Knowldege Sharing Program on Financial Soundness/Stability Indicators

1. By Trilochan Pangeni Executive Director Office of the Governor Nepal Rastra Bank Knowldege Sharing Program on Financial Soundness/Stability Indicators

2. Financial System Stability Resembles: Principal component (Institution Market and Infrastructure) of the System are Jointly capable of absorbing adverse disturbances. Financial System facilitates a smooth and efficient allocation of financial resources from savers to investors. Financial risks are priced and assessed reasonably. Risks are efficiently managed. What is Financial Soundness or Stability?

3. Financial Stability It is undeniable an important concept that policy makers aim to strive for the term denote different meanings to different commentators on the topic. It is convenient & useful to analyze financial stability based on its negative counterpart financial instability. It is easier to identify situations of financial instability and their possible causes. What is Financial Soundness or Stability? Contd.

4. Costs of Financial Crisis (Hoggarth et al 2001)

5. Financial stability is precondition for monetarystability • payments system • transmission mechanism • efficient allocation of credit Price stability Macroeconomic balance Financial Market Stability Monetary Policy Transmission Mechanism Healthy Banking Sector Robust Payment System Institutional & regulatory framework Implementation of Monetary Policy

6. Financial Crises of 1990s promoted the search for financial system soundness. This calls for devising and using an appropriate and effective monitoring and policy formulation system for detecting and addressing vulnerabilities leading to instability. IMF and World Bank have promoted the measurement and use of Financial Soundness Indicators (Compilation guide to financial Soundness Indicators 2004) Search for Financial Soundness

7. Central Banks and Financial Supervisory agencies prepare and publish the financial soundness indicators. Wide coverage that capturing a range of factors that may pose risk to the Financial System. Financial Indicators are useful tools for comparison within country across time and between countries. Time series data on financial soundness indicators are quite limited. Search for Financial Soundness

8. Financial Soundness Indicators are used to : Monitor soundness of financial system Assess systemic risks How they are used? Identify main sector vulnerability Assess capacity of the system to absorb lossess Target assessments and baseline for the stress testing Use of Financial Soundness/Stability Indicators

9. Financial soundness indicators are constructed from the data of : Balance sheet and income statement of different banks and financial institutions. Information on ownership structure of Banks and Financial Institutions. Information on inter linkages among Banks and Financial Institutions. Financial Soundness/Stability Indicators

10. Some Economic theories of Financial Instability might be relevant foundation for analysis of trends in Financial Sector, Microeconomic Theories Bank Panic: Liquidity Crises: sound bank can become insolvent, Asymmetric Information: Non optimal allocation of Resources, Adverse selection and moral hazard, Governance issue, Financial Soundness/Stability Indicators

11. Macroeconomic Theory Debt and price bubbles Inflation, Exchange rate Debt and corporate balancesheet deterioration Balance of Payment Crisis Industrial Economic Approach Growing competition induced by liberalization Lack of Market Regulation & Supervision Financial Soundness/Stability Indicators

12. Financial Soundness/Stability Indicators • Post-Keynesian theory – Minisky’s Financial Instability Hypothesis (FIH) • According to FIH, economic agents in the market economy tends to move from Hedge Speculation Ponzi situation, then bust. • Normally, even during tranquility and boom phase, such a transformation occurs which leads to financial fragility. • Regulators should check such a development.

13. Table A: Measures of financial instability based on banking crises

14. Table B: Determinants of banking crises

15. Table B: Determinants of banking crises

16. Table B: Determinants of banking crises

17. Table B: Determinants of banking crises

18. Type of Financial Soundness Indicators Core Indicators Encouraged Indicators Other Indicators Core Indicators Capital Adequacy Regulatory Capital/risk weighted assets Regulatory tier 1 capital/risk weighted assets Assets Quality Non performing loans/total gross loans Non performing loans net of Provision/Capital Sectoral Distribution of loans/total loans Large exposures/capital Financial Soundness/Stability Indicators

19. Earnings and Profitability ROA, ROE Interest margin/gross income Non interest expenses/gross income Liquidity Liquid Assets/total assets Liquid Assets/short-term liabilities Sensitivity to market risk Maturity mismatches: Duration Assets Vs Liabilities Foreign Exchange net open position/capital Financial Soundness/Stability Indicators

20. Encouraged Indicators (Other banking sectors FSIs) Capital/Total Assets Large Exposure to capital Geographical distribution of loans/Total loans Gross Asset position in financial derivative to capital Interest spread between reference lending and deposit rates Interest spread of Inter Bank Rate Customer Deposit/Total loans Financial Soundness/Stability Indicators

21. Encouraged Indicators (Other banking sectors FSIs) FX loans/total loans FX liabilities/total liabilities Household Sector Total debt /equity ratio Return on equity Asset/GDP Household debt/GDP Household debt service and principal payments to income Market Liquidity Average bid/Ask spread in security market Real State Real estate price Residential and non residential loans to total loans Financial Soundness/Stability Indicators

22. Other Indicators (Macroeconomic Indicators) With regard to financial stability it is relevant to consider macroeconomic indicators such as: Economic growth (e.g. aggregated growth rates and possible crises in certain sectors). Inflation (e.g. shift in inflation level) Development in interest rates (e.g. the development in the level of interest rates in general and development in real interest rates). Financial Soundness/Stability Indicators

23. Development in stock prices (e.g. assessment of whether there are bubbles in the stock market, and assessment of the stock markets with which the market is correlated). Balance of payments (e.g. external debts and the composition and maturity of capital flows). Development in exchange rates. Financial Soundness/Stability Indicators

24. Risk Assessment with Financial Soundness Indicators Capital Adequacy: It indicates capacity to absorb losses. Tier 1 capital provides most protection Tier 2 capital (Tier 1 _ Subordinated debt, unrealized capital gains) gives less protection to creditors Valuation problems can cause over estimation of capital Financial Soundness/Stability Indicators

25. Asset Quality NPL/Loan = Is imperfect Measure may differ from bank's ex-ante internal assessment Tend to be lagging indicator (NPL-Provision)/Capital = Indicates additional provisions that need to be taken. Loan concentration = Positive vulnerability Financial Soundness/Stability Indicators

26. Asset Quality Banking sector liquidity Liquidity is a key source of systemic risk. Liquidity ratio (Liquid Assets/total assets) Assess the balance sheet shrinkage, the system can absorb before selling assets at fire sale prices Liquid Assets/Short-term Liabilities - Assess potential scale of bank run and assets available to cover losses. Market Liquidity Indicates liquidity of markets which bank assets are traded and banks' capacity to obtain liquidity by liquidating assets Financial Soundness/Stability Indicators

27. Key Challenges in using FSIs, Capital Adequacy: Assessing the level of risk with an indicator value Problems in detecting vulnerabilities at an early stage Peer group identification problem Improving data quality and comparability Financial Soundness/Stability Indicators

28. Key Challenges in using What are the critical channels of interaction between the macro-economy, financial markets and financial institutions? What is the role of the Financial sector per se in initiating amplifying or muting disturbances in the economy and transmitting such effects internationally? So Financial sector stability indicators must be made of a broader set of indicators. Financial Soundness/Stability Indicators

29. New Direction 1. Regarding Complex balance sheet linkages, there is no single widely accepted methodology for assessing financial sector stability. 2. One now needs to move towards Macro-prudential Indicators (MPI) which encompasses FSIs and other relevant information that can provide a broad picture of a country’s economic and financial condition. 3. FSIs are a special subset of MPIs that specifically monitor the health and soundness of financial institutions and markets, and their corporate and household counterparts. Financial Soundness/Stability Indicators

30. Thank you