Analysis of Financial Soundness Indicators

FSIs are used to monitor the financial system’s vulnerability to shocks and its capacity to absorb the resulting losses. Work on FSIs has produced a set of core FSIs and a set of encouraged FSIs (see chapter 2).6

• The core set of FSIs covers only the banking sector, thereby reflecting its central role. Those FSIs are considered essential for surveillance in virtually every financial system and, thus, serve as a small common set of FSIs across countries. Also, the data to compile those FSIs are generally available.

• The encouraged set of FSIs covers additional FSIs for the banking system and FSIs for key non-financial sectors because balance-sheet weaknesses in those sectors are a source of credit risk for banks and, thus, help detect banking sector vulnerabilities at an earlier stage. The encouraged set of FSIs are relevant in many, but not all, countries.

The choice of FSIs depends on the structure of a country’s financial system and data availability. Although the core set provides an initial prioritization, the choice should not be limited to this set. In bank-dominated systems, the core and some relevant encour­aged FSIs may be adequate. FSIs for other types of financial institutions may be needed if those institutions are systemically important. Of course, some countries may have other relevant indicators that are not included in the core or encouraged sets that may need to be monitored. In countries with well-developed markets, with information on key prices, spreads, and price volatility, other market information, including ratings, can be used as market-based indicators to monitor risks in individual sectors and institutions and to help assess the evolution of relative risks, thereby facilitating supervision and macroprudential surveillance (see box 3.1).

The analysis of FSIs typically involves examination of trends, comparison between relevant peer groups of countries and institutions, and disaggregation into various group­ings. Control is often an important criterion for disaggregation because it can indicate the sources of outside support that are potentially available to institutions in distress and thus can influence their vulnerability to bank runs, as well as their exposure to cross-border contagion.

Domestically controlled banks are overseen by a country’s central bank and supervisor and, in a crisis, would be recapitalized by the banks’ domestic owners or otherwise by the state. Within this peer group, public banks, which have a state guarantee, are typically distinguished from private banks, which may fail if losses exceed some minimum level of capital and consequently may be more prone to bank runs. Within the group of domesti­cally owned, private banks, internationally active banks may be grouped into a separate peer group because they are exposed to cross-border contagion. Those banks could entail

Box 3.1 Market-Based Indicators of Financial Soundness

 

Market-based indicators are among the key data sets used by macroprudential analysis, along with aggre­gated prudential data, macroeconomic data, stress tests, structural data, and qualitative information. They include market prices of financial instruments, indicators of excess yields, market volatility, credit ratings, and sovereign yield spreads.

The market-based indicators have a wide array of uses. In particular, market prices of financial instru­ments issued by financial institutions and their cor­porate counterparts can be used to assess financial soundness of the issuers. Sovereign yield spreads are commonly watched indicators of country risk. Market price data from the stock, bond, derivatives, real estate, and other financial markets can be used to monitor sources of shocks to the financial sector. Indicators of market price volatility can help assess the market risk environment. Finally, sovereign rat­ings and ratings of financial institutions and other firms (as well as the accompanying analysis by the rating companies) are important sources of informa­tion to any analysis of vulnerabilities.3

Analysis of the market-based indicators comple­ments the analysis of aggregated microprudential data. The use of market-based indicators to moni­tor financial institutions’ soundness is based on the premise that market prices of financial institutions’ securities could reveal information about their con­ditions beyond that of balance-sheet data and other aggregated microprudential data. If this premise is true, then the market-based indicators can usefully complement the FSIs, a majority of which—includ­ing all core FSIs—are based on aggregating financial institutions’ microprudential data. The key premise is that the asset prices contain information on market beliefs, which, in turn, contain information about the future. In particular, option prices reflect market beliefs about the future prices of the underlying assets. This information can be used to extract a probability distribution, including the probability of default.

An advantage of using market prices rather than prudential data is that the price data are generally available at high frequency. The advantage of equity and debt data is that they are frequent, which allows for more sophisticated analysis, such as the analysis of volatility and covariance. Also, although the accounting measures of risk (such as nonperforming loans [NPLs] and loan loss reserves) are essentially backward looking, market price data should provide a forward-looking assessment (e. g., Bongini, Laeven,

 

and Majnoni 2002; Gropp, Vesala, and Vulpes 2002). In addition, confidentiality is generally not an issue with market data, which should make it easier for independent analysts to obtain input data and for the results to be publicly shared and verified.

The quality of the market-based indicators depends on the extent and quality of the financial markets. For asset prices to contain useful information, it is important that the market be robust and transpar­ent. If it is not, then asset prices may be substantially affected by factors other than the financial health of the issuer or the underlying quality of the asset. In addition, the usefulness of market-based indicators to assess financial sector soundness may be limited if some financial institutions’ securities are not publicly traded or if their trading is limited (as may be the case, for instance, for government-owned banks or family-owned banks). Finally, if relevant informa­tion is not publicly disclosed (e. g., loan classification data that are not disclosed in some countries), but if that type of information is collected by supervisors, then prudential data can be superior to market-based indicators in measuring financial sector soundness. However, market-based indicators can still be use­ful in assessing the potential shocks to the financial institutions arising from or transmitted through financial markets.

Empirical studies show that market prices can be helpful in forecasting bank distress. For example, recent studies for the United States suggest that sub­ordinated yields explain not only bank rating chang­es but also regulatory capital ratios (Evanoff and Wall 2001), that equity prices provide useful information on bank failure (Gunther, Levonian, and Moore 2001), and that both equity prices and bond yields explain ratings (Krainer and Lopez 2003).

However, early warning systems that combine market information with other data tend to perform better than the nonmodel market-based indicators. Berg and Borensztein (2004) find that “market views,” as expressed in spreads, ratings, and surveys, are not reliable crisis predictors, important as they may be in determining market access. They find that early warning system models, which combine a range of indicators, have outperformed purely market-based measures of vulnerability such as bond spreads and credit ratings. Their study was focused on predicting currency crises, but there is even less evidence about the market indicators’ efficiency in predicting banking sector crises.

 

a. When assigning ratings, rating companies typically use a range of analytical approaches and data, including available prudential indicators. Nonetheless, ratings are classified as market-based indicators, thus recognizing that they are produced mainly for use by market participants.

 

significant risk exposure through their foreign branches and subsidiaries. FSIs should include the activities of those foreign branches and subsidiaries, even though the latter are not part of the domestic activity, because they are a source of risk to the banking system.

For the domestic branches and subsidiaries of foreign-controlled banks, support in a crisis can be expected to come in the first instance from their foreign owners. This type of support may be based (a) on the foreign bank’s legal obligation, which generally extends to branches but not to subsidiaries abroad; (b) on broader reputation or operating con­cerns, which may lead the foreign bank to support its subsidiaries abroad in a crisis; or (c) both of those elements. At the same time, FSIs of the foreign parent banks may also deserve examination because the soundness of the parent bank would influence not only the potential for support to its subsidiaries but also the risk of contagion. Those FSIs are typically produced by the home country of the parent bank. When foreign-controlled deposit-takers play a significant role in the financial system, separate FSIs may need to be compiled for the local subsidiaries of those deposit-takers.

Quantitative information on the structure, ownership, and degree of concentration of the financial system helps to set priorities for analyzing FSIs while also providing a basis for the identification of structural issues and developmental needs. This information indicates the relative importance of different types of financial institutions (e. g., banks, securities companies, insurance companies, pension funds); the relative importance of dif­ferent types of ownership (private, public, foreign); and the concentration of ownership. It provides a basic understanding of the main components of the sector and its degree of diversification (see chapters 2 and 4 for a further discussion of financial structure and its determinants).

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