finlawmetrics june 2013 1 of 35 Čihák, muñoz, teh sharifuddin, and tintchev financial stability...

FinLawMetrics June 20131 of 35

Čihák, Muñoz, Teh Sharifuddin, and TintchevFinancial Stability Reports: What Are They Good For?

FinLawMetrics 2013

M. Čihák (IMF and World Bank)

Joint with S. Muñoz, S. Teh Sharifuddin, and K. Tintchev

Views expressed here do not necessarily represent those of the IMF or the World Bank.

Central Banks’ 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…”

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

Iceland’s Financial Stability Report (2008)

Latvia’s Financial Stability Report (2007)



Introduction and preview of results

Background Current frameworks include financial stability reports (FSRs), usually published by central banks

Early reviews of the FSR experience have been mixed

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

Ongoing search for “effective policy framework for financial stability”



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 rapidly growing “industry”

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Global trends reflect the evolving experience with FSRs

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 major revamp in 2006

• Existing elements shortened and new features added



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

Data publication

•Increasing number of central banks publishing underlying data



Other basic attributes of FSRs have not changed significantly in the last 15 years

Semi-annual

Annual

FSR publication frequency:

• Several countries have switched frequency of FSR publication, but globally, the balance between annual and semi-annual frequency has remained unchanged

• Average length of FSR has declined somewhat, but not significantly

• Several countries have revamped their FSRs, but the typical report structure has not changed much





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

Canada

Advanced

Minimal crisis in 2008

Iceland

Advanced

Major crisis in 2008

Brazil

Emerging market


Spain

Advanced

Crisis in 2008

Latvia

Emerging market

Major crisis in 2008

Korea

Emerging market


New Zealand

Advanced

Minimal crisis in 2008South Africa

Emerging market




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

tso

f th

e re

po

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

tso

f th

e re

po

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

tso

f th

e re

po

rt

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

consistently with previous reports? (5 % weight)





A. Aims


C. Issues




“Three Cs”

Key

ele

men

ts

of

the

rep

ortE.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: clearly indicated in most of the FSRs

• Objectives are usually presented at the beginning of the report

• Significant variation in FSR objectives across the reports:

• Identify and analyze 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

• Highlight efforts and policies of regulatory authorities in mitigating risks



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

International banks

Domestic banks

Household and corporate

sectorSovereigns

• No analysis or explanation of linkages or exposures among domestic banks, except for:

• Korea (Nov 2010 FSR, box article), and

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

• All 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 such as:

• “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 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

1

Latvia

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

Legend

For 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

1

Brazil



FSR discussion on policies tends to extend 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 type) should be tied to 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

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2. Case studies





Is there an empirical link between FSRs and financial stability?

Macroeconomic and institutional environment

Measures of financial stability

?FSR

publication

? FSR quality



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 likelihood of banking problems and thus enhances financial stability

Literature overview

Nier (2005)

Oosterloo et al (2007)

Some evidence that FSR quality matters, 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 endogeneity/selection bias, a two equation model:

• FSRi,t=1 if country i published an FSR at time t, =0 otherwise

• Crisisi,t-3 =1 if country i had a banking crisis at t-3, =0 otherwise

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

• FSRNt-1 = total number of countries publishing FSRs at 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

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Summary resultsV

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2. Case studies





FSRs effectiveness depend on their quality

Higher-quality reports (those that are clear, consistent, and have good coverage)are associated with more stable financial environments, even after controlling for macro, banking, and other factors

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 does FSR quality promote financial stability? Improved information in the market, stronger market discipline Clearer signals for policymakers and regulators Other channels?

Which institutional frameworks for FSRs work better than others?



Institutional framework: selected “desirables”…

General

1. Central bank should 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.

Effective identification, analysis, and monitoring of systemic risk

7. 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.

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



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!

finlawmetrics june 2013 1 of 35 Čihák, muñoz, teh sharifuddin, and tintchev financial stability...

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