Effect of Financial Soundness on Macroeconomic Developments

A key macrofinancial linkage that is important in almost all countries derives from the dependence of nonfinancial sectors on financing provided by banks.18 The potential effect

on macroeconomic conditions of banking soundness problems in the banking sector may be detected using FSIs compiled by local and foreign authorities. Data on nonfinancial sectors’ borrowing not only from the domestically controlled banking sector but also from foreign-controlled banks by country are needed for analysis. The data on the former are the same data used to compile the exposure concentration of FSIs. Data on borrowing by the nonfinancial private and government sectors from banks headquartered in BIS – reporting countries can be obtained from the BIS consolidated banking statistics.19 The coverage of the data is comprehensive because almost all international banking activity is conducted by internationally active banks from those countries. These BIS data indicate the scale of the potential reduction in financing to the domestic private and government sectors that could result from a deterioration in the soundness of the banking sector in that country.20 The prospects for this type of deterioration can be monitored by examining the FSIs for banking in each BIS reporting country.

An example of this type of macrofinancial linkage is trade finance. IMF (2003d) discusses this linkage in more detail, noting that during recent financial crises, the trade financing to the crisis countries fell dramatically (more sharply than would seem to be justified by fundamentals and risks involved). The paper attributes the decline to the response by banks as leveraged institutions, to the lack of insurance when it was needed, to herd behavior (among banks, official export credit agencies, and private insurers), and to weaknesses in domestic banking systems. Because bank-financed trade credits are typi­cally short-term, are backed by receivables, and are self-liquidating, their performance, transfer, and convertibility risks are considered lower than those for other cross-border lending. The loss of financing to the trade sector appears to have disrupted countries’ trade and growth performance, possibly exacerbating the crisis.

Macrofinancial linkages also derive from residents’ deposits and wealth placed with domestically owned and foreign-controlled financial institutions, which would be at risk in crises at home or abroad. The importance of this linkage depends on institutional fea­tures such as the extent to which the deposits are covered by domestic and foreign deposit insurance schemes. The linkage can be assessed using data on residents’ deposit holdings, which, in principle, need to cover both (a) deposits held within the country with domesti­cally owned banks or the local branches and subsidiaries of foreign banks and (b) deposits held abroad, either with domestic banks’ branches and subsidiaries abroad or with foreign banks (in both domestic and foreign currency). Data from monetary statistics typically capture the first but miss the second (which can be substantial, especially in dollarized economies). Some information on the latter can be obtained from international invest­ment position data and from the locational BIS international banking data.21 In this case too, FSIs monitor the soundness of the banking sector while the data on wealth placed with financial institutions give an indication of how much could be lost in the event of a banking crisis (taking into account the extent of protection provided by deposit insur­ance schemes).

Another linkage results from the effect of banking sector problems on the monetary policy transmission mechanism. Both the domestically owned banks and branches and the subsidiaries of foreign banks play a role in monetary transmission, so a deterioration in banking sector soundness, either domestically or abroad, could alter the effect of changes in monetary policy on the real economy. This linkage implies that it can be useful to ana-

lyze FSIs in combination with monetary data to understand how the effect of monetary policy could be affected by the soundness of the financial sector. The analysis would have to take account of financial structure, including the relative importance of market and bank financing, the role of foreign banks in financial intermediation, and the central bank operating procedures.

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