Download Report on COMESA Regional Workshop on Financial Stability

REPORT
ON
“COMESA REGIONAL WORKSHOP ON FINANCIAL STABILITY ASSESSMENT
FRAMEWORK,” NAIROBI KENYA, 29 OCTOBER 2012 TO 2 NOVEMBER 2012
By Gift Chirozva
NOVEMBER 2012
1
Introduction
2
Reports by Member Countries
2.1 Regarding the member country reports, it was noted that most COMESA
member states have set up Financial Stability Units. The member states are at
various stages of setting up the Financial Stability Committees. Member
countries are still working toward the conduct of SHIELDS ratings of financial
stability once the requsite institutional and logistical arrangements have been
finalised. It was further noted that Financial Stability Assessments and
Macroprudential Supervision are new concepts, which have gained increased
attention following the Global Financial Crisis. As such there are still a number of
challenges in respect of resources and sills endowment.
2.2 Following the sharing of country experiences, it was noted that building a robust
financial stability assessment regimes an ex-ante commitment of substantial time
and resources. There is need for extensive training on financial stability
assessments, macro prudential assessments, macro stress testing, and
preparation of forward looking financial stability reports.
2.3 Given the multi-faceted nature of financial stability assessments reliance should
be placed on a broad range of specialist skills. As such supervisory authorities
may need to rethink appropriate mix of skills and expertise and hire specialists
with competences in such fields as economics, finance, banking, econometrics,
statistics, law, & accounting.
2.4 Care should be taken to avoid duplication of effort. Cooperation with internal
(within the institution) and external stakeholders is needed. Establishment of
good working contacts with other regulatory and supervisory agencies facilitates
ease exchange of information.
2.5 It was emphasized that reliance may be placed on simple methodologies that are
well understood as opposed to adoption of sophisticated models which may be
ill-fitted to the fundamental structural, organizational and institutional conditions
on the ground.
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Overview of the COMESA Financial Stability Assessment Framework
3.1 It was further noted that Financial Stability Assessments and Macroprudential
Supervision are new concepts, which have gained increased attention following
the Global Financial Crisis. As such, there are still a number of challenges in
respect of resources and sills endowment.
3.2 Financial stability is often characterised as a multifaceted phenomenon prone to
various internal and external shocks. Accordingly, the COMESA Framework for
Financial Stability Assessments provides for systematic monitoring of the
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individual parts of the financial system (institutions, markets, and infrastructure);
components of the real economy (households, firms, & public sector); global
macro-financial developments; and event risk (e.g. catastrophes).
3.3 It was noted that the SHIELDS rating system has inbuilt flexibility which allows
Financial Stability Assessment practitioners to employ the most appropriate tools
and instruments in accordance with developments in the real and financial
sectors.
3.4 Regarding the choice of an appropriate regulatory structure to facilitate effective
financial stability assessment it was noted that there is no one best solution as
regulatory architecture varies across jurisdictions.
3.5 In some jurisdictions the Financial Stability Unit (FSU) is a subset of the Banking
Supervision Department while in some the FSU is housed in Economic
Research. One approach is to set up a stand alone FSU.
3.6 The key conceptual issues to consider are accesses to data, propensity to act
and independence. Financial stability units are usually established within central
banks to draw on accumulated prudential and/or financial system data as well as
economic research competences. Propensity to act considers responsiveness,
incentives and competences to act on financial stability developments.
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The Financial Stability Assessment Process (FiSTAS)
4.1 Whereas, financial stability is regarded as an important economic policy objective
in most countries, in practice in practice financial stability assessment
frameworks in some central banks are largely under-developed with no clear
institutional objective and/or legal backing. Some countries have no standardised
frameworks to inform the gathering, processing, analysis and/or interpretation of
financial and macroeconomic indicators for financial stability purposes. As such,
many countries still produce financial stability reports lacking in overall financial
stability assessment, forward looking outlook and granularity.
4.2 The development of a coherent Framework for Financial Stability Assessment
will facilitate comparison of financial stability assessments over time within a
given country and across nations.
4.3 It was noted that the COMESA Financial Stability Assessment Framework
provides a structured, comprehensive, and conceptually sound analytical
framework for the assessment and measurement of systemic stability over time
and across nations, via the SHIELDS rating system.
4.4
The Financial Stability Assessment System (FiSTAS) provides a standardised
but flexible format by which macroprudential authorities may identify, analyse,
measure, mitigate, monitor and report financial stability issues, risks and
vulnerabilities. The SHIELDS rating system also provides structure and discipline
to the process of continuous information gathering, analysis, and monitoring; as
well as formulation of risk mitigation strategies. By construction the SHIELDS
rating system can accommodate any theoretical and empirical advances,
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judgemental and professional insights as part of the overall assessment of
financial stability.
4.5 It was noted that the SHIELDS rating system is implementable in all countries
notwithstanding their level of regulatory sophistication. The framework relies, for
its inputs, on concepts and international standards that are well established in
the microprudential supervision fraternity. Most bank examiners are familiar with
Financial Soundness Indicators as well as stress testing. The multi-component
construction of SHIELDS, for instance, is familiar to most bank examiners using
CAMELS rating system. The SHIELDS rating system, like CAMELS, is based on
a comprehensive quantitative and qualitative evaluation criteria. It was further
noted that the rating of Sovereign risk, also makes use of a number of cross
sectoral factors.
4.6 The COMESA Framework for Financial Stability Assessment relies, for its inputs,
on concepts and international standards that are well established in the
microprudential supervision fraternity. The SHIELDS rating system, like
CAMELS, is based on a comprehensive quantitative and qualitative evaluation
criteria.
4.7
Full implementation of the COMESA Framework for Financial Stability
Assessment by member countries will facilitate comparison of financial stability
assessments over time within a given country and across nations.
4.8
Adherence to the framework by COMESA member countries will provide
minimum benchmarks as well as ensure uniformity in the assessment of financial
stability in the region, which is an essential building block towards the attainment
of regional harmonisation.
4.9
Timely production of COMESA-wide Financial Stability Reports will complement
reviews produced by central banks of the member countries.
Recommendations
4.10
There were calls for regional benchmarks to facilitate implementation of the
SHIELDS rating system. The consultants advised that regional benchmarks may
not be desirable where there is no full monetary and fiscal union. The best way to
go may be the development of an implementation manual given the country
specific circumstances of member countries.
4.11
There is still room for great improvement toward implementation of the COMESA
Framework for Financial System Stability, by way of aggressive in-country
workshops and practical missions focusing on macroprudential analysis, overall
assessment of financial stability and production of forward looking financial
stability reports.
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5.1
Macroprudential Policy & Systemic Risk
The Consultants emphasised that the Global Financial Crisis (GFC) rekindled
interest in macro-prudential analysis to supplement micro-prudential analysis. It
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was noted that the concept of macroprudential analysis is not new, and has been
traced to unpublished documents in the 1970s. The GFC, however, reconfirmed
that financial systems have inherent tendencies towards booms and busts,
whose depth and severity are amplified by the highly interconnected nature of
financial institutions and markets, as well as feedback effects between the macro
economy and the financial system. Cognisant of these challenges, on November
12, 2010, the G-20 leaders asked the Financial Stability Board (FSB),
International Monetary Fund (IMF), and the Bank of International Settlements
(BIS) to develop and fine-tune macroprudential policy frameworks.
5.2
It was noted that macroprudential analysis is a key building block of any policy
framework for vulnerability analysis. Macroprudential analysis focuses on the
health and stability of financial systems, whereas microprudential analysis deals
with the safety and soundness of individual financial institutions.
5.3
Macroprudential analysis is a methodological tool that helps with the
identification, quantification and qualification of the soundness and vulnerabilities
of the overall financial systems. It uses aggregated prudential data to obtain
direct information on the current health of financial institutions; macroeconomic
data to help set the analysis in the context of broader economic and financial
trends; stress tests and scenario analysis to determine the sensitivity of the
financial system to macroeconomic shocks; market based information –such as
prices and yields of financial instruments and credit ratings as complementary
variables conveying market perceptions of the health of financial institutions; and
qualitative information on institutional and regulatory frameworks to help interpret
developments in prudential variables. Structural data including aggregates of the
size of the main segments of the financial system, ownership structures, and
concentrations, typically supplement the analysis.
5.4
The quantitative macroprudential analysis typically involves monitoring, at a
suitable level of aggregation, a range of FSIs of banks, of key non-bank financial
sectors and relevant non-financial sectors, analyzing their economic and
institutional determinants, and examining the impact of various plausible, but
exceptional macroeconomic and institutional shocks on the FSIs. Such
monitoring and analysis of FSIs, referred to as macroprudential surveillance,
includes the stress testing of the system and helps identify the key sources of
risks and vulnerabilities.
5.5
Macroprudential surveillance also encompasses a surveillance of financial
markets that helps assess likelihood of economic shocks, and an analysis of
macrofinancial linkages that focuses on the extent to which shifts in financial
soundness may itself affect macroeconomic and real sector developments. This
combination of approaches captures the two way linkages between macro
economy and financial soundness in formulating an overall stability assessment.
5.6
In addition, the analysis should consider the linkages of domestic financial
markets to global markets, and the extent to which government policies (taxes,
subsidies, monetary and exchange regimes etc) affect market discipline and risk
taking.
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5.7
Quantitative analysis should be complemented by qualitative assessments of the
effectiveness of financial sector supervision and robustness of financial
infrastructure. Qualitative assessments help identify the key institutional and
policy issues mitigatory to the identified risks and vulnerabilities and help inform
overall stability assessment and policy actions
5.8
A policy that uses primarily prudential tools to limit systemic or system-wide
financial risk, thereby limiting the incidence of disruptions in the provision of key
financial services that can have serious consequences for the real economy, by:
(a) dampening the build-up of financial imbalances and building defences that
contain the speed and sharpness of subsequent downswings and their effects on
the economy; and (b) identifying and addressing common exposures, risk
concentrations, linkages and interdependencies that are sources of contagion
and spillover risks that may jeopardise the functioning of the system as a whole.
5.9
Macroprudential policy has two dimensions (a) time dimension that focuses on
pro-cyclicality in the financial system; and (b) cross-sectoral dimension
addressing “fault lines” arising from risk concentrations and balance sheet
linkages. The goal of on-going surveillance is become aware of developing risks
before they result in a crisis. This calls for use of many prudential tools on an ongoing basis and as needed to reduce systemic risk and increase resilience.
Continuous preventive monitoring requires ability to analyze several types of data
at the firm, market, national, and international level on a regular basis. Given
complementary nature of macroprudential and other areas of economic policy,
agencies in charge of its implementation should inform and be informed by
monetary, fiscal, and other government policies.
6
Systemic Risk & Systemically Important Financial Institutions
6.1
A representative definition of systemic risk following the work of the IMF, FSB
and BIS is “a risk of disruption of financial services that is caused by an
impairment of all or parts of the financial system and has the potential to have
serious negative consequences for the real economy.”
6.2
Systemic risk takes a system-wide perspective rather than the soundness of
individual markets/institutions. Systemic risk is endogenous as collective
behaviour of financial institutions can result in crystallisation of vulnerabilities and
severe disruptions to the financial system, which could be self-feeding, procyclical and mutating.
6.3
Macroprudential policy does not seek to eliminate risk and volatility entirely. Risk
and volatility are essential elements of a properly functioning financial system.
Macroprudential policy seeks to enhance the resilience of the financial system
and to prevent risk and volatility from threatening financial stability. A strong
Macroprudential Policy does not, therefore, prevent financial crises but minimises
their impact. It follows that macroprudential policy, like macroeconomic policy, is
both prospective and preventive, and not merely a set of tools to be used upon
the near failure of systemically important financial institutions.
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6.4
According to the FSB, systemically important financial institutions may be
identified on the basis of three key criteria:
a. size (the volume of financial services provided by the individual component of
the financial system);
b. substitutability (the extent to which other components of the system can
provide the same services in the events of a failure); and
c. interconnectedness (linkages with other components of the system).
6.5
Systemic importance is often time-dependent, and can change in a crisis. There
is need to gather underlying information to assess potential systemic impact at
any given time. Application of macrprudential policy must begin before risks have
propagated through the system.
6.6
Macroprudential supervisors must identify, analyse, publish anticipatory guidance
on, and address systemic risks as they emerge. A fundamental concern of
macroprudential policy is the way interlinkages of financial institutions and
markets and their common exposure to economic variables create risks, whose
propagation may increase riskiness and fragility of the whole financial system.
6.7
Systemic risk has two dimensions, namely a cross-sectional dimension, and a
time dimension.
6.8
Cross sectional dimension pertains to how risk is allocated within the financial
system at a point in time. The sources are common exposure and interlinkages
leading to domino effect (contagion) or to joint failure. Some of the indicators
include mmeasures of interdependence, interlinkages and exposure to common
risk factors. The assessment criteria may involve an analysis of funding
structures, asset structures, large exposures, hedging activity, financial
infrastructure.
6.9
The degree of interconnectedness and common exposures renders the financial
system vulnerable to a rapid propagation of failures. For instance, the failure of
Bear Stearns, Lehman Brothers, and AIG, and liquidity challenges of major
banks during the GFC thrust the interconnectedness of financial institutions into
the public consciousness.
6.10
Large financial institutions have definitive benefits stemming from economies of
scale. Well-managed, large firms can be less risky and often play a key role in
resolution actions. It was noted that ideally, as a matter of policy, no institution
should be “too big to fail.” In practice small institutions can be ‘systemic as a
group’ as otherwise unimportant institutions can become systemic if their
problems are seen as representative of broader problems shared by other
institutions.
6.11
Time dimension deals with how aggregate risk in the financial system evolves
over time. Source is the pro-cyclicality of financial system. Systemic risk can also
arise from herd behaviour by financial institutions, nonfinancial firms, individuals
& other activities that cause procyclical movement. Time dimension thus involves
the assessment of trends and developments over time. In this perspective, the
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primary source of risk is procyclicality, while the indicators may include credit and
asset price trends, changes in risk premia, liquidity trends, and general
underpicing of risk. The assessment criteria may espouse time series analyses,
correlations, standard deviation, causality tests, volatility indicators, ‘excessive’ or
exceptional trends relative to benchmarks and historical norms.
6.12
In summary systemic risk builds up through contagion (inter-connectedness) and
common exposures; procyclical nature of financial system and prudential
regulations; as well as regulatory arbitrage due to limited perimeter of regulation,
and financial innovation involving opaque and poorly understood products
6.13
Various macrprudential tools which may be deployed to manage systemic risk
were discussed.
6.14
A single macroprudential regulator may be given control over macroprudential
tools, along with a well formulated mandate, sufficient authority and resources,
professional independence with accountability. A large body of literature favours
the Central Bank to be designated as the macroprudential regulator in view of
the perceived expertise, reputational authority, deep knowledge of financial
markets (and institutions where it is microprudential regulator), handling of
monetary policy and experience in handling financial stability issues
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Macrofinancial linkages, Transmission Channels & and their Implications on
Financial Stability
7.1
It was noted that there is rich and divergent intellectual history of interactions
among money, credit, asset prices, inflation, expectations, and business cycles.
Some of the perspectives are discussed hereunder for illustrative purposes.
Classical economics emphasises the neutrality of the financial system while
others, for instance, Schumpeter’s (1936) acknowledged the real effects of
finance.
7.2
Irving Fisher’s Debt-deflation (1933) theories put emphasise on interactions
between credit crunches, falls in asset prices, profits, and the general price level
in generating a dynamics of deflation and crises.
7.3
In Arrow-Debreu models there is no specific role for the financial system.
Following the Modigliani-Miller theorem (1958) banks and other financial
institutions were considered irrelevant. The formalization of Keynes’ theory and
the monetarist theory reserved no special role for banks other than money
creation. The Efficient Markets Hypothesis (EMH), associated with work of
Eugene Fama (1970), Samuelson (1965), Robert Merton (1974), etc wherein
asset prices are expected to follow a random walk, does not acknowledge the
‘specialness’ of banking institutions.
7.4
The development of information asymmetry theories provided roles for banks and
other financial intermediaries to mitigate these information problems. Hyman
Minsky’s (1963, 1975, 1986) Financial Instability Hypothesis considered financial
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institutions to be inherently unstable. Keynes’ (1936) “animal spirits” in private
investments also leads to cycles “casino economics”
7.5
Kindleberger’s book Manias, Panics, and Crashes applied Minsky’s and Fisher’s
ideas to the role of credit and debt in fuelling booms, via acquisition of
speculative assets, and indebtedness makes recovery from crashes and
recessions complex and protracted. Literature on Imperfect Markets by George
Akerloff, Joseph Stiglitz, Ben Bernanke etc draw several inefficiency results
showing sub-optimal equilibrium in financial markets.
7.6
Credit and financial markets transmit and amplifying the effects of real or
monetary shocks on real economic activity, through the so-called credit channel
and financial accelerator (Bernanke, 2007) which may be detrimental to financial
stability.
7.7
Analysis of macro-financial linkages focuses on the transmission of shocks
through the financial system to the macroeconomy and vice versa, which arises
from the many ways in which different non-financial sectors rely on
intermediation by the financial sector in order to conduct their activities.
7.8
For most developing countries the focus is on the banking sector in terms of its
relative size in the financial sector, potential for vulnerability, and provision of
credit to small to medium enterprises (SMEs).
7.9
Although the macro-financial linkages differ significantly across countries, the
main linkages are likely to derive from:
a. The dependence of non-financial sector (e.g. corporate, households, and
public sectors) on financing provided by domestic and foreign banks;
b. Deposits and wealth of these sectors placed with the financial sector (that is,
domestically owned and foreign controlled financial institutions), which would
be at risk in crisis at home or abroad;
c. The role and impact of the banking sector (problems) on the monetary
transmission mechanism; and
d. The financial sector’s holdings of securities issued by, and loans to, the
government, such that problems in the financial sector could adversely affect
debt sustainability.
7.10
Analysis of macro-financial linkages is essential as monetary stability and
financial stability are connected. A significant disruption in the financial system
would affect the implementation and effectiveness of monetary policy, while
macroeconomic stability helps reduce risks to financial stability. Thus the fragility
of the financial system also depends on macroeconomic conditions.
7.11
Hence, from a financial stability point of view, the analysis of macro-financial
linkages is essential, as it is important to understand the developments in
macroeconomic conditions such as disposable income of households and firm,
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profits, or unemployment and bankruptcy rates, and how these developments
affect financial stability.
7.12
Developments in financial system soundness can have a significant impact on
debt sustainability of households, corporations, and governments and debt
sustainability problems in different sectors are mutually reinforcing. Debt
sustainability problems in the non-financial sectors can further weaken the
financial system by affecting the value of loans and securities held by the
financial sector. Strong growth in debt burdens, imbalances in asset prices, and
national or international macroeconomic disturbances that cause debt servicing
abilities or collateral values to decrease, may negatively affect financial stability.
7.13
Financial dollarization also increases the vulnerability of financial systems to
solvency and liquidity risks. Unless liquid dollar liabilities are backed by sufficient
liquid dollar assets abroad, banks may run out of dollar liquid reserves and fail to
pay off dollar liabilities. Similarly central banks may run out of international
reserves to provide dollar lender of last resort support to distressed banks. In
highly dollarized countries, it is therefore, necessary that financial stability
assessment should thus indicate the extent to which dollarisation is a potential
source of vulnerability and suggests appropriate risk mitigation measures
.
7.14
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Relevance of these mechanisms will vary over time and across countries, subject
to the degree of institutional development, depth, breadth, and liquidity of
financial markets, modalities for conducting monetary policy, degree of financial
integration with the rest of the world, and other factors.
Macroeconometric Modelling and Macrofinancial Linkages
8.1
In practice financial stability is a complex phenomenon dependable on iterative
interactions of many risks and feedback effects from financial stability to the real
economy. Most academics and practitioners concur there will never be one best
model for all purposes, hence the need for a suite of models.
8.2
Bårdsen, Lindquist and Tsomocos (2006, 15), following Pagan (2003) propose
that there is a spectrum of modelling approaches ranging from theory coherency
models to data coherency models with little explicit theoretical content as
illustrated in the chart below:
8.3
Under hybrid models the equilibrium relationship among variables is determined
by some theoretical specification, while the dynamic adjustment mechanisms are
determined by the data.
8.4
The workshop considered the role and applicability of various approaches to
macroeconomic modelling:
a. Large scale macroeconomic models
b. Unrestricted, Bayesian and structural VARs
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c. Dynamic stochastic general equilibrium
d. Structural cointegration VAR approach
8.5
It was noted that models used for financial stability purposes should take into
account the following characteristics:
Desirable Characteristics for Financial Stability Models
No.
Characteristic
1. Contagion
Description
Possibility of interactive contagion due to direct interbank
linkages or indirect interactions with other market
participants via credit and loans markets.
2.
Default
Possibility of default as an equilibrium outcome
stemming form economic agents’ optimal behaviour to
uncertainty. Implies discontinuous non-linear properties
which are difficult to model.
3.
Missing Financial
Markets
In real life markets are incomplete or otherwise
imperfect. Missing markets justify regulatory policy
intervention and analysis of consequences thereof.
With incomplete markets, the economy may fail to
reach constrained Pareto-optimality while policy
intervention may induce welfare improvements.
4.
Roles for Money,
Modelling systemic risk should incorporate liquidity and
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Banks, Liquidity and
Default Risk
incomplete financial markets. As long as money has a
distinct role in the economy (not substitutable) liquidity
affects both real and nominal sectors.
5.
Heterogeneous
Agents
Agent heterogeneity is an important property for
modelling contagion, as well as crisis prevention and
management. It provides incentives for inter-bank
trading. Assumptions for a representative banks and
identical customers are not realistic.
6.
Macroeconomic
Conditions
Financial stability models should incorporate
exogenous risk factors and the impact of macrofinancial linkages on stability. Macroeconomic
conditions affect the number of bankruptcies, level of
unemployment, and the benevolence of banks which
may amplify macroeconomic shocks.
7.
Structural Microfoundations
There is a wide range of models for financial stability
analysis stretching from data congruence to theoretical
coherence models.
8.
Empirically Tractable
Theoretical models will not have practical relevance
unless they are empirically tractable, i.e. usable to
assess financial stability using real data.
9.
Forecasting and
Policy Analysis
Forecasting models should be robust, i.e. invariant to
shocks (external events and policy changes). In view of
the Lucas Critique (1976) & Goodhart’s Law (1975)
models applied for policy analysis should clarify the
transmission mechanism involved.
10.
Testing Device
Potential to test alternative theories of relevance. Act as
a reliance reality check in many situations.
8.6
The workshop noted other econometric techniques which have been utilized in
some other jurisdictions, which include:
a. Cointegration and Long Run Structural Modelling
b. Banking Stability Measures including the Consistent Information Multivariate
Density Optimizing (CIMDO) approach;
c. Merton Failure Prediction Model;
d. Distance to Default and Distance-to-Capital;
e. CISS – Composite Indicator of Systemic Stress developed by researchers at
the ECB;
f. GIFT – Global Index of Financial Turbulance developed at the ECB in 2009
g. MOSES - Model of swedish economic studies; and
h. Macro Stress Testing Framework
8.7
A key consideration in the development of macro financial models is the need for
policymakers to understand the macroeconomic effects of macroprudential policy
tools, skills,operational applicability thereof, and implications for financial stability.
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