Financial Soundness Indicators for Financial Sector Stability

A Tale of Three Asian Countries

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• Publisher: Asian Development Bank
• Year: 2015
• Print ISBN: 9789292570859
• eBook ISBN: 9789292570866
• Topic: Business
• Subtopic: Finance
• Index: Business

The development and analysis of financial soundness indicators help policy makers identify the strengths and vulnerabilities in their countries' financial systems and take preventive action to avert a crisis or at least minimize its effects. This publication presents the country-case studies for Bangladesh, Georgia, and Viet Nam focusing on the growing evidences in the development of financial soundness indicators to effectively monitor the financial performance of the country. With the support from Investment Climate Facilitation Fund under the Regional Cooperation and Integration Financing Facility, the tales of three countries shows the diverse financial vulnerabilities of each economy. For example, Georgia and Viet Nam have met capital adequacy standards but Bangladesh has faltered in this aspect for it requires an injection of capital into state-owned commercial banks that is contingent upon improved governance. On the other hand, Georgia and Viet Nam could have been more susceptible to global economic crises than Bangladesh. A significant amount of public and private debt in Georgia is denominated in foreign currency while Viet Nam's economic openness---largely because of rapid economic integration in East Asia---has made it vulnerable to global economic slowdowns.

1. Introduction: Financial Soundness for Financial Sector Stability in Bangladesh, Georgia, and Viet Nam

Astrong financial sector is a necessary condition for sustained economic growth since a sound financial system will support economic activities by pooling and mobilizing saving for productive use; providing information on potential and existing investments; exerting corporate governance; and facilitating trading, diversification, and risk management. Therefore, financial stability is a key and integral part of financial development as well as economic development in general. Furthermore, the empirical study has also confirmed the positive correlation between financial sector development and economic growth, even though the direction of causation remains challenging.

The 1997 Asian financial crisis and the 2008 global financial and economic crisis further highlighted the importance of financial stability in supporting economic growth. In addition to showing the costly effect of such crises, both crises demonstrated how balance sheets of financial institutions could negatively impact the financial sector and lead to financial sector crises. Moreover, vulnerability of the financial institutions could exist along with robust macroeconomic indicators. This calls for a systematic and regular monitoring of the financial institutions’ balance sheets in addition to macroeconomic performance.

Financial soundness is key for financial stability and monitoring the soundness of financial institutions will help detect any possible buildup of systemic risk that may lead to a crisis. For this purpose, the financial soundness indicators (FSIs) were developed. In 2006, the International Monetary Fund (IMF) established the FSIs to examine the strengths and weaknesses of a financial system.² The development of FSIs is defined in the compilation guide—with its 2009 amendment—containing the list of core and encouraged FSIs. The guide also provides information, recommendations, and advice on the conceptual framework; concepts and definitions; and sources and techniques to use to compile and disseminate FSIs. It also defines the types of financial institutions, explains the accounting rules and instrument valuation, and provides conceptual guidance on individual line items in income and expenditure and balance sheet accounts, from which the FSIs can be calculated.

Concepts of preferred approaches to aggregation and consolidation are explained, and information on how to develop and disseminate FSIs including for cross-country comparisons is included. In addition, as each country has its unique financial structure that affects the range of FSIs that may be computed and their assessment, the guide outlines a list of structural indicators to be compiled in addition to the set of core and encouraged FSIs. The structural indicators provide some indication of the types of markets that exist in a country and their stage of development.

FSIs can also provide an additional set of indicators that investors can use to assess the investment climate condition before committing to investment strategies and decisions. FSIs have two components: core indicators and encouraged indicators. The core set has 12 indicators to measure potential vulnerabilities of deposit-takers, while the encouraged set may be collected according to the country’s need, including 13 additional indicators for deposit-takers, 5 for nonfinancial corporations, 2 for other financial corporations, 2 for households, 2 for market liquidity, and 4 for real estate markets.

To assist its developing member countries to develop their FSIs, ADB launched a capacity development technical assistance (CDTA) project in November 2010 with the specific purpose of supporting some countries in strengthening their institutional capacity to compile and analyze internationally comparable FSIs. Bangladesh, Georgia, and Viet Nam participated in the project. Financial sector development is one of the five core areas in ADB’s Strategy 2020. The development of high-quality and internationally comparable FSIs and their analysis in participating DMCs will help in monitoring the state of the finance sector in them and in ensuring that efforts to develop the sector are effective.

The project aims to help the countries to be able to regularly produce and disseminate FSIs and be able to assess their performance relative to their regional and development counterparts following the specific guideline provided in the IMF’s Financial Soundness Indicators Compilation Guide and its 2009 amendment.

This synthesized report summarizes key findings and their policy implications derived from the country reports of Bangladesh, Georgia, and Viet Nam. The organization of the reports runs as follows: section 2 provides a justification on why the financial sector is important for economic development. Section 3 provides a general methodology of the research and background on the FSIs, including definitions and changes since its release. Section 4 establishes the macroeconomic context in Bangladesh, Georgia, and Viet Nam.

2. The Financial Sector in the Economy

The financial sector has been described as the brain of the economy as financial sector development plays a vital role in facilitating economic growth (Zhuang et al. 2009). A sound financial system supports growth through pooling and mobilizing savings; providing useful information about possible investments; monitoring investments and exerting corporate governance; facilitating the trading, diversification, and management of risks; and facilitating the exchange of goods and services.

The Importance of Financial Stability

Financial stability is a necessary condition for financial sector development. The 1997 Asian financial crisis (AFC) and the 2008 global financial and economic crisis (GFC) highlighted the importance of financial stability. For example, the AFC revealed weaknesses and vulnerable areas that prevented financial systems in Asia from performing their role effectively. The common financial weaknesses and vulnerable areas identified were as follows:³

• the banking sector’s predominance in financial intermediation and the lack of long-term credit and underdevelopment of capital markets, especially of bond markets;

• lacks of a strong domestic credit and a rating system, and for domestic debt issuers a lack of competition in the domestic financial sector;

• a lack of skilled financial operatives and agents;

• a reliance on weak accounting and reporting standards; and

• weaknesses in regulatory and supervisory frameworks and poor corporate governance.

The AFC revealed a need to consider the problems in the financial sector due to its balance sheet effects, a sharp reversal of capital flows, a plunge in absorption, and a free fall of the exchange rate. Krugman (2002) discusses several variants of future models of balance of payment crises, but emphasizes the balance-sheet effects of currency depreciation.

A key lesson that can be derived from the AFC is related to the double mismatch problem of the banking system: a mismatch in terms of maturity and currency. A maturity mismatch is generally inherent in the banking industry, but this was amplified during the AFC because a significant amount of capital inflows into East Asia was short term. On the other hand, the currency mismatch was a result of substantial unhedged foreign borrowing.

A consolidated view of the main cause of the AFC can be derived from the distinction between weakness and vulnerability. It can be argued that the AFC was triggered by the collapse of the Thai baht due to weaknesses in the Thai financial system and a widening current account deficit that was deemed unsustainable. Overexposure to the real estate market and poor corporate governance were the underlying causes of weaknesses in the financial system of Thailand. The widening current account deficit was due to a fixed dollar peg that led to an overvalued currency and a fall in local competitiveness. Eventually the baht had to depreciate and this transformed the vulnerabilities in bank balance sheets caused by the double mismatch problem into weaknesses.

Meanwhile, on 15 September 2008, the global investment bank Lehman Brothers filed for bankruptcy protection, sending shock waves across the international financial system. This was soon followed by other bankruptcies, bailouts, and takeovers of financial institutions in the US and Europe. Subsequently many economies—Germany; Japan; Singapore; and Hong Kong, China, among others—were declared to be in recession. The high point came when the National Bureau of Economic Research announced on 1 December 2008, that the US economy had been in recession since December 2007.The extent of the global financial and economic crisis (GFC) became clear when a synchronized recession in major industrialized countries—a rare event after the last world war—took place in 2009.

Brunschwig et al. (2011) studied the effects of the GFC and their policy responses in Asia. The GFC’s immediate impact was a synchronized global slowdown starting in the second half of 2008. Transmissions through trade and financial channels increased output volatility and overall economic vulnerability in countries with strong links to international markets. The impact, however, differed among economies depending on the degree of dependency to external demand and credit. Asia in general was not excessively affected, especially compared with the AFC. However, many of the more export-dependent countries, such as the Republic of Korea and some countries in the Southeast Asia, experienced a marked slowdown in export demand that had negative spillover effects into the economy.

Financial Soundness and Financial Sector Stability

Financial sector stability depends a great deal on the health of the financial institutions. The latter is reflected in their certain balance sheets that are directly related to financial soundness. For example, the V-shaped recovery of GDP growth in most Asian economies during the AFC and GFC highlights the role of the financial sector in fomenting the crises. More specifically, despite the relatively strong macroeconomic fundamentals at that time, Asian economies were still drawn into the crises. Currency mismatch, contagion effects, and reversal of capital flows were crucial in the AFC. Meanwhile, in the GFC, a substantial part of the spillovers was due to a massive wave of investor pessimism that led to an abrupt swing in the mispricing of risk: from a large underpricing before the crisis to a significant overpricing after the Lehman bankruptcy. In other words, a large negative asset price bubble spilled over to Asia (Filardo, 2011).⁴

Therefore, even if macroeconomic fundamentals show no vulnerability, it is still important to monitor financial soundness. The experience with the AFC and GFC demonstrates the need to have macroprudential policies in support of prudent macroeconomic policies. The latter includes effective financial regulation and supervision. Kawai (2009) argues that if prudential supervisory cannot prevent a buildup of systemic risk, the central bank, as a macrofinancial overseer, should react to credit booms, rising leverage, sharp asset price increases, and the buildup of financial vulnerabilities by applying a tighter monetary policy. Each country should establish an effective “systemic stability regulator” that is in charge of crisis prevention, management, and resolution.

Even prior to the AFC, policy makers in Asia have undertaken significant efforts to strengthen their financial systems by expanding and deepening their scope. A typical agenda of reforms for building a resilient financial system includes (i) putting a strong prudential and regulatory framework into place, (ii) promoting depth and diversity in domestic capital markets to fill the funding gaps when needed, (iii) encouraging the development of local currency bond markets (LCBMs) to help reduce currency and maturity mismatches associated with external liabilities, (iv) ensuring that small borrowers that depend on banks for their funds can be served in times of crisis, and (v) permitting more active foreign participation to increase competition and introduce new products and best practices into the domestic market.⁵ This discussion points to the need for monitoring the “buildup of systemic risk.” That can be achieved by tracking the health of financial institutions. This is the primary role of FSIs.

3. Financial Soundness Indicators

The experience with the AFC and GFC shows how deterioration of balance sheets of banks can trigger an economy-wide slump. What should be prevented is therefore turning vulnerabilities of the financial sector into weaknesses. By monitoring FSIs, vulnerabilities of the financial sector can be detected early on and appropriate measures to reduce them can be implemented. This is essentially what is meant by “preventing the buildup of systemic risk.”

Background and Framework

Because international financial markets are susceptible to turbulence, the IMF began an initiative to identify a list of internationally comparable indicators that can be used for financial sector surveillance. In 2000 the IMF launched a project on financial soundness indicators (FSI) to enable researchers to assess and compare the soundness of financial systems of various countries. After research activities and consultations with central banks, supervisory agencies, academia, and other stakeholders, the IMF released the Financial Soundness Indicators: Compilation Guide 2006, a publication that describes detailed definitions and procedures for compiling and calculating FSIs.

The IMF proposed two subsets of indicators: core indicators and encouraged indicators. The core set consists of 12 indicators (Table 1) measuring the deposit takers’ soundness. All countries are expected to participate in the project by compiling and submitting core indicators to the IMF. The encouraged indicators comprise 28 indicators: 13 for deposit takers, 2 for other financial corporations, 5 for nonfinancial corporations, 2 for households, 2 for market liquidity, and 4 for real estate markets. Countries disseminate FSIs for different frequencies of reporting. Some countries have them quarterly and many have them monthly. Today, about 74 countries have reported their FSIs to the IMF, which disseminates the data on its website.

Table 1: Financial Soundness Indicators: The Core and Encouraged Sets

Core Set
Deposit-Takers
Capital adequacy	Regulatory capital to risk-weighted assets
	Regulatory Tier 1 capital to risk-weighted assets
	Nonperforming loans net of provisions to capital
Asset quality	Nonperforming loans to total gross loans
	Sectoral distribution of loans to total loans
Earnings and profitability	Return on...

Table of contents

• Front Cover
• Title Page
• Copyright Page
• Contents
• Tables and Figures
• Abbreviations
• Foreword
• Executive Summary
• 1. Introduction: Financial Soundness for Financial Sector Stability in Bangladesh, Georgia, and Viet Nam
• 2. The Financial Sector in the Economy
• 3. Financial Soundness Indicators
• 4. A Comparison of the Three Countries: Bangladesh, Georgia, and Viet Nam
• 5. Conclusion and Policy Implications
• Appendix 1: Systems of Accounts
• Appendix 2: Financial Soundness Indicators—Concepts and Definitions
• Appendix 3: Availability of Core and Encouraged Indicators in the International Monetary Fund Financial Soundness Indicators Database
• Appendix 4: Financial Soundness Indicators for Georgia: Changes to the Current Financial Soundness Indicators List
• Appendix 5: Data Issues and Comparability: Georgia and Viet Nam
• Appendix 6: Additional Project Activities in Bangladesh
• Appendix 7: Insights into the Investment Climate of Georgia
• Appendix 8: Excel-Based Framework for Calculating Financial Soundness Indicators in the Banking Sector in Viet Nam
• References
• Back Cover