14. What Use Can Be Madeof the Spec

14. What Use Can Be Made
of the Specific FSIs?
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Introduction
14.1 The previous chapter explained the need for
FSIs and how they fit into the wider concept of macroprudential
analysis. This chapter considers the use that
can be made of the FSIs that have been agreed by the
IMF’s Executive Board.1 These are considered below
by sector.
Deposit Takers
14.2 The strengths and vulnerabilities of deposit takers
can be analyzed under the headings of capital adequacy,
asset quality, earnings and profitability, liquidity,
and sensitivity to market risk. This is commonly
known as the CAMELS framework used by banking
supervisors in their assessment of the soundness of
individual institutions, less—for FSI purposes—the
“M,” which represents the quality of management.2
Capital Adequacy
14.3 Capital adequacy and availability ultimately
determine the robustness of financial institutions to
withstand shocks to their balance sheets. Aggregate
risk-based capital ratios (for example, the ratio of
regulatory capital to risk-weighted assets) are the most
common indicators of capital adequacy, based on the
methodology agreed to by the BCBS in 1988 (see
Box 4.2). Simple leverage ratios, such as the ratio of
capital to assets, often complement this measure. An
adverse trend in these ratios may signal increased
exposure to risk and possible capital adequacy problems.
In addition to the amount of capital, 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. If these elements of capital
can be reported separately, they can serve as additional
indicators of the ability of banks to withstand
losses and help to put overall capital ratios into context.
14.4 The BCBS has recently updated the standard
capital ratios to introduce greater sensitivity to risk
in the capital requirements by taking into account the
rapid development of risk-management techniques
and financial innovation.3 These proposals introduce
greater refinement into the existing system of risk
weighting to relate its categories more accurately to
the economic risks faced by banks. These risks could
be measured by banks’ own internal ratings systems.
Alternatively, they could be measured on the basis
of ratings given by external rating agencies. However,
improved risk measurement could come at the
expense of comparability of information among banks,
because under these new proposals each bank’s methods
of estimating credit risk can differ. The resulting
differences among banks in risk-weighted assets and
capital ratios would make aggregation of individual
banks’ data problematic.
14.5 An important indicator of the capacity of bank
capital to withstand losses from NPLs is the ratio of
NPLs net of provisions to capital. This FSI can help
detect situations where deposit takers may have
delayed addressing asset quality problems, which
can become more serious over time as a result.4
Well-designed loan classification and provisioning
rules are key to obtaining a meaningful capital ratio.
Loan classification rules are commonly a determinant
of the level of provisioning,5 which in turn affects
1This chapter draws on Sundararajan and others (2002).
2The quality of management is an important potential source of
vulnerability. However, rather than using quantitative indicators on
which there is no consensus, financial sector licensing and supervisory
authorities usually assess this vulnerability qualitatively.
3See BCBS (2004). At the time of writing this Guide, Basel II
was not yet finalized. 4This ratio does not show whether the borrower has provided the
lender with collateral or other forms of credit risk mitigation. An
alternative version of this FSI including collateral is provided in
Appendix III. 5This is discussed in more detail in Appendix VI.Financial Soundness Indicators: Compilation Guide
capital indirectly (by reducing income) and directly
(through the inclusion of general provisions in regulatory
capital). Moreover, in the FSI framework
banks should deduct specific provisions from loans
(that is, credit should be calculated on a net basis),
which reduces the value of total assets and hence of
capital (when the latter is calculated residually).
Asset Quality
14.6 Risks to the solvency of financial institutions
most often derive from an impairment of assets, which
in turn can arise from a deterioration in the financial
health and profitability of the institutions’ borrowers,
especially the nonfinancial corporations sector (discussed
below). The ratio of NPLs to total gross loans
is often used as a proxy for asset quality. The coverage
ratio—the ratio of provisions to NPLs—provides a
measure of the share of bad loans for which provisions
have already been made.
14.7 Lack of diversification in the loan portfolio signals
the existence of an important vulnerability of the
financial system. Loan concentration in a specific
economic sector or activity (measured as a share of
total loans) makes banks vulnerable to adverse developments
in that sector or activity. This is particularly
true for exposures to the real estate sector. Countryor
region-specific circumstances often determine the
particular sectors of the economy that should be monitored
for macroprudential purposes.
14.8 Exposure to country risk can also be important
in countries that are actively participating in the international
financial markets. Data on the geographical
distribution of loans allow the monitoring of credit
risk arising from exposures to particular (groups of)
countries and an assessment of the impact of adverse
events in these countries on the domestic financial
system.
14.9 Concentration of credit risk in a small number of
borrowers may also result from connected lending and
large exposures. Monitoring of connected lending,
usually measured as the share of capital lent to related
parties, is particularly important in the presence of
mixed-activity conglomerates in which industrial
firms control financial institutions. Credit standards
may be relaxed for loans to affiliates, even when loan
terms are market based. The definition of what constitutes
a connected party is usually set in consideration
of the legal and ownership structures prevalent in
a particular country, which makes this indicator often
difficult to use in cross-country comparisons. The
assessment of large exposures, usually calculated as a
share of capital, aims at capturing the potential negative
effect on a financial institution should a single
borrower experience difficulties in servicing its obligations.
Identifying the number of such exposures
provides an indication of how widespread such large
exposures are. In addition, exposures of the largest
deposit takers to the largest resident entities provide
an indication of concentrated lending among the
largest entities in the economy.
14.10 In countries where domestic lending in foreign
currency is permitted, it is important to monitor the
ratio of foreign-currency-denominated loans to total
loans.6 Delgado and others (2002) note that ideally, a
measure of risk from domestic lending in foreign currency
should identify loans to unhedged domestic borrowers.
In these cases, hedging would also include
“natural hedges,” or borrowings for which an adverse
exchange rate impact on foreign currency obligations
is compensated by a positive impact on revenue and
profitability. The level of the above ratio is related to
that of foreign-currency-denominated liabilities to
total liabilities, although differences may be observed,
notably when sources of foreign currency financing
are available from foreign lines of credit and other
foreign capital inflows. It should be noted that owing
to the compound nature of credit and currency risk in
foreign-currency-denominated lending, even institutions
with a balanced foreign exchange position face
risks. For example, an exchange rate depreciation
can impose losses directly on the banking sector but
also have an indirect effect on asset quality by causing
losses in the nonfinancial corporations sector.
14.11 Derivatives can be a source of vulnerability.
Positions in these instruments should be explicitly
monitored and recognized on balance sheets using
market value or an equivalent measure of value. In
addition, monitoring bank soundness requires tracking
the risks involved in off-balance-sheet operations
(on account of guarantees and contingent lending
arrangements). As a general rule, “exposures” should
include positions that are both on balance sheet and
off balance sheet, rather than merely positions on the
balance sheet. However, off-balance-sheet positions
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6Data on credit—assets for which the counterpart incurs a debt
liability—are a more comprehensive concept than loans and could
additionally be used.14 • What Use Can Be Made of the Specific FSIs?
can present special problems in evaluating the condition
of financial institutions, because of the lack of
reporting of such positions in some countries.
Earnings and Profitability
14.12 Accounting data on bank margins, income,
and expenses are widely used indicators of bank profitability.
Common operating ratios used to assess
bank profitability include net income to average total
assets (also known as return on assets [ROA]) and net
income to average equity (also known as return on
equity [ROE]).7
14.13 Differences in capital structure and business
mix across countries should be considered in analyzing
bank performance and highlight the need to look
at several operating ratios at the same time.8 Banks
with lower leverage (higher equity) will generally
report higher ROAs but lower ROEs. Hence, an
analysis of profitability based exclusively on ROEs
would tend to disregard the greater risks normally
associated with high leverage. Income ratios may also
be affected by leverage. In th