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 significant risk exposure through their foreign branches and subsidiaries. FSIs should include the activities of those foreign branches and subsidiaries, even though the latter are not part of the domestic activity, because they are a source of risk to the banking system.

For the domestic branches and subsidiaries of foreign-controlled banks, support in a crisis can be expected to come in the first instance from their foreign owners. This type of support may be based (a) on the foreign bank’s legal obligation, which generally extends to branches but not to subsidiaries abroad; (b) on broader reputation or operating concerns, which may lead the foreign bank to support its subsidiaries abroad in a crisis; or (c) both of those elements. At the same time, FSIs of the foreign parent banks may also deserve examination because the soundness of the parent bank would influence not only the potential for support to its subsidiaries but also the risk of contagion. Those FSIs are typically produced by the home country of the parent bank. When foreign-controlled deposit-takers play a significant role in the financial system, separate FSIs may need to be compiled for the local subsidiaries of those deposit-takers.

Quantitative information on the structure, ownership, and degree of concentration of the financial system helps to set priorities for analyzing FSIs while also providing a basis for the identification of structural issues and developmental needs. This information indicates the relative importance of different types of financial institutions (e.g., banks, securities companies, insurance companies, pension funds); the relative importance of different types of ownership (private, public, foreign); and the concentration of ownership. It provides a basic understanding of the main components of the sector and its degree of diversification (see chapters 2 and 4 for a further discussion of financial structure and its determinants).

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 should form the basis of the stress-testing scenarios. A working group of selected experts may facilitate the process.

Once a set of adjustment scenarios has been produced in a consistent macro-framework, the next step is to translate the various outputs into the balance sheets and income statements of financial institutions. There are two main approaches to translating macro-scenarios into balance sheets: (a) the “bottom-up” approach in which the effect is estimated using data on an individual institution’s portfolios and (b) the “top-down” approach in which the effect is estimated using aggregated data.

A variety of metrics can be used to summarize the results of stress tests. The most common ones use measures that express the effect of a shock as a percentage of capital, assets, or profitability. For example, the estimated decline in the value of assets (or in equity) or a reduction in net income caused by higher loan loss provisions or by interest rate shock can be expressed as a ratio involving either (a) capital or assets or (b) profitability. The dispersion of the effect (the standard deviation of the effect across the sample of banks) is also a key statistic to monitor. Public dissemination of the results of stress tests may present some difficulties, but the publication of results by a broad range of countries has shown that those difficulties are not insurmountable.

Stress tests are useful because they provide a quantitative measure of the vulnerability of the financial system to different shocks. This measure can be used with other analyses to draw conclusions about the overall stability of a financial system. The value added from system stress tests derives from a consultative process that integrates a forward-looking macroeconomic perspective, a focus on the financial system as a whole, and a uniform approach to the assessment of risk exposures across institutions. Recent trends in Financial Sector Assessment Program (FSAP) stress testing show a shift toward greater integration of a macroeconomic perspective, more involvement by country authorities and individual institutions, and greater coverage of the financial sector.

3.4.1 Effect of Financial Soundness on Macroeconomic Developments

A key macrofinancial linkage that is important in almost all countries derives from the dependence of nonfinancial sectors on financing provided by banks.¹⁸ The potential effect on macroeconomic conditions of banking soundness problems in the banking sector may be detected using FSIs compiled by local and foreign authorities. Data on nonfinancial sectors’ borrowing not only from the domestically controlled banking sector but also from foreign-controlled banks by country are needed for analysis. The data on the former are the same data used to compile the exposure concentration of FSIs. Data on borrowing by the nonfinancial private and government sectors from banks headquartered in BIS- reporting countries can be obtained from the BIS consolidated banking statistics.¹⁹ The coverage of the data is comprehensive because almost all international banking activity is conducted by internationally active banks from those countries. These BIS data indicate the scale of the potential reduction in financing to the domestic private and government sectors that could result from a deterioration in the soundness of the banking sector in that country.²⁰ The prospects for this type of deterioration can be monitored by examining the FSIs for banking in each BIS reporting country.

An example of this type of macrofinancial linkage is trade finance. IMF (2003d) discusses this linkage in more detail, noting that during recent financial crises, the trade financing to the crisis countries fell dramatically (more sharply than would seem to be justified by fundamentals and risks involved). The paper attributes the decline to the response by banks as leveraged institutions, to the lack of insurance when it was needed, to herd behavior (among banks, official export credit agencies, and private insurers), and to weaknesses in domestic banking systems. Because bank-financed trade credits are typically short-term, are backed by receivables, and are self-liquidating, their performance, transfer, and convertibility risks are considered lower than those for other cross-border lending. The loss of financing to the trade sector appears to have disrupted countries’ trade and growth performance, possibly exacerbating the crisis.

Macrofinancial linkages also derive from residents’ deposits and wealth placed with domestically owned and foreign-controlled financial institutions, which would be at risk in crises at home or abroad. The importance of this linkage depends on institutional features such as the extent to which the deposits are covered by domestic and foreign deposit insurance schemes. The linkage can be assessed using data on residents’ deposit holdings, which, in principle, need to cover both (a) deposits held within the country with domestically owned banks or the local branches and subsidiaries of foreign banks and (b) deposits held abroad, either with domestic banks’ branches and subsidiaries abroad or with foreign banks (in both domestic and foreign currency). Data from monetary statistics typically capture the first but miss the second (which can be substantial, especially in dollarized economies). Some information on the latter can be obtained from international investment position data and from the locational BIS international banking data.²¹ In this case too, FSIs monitor the soundness of the banking sector while the data on wealth placed with financial institutions give an indication of how much could be lost in the event of a banking crisis (taking into account the extent of protection provided by deposit insurance schemes).

Another linkage results from the effect of banking sector problems on the monetary policy transmission mechanism. Both the domestically owned banks and branches and the subsidiaries of foreign banks play a role in monetary transmission, so a deterioration in banking sector soundness, either domestically or abroad, could alter the effect of changes in monetary policy on the real economy. This linkage implies that it can be useful to analyze FSIs in combination with monetary data to understand how the effect of monetary policy could be affected by the soundness of the financial sector. The analysis would have to take account of financial structure, including the relative importance of market and bank financing, the role of foreign banks in financial intermediation, and the central bank operating procedures.

3.4.2 Effect of Financial System Soundness on Debt Sustainability

Debt sustainability refers to the ability of a borrower to service a given stock of debt, given the anticipated payments of interest and principal. Debt servicing ability depends on the stream of income accruing to the borrower, the stock and residual maturity profile of the borrowers’ assets, the stock of debt outstanding, and the agreed terms—chiefly, the interest rate, currency, and time profile.²²

Developments in financial system soundness can have a significant effect on debt sustainability of households, corporations, and governments; debt sustainability problems in different sectors are mutually reinforcing. The resulting financial instability can impose massive restructuring costs on an economy and can lower overall growth rates, thus undermining the debt servicing capacity of the economy and potentially causing a sovereign default. Debt servicing difficulties in any one sector could arise because of market risk, rollover risk, or liquidity risk—or more fundamentally because of unsustainable debt levels and insolvency risk—and difficulties can spread throughout the system.

Even when sovereign debt is initially at a sustainable level, the realization of contingent liabilities in the event of a crisis can result in deterioration of the government’s balance sheet and unsustainable debt ratios. Debt sustainability problems in the nonfinancial sectors can further weaken the financial system by affecting the value of loans and securities held by the financial sector. Sovereign defaults, in particular, have a severe effect on the financial system because of the key role that government securities often play in financial institutions’ balance sheets as a risk-free asset, as a store of collateral, and as a liquid asset. In general, doubts about the debt servicing capacity of any large borrower or group of borrowers can cause a loss of confidence by depositors and other holders of securities, thereby prompting a flight to quality or a more widespread run on banks and other institutions. The economic dislocation caused by debt defaults or by a loss of confidence can be magnified by the effect on financial prices as interest rates typically rise and as credit becomes less readily available—unless the monetary authorities take concerted and credible actions. The exchange rate may also come under pressure if domestic assets as a whole become less attractive relative to foreign assets. The effect on financial markets can thus magnify the effect of debt sustainability problems on the macroeconomy.

Assessing debt sustainability and monitoring the two-way linkages between financial system soundness and financial soundness of nonfinancial sectors are key to fostering financial stability. Although it is difficult to specify a precise level at which a given stock of debt becomes “unsustainable,” it is possible to detect warning signs of excessive debt accumulation by examining a few key indicators and ratios. At the most simple level, growth rates of the stock of debt provide an indicator of potential problems if the growth rates exceed reasonable estimates of the growth rate of productive capacity, which ultimately determine the ability to repay. The evolution of financial soundness indicators of nonfinancial sectors—including the relative size of the debt stock (e.g., debt-to-GDP or debt-to-equity ratios; see section 3.3.1) and its key determinants—provides some useful information on prospective developments in debt ratios or in debt service capacity. For example, a common rule of thumb for public sector debt sustainability is to relate primary fiscal balance to the real interest rates and real growth rates. Similarly, an analysis of the determinants of corporate debt-to-equity ratios (real interest rates, rate of profit, and real return on equity are likely to be among the determinants) could provide an indication of the dynamics of this ratio.

3.4.3 Effect of Financial Soundness on Growth and Financial Development

The issue of whether financial sector soundness influences growth has received little attention in cross-country empirical research. There is a growing consensus that more finance (i.e., a larger financial sector) causes more growth.²³ Recent empirical evidence suggests that countries with better-developed financial systems indeed tend to grow faster. Specifically, the size of the banking system and the liquidity of stock markets are each positively linked with economic growth. Better functioning financial systems ease the external financing constraints that impede corporate and industrial expansion.²⁴

Even though empirical cross-country studies on the issue are limited, there are cases of countries with protracted output losses because of financial sector crises. There is ample case-study evidence (e.g., from the Asian crisis²⁵ or bank restructuring episodes in the Central and Eastern Europe [CEE] countries in the late 1990s) suggesting that financial sector problems can result in significant or protracted output losses. Although few empirical cross-country studies directly address the issue, there seems to be a consensus that is based on the theory and the analysis of country cases that, in the medium to long run, financial soundness is positively related to economic growth.

In the short run, country authorities may be faced with a tradeoff between economic growth and financial sector soundness. Fast growth can make financial markets vulnerable to shocks, constraining potential output.²⁶ In particular, rapid credit expansion may, at times, exceed banks’ capacity to assess risks, thereby leading to reduced asset quality. At the same time, credit expansions can be only a symptom of rapid financial deepening.²⁷ In a country experiencing rapid credit growth and rapid output growth, the key is to determine whether the credit growth can be interpreted as a structural and positive development (e.g., if it follows a period of financial liberalization and bank restructuring). Even if credit growth is determined to be the result of structural developments., as has arguably been the case in some transition countries in the late 1990s and early 2000s,²⁸ policy makers have to evaluate carefully its implications for financial stability and macroeconomic developments. In particular, they need to distinguish to what extent a rapid financial sector growth reflects improvements in access to finance and to what extent the growth reflects a loosening in risk management practices and supervision.

3.5.1 International Financial Centers and Offshore Financial Centers

International Financial Centers (IFCs) are the primary markets where finance capital and currency are collected, switched, disbursed, and exchanged on a regional or global basis.²⁹ An IFCs share in the global financial business is disproportionately large relative to its size as measured by area, population, or nonfinancial economic activity. In most rankings, London, New York, and Tokyo (in this order) are the world’s three primary IFCs. They are complemented by a range of secondary and tertiary IFCs, which play important roles as regional financial centers or as major offshore financial centers (OFCs). Although IFCs and OFCs are quite distinct in terms of scale and structure, they are treated together in this section for convenience because they have in common certain stability issues that arise as a result of their international operations.

Although there is no generally approved definition of an OFC, a useful one defines it as a center where the bulk of financial sector activity is offshore on both sides of the balance sheet (that is, the counterparties of the majority of the financial institution’s liabilities and assets are nonresidents), where the transactions are initiated elsewhere, and where the majority of the institutions involved are controlled by nonresidents. Thus, OFCs are usually referred to in the following ways (the third listed is the most popular):

• Jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with nonresidents

• Financial systems with external assets and liabilities that are out of proportion to domestic financial intermediation designed to finance domestic economies (For most OFCs, the funds that are on the books of the OFC are invested in the major international money-center markets.)

• Centers that provide some or all of the following services: low or zero taxation, moderate or light financial regulation, and banking secrecy and anonymity (Activities of OFCs are centered around international banking and around asset and risk management, including setting up special purpose vehicles and trusts that are aimed at large corporate entities and at high net worth.)

The key defining characteristics of an IFC are (a) the economies of scale and scope in financial activities, (b) the extent of international economic and banking links, (c) the credibility of government policies, and (d) the creditworthiness of the financial sector. Important requirements or prerequisites are economically strong and credible banks within a strong legal system, including property rights, contract enforcement, a functional and credible court system, and bankruptcy processes. Although those conditions are necessary to become an IFC, they are not necessarily sufficient; there are also various historical and other reasons why certain places have become IFCs. Moreover, any financial center requires a long time to establish itself as an IFC. IFCs typically engage in a variety of onshore and offshore financial activities, including foreign exchange trading such as cash, forward, and swap transactions. IFCs also engage in a wide range of equity and debt securities and derivatives trading on the cash, futures, and options markets, not only in organized exchanges and over-the-counter transactions but also in activities such as money management, payments clearing and settlement, merger and acquisition, and securities underwriting. In some cases, some of this activity is carried on in institutions that are favorably treated for tax and other purposes.

Development of an IFC has several potential benefits for the host economy. There is some evidence in the literature quoted earlier that the large presence of foreign banks in IFCs tends to increase competition. More intensive competition, apart from its static benefits, can also widen the range of financial services available to clients. However, there are also cases of IFCs in jurisdictions where domestic markets have failed to overcome some inherent inefficiencies. An important issue to consider is the competition that is taking place among IFCs. From the viewpoint of global welfare, the competition among countries to host offshore banking can result in a gain to a host center that may represent little net gain overall.

At the same time, the presence of an IFC or OFC may be an additional source of instability for the host economy. Financial surveillance needs to analyze not only the complex structure of the key financial institutions operating in an IFC but also the operations in which those institutions are engaged so people can understand the sources of the risks (which are often outside the host jurisdiction) and the transfers of risks within and from the IFC. The effect on domestic financial stability caused by the presence of an IFC or OFC arises from both macro-channels and structural channels. Financial stability would be affected if the domestic economy were more susceptible to shocks than would otherwise be the case, because a segment of the global or regional financial services that are provided takes place in the domestic economy (through the OFC–IFC transactions). Some of those additional factors affecting financial stability follow:

• Additional cross-border business in an IFC or OFC could add to the demands on domestic clearing and settlement systems.

• The presence of an IFC or OFC may make it easier for domestic residents to invest offshore or for nonresidents to invest in securities or claims issued by domestic residents. This condition may improve liquidity in domestic markets and facilitate technology transfer; it may also facilitate excessive risk taking unless restrained by supervision or market forces.

• The effect on domestic economic activity and employment resulting from the presence of an IFC or OFC could be substantial—as is often the case in many OFCs; hence, shocks to the volume and stability of IFC operations could affect the domestic economy and could indirectly affect domestic financial stability.

• Although foreign institutions operating in an IFC or OFC are supervised by their home regulators, the trading activities among those institutions—particularly in OTC markets occurring in the IFC or OFC—may be largely self-regulated and may call for the involvement of host authorities to achieve stability.

• The global reach, large size, and complexity of transactions of domestic-or foreign-controlled institutions in an IFC or OFC may pose supervisory challenges for both host and home jurisdictions.

The operations of large and complex financial institutions (LCFIs) in an IFC or OFC may have financial stability implications. An LCFI is typically a large player in both wholesale and retail financial markets and has substantial international operations spanning a number of financial activities. The group is likely to be prominent in the local payments, clearing, and settlements structure. The group is likely to encompass many different legal entities, and the link between those and the group’s internal management structure may appear complicated or even opaque. The group may not have an overall lead supervisor monitoring its activities at an overall level on a consolidated basis. At the host-country level, responsibility for supervision of an LCFFs local affiliates may reside within a single regulator or several functional regulators. The size of the LCFI and its geographical diversification has the potential to threaten financial stability not only in the IFC but also in several countries and markets. The operations may be of concern not only to its many financial regulators but also to the central banks and insurance or guarantee agencies. The latter group of institutions, in the event of a crisis, could be involved in providing or facilitating liquidity or other official financial support, either to the LCFI itself or to its local counterparties.³⁰

The assessment and monitoring of offshore financial centers has increased in recent years, in part, because of heightened concerns about consolidated supervision and money laundering and because of the associated emphasis on cross-border cooperation and information exchange with OFCs.³¹ The assessment methodology for OFCs places emphasis on fostering compliance with international standards for supervision and financial integrity. Because they reflect the concerns about consolidated supervision and money laundering or terrorist financing, the assessments generally focus on compliance with the supervisory standards in banking and standards for anti-money laundering and for countering the financing of terrorism. In addition, when warranted, the assessments also include securities and insurance supervision.³²

Levels of compliance with financial sector standards in OFCs tend to be, on average, higher than in other jurisdictions assessed by the Fund; however, shortcomings remain in the supervisory systems of many of the OFCs. The higher level of financial standards compliance in OFCs reflects, in part, the higher income levels of the OFCs and their concerns to protect their reputation. The shortcomings arise mainly from inadequate resources and expertise in the supervisory agencies located in OFCs with lower per capita income. Those shortcomings are reflected in lower conformity with principles that are concerned with the effectiveness of onsite supervision and in technical areas such as risk management and guidance for financial institutions (IMF 2004c).

The evidence that OFCs pose a risk to financial stability in non-OFC countries is limited. The potential for risk is seen to lie in the following areas:

• Banks have been the most common source of financial instability, and most major OFCs have branches or subsidiaries of globally important banks. Many of those banks are also conglomerates, which pose additional risks. Potential threats to financial instability may increase with weaknesses in consolidated supervision and cross-border consolidated supervision of those institutions.

• The lack of information about the activities booked in OFCs restricts the ability to understand global financial flows and to analyze potential stability effects.

• Hedge funds and reinsurance companies located offshore have the potential to affect stability through their high leverage and exposure to catastrophic events, respectively.

However, an OFC itself may face significant macroeconomic risks, which result from its characteristics as an OFC. Given that financial intermediation in the OFC is typically out of proportion with the size of the domestic economy, most OFCs depend on the financial intermediation as a source of income. Shocks to the volume of financial intermediation (e.g., those caused by shocks to the reputation of the OFC) are likely to have a substantial effect on the domestic macroeconomy.

3.5.2 Capital Account Liberalization

Capital account controls can have a significant effect on the way that external shocks are transmitted to the domestic financial system and on how domestic financial developments affect the macro-economy. When one considers the effect of the capital account on domestic financial stability, it is important to be aware of existing capital controls, including the nature and scope of recent liberalizations and any plans to relax them.³³ Experience has demonstrated that liberalizing the capital account before the home-country financial system has been adequately strengthened can contribute to serious economic problems.³⁴ For example, studies have shown that a significant number of countries that suffered from a financial crisis have liberalized their financial systems, including their capital accounts, within the past 5 years before the crisis.³⁵ These experiences have highlighted the importance of (a) appropriate sequencing and coordination when opening capital accounts and (b) domestic financial liberalization policies to preserve financial stability. See box 3.2 and chapter 12 for additional discussion.

3.5.3 Dollarization: Implications for Stability

Dollarization can have important implications for financial stability. A dollarized economy can be defined as one where (a) households and firms hold a fraction of their portfolio (inclusive of money balances) in foreign currency assets, (b) the private and public sector have debts denominated in foreign currency, or (c) both. Dollarization can be “official” when the U.S. dollar is adopted as the legal tender or “partial” when the local currency remains the legal tender, but transactions are allowed to be denominated in dollars, thus effectively allowing a bicurrency system to take hold. It is useful to distinguish among three generic types of dollarization that broadly match the three functions of money: (a) payments dollarization (currency substitution) is the resident’s use of foreign currency for transaction purposes in cash, demand deposits, or central bank reserves; (b) financial dollarization (asset substitution) consists of the resident’s holdings of financial assets or liabilities in foreign currency (either domestic or external); and (c) real dollarization is the indexing, formally or de facto, of local prices and wages to the dollar.³⁶ Dollarization can be measured using a variety of statistics, including the ratio of onshore foreign currency deposits to total onshore deposits, the ratio of foreign currency deposits to broad money, the ratio of domestic government debt in foreign currency to total government debt, and the share of private sector debt in total external debt.³⁷ Additional risks to financial stability resulting from dollarization and the implications for financial policy are discussed below.

Empirical evidence suggests that financial dollarization may increase the vulnerability of financial systems to solvency and liquidity risks. Cross-country estimates of the effect of dollarization on key financial soundness indicators are consistent with the hypothesis that increased dollarization increases financial vulnerability. The variance of deposit growth is positively and significantly correlated with dollarization, suggesting that dollarized financial systems may be more exposed to credit cycles and liquidity risk. A cross-country comparison of estimates of nonperforming loans (NPLs) or a composite systemic risk measure will show that dollarized economies also tend to be more exposed to solvency risk.

The limited backing of banks’ dollar liabilities by U.S. dollars and their convertibility at par subjects the financial system to a very specific type of liquidity risk. Systemic liquidity risk arises when the demand for local assets falls because of a perceived increase in country or banking risk, thus prompting foreign banks to recall short-term lines of credit and depositors to convert their deposits into dollars or to transfer them abroad. Unless liquid dollar liabilities are backed by sufficient liquid dollar assets abroad, banks could run out of dollar liquid reserves and could fail to pay off dollar liabilities. Similarly, central banks could run out of international reserves to provide dollar lender-of-last-resort support to distressed banks. When those international reserves are depleted, deposit (or loan) contracts may need to be broken and disruptive or confiscatory measures taken, thereby imposing a heavy cost on the financial system.

Dollar deposits are often more vulnerable to runs than local currency deposits, even in the absence of exchange rate adjustments. In highly dollarized countries, local currency deposits are mostly held for transaction purposes and are less affected by expected yield differentials than dollar deposits, which are predominantly held as store of value and are close substitutes for deposits abroad or dollars cash. Moreover, even when the demand for local currency deposits is affected, the small size of these deposits in the most highly dollarized countries limits the threat they represent for banks’ liquidity.

The lack of dollar monetary instruments can further inhibit the scope for interest rate defenses against deposit withdrawals. An interest rate defense may be ineffective once a run has started, because the central bank has limited ability to raise the interest rate on dollar deposits. Banks are often reluctant to raise interest rates on dollar deposits, because of concerns that increasing rates may be interpreted as a sign of weakness, thus further exacerbating deposit withdrawals.

The main solvency risk faced by dollarized financial systems results from currency mismatches in the event of large depreciations. Currency-induced credit risk is generally the key source of vulnerability because borrowers are highly susceptible to defaulting on dollar-denominated loans in the event of a large depreciation. Banks with large domestic dollar liabilities must balance their foreign exchange positions either by extending dollar lending to local currency earners or by holding dollar assets abroad. Thus, to maintain their profitability (especially in light of generally lower rates of return on foreign assets than on local dollar assets) and to satisfy the pent-up demand for loans, banks generally end up lending domestically a large share of their dollar deposits, thus effectively transferring the currency risk to their unhedged clients and retaining the resulting credit risk. Borrowers’ currency mismatch is enhanced by the fact that prices and wages may continue to be set in local currency even when financial dollarization is widespread. Counterparty exposure is also amplified if collateral is denominated in domestic currency, and it declines relative to the loan after a depreciation. Banks’ direct exposure to currency risk is generally limited by tight regulatory limits on open foreign exchange positions, but off balance-sheet positions (e.g., in derivatives) are often misreported and may cause exposures to be underestimated.

In the event of large depreciations, widespread currency mismatches can have systemic effects that compound the deterioration of banks’ financial situation. Because of balance-sheet effects, large devaluations in highly dollarized economies are more likely to be contractionary, further undermining borrowers’ capacity to service their debts. Because it impairs the solvency of both borrowers and banks, the credit risk deriving from a large devaluation also increases the scope for a credit crunch and heightens the risk of deposit withdrawals by concerned depositors. Thus, solvency and liquidity risks are closely interrelated.

The interaction between prudential risks and the monetary regime, which instills fear of floating, subjects the financial system to risks similar to those incurred under a rigid exchange rate system. The more financially dollarized an economy is, the more vulnerable to large exchange rate fluctuations it becomes; hence, the less disposed the monetary authorities are to let the exchange rate float. Empirical evidence indicates that both nominal and real (bilateral) exchange rates are less volatile in more dollarized economies (see Gulde and Ize 2004). Instead, interest rates must bear the brunt of the adjustment to shocks, thereby raising interest rate risk both for local currency and for dollar intermediation and then heightening credit cycles. Credit booms are accentuated by the fact that incoming dollar flows feed domestic lending and, through the banking multiplier, boost dollar intermediation.

The dollarization of public debt can be an important collateral source of financial fragility when banks have large holdings of public securities. Sharp exchange rate depreciations can undermine the sustainability of the public debt and, in turn, can undermine the solvency of banks when the latter hold large volumes of public securities.

In countries with a high degree of dollarization, stability assessments should indicate the extent to which dollarization is a potential source of vulnerability and should suggest appropriate measures. Where available, reports also should provide supporting quantitative information such as the degree of co-circulation, shares of foreign currency deposits and loans, short-term foreign assets and liabilities of the main financial institutions, net foreign assets, and net open foreign currency positions of banks.

3.5.4 Islamic Banking—Stability Issues

The provision and use of financial services and products that conform to Islamic religious principles pose special challenges for a stability assessment. Institutions offering Islamic Financial Services (IIFS) and Islamic capital market instruments constitute a significant share of the overall financial system in several countries; in Sudan and Iran, the entire system is based on Islamic finance principles. This situation requires the recognition of the unique mix of risks in IIFS and key aspects of Islamic securities markets not only in stability assessments but also in the design of policies. See box 3.3 for details.