14.1 The previous chapter explained the need for FSIs and how they fit into the wider concept of macro- prudential analysis. This chapter considers the use that can be made of the FSIs that have been agreed by the IMF's Executive Board. 1 These are considered below by sector.
14.2 The strengths and vulnerabilities of deposit takers can be analyzed under the headings of capital adequacy, asset quality, earnings and profitability, liquidity, and sensitivity to market risk. This is commonly known as the CAMELS framework used by banking supervisors in their assessment of the soundness of individual institutions, less-for FSI purposes-the "M," which represents the quality of management. 2
14.3 Capital adequacy and availability ultimately determine the robustness of financial institutions to withstand shocks to their balance sheets. Aggregate risk-based capital ratios (for example, the ratio of regulatory capital to risk-weighted assets) are the most common indicators of capital adequacy, based on the methodology agreed to by the BCBS in 1988 (see Box 4.2). Simple leverage ratios, such as the ratio of capital to assets, often complement this measure. An adverse trend in these ratios may signal increased exposure to risk and possible capital adequacy problems. In addition to the amount of capital, it may also be useful to monitor indicators of capital quality. In many countries, bank capital consists of different elements that have varying availability and capability to absorb losses, even within the broad categories of Tier 1, Tier 2, and Tier 3 capital. If these elements of capital can be reported separately, they can serve as additional indicators of the ability of banks to withstand losses and help to put overall capital ratios into context.
14.4 The BCBS has recently updated the standard capital ratios to introduce greater sensitivity to risk in the capital requirements by taking into account the rapid development of risk-management techniques and financial innovation. 3 These proposals introduce greater refinement into the existing system of risk weighting to relate its categories more accurately to the economic risks faced by banks. These risks could be measured by banks' own internal ratings systems. Alternatively, they could be measured on the basis of ratings given by external rating agencies. However, improved risk measurement could come at the expense of comparability of information among banks, because under these new proposals each bank's methods of estimating credit risk can differ. The resulting differences among banks in risk-weighted assets and capital ratios would make aggregation of individual banks' data problematic.
14.5 An important indicator of the capacity of bank capital to withstand losses from NPLs is the ratio of NPLs net of provisions to capital. This FSI can help detect situations where deposit takers may have delayed addressing asset quality problems, which can become more serious over time as a result. 4 Well-designed loan classification and provisioning rules are key to obtaining a meaningful capital ratio. Loan classification rules are commonly a determinant of the level of provisioning, 5 which in turn affects Page 156 capital indirectly (by reducing income) and directly (through the inclusion of general provisions in regulatory capital). Moreover, in the FSI framework banks should deduct specific provisions from loans (that is, credit should be calculated on a net basis), which reduces the value of total assets and hence of capital (when the latter is calculated residually).
14.6 Risks to the solvency of financial institutions most often derive from an impairment of assets, which in turn can arise from a deterioration in the financial health and profitability of the institutions' borrowers, especially the nonfinancial corporations sector (discussed below). The ratio of NPLs to total gross loans is often used as a proxy for asset quality. The coverage ratio-the ratio of provisions to NPLs-provides a measure of the share of bad loans for which provisions have already been made.
14.7 Lack of diversification in the loan portfolio signals the existence of an important vulnerability of the financial system. Loan concentration in a specific economic sector or activity (measured as a share of total loans) makes banks vulnerable to adverse developments in that sector or activity. This is particularly true for exposures to the real estate sector. Country- or region-specific circumstances often determine the particular sectors of the economy that should be monitored for macroprudential purposes.
14.8 Exposure to country risk can also be important in countries that are actively participating in the international financial markets. Data on the geographical distribution of loans allow the monitoring of credit risk arising from exposures to particular (groups of) countries and an assessment of the impact of adverse events in these countries on the domestic financial system.
14.9 Concentration of credit risk in a small number of borrowers may also result from connected lending and large exposures. Monitoring of connected lending, usually measured as the share of capital lent to related parties, is particularly important in the presence of mixed-activity conglomerates in which industrial firms control financial institutions. Credit standards may be relaxed for loans to affiliates, even when loan terms are market based. The definition of what constitutes a connected party is usually set in consideration of the legal and ownership structures prevalent in a particular country, which makes this indicator often difficult to use in cross-country comparisons. The assessment of large exposures, usually calculated as a share of capital, aims at capturing the potential negative effect on a financial institution should a single borrower experience difficulties in servicing its obligations. Identifying the number of such exposures provides an indication of how widespread such large exposures are. In addition, exposures of the largest deposit takers to the largest resident entities provide an indication of concentrated lending among the largest entities in the economy.
14.10 In countries where domestic lending in foreign currency is permitted, it is important to monitor the ratio of foreign-currency-denominated loans to total loans. 6 Delgado and others...