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Chapter IV: Risks from Financial Sector Vulnerabilities

Author(s):
Olivier Basdevant, and Borislava Mircheva
Published Date:
February 2013
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A. Risks Stemming from Vulnerabilities in the Banking Sector

All commercial banks are well capitalized and have maintained strong risk-adjusted capital adequacy ratios (CAR) over the years. The regulatory capital to risk-weighted assets ratio for the whole banking system stood at 21.4 percent at end-September 2012, with a slight increase compared with the level at end-December 2011. The CAR positions of the four banks range from 11.5 to 35.7 percent (end-September 2012), well above the minimum statutory requirement of 8 percent. In addition, banks have been profitable and have maintained a strong position between 2006 and 2011, with the ratios of return on assets and return on equity above international standards.15

However, the first nine months of 2012 have experienced a worsening of some financial sector stability indicators (FSIs), compared to the end of 2011. Specifically, return on assets and return on equity have decreased while the ratio of nonperforming loans to total loans has remained somewhat flat. The worsening in these indicators reflects the current difficulties faced by commercial banks because of the economic contraction. Specifically, customers are struggling to meet their financial obligations while loan books and deposits are stagnant or growing only marginally.

In addition, stress tests of commercial bank balance sheets point to some underlying risks for the banking system in Swaziland (Box 6). Specifically, exchange rate, credit, liquidity, and concentration risks could potentially pose a challenge to commercial banks. Foreign exchange risk is related to the risk that changes in the exchange rate can affect the value of bank’s assets and liabilities denominated in foreign currency. For banks in Swaziland, the exchange rate risk would stem from a possible appreciation of the local currency against other major currencies. Credit risk encompasses the risk that the promised cash flow from loans on the books of commercial banks may not be paid. In Swaziland, the main vulnerability lies in loan provisioning that is not adequate and would cover only a small portion of the losses should borrowers default. Concentration risk is a type of credit risk where the vulnerability is embedded in the exposure of banks to one or more large borrowers. Liquidity risk can be faced in the event that deposits are withdrawn from the system. For commercial banks in Swaziland, liquid assets only cover about 25 percent of liquid liabilities, indicating that banks would become illiquid quickly in the event of large deposit withdrawals.

Box 5.Stress Tests: Assumptions and Methodology

Credit Risk

Measures banking sector vulnerability to shocks related to an assumed weakening loan portfolio of all banks where 9 percent of all current loans will migrate to nonperforming loans (NPLs). In addition, an increase in NPLs is assumed where the asset quality of exiting NPLs will deteriorate. Specifically, substandard loans will become doubtful, and doubtful loans will become bad.

Exchange Rate Risk

The exchange rate stress assesses different movements of the lilangeni against other major currencies and measures the impact of an exchange rate shock on the bank’s capital position.1

Liquidity Risk

The liquidity stress test identifies the banks that would first experience problems meeting the demands of their depositors in the event of a systemic crisis.

Concentration Risk

The concentration risk assesses the exposure of the banking system to large borrowers and the effect that a failure of the largest borrower(s) would have on the capital adequacy ratio of the banking system.

1 The net income effect of exchange rate risk is not analyzed, because examination of historic trends in banks’ income from foreign exchange dealing suggests that this type of income is not influenced by the level of the exchange rate but rather by the buy-sell spreads.

This tight liquidity position, as well as the challenging economic situation in Swaziland, puts additional pressure on commercial banks. Should there be a significant deposit outflow, there is no crisis resolution mechanism in place to protect depositors in the event of a bank failure. The central bank has the role of lender of last resort. However, it may not be in a position to exercise this role fully, owing to its limited resources and the need to preserve the parity against the rand. Therefore, there is a need for legislation for the government to provide enough resources, if needed, for the central bank to intervene in commercial banks. Such legislation could also introduce a limited deposit insurance scheme to protect depositors from possible bank failures.

B. Risks Posed by Nonbank Financial Institutions

The nonbank financial sector has been growing rapidly. In particular, savings and credit cooperatives have become increasingly popular, comprising 67 institutions serving about 37,000 members (out of a total population of 1.2 million) and holding about 2 percent of the assets of the whole financial system.16 Loans from savings and credit cooperatives are more accessible to Swaziland’s population and are more affordable, as cooperatives do not have to abide by risk-weighted prudential regulations. In addition, commercial banks are generally more risk averse and reluctant to lend, which has made cooperatives preferred, even among civil servants. Consequently, savings and credit cooperatives play a major role in the financial system of Swaziland because they mobilize domestic savings and create investment opportunities for small savers.

Capital market institutions are another import element to the financial system in Swaziland. Although this segment comprises a small number of institutions, comprising four collective investment schemes (CIS) and two licensed stock brokerage firms, it has grown considerably in the past five years, currently managing about 14 percent of all assets in the financial system, equal to about 16 percent of GDP. In addition, of the four CIS, one controls about 70 percent of the total funds under management.

Making the Financial Sector Regulatory Authority (FSRA) operational has been a welcome step towards the adequate supervision and regulation of nonbank financial institutions. All SACCOs have been requested to provide financial statements in order for the FSRA to be able to undertake off-site supervision. In addition, a regulatory framework for SACCOs is in the development stage. However, CIS are yet to be properly regulated and supervised, thus posing potential risks to the stability of the financial system.

Because of the lack of regulation and supervision, nonbank financial institutions could pose a risk to financial stability in Swaziland. A failure of one or more capital market institutions on one or more savings and credit cooperatives (SACCOs) could jeopardize financial stability. These institutions are quite vulnerable in the event of a shock to the economy because there are no safety nets in place to protect depositors. Specifically, nonbank financial institutions do not provide deposit insurance guarantees and do not have access to the central bank as lender of last resort.

Introducing a limited deposit insurance scheme could be affordable. Covering 80 percent of deposits in the SACCOs would cost about E 0.6 billion (2 percent of GDP). In the absence of such safety nets, the contagion effect could spread to commercial banks and lead to considerable deposit outflow. Such a turn of events would not only weaken the reserve position of the central bank but also restrain commercial banks’ capacity to finance the private sector and thus stimulate private sector-led growth.

C. Looking at Risks from the Balance Sheet Approach Point of View

The Balance Sheet Approach (BSA) analysis identifies the main vulnerability for Swaziland’s financial system (Table 9.1).17 The BSA analysis applied to Swaziland allows for a point-in-time assessment of the existing mismatches in the country’s main balance sheets and highlights cross-sectoral risks (Box 6).18 The financial structure of an economy, in particular the composition and size of assets and liabilities of the main sectors, provides important information regarding possible vulnerability to shocks.

Table 9.1.Swaziland: Net Intersectoral Asset and Liability Positions, 2011
Public sectorFinancial SectorNonfinancial Private SectorRest of the World
Issuer of liability (debtor) →Central BankCentral GovernmentState and Local GovernmentPublic Nonfinancial CorporationsOther Depository CorporationsOther Financial CorporationsNonfinancial CorporationsOther Resident SectorsNonresident
↓ Holder of liability (creditor) ↓A1LNPALNPALNPALNPALNPALNPALNPALNPALNP
(Emalangeni billions)
Central bank1.90.81.10.90.00.90.40.00.40.10.00.10.13.7–3.6
In domestic currency1.80.81.10.90.00.90.40.00.40.10.00.10.00.00.0
In foreign currency0.10.10.03.7–3.6
Central government0.81.9–1.11.20.50.71.41.43.43.4
In domestic currency0.81.8–1.11.20.50.71.41.4
In foreign currency0.1–0.13.43.4
State and local government0.00.00.0
In domestic currency0.00.00.0
In foreign currency
Public nonfinancial Corps.0.20.4–0.2
In domestic currency0.20.4–0.2
In foreign currency
Other depository corporations0.00.9–0.90.51.2–0.70.00.00.00.40.20.20.90.20.74.44.10.32.13.6–1.51.01.5–0.5
In domestic currency0.00.9–0.90.51.2–0.70.00.00.00.40.20.20.90.20.74.44.10.32.13.6–1.50.00.0
In foreign currency1.01.5–0.5
Other financial corporations0.00.4–0.40.20.9–0.7
In domestic currency0.00.4–0.40.20.9–0.7
In foreign currency
↓ Holder of liability (creditor) ↓A1LNPALNPALNPALNPALNPALNPALNPALNPALNP
Nonfinancial corporations1.4–1.44.14.4–0.312.016.5–4.5
In domestic currency1.4–1.44.14.4–0.3
In foreign currency12.016.5–4.5
Other resident sectors0.00.1–0.13.62.11.5
In domestic currency0.00.1–0.13.62.11.5
In foreign currency
Nonresidents3.70.13.63.4–3.41.51.00.516.512.04.5
In domestic currency0.00.00.00.00.0
In foreign currency3.70.03.63.4–3.41.51.00.516.512.04.5
(Percent of GDP)
Central bank6.62.63.93.00.03.01.20.01.20.20.10.20.212.8–12.6
In domestic currency6.32.63.73.00.03.01.20.01.20.20.10.20.00.00.0
In foreign currency0.20.20.212.7–12.6
Central government2.66.6–3.94.31.92.44.84.811.611.6
In domestic currency2.66.3–3.74.31.92.44.84.8
In foreign currency0.2–0.211.611.6
State and local government0.10.10.0
In domestic currency0.10.10.0
In foreign currency
↓ Holder of liability (creditor) ↓A1LNPALNPALNPALNPALNPALNPALNPALNPALNP
Public nonfinancial corps.0.71.5–0.7
In domestic currency0.71.5–0.7
In foreign currency
Other depository corporations0.03.0–3.01.94.3–2.40.10.10.01.50.70.73.20.82.415.314.31.17.412.7–5.23.55.0–1.6
In domestic currency0.03.0–3.01.94.3–2.40.10.10.01.50.70.73.20.82.415.314.31.17.412.7–5.20.00.0
In foreign currency3.55.0–1.6
Other financial corporations0.01.2–1.20.83.2–2.4
In domestic currency0.01.2–1.20.83.2–2.4
In foreign currency
Nonfinancial corporations4.8–4.814.315.3–1.141.657.2–15.5
In domestic currency4.8–4.814.315.3–1.1
In foreign currency41.657.2–15.5
Other resident sectors0.10.2–0.212.77.45.2
In domestic currency0.10.2–0.212.77.45.2
In foreign currency
Nonresidents12.80.212.611.6–11.65.03.51.657.241.615.5
In domestic currency0.00.00.00.00.0
In foreign currency12.70.212.611.6–11.65.03.51.657.241.615.5
Source: Swaziland authorities; and IMF staff estimates and computations.

A: Assets, L: liabiltiies, NP: Net Position (A–L).

Source: Swaziland authorities; and IMF staff estimates and computations.

A: Assets, L: liabiltiies, NP: Net Position (A–L).

The financial sector’s credit exposure to the private non-financial sector is a central transmission channel for balance sheet vulnerabilities. Most banking sector assets are loans to the private non-financial sector, making their performance under a fiscal crisis critical to solvency. In addition, the central bank’s gross official reserves (E 3.6 billion) at end-2011 are below the level of private sector deposits in the domestic banking system (E 4.4 billion). This low level of reserves may not be sufficient to provide a cushion in the event of an external shock. At the same time, the private sector’s foreign assets (E 16.2 billion) exceed the level of deposits in the banking system. However, it is not clear to what extent the external assets of the private sector can cushion an external shock as these are long-term assets invested abroad, which are less liquid.

At end-2011, the private sector was exposed primarily to the rest of the world and the government with net positions of E -5.1 billion and E -1.7, respectively. The government’s liabilities at end-2011 amounted to E 6.8 billion (23.6 percent of GDP), driven by the lack of financing and the accumulation of external public debt (E 3.4 billion, 11.6 percent of GDP). At the same time, the government’s assets are predominantly illiquid (i.e., part or full ownership of companies in competitive sectors) and cannot be sold quickly in the event of an external shock. The government’s limited liquid financial assets were deposited at the central bank (E 1.9 billion, 6.6 percent of GDP) and also cannot be used because this would create pressures on the gross official reserves of the central bank.

The dominance of the government in the economy and the presence of a small number of large borrowers also present a risk to the financial system. A number of state-owned enterprises (SOEs) and small and medium-size enterprises (SMEs) are heavily dependent on business from the government. When the private sector (corporate and household) does reach a point where the nonpayment of arrears results in bankruptcies, not only will banks be affected but the whole economy may face a significant recession.

Against this background, if market perceptions about the solvency of the private sector turn negative, the risk of portfolio outflows could rise. The financial system could withstand a shock of up to E2 billion in deposit outflows. However, should there be larger deposit outflows, the balance sheets of banks would shrink by more than half; and reserves of the central bank could be depleted to a level where external stability could be jeopardized (Table 9.2).

Table 9.2.Swaziland: Balance Sheet Impact of a Deposit Outflow
Public sectorFinancial SectorNonfinancial Private SectorRest of the World
Issuer of liability (debtor) →Central BankCentral GovernmentState and Local GovernmentPublic Nonfinancial CorporationsOther Depository CorporationsOther Financial CorporationsNonfinancial CorporationsOther Resident SectorsNonresident
↓ Holder of liability (creditor) ↓A1LNPALNPALNPALNPALNPALNPALNPALNPALNP
(Emalangeni billions)
Central bank1.90.81.10.90.00.90.40.00.40.10.00.10.11.7–1.6
In domestic currency1.80.81.10.90.00.90.40.00.40.10.00.10.00.00.0
In foreign currency0.10.10.01.7–1.6
Central government0.81.9–1.11.20.50.71.41.43.43.4
In domestic currency0.81.8–1.11.20.50.71.41.4
In foreign currency0.1–0.13.43.4
State and local government0.00.00.0
In domestic currency0.00.00.0
In foreign currency
Public nonfinancial Corps.0.20.4–0.2
In domestic currency0.20.4–0.2
In foreign currency
Other depository corporations0.00.9–0.90.51.2–0.70.00.00.00.40.20.20.90.20.72.42.10.30.11.6–1.51.01.5–0.5
In domestic currency0.00.9–0.90.51.2–0.70.00.00.00.40.20.20.90.20.72.42.10.30.11.6–1.50.00.0
In foreign currency1.01.5–0.5
Other financial corporations0.00.4–0.40.20.9–0.7
In domestic currency0.00.4–0.40.20.9–0.7
In foreign currency
↓ Holder of liability (creditor) ↓A1LNPALNPALNPALNPALNPALNPALNPALNPALNP
Nonfinancial corporations1.4–1.42.12.4–0.314.018.5–4.5
In domestic currency1.4–1.42.12.4–0.3
In foreign currency14.018.5–4.5
Other resident sectors0.00.1–0.11.60.11.52.02.00.0
In domestic currency0.00.1–0.11.60.11.5
In foreign currency2.02.00.0
Nonresidents1.70.11.63.4–3.41.51.00.518.514.04.52.02.02.0
In domestic currency0.00.00.00.00.0
In foreign currency1.70.01.63.4–3.41.51.00.518.514.04.52.02.02.0
(Percent of GDP)
Central bank6.62.63.93.00.03.01.20.01.20.20.10.20.25.8–5.6
In domestic currency6.32.63.73.00.03.01.20.01.20.20.10.20.00.00.0
In foreign currency0.20.20.25.8–5.7
Central government2.66.6–3.94.31.92.44.84.811.611.6
In domestic currency2.66.3–3.74.31.92.44.84.8
In foreign currency0.2–0.211.611.6
State and local government0.10.10.0
In domestic currency0.10.10.0
In foreign currency
Public nonfinancial corps.0.71.5–0.7
In domestic currency0.71.5–0.7
In foreign currency
Other depository corporations0.03.0–3.01.94.3–2.40.10.10.01.50.70.73.20.82.48.47.31.10.55.7–5.23.55.0–1.6
In domestic currency0.03.0–3.01.94.3–2.40.10.10.01.50.70.73.20.82.48.47.31.10.55.7–5.20.00.0
In foreign currency3.55.0–1.6
In domestic currency0.01.2–1.20.83.2–2.4
In foreign currency
Nonfinancial corporations4.8–4.87.38.4–1.148.664.1–15.5
In domestic currency4.8–4.87.38.4–1.1
In foreign currency48.664.1–15.5
Other resident sectors0.10.2–0.25.70.55.26.96.90.0
In domestic currency0.10.2–0.25.70.55.2
In foreign currency6.96.90.0
Nonresidents5.80.25.611.6–11.65.03.51.664.148.615.56.96.90.0
In domestic currency0.00.00.00.00.0
In foreign currency5.80.25.711.6–11.65.03.51.664.148.615.56.96.90.0
Source: Swaziland authorities; and IMF staff estimates and computations.

A: Assets, L: liabiltiies, NP: Net Position (A–L).

Source: Swaziland authorities; and IMF staff estimates and computations.

A: Assets, L: liabiltiies, NP: Net Position (A–L).

The occurrence of deposit outflows would have an additional second-round effect on the financial system. With a much smaller deposit base, banks will need to shrink their domestic assets, bringing about a sizable negative impact on private sector credit. This would ultimately lead to a decline in economic activity. With lower economic activity, the risk of loans becoming nonperforming becomes even higher. With an increase in nonperforming loans, commercial banks would be put under additional pressure because they would have to increase the level of provisioning. With the additional liquidity squeeze, banks would have to ask the central bank to step in as a lender of last resort. However, the central bank would not be able to do so because it would not have sufficient reserves. Therefore, unless the fiscal sector stabilizes where expenditure is brought in line with available financing, and confidence in the government sector is restored, it is the private sector that will have to adjust through a much lower level of economic activity and consumption.

Box 6.The Balance Sheet Approach1

The Balance Sheet Approach (BSA) helps identify sources of vulnerability in the economy from mismatches between sectoral balance sheets. This approach examines the stock of variables in the sectoral balance sheets of a country and its assets and liabilities. Four types of balance sheet mismatches are identified. All four can help determine the ability of a country to honor its commitments in the event of an internal or external shock.

  • Maturity mismatches, i.e., a gap between the liabilities due in the short run and available liquid assets. In such a scenario, the government (or any other sector) faces a short-term risk of much higher interest rates, which would strengthen its liquidity and eventually become a rollover risk as investors choose not to roll over maturing debt.
  • Currency mismatches, i.e., a risk associated with capital loss owing to a change in the exchange rate. Considering that banks have a large volume of liabilities denominated in foreign currency, a large depreciation of the domestic currency can increase the burden of the debt held in foreign currency. It can also lead to a contraction of investment, especially foreign investment.
  • Capital structure problems, i.e., a heavy reliance on debt rather than equity financing. When debt financing is preferred to equity financing, banks are less likely to be in a position to offset shocks. This is because debt repayments remain unchanged regardless of the situation of the country while equity could be used as a buffer because if earnings drop so would remit dividends. Therefore, a country that finances its current account deficit with debt, especially short term, places itself at a greater risk than it would if long-term debt or foreign direct investment were used.
  • Solvency problems, i.e., when assets are not sufficient to cover liabilities. When a country is facing a solvency problem, liabilities (including contingent liabilities) are not commensurate with assets or with the future revenue stream. Such a situation occurs, for example, in a country where the government debt is well above its available assets and the net present value of its expected future fiscal balances.

The balance sheet approach can also assess the case for external financial intervention. If vulnerabilities stem from the balance sheet of the private sector, the government could intervene by restructuring the sector’s liabilities. In some cases, external financial support may be justified, e.g., when the central bank does not hold an adequate level of foreign exchange reserves.

1 See Allen and others (2002), Rosenberg and others (2005), and Mathisen and Pellechio (2006).

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