Financial Risks, Stability, and Globalization
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Author(s):
Omotunde Johnson
Published Date:
April 2002
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Author(s)
YOUSSEF EL-KHALIL

It gives me great pleasure to be a member of the panel discussing the study by Messrs. Ingves, Leone, Hilbers, and O’Brien, “Assessing Financial Sector Soundness: The Role of the IMF.” I find it a challenging task to comment on a very informative description of the Financial Sector Assessment Program (FSAP). The study presents the background, context and related work of the program while raising the essential questions and worries that can be addressed, grasping the lessons that can be drawn from a relatively recent experience, and projecting the program into the future.

My comments will be put on two levels, starting by placing the FSAP within the rapidly evolving global context, then shifting to address some issues related to the program’s methodology.

New Roles in a Dynamic World

The FSAP emerges in a rapidly changing context imposed by the deepening of globalization and the sophistication of the various financial tools and instruments. Only 10 to 12 years ago, terms like derivatives, options, and swaps hardly existed in the best-selling management books. Not more than five years ago, The Economist1 published a survey on corporate risk management, explaining the concept of derivatives and chal-lengingly proposing a crib sheet where it defined the then “newly expanding jargon terms of forwards, futures, swaps, leverage, over-the-counter derivatives, exotics,” etc., raising the polarization problem of general and financial managers and questioning how closely the two breeds can work together. Regulators and supervisors continuously have to labor hard in order to follow up changes, understand new concepts, and get accustomed to new jargon terms, while always having to react to rather than anticipate new developments.

The emergence of financial markets in the less-developed countries where supervisory and regulatory frameworks are not developed and, at a higher level, the consolidation of financial hubs in the developing world necessitate a new approach and implicate new roles for international financial agencies and, specifically, the IMF. In the realm of the increasing financial exchanges and interdependence in the global system, prudentiality requires stronger adherence to common standards and good practices.

Financial and monetary developments are assigning new roles to concerned institutions. An increasing consensus is building, for instance, in favor of central banks’ more active involvement in foreign exchange and asset prices in the developed economies, while growing pressures are being manifested in favor of more prudential roles for the monetary authorities in the emerging world.

From a theoretical point of view, the 1990s witnessed a definite revival of macroeconomics and a wide acceptance of the beneficial interaction between the micro and macro branches in economic analysis. Investors and financial markets realized as well—alas, at a high cost—the relationship between the two parts of the economy during the Asian and Russian crises, as exposure to currency risk, foreign borrowing, nonperforming loans, and capital adequacy on individual and aggregate levels, together with general macro indicators, is increasingly taken into consideration in the decision-making process. One can see in this context how international institutions such as the IMF and the World Bank, on the one hand, and credit agencies on the other, are getting closer on common ground, as the former group relies increasingly on micro considerations while the latter increasingly stresses macro indicators in financial assessments.

From a developmental point of view, increasing common wisdom links economic development, the alleviation of poverty, and the efficient channeling of aid to institutional development, efficient payment systems, solid financial markets, and macroeconomic stability. It is reassuring from this perspective to note the participation of the World Bank in the implementation of the FSAP, especially with respect to emerging nations.

The above arguments undoubtedly play in favor of the FSAP’s attempt to bridge the gaps for a more robust assessment of the situation on the financial scene.

Combining Microprudential and Macroeconomic Indicators in the FSAP

The areas covered by the FSAP’s scope of action provide a useful checklist that helps in assessing the performance of the financial system under study. The assessment is undertaken at different levels ranging from the macro environment to the market structure, with an evaluation of the role of monetary policy with respect to prudential supervision, liquidity provision, and the development of the payments system. By covering the legal framework as a scope of the FSAP mission, the system assessment links legal arrangements to contingency plans and the existence of crisis exit policies at the regulators’ as well as at the market agents’ levels. Such a comprehensive approach can highlight major weaknesses and predict their potentially amplified effects when interacting with the different branches of the individual financial structure. In the case of Lebanon, for instance, the FSAP report was successful in underlining the need to develop nonbank financial markets and institutions, to modernize the social security system, to strengthen regulation in the insurance sector, and to establish an independent capital market regulatory body, with the initial task of appraising the financial structure and its exposure to systemic risks linked to exchange rate pressures, fears of default in government debt servicing, imprudent risk taking on the part of banks, and undetected defects in the banks’ accounting and reporting systems.2

The combination of macro variables with microprudential indicators is a useful contribution of the FSAP to increasing the explanatory power of the assessment models and is very appropriate for understanding the recent financial crises. Macroeconomic indicators are traditionally incorporated in assessment models. The World Bank and the IMF country reports within or outside the Article IV consultations are typically undertaken within a macro-assessment framework.

The increasing focus on microprudential variables in this context is daringly adopted by the FSAP in an endeavor to develop indicators that can be applicable in general across countries for comparison purposes. A possible drawback of following such an approach, however, is the problem of adopting a uniform model to be applied across the board to different countries despite the diversity of financial structures on the international scene. This might lead to neglecting the specificities of countries and harm the accuracy of the assessment. The FSAP for Lebanon, for example, focused mainly on the national currency side of the banking sector’s consolidated balance sheet. This would be a normal procedure in another country but might not be the most accurate approach for a highly dollarized economy such as Lebanon’s, where foreign currency constitutes 60 percent of total deposits and where the Lebanese pound is used in only 15 percent of financial transactions.

The combination of the microprudential indicators (CAMELS indicators), together with market-based indicators (sovereign yield spreads, credit ratings, prices of financial instruments), covers a wide array of variables that determine, to a large extent, the level of risk exposure of financial institutions. While the FSAP comprehensively covers these indicators, stress tests generally tend to focus more on the asset side of balance sheets. Items on the liability side would widen the spectrum of the assessment exercise and might include indicators related not only to the maturity of deposits but also to their concentration by depositor, and to the behavior of depositors in previous crises.

While the main target of stress testing in the context of FSAP is to assess the magnitude of shocks on the financial sector, an interesting expansion of the exercise lies in considering the effects of “second-generation shocks” on borrowers, economic sectors, and depositors as well. As for the assessment of the shock effects on the borrowing economic sectors, specific issues with respect to emerging markets could be incorporated for a more accurate evaluation of risk assessment. Small- and medium-scale enterprises do not dissociate in general between household and business financial statements, and a considerable proportion of their borrowings are for consumption, thus tending to inflate the sectoral distribution of loans. A useful technique to assess more accurately the proportion of loans going to economic activity would be the development of reliable macroeconomic ratios, estimating each borrowing sector’s share of GDP, and deflating accordingly its allocated credit.

As for management soundness, it is approached mainly by addressing return indicators such as expense ratios and earnings per employee. A more comprehensive approach to the assessment of quality management—although not necessarily an easy task to achieve—might involve getting more into the administrative structure of the tested institutions and checking the presence of the appropriate bodies and the quality of their interaction. How does the credit committee deal with grading, portfolio allocation, and review? Does it have sanctioning resorts against large exposures? Does it elaborate dynamic exit strategies? Does an asset liability committee exist, and what levels of control does it have on the management of liquidity, interest rate, and price risks? How are capital planning and management responsibilities shared between the chief executive and the chief financial officer? Does a risk management committee exist to supervise the work of the other bodies and provide unified reporting to the board?3 While the FSAP cannot go into deep analysis of the organization of financial institutions, it could aim at developing a checklist, targeting rapid consideration of the profiles and roles of key managers, the presence of bodies and their position in the organizations and the existence of charts, manuals of procedure, and exit strategies.

Operating risks constitute a different set of risks that could be incorporated more thoroughly by the FSAP. While these risks can be alleviated by a high-quality administrative structure, they are more diverse than the other categories of banking risks and cannot be reduced to a single systematic treatment. Operating risks can stem from different sources of malfunctioning. The rapid development of information technology has concentrated a substantial part of the financial work on high-risk processing “center”s where defaults, malpractices, and failures might have knock-on effects and might amplify the exposure to liquidity, credit, and price risks. The Y2K paranoia experience clearly revealed the link between information system failures and systemic risks. On the micro level, new tools of payment like credit and debit cards, e-commerce, and soon m-commerce bring along the risks of system failures and fraud, and intensify the necessity to scrutinize the quality of administration and the existence of external insurance on the institutional level and business continuity plans on the aggregate level.

Conclusion

The FSAP is a welcome step in international financial risk assessment. By raising and scrutinizing the various sources of risk in a given economy, the program highlights the major weaknesses and hopefully attracts the attention of regulators in favor of policy implementation. As the program addresses specific micro issues and evaluates the risk exposure level of individual institutions, more confidentiality might be required than with other IMF and World Bank reports, especially before clearance authorization is extended by the concerned authorities.

The FSAP’s endorsement of larger sets of indicators continuously increases the explanatory power of the applied models. Stress testing always learns from experience and adds or removes variables accordingly. It also involves “thinking the unthinkable” by always having to simulate worst-case scenarios and imagining different combinations of unusual events. As suggested in this discussion, a higher emphasis could be given by the FSAP to liabilities risk assessment and sectoral considerations as well as to the organizational structure of financial institutions.

A potential danger with respect to the development of FSAP is its adoption of a rigid approach and its reliance on a uniform set of indicators that might lead to neglecting the impact of specific financial characteristics in individual countries. The incorporation of the FSAP within the Article IV framework decreases that risk as the periodic consultations would be more suitable in addressing the individual specificities and adjusting the assessment program accordingly.

The FSAP clearly fits the role of the IMF in the rapidly evolving international context and will surely contribute to a more informed environment on the international scene.

References

    CadeEddie1997Managing Banking Risks (Cambridge, England: Gresham Books, 1st edition, published in association with the Chartered Institute of Bankers).

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    Committee on the Global Financial System2000Stress Testing by Financial Institutions: Current Practice and Aggregation Issues (Basel).

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    The Economist1996A Survey of Corporate Risk Management,The Economist (London) February10.

    MarstonD. and D.Woo1999Lebanon: Financial System Stability Assessmentprepared by the Monetary and Exchange Affairs and the Middle Eastern Departments (Washington: International Monetary Fund).

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1See The Economist, 1996, p. 6 for a glossary of terms and pp. 16-18 for risk-spreading techniques.

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