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Transcript of Financial Soundness
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Financial Soundness Indicators
Paul J.van SluijsPaul J.van Sluijs
World BankWorld BankNairobi, May 15Nairobi, May 15 17, 200617, 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 ofabsorbing adverse disturbances
Financial system facilitates a smooth and efficient reallocationof 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 indicators
Stress testing
Supervision and surveillance
Analysis of macro-financial linkages
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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 are indicators used to
Monitor thesoundness of a financial system
Assesssystemic 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 differentBalance sheets & income statements of different
banksbanks
Information on ownership structure of financialInformation 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 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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FSIs for non-financial
sector Macroeconomic
conditions and shocks
FSIs monitoringvulnerabilities
FSIs of capacity to
absorb losses
Institutional factors
Macro conditions
Debt sustainability
Macro policies
Cost of capital
External shocks
Macro-prudential analysis using FSIs
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What are FSIs?Two types ofFSIs
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 assetsRegulatory 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 incomeNon-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 assetsCapital/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/capitalNet open position equities/capital
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What are FSIs? Securities market liquiditySecurities market liquidity
Average bidAverage bid--ask spreadask 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 creditorsNumber 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 FSIs
FSIs that need to be monitored depends on a countrys
financial structureSystemic 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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Availability ofFSIs
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?
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Data limitationsData limitations Ways to address themWays to address them
Available data gives poorAvailable data gives poor
coverage of some risks (e.g assetcoverage of some risks (e.g asset
quality, contagion risk)quality, contagion risk)
Complement FSIs with otherComplement FSIs with other
information (from stress tests &information (from stress tests &
CPs and codes & standardsCPs and codes & standards
assessments)assessments)
Inconsistent data definitions andInconsistent data definitions and
reporting across countriesreporting across countries
Use FSAPs, TA andUse FSAPs, TA and CompilationCompilation
GuideGuide to improve datato improve data
comparabilitycomparability
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 toPeer groups: based on features relevant to
financial stability, including whether:financial stability, including whether:
Domestic or foreign is lender of last resort/paysDomestic 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 groupsExample 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
PrudentialPrudential
ratiosratios
Regulatory andRegulatory and
supervisory frameworksupervisory framework
IndividualIndividual
institutionsinstitutions
Peer groupsPeer groups BankingBanking
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, unrealisedcapital 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 aconcentrated 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
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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
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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 sellingassets 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 riskFSIs
Limitations of existing measures
Probabilities of movements in exchanges rates & interest rates ignored
No allowance for correlation effects among balance sheet items
Value-at-Riskmeasures help to overcome these limitations
Key-rate duration overcomes problems with maturity bucket approach
VaR provides a comprehensive measure of exposure to all sources ofmarket risk undernormalmarket conditions
However,
Stress tests needed to assess market risk in abnormalmarket 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 bysupervisors
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 corporatesector (e.g. FX shock raises default risk)
Real estate sector FSIs
Real estate price FSI may detect potential bubble in the realestate 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 ofAdditional 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 marketsMarket 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 FSIsEstimate credit links of impact
of corporate FSIs on assetsquality FSIs
FSIs of financial
sector vulnerabilities
Accounting links show how afall in asset quality reduces
capital ratiosFSIs 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 ofasset quality FSI on capital ratio
Use info on rules & definitions from BCP assessments andcountry 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 relationshipfor 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 & aggregatedso
is bottom-up
Output of stress test is on capital ratio FSI
Stress test impact reflected in FSIs and so helps benchmark linksbetween FSIs
Links between FSIs and other
surveillance tools
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Linking FSIs & core principles assessments
Indicates how effectively banks & supervisors respond to risksrevealed by FSIs
Assesses how compliance with criteria reduces specific risk
monitored by an FSI
Analysis shows where improving compliance reduces risks to financialstability
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 onlymeasure 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 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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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