New Tools for Assessing Financial System Soundness

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This article which was published in Finance and Development explains that macro-prudential indicators (MPIs) — defined broadly as indicators of the health and stability of the financial system — can help countries assess their banking systems’ vulnerability to crisis. In recent years, an increasing amount of work has been done on such indicators as part of efforts to strengthen the international financial architecture.

MPIs comprise both aggregated micro-prudential indicators of the health of individual financial institutions and macroeconomic variables associated with financial system soundness. One commonly used framework for analyzing the health of individual institutions is the CAMELS framework, which looks at six major aspects of a financial institution: capital adequacy, asset quality, management soundness, earnings, liquidity, and sensitivity to market risk. Among the relevant macroeconomic indicators are data on aggregate and sectoral growth, trends in the balance of payments, the level and volatility of inflation, interest and exchange rates, the growth of credit, and changes in asset prices, especially stock and real estate prices.

In discussing how these indicators should be used, the authors say that the assessment of financial system soundness also requires an ability to couple the analysis of MPIs with informed judgments on the adequacy of the institutional and regulatory frameworks. These frameworks include the structure of the financial system and markets; accounting standards and disclosure requirements; loan classification, provisioning and other prudential regulations; the quality of supervision of financial institutions; the legal infrastructure (including those parts of it covering bankruptcy and foreclosure); incentive structures and safety nets; and liberalization and deregulation. The interpretation of MPIs is contingent on these institutional circumstances, and the monitoring of such indicators can only complement, not substitute for, institutional judgment.

The article goes on to discuss how these indicators can be measured and some of the statistical challenges that exist. The authors conclude that knowledge about MPIs is still limited. They believe we need to acquire a better understanding of what determines financial system soundness and to identify which signals might help policymakers prevent financial crises.

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