II Indicators for Macroprudential Surveillance
- Paul Hilbers, Alfredo Leone, Mahinder Gill, and Owen Evens
- Published Date:
- April 2000
The ability to monitor financial soundness presupposes the existence of indicators that can be used as a basis for analyzing the current health and stability of the financial system. These macroprudential indicators comprise both aggregated microprudential indicators of the health of individual financial institutions, and macroeconomic variables associated with financial system soundness. Aggregated microprudential indicators are primarily contemporaneous or lagging indicators of soundness;4 macroeconomic variables can signal imbalances that affect financial systems and arc, therefore, leading indicators. Financial crises usually occur when both types of indicators point to vulnerabilities, that is, when financial institutions are weak and face macroeconomic shocks.
The indicators that are the focus of this paper are quantitative variables. The availability of these indicators alone is not sufficient to make an overall assessment of financial system soundness. Such assessments also depend on a broad range of elements that are not easily quantifiable. In particular, the adequacy of the institutional and regulatory frameworks governing the financial system significantly affects the system’s soundness. Elements include the structure of the financial system and markets; regulations regarding accounting and other standards, and disclosure requirements; loan classification, provisioning and income recognition rules, and other prudential regulations; the quality of supervision of financial institutions; the legal infrastructure (including in the areas of bankruptcy and foreclosure); incentive structures and safety nets; and liberalization and deregulation processes.
The importance of these qualitative elements calls for a high degree of experience in analyzing them, and an ability to couple the analysis of MPIs with informed judgment on the adequacy of the institutional and regulatory frameworks of individual countries.5 Although it may be possible to develop a reasonably clear picture of these elements in a given country fairly quickly, a deeper understanding of how well the financial system actually works is generally expected to develop only after careful observation over a period of time.
Because the relevance of individual indicators may vary from country to country, MPIs cannot be used mechanically.6 Rather, any assessment needs to be based on a comprehensive set of indicators, taking into account the overall structure and economic situation of a country and its financial system. In many instances, monitoring of indicators over time (an intertemporal comparison) can be more meaningful than comparisons across countries, due to differing accounting and prudential standards as well as differences in the structure of financial systems. Changes in regulations such as accounting and provisioning norms can, however, lead to breaks in time series.
Prudential indicators should be monitored not only for the (narrowly defined) banking system, but, if systemically relevant, for other financial institutions as well, including nonbank depository corporations (if they exist) and nondepository financial intermediaries.
A limited set of macroeconomic indicators that are considered most relevant for a particular country may be used for stress tests, to evaluate quantitatively the impact of large changes in those indicators on the portfolios of financial institutions, and on the aggregate solvency of the financial system. Using the IMF’s macroeconomic forecasts, and observing past relationships between macroeconomic and prudential indicators, it may also be possible, to some degree, to project likely future developments in prudential indicators.
A set of indicators that the IMF has identified through its financial sector surveillance, technical assistance, and program work over the years is described in Table 1. Background is provided on MPIs that have been used for monitoring the soundness of financial systems, along with discussion of the usefulness of these indicators. The MPIs are divided into two broad categories: (1) aggregated microprudential indicators; and (2) indicators of macroeconomic developments or exogenous shocks that could affect the financial system. Table 1 provides a comprehensive listing of the MPIs identified thus far.
|Aggregated Microprudential Indicators||Macroeconomic Indicators|
|Capital adequacy||Economic growth|
|Aggregate capital ratios||Aggregate growth rates|
|Frequency distribution of capital ratios||Sectoral slumps|
|Asset quality||Balance of payments|
|Lending institution||Current account deficit|
|Sectoral credit concentration||Foreign exchange reserve adequacy|
|Foreign currency-denominated lending||External debt (including maturity structure)|
|Nonperforming loans and provisions||Terms of trade|
|Loans to loss-making public sector entities||Composition and maturity of capital flows|
|Risk profile of assets||Inflation|
|Connected lending||volatility in inflation|
|Borrowing entity||interest and exchange rates|
|Debt-equity ratios||Volatility in interest and exchange rates|
|Corporate profitability||Level of domestic real interest rates|
|Other indicators of corporate conditions||Exchange rate sustainability|
|Household indebtedness||Exchange rate guarantees|
|Management soundness||Lending and asset price booms|
|Expense ratios||Lending booms|
|Earnings per employee||Asset price booms|
|Growth in the number of financial institutions||Contagion effects|
|Earnings and profitability||Trade spillovers|
|Return on assets||Financial market correlation|
|Return on equity||Other factors|
|Income and expense ratios||Directed lending and investment|
|Structural profitability indicators||Government recourse to the banking system|
|Arrears in the economy|
|Central bank credit to financial institutions|
|Segmentation of interbank rates|
|Deposits in relation to monetary aggregates|
|Maturity structure of assets and liabilities (liquid asset ratios)|
|Measures of secondary market liquidity|
|Sensitivity to market risk|
|Foreign exchange risk|
|Interest rate risk|
|Equity price risk|
|Commodity price risk|
|Market prices of financial instruments, including equity|
|Indicators of excess yields|
|Sovereign yield spreads|
Aggregated Microprudential Indicators
Indicators of the current health of the financial system are primarily derived by aggregating indicators of the health of individual financial institutions. One commonly used framework for analyzing the health of individual institutions is the so-called CAMELS framework, which involves the analysis of six groups of indicators reflecting the health of financial institutions:
- Capital adequacy,
- Asset quality,
- Management soundness,
- Liquidity, and
- Sensitivity to market risk.7
Indicators of market perceptions often supplement these indicators. Because the CAMELS categorization of indicators is helpful in analyzing the various possible areas of vulnerability, the discussion of system wide indicators in this chapter follows the same structure.
Capital Adequacy Indicators
Capital adequacy and availability ultimately determine the robustness of financial institutions to shocks to their balance sheets. Thus, it is useful to track capital adequacy ratios that take into account the most important financial risks—foreign exchange, credit, and interest rate risks—including risks involved in off-balance sheet operations, such as derivative positions.8
Aggregate Risk-Based Capital Ratios. The most commonly used indicator in this respect is the aggregate risk-based capital ratio (the ratio of capital to risk-adjusted assets). A declining trend in this ratio may signal increased risk exposure and possible capital adequacy problems. It is possible to estimate vulnerability based on average sectorwide capital adequacy ratios, but these may be misleading under some circumstances (see Section VI). In addition to adequacy, it may also be useful to monitor indicators of capital quality. In many countries, bank capital consists of different elements that have varying availability and capability to absorb losses, even within the broad categories of Tier 1, Tier 2, and Tier 3 capital.9 If these capital elements can be reported separately, they can serve as more reliable indicators of the ability of banks to withstand losses, and help in putting overall capital ratios into context.
Frequency Distribution of Capital Ratios. As an alternative to the use of aggregate capital ratios, it may be possible to build an aggregate view based on the analysis of the capital ratios of individual institutions, or groups of selected large institutions, such as the three largest banks. It may often be useful to focus on particular subgroups such as state-owned banks and previously intervened banks. Another way of avoiding problems of aggregation is to look at the number of banks (and their market share) with risk-based capital ratios below certain thresholds, such as the minimum required under international or domestic standards.10
Asset Quality Indicators
The reliability of capital ratios depends on the reliability of asset quality indicators. Risks to the solvency of financial institutions often derive from impairment of assets, so it is important to monitor indicators of asset quality. First, we deal with indicators that directly reflect the current state of credit portfolios; macroeconomic indicators that indirectly impact asset quality are outlined below. Indicators of asset quality need also to take into account credit risk assumed off-balance sheet via guarantees, contingent lending arrangements, and derivatives. In some countries, trust activities and operations of offshore banks also pose significant contingent risk and the indicators should, as much as possible, reflect consolidated information. Indicators of asset quality include indicators at the level of the lending institution, and indicators at the level of the borrowing institutions.
Indicators at the Level of the Lending Institution
Sectoral Credit Concentration. A large concentration of aggregate credit in a specific economic sector or activity, especially commercial properly, may signal an important vulnerability of the financial system to developments in this sector or activity. Many financial crises in the past (including the Asian crises) have been caused or amplified by downturns in particular sectors of the economy spilling over into the financial system via concentrated loan books of financial institutions. In practice, this has often been the case for concentration in real estate, which can be subject to severe boom and bust price cycles. Loan concentration can be dangerous in almost any sector of the economy, however, including commodities and certain export industries.
Foreign Currency-Denominated Lending. Several financial crises have been preceded by periods of fast growth of foreign currency-denominated credit to domestic firms that frequently lacked a stable source of foreign exchange revenues.11 These transactions shift the foreign exchange risk to final borrowers, but often imply a higher credit risk to the lenders.12
Nonperforming Loans. An increasing trend in the ratio of nonperforming loans to total loans signals a deterioration in the quality of credit portfolios and, consequently, in financial institutions’ cash flows, net income, and solvency.13 It is often helpful to supplement this information with information on non-performing loans net of provisions, and on the ratio of provisions plus interest suspension on impaired loans to total loans—particularly if impaired loans have not yet been classified as nonperforming.14 Although these indicators are primarily backward looking, reflecting past problems that have already been recognized, they can be useful indicators of the current health of the financial system, and are often used in connection with stress tests of financial institutions. Trends in nonperforming loans should be looked at in conjunction with information on recovery rates—for example, using the ratio of cash recoveries to total nonperforming loans. Such information points to the level of effort or the ability of financial institutions to cope with high nonperforming loan portfolios.
Loans Outstanding to Loss-Making Public Sector Entities (notably public enterprises or regional governments). The presence of such loans, which are often the result of past directed lending, may also signal significant credit risk. Depending on the country, loans to loss-making public enterprises or to regional governments may not be classified as nonperforming, even though they may not be repaid on a timely basis and/or in full.
Risk Profile of Assets (ratio of risk-weighted assets to total assets by weight category). A high ratio of investment in securities with low regulatory risk weights (such as bonds issued by governments of OECD member countries) to total assets usually indicates a conservative investment policy on the part of financial institutions. At the same time, it is often a reflection of the structure of the economy, and regulatory incentives that favor government financing in particular. In some instances, however, it might be an indication of trouble at some institutions that invest in securities with low risk weights because of capital adequacy problems.15
Connected Lending. A high ratio of connected lending to total loans indicates a concentration of credit risk on a small number of borrowers, that is, a lack of diversification. Lending to entities that form part of the same group as the financial institution itself is common in many countries, and can be indicative of deficiencies in credit analysis. Loans to entities of the same group are often easily approved (“pocket banks”), regardless of credit quality, and problems in these entities can spill over into the financial institution.16
Leverage Ratios. Financial institutions’ leverage—measured by the ratio of assets to capital—increases when bank assets grow at a faster rate than capital. For institutions that are primarily involved in lending activities, the ratio of loans to capital roughly approximates the leverage. It is the reverse of the capital adequacy ratio (a simplified version).17
Indicators at the Level of the Borrowing Entity
The quality of financial institutions’ loan portfolios is directly dependent upon the financial health and profitability of the institutions’ borrowers, especially the nonfinancial enterprise sector. Therefore, any analysis of asset quality needs to take into account indicators of the likelihood of borrowers to repay their loans.
Debt-Equity Ratios. Excessive corporate borrowing has often preceded periods of financial system distress. Thus it is important to monitor nonfinancial private sector leverage.18 Fast growth of corporate indebtedness—for example, at a rate higher than GDP growth—may be seen as a sign that banks’ credit screening procedures have been relaxed. It is important to monitor if the increase in corporate indebtedness is concentrated in sectors that are particularly vulnerable to shifts in economic activity, such as real estate, or to exogenous economic shocks, such as export industries.19
Corporate Sector Profitability. Sharp declines in corporate sector profitability, for example, as a result of economic deceleration, may serve as a leading indicator of financial system distress.20
Other Indicators of Corporate Conditions. Besides debt-equity ratios, several other indicators also provide information on corporate financial vulnerability. These include cash flow-based indicators such as the interest coverage ratio (the ratio of operating income to interest expenses), and composite indicators such as the Altman’s Z-score.21 Alternative indicators that could help assess the conditions of corporations and the implications for the banking system, include delays in payments, the trend in the currentness of loans to the largest borrowers, and frequency information on application for protection from creditors.22
Household Indebtedness. The quality of bank portfolios also depends on the condition of borrowers from the household sector. Information on the overall level of household indebtedness is useful in this context.
Management Soundness Indicators
Sound management is key to financial institutions’ performance. Indicators of the quality of management, however, are primarily applicable to individual institutions, and cannot be easily aggregated across the sector. Although aggregated indicators can be used, they are more likely to reflect financial sector structure and the country’s economic situation than management quality. Although several indicators can be used as proxies for the soundness of management, such evaluation is still primarily a qualitative exercise, particularly when it comes to the evaluation of the management of operational risk, that is, the functioning of internal control systems. This being said, the following indicators are sometimes used.
Expense Ratios. A high or increasing ratio of expenses to total revenues can indicate that financial institutions may not be operating efficiently. This can be, but is not necessarily due to management deficiencies. In any case, it is likely to negatively affect profitability.
Earnings per Employee. Similarly, low or decreasing earnings per employee can reflect inefficiencies as a result of overstuffing, with similar repercussions in terms of profitability.
Expansion in the Number of Financial Institutions. Another possible ratio of management soundness is the rate of expansion in the number of banks and other financial institutions. Whereas some expansion may reflect a healthy degree of competition, too rapid a rate of expansion may indicate lax licensing requirements, unsound management, and a gap in the supervisory capacity.
Earnings and Profitability Indicators
As chronically unprofitable financial institutions risk insolvency, it is important to follow indicators of profitability. Declining trends in those indicators may signal problems regarding the profitability of financial institutions. On the other hand, unusually high profitability may be a sign of excessive risk taking. The following (aggregate) ratios can serve as indicators of current financial sector profitability.
Return on Assets. The ratio of (net) profits to average total assets is one of the most commonly used measures of profitability. The ratio can be calculated with various profit measures, for example, before or after provisions, and before or after tax charges and (net) extraordinary items.23
Return on Equity. The ratio of (net) profits to average capital reflects the average return investors get from holding bank capital. The ratio has to be interpreted with caution, since a high ratio may indicate both high profitability as well as low capitalization, and a low ratio can mean low profitability as well as high capitalization. The usefulness of this ratio can be enhanced by employing different measures of capital, for example Tier 1 capital only versus total capital, and different measures of profits.
Income and Expense Ratios. In order to get a clearer picture of the sustainability of profits, and of the extent of risk-taking by financial institutions, it is useful to look at the sources of profitability such as (net) interest income, commissions, trading and foreign exchange results, and other operating income. Similarly, expense ratios can reveal sources of profitability problems. Expense ratios can be calculated on various kinds of expenses—staff expenses, administrative expenses, and other expenses.24 Ratios can be constructed by setting these against measures of total income and/or average total assets.
Structural Indicators. In addition to indicators of current profitability, there are a number of forward-looking indicators that are more geared toward medium- and long-term profitability. A narrow bank customer base, for example, may signal competitiveness problems of domestic institutions and their inability to foster financial deepening through a wider customer base. These problems have implications for financial system costs, margins, and profitability. The size of, and changes in interest rate spreads indicate whether institutions are operating in a favorable environment—and may signal the existence of oligopolistic financial market structures.
Initially solvent financial institutions may be driven toward closure because of poor management of short-term liquidity, so it is also important to monitor liquidity indicators. On the liability side, indicators should cover funding sources, including interbank and central bank credits. Liquidity indicators should also be able to capture large maturity mismatches in the largest financial institutions or in the overall financial sector.25
Central Bank Credit to Financial Institutions. A large increase in central bank credit to banks and other financial institutions—as a proportion of their capital or their liabilities—often reflects severe liquidity (and frequently also solvency) problems in the financial system.
Segmentation. A high dispersion in interbank rates may signal that some institutions are considered risky. Banks may also control their interbank positions by using quantitative controls, and high-risk institutions might be forced to engage in aggressive bidding for deposits. Changes in interbank credit limits or an unwillingness of some institutions to lend to other ones may indicate serious concerns. Very often, banks themselves first detect problems as they are exposed, or potentially exposed, to troubled institutions in the interbank market.
Deposits as a Share of Monetary Aggregates. A decline in the ratio of deposits to M2, for example, may signal a loss of confidence and liquidity problems in the banking system. It could also indicate that nonbank financial institutions are more efficient in that they offer an array of other financial products, or they are acting as banks in all but in name, or they may have set up pyramid schemes.
Loans-to-Deposits Ratios. Viewed over time, the ratio of credit to total deposits (excluding interbank deposits) may give indications of the ability of the banking system to mobilize deposits to meet credit demand. A high ratio may indicate stress in the banking system and a low level of liquidity to respond to shocks.26
Maturity Structure of Financial Institutions’ Assets and Liabilities. Indicators that reflect the maturity structure of the asset portfolio, such as the share of liquid assets to total assets (liquid asset ratio), can uncover excessive maturity mismatches and highlight a need for more careful liquidity management. A major shortening in the maturity structure of financial institutions’ liabilities may imply a higher liquidity risk and could also reflect the uncertainty of depositors and other creditors on the long-term viability of the institutions.27
Secondary Market Liquidity. Liquid asset ratios should be seen in connection with measures of the breadth and depth of secondary markets for liquid assets, such as bid-ask spreads and turnover figures.
Sensitivity to Market Risk Indicators
Banks are increasingly involved in diversified operations, all of which involve one or more aspects of market risk. A high share of investments in volatile assets may signal a high vulnerability to fluctuations in the price of those assets. In general, the most relevant components of market risk are interest rate and foreign exchange risk, which tend to have significant impacts on financial institutions’ assets and liabilities. Moreover, in some countries, banks are allowed to engage in proprietary trading in stock markets, so it is also of interest to track equity risk. Similarly, commodity risks derived from the volatility of commodity prices can be important in certain countries.28
Foreign Exchange Risk. Large open foreign exchange positions (including foreign exchange maturity mismatches) and a high reliance on foreign borrowing (particularly of short-term maturity) may signal a high vulnerability of financial institutions to exchange rate swings and capital flow reversals. Indicators of foreign exchange risk, which is incurred indirectly via foreign currency-denominated credit to local borrowers (without significant foreign currency cash flow), are considered in the section on credit risk.
Interest Rate Risk. Interest rate risk is one of the most common financial risks, and virtually all financial institutions are subject to it. Even though it is considered here as a market risk indicator, interest rate risk arises from both an institution’s banking book as well as from its trading book.29
Equity Price Risk. Financial institutions can, in many countries, incur substantial equity price risk, either by trading or investing in the stock market, or via derivatives, which exposes the institutions to the risk of stock market crashes. Indicators of equity price risk would include the absolute size of certain classes of financial institutions’ investment in equities, their size in terms of various balance sheet indicators, or the capital charges allocated against equity price risk.
Commodity Price Risk. The significance of commodity price risk for financial institutions varies significantly from country to country. Although the investment of most financial institutions in commodities or commodity derivatives is small, commodity prices are typically more volatile than exchange or interest rates, and markets are often less liquid. Indicators can be constructed that are similar to those for interest rate and equity risk, by looking at the absolute size of the investment in commodities or by following a maturity ladder approach.30
Although not included in the six-group CAMELS framework, market-based assessments of the financial sector, as implied by the prices (yields) of financial instruments and the creditworthiness ratings of financial institutions and large corporations, can also be useful indicators of financial system vulnerability.
Market Prices of Financial instruments Issued by Financial Institutions and Corporations. A decline in the stock prices of financial institutions (relative to average stock prices) may signal adverse market perceptions of the health of these institutions.31 Similarly, one could analyze the development of yield spreads of tradable financial instruments issued by financial institutions and large corporate issuers—especially subordinated debt—to detect signs of a “flight to quality.” notably on the part of investors.
Excess Yields. Yields offered by any institution (or group of institutions or market) that are significantly above others (excluding interbank deposits) may signal problems in these institutions or the existence of unsustainable schemes that would merit close examination.
Credit Ratings. A downgrade in the ratings of local financial institutions elaborated by international rating agencies may signal negative market perceptions at the international level. Credit ratings of the corporate sector can also be important, since they inform on the creditworthiness of the banks’ major borrowers. As the Asian crisis has shown, ratings have not always been good indicators of vulnerability. While they are certainly helpful in establishing an overall picture of the stability of the financial system, a relatively good rating, by itself, cannot always be taken as a reliable indicator of the robustness of a country’s financial system. For IMF purposes, financial strength ratings are likely to be more useful than ratings that incorporate the likelihood of government support.32
Market-based indicators of a country’s vulnerability—such as trends in sovereign yield spreads33 and sovereign ratings—reflect the market’s assessment of the credit and foreign exchange risks associated with investing in a particular country. Following the Asian crisis, such indicators now increasingly include assessments of the risks posed by a weak financial system, although the weight of financial vulnerability in the composite is difficult to isolate.
Macroeconomic Factors That Impact the Financial System
The operation of a financial system is dependent on overall economic activity, and financial institutions are significantly affected by certain macroeconomic developments. Most macroeconomic indicators are normally monitored in the broader context of Article IV surveillance. Recent empirical analysis has shown that certain macroeconomic developments have often predated banking crises, which suggests that financial system stability assessments need to take into consideration the broad macroeconomic picture, particularly factors that affect the economy’s vulnerability to capital flow reversals and currency crises. The following list includes a set of indicators of macroeconomic developments or exogenous shocks that could affect the financial system.
Aggregate Growth Rates. Low or declining aggregate growth rates often weaken the debt-servicing capacity of domestic borrowers and contribute to increasing credit risk. Recessions have preceded many episodes of systemic financial distress.
Sectoral Slumps. A slump in the sectors where financial institutions’ loans and investments are concentrated could have an immediate impact on financial system soundness. It deteriorates the quality of financial institutions’ portfolios and profitability margins, and lowers their cash flow and reserves. In transition economies, these problems may also arise due to lack of progress in the restructuring of state-owned enterprises.
Balance of Payments
Current Account Deficit. A rise in the ratio of the current account deficit to GDP is generally associated with large external capital inflows that are intermediated by the domestic financial system and could facilitate asset price and credit booms. A large external current account deficit could signal vulnerability to a currency crisis with negative implications for the liquidity of the financial system, especially if the deficit is financed by short-term portfolio capital inflows. Financial crises that have immediate repercussions for the financial system may happen when foreign investors consider the current account deficit unsustainably large and, hence, shift their financial investments out of the country.
Reserves and External Debt. A low ratio of international reserves (in the central bank and financial system as a whole) to short-term liabilities (domestic and foreign, public and private) is seen, particularly by investors, as a major indicator of vulnerability. Another popular indicator of reserve adequacy is gross official reserves in months of imports of goods plus services. Total external debt and its maturity structure are important indicators as well.34
Terms of Trade. Past experience indicates that a large deterioration in the terms of trade has been a contributing factor to banking difficulties in many countries. Small countries with high export concentration are the most vulnerable to banking crises induced by a sudden and large deterioration in the terms of trade. On the other hand, large improvements in the terms of trade have the potential of causing problems in the financial system through inflation and asset price bubbles. These impacts are exacerbated when the terms of trade improvement is transitory.
Composition and Maturity of Capital Flows. The composition of capital flows (portfolio versus direct foreign investment; official versus private; highly leveraged institutions and investment banks versus commercial banks and trade finance) may also be a good indicator of potential vulnerability. Countries are particularly vulnerable if their current account deficits are accompanied by low investment ratios, or by over-in vestment (low-productivity investments).
Volatility in Inflation. Such volatility makes the accurate assessment of credit and market risks more difficult. Inflation is often positively correlated with higher relative price volatility, a factor that raises portfolio risk and erodes the financial institutions’ information base for planning, investment, and credit appraisal. On the other hand, a significant and rapid reduction in the rate of inflation could lead to lower nominal income and cash flows, thereby adversely affecting the liquidity and solvency of financial institutions. In particular, in some cases banks can profit from the management of assets in a high inflation environment, and the sudden reduction of inflation exposes the weakness of their more traditional banking practices.35 In addition, collateral value could decline below the loan amount, particularly in cases of imprudent lending (including high ratios of loan to collateral valuation) prior to the turnaround in inflation.
Interest and Exchange Rates
Volatility in Interest and Exchange Rates. The more volatile these rates are, the higher the interest rate and foreign exchange risks are for financial institutions. The vulnerability of the financial system will be higher given (1) a higher external debt burden, and (2) a higher share of foreign portfolio investments in total foreign investment. Volatility in exchange rates could cause difficulties for financial institutions because of currency mismatches between bank assets and liabilities.36 Past experience has shown that rising international interest rates increase the vulnerability of emerging markets (and their financial systems) in three ways: through the asset substitution channel (capital outflows), through an adverse impact on the creditworthiness of emerging market borrowers, and through an exacerbation of information problems in credit markets (e.g., adverse selection). On the other hand, declining international interest rates promote capital inflows that could contribute to risky lending booms. Moreover, volatile domestic and international interest rates could have damaging effects on the financial system both directly—if banks cannot avoid taking interest rate risk-and indirectly through a deterioration of credit quality—if banks can shift interest rate risk to their customers.
Level of Domestic Real Interest Rates. Unless the economy has high growth rates, financial institutions tend to be stressed under high real interest rates. Increasing real interest rates contribute to higher nonperforming loans. On the other hand, persistent negative real interest rates could signal distortions in the financial system created by the government fixing of nominal interest rates (i.e., financial repression).
Exchange Rate Sustainability. A large real appreciation could weaken the export sector’s capacity to service debt. On the other hand, a large devaluation could improve the capacity of the export sector to service its debt but, at the same time, it could weaken the debt-service capacity of non-export-related domestic borrowers. Moreover, large changes in the exchange rate could put pressure on the financial system either directly by changing asset values, or indirectly via possible effects on the real economy.
Exchange Rate Guarantees. The existence of implicit or explicit exchange rate guarantees and inconsistencies of monetary and exchange rate policies are major contributors to volatility in capital flow and excessive foreign currency exposures.
Lending and Asset Price Booms
Lending Booms (rapid growth of the ratio of bank credit to GDP). Such booms have preceded severe financial crises. Rapid expansion in lending by financial institutions often occurs because of poor analysis of the quality of loan applications. In addition, a weak regulatory environment, including the presence of implicit or explicit public sector guarantees, could encourage excessive risk taking by individual financial institutions and contribute to risky credit expansions. Mortgage and other consumer lending and foreign currency loans have preceded recent lending booms, particularly in emerging market economies.
Asset Price Booms. Expansionary monetary policies, among other reasons, could contribute to excessive booms in the stock and real estate markets. A subsequent tightening of these policies has often led to large reductions in the value of stock and real estate and a downturn in economic activity, creating conditions for financial distress. Also, a capital market slump normally reduces financial institutions’ income and the value of investment portfolios and collateral.
Since a country’s financial system is linked to other countries’ systems through capital market flows and bilateral trade, the occurrence of financial crises in other countries could trigger a financial crisis or distress at the domestic level.
Trade Spillovers. When a country experiences a financial crisis marked by a significant depreciation of its currency, other countries may suffer from trade spillovers owing to the improved price competitiveness of the crisis country.
Financial Markets Correlation. Contagion risk is higher for countries that have similar macroeconomic characteristics or close financial links (such as through commercial banks, capital market flows;) with the country in crisis. In particular, correlation between stock market prices, exchange rates, and interest rates in different countries is often seen as an indicator of the risk of contagion.37
Directed Lending and Investment. Portfolio restrictions channeling credit to specific activities or sectors based on nonmarket criteria often lead to the inefficient allocation of resources and negatively affect the solvency of financial institutions.
Government Recourse to the Banking System and Quasi-Fiscal Imbalances. For example, a sudden increase in central bank credit to the government could lead to inflationary pressures and affect the financial system.
Arrears in the Economy. The buildup of arrears could signal debt-service difficulties by the government or by private sector borrowers. These problems negatively affect the solvency and liquidity of financial institutions.
Directions for Further Work
The set of indicators identified so far for conducting macroprudential analysis is already large and will potentially increase as a result of the additional research needed in this area. In particular, the conclusions of the September 1999 consultative meeting pointed to the need for better indicators of developments in specific sectors and markets that have proven relevant in assessing financial vulnerabilities, but that have been difficult to gauge in practice. These sectors and markets include real estate, the corporate and household sectors, nonbank financial institutions, and off-balance sheet exposures of financial institutions, including institutional investors (e.g., mutual funds, pension funds, insurance companies, and hedge funds).
In parallel with the development of more comprehensive indicators, work should also be done on selecting a smaller and more manageable subset of MPIs, notably for the purposes of periodic monitoring and data dissemination. Indicators included in such a subset, or core set, of MPIs would need to be focused on core markets and institutions, based on accepted analytical relationships, comparable across countries and relevant in most circumstances (i.e., not country-specific), among other things, to permit cross-country studies.38 Participants at the consultative meeting concluded that the research conducted so far has not produced a consensus on the composition of such a core set of indicators. A variety of different indicators appear to be relevant in different countries under different circumstances. Moreover, potential vulnerabilities may be exacerbated by country- or region-specific circumstances (including inadequate legal and financial infrastructure to absorb shocks), which a core set of quantitative indicators may not detect.
Participants at the consultative meeting also discussed the possibility of developing a composite indicator of financial system soundness. There was a general sense, however, that the complex reality of financial markets may not lend itself to being captured in such indicators. In particular, composite indicators could prove simplistic and potentially misleading, as they may conceal or misrepresent problems by offsetting positive and negative signals from different individual components.