3 Chapter 3 Assessing Financial Stability Financial system stability in a broad sense means both the avoidance of financial institu tions failing in large numbers and the avoidance of serious disruptions to the interme diation fun ions of the financial sy nesfacilitescediraoea and liquidity services. Within thi broad definitio terms of a cial systems can operating inside or outside the stable corridor (instability). Financial stability analysis is intended to help identify threats to financial system stability and to design appropriate policy responses.It focuses on exposures,buffers,and linkages to assess the soundness and vulnerabilities of the financial system.as well as the economic,regulatory,and institutional determinants of financial soundness and stabil- ity.It considers whether the financial sector exhibits vulnerabilities that could trigger a liquidity or solvency crisis,amplify macroeconomic shocks,or impede policy responses to shocks.The monitoring and analysis of financial stability involve :an a ent of mac of fi ncial institution nd markets,financial sy nd the the vul ow they are the extent of th ng managed.Depending on thi system's stability,policy prescriptions m continu ing prevention (when the financial system is inside th e stable corridor),remedia action (when it is approaching instability),and resolution(when it is experiencing instability) 3.1 Overall Framework for Stability Analysis and Assessment The analytic framework to monitor financial stability is centered around macropruden. tial surveillance and is complemented by surveillance of financial markets,analysis of 子
35 3 Financial system stability in a broad sense means both the avoidance of financial institutions failing in large numbers and the avoidance of serious disruptions to the intermediation functions of the financial system: payments, savings facilities, credit allocation, efforts to monitor users of funds, and risk mitigation and liquidity services. Within this broad definition, financial stability can be seen in terms of a continuum on which financial systems can be operating inside a stable corridor, near the boundary with instability, or outside the stable corridor (instability).1 Financial stability analysis is intended to help identify threats to financial system stability and to design appropriate policy responses.2 It focuses on exposures, buffers, and linkages to assess the soundness and vulnerabilities of the financial system, as well as the economic, regulatory, and institutional determinants of financial soundness and stability. It considers whether the financial sector exhibits vulnerabilities that could trigger a liquidity or solvency crisis, amplify macroeconomic shocks, or impede policy responses to shocks.3 The monitoring and analysis of financial stability involves an assessment of macroeconomic conditions, soundness of financial institutions and markets, financial system supervision, and the financial infrastructure to determine what the vulnerabilities are in the financial system and how they are being managed. Depending on this assessment of the extent of the financial system’s stability, policy prescriptions may include continuing prevention (when the financial system is inside the stable corridor), remedial action (when it is approaching instability), and resolution (when it is experiencing instability). 3.1 Overall Framework for Stability Analysis and Assessment The analytic framework to monitor financial stability is centered around macroprudential surveillance and is complemented by surveillance of financial markets, analysis of Chapter 3 Assessing Financial Stability
Financial Sector Assessment:A Handbook macrofinancial linkages,and surveillance of macroeconomic conditions.These four key elements play distinct roles in financial stability analysis. .Surveillance of financial markets helps to assess the risk that a particular shock or a combination of shocks will hit the financial sector.Models used in this area of 3 surveillance include early warning systems(EWSs).Indicators used in the analysis include financial market data and macro-data,as well as other variables that can be used for constructing early warning indicators (see section 3.2). Mac ess the health of the financial system and used fo macroprudential surveillance are the monitoring of financial soundness indicator (FSIs)and the conducting of stress tests.Those tools are used to map the condi tions of non-financial sectors into financial sector vulnerabilities.The analysis alsc draws on qualitative data such as the results of assessments of quality of supervision and the robustness of financial infrastructure (see section 3.3). Analysis of macrofinancial linkages attempts to understand the exposures that can cause shocks to be transmitted through the financial system to the macroeconomy. ()balance of the varou sectors in the economy and(b)indic eators of access to fi inanc 6 private sect or (to asse the extent t privat owners would be ab e to inject l to cove the potential losses identified through macroprudential surveillance)(see section 3.4). Surveillance of macroeconomic conditions then monitors the effect of the finan- cial system on macroeconomic conditions in general and on debt sustainability in particular(see section 3.4). Assessing financial stability is a complex process.In practice,the assessment requires eral ite ons.For example,the effects of the fin cial system on ma duce feedback effects on the fin ancial system no sdinou pu an qualitative assessments of effectiveness of supervision,and those effects,in turn,might influence the analysis of vulnerabilities and overall assessment of financial stability. 3.2 Macroeconomic and Financial Market Developments An analysis of macroeconomic and financial developments provides an important con- text for the analysis of financial sector vulnerabilities.The goal of the surveillance of macroeconomic developments and of financial markets is to provide a forward-looking sment of the likelihood of ex The literature on EWS aus pro vides useful guidance for this mo le of analysis .EWSs try-in a statistically optimal way (ie.,ina way that minimizes"false alarms"and missed crises)to combine a number of indicators into a single measure of the risk of a crisis.EWSs do not have perfect forecast. ing accuracy,but they offer a systematic method to predict crises.Two approaches to constructing EWS models have become common:the indicators approach(Kaminsky
36 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 macrofinancial linkages, and surveillance of macroeconomic conditions. These four key elements play distinct roles in financial stability analysis. • Surveillance of financial markets helps to assess the risk that a particular shock or a combination of shocks will hit the financial sector. Models used in this area of surveillance include early warning systems (EWSs). Indicators used in the analysis include financial market data and macro-data, as well as other variables that can be used for constructing early warning indicators (see section 3.2). • Macroprudential surveillance tries to assess the health of the financial system and its vulnerability to potential shocks. The key quantitative analytical tools used for macroprudential surveillance are the monitoring of financial soundness indicators (FSIs) and the conducting of stress tests. Those tools are used to map the conditions of non-financial sectors into financial sector vulnerabilities. The analysis also draws on qualitative data such as the results of assessments of quality of supervision and the robustness of financial infrastructure (see section 3.3). • Analysis of macrofinancial linkages attempts to understand the exposures that can cause shocks to be transmitted through the financial system to the macroeconomy. This analysis looks at data such as (a) balance sheets of the various sectors in the economy and (b) indicators of access to financing by the private sector (to assess the extent to which private owners would be able to inject new capital to cover the potential losses identified through macroprudential surveillance) (see section 3.4). • Surveillance of macroeconomic conditions then monitors the effect of the financial system on macroeconomic conditions in general and on debt sustainability in particular (see section 3.4). Assessing financial stability is a complex process. In practice, the assessment requires several iterations. For example, the effects of the financial system on macroeconomic conditions may produce feedback effects on the financial system. The profile of risks and vulnerabilities (ascertained through macroprudential surveillance) could feed into qualitative assessments of effectiveness of supervision, and those effects, in turn, might influence the analysis of vulnerabilities and overall assessment of financial stability. 3.2 Macroeconomic and Financial Market Developments An analysis of macroeconomic and financial developments provides an important context for the analysis of financial sector vulnerabilities. The goal of the surveillance of macroeconomic developments and of financial markets is to provide a forward-looking assessment of the likelihood of extreme shocks that can hit the financial system. The literature on EWSs—which deals with factors that cause financial crises—provides useful guidance for this mode of analysis. EWSs try—in a statistically optimal way (i.e., in a way that minimizes “false alarms” and missed crises)—to combine a number of indicators into a single measure of the risk of a crisis. EWSs do not have perfect forecasting accuracy, but they offer a systematic method to predict crises. Two approaches to constructing EWS models have become common: the indicators approach (Kaminsky
Chapter 3:Assessing Financial Stability Lizondo,and Reinhart 1998,and Kaminsky 1999)and limited dependent variable probit- logit models(B those modelsand find that they such as bond spreads and credit ratings.However,although those models can anticipate some crises,they also generate many false alarms. ews models are seen as one of a number of inputs into the imfs surveillance pro 3 cess,which encompasses a comprehensive and intensive policy dialogue.The IMF puts significant efforts into developing EWS models for emerging market economies,which esulted am other thing ers by Kar nsky.Lizondo,and Reinhart ()and by gand (19).The MF uses a com ion of EWS approach in particular,the Devel ping Country Studies Division model and a modification of the Kaminsky,Lizondo,and Reinhart model,both of which use macro-based indicators of cur rency crises (IMF 2002b).It also makes use of market-based models that rely on implied probability of default and balance-sheet-based vulnerability indicators (e.g.,see Gapen and others 2004). In recent yea s,other institutions and individuals have also developed EWS models T ncluded EWS models developed or studied by staff mem hers at the IS Federal Rese e (Ka Schindle and s el2001), E Central Bank (Bussiere and Fratzscher 200),and the Bundesbank(Schnatz1998) Academics and various private sector institutions also developed a range of EWS models.The private sector EWS models include Goldman Sachs's GS-watch (Ades,Masih,and Tenengauzer 1998),Credit Suisse First Boston's(CSFB's)Emerging Markets Risk Indicator (EMRI) (Roy 2001),Deutsche Bank's Alarm Clock (Garber,Lumsdaine,and Longato 2001),and Moody's Macro Risk model (e.g.,Gray,Merton,and Bodie 2003). The EWS lite of crises crises (sudden sizable depreciation of th e rate and loss of reserves),debt crises (default or re ing on exteral debt),and banking crises (rundown of bank deposits and widesprea failures of financial institutions).One can distinguish three "generations"of crises mod. els,depending on what determinants the models take into account.The first generation focuses on macroeconomic imbalances (e.g.,Krugman 1979).The second generation focuses on self-fulfilling speculative attacks,contagion,and weakness in domestic finan- cial markets (eg..Obstfeld 1996).The third ge eration of models introduces the role l he caus sset price ca eful leading indicator of crises (e.g..Chang and Velasco 2001).In general,empiri studies (e.g.,Berg and others 2000)suggest that currency crises occur more often tha debt crises (roughly 6:1)and that a large portion of the debt crises happened along with or close to the currency crises.Banking crises are hard to identify.tend to be protracted. and,thus,have a larger macroeconomic effect.Banking crises also tend to occur with or shortly after a currency crisis. Forecasting banking crises is based on three approaches .The macroeconomic approach is based on the idea that macroeconomic policies ause cris nd it tries to predi anking cris onomic variables For example,Demirgus-Kunt and Detragiache(1998)study the factors of sys banking crises in a large sample of countries using a multivariate logit model anc 37
37 Chapter 3: Assessing Financial Stability 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Lizondo, and Reinhart 1998, and Kaminsky 1999) and limited dependent variable probit– logit models (Berg and Pattillo 1999). Berg and others (2000) assess the performance of those models and find that they have outperformed alternative measures of vulnerability, such as bond spreads and credit ratings. However, although those models can anticipate some crises, they also generate many false alarms.4 EWS models are seen as one of a number of inputs into the IMF’s surveillance process, which encompasses a comprehensive and intensive policy dialogue. The IMF puts significant efforts into developing EWS models for emerging market economies, which resulted, among other things, in influential papers by Kaminsky, Lizondo, and Reinhart (1998) and by Berg and Pattillo (1999). The IMF uses a combination of EWS approaches, in particular, the Developing Country Studies Division model and a modification of the Kaminsky, Lizondo, and Reinhart model, both of which use macro-based indicators of currency crises (IMF 2002b). It also makes use of market-based models that rely on implied probability of default and balance-sheet-based vulnerability indicators (e.g., see Gapen and others 2004). In recent years, other institutions and individuals have also developed EWS models. Those efforts included EWS models developed or studied by staff members at the U.S. Federal Reserve (Kamin, Schindler, and Samuel 2001), the European Central Bank (Bussiere and Fratzscher 2002), and the Bundesbank (Schnatz 1998). Academics and various private sector institutions also developed a range of EWS models. The private sector EWS models include Goldman Sachs’s GS-watch (Ades, Masih, and Tenengauzer 1998), Credit Suisse First Boston’s (CSFB’s) Emerging Markets Risk Indicator (EMRI) (Roy 2001), Deutsche Bank’s Alarm Clock (Garber, Lumsdaine, and Longato 2001), and Moody’s Macro Risk model (e.g., Gray, Merton, and Bodie 2003). The EWS literature covers three main types of crises: currency crises (sudden, sizable depreciation of the exchange rate and loss of reserves), debt crises (default or restructuring on external debt), and banking crises (rundown of bank deposits and widespread failures of financial institutions). One can distinguish three “generations” of crises models, depending on what determinants the models take into account. The first generation focuses on macroeconomic imbalances (e.g., Krugman 1979). The second generation focuses on self-fulfilling speculative attacks, contagion, and weakness in domestic financial markets (e.g., Obstfeld 1996). The third generation of models introduces the role of moral hazard as a cause of excessive borrowing and suggests that asset prices can be a useful leading indicator of crises (e.g., Chang and Velasco 2001). In general, empirical studies (e.g., Berg and others 2000) suggest that currency crises occur more often than debt crises (roughly 6:1) and that a large portion of the debt crises happened along with or close to the currency crises. Banking crises are hard to identify, tend to be protracted, and, thus, have a larger macroeconomic effect. Banking crises also tend to occur with or shortly after a currency crisis. Forecasting banking crises is based on three approaches: • The macroeconomic approach is based on the idea that macroeconomic policies cause crisis, and it tries to predict banking crises using macroeconomic variables. For example, Demirgüç-Kunt and Detragiache (1998) study the factors of systemic banking crises in a large sample of countries using a multivariate logit model and
Financial Sector Assessment:A Handbook real interest rates,the vulnerability to balance of payments crises,the existence of an explicit deposit insurance scheme,and weak law enforcement,on the other hand. 3 The bank balance-sheet approach assumes that poor banking practices cause crises and that bank failures can be predicted by balance-sheet data (e.g..sahaiwala and Van den Berg 2000:Jagtiani and others 2003). The market indicators approach assumes that equity and debt prices contain infor. ond that of bala sheet data.Market-based EWS that fin cial beliefs about th t prices contain info ure.I n particular,opt prices of the underlying assets.Thi n prices refle ect market belief is information can e used to extract a probability distribution,namely,the probability of default.The advan tage of equity and debt data is that they can be available in high frequency and that they should provide a forward-looking assessment (e.g.,Bongini,Laeven,and Majnoni 2002;Gropp,Vesala,and Vulpes 2002).3 3.3 Macroprudential Surveillance Framework Surveillance of the soundness of the financial sector as a whole-which is macropruden tial surveillance- -complements the surveillance of individual financial institutions by supervisors-which is microprudential surveillance.Macroprudential surveillance derive from the need to identify risks to the stability of the system asa whole.resulting from the of the a ies of man Mac clos and other monitoring vulnera abilities and focus on vulnerabilities in the extemal position while using macroec nomic indicators as key explanatory variables.Macroprudential analysis (analysis of FSIs and stress test ing)focuses on vulnerabilities in domestic financial systems arising from macroeconomic shocks,whose likelihood and severity can be judged from EWSs.At the same time,infor mation from macroprudential analysis can provide input into assessing macroeconomic vulnerabilities.Analysis of FSIs for individual banks,along with other supervisory infor- mation,serves as a form of EWS for the financial condition of individual banks in many supervisory assessment systems(Sahajwala and Van den Berg 2000). combination of qualit nd ntitative meth ve m ethods fo ality of the le al iudicial,and nce p actices in the fir pervision. important part of the qualitati e into a ten gathered through the internationally accepted standards and The quantitative methods include a combination of statistical indicators and techniques designed to summarize the soundness and resilience of the financial system. The two key quantitative tools of macroprudential surveillance are the analysis of FSIs and stress testing.The analysis of FSIs includes assessing their variation over time
38 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 find that crises tend to erupt when growth is low and inflation is high. They also find some association between banking sector problems, on the one hand, and high real interest rates, the vulnerability to balance of payments crises, the existence of an explicit deposit insurance scheme, and weak law enforcement, on the other hand. • The bank balance-sheet approach assumes that poor banking practices cause crises and that bank failures can be predicted by balance-sheet data (e.g., Sahajwala and Van den Berg 2000; Jagtiani and others 2003). v The market indicators approach assumes that equity and debt prices contain information on bank conditions beyond that of balance-sheet data. Market-based EWS models are based on the premise that financial asset prices contain information on market beliefs about the future. In particular, option prices reflect market beliefs about the future prices of the underlying assets. This information can be used to extract a probability distribution, namely, the probability of default. The advantage of equity and debt data is that they can be available in high frequency and that they should provide a forward-looking assessment (e.g., Bongini, Laeven, and Majnoni 2002; Gropp, Vesala, and Vulpes 2002).5 3.3 Macroprudential Surveillance Framework Surveillance of the soundness of the financial sector as a whole—which is macroprudential surveillance—complements the surveillance of individual financial institutions by supervisors—which is microprudential surveillance. Macroprudential surveillance derives from the need to identify risks to the stability of the system as a whole, resulting from the collective effect of the activities of many institutions. Macroprudential analysis also closely complements and reinforces EWSs and other analytical tools for monitoring vulnerabilities and preventing crises. EWSs traditionally focus on vulnerabilities in the external position while using macroeconomic indicators as key explanatory variables. Macroprudential analysis (analysis of FSIs and stress testing) focuses on vulnerabilities in domestic financial systems arising from macroeconomic shocks, whose likelihood and severity can be judged from EWSs. At the same time, information from macroprudential analysis can provide input into assessing macroeconomic vulnerabilities. Analysis of FSIs for individual banks, along with other supervisory information, serves as a form of EWS for the financial condition of individual banks in many supervisory assessment systems (Sahajwala and Van den Berg 2000). Macroprudential surveillance uses a combination of qualitative and quantitative methods. The key qualitative methods focus on the quality of the legal, judicial, and regulatory framework, as well as governance practices in the financial sector and its supervision. An important part of the qualitative information is often gathered through the assessments of internationally accepted standards and codes of best practice. The quantitative methods include a combination of statistical indicators and techniques designed to summarize the soundness and resilience of the financial system. The two key quantitative tools of macroprudential surveillance are the analysis of FSIs and stress testing. The analysis of FSIs includes assessing their variation over time
Chapter 3:Assessing Financial Stability and amon assess the shocks.Stress testing viding an estimate of how th value of each financial institution's portfolio will change when there are large changes to some of its risk factors (such as asset prices). 3 3.3.1 Analysis of Financial Soundness Indicators FSIs are used to monitor the financial system's vulnerability to shocks and its capacity to absorb the resulting losses.Work on FSIs has produced a set of core FSIs and a set of encouraged FSIs (see chapter 2). .The core set of FSIs covers only the banking sector,thereby reflecting its central role.Those FSIs are considered ess otial for ru fin ia ystem and,thus, small co across co ies.Also. ta to compi are gene encouraged set of FSIs covers add y availabl for key non-financia l sectors because balance-sheet weaknesses in those sectors are a source of credit risk for banks and,thus,help detect banking sector vulnerabilities at an earlier stage.The encouraged set of FSIs are relevant in many,but not all, countries. The choice of FSIs depends on the structure of a country's financial system and data availability.Although the be limited d to this et.In bo ore set provides n initial prioritiztion,the choice shouldo minated ystems,the vant equate. or other type f financial institutions may b need tions are systemically important. Of course,some countre s may have othe relevant indicators that are not included in the core or encouraged sets that may need to be monitored.In countries with well-developed markets,with information on key prices spreads,and price volatility,other market information,including ratings,can be used as market-based indicators to monitor risks in individual sectors and institutions and to help assess the evolution of relative risks.thereby facilitating supervision and macroprudential surveillance (see box 3.1). The of FSIs typically involves amination of trends,comparison betweer relevant peer gro ups of countries and institut ons,and disaggregation into vari ings.Control is often an important criterion for dis aggregation because it can indicate the sources of outside support that are potentially available to institutions in distress and thus can influence their vulnerability to bank runs,as well as their exposure to cross-border contagion. Domestically controlled banks are overseen by a country's central bank and supervisor and,in a crisis,would be recapitalized by the banks'domestic owners or otherwise by the state.Within this peer gro distinguished from pri public banks,which have a state guarantee,are typically which may fail if los mini vel of ital and onsequently may be more pr one to ba hin the group of domesti llywed k intoactive ed peer group because they are exposed to cross-border contagion.Those banks could entail
39 Chapter 3: Assessing Financial Stability 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 and among peer groups, as well as assessing their determinants. FSIs help to assess the vulnerability of the financial sector to shocks. Stress testing assesses the vulnerability of a financial system to exceptional but plausible events by providing an estimate of how the value of each financial institution’s portfolio will change when there are large changes to some of its risk factors (such as asset prices). 3.3.1 Analysis of Financial Soundness Indicators FSIs are used to monitor the financial system’s vulnerability to shocks and its capacity to absorb the resulting losses. Work on FSIs has produced a set of core FSIs and a set of encouraged FSIs (see chapter 2).6 • The core set of FSIs covers only the banking sector, thereby reflecting its central role. Those FSIs are considered essential for surveillance in virtually every financial system and, thus, serve as a small common set of FSIs across countries. Also, the data to compile those FSIs are generally available. • The encouraged set of FSIs covers additional FSIs for the banking system and FSIs for key non-financial sectors because balance-sheet weaknesses in those sectors are a source of credit risk for banks and, thus, help detect banking sector vulnerabilities at an earlier stage. The encouraged set of FSIs are relevant in many, but not all, countries. The choice of FSIs depends on the structure of a country’s financial system and data availability. Although the core set provides an initial prioritization, the choice should not be limited to this set. In bank-dominated systems, the core and some relevant encouraged FSIs may be adequate. FSIs for other types of financial institutions may be needed if those institutions are systemically important. Of course, some countries may have other relevant indicators that are not included in the core or encouraged sets that may need to be monitored. In countries with well-developed markets, with information on key prices, spreads, and price volatility, other market information, including ratings, can be used as market-based indicators to monitor risks in individual sectors and institutions and to help assess the evolution of relative risks, thereby facilitating supervision and macroprudential surveillance (see box 3.1). The analysis of FSIs typically involves examination of trends, comparison between relevant peer groups of countries and institutions, and disaggregation into various groupings. Control is often an important criterion for disaggregation because it can indicate the sources of outside support that are potentially available to institutions in distress and thus can influence their vulnerability to bank runs, as well as their exposure to cross-border contagion. Domestically controlled banks are overseen by a country’s central bank and supervisor and, in a crisis, would be recapitalized by the banks’ domestic owners or otherwise by the state. Within this peer group, public banks, which have a state guarantee, are typically distinguished from private banks, which may fail if losses exceed some minimum level of capital and consequently may be more prone to bank runs. Within the group of domestically owned, private banks, internationally active banks may be grouped into a separate peer group because they are exposed to cross-border contagion. Those banks could entail