Financial Risks, Stability, and Globalization

18 Assessing Financial Sector Soundness: The Role of the IMF

Omotunde Johnson
Published Date:
April 2002
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The need to strengthen countries’ financial systems has been a major focus of the IMF’s work in recent years. This paper focuses on the Financial Sector Assessment Program—or FSAP—which is the key initiative of the IMF in this area. The FSAP, which is being undertaken in conjunction with the World Bank, is aimed at bringing together and building on the issues that are being addressed in this seminar and complementing the efforts of others in the area of improving financial system soundness. On the basis of the work under the FSAP, the IMF staff prepares Financial System Stability Assessment (FSSA) reports, which feed into the IMF’s surveillance of member countries’ economies.


The FSAP was launched in mid-1999 in response to calls from the international community, in the aftermath of the Asian and Russian crises, for the IMF and the Bank to step up their efforts to help strengthen countries’ financial systems. These crises showed that the interlinkages between macroeconomic policies, real sector developments, and financial system soundness could be much stronger than had been expected in these countries, and the contagious effects of the crises were serious. The program is therefore designed to identify financial system strengths and vulnerabilities so as to reduce the potential for crisis and cross-border contagion. The emphasis of the program is on prevention and mitigation, rather than on crisis resolution, through the preparation and delivery to national authorities of comprehensive assessments of their financial systems.

Undertaking the FSAP jointly with the World Bank is seen as useful by the international community, as both the IMF and the Bank were already undertaking this kind of work to some degree in support of their individual mandates. Working together avoids duplication of effort, contributes to consistent advice, reduces the costs to each, and optimizes the use of scarce expert resources. The program also involves experts from national authorities and international standard-setting bodies, particularly those in the area of assessing observance of financial sector standards, codes, and good practices. The involvement of these experts adds an element of “peer review” to the program. Experts from a number of such institutions have already participated in the assessments that have been carried out so far.

It is important to realize that while the FSAP may be new, the IMF’s work on financial system soundness issues is not. Financial system soundness has always been seen as a key contributor to macroeconomic stability and growth in member countries, making them more resilient to contagion. In addition to assisting its member countries through its technical assistance program, including in financial crisis resolution and bank restructuring, the IMF has for some time been strengthening the monitoring of financial systems in the context of its Article IV consultation discussions with member countries, which cover a broad set of macroeconomic policy and structural issues. The FSAP is a significant step forward to further strengthen the IMF’s core surveillance activities.

It is also important to remember that no countries, not even the more developed ones, are immune from financial system problems. This is illustrated by experience: since 1980, more than 130 countries, comprising three-fourths of the IMF’s membership, have experienced significant financial system problems.1

Structure of an Assessment

Following on from the decision to undertake the FSAP are the questions of what should be its scope and coverage and how it should be carried out. The focus of the FSAP is on system-wide issues, rather than institution-specific ones. Even so, as shown in Box 18.1, this leaves a wide range of issues that can potentially be addressed by FSAP missions.

Box 18.1.Scope of FSAP Missions

I. Macroeconomic environment

FSAP missions aim to identify factors in the macroeconomic environment relevant to the performance of, and their implications for, the financial sector. Also, they assess the implications of the soundness and performance of the financial system on macroeconomic policies and conditions.

II. Financial institutions’ structure and soundness

FSAP missions investigate the structure of financial markets and the soundness of financial institutions, both bank and nonbank, and assess their resilience to macroeconomic developments. Missions may use stress-testing methodologies and sensitivity analysis of aggregate and disaggregated data on financial institutions and markets. They also review the monetary and fiscal implications of restructuring and reforms with national authorities, as warranted.

III. Financial market structure and market liquidity

FSAP missions investigate the structure and efficiency of organized money, capital, and foreign exchange markets, as necessary. They consider various aspects of monetary operations, including central bank lending policies and money market interventions from the perspective of liquidity management, and lender-of-last-resort and contingency liquidity arrangements. Attention is also paid to foreign exchange market intervention systems and policies, contingent liabilities, and external debt exposures in some cases.

IV. Review and assessment of systemic risks in payment systems, and risk management procedures

FSAP missions investigate developments in transactions, instruments, and regulations in major domestic payment systems; the operation of the clearing and settlement process, including for securities; and the status and developments in risk management and loss-sharing arrangements with a view to identifying potential systemic risks in payment systems.

V. The legal framework and the system of official oversight, prudential regulations, and supervision, including observance of standards, core principles, and good practices

FSAP missions generally review bank legislation, regulations, and supervisory systems and procedures, and observance of relevant standards, codes, and good practices, particularly observance of the Basel Core Principles for Effective Banking Supervision and transparency practices in monetary and financial policies. They also review the status of capital market and insurance regulation and oversight.

VI. The institutional and legal arrangements for crisis management, financial safety nets, financial institution and corporate intervention, and workout mechanisms

FSAP missions assess the adequacy of bank exit frameworks and policies and deposit insurance systems. They also devote attention to the institutional/legal framework for corporate bankruptcy, corporate restructuring, loan recovery, corporate governance incentives and practices, and other general factors affecting access to credit.

VII. Key reforms to reduce vulnerabilities in the financial system and to minimize systemic risks

FSAP missions assess key structural vulnerabilities and deviations from best practice. Based on that assessment, they formulate action plans of financial system reforms and propose a sequencing of specific measures to be implemented in the short-to-medium term. Missions also seek to identify sector development and technical assistance needs to support these reforms.

FSAP missions aim to assess the strengths, risks, and vulnerabilities of a financial system, taking into account the institutional setting and the macroeconomic environment. Actions that are seen as important to strengthen the financial system, together with any needed contingency plans, are flagged, and an evaluation of the monetary and fiscal implications of these actions is provided.

Efficient and effective implementation of monetary and exchange policy requires an adequate microstructure, supported by well-designed payment systems to manage systemic liquidity and credit risks. FSAP assessments therefore review the structure and operations of money and foreign exchange markets and include an analysis of systemic risks in payment systems.

In addition to judging the present economic performance of the system, national authorities’ strategic vision for system development needs to be considered. For instance, in developing countries, it may be appropriate to devote special attention to the potential development of capital markets, insurance, pension fund, and contractual savings, as these areas can contribute to the healthy development of the financial system as a whole.

Sustained systemic soundness depends, in large part, on adequate prudential regulations and incentive structures. FSAP assessments therefore review the legislative and regulatory underpinnings of the financial sector. Other relevant institutional issues that bear on the financial sector are also reviewed.

Observance of financial sector standards, codes, and good practices is a key element of a strong financial system, and assessments of observance of these standards are an integral aspect of the FSAP. Typically, detailed assessments of the observance of relevant financial sector standards, based on methodologies established by the standard-setting bodies, are undertaken during the FSAP mission and presented in the FSAP report. Summaries of these detailed assessments comprise modules in the joint IMF/World Bank Reports of Observance of Standards and Codes (ROSCs), which are provided to both institutions’ Boards.2 Countries are encouraged to make ROSCs available to the public.

The range of areas that can be examined is thus very extensive and demanding in terms of staff and experts’ resources. Every effort is therefore made during the preparatory phase of an assessment to identify, on a case-by-case basis, the areas that need to be addressed. This preparatory work benefits from the substantial in-house background knowledge in both the Fund and the Bank. That being said, the approach so far has been fairly comprehensive in most cases, so that FSAP teams gain experience with a variety of financial sector issues as well as with the operational aspects of delivering and reporting on these assessments. Most important, focusing in too early on only certain pre-identified areas of the financial sector across countries—for example, the banking system—could result in misleading conclusions due to ignoring serious systemic risks that may arise in other areas.

Undertaking such broad assessments requires a wide range of expertise. FSAP teams, therefore, typically include experts from other national authorities and international standard-setting agencies in addition to IMF and Bank staff. For example, in the case of Canada that involved a very comprehensive assessment, the FSAP team included experts from the Australian Securities and Investment Commission, the Central Bank of Brazil, the Bundesbank, the Swedish Financial Supervisory Authority, and the Board of Governors of the United States Federal Reserve System.

The findings of an FSAP assessment are presented to national authorities in a comprehensive report. Based on the FSAP findings, the staffs of the IMF and the Bank then prepare specific reports for their respective Boards that focus on the financial sector issues that are relevant to each institution. In the IMF, the staff prepares a Financial System Stability Assessment, or FSSA, for the IMF’s Board, which is the basis for the Board’s enhanced financial sector surveillance in the context of Article IV consultations. FSSAs focus on countries’ financial system vulnerabilities and risks that may have significant macroeconomic implications or be triggered by macroeconomic shocks and imbalances. The policy responses that are felt to be appropriate are also identified. Where appropriate, the Bank’s staff similarly report to its Board, but focuses less on immediate risks and more on medium-term structural and developmental issues.

Related Work

Several other initiatives in the IMF are linked to, and feed into, the FSAP, particularly as regards improving the capability to undertake analysis of the interlinkages between macroeconomic developments and financial system soundness. Enhancing capabilities in this area is an ongoing task, with particular efforts being focused, at present, on the development of a core set of indicators of financial system soundness, or macroprudential indicators (MPIs), and the development of analytical tools, including stress tests, based on these MPIs.


MPIs3 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; macroeconomic variables can signal imbalances that affect financial systems and are, 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 analytical research aimed at identifying MPIs is not conclusive. Much of the earlier literature focused on aggregated microprudential indicators following the categorization of the CAMELS rating.4 The variables identified using this approach have, however, been used in empirical research less frequently than macroeconomic indicators, due to the availability of higher frequency data for the latter. More recent analytical studies emphasize the important role of foreign borrowing, to measure the degree of exposure to currency and inflation risks and the level of nonperforming loans and capital adequacy.5 This is consistent with theoretical explanations for the eruption of the Asian financial crisis, which posits financial institutions’ weaknesses as a major cause of the crisis.

Other indicators to capture financial vulnerability that have been investigated include a measure of segmentation (often proxied by an interbank interest rate differential), the deposits-to-M2 ratio, and aggregate stock indices. However, even with these variables, the ability to detect events in an out-of-sample forecasting context has so far been limited. The most recent research would seem to indicate that a combination of differing MPIs—i.e., both micro and macro factors—works best in explaining banking fragility, and concludes that the introduction of macroeconomic variables significantly improves the explanatory power of models based on microprudential indicators only.6

The work on MPIs in the IMF aims, among other things, to identify a manageable set of MPIs that may be applicable in general across countries. This will support the Fund’s FSAP work, as well as the efforts of national authorities to identify potential weaknesses and take appropriate steps to address them at an early stage. The work is being carried out on a number of fronts, including practical experience in the field with the FSAP, analytical research, and outreach consultations with other government and academic institutions working in this field.

The set of indicators so far identified by the IMF, which are seen as suitable for macroprudential analysis, is rather large and will potentially increase as a result of the ongoing research and field work. In particular, there is a need for better indicators of developments in specific sectors and markets that have proven to be 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 will be conducted to select a smaller and more manageable subset of MPIs, notably for the purpose of periodic monitoring and for 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), inter alia, to permit cross-country studies. To help develop such a core set, the IMF is currently conducting a survey among the authorities of its member countries on the use of MPIs and on current compilation and dissemination practices.

Stress Testing

Stress tests are techniques used to gauge the impact on financial institutions’ balance sheets of changes in key policy variables and in the overall macroeconomic environment. Examples of such variables are interest rates and exchange rates. The tests may also involve comparative static exercises evaluating the impact of an increase in the ratio of nonperforming loans on bank solvency. While stress tests focus on individual institutions, the results of tests on the most systemically important financial institutions may help us understand the sensitivity of the financial system as a whole to various shocks. In addition, as noted recently by the Committee on the Global Financial System, financial firms’ stress test results may be able to be aggregated in some cases, thereby yielding results at the macro level.7

All the FSAP cases to date have included stress tests of various sorts. The availability of financial data for individual financial institutions is critical to undertaking these stress tests. In many countries, however, supervisors are legally prohibited from passing on information on individual institutions. In these cases, institutions themselves may be willing to provide necessary data or to carry out the tests and provide the results to FSAP mission teams. If not, stress tests may have to be based on data for (sub)sets of financial institutions or restricted to data that are publicly available. In the FSAP cases to date, the data were obtained from a variety of sources, including from the banking supervisory authority, from the financial institutions themselves, and from published annual reports.

In view of still-evolving methodologies, differences in the level of sophistication of financial systems among countries, and the significant variations in data availability and reliability, FSAP missions have often considered it useful to combine elements of different methodologies. It may be interesting to summarize the experiences so far with the stress testing as a macroprudential analysis tool in the context of the FSAP, focusing on credit, interest rate, foreign exchange, commodity price, and equity price risks.

For credit risk, most of the assessments included an estimation of the losses in bank loans that would lead to negative equity or to a substantial undercapitalization in any of the banks in the sample. Starting with an estimate of the system-wide share of substandard loans to total loans and a reasonable provisioning rate, the solvency ratios for these institutions were tested against various scenarios that would lead to increases in nonperforming loans (loans in the doubtful and loss categories), with the additional increments of nonperforming loans subject to higher provisioning. In one of the countries assessed to date, this “traditional” stress test was supplemented by a simulation model designed to capture the correlation between credit and market risk and among the various market risks, as well as to assign probabilities to the various scenarios.8 In one country that was already facing banking sector distress, the credit stress test consisted of adjustments of valuations (“stress testing of valuations”) and loan classification, resulting from the deterioration in credit quality that had already occurred, as well as some extrapolation.9 Attempts at capturing the interaction between credit and market risk, including the impact of market price fluctuations (e.g., in real estate prices) on credit portfolios (indirect market risk), have been made in some of the pilot cases, but further research in this area is needed, inter alia, as part of the further development of macroprudential indicators.

For interest rate risk, several approaches were used, depending on the information available to each mission. Where detailed information on the structure of cash flows was available, missions generally used a duration approach to estimate the impact of changes in interest rates on bank equity, by aggregating the duration of assets and liabilities of financial institutions. In one case, the data provided to the mission were not detailed enough to calculate duration exactly, so that an average duration was estimated from the duration of one bank holding a typical portfolio and by using a plausible assumption about current market values of securities that were recorded at book value. The integrated model referred to above involved scenarios that included various increases in T-bill yields. In another case, the mission considered it preferable to rely primarily on the interest rate stress tests carried out by the financial institutions themselves, as published in their annual reports.10

For foreign exchange risk, it was possible, in those cases where the (net) open foreign exchange positions of financial institutions were known, to estimate the impact of a significant change in the exchange rate on banks’ solvency ratios. In one case, staff used a univariate value-at-risk (VAR) model with an observation period of two years, stress testing for the most extreme observations that occurred during that period. In another country, a stress test for foreign exchange was carried out but was considered only marginally relevant in light of strict prudential limits on foreign exchange exposures. In yet another case, the mission relied, as with the interest rate stress test, primarily on those tests carried out by the financial institutions themselves, as published in their annual reports.

For commodity price risk, it can sometimes be useful to estimate the impact of a significant change in commodity prices on solvency ratios. Whereas financial institutions in most countries do not take positions in commodities directly, the impact via loan portfolios can be significant. In most pilot countries, commodity exposure by the financial system was not considered sufficiently high in relation to overall business activity to warrant stress tests of commodity-linked portfolios. In one country, however, the scenario used in the integrated model included a potential drop in commodity prices.

For equity price risk, missions tried, where relevant, to estimate the impact on solvency ratios of various scenarios of declining stock market indices. In one country, where financial institutions were presumably exposed to equity prices (domestic and foreign), the mission considered the impact of previous stock market declines on the banking sector. Given both the complexity of exposures and the confidentiality of individual data, this was considered the only feasible approach. In the country where the integrated model was used, the scenario included a potential decline in stock prices. For the other pilot countries, bank exposures to equity price risk were not considered sufficiently high in relation to overall business activity to warrant stress testing.

Implementation of the FSAP and Lessons to Date

Implementing the FSAP has been a labor-intensive exercise. In addition to the usual tasks of initiating a new program, it has required the development of databases of MPIs, new analytical tools, the enhancement of existing expertise, and the introduction of new administrative procedures, in particular to coordinate the efforts of the IMF and the World Bank in this joint program. To codify these initiatives and to ensure consistency in the structure and coverage of assessments in different countries, a handbook of procedures and guidelines has been developed. This handbook will evolve over time as experience with the program grows. The FSAP is currently just finishing its initial one-year pilot phase. During the pilot, assessments were undertaken for 12 countries, which provided a diversity of financial systems, in terms of development and complexity, as well as a geographic spread. While the mission work has been completed and the results discussed with the authorities in all cases, the Executive Boards of the IMF and the World Bank have yet to have the opportunity to review the results in several of them. Nevertheless, the pilot is largely completed and when the Executive Directors of both institutions recently reviewed the experience with the FSAP, they concluded that the program is working effectively and that it should continue, with a target of 24 country assessments a year.

The FSAP has also received widespread support in international fora such as the Group of Seven and the Group of 20. Feedback obtained from the individual national authorities of countries that have already participated in the FSAP, which includes industrial, emerging, and developing countries, has similarly been very positive. While pointing to areas where the program could be improved and refined, they have uniformly supported the work of the FSAP teams. They have noted that the program has helped them to identify areas in need of strengthening and, where relevant, has guided the adoption and sequencing of necessary reforms. In some cases, the program also provided a stimulus for officials to focus attention on significant financial system issues more than they otherwise would have. In most cases, national authorities have already begun to act upon the recommendations of the FSAP team.

Although the program is still in its early stages, the two Boards and the staffs of both institutions have found the FSAP helpful in supporting their financial sector work. In the IMF, the FSSAs, which, as noted earlier, are prepared by the IMF staff based on FSAP reports, have been found to be helpful to the IMF’s Board. In countries with clear vulnerabilities, these have been a focus of Article IV discussions. Even in other countries with no significant problems in their financial sectors, the FSSAs have been found useful in providing a better overall context for the Article IV consultation discussions. The staffs have also regarded the findings of FSAP missions as very useful in helping to establish subsequent technical assistance and other work priorities.

Some specific lessons are also starting to be drawn from the FSAP experience to date. For example, while not necessarily a unanimous view, it would seem that to be most useful and effective, assessments of observance of standards should be conducted in a broad institutional and macroeconomic context rather than on a stand-alone basis. This view is supported by the Basel Core Principles Liaison Group and the Basel Committee Secretariat, which consider Core Principles assessments most useful when carried out in the context of broader assessments of preconditions, including of the macroeconomic and institutional setting. For these reasons, it may be concluded that assessments of observance of relevant financial sector standards are best undertaken as an integral part of the FSAP process. Resource constraints do, however, call for FSAP missions, in consultation with national authorities, to be selective in deciding ahead of time which standards are most relevant in each particular case.

From the experience to date, it is also clear that there is still work to be done in developing the analytical tools and understanding needed for the FSAP. In that regard, there is clearly a role in the FSAP for stress tests and scenario analysis, in part because they highlight the link to macro-economic developments and can be a useful tool to help missions form an overall view of a financial system’s robustness. However, it is also clear that stress tests are subject to limitations. They can provide only a static analysis of financial system health based on specific (and often crude) assumptions on the evolution of key variables as well as on the reliability of past behavioral relationships and available balance sheets. Further, sufficiently detailed data on individual institutions may not exist or may not be provided to FSAP teams.

Finally, on lessons to date, outside experts from national central banks, supervisory authorities, and standard-setting agencies have been found to have a key role to play in the FSAP. Their contributions are particularly effective in specialized areas, including supervisory and payment system issues and standards assessments. Expert participation has brought an element of peer review into these aspects of the exercise and has increased the credibility and acceptance of the FSAP. Therefore, the group of institutions invited to participate in the FSAP has recently been broadened.

FSAP in the Future

Several important matters have yet to be addressed regarding how the FSAP is likely to operate in the coming period and beyond. First, as a result of the resource intensity of the FSAP, it will not be possible to undertake assessments of every member country on an annual basis. The plan is to undertake FSAPs in 24 countries in the coming year, compared with 12 countries during the pilot period. Even if the pace of assessments were to be stepped up further in later years, it would take a number of years for the entire membership to be covered, should that be desired.

This, in turn, raises several important issues. First, should the coverage of the FSAP be universal, or should the program be focused on a subgroup of the membership? On the one hand, arguments can be made for focusing the FSAP toward those countries and regions that are judged most likely to be at risk of crisis or contagion. However, if this was known ahead of time, the FSAP would not be needed. Moreover, as already noted, financial crises can occur across the whole range of the IMF’s membership, from the smallest to the largest and from the least to the most developed. Even in those countries most able to carry the costs themselves, these costs as well as the possible spillover effects can be great, and consequently, every effort should be made to avoid or reduce them. Furthermore, if the program were seen in the marketplace to be “targeted” at countries judged to be at risk, strong incentives could be created for countries not to participate in order to avoid the costs that could follow being so labeled.

For these reasons, it can be argued the coverage of the FSAP should be universal. This would be consistent also with the nature of IMF surveillance. That being said, as there are limits to the number of FSAP assessments that can be carried out in a given year, some prioritization would be expected in the early years. Consequently, in these early stages, priority should probably be given to those countries, such as the emerging markets, whose financial systems are of significance in their regions, or that already have relatively large or rapidly developing financial systems and whose supervisory and regulatory capabilities are not fully developed. At the same time, it would be important to keep a balanced sample of countries in terms of geographical spread and degree of development in their financial sectors.

Finally, one issue that arises from the relative infrequency of assessments is how to keep them up-to-date in order to maintain their usefulness for the authorities as well as for the IMF and the Bank. Financial systems can change very quickly, especially in countries such as the emerging markets group. Again, this is an area where the thinking is not fully developed. Nevertheless, given that the Fund’s Article IV consultations are carried out on a regular and frequent cycle, one option may be for the Article IV staff missions that visit countries to undertake the follow-up consultation discussions on the issues that have been identified during an FSAP exercise. This should minimize the need for frequent comprehensive FSAP missions, although there will likely still be a need for such missions to some countries on an ad hoc basis.


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See Lindgren, Garcia, and Saal (1996), p. 3. See also Caprio and Klingebiel (1996), for a comparative study of banking crises.


ROSCs also include summaries of assessments of other standards that are not assessed as part of the FSAP, including the IMF’s General Data Dissemination System (GDDS) and Code of Good Practices on Fiscal Transparency.


For a detailed review of work in the IMF and elsewhere on developing MPIs, see Evans and others (2000). For a summary of work that has subsequently taken place in the IMF on developing a set of financial soundness indicators (FSIs), see Sundararajan and others (2002).


See, for example, Thomson (1991).


González-Hermosillo (1999), for example, provides empirical evidence that the CAMELS-type assessment (capital, asset quality, management, earnings, liquidity, sensitivity to market risk) is statistically significant only if nonperforming loans and capital adequacy ratios are simultaneously considered, while a comprehensive study by Kaminsky, Lizondo, and Reinhart (1998) concludes that CAMELS-based indicators are less able to explain currency crises than is exchange rate misalignment.


This latter approach was considered to yield more accurate results, but required much more detailed data from individual financial institutions than may be available in some countries, and was, of course, dependent on the assumptions built into the model.


Loan-loss reserves were increased until they reached a level compatible with international standards, loss reserves for foreclosed assets increased until they covered the depreciation of real estate, and loan classifications adjusted to reflect evergreening.


In addition, a simplified stress test for interest rate risk, assuming a parallel yield-curve shift and neglecting taxation effects, as well as early repayment and deposit retention rates, was also undertaken by the FSAP mission team itself.

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