Annex 1.A Tailoring Financial Sector Assessment to Country Needs

Countries with less-developed financial systems may need more attention with respect to medium-term development issues such as institution building and financial market development. Coverage of the financial sector in those countries may thus need to focus on specific aspects of financial sector development, including capacity of banking super­vision; the legal and regulatory framework for bank and non-bank institutions and pay­ment systems; credit information systems, enforcement of creditor rights, and insolvency regimes; accounting and auditing practices and disclosure rules; the status of the central bank and monetary policy implementation; and bank restructuring. Also, an analysis of factors explaining why markets are missing can help to identify the important structural and capacity building needs for the country.

Systemically important countries need attention to contagion and cross-border issues. Countries particularly vulnerable to a rapid increase in competition from foreign financial institutions may need particular attention with respect to (a) the appropriate sequencing of liberalization, including institutional preconditions, and (b) the ability of domestic incumbents to withstand more intense competition. Of particular note are countries par­ticipating in new free-trade arrangements or undertaking substantive financial services commitments in the World Trade Organization. Those types of agreements may facilitate the cross-border provision of services or the establishment of subsidiaries and branches. Countries may commit to dispute settlement provisions and to constraints on their recourse to capital controls. In those cases, emphasis might be placed on (a) the capacity of the regulatory authorities to conduct cross-border consolidated supervision of financial institutions; (b) the conditions that might lead to an unsustainable buildup of short-term financial flows; (c) the dependence of local incumbents, including public service banks, on fee-based and large-customer business that may be particularly vulnerable to foreign competition; and (d) any systemic vulnerabilities that may result from their failure.

In many countries, dollarization poses unique financial risks that need to be addressed. Where available, assessors should provide supporting quantitative information such as shares of foreign currency deposits and loans, the degree of cocirculation, short-term foreign assets and liabilities of the main financial institutions, net foreign assets, and net open foreign currency positions of banks (Gulde and others 2003).

In non-crisis countries with significant financial distress where a large share of banks (or insurance companies or other financial institutions) are undercapitalized and under­performing, the assessors will have to focus on vulnerabilities to various plausible shocks and to resolution measures.2 Vulnerabilities could be detected through stress testing and estimation of likely macroeconomic consequences. In case a macroeconomic shock were to occur, sufficiently rapid financial restructuring could avert a crisis. This reasoning sug­gests that the focus of assessment should be on measures to restore normalcy and imple­mentation of resolution strategies, including contingency planning and structural reforms that could bolster the capacity for restructuring and liquidation of banks and non-banks. In cases such as those, FSIs would need to be carefully interpreted, possibly until excep­tional resolution arrangements have run their course and normalcy has been fully restored (Hoelscher and Quintyn 2003).

In countries that are part of a currency union, assessors would have to be sensitive to the division of supervisory responsibility between the national and the supranational level (Van Beek and others 2000). In particular, supervisory responsibilities for financial institutions may reside at the national level with varying degrees of harmonization of rules and practices such as loan classification and provisioning as well as licensing and other entry requirements. The degree of control over cross-border transactions in relation to third countries may also differ. By contrast, monetary-exchange rate policy functions in those cases are performed at the supranational level, creating the potential for ambiguities about lender of last resort and crisis resolution arrangements.

In countries with significant presence of Institutions offering Islamic Financial Services (IIFS), assessors would need to consider whether the supervisory framework is adequately adapted to address the specific risk characteristics of IIFS. Risks in IIFS may differ from those in conventional finance because of the contractual design of instruments based on Islamic Law (Sharia’a), and the overall infrastructure governing Islamic finance. In the absence of adequate institutional infrastructure and effective risk mitigation, IIFS may be more vulnerable than conventional institutions for a range of risks (operational, liquidity, and market risk—including commodity prices). Where available and appropriate, asses­sors should also provide quantitative information on the size of the industry; the share of Islamic modes of financing; and FSIs on capital, non-performing loans, provisioning, and earnings for Islamic banks. The definitions of those variables would need adjustments to reflect the specific accounting treatments of Islamic financial contracts. Although some guidance is available in the IMF’s Compilation Guide on Financial Soundness Indicators (International Monetary Fund 2004), work in this area is evolving.

Notes

1. For the purposes of the Handbook, a narrow definition of market integrity is used mainly to cover anti-money-laundering initiatives and efforts to counter the financ­ing of terrorism. A broader concept also will cover transparency and governance ele­ments.

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