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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. 3 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 1 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. 4 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, 2 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. 5 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 3 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. 4 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. 5 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 6 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 7 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 7 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, 8 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 8 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 9 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 10 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. 11