FSAP provides a framework for identifying financial sector vulnerabilities in countries

• Author: Prakash Loungani
• Position: IMF External Relations Department
• Pages: 76-77

Page 76

Financial crises, particularly banking crises, have been common in recent years.While crises have occurred with somewhat greater frequency in developing and emerging market economies, industrial countries have not been spared either. Such crises impose significant costs on the economy. In the great majority of cases, for instance, banking crises are followed by recessions, with the cumulative loss in output sometimes running as high as 10 percent of GDP.

The high incidence of these crises has prompted a global effort to promote greater financial stability. One initiative that has come out of this effort is the Financial Sector Assessment Program (FSAP), jointly introduced by the IMF and the World Bank. Launched on a pilot basis in May 1999, the program involved a dozen countries, including industrial countries such as Canada and Ireland, emerging market countries such as South Africa, and developing economies such as Cameroon and El Salvador.

The IMF's Executive Board reviewed the pilot program in mid-December, and the World Bank's Board did so in early January 2001. The program received a strong endorsement, with the IMF Board stating that "the FSAP process provides a sound framework for identifying financial sector vulnerabilities, strengthening the analysis of macroeconomic and financial stability issues, identifying development needs, and helping national authorities develop appropriate policy responses."

Components of FSAP

The FSAP is, in effect, a comprehensive health checkup for a country's financial sector.What tests are performed? One assesses how well the country's financial institutions handle adversity. FSAP "stress tests" show whether individual institutions, and the financial sector as a whole, are likely to remain solvent in the face of shocks such as sharp changes in the country's exchange rate or world interest rates.

The FSAP also provides a reading on "macroprudential indicators" that have in the past signaled crises. For example, high levels (in excess of a country's foreign exchange reserves) of short-term borrowing in foreign currencies have been associated with many past crises. High readings may suggest the need for remedial measures.

In addition, the FSAP assesses the extent to which countries are observing internationally accepted standards and codes, such as the Basel Core...