Mapping Financial Sector Vulnerability in a Non-Crisis Country
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Contributor Notes

Author’s E-Mail Address: PDownes@imf.org, DMarston@imf.org, IOtker@imf.org

The forward-looking framework expounded in this paper links a qualitative evaluation of system-wide vulnerability (covering macro, sectoral, institutional, and systemic liquidity issues) with a quantitative assessment of the financial condition of significant financial institutions. Based on vulnerability criteria and judgmental stress tests, twelve indicators of soundness (measuring risk exposure, solvency, liquidity, profitability, and supervisory assessment) are developed. This holistic methodology can be used not only as an early warning/crisis-avoidance system to identify potential systemic problems—and problem institutions—requiring immediate attention, but also to pinpoint needed reforms in the legal, regulatory, and institutional infrastructure that can lessen the likelihood of a future crisis.

Abstract

The forward-looking framework expounded in this paper links a qualitative evaluation of system-wide vulnerability (covering macro, sectoral, institutional, and systemic liquidity issues) with a quantitative assessment of the financial condition of significant financial institutions. Based on vulnerability criteria and judgmental stress tests, twelve indicators of soundness (measuring risk exposure, solvency, liquidity, profitability, and supervisory assessment) are developed. This holistic methodology can be used not only as an early warning/crisis-avoidance system to identify potential systemic problems—and problem institutions—requiring immediate attention, but also to pinpoint needed reforms in the legal, regulatory, and institutional infrastructure that can lessen the likelihood of a future crisis.

I. Introduction

The recent experiences of a number of Asian countries in dealing with full-blown financial crises have led to an increased emphasis on the crucial two-way relationship between sound financial systems and the pursuit of sustainable macroeconomic and structural policies. While much of the response to date has concentrated on firefighting and crisis management, increasing attention is being paid by policymakers and regulators to revamping the international financial “architecture” and placing greater emphasis on crisis prevention measures. An important aspect of this work at the IMF is to develop operational procedures to carry out enhanced oversight of financial systems in the context of Article IV surveillance and Fund program work. As a contribution to this ongoing task, this paper draws on some of the earlier experiences in field testing a framework for financial system vulnerability assessment in non/near-crisis countries. It outlines a practical methodology to evaluate financial system soundness, complementing current Fund/MAE work in evolving a methodology for financial system stability assessment (FSSA).

A sound banking system may be defined as one in which most banks are solvent and are likely to remain so. Solvency is measured by the difference between a bank’s balance sheet assets and liabilities (excluding capital and reserves). Soundness can then be assessed based on measures and projections of capitalization. There are well-known difficulties, however, in measuring solvency.1 Solvency is also a static concept, characterizing the banking system at a given point in time, while the concept of soundness should encompass its dynamic development and its susceptibility to shocks. In addition, insolvency is a lagged indicator of potential problems which may have started before the balance sheet data indicate solvency problems. The likelihood of remaining solvent will, inter alia, also depend on banks being profitable and well managed. At the level of individual banks, supervisors worldwide have evolved supplemental indicators to assist their analyses. Lindgren, Garcia, and Saal (1996) outline three potential approaches to assessing banking system unsoundness.

The first, a “bottom-up approach,” estimates the probability of insolvency developing for each individual bank, based on a balance sheet model. Systemic stability concerns arise when the probability of insolvency becomes significant for a large proportion of total banking assets or when the probability increases substantially in any period in time. Among the problems noted with this approach are its reliance on bank specific data and that it may ignore key roles and interactions between banks (e.g., through interbank markets and payment systems). The second, an “aggregative approach,” estimates the probability of systemic insolvency using aggregate banking sector data, and applies tests typically used in the case of an individual bank to a synthetic aggregate bank. Beyond the drawback of aggregation potentially masking problems in important segments of the banking system, the data series for an individual country may contain insufficient cases of systemic unsoundness for the approach to be predictive. The third method, a “macro-economic approach,” relies on the fact that banks are derivative institutions, in that their health reflects the health of their customers, which in turn reflects that of the economy as a whole. The approach seeks to establish systematic relationships between economy-wide variables and indicators of soundness, and where bank-specific data are available, vulnerability criteria derived from macroeconomic risk factors could be applied to individual banks to indicate their sensitivity to particular risks. This approach has much to recommend it, and the methodology outlined in this paper seeks to build on it by combining it with the other two.

The rest of the paper is organized as follows. Section II outlines a framework for a broad-based qualitative evaluation of financial system vulnerability by identifying macro, sectoral, institutional, and systemic liquidity risk factors that can be used to develop potential vulnerability criteria for a particular country. Drawing on this broad evaluation, Section III sets out the modalities of the quantitative assessment of the individual financial institutions. Inter alia, some key system-wide vulnerability criteria are used to identify banking system risk factors that are, in turn, incorporated into stress tests applied to individual bank data. Leading, indicators of bank condition, such as illiquidity and risk factors evident from banks’ balance sheet data, are used to augment the tests for prospective solvency of the banking system. Section IV deals with the interpretation of the results, the upshot of which is a table incorporating 12 indicators that can give an overall forward-looking picture of the extent of banking system fragility. Finally, Section V stylizes the type of conclusions to be drawn from the assessment in Sections II to IV. These can provide a framework for identifying potentially vulnerable institutions, as well as sources of vulnerability, in a manner that facilitates putting together a comprehensive program of reform. In addition, some preliminary lessons learned from field testing the methodology that can complement ongoing efforts to develop financial sector stability assessment techniques and early warning systems are included.

II. Qualitative Evaluation of Overall Financial System: Identifying Risk Factors and Deriving Vulnerability Criteria

In developing an approach that combines macroeconomic and micro-institutional considerations into an overall evaluation of the financial sector condition in a country, the areas that could entail risks for the soundness of the financial system and that need to be evaluated can be described under four categories as follows:

  1. Macroeconomic risk factors. The focus is on the macroeconomic developments and exogenous shocks that could increase the vulnerability of the financial institutions. Some examples are: lending booms; asset price movements; deterioration in external balances; low or declining economic growth; level and volatility of exchange and interest rates; sectoral activity where most loans and loan collateral concentrate; and reliance of banks and corporate entities on short-term foreign borrowing.

  2. Sectoral indicators of financial system health. Attention is directed to a set of potential fragility indicators that could develop into significant liquidity and solvency problems. Examples include: foreign exchange exposure of financial institutions; sectoral credit concentration; exposure to holdings of stocks and property; trends in the aggregate ratio of NPLs to total loans; aggregate risk-based capital adequacy; central bank provision of liquidity support to financial institutions; segmentation of interbank money markets; aggregate loan-deposit ratio; maturity and currency structure of bank assets and liabilities; trends in stock exchange prices and changes in credit ratings of banks; and aggregate average returns of financial institutions.

  3. Institutional and regulatory framework. Here the focus is on. identifying possible sources of weaknesses that fail to discourage excessive risk taking by financial institutions and contribute to weak capital bases that constrain their ability to absorb unexpected losses and shocks. In general, the degree of compliance with Basle Core Principles is also reviewed. Some of the sources of weaknesses are: (i) disclosure, accounting and legal frameworks, also including internal controls, supervisory capacity, and loan classification and provisioning rules; (ii) prudential regulations, including capital adequacy standards, limits against excessive risk-taking, rules and regulations on the control of systemic risks and payment and clearing systems, and regulatory framework for capital account that may impact the financial system; (iii) incentive structures and safety nets, including the existence and structure of deposit insurance, and licensing-exit policies; and (iv) the structure of the financial system.

  4. Systemic liquidity arrangements (including the design of central bank facilities and instruments, payments and settlement arrangements, foreign exchange management practices, and regulations for banks’ liability and asset portfolio management) can have an important bearing on the system’s resilience, particularly on its capability to cope with episodes of unsoundness when perceptions of counter-party risks change. Banks typically manage their liquidity positions by asset and/or liability management techniques through money and foreign exchange markets. The scope and effectiveness of these operations are critically dependent on the existence of liquid money markets and the ability of banks to access these funding sources. Thus, this part of the evaluation is directed at highlighting institutional arrangements for money markets that affect depth and liquidity as well as measures that can hamper the capability of banks to manage liquidity, e.g., rigidities in the design of instruments; restrictions on asset and liability management (e.g., credit ceilings and interest rate restrictions); information deficiencies; and the insufficiency of collateral to secure both central bank and interbank lending operations.2

These four sets of indicators can be established for a given country in order to (1) develop a snapshot view of the extent of vulnerability of the overall financial system, and (2) identify qualitatively the various risk factors that could impact the health of the financial system in the country. Examples of such risk factors, in each of the four categories respectively, are weak property/stock prices and volatile interest and exchange rate movements; exposure to lending for stocks and property; weak loan classification and provisioning rules; and segmentation or other liquidity constraints in the interbank market.

III. Quantitative Bank-by-Bank Assessment of The Soundness of the Financial System

The next step in the methodology involves incorporating the risk factors identified from the qualitative evaluation above into basic solvency stress tests on bank-by-bank balance sheet data, in order to derive a quantitative forward-looking assessment of the solvency condition of banks. The condition of the financial system is then mapped and assessed using a full range of criteria of financial system soundness (nature of exposure of financial system to risk, solvency condition, liquidity condition, profitability, and supervisory assessment). As banks may exhibit different degrees of vulnerability over time, the assessment of the current condition is augmented with an assessment of the outlook for individual banks, taking into account the various risk factors that may lead to further deterioration in the soundness of the financial institutions. Deciding on which vulnerabilities are most relevant in a particular country and how to translate them into stress-testing parameters is basically a judgmental exercise. The implications of this bank-by-bank analysis are then used to assess the soundness of the overall banking system by using the share of each institution in total bank assets (the “bottom-up approach”). The linkages between the broad qualitative evaluation in Section II and the quantitative bank-by-bank assessment in this section are graphically illustrated in Diagram 1 and Table 1. The following paragraphs explain in greater detail the various vulnerability criteria used in the approach.

Diagram 1.
Diagram 1.

Alternative Approaches to Diagnosing Financial System Vulnerability

Citation: IMF Policy Discussion Papers 1999, 004; 10.5089/9781451973433.003.A001

Table 1.

Criteria and Indicators of Financial Sector Vulnerability

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A. High Exposure to Risk

Some typical risks (credit, foreign exchange, liquidity, and market risks) faced by banks in the course of intermediation, and proxy measures and determinants of such risks, are illustrated in Table 1. Other things being equal, the greater a bank’s exposure to risk, the greater is the degree of financial vulnerability.

Among the most commonly used indicators to assess a bank’s exposure to credit risk are the ratios of the bank’s NPLs to its total loans and the loan-to-deposit ratio. An increase in a bank’s NPL ratio would be an indication of a deterioration in the quality of its asset portfolio (e.g., as a result of a sharp deterioration in economic growth, adverse developments in interest and exchange rates, heavy exposure to sectors adversely affected by worsening economic conditions, and deficiencies in the prudential and supervisory framework and incentive systems that result in risky lending). A high NPL ratio would thus signal heavy exposure to credit risk and low profitability, as well as capital impairment, since greater provisioning would need to be made against the loans that are nonperforming. The loan-to-deposit ratio of a bank measures the degree of leverage and the extent the bank is relying on “nontraditional” sources of funding. When times are good, a bank will often maximize the leveraging of its balance sheet, increasing its loan-to-deposit ratio by seeking less traditional, perhaps more volatile, funding sources. A bank with a high ratio would be subject to greater maturity risk, and is particularly likely to incur losses and suffer capital erosion when economic conditions deteriorate, as borrowers become increasingly unable to repay their loans and investors withdraw their deposits.3 Under such economic conditions, those banks that rely on less traditional funding sources often find themselves in severe need of liquidity, all the more so if their perceived financial condition is also declining.

Exposure to market risk can also be a source of financial vulnerability. One indicator to assess such exposure is the share of property sector and stock market lending to total loans.4 Such lending generally carries higher risk compared with the other parts of the loan book because of the inherent volatility in property and stock markets, and in the case of property related lending, the tendency of developers to use high levels of leverage. Banks may be exposed to property or share sectors also indirectly through the use of property and shares as major sources of collateral. This indirect effect may need to be taken into account in the treatment of collateral and thus in stress testing bank’s capital condition.

Another significant source of market risk for banks is their foreign currency exposure. Such risks may manifest themselves in losses associated with changes in exchange rates when such exposure is not hedged, in particular where high differentials between domestic and foreign interest rates in the context of pegged or tightly managed exchange rate regimes may create incentives for excessive foreign borrowing by banks (on-lent to individuals with little foreign exchange earning potential) in an environment with a relatively liberalized capital account and/or insufficiently tight prudential and supervisory frameworks. One way to incorporate foreign exchange rate risk is to examine the extent to which banks’ net open foreign currency positions as a ratio of their capital exceeds what is permitted by formal open position limits. Subject to data availability, an alternative way is to separate banks’ foreign currency denominated assets and liabilities from their local currency counterparts and evaluate the impact of exchange rate changes on bank balance sheets.5

The extent of a bank’s vulnerability to risk exposure could be reduced if the bank were to set aside adequate provisions against the possibility of impaired loans and to accumulate sufficient capital to withstand adverse conditions arising from such risks. Accordingly, to ensure an adequate degree of rigor, the assessment of financial vulnerability based on risk exposure must be done with solvency tests that evaluate the financial condition of a bank after adjustments for such provisioning deficiencies are made (see below).

B. Solvency Condition and Stress Testing.

Solvency is reflected in the positive net worth of a bank, as measured by the difference between the assets and liabilities (excluding capital and reserves) in its balance sheet. The solvency of a bank, therefore, can be measured in terms of the bank’s capitalization which can in turn be measured by the capital adequacy ratio, or the ratio of total bank capital (sum of tier 1 and tier 2 capital)6 to its risk-weighted assets reported in a bank’s balance sheet data. Insolvency results when the bank’s net worth is negative.

To assess the degree of capitalization, a bank’s capital adequacy ratio at a given point in time can be compared with the Basle recommended minimum capital adequacy ratio for credit risk, that is, 8 percent (tier 1 and tier 2 capital) of risk-weighted assets, and at least 4 percent tier 1 capital.7 However, in computing the capital adequacy ratio of a bank, care should be exercised to ensure that (1) the balance sheet data are on a consolidated basis, or at least that they include the activities of bank branches and subsidiaries, to avoid underestimation of the level of a bank’s risk assets; (2) banks’ off-balance sheet commitments (contingent liabilities) that may expose them to additional risks are taken into account; and (3) loan classification and provisioning standards for NPLs conform with international best practices to avoid the risk of inadequate provisions. Where prudential and supervisory standards do not comply with best practices, adjustment to such standards could reveal further deterioration in the solvency condition of banks.

Initial stress tests can then be performed in order to measure the sensitivity of the bank’s solvency to stricter loan classification and provisioning standards (see Box 1). Sensitivity of the institution’s capital base could also be evaluated with respect to various other risk factors (as identified in Section II) or hypothetical scenarios regarding its exposure to various types of risk, including for example, risks resulting from changes in exchange and interest rates, or in stock market or property prices. Such stress tests are useful in assessing the overall impact of a number of different simulations (including, perhaps, best and worst case scenarios) on the capital base of the institutions. In many cases, results may turn out to be not far from the actual situation in view of the potential measurement errors or other deficiencies in official bank-by-bank data and of the backward-looking (lagged) nature of the loan classification and provisioning rules. Moreover, deterioration of macroeconomic and banking sector conditions may take some time to be fully reflected in “the balance sheets of the institutions, which means that the condition of the banking system measured by solvency condition based on the most recent balance sheet data would be a backward-looking indicator of soundness. The stress tests to assess the current condition should therefore be complemented with a forward-looking analysis of the outlook for the system in the light of vulnerability and risk factors.

Based on the results of these stress tests, banks can be classified into three groups as potentially “solvent and adequately capitalized (or strong),” “solvent but undercapitalized (or weak),” and “insolvent (or serious)” to form a basis for identifying those institutions that require more focused attention in subsequent restructuring efforts. Finally, under each alternative simulation, the corresponding capital shortfall to meet the Basle minimum capital requirement could be calculated for individual banks, which could then be used in estimating recapitalization need for the banking system as a whole; this figure also provides an indication of potential fiscal cost to the extent that private sector capital is not forthcoming and the state has to become involved in recapitalization.

Stress Testing

Stress testing to identify events or influences that could greatly impact banks is a key component of a bank’s assessment of its capital position (see Report on the Working Group on Quantitative Issues, Institute of International Finance (1996)). The main objectives of stress testing are to identify and, if possible, quantify hidden hazards which may be overlooked and which may turn out to be crucial in stressful situations; to evaluate the capacity of the bank’s capital to absorb potential large losses; and to identify steps the bank can take to reduce its risk and conserve capital (see Mori, Moshawa, and Shimizu (1995)). In particular, stress tests examine the overall sensitivity of an institution’s capital base to adverse market movements or hypothetical worst-case scenarios regarding banks’ exposure to various types of risk (see Dimson and Marsh (1997)).

A number of stress tests to evaluate the sensitivity of individual financial institutions’ capital base to a variety of risk factors may be identified from the macroeconomic evaluation of the financial system. Identifying the appropriate risk factors, however, may be a difficult exercise, as unforseen movements in economic variables may occur. Deciding on which vulnerabilities are most relevant in a particular country’s financial system and how to translate them into stress-testing parameters is thus a judgmental exercise. Examples of possible stress tests include:

(i) Deviation from internationally accepted regulatory and supervisory standards: Correcting for such deviations involves measuring the sensitivity of a bank’s solvency to the stricter loan classification and provisioning standards, including: use of consolidated data to assess capital situation, use of off-balance sheet commitments in provisioning,10 and application of appropriate loan classification and provisioning rules and percentages to balance sheet data. The capital adequacy ratio for each institution could then be calculated by adjusting its total capital and risk-adjusted assets with the provisioning deficiency that would arise, assuming that the actual specific provisions held by the institution fall short of the provisions that would be required according to internationally accepted classification and provisioning rules.

(ii) Exposure to market risks: Banks may be exposed to stock market and property sectors not only through their lending to these sectors, but also through their reliance on property and shares as major sources of collateral. When property and shares make up the bulk of collateral, and no provisioning is required against the uncollateralized portion of loans, adverse developments in these sectors may reduce the value of collateral, and thus banks’ capital position may be overstated. Banks’ capital and thus the capitalization need for each institution could be stress tested against alternative scenarios for collateral value in light of the uncertainties about the prices of property and shares.

(iii) Further deterioration in macroeconomic and banking sector indicators: Such development highlights the need to measure the impact on bank capital of a potential future deterioration in asset quality, as a result, for example, of adverse movements in exchange and interest rates, economic growth, and other relevant factors. In order to estimate this impact, projections can be made regarding the evolution of the NPLs of the financial institutions. Such projections could be based on an extrapolation of past trends given the evolution of the NPLs in previous months, or alternatively on simple econometric techniques that recognize the various risk factors identified at the aggregate macro-based assessment.11 Because actual NPLs could be affected by the interaction of additional macroeconomic and financial data that cannot be included in the empirical analyses for the lack of adequate time series data, relying solely on the estimated NPLs from this analysis may risk under or overestimating the actual NPLs. Accordingly, it may be more preferable to use the results of the estimations in combination with judgements derived from the evaluation in Section II of this paper.

10The incorporation of off-balance sheet items is in general limited by the availability of adequate information on the amount and riskiness of such obligations. In the absence of such information, one simple way to adjust for such items is to allow for a given percentage of total loan portfolio (e.g., same percentage applied to general provisions) to be set aside as provisioning against potential losses on these items.11For example, by using time series data, aggregate NPLs of financial institutions can be regressed on a range of macroeconomic and financial indicators, including nominal and/or real exchange rates and interest rates, economic growth, inflation performance, external balance, the share of short-term and foreign currency liabilities of the banking institutions, stock market prices, activity in the sectors where most banking loans are concentrated, the share of broad property sector or stock related lending in total loans, debt-equity ratio of nonfinancial firms, etc. See models of early warning indicators of financial fragility for the idea underlying this approach (e.g., Gonzalez-Hermosillo, Pazarbasioglu and Billings (1997)).

C. Liquidity Tests

While conducting solvency and stress tests as outlined above is essential in assessing banking system soundness, solvency may be a lagging indicator of a bank’s financial condition. Although insolvency normally precedes illiquidity, problems may first become evident through illiquidity. Weak or potentially insolvent institutions typically incur difficulties in raising new liabilities which are manifested in increased funding costs and segmentation in interbank market. In extreme cases, and as funding options harrow, this difficulty could eventually manifest itself in noncompliance with prudential or regulatory limits, such as statutory reserve (SRR) or liquid asset requirements (LAR), coupled with excessive and protracted reliance on central bank refinancing or lending.8

In such circumstances, illiquidity could be used as a leading indicator of potential solvency problems, particularly when liquidity problems occur on a persistent basis. The trends in the extent of total liquidity support by the central bank—whether on a formal basis through collateralized borrowing from a lender-of-last-resort (LOLR) facility or through effective overdraft vis-à-vis required reserve holdings or breaching of liquid asset requirements—in itself may suggest that the central bank had been replacing funds lost by weak institutions that are no longer able to obtain funds from the interbank market because of market concerns over their solvency. Accordingly, liquidity condition could be assessed by a composite measure, which incorporates these elements, that is, access to central bank liquidity support and compliance with required regulatory ratios.9 Bank-by-bank examination of the developments in a given bank’s recourse to the central bank may help identify those institutions that are potentially insolvent, although their balance sheet data at that time may suggest otherwise. Simultaneous observation of illiquidity and low capital ratio would in turn reinforce the assessment of weak financial condition.

D. Profitability

In addition to being sufficiently well-capitalized and liquid, the likelihood of banks remaining solvent and viable would also depend on their profitability. Profitable banks can make required provisions to withstand adverse conditions, add to their capital, and build investor confidence by paying attractive dividends, while those producing losses deplete capital. The profitability of banks (measured in this case by the ratio of net profits to assets (ROA)) can be used to complement the solvency and liquidity tests in assessing the overall soundness of the institutions. A low ratio, as well as a declining trend in this ratio may signal problems regarding the profitability of a given financial institution.

E. Supervisory Assessment

Many countries make a full-scale evaluation of the condition of a bank by constructing a CAMEL rating (a measure of the relative soundness of a bank, calculated on a 1-5 scale, with the best rating being 1). This rating assesses Capital adequacy, the quality of Assets, the adequacy of Management and a system of internal controls, Earnings, and Liquidity. In some countries, the supervisory authority may also maintain a “watch list,” classifying financial institutions under “primary” or “secondary” watch categories based on a number of criteria, including capital adequacy, CAMEL ratings, and degree and frequency of access to central bank liquidity support facilities. These qualitative assessments, which are generally based on on-site inspections, can be used to complement the quantitative assessment of financial condition. Where available, assessments by rating agencies or market assessments revealed through share prices of individual banks may provide additional information on market perceptions of the health of these institutions.

IV. Interpretation of the Results and Overall Assessment of Banking System Soundness

Once the analyses of the current and future condition of the banks within the banking system are completed, the results can be summarized in the form of a table which presents 12 indicators of financial condition that can be applied to individual banks according to the various criteria that are used to evaluate financial vulnerability (see Table 2 for an illustration). These indicators fall under the following five broad categories:

  • risk exposure (as measured by the NPL ratio, loan-to-deposit ratio, share of property and share-related lending in total loans, and net foreign exchange exposure);

  • solvency condition (as measured by capital adequacy ratios in the current and future periods—the latter based on best judgment stress tests and NPL projections);

  • liquidity problems (as measured by access to central bank LOLR facilities, noncompliance with required prudential ratios, or a composite liquidity indicator);

  • profitability (as measured by the return on bank assets); and

  • supervisory assessment (based on CAMEL ratings and supervisors’ watch list).

Table 2.

A Hypothetical Illustration of Diagnosis of Vulnerable Financial Institutions

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Stress’ test results are incorporated here; the current C/A ratio ideally should be based on bringing loan classification and provisioning rules to best international standards; for many countries this in itself could be regarded as a stress test. The projected C/A ratio incorporates judgementally the risk parameters impacting on the future level of NPLs. The numbers reported here are purely hypothetical, generated for illustration purposes.

These 12 measurement indicators could be classified as “red” warning indicators in situations where they fall below what could be regarded as a “threshold” norm.10 Conversely, the indicators would be “green lights” if well above the threshold and “orange” if approaching it. The result, in terms of the number of “red” lights for each bank, would in turn provide a broad-based assessment of financial condition. The usefulness of this “traffic light” methodology is twofold.

First, it can help identify the financially vulnerable banks in the system by scoring the number of vulnerability criteria that each individual bank transgresses. If a bank transgresses all or most of the criteria used, this would indicate that the bank is potentially very vulnerable. This, in turn, is helpful in grouping the banks into the categories of “serious,” “weak,” and “strong” and forming a “watch list” of those banks that require more focused attention in subsequent rehabilitation efforts. The degree of a bank’s vulnerability according to each of the criteria could also help identify particular sources of weakness for that bank. Moreover, by using the market share of each bank in total system assets, it is possible to obtain an overall assessment of the vulnerability of the financial system in the country, and thus the risk of a systemic banking crisis.11

Second, the methodology may also be helpful in identifying the potential areas of vulnerability in a given financial system. For example, failure of liquidity tests by many banks that happen to pass most of the other tests of vulnerability may suggest that liquidity problems have been caused by factors other than the soundness of the financial institutions (e.g., by rigidities in market arrangements and instruments of monetary policy that reduce the ability of the financial institutions to manage their liquidity). High loan-to-deposit ratios by most institutions can also be symptomatic of structural vulnerability in the corporate sector, as reflected in highly leveraged balance sheets and inherent shortcomings in the financial markets structure (e.g., underdeveloped stock and bond markets, or deficiencies in the corporate ownership structure, or a culture that favors dependence on highly leveraged sources of financing from banks). This information could in turn be helpful in identifying the particular areas that require most attention in subsequent financial reform efforts. Of course, the greater the number of criteria according to which most banks in the system appear vulnerable, the more serious would be the severity of unsoundness of the system as a whole.

Finally, if potential systemic problems are revealed, the framework can also produce estimates of cost of filling the “hole” arising from capitalization shortfalls, and possible implications for use of public funds, if such funds cannot be generated by the private sector.

V. Conclusions and Some Policy Lessons

The combined qualitative and quantitative framework outlined for assessing the health of a financial system and its potential vulnerabilities is essentially one of mapping the system against derived indicators of risk and resilience. It is important to underscore that the method of using bank-by-bank data is crucial to identifying vulnerable institutions, which may have a systemic role in the financial system. While release of individual bank data can present legal problems for some national regulatory agencies, without individual bank data it would be impossible to assess the degree of systemic risk. Second, some vulnerability indicators may have different meanings depending on the structure of the financial system (e.g., where there are specialized mortgage institutions, one would normally expect the share of property lending in total bank loans to be low). Third, in inferring sources of vulnerability and hence potential priorities for reform, an inherent caution is warranted in interpreting simulation exercises and stress tests often underpinned by tentative assumptions and forecasts. Nevertheless, as the framework attempts to combine both qualitative and quantitative analyses, results may be sufficiently rigorous and significant to at least flag the need for improved vigilance, if not immediate action. In this context, the approach can point a range of preemptive steps and other structural reform measures that need to be addressed.

Preemptive reform could help avoid an immediate or near-term financial sector crisis, and where warranted, may require: (1) prompt resolution action to address problem banks whether through merger, conservatorship or closure; (2) strengthening the regulatory framework governing prudential rules and practices to cover issues such as inadequate provisioning rules and lack of enforcement of limits against excessive risk taking; improving the treatment of exemptions to prudential rules; enhancing disclosure and reporting arrangements, including consolidation of subsidiaries and contingent liabilities; and increasing the frequency of off-site inspection with improved focus on loan quality and liquidity; (3) urging banks to take preemptive steps to recapitalize and build solvency strength in expectation of increasing NPLs; and (4) identifying circumstances and conditions under which it may be appropriate to use public funds for bank recapitalization.

Further structural reforms identified from the analyses could lessen the likelihood of a crisis in the future. Such reforms could include improvements in enabling legislation and related institutional strengthening, for example, to ensure the capability of the regulatory authorities to take prompt corrective action, and undertake a comprehensive restructuring strategy where needed, including failure resolution; to reduce potential central bank moral hazard; and to promote market discipline. Such changes would aim at giving the central bank or supervisory agency greater independence in bank regulation and foster an appropriate balance between the price and financial stability objectives of the central bank, while strengthening accountability. The approach could also identify reform measures to improve money and capital market arrangements, strengthen the payment system, and remove rigidities which affect banks’ abilities to manage assets and liabilities with minimal official intervention.

While it is not feasible for confidentiality reasons to reveal country-specific details on the outcome of the relatively limited field testing of this framework, a number of generic lessons are salutary and worth mentioning in the context of defining or further refining a methodology for financial system stability assessment in non- or near-crisis countries.

  • Criteria for stress testing balance sheets of individual institutions need to be presented as hypothetical simulations in order to balance the “alarmist” versus “warning” approach in making an assessment of a financial system in a country that is not yet in a financial crisis; in this context, it is essential that the regulatory authorities take ownership of criteria used and the outcome of stress tests.

  • In projecting future solvency conditions of financial institutions based on NPL predictions, due regard should be given to the “hammock effect” (see Ingves and Lind (1997)), that is, the possibility, based on professional evaluation of future asset quality and likely macro or sectoral economic improvements, that some banks’ apparently poor condition may be temporary.

  • A high level of ongoing central bank liquidity support for individual financial institutions, notwithstanding apparent good solvency ratios, is an important leading indicator of future solvency problems and needs to be given due weight in a quantitative assessment of health.

  • The Basle Core Principles (some of which, like capital adequacy ratios and loan classification and provisioning rules, also require further work, especially as regards their suitability for conditions in emerging markets or developing countries), are bare minimum, necessary requirements for good banking supervision compliance and do not at all provide an assurance of financial system soundness.

  • In the context of addressing potential banking system problems, adequate attention must be given to ensure development of efficient money and capital markets and robust payment systems; capital market development is particularly important in systems that exhibit vulnerability in the form of high dependency of corporate entities on bank financing, as manifested in high loans to deposits and loans to GDP ratios.

  • While this methodology is presented as one possible prototype to be used in strengthening financial system oversight in the context of IMF surveillance of member countries, it can equally be used by member countries to carry out self-assessment of weaknesses in a financial system. Indeed the methodology is also as applicable to systems in crisis as to non- or near-crisis situations.

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  • Report of the Working Group on Quantitative Issues: Capital Adequacy and Treatment of Specific Risk, 1996 Amendment to the Capital Accord to Incorporate Market Risks, Section B.5 on Stress Testing, Institute of International Finance. Inc., September 1996.

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APPENDIX I

Worksheets: Identification of System Vulnerabilities at an Aggregate and Qualitative Level

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Note: These worksheets build on guidelines that were developed during 1997 as part of the IMF staff efforts to develop operational procedures for enhanced oversight of financial systems.

The comments presently inserted in this column are intended to provide guidance in assessing the situation in a given country as would be summarized in the preceding column. The actual assessment could indicate a positive (+) or negative (-) trend for each indicator in the first column.

1

These include difficulties in valuing loans; problems in measuring and defining non-performing loans (NPLs) given difficulties in valuing and projecting uncertain future receipts; presence of off-balance sheet items that may involve losses; and problems in consolidating the balance sheets of subsidiaries and other related parties.

2

More detailed lists for each of the four areas are provided in Appendix I, which includes samples of worksheets/questionnaires to facilitate the identification of vulnerability criteria.

3

Banks with good standing may also have high loan-to-deposit ratios, reflecting their ability to source cheaper wholesale funds overseas and their good quality, saleable loans.

4

Market risks could also arise from other types of asset concentration, such as holdings of bonds or securities that are marked-to-market.

5

A similar analysis could be done to separate banks’ assets and liabilities sensitive to interest rates and to evaluate the impact of a given change in interest rates on bank balance sheets.

6

Tier 1 capital consists of paid-up capital (common stock) and disclosed reserves, while tier 2 capital consists of undisclosed, revaluation, and general loan-loss reserves, some subordinated debt, and hybrid debt instruments.

7

A higher ratio may be appropriate for emerging market economies to make allowance for higher risks that may be involved.

8

However, financial institutions may incur difficulty in attracting deposits or accessing funds through the interbank market even when their financial condition is not weak. This may happen, e.g., when deficiencies in disclosure standards result in a lack of adequate and accurate information and uncertainty about the financial condition of banks, and cause surplus institutions to be reluctant to recycle their liquidity. More broadly, illiquidity could occur as a consequence of rigidities in the design of monetary instruments, insufficient collateral, and portfolio constraints on asset/liability management practices of banks.

9

One such measure compares a bank’s holdings of liquid assets to the funds it has borrowed from the central bank, measured in relation to its eligible liabilities for the regulatory ratios:

L=(LAR+SRR+SurplusonLAR+SurplusonSRR)LOLRSupportEligibleLiabilities

A negative value for this ratio would be seen as an indication of illiquidity. Moreover, the lower the ratio, the more serious would be the institution’s liquidity condition.

10

For example, the “threshold” norm occurs when loan-to-deposit ratio exceeds 90 percent; the NPL ratio exceeds 5 percent; the ratio of property sector or stock-related lending is high (e.g., when exposure exceeds 20 percent of capital plus provisions or 30 percent of total loans); net foreign exchange exposure exceeds the legally required open position limits (if any); the capital adequacy ratio falls short of the 8 percent minimum Basle total capital requirement; the bank borrowed from the central bank in excess of a certain amount, say, 50 percent of capital; the composite liquidity measure is negative or low; return on assets of the bank is negative or very low; CAMEL ratings exceed 3, or when the bank is included in the supervisory watch list. The critical threshold levels of these indicators, however, are judgmental and depend in part on the risk aversion of the supervisor or policymaker undertaking the evaluation and in part on other factors, including the severity of economic conditions and risk characteristics of the country (e.g., more stringent standards for developing countries).

11

This approach assigns equal weight to all indicators in arriving at an overall view of systemic vulnerability. In cases when the story told by the various indicators is more mixed, some judgement would have to be used in interpreting the results in terms of implications for systemic vulnerability. In some cases, the conjunction of different factors (e.g., large foreign currency exposure of banks in light of other factors such as macroeconomic imbalances) may increase systemic vulnerability. In any event, the approach would be useful to identify the sources of vulnerability for each institution, as well as the system as a whole (see below).

Mapping Financial Sector Vulnerability in a Non-Crisis Country
Author: Ms. Inci Ötker, Mr. Patrick Downes, and Mr. Dewitt D Marston