financial stability reports: what are they good for?

Financial Stability Reports: What Are They Good For? June 20, 20121 of 38Čihák, Muñoz, Teh Sharifuddin, and Tintchev

M. Čihák, S. Muñoz, S. Teh Sharifuddin, and K. TintchevJune 20, 2012

FPD Academy

Comments from staff at IMF, the World Bank, and several central banks gratefully acknowledged. Views expressed here are those of the authors and do not necessarily

represent those of the IMF, the World Bank, or any other organization.

Financial Stability Reports: What Are They Good For?


Motivation

“Banks are well prepared to withstand increased delinquency and loan losses, which have been extremely low to date…”

“Nowhere has it been suggested that the banking systems of individual countries should be subjected to size limitations…”

Iceland’s Financial Stability Report (2008)

“Low probability that in 2008 that existing risks might materialize to the extent that it will have an impact on bank performance…”

Latvia’s Financial Stability Report (2007)


Introduction, objectives, and preview of results

Background

Wide range of instruments tools and devices are being considered

Current financial stability framework includes financial stability reports (FSRs), which aim to communicate key risks and vulnerabilities

Early reviews of FSRs experience have been mixed

Objective Ascertain to what extent and in what form FSRs should be part of the new framework

Need for effective policy framework for financial stability

Preview of results

Simply publishing a report has no significant impact. However, higher quality reports tend to be associated with a more stable financial environment.

Areas for improvement: forward-looking assessment, interconnectedness analysis, data issues


Financial stability reports: what are they good for?

1. Trends in financial stability reporting

2. Case studies

3. Empirical evidence

4. Conclusions, further research


FSRs: a growing “industry” (1996–2011)

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2010

...0

10

20

30

40

50

60

70

80

90

Cou

ntrie

s pu

blis

hing

FSR

s

Rapid growing “industry” of FSR publications

Less rapid growth in number of FSRs

published

*Estimate: Newly published FSRs in 2011 and assumed all the central banks that have published FSRs previously will continue to publish in 2011


Global trends reflect the evolving experience with FSRs and dynamics of financial stability communications

USA• US recently published its first FSR

• Report is published by the Financial Stability Oversight Council (FSOC)

• Central bank is represented in the publishing body, but not the sole publisher

Ireland• Ireland ceased to publish its FSRs from 2008 onwards

France• Banque de France stopped publishing its FSR in 2007

• FSRs currently for internal use only

• Central bank website contains a link to FSRs, but the FSRs are a collection of articles or conference materials on a featured topic

Israel• Bank of Israel stopped issuing FSRs as a stand-alone publication in 2005

• Financial stability issues are covered as a chapter in its annual report

United Kingdom• Bank of England’s (BoE) FSR went through a marked revamp in 2006

• Existing elements shortened and new features added


General trends of FSR publication have not changed dramatically in the last 15 years

Semi-annual

Annual

Composition of FSRs in terms of publication frequency

• Frequency, length and structure have not changed dramatically

• Several countries have switched frequency of FSR publication

• Average length of FSR has declined somewhat, but marginally


Other common trends observed in worldwide FSR publication

Coverage •Coverage of issues in FSRs tends to increase over time

Market-based indicators

•Increasing use of market-based indicators such as credit-default swaps (CDS)

Data publication

•Increasing number of central banks publishing underlying data




2. Case studies




Eight case studies of FSRs – Background

• Eight countries selected with a view to having a reasonably balanced coverage; geographically, advanced vs. emerging markets

• Analyzed based on “good practices” proposed by Čihák (2006) – CCC framework

CanadaAdvanced

Minimal crisis in 2008

IcelandAdvanced

Major crisis in 2008

BrazilEmerging market


SpainAdvanced

Crisis in 2008

LatviaEmerging market

Major crisis in 2008

KoreaEmerging market


New ZealandAdvanced

Minimal crisis in 2008South Africa

Emerging marketMinimal crisis in 2008


Framework introduced in Čihák (2006)

Clarity Consistency Coverage

A. Aims

B. Overall assessment

C. Issues

D. Data, assumptions, and tools

E. Structure and other features

Based on methodology used by Fracasso, Genberg, and Wyplosz (2003) to assess central banks’ inflation reports. They showed that for inflation reports, higher ‘quality’ measured this way was associated with lower dispersion in inflation expectations and lower inflation, on average.

“Three Cs”

Key

ele

men

tsof

the

repo

rtE.g.: . Is it clear what data were used to arrive at the results

presented in the report? (5 % weight)




A. Aims


C. Issues




“Three Cs”

Key

ele

men

tsof

the

repo

rt

E.g.: . Is it clear what assumptions were used to

arrive at the results presented in the report? (5 % weight)




A. Aims


C. Issues




“Three Cs”

Key

ele

men

tsof

the

repo

rt

E.g.: Is the overall assessment of financial stability presented

consistently with previous reports? (5 % weight)




A. Aims


C. Issues




“The three Cs”

The

key

elem

ents

of

the

repo

rtE.g.: Does the report use a wide range of tools, both quantitative (stress tests

etc) and qualitative (supervisory, market participant surveys, etc.)?

(5 % weight)


Report’s objective: clearly indicatedDefinition of financial stability: mixed experience

Financial stability definition is typically featured at the beginning of the report

Definition of financial stability included?

Yes No

• Canada• Iceland• Korea• South Africa

• Brazil• Latvia• New Zealand• Spain

• Aims or objectives of FSR are clearly indicated in most of the FSRs reviewed

• Objectives are usually presented at the beginning of the report

• Significant variation in FSRs objective is observed across the reports:

• Identifying and analyzing risks to the financial system

• Provide information for major participants in the financial industry to evaluate and manage risks

• Stimulate dialogue and discussions on financial stability issues

• Highlighting efforts and policies of regulatory authorities in mitigating risks


A fair degree of consistency in covering key systemic risk factors

• Issues and developments in the FSRs examined are consistently followed-up

• Some countries provided detailed analysis on specific risks

2008 2009 2010 2011BrazilCanadaIcelandKoreaLatvia*New ZealandSouth AfricaSpain

Least Moderate Greatest

Coverage of systemic risks across countries 1

1 Exclude specif ic risk coverage by a particular country


Less attention to analysis on contagion risks and interconnectedness in the FSRs reviewed

International banks

Domestic banks

Household and

corporate sector

Sovereigns

• No analysis or explanation of linkages or exposures among domestic banks

• Two exceptions:• Korea: November 2010

FSR, box article• South Africa: March 2011

FSR, working paper appendix

• No analysis on sovereign exposures of the banking system reported in our sample FSRs

• Not reported regularly in the sample FSRs

• Some countries do perform ad-hoc analysis depending on current macroeconomic and financial conditions:

• All eight countries’ FSRs feature a regular assessment of corporate sector and households

• Description of the health of household and corporate sector and impact on banks’


Forward looking views, assessments or projections are neither consistently nor comprehensively reported

• Bulk of analyses and discussions concentrate on current level of ratios and indicators

• FSRs reviewed seldom include statements, assessments or even survey results, e.g:

• “Going forward, substantial upward pressure on real estate prices seem to still exist..”

• “…a modest increase in the aggregate rate of impairment are likely to continue into 2011.”

• Nonetheless, most of the sample FSRs do provide qualitative outlook on credit risk


Four countries’ FSRs in our sample reported stress test results on a regular basis

• FSRs for Canada, Korea, Latvia and Brazil usually report at least one type of stress test results in each publication• In some cases, stress tests done by other regulators: Australia Prudential Regulatory Authority (APRA) in New Zealand’s FSR,

Financial Supervisory Authority (FME) in Iceland’s FSR and ECB in Spain’s FSR


Reporting of stress test results across countries (2008-2011)

Assumptions

Graphically

GranularMethodology

Text

0

0.5

1

CanadaAssumptions

Graphically

GranularMethodology

Text

0

0.5

1

IcelandAssumptions

Graphically

GranularMethodology

Text

0

0.5

1Latvia

Assumptions

Graphically

GranularMethodology

Text

0

0.5

1

New ZealandAssumptions

Graphically

GranularMethodology

Text

0

0.5

1

South Africa Assumptions

Graphically

GranularMethodology

Text

0

0.5

1

Spain

LegendFor each of these questions, a response of ‘yes’ gets a value of 1, while a 0 is assigned to a ‘no’• Assumptions: Are the assumptions to the stress tests included whenever the results of a stress test are reported?• Graphically: Does the reporting of the stress test results include any graphical presentations, either as a diagram or in a table?• Granular: Do the FSRs report stress test results beyond aggregated level i.e. there is some degree of granularity e.g. no. of institutions, percentage of banks?• Methodology: Is the methodology of the stress test s explained in the FSR?• Text: Are the results to the stress tests reported as part of regular text of the report?

Assumptions

Graphically

GranularMethodology

Text

0

0.5

1

Korea

Assumptions

Graphically

GranularMethodology

Text

0

0.5

1Brazil


In practice, FSR discussion on policies extends beyond macroprudential policies

FSRs policy discussions

Monetary policy

Financial sector development

Regulatory updates and changesCrisis-type policies

Broad discussions

Microprudential

Macroprudential• E.g. measures on improving access to financing for SMEs, merger between exchanges

• E.g. new responsibilities granted to central bank and announcement of new mandates

• Policies and measures to mitigate the impact of the global financial crisis, especially post-Lehman

• E.g. developments and progress on financial stability made at the G-20, analysis and reforms regarding the Basel II framework

• Ideally, policy discussions (regardless of the type) should be tied back to its impact on financial stability


Scope to improve standardization in FSR …… and to be more open about data constraints• FSRs with standardized period of coverage also have standardized timing of release• Most FSRs rarely caution or raise concerns on data gaps issues

012345678

All F

SRs

feat

ure

an

Engl

ish v

ersio

n

Sem

i-an

nual

pu

blic

ation

Stan

dard

ized

perio

d of

co

vera

ge

Stan

dard

ized

timin

g of

FS

R re

leas

e

Regu

lar p

ublic

ation

of

supp

ortin

g m

ater

ials

Raise

con

cern

on

data

ga

ps

No.

of c

ount

ries

Yes

No




2. Case studies




Is there an empirical link between FSRs and financial stability?

Macroeconomic and institutional environment

Banking system fragilities

?FSR

publication

? FSR quality

Financial Stability


Motivation: diverse country experiences during crisis

United States

No FSR (until 2011)

Major crisis

Iceland

FSR since 2000 (2005)

Major crisis

Latvia

FSR since 2003

Major crisis

Canada

FSR since 2002

Little crisis impact

Australia

FSR since 1999

Little crisis impact


Transparency Financial Stability

Bank-level transparency reduces the likelihood of banking problems and thus enhances financial stability

Literature overview

Nier (2005)

Oosterloo et al (2007)

Evidence generally supportive but limited data. Income level and time since first publication affect FSR quality

Born et al (2011) FSR communication about financial stability moves financial stock prices in the expected direction and reduces price volatility

Čihák (2006)

Little evidence of a direct relationship between FSR transparency and financial stability


Baseline model (probit/panel with random effects)

Dependent variable:

• Probability of a banking crisis

• Moody’s Banking Sector Financial Strength Rating

• Stock market volatility• ICRG sovereign financial

risk rating• 1-year median banking

system EDF

Independent variables:

• Two alternative FSR specifications: FSR publication dummy FSR quality index (CCC framework as in Čihák, 2006)

• MACRO: Macroeconomic controls• BANK: Banking controls• IQ: Institutional quality controls

t,i1t,i51t,i41t,i3t,i21t,i IQBANKMACROFSRFS


Heckman model

• To address issues of endogeneity/selection bias• Two equation model:

• FSRi,t-1= a dummy =1 if country i published an FSR at time t

• Crisisi,t-3 is a dummy =1 if country i had a banking crisis (3rd lag)

• GDPi,t-1 and Credit/GDPi,t-1 are GDP per capita and credit over GDP at t-1

• FSRNt-1 is the total number of countries publishing FSRs at time t-1

• λt is the inverse of the Mills ratio (defined as the normal probability density of the prediction in the first equation, divided by the cumulative normal density).

• Meaning of the other variables same as in the baseline model

t,i1t,i51t,i41t,i33t,i21t,i FSRNGDP/CreditGDPCrisisFSR

t,it1t,i51t,i41t,i3t,i21t,i IQBANKMACROFSRFS

Mac

roec

onom

ic

cont

rols

Ban

king

co

ntro

ls Summary results

Varia

bles

of

inte

rest

Oth

er

cont

rols




2. Case studies




FSRs effectiveness depend on their quality

Higher-quality reports (those that are clear, consistent, and have good coverage)tend to be associated with more stable financial environments; low-quality FSRs seem associated with sub-par financial stability.

Publication of an FSR by itself does not have a robust empirical link to financial stability

Despite some improvements in recent years, FSRs still leave much to be desired in terms of clarity/coverage/consistency over time

!


Major areas for improvement

Analysis of interconnectedness!

Lack of a forward-looking nature of the reports!

Data issues (clarity on what are the “blind spots”) !


Areas for further research …

How (by what channels) does FSR quality promote financial stability? Improved information in the market, stronger market discipline Signals the FSR provides for policymakers and regulators Other factors

Which institutional frameworks for FSRs work better than others?


Institutional models for macro-pru (and FSRs)

Source: IMF Staff Discussion Note “Institutional Models for Macroprudential Policy” (SDN/11/18)


Institutional framework: key “desirables”…

General1. Central bank to play an important role in macroprudential policymaking.2. Complex and fragmented regulatory structures should be avoided.3. Participation of the treasury in the policy process is useful, but a leading role poses risks.4. Systemic risk prevention and crisis management should be supported by separate organizational

arrangements.5. Macroprudential policy frameworks should not become a vehicle to compromise the autonomy of

other established policies.6. Arrangements need to take account of country-specific circumstances. Provide for effective identification, analysis, and monitoring of systemic risk7. Mechanisms for effective sharing of information to assess risks should be in place.8. At least one institution involved in assessing systemic risk should have access to all relevant

information. It should be the one that disposes of the best expertise to assess systemic risk.9. Mechanisms are needed to challenge dominant views of one institution.Provide for timely and effective use of macroprudential policy tools10. Institutional mechanisms should support willingness to act against the buildup of systemic risk

and reduce the risk of delay in policy actions.



Institutional framework: key “desirables” (continued)

11. A lead authority should be identified and be provided with a clear mandate and powers, in a manner that harnesses incentives of existing institutions to mitigate systemic risk.

12.The mandate needs to be matched by powers, including to initiate the use of prudential tools to address systemic risk. Mechanisms should be established to expand powers when needed.

13. The mandate should give primacy to the mitigation of systemic risk, but include secondary objectives to ensure that the policymaker takes into account costs and trade-offs.

14.To guard against overly restrictive or inadequate policy, accountability and transparency need to be put in place, without unduly compromising the effectiveness of macroprudential policy.

Provide for effective coordination across policies to address systemic risk15. Institutional integration of financial regulatory functions within the central bank can support

effective coordination of macroprudential policy with monetary as well as microprudential policy, but also requires safeguards.

16. Where separation of policy decisions and control over policy tools cannot be avoided, legal framework needs to assign powers to recommend or direct action of other policymakers.

17.Where there is distributed decision making among several agencies, establishing a coordinating committee is useful, but may not necessarily be sufficient to overcome collective action and accountability problems.



Institutional frameworks in practice

Source: Calculations based on 2011 update of World Bank’s Banking Regulation and Supervision Database. Data for 135 jurisdictions.


Thank you!

financial stability reports: what are they good for?

Documents

published fsrs

number of fsrs

form fsrs

teh sharifuddin

stable financial environment

higher quality reports

world bank

central banks