Back Matter

Appendix. Macro-Financial Surveillance

Problem of Identifying Systemic Risks

Systemic oversight requires close monitoring of data and information. Measuring just how much systemic risk exists in the financial system at any particular point in time is extremely challenging.24 It becomes visible when the functioning of the financial system breaks down, forcing countries to become reactive, as was the case in Mongolia when two medium-sized banks had to be rescued in 2009. To enable countries to proactively mitigate the risks from procyclicality (or rising common exposure), “ex ante” monitoring is needed to help the authorities identify the sources of systemic risk and the various channels through which these risks are propagated. Deficiencies in measuring systemic risk are, however, numerous. Advances in developing measures of risk and related risk management models had led many to believe that risks were under control. However, the global financial crisis showed that important risks that could not be measured were often being ignored. The main dimensions of the problem relate to: (i) short-sighted risk measures, driven mainly by concurrent volatility; (ii) insufficient recognition of the buildup of latent, endogenous systemic instability; and (iii) non-measurable risks (See Huang, Zhou and Zhu, 2009).25 Besides the difficulty of identifying systemic risk, market prices may not always be timely indicators of actual systemic risk, particularly in periods of calm or high stress.

Instead of trying to measure systemic risk, financial stability analysis often aims to identify a set of leading indicators to convey a broad sense of how risk in the financial system is evolving. A parsimonious, but useful, set is commonly derived from the behavior of credit and asset prices (see Borio and Drehmann, 2009). In particular, there is evidence that sustained rapid credit growth combined with large increases in property prices increases the probability of an episode of financial instability. The challenge in Mongolia is to differentiate between an expansion in credit that is the corollary of a successful financial deepening program, and one that is suggestive of imprudent borrowing. A good understanding of credit—who is borrowing, how much and why—is a basic building block of macro-prudential surveillance. Similarly, an understanding of the terms of credit (e.g., length)—both in aggregate and by industry—can provide some valuable insights into the evolving risk environment.

Even more useful, but more data-intensive, are leading indicators obtained from the analysis of sectoral balance sheets: those of the household, corporate, and public sectors. By tracking debt and debt-servicing requirements over time, balance sheet analysis aims to anticipate the potential for higher levels of default should economic growth falter. Similarly, the analysis of state and local government balance sheets may also be rewarding if any doubts exist over their debt servicing capabilities and whether the central government stands behind them. This type of leading indicator may be more difficult to estimate in emerging market economies due to limitations in the national accounts data.

Early Warning Systems

Ultimately, surveillance efforts will only be useful to policy-makers if they provide some early warning of potential problems. However, a crisis may be triggered by any number of macroeconomic, financial, or geo-political shocks—some completely unforeseen, others which are the realization of known risks. The subsequent amplification of these shocks is then dependent on systemic linkages and the existence of economic and financial vulnerabilities. This means that an increase in systemic risk may present itself as either a higher probability of a shock, or as an expansion in the number and/or size of the underlying vulnerabilities. An increase in housing prices above their “fundamental” value, for example, increases the probability of a shock in the form of a housing price “bust,” but it will be higher financial leverage on household and financial sector balance sheets that will ultimately convert the price shock into adverse real effects.26

An early warning system (EWS) needs to organize surveillance efforts so that they both identify vulnerabilities and rank them as a threat to financial stability. Although no EWS will constitute a fail-safe crisis prediction device, the use of an EWS that maps problems from different angles and drills down to the underlying issues can make a constructive contribution to the policy debate.

Except for early warning indicators (EWIs) based on an endogenous cycle perspective, existing approaches to measuring latent financial instability do not appear promising. Borio and Drehmann (2009) assess a range of measuring tools along three dimensions (Table 6): (i) the extent to which leading indicators are used, as opposed to contemporaneous indicators; (ii) the extent to which behavioral interactions that amplify systemic distress are considered; and (iii) the extent to which the approaches “tell a story” about the transmission mechanism of financial distress. Their results are summarized in Table 6 below. Borio and Drehmann conclude that the usefulness of the tools is generally limited and that the tools typically provide too little lead time for adequate remedial action. Notable exceptions are deviations from long-term trend in the credit/GDP ratio and in real estate and equity prices.

Measuring Latent Financial Instability

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Source: Authors’ compilation based on Borio and Drehmann (2009).

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1

This paper was presented at a seminar held at the Bank of Mongolia in January 2012 and the authors benefited from comments received from Bank of Mongolia. The authors would like to thank Gerard Almekinders, Heedon Kang, and Jongsoon Shin for their useful comments. Editing suggestions provided by Graham Colin-Jones and Gabriela Ionescu are also very much appreciated. All remaining mistakes are the responsibility of the authors.

2

More than 300 companies are currently listed on the Mongolia Stock Exchange (MSE), and market capitalization has surpassed 25 percent of GDP in 2011. However, companies have a very limited trading record as they were only privatized in the early 1990s, and the index retreated 26 percent during the first 10 months of 2012.

3

The Z-score measures the number of standard deviations a return realization has to fall in order to deplete equity—under the assumption of normality of banks’ returns. As such, the Z-score can be thought of as a measure of resilience, with a higher Z-score implying stronger resilience to shocks.

4

There is a growing consensus in the literature that the degree of bank-based versus market-based system does not matter much for economic growth (see Allen and Gale, 2000). The overall financial development is more important than the particular institutional arrangements that provide financial services to the economy.

5

It should be noted that not all credit booms lead to a crisis. Chapter 4 in IMF Country Report No. 06/19 found that, for a sample of 73 countries for the period 1980–2002, out of 150 credit booms identified, about a fifth (31) preceded systemic banking crises, with that proportion rising to about a third (47) if minor episodes of financial distress were included. Experience has shown that longer-lasting and more-pronounced booms have a higher chance of leading to a crash.

6

The FSL passed in 2010 includes several key numerical targets: (i) a structural deficit of two percent of GDP by 2013, which is calculated by using smoothed mineral prices to estimate revenue, but does not adjust for the business cycle; (ii) starting in 2013, spending to grow by less than the greater of non-mineral GDP growth in the budget year or the average of the previous 12 years, allowing for counter-cyclical spending; and (iii) the ceiling on the NPV of public debt to fall from 60 percent of GDP in 2012, to 50 percent of GDP in 2013, and 40 percent of GDP in 2014.

7

The housing market is often perceived as a public good, with governments likely to support it through a variety of measures, with both direct and indirect subsidies. These include mortgage interest deductibility and preferential treatment for capital gains. The authorities in Mongolia have a program of providing 100,000 apartments, through providing preferential mortgages to civil servants. This program aims to build 100,000 apartments, including 75,000 in the capital. A groundbreaking ceremony was held last August in Yarmag, where 15,000 apartments are to be built in three parts, with each part to be constructed in two phases. The government has decided to allocate 1 million togrogs to citizens who buy an apartment in the project, and the 2012 budget allocates 100 billion togrogs. There is also pent-up demand for housing with many low-income urban residents living in “gers” with limited access to electricity or running water.

8

This section draws on Nier and others (2011a, b) and IMF (2011).

9

The degree of integration can be full, partial or nonexistent. Full integration between the central bank and supervisory agencies means that all financial supervisory and regulatory functions are carried out by the central bank or by its subsidiaries. Partial integration means that the securities supervisor or business conduct supervisor are separate entities, while banking supervision (or prudential supervision more broadly, also covering insurance) is conducted by the central bank (see IMF, 2011).

10

BOM Governor’s order No. 460 on July 30, 2010—Regulation on setting and supervising prudential ratios of banking operations.

11

BOM Governor’s order No.118 date March 5, 2007.

12

BOM Governor’s order No. 460 on July 30, 2010—Regulation on setting and supervising prudential ratios of banking operations.

13

Basel Committee on Banking Supervision, “Group of Governors and Heads of Supervision announce higher global minimum capital requirements” Press Release 12 September 2010. These proposals include a conservation capital buffer of 2 ½ percentage points on top of minimum requirements and an additional counter-cyclical buffer of 0-2 ½ percent.

14

Work is still underway to delineate the modalities for addressing systemic risk, but a systemic capital surcharge to SIFIs, particularly those with a significant cross-border presence, has already been adopted, which varies from 0.5-2.5 percent of capital.

15

Khan Bank, Golomt Bank, Trade and Development Bank (TDB), Xac Bank, and Savings Bank.

16

Other criteria that may apply to SIFIs are: (i) substitutability—some banks provide services that are critical to the operation of the financial system that couldn’t be replaced in case of their exit; and (ii) concentration— some market segments feature a few large players that dominate a market for a given financial service, with few alternatives. However, these criteria are likely to be of lesser importance in the Mongolian context.

17

A forward market in foreign exchange is the most basic risk management tool, and is usually the first market to develop after the spot market. The development of a forward market depends on the existence of a reliable yield curve in order to price the forward rate. The existence of forward transactions, in turn, reinforces the money market, establishing a virtuous circle.

18

Agents envisaging exchange rate depreciation may prefer to borrow in foreign currency, at least on a short-term basis, if they perceive that the exchange rate would not change according to expectations at least until after the loans are repaid. Thus, borrowing in foreign exchange might still be preferred even in times of increasing risk.

19

A limit, of say 100 percent, on the ratio of USD denominated loans to USD denominated deposits would help to limit liquidity risk inherent to dollar lending.

20

Borio and Drehmann (2009) argue that, once in place, (i) automatic stabilizers do not need continuous justification; (ii) provided they are linked to robust aspects of the financial cycle and are not too ambitious, they leave less room for error; and (iii) the corresponding measures need not track system-wide risk perfectly but just provide a rough gauge.

21

Assenmacher-Wesche and Gerlach (2008) have argued that it is extremely costly in terms of reductions in GDP to use monetary policy to deal with real estate bubbles, suggesting that monetary policy alone should not be used to prick real estate bubbles, as it is just too costly.

22

These macro-prudential instruments aim at addressing vulnerabilities regarding leverage, market risks, and interconnectedness and include changes in the use of the following tools: capital ratios, risk weights, provisioning, profit distributions, credit growth caps, loan-to-value ratios, debt service and income caps, maturity cap, margin haircut limits, valuation rules, reserve requirements (in local or foreign currency), central banks’ balance sheet operations, exchange trading, capital surcharges for systematically important financial institutions, and central counterparties.

23

Indeed, lower interest rates in this case might promote the buildup of financial imbalances through the risk-taking channel.

25

Often, when risks are identified, acting to mitigate the risk is hindered by strong political opposition.

26

Risks and vulnerabilities may be different aspects of the same problem. For example, high financial leverage may have contributed to a housing bubble in the first place.

Macroprudential Policies for a Resource Rich Economy The Case of Mongolia
Author: Mr. Rodolfo Maino, Patrick A. Imam, and Mr. Yasuhisa Ojima