Financial Soundness Indicators

Paul J.van Sluijs World Bank 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

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
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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)

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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
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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
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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
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Macro-prudential analysis using FSIs

FSIs for non-financial sector FSIs monitoring vulnerabilities FSIs of capacity to absorb losses Macro conditions Debt sustainability Institutional factors Macroeconomic conditions and shocks

Macro policies Cost of capital External shocks

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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 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
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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 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
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What are FSIs?

 

Securities market liquidity  Average bid-ask spread bid 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
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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

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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
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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
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What are FSIs?

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

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What are FSIs?

Strategies to address data limitations
Data limitations Ways to address them Complement FSIs with other information (from stress tests & CPs and codes & standards assessments) Use FSAPs, TA and Compilation Guide to improve data comparability
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Available data gives poor coverage of some risks (e.g asset quality, contagion risk)

Inconsistent data definitions and reporting across countries

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 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
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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
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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 ratios Regulatory and supervisory framework

Individual institutions

Peer groups

Banking system
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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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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

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

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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

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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

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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

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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

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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
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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
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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 GDP  Household 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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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
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FSIs of financial 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
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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

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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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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 & aggregatedso is bottom-up of stress test is on capital ratio FSI

Output Stress

test impact reflected in FSIs and so helps benchmark links between FSIs

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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
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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

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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 annex  Banking sector  Non-bank financial sector  Markets  Large 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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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

  

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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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