Chapter 3:Assessing Financial Stability infrastructure (rading syst m payment systems,clearing and setlement system cen tral bank operation angements anagement practices)affects fin funding on the liabilities side of their balance sheets,their ability to liquidate positions on the asset side,and their exposure to systemic and operational risk in the clearing and settlement system.This information can be derived from assessments of the Organization 3 of Securities Commissions (IOSCO)objectives and principles(see also chapter 5),the Committee on Payment Settlement Systems(CPSS)-IOSCO recommendations for secu. rities settlement systems (see also chapter 11),the CPSS core principles (see also chapter 11),and other rces such as event studies of past disturbar on n ources can be sed to assess ho ell financial institu ons can naintain access to fur ng in a crisi The robustness of markets are based on over-the-counter(OTC)or are exchange-based.For OTC markets information on features affecting the capacity of market makers to make markets- example,the number and capitalization of market makers and the size of the positions they take-could be useful.For exchanges,information on the trading systems,price transparencv.marining rles and capiral committed by the exchantospporad ing could be u ms.an indicat saction size rele extent o which closely related as are traded or erent types of markets,which can substitute for one another if one marke t lose: liquidity. Information on the operation of the payment systems,the clearing and settlement systems,and the safety nets is also useful for interpreting FSIs for securities markets,and it provides insights into access to liquidity in a crisis.Indicators of payment system function- ing include the relative size of intradav inter-bank exnosures and davlight overdrafts the length of settlement lags.the scope of loss-sharing arrangements.the level of reliance on collateral,and the particular markets that have real time gross settlement.All those indi cators vide info on the pote tial credit and ttlement risks in the t a nd t central nks'providing of liquidity to markets infl anks: other market interm diaries can continue to acce s marke liquidity in a crisis.Central bank operating procedures are a key determinant of money market liquidity and of the liquidity of other markets in longer-term paper,where position taking by dealers is supported by access to money markets. 3.3.1.4 Analysis of FSIs for Nonfinancial Sectors Monitoring the financial condition and vulnerabilities of the corporate,household,and real estate sectors can enhance the capacity to assess risks to the financial sector.Loans to the co corporate sector typically account for a sigificant oronankn porfolios thus,the alth of the ector system.“Houschold nts a majo play an importar mers(of go ods,as vell as financia products and services),as depositors,and as holde risky asse ancial position can have significant ct on both the real economy and market activity.The real estate sector also has been an important source of risk because 45
45 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 infrastructure (trading systems, payment systems, clearing and settlement systems, central bank operations and other systemic liquidity arrangements, and government foreign exchange reserve and debt management practices) affects financial institutions’ access to funding on the liabilities side of their balance sheets, their ability to liquidate positions on the asset side, and their exposure to systemic and operational risk in the clearing and settlement system. This information can be derived from assessments of the Organization of Securities Commissions (IOSCO) objectives and principles (see also chapter 5), the Committee on Payment Settlement Systems (CPSS)–IOSCO recommendations for securities settlement systems (see also chapter 11), the CPSS core principles (see also chapter 11), and other sources such as event studies of past disturbances. Information on market microstructures and the diversity of funding sources can be used to assess how well financial institutions can maintain access to funding in a crisis. The robustness of market liquidity depends on market microstructure, including whether markets are based on over-the-counter (OTC) or are exchange-based. For OTC markets, information on features affecting the capacity of market makers to make markets—for example, the number and capitalization of market makers and the size of the positions they take—could be useful. For exchanges, information on the trading systems, price transparency, margining rules, and capital committed by the exchange to support trading could be used. For electronic trading systems, an indicator of liquidity is the standard transaction size. Also relevant is the extent to which closely related assets are traded on the different types of markets, which can substitute for one another if one market loses liquidity. Information on the operation of the payment systems, the clearing and settlement systems, and the safety nets is also useful for interpreting FSIs for securities markets, and it provides insights into access to liquidity in a crisis. Indicators of payment system functioning include the relative size of intraday, inter-bank exposures and daylight overdrafts, the length of settlement lags, the scope of loss-sharing arrangements, the level of reliance on collateral, and the particular markets that have real time gross settlement. All those indicators provide information on the potential credit and settlement risks in the payment system. The safety net and the central banks’ providing of liquidity to markets influence the extent to which banks and other market intermediaries can continue to access market liquidity in a crisis. Central bank operating procedures are a key determinant of money market liquidity and of the liquidity of other markets in longer-term paper, where position taking by dealers is supported by access to money markets. 3.3.1.4 Analysis of FSIs for Nonfinancial Sectors Monitoring the financial condition and vulnerabilities of the corporate, household, and real estate sectors can enhance the capacity to assess risks to the financial sector. Loans to the corporate sector typically account for a significant portion of bank loan portfolios; thus, the health of the corporate sector represents a major source of risk to the financial system.14 Households play an important role as consumers (of goods, as well as financial products and services), as depositors, and as holders of risky assets; hence, changes in their financial position can have significant effect on both the real economy and financial market activity.15 The real estate sector also has been an important source of risk because
Financial Sector Assessment:A Handbook of the key role that real estate plays as collateral,but this dimension has proved difficul to monitor because of the paucity of data on real estate prices. FSIs for the corporate,household,and real estate sectors can serve as early warning indicators of emerging asset quality problems.Shocks to their balance sheets,if signifi- 3 cant,are eventually transmitted to the balance sheets of banks and other financial institu tions.However,if one is to make eff use of FSIs for thos etors for this purpo is necessary to assess the exposure of the financial system to each sector(e.g.,using FSI of the sectoral distribution of lending)and to estimate how a deterioration of the financial condition of nonfinancial sectors.which would be based on esls for those sectors.is likely to affect banking sector asset quality.In some assessments,FSIs for corporate and house hold sectors w ade endoc mating the effec of change the relative price of debt toequity,leve interest rates,cyclical po profitability and unemployment.The prospective evolution of corporate and household leverage can then be projected by using the above variables,and such projections can help assess likely changes in asset quality of financial firms. 3.3.2 System-Focused Stress Testing Stress testing,in the context of financial sector surveillance,refers toa ra o help a eof technique ss the vulnerability of cal syster usible e It is based on applying a common set of shocks and scenari to a set of individual fina cial institutions and subgroups of institutions to analyze both the aggregate effect and the distribution of that effect among the institutions.Stress tests were originally developed for use at the portfolio level so one can understand how the value of a portfolio changes if there are large changes to some of its risk factors(such as asset prices).Those tests ha come w videly used as a managem t tool I by fir the techniques have been applied in a broader context,with the goal of measuring the sensitivity of a group of institutions(such as commercial banks)or even an entire finan. cial system to common shocks. System-focused stress testing is best seen as a multi-step process that involves examin and providing ugh estimate of sensitivity of balance sheets to a variety of sh s.This process entails (a) entifying the major risk and exposures in the system and formulating questions about those risks and exposures (b)defining the coverage and identifving the data that are required and available,(c) calibrating the scenarios or shocks to be applied to the data,(d)selecting and implement- ing the methodology,and (e)interpreting the results.System-focused stress tests attempt ith an a ent of the sensitivity collection of institutions to major changes in the econom c and financial environment The process of conducting a system-focused stress test begins first with the identifica- tion of specific vulnerabilities or areas of concern and then with the construction of a scenario in the context of a consistent macroeconomic framework.Isolating key vulner abilities is an iterative process involving both qualitative and quantitative elements.A of nu umerical indic an be d to bel tial weakne hrof marolevel indicato,cdicatrand tion-focused or micro-level indicators.Ideally,a macro-econometric or simulation model
46 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 of the key role that real estate plays as collateral, but this dimension has proved difficult to monitor because of the paucity of data on real estate prices.16 FSIs for the corporate, household, and real estate sectors can serve as early warning indicators of emerging asset quality problems. Shocks to their balance sheets, if significant, are eventually transmitted to the balance sheets of banks and other financial institutions. However, if one is to make effective use of FSIs for those sectors for this purpose, it is necessary to assess the exposure of the financial system to each sector (e.g., using FSIs of the sectoral distribution of lending) and to estimate how a deterioration of the financial condition of nonfinancial sectors, which would be based on FSIs for those sectors, is likely to affect banking sector asset quality. In some assessments, FSIs for corporate and household sectors were made endogenous by estimating the effect on those FSIs of changes in the relative price of debt to equity, level of interest rates, cyclical position, profitability, and unemployment. The prospective evolution of corporate and household leverage can then be projected by using the above variables, and such projections can help assess likely changes in asset quality of financial firms. 3.3.2 System-Focused Stress Testing Stress testing, in the context of financial sector surveillance, refers to a range of techniques to help assess the vulnerability of a financial system to exceptional but plausible events.17 It is based on applying a common set of shocks and scenarios to a set of individual financial institutions and subgroups of institutions to analyze both the aggregate effect and the distribution of that effect among the institutions. Stress tests were originally developed for use at the portfolio level so one can understand how the value of a portfolio changes if there are large changes to some of its risk factors (such as asset prices). Those tests have now become widely used as a risk management tool by financial institutions. Gradually, the techniques have been applied in a broader context, with the goal of measuring the sensitivity of a group of institutions (such as commercial banks) or even an entire financial system to common shocks. System-focused stress testing is best seen as a multi-step process that involves examining the key vulnerabilities in the system and providing a rough estimate of sensitivity of balance sheets to a variety of shocks. This process entails (a) identifying the major risks and exposures in the system and formulating questions about those risks and exposures, (b) defining the coverage and identifying the data that are required and available, (c) calibrating the scenarios or shocks to be applied to the data, (d) selecting and implementing the methodology, and (e) interpreting the results. System-focused stress tests attempt to marry a forward-looking macro-perspective with an assessment of the sensitivity of a collection of institutions to major changes in the economic and financial environment. The process of conducting a system-focused stress test begins first with the identification of specific vulnerabilities or areas of concern and then with the construction of a scenario in the context of a consistent macroeconomic framework. Isolating key vulnerabilities is an iterative process involving both qualitative and quantitative elements. A range of numerical indicators can be used to help isolate potential weaknesses, including the “big picture” or macro-level indicators, broad structural indicators, and more institution-focused or micro-level indicators. Ideally, a macro-econometric or simulation model