1 Systemic Surveillance and the Use of Macro Prudential Indicators Mariano Cortés IMF Monetary and Capital Markets Department World Bank/International Monetary Fund/Federal Reserve System Seminar for Senior Bank Supervisors from Emerging Economies October 23, 2008
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Systemic Surveillance and the Use of Macro Prudential Indicators
Mariano Cortés
IMF
Monetary and Capital Markets Department
World Bank/International Monetary Fund/Federal Reserve SystemSeminar for Senior Bank Supervisors from Emerging Economies
October 23, 2008
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Agenda I. What is macro-financial system surveillance
(MFSS) and why should we care?
II. The building blocks of MFSS
III. Financial Soundness Indicators and MFSS
IV. The crisis and the analysis of FSIs
Liquidity
Capital
V. Combining FSIs and market indicators
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Agenda
I. What is macro-financial system surveillance (MFSS) and why should we care?
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What is macro-financial system surveillance?
It is the process of identifying strengths and vulnerabilities in countries’ financial systems so that, if necessary, actions could be taken in a timely and informed manner to prevent crises from occurring.
In other words, it is a methodology that aims to preserve systemic financial stability.
Note that the focus is the system and therefore the contained failure of individual institutions are not ruled out; it is a “top-down” approach.
The health of individual institutions is the focus of micro-prudential surveillance (e.g., supervision); it is a “bottoms-up” approach.
The environment (e.g., macroeconomic, regulatory, legal) in which financial systems operate is key for assessing sources of risks and incentives
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Why we should care about macro-financial system surveillance
The macroeconomic impact of financial sector weaknesses, and most certainly crises, include…
Negative effects on growth
through credit and capital misallocation
More pronounced business cycles—
reluctance to lend
prone to disorderly de-leveraging in downturns (i.e., credit crunch and contagion to other financial institutions)
Possible cross-border contagion
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Why we should care about macro-financial system surveillance (continued)
Monetary policy implementation is made more difficult
bank responses to interest rate policy changes are less predictable,
concerns over the health of banks may limit the scope for policyaction
Negative fiscal consequences
potentially large build-up of debt to support/resolve banks and to recapitalize the central bank
build-up of contingent liabilities in the form of guarantees of deposits and credits
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Why we should care about macro-financial system surveillance (final)
Large fiscal costs of financial system crises
222001-3Argentina
CostYearCountryCostYearCountryCrisis cost in percent of GDPCrisis cost in percent of GDP
The building blocks of macro-financial system surveillance
Assessment of macroeconomic developments with a potential bearing on the soundness of the financial system
e.g., risk of sudden stop triggering an exchange rate correction with adverse impact on banks, households, and corporations with large un-hedged liabilities
Assessment of the strength and vulnerabilities of financial institutions and the system
Assessment of financial sector linkages back to the real economy
e.g., following an adverse shock, weak banks become de-capitalized and trigger a credit-crunch with serious adverse consequences on economic activity
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Financial Systems—Strengths and Vulnerabilities: Assessments Tools
A range of tools is deployed, including:
Review of FSIs and other balance sheet, income, and expenditure aggregates; review of market indicators
Stress testing and scenario analysis
Assessment of regulatory and supervisory frameworks (e.g., compliance with prudential standards--BCPs)
Assessment of financial system safety nets (e.g., deposit insurance, LOLR facilities)
Assessment of markets (e.g., money and T-bills) and their infrastructure (e.g., payment and securities settlement systems)
Crisis management arrangements (e.g., bank resolution framework)
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Tools—Stress Testing and Scenario AnalysisStress testing is a range of techniques used to assess the vulnerability of the financial system to exceptional but plausible shocks.
Stress tests impose a coherent structure in which to discuss risks and can add rigor to systemic analyses.
Stress test were originally developed for use at the level of portfolios and for individual institutions.
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Tools—Stress Testing and Scenario Analysis (continue)
Stress tests attempt to
combine a forward-looking macroeconomic perspective
with an assessment of the sensitivity of financial institutions to major shocks in the economic and financial environment.
The system-wide nature does not imply that the tests should be performed only on aggregate data
Aggregate data can disguise substantial exposures and risk concentrations at the institutional level that would be netted out through aggregation
It is therefore important to perform stress tests on an institution-by-institution basis as much as possible
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Tools—Stress Testing (continue)Stress tests should be tailored to:
country-specific circumstances
complexity of the financial system
data availability.
Stress testing balance-sheet positions only can be misleading because:
off-balance-sheet positions can quantitatively and qualitatively alter on-balance-sheet exposures.
it may not be clear where market and credit risks ultimately reside—credit risk derivatives or contingent liabilities.
off-balance-sheet funding vehicles (conduits and SIVs) can also be sources of vulnerabilities.
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Tools—Stress Testing (final)
Three main types of stress tests:
Single-factor sensitivity analysis—to identify how portfolios respond to changes in relevant economic variables such as interest rates, exchange rates, and equity prices;
Scenario analysis (model-based simultaneous moves in a group of risk factors)—to assess the resilience of financial institutions and the financial system to exceptional events;
Contagion analysis—to take account of the transmission of shocks from individual institutions to the financial system as awhole.
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MFS and the FSAPThe IMF and the World Bank undertake comprehensive assessments of member countries financial systems through the jointly run FSAP program
The program was launched in 1999 as part of the international community’s efforts to strengthen the global financial architecture
Today, some 126 countries/currency unions have undergone initialassessments, of which 46 have already undertaken at least one update assessment
Going forward, the Fund is likely to step up its financial stability assessment work
Focus on implementation of FSF recommendations
Should the FSAP be mandatory?
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Agenda
III. Financial Soundness Indicators and MFSS
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What are financial soundness indicators (FSIs)?
• FSIs mainly aggregate bank-level supervisory data
Needed to assess risks to the financial system as a whole
• FSIs complement supervisory indicators for a bank
The later help assess risks at the individual bank level (e.g. CAMEL)
• Aggregation reveals risks missed at micro level
• FSIs are a subset of the much broader group macro-prudential indicators (e.g., debt/GDP, international reserves)
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FSIs must be used with other indicators
Financial market data, early warning indicators, macro forecasts & data
4. Feedback mechanism: from financial sector to the real economy, which could portend more problems for the financial sector from a deeper macro downturn (2nd
round effects on the FS balance sheets)
5. crisis
Focus ofsurveillance using FSIs
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Types of FSIs• Core FSIs (12)
• FSIs essential to surveillance
• Covers banking sector which is important in every country
• Can be compiled by many countries with existing data
• Encouraged FSIs (28)
• Are relevant to some countries depending on need
• May require additional analytic work
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Core FSIs—bank sectorRegulatory capital ratios• Regulatory capital/RWAs• Tier 1 capital/RWAs• (NPLs-provisions)/capitalAsset quality• NPLs/total loans• Sector exposure concentrationsEarnings and profitability• ROE, ROA, Expense ratio• Interest margin/gross incomeLiquidity• Liquid asset ratio• Liquid assets/short term liabilitiesMarket risk• FX net open position/capital
Core concept is source of control • For domestic-controlled banks
Banks must rely on domestic resources in a crisis & country bares cost
Supervision and policy options based on domestic control
however …
• Consolidation must be cross-border to capture risk abroad
Thus, domestic banks’ subsidiaries and branches abroad are captured in home country FSIs
Failure to do this leads to miss-measurement of exposure and capital
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FSIs and foreign-owned banks• Compile FSIs for subsidiaries of foreign-owned banks separately
Gives coverage of all domestically incorporated banks
• Risk depends on extent of parent bank support—two cases
Weak parents that may not give support, so subsidiaries treated as locals
Strong parent typically support subsidiaries in a crisis
Reflects concern about reputation risk by large global banks
Consolidate branches and subsidiaries with foreign parent by country
Use those banks’ home country FSIs to assess risk
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Foreign banks pose capital account risk• Risks different when strong foreign banks dominate system
Parent almost always supports subsidiary to protect reputation
• Risks to financial stability come from impact on capital flows
Banks provide external financing to fund credit growth
When risks materialize, banks could stop financing and repatriate funds
Risk depends on exchange rate regime—fixed or managed
Risk of contagion if banks follow same strategy in region
Focus on share of CAB financing due to bank-intermediated flows
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FSIs and stress testing• Stress testing gives forward-looking perspective, combining
potential macro shocks (large but plausible)
vulnerabilities identified using FSIs to assess risk
• Shocks are applied to individual bank balance sheets and P&L accounts
bank-by-bank results aggregated by peer group
aggregation is identical to that used to compile FSIs peer groups
• Baseline of stress test is existing FSIs
• Output of stress test is changes in FSIs due to shock
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Other Ratios needed FSIs needed
0.013
earning /assets (ROA)
0.5520.4940.0330.0690.1160.065
RWA/ assets
Loans/ assets
Provisions/ loans
Capital/ assets
Regulatory capital/RWA
NPL/ loans
Italian banking system ratios
Mapping FSIs into stress test
0.087-0.00960.0975
Regulatory capital/RWA
earning /assets (ROA)
NPL/ loans
Italy: Impact of a 50% increase in NPL ratio on
FSIs
Calculations (back of envelope)
∆NPL/L = New provisions/L
New provisions/L = ∆Earnings/L
∆Earnings/L = ∆Capital/L
∆Capital/L • L/A • A/RWA= ∆Capital/RWA
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Agenda
IV. Lessons from the crisis for the analysis of FSIs
• Liquidity
• Capital
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More focus on liquidity risk
Liquidity shortages were a key feature of financial crises
“A remarkable feature of the last 40 years is the degree to which attention… has swung from concerns about liquidity to a concentration on capital requirement. In my view this pendulum has swung too far.”
Charles Goodhart, Per Jacobsson Lecture, BIS
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Liquidity risk Originates in maturity transformation: a core bank function
Banks are opaque, creating counterparty risk
In crisis, refinancing risk not bankruptcy was key concern
Interbank market is a channel of contagion
Uncertainty that repayment failure could trigger others
• Banks face liquidity risk in securities market
Crisis highlighted role of mark-to-market pricing in these markets
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Liquidity FSIs show vulnerability to a liquidity crisis
• Liquidity ratio (liquid assets/total assets)
Indicates balance sheet shrinkage the system can absorb
Identifies the point when illiquid assets must start to be sold (at a loss)
Broad or narrow measures reflect liquidity in different securities markets,
but it could overstate liquidity in a crisis.
• Liquid assets/short term liabilities
Liquid assets relative to liabilities that can be withdrawn quickly
40%Dollarization ratio: FX loans/loans2.5%∆private sector credit/∆nominal GDP
0ROA4%NPL/Loans10%Capital adequacy ratio
Threshold for ratings FSI/Indicator
• These are illustrative, have changed and may differ by region/country
• Thresholds for credit growth from econometric crisis prediction model
• Accounting rules affect threshold from supervisors (e.g. NPLs, CARs)
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IMF: uses 6 types of market indicators
Monetary and financial conditions
Risk appetite
Macroeconomic risks
Emerging market risks
Credit risk
Market risk
Conditions and Risks Changes since April 2008 GFSR
Monetary and Financial Conditions ↓G-7 real short rates ↔G-3 excess liquidity ↓Financial conditions index ↓Growth in custodial reserve holdings ↑G-3 lending conditions ↓
Risk Appetite ↓Investor survey of risk appetite ↓Investor confidence index ↔Emerging market fund flows ↓Risk aversion index ↓
Macroeconomic Risks ↑World Economic Outlook global growth risks ↔G-3 confidence indices ↑Economic surprise index ↓OECD leading indicator ↑Implied global trade growth ↑Global breakeven inflation rates ↓
Credit Risks ↑Global corporate bond index spread ↑Credit quality composition of corporate bond index ↑Speculative-grade corporate default rate forecast ↑Banking stability index ↔Loan delinquencies ↑
Market Risks ↑↑Hedge fund estimated leverage ↓Net non-commercial positions in futures markets ↔Common component of asset returns ↑World implied equity risk premia ↓Composite volatility measure ↑Financial market liquidity index ↑
Source: IMF staff estimates.
Table 1.6. Changes in Risks and Conditions Since the April 2008 Global Financial Stability Report
Note: Changes are defined for each risk/condition such that ↑ signifies higher risk, easier monetary and financial condition, or greater risk appetite, and ↓ signifies the converse; ↔ indicates no appreciable change. The number of arrows for the six overall conditions and risks correspond to moves on the global financial stability map.
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April 2008 GFSROctober 2008 GFSRApril 2008 GFSROctober 2008 GFSR
Credit risksEmerging market risks
Market andliquidity risks
Macroeconomic risks
Monetary and financial Risk appetite
Conditions
Risks
Figure 1.1. Global Financial Stability Map
Source: IMF staff estimates.Note: Closer to center signifies less risk, tighter monetary and financial conditions, or reduced risk appetite.
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Monetary and financial indicators
-2
0
2
4
6
8
10
12
1991 1993 1995 1997 1999 2001 2003 2005 2007
G-7 Real Short-Term Interest Rate1
(In percent, GDP-weighted average)
Sources: Bloomberg L.P.; and IMF staff estimates. 1Canada and the United Kingdom are included in the compsoite but not shown separately.
Euro area
Japan
United StatesComposite
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Monetary and financial indicators
-20
-10
0
10
20
30
40
50
60
70
80
1991 1993 1995 1997 1999 2001 2003 2005 2007-90
-80
-70
-60
-50
-40
-30
-20
-10
0G-3 Bank Lending Conditions1
(Net percentage of domestic respondents tightening standards for loans)
Tighter lending conditions
Sources: Lending surveys by Bank of Japan, European Central Bank, and Federal Reserve Board for households and corporates; and IMF staff estimates.1Monthly-interpolated GDP-weighted average. Euro area 1999:Q1 to 2002:Q4 based on values implied by credit growth.
Japan(right scale)
Euro area
United States
Composite
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Risk appetite indicatorsMerrill Lynch Fund Manager Survey(Net percent of investors reporting higher risk-taking than benchmark)
Sources: Credit Suisse; JPMorgan Chase & Co;, and IMF staff estimates.Note: JPMorgan Emerging Market Bond Index Global and Credit Suisse Emerging Market Corporate Bond Index.
Sources: Federal Reserve; Mortgage Bankers Association; and IMF staff estimates.130-, 60-, and 90-day delinquencies for residential and commercial mortgages, and credit card loans in the United States.
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Credit risk indicators
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
Expected Number of Bank Defaults Given At Least One Bank Default(Among 15 selected banks)
Sources: Bloomberg L.P.; and IMF staff estimates.
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Credit risk indicators
0
2
4
6
8
10
12
14
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
Actual default rate
Forecast default rate
Source: Moody's.
Moody's Speculative Grade Default Rates: Actual and 12-Month Forecast (In percent)
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Market risk indicators
0
100
200
300
400
500
600
Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
Funding and Market Liquidity Index(January 1996 = 100)
Sources: Bloomberg L.P.; and IMF staff estimates.Note: Based on the spread between yields on government securities and interbank rates, spread between term and overnight interbank rates, currency bid-ask spreads, and daily return-to-volume ratios of equity markets. A higher value indicates tighter market liquidity conditions.
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Market risk indicators
0.35
0.40
0.45
0.50
0.55
0.60
0.65
0.70
Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07
Sources: Bloomberg L.P.; JPMorgan Chase & Co.; and IMF staff estimates.
Estimated Common Component in Asset Class Returns(Share of variation in returns, 90-day moving average)
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Market risk indicatorsComposite Volatility Index(In standard deviations from the period average)
-2.0
-1.0
0.0
1.0
2.0
3.0
Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08Sources: Bloomberg L.P.; and IMF staff estimates.Note: Representing an average z-score of the implied volatility derived from options from stock market indices, interest, and exchange rates. A value of 0 indicates the average implied volatility across asset classes is in line with the period average (from 12/31/98 where data is available). Values of +/-1 indicate average implied volatility is one standard deviation above or below the period average.
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Concluding Thoughts• Use FSIs flexibly in combination with other indicators
• Obtaining FSIs is now easy relatively easy, the challenge is interpretation
• Assess data quality (incentives to misreport high in crisis)
• Use accounting linkages to consider simple stress scenarios
• Follow up with analysis of macro-financial linkages