Modifications to the Current List of Financial Soundness Indicators - Background Paper
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International Monetary Fund
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Publication Date:
14 Nov 2013
eISBN:
9781498341080
Language:
English
Keywords:
PP; capital; Basel; Tier 1; conservation buffer; balance sheet capital; mortgage loan; capital consist; capital conservation buffer; capital to assets; equity capital
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Modifications to the Current List of Financial Soundness Indicators - Background Paper

Abstract

Modifications to the Current List of Financial Soundness Indicators - Background Paper

Introduction

1. This background paper provides the underpinning to the discussion in the main policy paper “Modifications to the Current List of Financial Soundness Indicators (FSIs),” including the rationale for the amendments to the current FSI list and the introduction of new FSIs and the exclusion of certain FSIs in the revised FSI list. It reports extensively on the work conducted by the IMF’s Statistics Department (STA) in close collaboration with a broad-based group of national and international experts, known as the Financial Soundness Indicators Reference Group (FSIRG), international standard setting bodies, and relevant IMF departments, and in consultation with all FSI-reporting countries and concerned international organizations. The revision of the current list of FSIs is in response to the global financial crisis, the adoption of the Basel III Accord, and the G-20 Data Gaps Initiative’s (DGI) call in Recommendation no. 2 to review the current FSI list.

2. The paper draws from three position notes prepared by STA to implement an internationally-agreed work program on FSIs jointly developed with the FSIRG and the other above-mentioned parties. The FSIRG and the FSI-reporting countries broadly supported the thrust of the three position notes, including the identified modifications to the current FSI list. Draft position notes were circulated for review to the FSIRG, as well as all FSI-reporting countries and concerned international organizations, and comments received were reflected in the final position notes. These position notes were posted on a dedicated FSIRG website, which is accessible by national authorities of all FSI-reporting countries. The final position notes provide the rationale for the identified modifications to the current FSI list, as explained below.

Deposit Takers

This section discusses how the current FSIs will be affected by the introduction of the Basel III regulatory framework, and which new capital-based and other indicators will need to be included in the set of core and additional FSIs for deposit takers (DTs). It also addresses other relevant issues as agreed with the FSIRG.

3. The adoption of the new Basel III Accord was at the center of the FSIRG discussions at its November 2011 meeting. Most participants indicated that their countries will implement Basel III on time or even earlier than the phased-in schedule developed by the Basel Committee on Banking Supervision (BCBS). In some instances, Basel II and Basel III will be implemented simultaneously for different types of institutions. Breaks in time series would thus be unavoidable, but not expected to be significant due to the considerable length of the transition period. The consensus was that, as Basel III is implemented, the definitions of existing capital-based FSIs will need to be reviewed and eventually revised to comply with the new regulatory framework.

A. Capital-Based FSIs

Basel III and Capital Measures

4. Basel III has redefined the elements to be included in total regulatory capital, placing a greater emphasis on common equity. In particular, the instruments included in Tier 1 and Tier 2 capital and the general definition of total regulatory capital will need to be amended. The corresponding sections of the FSI Compilation Guide (FSICG) will need to be revised accordingly in due course.

5. On capital adequacy, the way of measuring the capital base has changed in favor of a narrower definition with very specific components of capital, compared with Basel II. Tier 1 capital has been split into two components: Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1) capital. Basel III states that “Tier 2 capital will be harmonized, and Tier 3 capital instruments, available to cover market risks, will be eliminated.”1 The components of total regulatory capital will shift towards equity capital (Tier 1) and away from subordinated debt (Tier 2). A new Capital Conservation Buffer comprised solely of CET1 has been established above the regulatory minimum capital requirement with constraints on capital distribution when capital levels fall below a certain range. In addition, a new Countercyclical Capital Buffer is to be met by CET1 only, although the BCBS is reviewing the possibility of accepting “other fully absorbing capital beyond CET1.”

Regulatory Capital

Tier 1 Capital

6. Under Basel II, Tier 1 capital consists primarily of equity capital and freely available disclosed reserves. A minimum of 4 percent capital ratio (Tier 1 to risk-weighted assets) is required.

7. Under Basel III, Tier 1 capital is split into two components: (i) CET1, consisting of common shares, retained earnings and accumulated other comprehensive income, and other disclosed reserves; and (ii) AT1, consisting of subordinated instruments with no maturity and neither secured nor covered by a guarantee of the issuer. The minimum CET1 capital ratio will increase from 3.5 percent in 2013 to 4.5 percent in 2015. The minimum total Tier 1 capital ratio will increase from 4.5 percent in 2013 to 6 percent in 2015. In most cases, regulatory adjustments will be applied when calculating CET1. Since the new CET1 of Basel III corresponds broadly to Basel I and Basel II Tier 1 capital, CET1 for the DT sector as a whole should be derived by aggregating Tier 1 capital calculated under Basel I and/or Basel II and CET1 calculated under Basel III for financial institutions using different Basel accords’ definitions.

Tier 2 Capital

8. Under Basel II, Tier 2 capital consists of the following components: undisclosed reserves, asset revaluation reserves on fixed assets and long-term holding of equities, general provisions up to 1.25 percent of risk-weighted assets,2 some hybrid instruments and long-term (more than five years) unsecured subordinated debt. Tier 2 capital is limited to 100 percent of Tier 1 capital.

9. Under Basel III, Tier 2 capital includes only the following: long-term (more than five years) subordinated, non-guaranteed instruments issued by the bank, plus general provisions up to 1.25 percent of credit risk-weighted assets, and excess of total eligible provisions up to a maximum of 0.6 percent of credit risk-weighted assets.

Total Regulatory Capital

10. Under Basel II, total regulatory capital includes Tier 1, Tier 2, and Tier 3 capital3. The total capital adequacy ratio must be no lower than 8 percent.

11. Under Basel III, Tier 3 capital is eliminated. Hence, the new total regulatory capital will comprise only Tier 1 and Tier 2 capital, as defined under Basel III (see paragraphs 6-9). As with Basel II, the minimum total capital adequacy ratio must be no lower than 8 percent, but with a minimum of 6 percent constituted by Tier 1 capital.

Capital Conservation Buffer

12. Basel III establishes a capital conservation buffer of 2.5 percent of risk-weighted assets above the regulatory minimum capital requirement, which consists solely of CET1 and will be fully effective as of January 1, 2019. The capital conservation buffer is designed to ensure that banks build up capital buffers outside periods of stress, which can be drawn down as losses are incurred. When buffers have been exhausted, banks should rebuild them through reducing discretionary distributions of earnings. The capital conservation buffer will be phased-in between January 2016 and end-2018, with an initial requirement of 0.625 percent of risk-weighted assets and additional 0.625 percent each year to reach 2.5 percent in 2019.

13. As designed, the capital conservation buffer is to be a flexible requirement, which will affect the dividend distributions but not the operational capacity of banks. Although the minimum capital adequacy ratio of Basel III will continue to be 8 percent of risk-weighted assets, the introduction of the capital conservation buffer will increase this minimum up to 10.5 percent in 2019.

Countercyclical Capital Buffer

14. A countercyclical capital buffer is to be implemented based on national authorities’ assessments of the build-up of system-wide risks and the geographical credit exposure of internationally active banks. When in place, the countercyclical capital buffer will be an extension of the conservation buffer. The countercyclical capital buffer regime will be phased-in in parallel with the capital conservation buffer between January 1, 2016 and end-2018.

Leverage Ratio

15. Basel III introduces a simple, transparent, and non-risk based leverage ratio, which serves as a supplementary measure to the risk-based capital requirements. The capital measure for the leverage ratio is based on the new definition of Tier 1 capital. The denominator comprises all balance sheet assets (with an add-on for potential future exposures of derivatives and securities financing transactions) and off-balance sheet commitments, the latter including commitments, unconditionally cancellable commitments, direct credit substitutes, acceptances, stand-by letters of credit, trade letters of credit, failed transactions, and unsettled securities.

16. The ratio is to be calculated as the average of the monthly leverage ratio over the quarter based on the definitions of capital (the capital measure) and total exposure (the exposure measure). The leverage ratio is set at 3 percent. It will be tested during a parallel run period between 2013 and 2017, with a migration to Pillar 1 foreseen for 2018.4 The BCBS is intending to collect data during the transition period to track the potential impact of using the total regulatory capital and CET1.

Revised Capital-Based FSIs

17. In line with the Basel III framework, the regulatory capital used to compile FSIs should explicitly defer to Basel III definitions. The proposed revisions to the definitions of capital-based FSIs are discussed below. These revisions reflect the need to standardize, as far as possible, the definitions of the revised capital-based indicators to enhance cross-country comparability, while allowing flexibility in a very few specific cases, as indicated below, when good analytical reasons are presented by reporters for such flexibility.

Solvency indicators

18. I01 – Total Regulatory Capital to Risk-Weighted Assets. There will be no change beyond the move to the Basel III definition of total regulatory capital for jurisdictions that adopt Basel III. The indicator will use as the numerator total regulatory capital, which includes Tier 1 and Tier 2 capital as defined in Basel III.

19. I02 – Regulatory Tier 1 Capital to Risk-Weighted Assets. There will be no change beyond the move to the Basel III definition of Tier 1 capital for jurisdictions that adopt Basel III. The inclusion of AT1 will increase the minimum Tier 1 capital requirement to 6 percent, while including the conservation buffer would bring this ratio to 8.5 percent (compared with the current minimum Tier 1 capital ratio of 4 percent).

20. I03 – Non-performing Loans (NPLs) Net of Provisions to Capital. There will be no change beyond the move to the Basel III definition of total regulatory capital for jurisdictions that adopt Basel III. This indicator is intended to measure the potential impact on capital of NPLs. As the ratio I03 is a solvency-related indicator, the preferred definition of the denominator is the total regulatory capital, while allowing flexibility for countries to use balance sheet capital in the case where domestic consolidation (DC) is used as foreign-owned branches are not required to hold regulatory capital.

21. I12 – Net Open Position in Foreign Exchange to Capital. The option of using Tier 1 capital is eliminated, leaving the denominator as total regulatory capital only. The ratio I12 is a solvency-related indicator.

22. I14 – Large Exposures to Capital. The option of using Tier 1 capital is eliminated, leaving the denominator as total regulatory capital only. The ratio I14 is a solvency-related indicator, which is intended to identify vulnerabilities arising from the concentration of credit risk.

23. I16 – Gross Asset Positions in Financial Derivatives to Capital. Total regulatory capital replaces Tier 1 capital. This indicator is aimed at measuring exposures relative to capital, and total regulatory capital is to be used as the denominator. Alternatively, as the numerator is a balance sheet item, balance sheet capital may also be used.

24. I17 – Gross Liability Positions in Financial Derivatives to Capital. Total regulatory capital replaces Tier 1 capital. This indicator is aimed at measuring exposures relative to capital, and total regulatory capital is to be used as the denominator. Alternatively, as the numerator is a balance sheet item, balance sheet capital may also be used.

25. I25 – Net Open Position in Equities to Capital. This indicator, intended to identify DTs’ exposures to equity risk, is deleted from the revised list of FSIs as recommended by the FSIRG, given the limitation of source data needed for compiling the indicator. The reporting rate of this indicator has been very low.

Leverage Indicators

26. I13 – Capital to Assets. This indicator is moved to the core set and its calculation is revised to use Tier 1 capital as numerator and total assets (financial and nonfinancial) as denominator. The option of using balance sheet capital is eliminated. This indicator should be replaced by the new Basel III leverage ratio for jurisdictions that adopt Basel III, once that indicator is active. Regulatory Tier 1 capital to assets is encouraged in the Special Data Dissemination Standard (SDDS) and required in the SDDS Plus. The implications of the changes introduced by Basel III for the definitions of FSIs included in the SDDS and SDDS Plus will be addressed in the Ninth Review of the Data Standards Initiative scheduled for early 2014 (See Box 1). These revisions reflect the following considerations: (i) the new Basel III regulatory focus on the leverage ratio; (ii) the costs and benefits of keeping the current indicator I13 after the new leverage ratio is included in the FSI set; and (iii) the need for maintaining a parsimonious approach to the number of indicators, thus including only one leverage ratio in the list of FSIs.

Dissemination of FSIs and the Fund’s Data Standards Initiatives5

  • The Special Data Dissemination Standard (SDDS) was established in 1996. Its purpose is to guide IMF members in the provision of economic and financial data and the dissemination of timely and comprehensive statistics in pursuit of sound macroeconomic policies and financial sector stability. As of September 2013, the SDDS has 71 subscribers.

  • In February 2012, at the Eighth Review of the Fund’s Data Standards Initiatives, the Executive Board approved enhancements to the SDDS and established the SDDS Plus. The SDDS Plus is the third and highest tier of these initiatives and is aimed at countries with systemically important financial systems, although it is open to all SDDS subscribers.6

  • The SDDS encourages the dissemination of the following seven FSIs with quarterly periodicity and quarterly timeliness: i) regulatory Tier 1 capital to risk-weighted assets; ii) regulatory Tier 1 capital to assets; iii) nonperforming loans net of provisions to capital; iv) nonperforming loans to total gross loans; v) return on assets; vi) liquid assets to short-term liabilities; and vii) net open position in foreign exchange to capital. These seven FSIs were brought into the SDDS to help address data gaps stemming from credit, liquidity, leverage, and solvency risks facing financial systems. SDDS subscribers that choose to disseminate these data are to include release dates in their Advance Release Calendar and disseminate the data on their National Summary Data Page. Links to these can be found on the Fund’s Dissemination Standards Bulletin Board (DSBB).7

  • The SDDS Plus requires the dissemination of the following seven FSIs with quarterly periodicity and quarterly timeliness: the first six FSIs listed above (i-vi) and residential real estate prices. It does not require dissemination of the net open position in foreign exchange to capital. The SDDS Plus is in the process of implementation, with many countries expressing interest in adherence and is expected to be launched in Fiscal Year 2014.

Profitability Indicators

27. I07 – Return on Equity (ROE). The option of using Tier 1 capital is eliminated, leaving the denominator as total balance sheet capital and reserves only. This indicator is intended to measure efficiency in using capital. Considering that balance sheet capital—defined as the difference between balance sheet assets and liabilities without any regulatory deductions—is the most common measure of capital used by the financial industry to compare profitability, balance sheet capital is most appropriate for the compilation of this indicator. Average balance sheet capital will continue to be used.

New Capital-Based FSIs

Solvency

28. Given the importance of the new CET1 within the Basel III proposals, a new CET1-based solvency FSI for DTs is introduced (CET1 to RWA) for jurisdictions that adopt Basel III. The BCBS already collects this indicator. Hence, costs to countries of including this new indicator should not be significant. This new indicator will be complementary to the current indicator I02 and is to be part of the core set. For jurisdictions that do not adopt Basel III, this indicator is not to be reported.

Leverage

29. The leverage ratio introduced by Basel III relies on the new definition of regulatory Tier 1 capital and on an exposure measure. The latter includes on-balance sheet items (with an add-on for potential future exposures of derivatives and securities financing transactions) and off-balance sheet items.

30. The new definition of the leverage indicator consistent with Basel III will be introduced for jurisdictions that adopt Basel III once the BCBS informs national supervisors to start monitoring this ratio.8 This new indicator will use regulatory Tier 1 capital as the numerator. Regarding the denominator, adopting fully the Basel III definitions will imply including also off-balance sheet items. Jurisdictions that do not adopt Basel III should continue compiling FSI I13, which will be defined as Tier 1 capital to balance sheet assets. The leverage indicator will be included in the core set of FSIs.9

Capital Conservation buffer and Countercyclical Capital Buffer

31. If Basel III is adopted, I02 should be calculated taking the entirety of CET1, which would include the capital conservation buffer and countercyclical buffers to the extent that deposit-takers are required to maintain them. The usefulness of specific indicators based solely on the capital conservation or countercyclical buffers will be diminished by the lack of comparability and their expected variability. The delayed phased-in period for the full introduction of the buffer would also detract from the potential usefulness of an indicator based on it. At this time, no specific capital conservation buffer- or countercyclical capital buffer-related indicators will be introduced to the FSI list.

B. Liquidity FSIs

Basel III and Liquidity Standards

32. Basel III has introduced two internationally harmonized global liquidity standards as complements to capital adequacy requirements: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). These two ratios comprise specific parameters, which are internationally “harmonized” with prescribed values. Nevertheless, certain parameters contain elements of national discretion to reflect jurisdiction-specific conditions. The home supervisory parameters should apply to all the entities being consolidated.

33. The LCR is intended to promote resilience to potential liquidity disruptions over a thirty-day horizon. Following the LCR, high-quality liquid assets must equal or exceed highly-stressed one-month cash outflows. After an observation period, it will be introduced in January 2015. The LCR standard is defined by dividing the stock of high quality liquid assets to net cash outflows over a 30-day time period under stress. Individual banks should meet this standard permanently and hold a stock of unencumbered, high-quality liquid assets to face a severe stress scenario. The LCR is calculated using stock of high-quality liquid assets as numerator and total net cash outflows over the next 30 calendar days as denominator:

  • High-quality liquid assets are those assets that can be easily and immediately converted into cash at little or no loss of value. Basel III sets out fundamental and market-related characteristics and operational requirements that high-quality liquid assets should possess or satisfy.

  • Total net cash outflows are defined as the total expected cash outflows minus total expected cash inflows in the specified stress scenario for the subsequent 30 calendar days. Total expected cash outflows are calculated by multiplying the outstanding balances of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down. Total expected cash inflows are calculated by multiplying the outstanding balances of contractual receivables by the rates at which they are expected to flow in under the scenario up to an aggregate cap of 75 percent of total expected cash outflows.

34. The NSFR has been developed to promote more medium and long-term funding of the assets and activities of banking institutions. The NSFR measure is designed to act as a minimum enforcement mechanism to complement the LCR. The NSFR is defined as the available amount of stable funding relative to the amount of required stable funding as calculated by banks and this ratio must be greater than 100 percent. Basel III provides definitions and the framework for deriving the available amount of stable funding and the amount of required stable funding for calculating this ratio.

Changes and Additions to the Liquidity FSIs

35. Changes and additions to the liquidity FSIs can be summarized as follows:

  • Liquidity coverage ratio (LCR): This indicator will be included in the core set for jurisdictions that fully adopt Basel III LCR, and will replace I11 liquid assets to short-term liabilities. The LCR is added because it is intended to promote resilience to potential liquidity disruptions over a 30-day horizon, making it very useful for financial stability analysis and systemic risk monitoring. For jurisdictions that do not adopt Basel III, I11 FSI remains defined as liquid assets to short-term liabilities.

  • Net Stable Funding Ratio (NSFR): This indicator will be included in the core set when jurisdictions adopt Basel III NSFR. This ratio provides important information on the funding structure of the DT sector over a one-year horizon and is designed to act as a minimum enforcement mechanism to complement the LCR. Jurisdictions that do not adopt Basel III do not report this FSI.

C. Additional FSIs

36. A new FSI for DTs, credit growth to the private sector will be added to the additional set of FSIs. This indicator is intended to capture emerging systemic risks and can serve as a forward-looking indictor of potential assets quality problems and vulnerabilities in the DTs sector. The indicator will be calculated as annual growth rate of nominal loans to the private sector, which is defined to include private nonfinancial corporations (NFCs) and households (HHs).10 Rapid credit expansion may, at times, exceed banks’ capacity to assess risks, thereby leading to reduced asset quality and increased probability of a crisis event. Cross-country empirical studies of systemic bank distress (Bell and Pain, 2000) suggest that banking crises tend to be preceded by credit booms. On this basis, this new indicator can provide signal of a need for further evaluation of the implications of credit growth for financial stability and macroeconomic developments. In particular, it may be needed to distinguish to what extent a rapid credit growth reflects improvements in access to finance and to what extent the growth reflects a loosening in risk management practices and supervision.

D. Other issues

“NPL Net of Provisions to Capital” (I03)

37. The current FSI Compilation Guide recommends the use of a broader concept of loans for gross loans, NPLs, and NPLs net of specific provisions for compiling this FSI. Thus, in the current FSICG, gross loans and NPLs should be measured at nominal value gross of specific provisions for loan losses.

38. Fund staff proposes that national authorities continue to use the current definition of NPLs and provisions for loan losses in the FSICG when compiling FSI I03, as this approach is consistent with supervisory concepts and definitions specifically for NPLs, and provisions for loan losses.

Provisions to NPLs – new core FSI

39. Currently, the indicator “provisions to NPLs” is included in the FSI tables of the Global Financial Stability Report (GFSR), and will be added to the revised list of core FSIs for DTs. The data series for provisions are derived from the reported underlying data series used for the existing core indicator I03—NPLs net of provisions to capital.

Data Aggregation for Supervisory-Based Capital

40. Implementation of Basel III may co-exist at least temporarily with previous capital requirements (Basel II or even Basel I). In the circumstances, the FSIRG requested guidance on data aggregation for supervisory-based capital. Staff’s recommended aggregation approach is summarized in Table 1.

Table 1.

Recommended Aggregation of Capital Components under Basel III and Basel II (and/or Basel I) for Deriving Sectoral Data

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41. Countries should clearly indicate in their metadata, if they conduct data aggregations for financial institutions within their jurisdictions using different Basel accords. Information on the number of deposit-takers and percent share of capital compiled using each Basel accord would be useful and should be provided, if possible.

Breaks in Time Series and Related Issues

42. The introduction of the new Basel III concepts will result in time series breaks and thus the need to manage time series breaks. Even if the label (Tier 1, Tier 2, and total regulatory capital) of the variables used to calculate the capital-based indicators do not change, the instruments included in them, and the supervisory deductions they are subject to, will change, affecting the comparability of historical series. Table 2 shows the status of capital definitions used by FSI-reporting countries as of end-July 2013 (according to the metadata posted by countries).

Table 2.

Capital Definitions Used by FSI Reporters, end-July 2013

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43. To help with the conversion process, STA will publish a “frequently asked questions” note providing guidance to users on the changes and revisions. Countries could refer to this note. Countries would need to clearly indicate breaks in the time series in the published data and metadata. In addition, STA will inform the FSIRG well ahead of the date on which the IMF’s FSI website will be changed to reflect the new FSI list and definitional changes.

D. Other Financial Corporations

This section discusses the current FSIs for OFCs, the envisaged split of the OFC sector into four main subsectors—money market funds (MMFs), insurance corporations (ICs), pension funds (PFs), and other OFCs, and new indicators for the OFC subsectors.

A. Splitting the OFC Sector

44. As corporations comprising OFCs are very diverse, there is a need to disaggregate this sector into subsectors. In this connection, the OFCs sector will be subdivided into four subsectors: (i) MMFs; (ii) ICs; (iii) PFs; and (iv) other OFCs, covering all residual OFCs not included in the previous three subsectors.12

45. The split of the OFC sector into subsectors is broadly in line with the split supported by the FSIRG (Table 3). The split between ICs and PFs was considered advisable given differences in their business models and varying importance across countries. National compilers may wish to compile FSIs for additional categories in the other OFC subsector separately for their own analysis and for publication if these categories (e.g., Special Purpose Vehicles, investment funds, trust funds) account for a significant share of their financial systems.

Table 3.

Splitting the OFC Sector

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B. Revisions to the Current FSIs for OFCs

46. The current set of FSIs includes two indicators for OFCs—assets to total financial system assets (I26) and assets to GDP (I27). The numerator for both indicators is OFCs’ total financial assets. These FSIs are intended to measure the importance of OFCs within the domestic financial system and the domestic economy, respectively. Fund staff is of the view that these FSIs remain useful to monitor broad developments in the OFCs sector, especially in those countries where OFCs are still in an embryonic stage. Hence, these two FSIs for the OFCs sector will be kept as a whole and subsector splits added as shown in Table 4 below. For the purpose of compiling the two FSIs for the OFCs sector as a whole, the OFCs sector would include all financial corporations that are not classified as DTs, including MMFs, ICs, PFs, other financial intermediaries (other than MMFs, ICs, and PFs), and financial auxiliaries.

Table 4.

FSI 26 and FSI 27 for the OFCs Sector and its Subsector Splits

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C. New FSIs for the OFC Subsectors

47. The framework for measuring the financial soundness of the OFC subsectors follows broadly that for the DT sector, which is intended to cover aspects of, where applicable, capital adequacy, asset quality, earnings and profitability, and liquidity conditions. The methodology for compiling new FSIs for OFCs will be developed and included in the revised FSICG.

48. Fund staff has adopted a parsimonious approach in proposing new FSIs for OFCs, given differences in the level of development in the OFCs subsectors across countries, variations in data reporting practices, and limited data availability in many countries. The new FSIs for OFCs are included in the additional FSI set.

49. The consolidation basis to be used for compiling the new FSIs for OFCs subsectors should follow that used for compiling the current indicator I26, which could be either on a cross-border consolidated basis or a domestic consolidated basis, depending on data availability and on whether there exist significant branches and/or subsidiaries’ activities abroad.

New FSIs for MMFs

50. The systemic relevance of MMFs varies across countries. In some jurisdictions, MMFs can be characterized by their investment objectives and types of investors. As with other mutual funds, investors in MMFs are considered as shareholders and they are often entitled to receive the value of each share with its accumulated income. In these cases, MMFs determine their price, by dividing the net asset value (NAV) of the fund by the number of shares of the fund. However, there are also constant NAV MMFs in which the yield is predetermined and does not vary with prices of the underlying assets. Investments in MMFs are typically not covered by deposit insurance.

51. MMFs typically invest in high-quality and low-duration income instruments, such as commercial papers, certificates of deposits, and repurchase agreements. Despite the relatively high quality of the invested instruments, the maturity and the issuing sectors of these instruments can have impact on the asset quality.

52. MMFs provide short-term funding to DTs and, therefore, a run on MMFs could have an impact on DTs’ short-term liquidity. Constant NAV MMFs could be prone to runs if a significant shortfall emerges between the value of the underlying assets and the obligations. The liquidity problems might be exacerbated if DTs also have investments in MMFs as DTs may withdraw funds from their share accounts with MMFs as a consequence of the potential loss perception (feedback loop). The maturity transformation through MMFs is also relevant for financial stability analysis as some of MMFs’ assets have maturities more than 90 days while balances in their share accounts may be withdrawn on demand.

53. Based on the above considerations, two FSIs for MMFs are added to assess their asset quality and liquidity (Table 5).

Table 5.

New FSIs for MMFs

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54. The new asset quality indicator provides information on MMFs’ assets distributed by debtor sectors. This FSI is useful as different debtors have different risk profiles. Changes in the distribution would also capture MMFs’ asset reallocation based on yields and/or risk perception. Additionally, this FSI captures a financial link between MMFs and DTs.

55. The new liquidity indicator is aimed at assessing the level of liquidity by monitoring the asset maturity. For calculating this FSI, remaining maturity would be recommended. A large concentration of assets with maturity more than 90 days could signal potential liquidity vulnerabilities.

New FSIs for ICs13

56. The new FSIs for ICs are to cover three categories of financial soundness—capital adequacy, reinsurance issues, and earning and profitability (Table 6).

Table 6.

New FSIs for ICs

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57. Capital is one of the key indicators of ICs’ financial soundness, which measures the corporations’ capital strength to absorb losses. One indicator will be added to measure capital—shareholders equity to invested assets ratio—intended to measure the level of capital that is available to meet potential losses from ICs’ investments.

58. ICs may also arrange reinsurance. This is insurance provided by one insurer (usually specializing in reinsurance) to another whereby the reinsurer agrees, in exchange for a premium, to indemnify the latter for losses on one or more contracts which it has issued. Reinsurers may themselves arrange reinsurance, known as “retrocession.”

59. On reinsurance issues, a risk retention ratio (total premium income minus premium ceded by primary insurers to total premium income) will be added to measure the risk that is passed on to reinsurance companies. Low and declining levels of this ratio may signal the presence of financial difficulties of primary insurers and would warrant a closer look at the concerned insurance company.

60. Low profitability may signal fundamental problems for ICs and may be considered as a leading indicator for solvency problems. In this regard, two new FSIs are added to assess earnings and profitability: (i) ROA—intended to measure ICs’ efficiency in using their assets; and (ii) ROE—intended to measure ICs’ efficiency in using their capital.

New FSIs for PFs

61. PFs play an important role in the financial system in certain countries and have a potential impact on the stability of financial markets in several ways, most significantly through their investment behavior. PFs hold a large proportion of financial assets and, therefore, any sizable reallocation of their assets (e.g., between fixed income and equities) could have macro-financial implications.

62. On liquidity, it is important to assess the adequacy of liquid assets to cover future pension payments. This may be measured by the proposed ratio of liquid assets to estimated pension payments in the next year. Moreover, in revising the FSICG considerations will be given to the fact that most pension schemes receive regular cash inflows, which to some extent reduces the liquidity risk.

63. Like other types of financial corporations, profitability is a key determinant of PFs’ strength to withstand shocks. The proposed ROA ratio would measure the efficiency of PFs in using their assets. Table 7 summarizes the new indicators for PFs.

Table 7.

New FSIs for PFs

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New FSIs for other OFCs

64. Other OFCs are engaged in a broad range of financial intermediary and financial auxiliary activities. This subsector may include very different types of institutions, as illustrated in Table 3 above. Given limited data availability in many countries and likely serious data comparability issues, other OFCs will not be split further, as noted previously. Nevertheless, national compilers will be encouraged to calculate FSIs for additional categories in the other OFCs subsector separately for their own analysis and publication if these categories accounted for a significant share of their financial systems.

Non-Financial Corporations, Households, and Real Estate Markets

This section discusses FSIs and changes and revisions for non-financial corporations (NFCs), households (HHs), and real estate markets.

A. Changes to FSIs for NFCs

65. “Earnings to interest expenses” is added as a new indicator while keeping the current FSI I30 “earnings to interest and principal expenses.”14 This would avoid data covering earnings to interest expenses being reported under the label “earnings to interest and principal expenses” in cases where data on principal expenses are not available.

66. “Liquidity ratio” is added as a complementary indicator to assess liquidity conditions in NFCs. This indicator is defined as the ratio of liquid assets to total assets, the same ratio as the liquidity asset ratio for deposit-takers.15 This ratio is a proxy for the “current ratio,”16 as there are difficulties/costs of compiling short-term liabilities on a remaining maturity basis.

67. “External debt to equity” and “foreign currency debt to equity” ratios are added as supplementary ratios to FSI I28 “total debt to equity.” These two new ratios would be very useful for macroprudential analysis, as they would allow the monitoring of NFCs’ exposures by residency of creditors, as well as indicate the extent to which NFCs rely on foreign currency borrowing.17 Data on external debt may be available from the external debt statistics, which along with data from the International Investment Position may also provide information on foreign currency debt to the extent it is owed to nonresidents. Data on foreign currency debt from the central bank, resident DTs, and OFCs are available from the SRFs.

68. “NFC debt to GDP” is added. This indicator is intended to measure NFCs’ leverage relative to GDP and should be analyzed together with the current I28 “total debt to equity.” Both underlying data series for this new indicator are used for existing FSIs.

69. ROA is added. ROA along with the existing I29 ROE provide an indication on management’s effectiveness in deploying resources. Furthermore, ROA may better capture NFCs’ profitability in cases where NFC debt is converted into equity, thus diluting the meaningfulness of the ROE ratio over time.

70. FSI I32 “number of bankruptcy proceedings initiated” is dropped. The comparability of this indicator is limited as it is influenced by the quality and nature of national bankruptcy and related legislation along with the size of the financial system, all of which may vary significantly across countries.18

71. FSI I31 “Net foreign exchange exposures to equity” is dropped. This indicator is only reported by a very small number of reporters—it is the least reported FSI.

B. Changes to FSIs for HHs

72. Despite becoming an increasingly important sector, the reporting rate of the FSIs for HHs has been low. In particular, FSI I34 (“Household debt service and principal payments to income”) has a very low rate of reporting, which can be largely attributed to the limitations faced by many national compilers in collecting household data outside the banking sector, as they lack the legal authority to request information.

73. Against this backdrop, the following additions and revisions are made to FSIs for HHs:

  • HH debt to gross disposable income of HHs is a new indicator intended to assess debt sustainability of the HHs sector. Countries are encouraged to compile the numerator using national accounts data. A growing or high ratio may signal vulnerabilities. This indicator should be analyzed together with the current I33 and I34.

  • For the current I33 (HH debt to GDP), countries are encouraged to compile the numerator using the national accounts data, which provide a broader coverage of HH debt. Countries that do not have HH debt data from national accounts sources, may use data from banking sector sources for the numerator and indicate so in the metadata.

  • For the current I34 (HH debt service and principal payments to income), countries are encouraged to compile the ratio using available data from national accounts sources. Countries that do not have data on the numerator (debt service and principal payments) from national accounts sources, may use data from banking sector sources for the numerator and indicate so in the metadata.

74. The FSIRG also suggested adding “HH equity to HH real estate value,” and “mortgage loan to home value.” However, these indicators will not be introduced at this stage as discussed below.

  • “HH equity to HH real estate value,” HH equity would be defined as the HHs’ current real estate market value less the value of HHs’ outstanding mortgage loans. Although this indicator may provide useful information on HHs’ and DTs’ exposure to real estate market, it may not be feasible for most countries to compile at this stage, as compilation of such data at the sectoral level may prove very costly. In addition, several factors may affect the reliability of the measurement and cross-country comparability of the indicator, such as how the HH equity is measured for the whole economy, in particular in countries where there is lack of active secondary housing markets. Moreover, the indicator could be difficult to interpret. As house prices rise HHs would have more equity thus may borrow more, so risks would rise. However, it is not evident in the indicator because the ratio may be little changed or unchanged even though HHs are leveraging up. Nevertheless, countries that have sufficient source data for compiling such indicator are encouraged to do so for their own analysis and dissemination.

  • “Mortgage loan to home value” indicator is used as a macro-prudential policy tool to reduce leverage in the real estate market in an increasing number of countries. This FSI would allow policy makers to monitor trends in this leverage and could be calculated by using new mortgage loans granted during a reference period as the numerator and the house value as the denominator. However, its compilation at the sectoral level may be costly and not be feasible for most countries. Importantly, it is a partial indicator, an average that might be hard to interpret, particularly if it is volatile from period to period as a consequence of a changing mix of properties purchased, and is unlikely to be comparable across countries. Thus, household debt to GDP FSI is considered a more comprehensive and reliable measure of rising household debt, and should be encouraged along with the development of data on nonfinancial assets of the household sector within the sectoral accounts. Nevertheless, national compilers that have sufficient source data are encouraged to compile a mortgage loan to home value FSI for their own analysis and dissemination.

C. FSIs for Real Estate Markets

75. For macroprudential analysis, it is highly desirable to have indices of real estate prices, because DTs may have large exposures (both direct and indirect) to the real estate market. Hence, they may be affected by the potential volatility of real estate price movements. At the same time, it is important to monitor DTs’ portfolio concentration on real-estate lending as DTs’ direct exposure to risks may arise from such lending.

76. The current set of FSIs includes, in the additional set of FSIs, four indicators for real estate market as follows:

  • I37—Residential real estate price index;

  • I38—Commercial real estate price index;

  • I39—Residential real estate loans to total loans; and

  • I40—Commercial real estate loans to total loans.

77. Regarding I37 and I38, the FSIRG reaffirmed their importance while noting compilation difficulties. Concerns were also expressed about the quality of these indicators given that in many countries real estate price indices are produced not by an official statistical agency but by commercial sources.

78. In the context of the G-20 DGI (Recommendation no. 19), a Handbook on Residential Property Price Indices (RPPI) has been published, Inter-Secretariat Working Group on Price Statistics, chaired by EUROSTAT.19 The RPPI Handbook provides guidelines on RPPI compilation to foster the development of homogeneous real estate statistics. The BIS has been collecting data on the RPPI from 48 countries, and these data (with various frequencies) are available on the BIS website. As of end-July 2013, 29 countries report I37 (residential real estate price index) to the IMF, of which 26 countries are BIS RPPI reporters.

79. Work has also commenced on the development of a Handbook on Commercial Property Price Indices (CPPI) to address statistical issues related to commercial estate prices. The CPPI Handbook is expected to be published by the end of 2015.

80. The current FSIs for real estate market will be retained as they remain useful for monitoring broad developments in real estate markets and for macroprudential analysis. Furthermore, the RPPI will become a core indicator, and the other three real estate indicators should remain in the additional set.

References

Appendix I.

FSIRG Composition

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Appendix II.

FSI Courses, Workshops, and Seminars, 2007–13

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Appendix III.

FSI-Reporting Countries and Data Coverage

(As of July 31, 2013)

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Appendix IV.

Frequency of FSI Reporting to the IMF

(In number of reporting countries1)

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Source: IMF Statistics Department

For July 2011 the number of FSIs reporters was 63. For July 2013 the number of FSIs reporters was 80.

“Other” refers to indicators reported only once.

Appendix V.

Current FSI List

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Appendix VI.

Changes to the Current FSI List

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1

BIS, 2011, p. 2, Para. 9.

2

The 1.25 percent of risk-weighted assets applies (both in Basel II and Basel III) only to those assets calculated under the standardized approach. Lower limits apply to assets under the internal ratings-based approach.

3

Tier 3 capital is used to support market risk, including foreign exchange risk and commodities risk. For short-term subordinated debt to be eligible as Tier 3, it needs, if circumstances demand, to be capable of becoming part of a bank’s permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum: be unsecured, subordinated, and fully paid up; have an original maturity of at least two years; not be repayable before the agreed repayment date unless the supervisory authority agrees; and be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement. BIS, January 1996, p. 7-8, Para. 2

4

Bank level disclosure of the leverage ratio and its components will start in January 2015.

5

This Box was prepared by Ethan Weisman and Yoko Shinagawa.

6

See www.imf.org/external/np/pp/eng/2012/013112.pdf. In March 2010, in line with the G-20 Data Gaps Initiative, the IMF Executive Board discussed how to broaden financial indicators in the SDDS, including FSIs (see http://www.imf.org/external/np/pp/eng/2010/022210A.pdf).

8

For the leverage ratio, the monitoring period began on January 2011. The parallel run period will start on January 2013 and will run until January 2017. The disclosure period at bank level will start in January 2015. The Basel Committee will test a minimum Tier 1 leverage of 3 percent during the parallel period from January 1, 2013 to January 1, 2017. The BCBS is also conducting a quantitative impact study (QIS) on the Basel III framework which is focused on changes to bank capital ratios under the new capital and liquidity requirements. The QIS results are available for June 2011, December 2011 and June 2012. A BCBS progress report on Basel III implementation was published in April 2013.

9

See paragraph 26 above for more details.

10

Loans to the public non-financial corporates are not included, as those corporates are not a part of the private sector.

11

Supervisory deductions apply to each component of the Total Regulatory Capital.

12

In preparing FSI proposals for OFCs, IMF staff consulted bilaterally with the Bank for International Settlements (BIS), European Central Bank (ECB), Financial Stability Board, International Association of Insurance Supervisors (IAIS), and the International Organization of Securities Commissions (IOSCO).

13

New FSIs for ICs were discussed and agreed with the IAIS Secretariat in January 2013.

14

Regarding I30, the FSIRG’s views differed on: (i) what would be the drawbacks of redefining I30 as “earnings to interest expenses” from “earnings to interest and principal expenses;” and (ii) whether the redefined indicator would be simpler and more meaningful. Some participants from countries where data on principal expenses are not available favored the redefined I30 (“earnings to interest expenses”). Other participants preferred the indicator as it is now (“earnings to interest and principal expenses”). Several participants also proposed alternative indicators, such as “earnings to short-term liabilities” or “NFC debt to GDP.”

15

The FSI Guide defines “liquid assets” as currency and deposits, with a broader measure including securities traded in liquid markets (paragraphs 4.78-4.80).

16

The current ratio is defined as a ratio of current (or short-term) assets to current (or short-term) liabilities. The current ratio is a commonly used liquidity measure in financial/investment analysis that evaluate the company’s ability to pay short-term obligations.

17

If data on “external debt to equity” is available, “domestic debt to equity” is a residual. Likewise, if data on “foreign currency debt to equity” is available, “domestic currency debt to equity” is a residual.

18

This indicator could be useful at national level for various types of analytical work, such as, trend analysis. Countries would be encouraged to compile and disseminate time series of this indicator at the national level if it is considered analytically useful.

20

The Government of Japan, through the Administered Account for Selected Fund Activities—Japan

21

LCR wil replace this indicator, when Basel III will be fully adopted (see paragraph 35).

22

Basel III leverage ratio will be introduced when the BCBG informs national supervisors to start monitoring this ratio (see paragraph 31).

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Cover Policy Papers
Modifications to the Current List of Financial Soundness Indicators - Background Paper
Author:
International Monetary Fund
Volume/Issue:
Volume 2013: Issue 092
Publisher:
International Monetary Fund
ISBN:
9781498341080
ISSN:
2663-3493
Pages:
47
DOI:
https://doi.org/10.5089/9781498341080.007