Financial Soundness Indicators and Macroprudential Analysis


Introduction. Why Are FSI Data Needed?. What Is the Financial Stability Framework Within Which FSI Data Can Be Used?. Analysis of Linkages Among FSIs. Corporate leverage and asset quality. Asset quality and capital adequacy. Taking account of macrofinancial linkages. What Are Some Other Tools That Can Enhance the Usefulness and Understanding of FSI Data?. Stress Testing and FSIs. Basel Core... (see full summary)


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13.1 This chapter provides an overview of the use of FSI data in macroprudential analysis. It focuses on three questions:

- Why are FSI data needed?

- What is the financial stability framework within which FSI data can be used?

- What are some other tools that can enhance the usefulness and understanding of FSI data?

13.2 The collection, compilation, and dissemination of data involve resource costs for suppliers and compilers. Therefore to justify such work, it is necessary to ask the following question.

Why Are FSI Data Needed?

13.3 The recognition of the need for FSI statistics among the international community arose out of the financial crises of the 1990s. 1 A review of recent decades shows that many IMF member countries experienced financial crises that often resulted in severe disruptions of economic activity. The significant costs of these crises, both direct (such as the cost of recapitalizing the deposit takers) and indirect (such as the loss of real economic activity), have highlighted the need to develop a body of-preferably high- frequency-statistics that could help policymakers in macroprudential analysis, that is, in identifying the strengths and vulnerabilities in their countries' financial systems. Such analysis could form the basis for taking action to prevent crises from occurring.

13.4 Understanding of the nature and causes of financial system crises has developed a great deal in recent years, but analytical work continues.

13.5 Financial system crises can arise from the failure of one or more institutions, whose effects then spread through a variety of contagion mechanisms to affect the whole system. The original shock that caused the failure is likely to be external or exogenous to the institution. Indeed, prudential supervision supports efforts to identify potential vulnerabilities in individual institutions before they become severe, and if they do become serious to inform actions that limit their systemic consequences.

13.6 Systemic crises can also arise from the exposure of a financial system to common risk factors. Under these circumstances, systemic stability is determined by behavior internal or endogenous to the system. In other words, financial crises arise when the collective actions of individual agents make the system itself vulnerable to shocks. The buildup of these vulnerabilities and risks tends to occur over time, such as during an economic upswing when confidence is high, before materializing in recessions.

13.7 The sources of vulnerability of the financial system can vary: for example, poor asset quality, undue exposures to market and credit risk, and lack of capital. The timing of a crisis and its immediate causes can also vary: for example, the deteriorating condition of private borrowers, excess government borrowing that undermines confidence, concern over a large current account deficit, and/or a sharp swing in the exchange rate. When the financial system is vulnerable, such events can result in a financial system crisis that imposes severe losses on an economy, both directly and indirectly: directly as depositors lose funds as banks fail and as governments incur fiscal costs to rebuild the financial system; indirectly as economic activity is reduced by the disruption of financial intermediation and/or payment systems. Moreover, there can be adverse social consequences from the economic and financial disruptions.

13.8 Experience has shown that actions or policies that seem appropriate from an individual entity's Page 148 viewpoint can have unwelcome systemic consequences. For instance, in the face of perceived higher risk caused by financial market developments, or a reduction in capital adequacy caused by weak profitability, individual deposit takers might tighten lending terms. This might impede economic activity over significant periods of time and/or precipitate financial stress and asset price declines, which in turn could increase financial system risk.

13.9 FSIs and the framework provided in this Guide have been developed to assist macroprudential analysis. The position at a single moment in time and developments over time, such as through a full business cycle, can be assessed. Indeed, understanding how vulnerabilities build up over time is particularly relevant to this analysis, along with an understanding of the mutually reinforcing dynamic interaction between the financial system and the real economy. The focus of this body of data is somewhat different from, but also complements, that for prudential supervision (which is rationalized in terms of deposit protection). The focus of this body of data is also different from that in the national accounts (which is used to monitor macroeconomic activity). Thus, while necessary, FSI data alone are not sufficient to meet all the needs of macroprudential analysis, as discussed later in this chapter.

13.10 If the need for the body of data is understood, how does the set of data series fit together? In short, it is necessary to ask the following question.

What Is the Financial Stability Framework Within Which FSI Data Can Be Used?

13.11 The development of a financial stability framework for the analysis of FSIs and related data is still at a relatively early stage, and, indeed, dissemination of data would support further empirical research. 2 In June 2003, the IMF staff presented to the IMF's Executive Board such a framework (see Figure 13.1). While it is considered a useful tool, it nonetheless requires further development.

13.12 The framework has four different elements:

- Assessment of the risk of a shock to the financial sector. Among the tools available are indicators used in early warning system (EWS) models. These indicators are typically based on country-specific data, developments in the global economy, and political risk. 3,4

- The use of FSIs to (1) assess the vulnerability of the financial sector to shocks; (2) assess the condition of nonfinancial sectors; (3) monitor financial sector vulnerabilities arising from credit, liquidity, and market risk; and (4) assess the capacity of the financial sector to absorb losses, as measured by capital adequacy, for example. 5

- Analysis of macrofinancial linkages to obtain an indication of the effect on macroeconomic conditions, debt sustainability, and impairment in the intermediation capacity of the financial sector.

- Surveillance of macroeconomic conditions to assess the effect of shocks on macroeconomic developments and debt sustainability.

13.13 From Figure 13.1 it can be seen that FSIs are part of a larger body of information and tools used to monitor financial stability, and there are interrelationships among the different elements.

13.14 While the financial stability framework indicates how a shock might be transmitted through the financial system, the direction of causality is not set. For example, weakness in banks' capital adequacy could result in a tightening of credit standards that would affect the condition of the nonfinancial sector, and declining productivity...

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