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Executive Board review: FSAP provides a framework for identifying financial sector vulnerabilities in countries

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2001
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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 “macro-prudential 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 Principles for Effective Banking Supervision. This assessment allows governments to compare their regulatory, supervisory, and other practices against best practices elsewhere in the world. It also helps them evaluate how well risks and vulnerabilities in the financial system are being managed and highlights gaps that may need to be addressed to ensure that all citizens have access to a reasonable range of financial services.

The tests conducted under the FSAP are not ends in themselves. The diagnostic results are integrated into the work of the Bank and the IMF. Based on the FSAP reports, the staffs of the two institutions prepare separate reports for their Executive Boards. The report to the IMF’s Board, called a Financial Sector Stability Assessment (FSSA), discusses the likely consequences of alternate macroeconomic policies, exogenous shocks, and financial sector reforms on the financial sector’s health.

Collaborative program

While financial sector assessment has always been an important part of IMF and World Bank activities, the FSAP envisages a greater collaborative effort, based on joint Bank-IMF missions. The program also supplements Bank and IMF staff expertise with outside experts. The knowledge and judgment of these outside experts also adds a valuable element of international “peer review,” particularly with regard to the assessment of financial sector observance of standards and codes. To date, more than 50 institutions—central banks, supervisory agencies, and others—have agreed to furnish experts for this program.

Next steps

As is the case with health checkups, follow-up on FSAP missions will be critical if countries are to derive the full benefit of this program. The IMF’s Board noted that “an underlying objective of the FSAP is to encourage national authorities to redress identified vulnerabilities and development needs.” The IMF and the World Bank are taking steps to ensure that technical assistance is available to countries that seek to remedy deficiencies identified by the FSAP.

The program has also been expanded to cover about 24 countries a year. The IMF and the World Bank intend to use a variety of criteria to establish priorities in selecting countries for the program: a country’s systemic importance, its external sector weakness or financial vulnerability, the nature of its exchange rate and monetary regime, and geographic balance among countries. Participation in the program remains voluntary.

Publication of findings

In recent years, both the IMF and the World Bank have taken giant steps toward making the findings of their missions a matter of public knowledge. In the case of FSAP findings, however, some caution has to be exercised. Some information needed to carry out the diagnostic aspects of an FSAP mission’s work, especially that related to individual financial institutions, is highly sensitive. Consequently, FSAP reports will continue to be prepared as confidential documents for national authorities. (An exception is that the detailed assessments of observance of standards and codes included in FSAP reports can be published.) However, FSSA reports can be published if the member country consents, under conditions broadly similar to those that currently govern the publication of the Article IV consultations—the IMF’s annual reviews of policies with member countries.

Contribution to reducing crises

Although its experience with FSAP so far has been positive, the IMF’s Board emphasized that the program “is still relatively new and is built on analytical techniques, tools, and methodologies that are evolving as all the parties involved in the process learn from their experience.”

But the IMF and the World Bank are aware that even a more mature FSAP cannot inoculate countries against all future financial crises. These tests can signal the buildup of vulnerabilities, but they are not foolproof. And, to some extent, risk taking—and occasional crises—are an integral part of a dynamic, market economy. But by identifying weaknesses in a country’s financial sector and suggesting remedial policies, the IMF and the World Bank believe the FSAP should, over time, contribute to reducing the incidence of crises.

On February 5, the IMF posted on its website Public Information Notice (PIN) No. 01/11, IMF Reviews Experience with the Financial Sector Assessment Program and Reaches Conclusions on Issues Going Forward, which summarizes the IMF Executive Board’s review of the FSAP pilot program. The full text of the PIN is available on the IMF’s website (www.imf.org).

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