualityAsset quality Duration match assets/liabilitiesDuration match assets/liabilities ReinsuranceReinsurance Earnings and ProfitabilityEarnings and Profitability LiquidityLiquidity Sensitivity to Market RiskSensitivity to Market Risk
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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
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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
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FSIs for household sector
Household debt to GDPHousehold debt to GDP Household debt burden to incomeHousehold debt burden to income
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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
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Non-financial sector FSIs
Estimate credit links of impact of corporate FSIs on assets
quality FSIsFSIs 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
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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
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Links between asset quality & corporate leverage
Objectives of the analysis
Identify risks to banking sector from credit linkagesHelp 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
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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
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FSIs & stress testsFSIs 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
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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
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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
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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
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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
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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
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Financial stability review: ECB
Data in charts and in statistical annexBanking sectorNon-bank financial sectorMarketsLarge value payments (TARGET)
www.ecb.int
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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
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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
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Key challenges in using FSIsFurther 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