The purpose of the BSA is to analyze vulnerabilities of sectors and transmission mechanisms among them. Key vulnerabilities that the BSA framework aims to capture can be summarized as follows:4
Maturity mismatches between short-term liabilities and longer-term assets expose borrowers to rollover risk (i.e., the inability to refinance maturing debts) and interest rate risk (the differential impact of interest rate movements on assets and liabilities, depending upon interest rate structure). For instance, maturity mismatches in foreign currency may create difficulties if, due to a change in market conditions, domestic borrowers do not have enough liquid foreign currency assets to cover short-term foreign currency debt. Financial entities that borrow in the short term to invest in long-term debt instruments with fixed interest rates would suffer from a rise in interest rates (e.g., due to cyclical developments or an interest rate defense of an exchange rate peg), which may have a significant impact on their liquidity or solvency.
Currency mismatches arise when borrowers’ liabilities are denominated in a foreign currency but their assets are in domestic currency. In the event of a sharp depreciation, these borrowers may well have trouble paying their creditors. Experience in a number of countries has shown that, in certain circumstances (e.g., longstanding fixed exchange rate regimes), borrowers and lenders may well underestimate exchange rate risk.
Capital structure mismatches may occur when a firm or a country relies on debt rather than equity to finance investment. Equity provides a buffer during hard times, because dividends drop along with earnings, whereas debt payments remain unchanged. At the country level, financing current account deficits with debt (particularly short-term debt) rather than direct investment has typically been seen as generating greater vulnerability.
In times of crisis, these risks are typically manifested as liquidity or solvency problems. Liquidity problems are generally associated with inadequate resources to cover short-term payment requirements. Solvency problems might arise when an entity’s liabilities are not commensurate with its assets and the net present value of future net income streams—for example, when government debt is too high in comparison with government assets and the net present value of primary surpluses. Liquidity and solvency problems might be separate events, but can be related, as when, for example, solvency problems spill over into liquidity problems or repeated liquidity problems raise concerns about solvency.
Maturity, currency, and capital structure mismatches can all increase the risk that a negative shock will cause liquidity problems or drive large parts of one or more sectors into insolvency (Reinhart, Rogoff, and Savastano, 2003a; Calvo and Reinhart, 2002). Often these problems are not evident, as maturity or currency mismatches are hidden in indexed or floating-rate debt instruments, making them less apparent. In some emerging market economies, liabilities may be formally denominated in local currency, but indexed to the exchange rate. Similarly, the nominal maturity of an asset may be long, but the interest rate it bears may be floating.
The BSA is designed to identify key indicators of a sector’s vulnerability, including the following:
Net financial position, defined as financial assets minus financial liabilities:5 a large negative position can point to solvency problems, especially if leverage—debt as a share of total liabilities—is high;
Net foreign currency position, defined as foreign currency assets minus foreign currency liabilities: a sector with a large negative (positive) position is vulnerable to exchange rate depreciation (appreciation); and
Net short-term position, defined as short-term assets minus short-term liabilities: a large negative short-term position indicates vulnerability to interest rate increases and to rollover risk.
As described in Rosenberg and others (2005). Other market risks that stem from potential sharp declines in the price of assets, such as government bonds, real estate, or equities, should be considered key balance sheet risks if exposure is sufficiently large.
Balance sheet analysis is largely based on financial statistics. Real assets, such as real estate—often a major component of public assets—are therefore not included, as they are not sufficiently liquid to be usable in a crisis. The concept of net financial position is therefore different from the net worth (or implied capital) often used to assess whether the operations of the entity (or sector) can be sustained over the medium to long term. A balance sheet analysis is not intended to reflect the “true economic position” of an economy or sector, but merely its macroeconomic vulnerability.