1 financial soundness indicators paul j.van sluijs world bank nairobi, may 15 – 17, 2006

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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

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Overview


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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


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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


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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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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


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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


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Banking sector earnings and profitability FSIs:

From reporting/calculate:Return on equity and assetsInterest marginLevel of non interest expenses


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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


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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


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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


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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


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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


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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


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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


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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


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Overview


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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


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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

1 financial soundness indicators paul j.van sluijs world bank nairobi, may 15 – 17, 2006

Documents

fsis slide

financial institution

fsis links

corporate fsis

users of fsis

financial system stability

financial stability

systemic risk fsis