Financial System Soundness and the Needs for Financial Soundness Indicators

Recent episodes of financial turmoil in the international financial markets, including the recent turbulence in sub prime mortgage markets that have hit the balance sheets of banks and other financial corporations, have highlighted the need for better tools to monitor financial risks and vulnerabilities. This was seen as important for identifying vulnerabilities in the financial system as a whole, including to international capital flow reversals as well as to shocks to the corporate and household sectors. However, the paucity of data in this area, and a lack of dissemination and cross country comparability have been recognized as key stumbling blocks.

Why are sound financial systems important?.
A country’s financial system includes its central bank and national regulators, banks (deposit taking companies), other financial corporations (e.g., insurance companies, pension funds, finance and leasing companies, and securities exchanges), and all of the firms and institutions that interact in financial markets, typically in a complex manner, for the purpose of carrying out economic transactions and help to channel savings into investment. Within the system, the role of financial institutions is primarily to intermediate between those that provide funds and those that need funds, and typically involves transforming and managing risks. Therefore, financial system problems can potentially reduce economic growth and the effectiveness of monetary policy, create large fiscal costs related to rescuing troubled financial institutions, trigger capital flight, and deepen economic recessions. Moreover, financial weaknesses in one country can rapidly spill over and contaminate others.

Financial soundness indicators plays an important role in financial sector surveillance:
In response to the need for better tools to monitor financial risks and vulnerabilities, the International Monetary Fund (IMF) has worked closely with national agencies (central banks and financial supervisory authorities) as well as regional and international institutions to develop a set of Financial Soundness Indicators (FSIs). This set of FSIs comprises of 12 core indicators for banks and 27 encouraged indicators (13 for banks, 2 for other financial corporations, 5 for nonfinancial corporations, 2 for households, 2 for market liquidity, and 3 for real estate markets). A complete set of FSIs is available for public in the following IMF website: http://www.imf.org/external/np/sta/fsi/eng/fsi.htm. These FSIs are compiled to monitor the health and soundness of financial institutions and markets, and of their corporate and household counterparts, with the objective of enhancing financial stability and, in particular, limiting the likelihood of failure of the financial system.

Given the complexity of linkages between the financial sector and the real economy, there is no single, widely accepted, detailed method for assessing financial sector stability. In practice, financial stability analysis must rely on a range of available tools and indicators. They include stress testing and sensitivity analysis, various balance sheet-type methods of risk analysis, inferential methods for extracting information from market-based assets and derivative prices, and a variety of indicators and sources of information. Along with quantitative tools, qualitative tools are also typically used—notably the assessments of observance of relevant financial sector standards and codes.

Nonetheless, FSIs are an essential starting point for financial surveillance. They provide a basic measure of a financial system’s exposure to different types of risk and can help gauge the system’s capacity to handle shocks should they occur (its resilience)—notably when used in the context of stress tests. FSIs typically serve as output to stress test, as the effects of shocks are illustrated as changes in FSIs. However, FSIs are typically viewed as current or lagging indicators of soundness (especially bank-related FSIs), and they are often complemented by an analysis of market-based data, which can provide more forward looking information on expectations and volatility, and at a high frequency (e.g., daily). Moreover, FSIs for nonfinancial corporations and households have empirically been found to be better leading indicators of vulnerability.

FSIs for Indonesia:
Indonesia (and other 56 countries) has participated in the voluntary Coordinated Compilation Exercise (CCE) for FSIs conducted by the IMF during 2004-2006 and has submitted 12 core FSIs and some encouraged FSIs for banks. However, as empirical data has proven that FSIs for nonfinancial corporations and households happen to be better leading indicators of financial system vulnerabilities, Indonesia – vis a vis Bank Indonesia – has to advance the work in compiling FSIs for other sectors than banking sector. Coordination with other supervisory agencies (e.g. the Ministry of Finance and BAPEPAM) and national statistical office (BPS-Statistics Indonesia) plays a pivotal role so as to develop a complete set of FSIs for Indonesia, hence to provide a better leading indicators of financial system vulnerability.

Finally, as with most indicators, FSIs need to be interpreted cautiously. This is because the legal and regulatory systems that produce them—including accounting and prudential definitions, and the broader legal, judicial, information, and governance infrastructure can vary significantly across countries and can affect both the interpretation and cross country comparability of the indicators. The CCE has revealed a diversity of methodologies in compiling FSIs on account of (i) diversity of supervisory and accounting practices across CCE participating countries; (ii) data availability in the participating countries; (iii) costs involved in collecting additional data to fully implement the recommendations of the Financial Soundness Indicators: Compilation Guide (Guide); and (iv) diversity of country views on the appropriate methodology of FSI compilation.