Developing a Composite Financial Stability Indicator - Essay Example

As a result of the financial crises faced by the world in the last two decades, financial authorities worldwide have realized the importance of maintaining a sound financial system as a precursor for economic growth and stability. Central Banks across the world have included financial market stability as a part of their mandate. However, one of the major stumbling blocks In analyzing financial system stability is the lack of a composite Indicator for measuring it.

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In this paper we analyze the work done on Financial Stability Indicators and look to build upon that to come up with a composite indicator for the South African economy. Contents l. Introduction system as a precursor for economic growth and stability. The global financial crisis that started In 2008 – the after effects of which are still being felt – demonstrated how Insufficient traditional micro-regulation Is to Identify vulnerabilities In the financial system.

The level of interconnectedness of financial markets has necessitated the need for a macro-prudential approach for addressing financial market stability. Central Banks across the world have included financial market stability as a part of their mandate. It makes logical sense for central banks to assume this responsibility In an economy as they are better placed than any other institution to understand the linkages between various financial Institutions and markets.

Moreover, given their mandate of maintaining price stability and economic growth they have an inherent interest in maintaining stability in the financial system as these objectives cannot be achieved without having a sound and healthy financial system. One of the major stumbling blocks in analyzing financial system stability is the lack of a composite indicator for measuring it. Unlike other macroeconomic objectives Like price stability and economic growth which can be measured, financial institutions operating under an increasingly interconnected scenario – not Just domestically but across economies.

The generally accepted norms for assessing financial stability are the Financial Soundness Indicators (Offs), specified by the MIFF, which are a set of indicators used for evaluating the health of financial institutions within a country. These comprise of a set of “core indicators” targeted specifically at the deposit taking financial institutions and another set of “encouraged indicators” arrested at all other financial institutions.

With the advent of unconventional (read accommodative) monetary policy in a number of developed economies, the emerging economies across the globe have been exposed to potential risks because of the increase in international capital flows. Not to mention, with the financial system evolving rapidly in these countries as a consequence of robust economic growth there is a greater need in these economies for active assessment of the health of the financial system. The Reserve Bank of South Africa intensified its focus in this aspect awards the end of the last millennium.

In 1999 it established a Financial Stability Committee with the primary mandate of enhancing financial stability. In 2001, a Financial Stability Department was established to monitor the stability of the financial system. In 2004, the Reserve Bank came out with its first edition of the “Financial Stability Review’ which has now become a regular bi-annual publication. This paper is structured as follows – the first section lays out the objectives of this paper. Then we review some of the relevant research that has been done in the field of financial debility.

The next section looks at the trends of various financial sector indicators (Offs) in South Africa that are recommended by the MIFF. The next section contains our recommendations on the set of variables to use as a measure for financial stability indicators. In this section we also do a cross country analysis to ascertain where does South Africa stand in comparison to other emerging countries. The next section goes on to try and establish a statistically significant relationship between various macroeconomic variables defined earlier and financial market stability.

We conclude tit our assessment of what are the most significant variables that the Reserve Bank of South Africa should track as indicators of the financial system soundness. II. Objectives The objectives of this paper are the following Looking at historical trends of the various Financial Stability Indicators (Offs), as defined by the MIFF, in South Africa and trying to identify periods of financial stress in the system Defining a set of macroeconomic variables that can be used to assess the health of the financial system and which can act as leading indicators for predicting stress in the system.

We also try to develop statistically significant variables by making use of proxy variables for financial market stability Conducting a cross country analysis to compare South Africa with other emerging economies to see how healthy and stable its financial system is Ill.

Literature Review CB defines financial stability as ‘a condition in which the financial system – comprising of financial intermediaries, markets and market infrastructures – is capable of withstanding shocks, thereby reducing the likelihood of disruptions in the financial intermediation process which are severe enough to significantly impair the allocation of savings to profitable investment opportunities’. Global economic outlook happening in various emerging and advanced economies.

In light of this, it becomes pertinent for regulatory authorities to take adequate steps towards ensuring resilience from these external shocks which could cause domestic financial instability. MIFF indicates that the impact of instabilities in the banking environment in the past decade has cost many economies -?10% of their GAP. Financial Stability Board (established in 2009) along with the member economies undertakes the task of insuring adequate flow of information and monitoring of policies by the concerned regulatory authorities to maintain global financial stability.

Miff’s outlook on Financial Stability It raises concerns over the following macroeconomic changes that transition to which should be aided by careful domestic policy making to avoid instabilities. Anticipated impact of normalization of accommodative monetary policies by Fed -Successive rounds of quantitative easing in US have encouraged capital flows into emerging economies, the quantum of which has made them highly sensitive to external vulnerabilities.

Now, when US growth prospects seem to be strengthening, fear of capital outflows coupled with weak domestic growth and elevated inflation is manifesting in exchange rate, current account, bond yield volatilities. Uncertainty regarding success of Bionics in Japan – If the intended structural and fiscal reforms are not accomplished, it will lead to outflow of large amount of domestic savings into emerging countries like Brazil, Turkey, Indonesia; and investment in high risk grade, structured products may pose instability risk in these economies.

Euro Area developments – Move towards a common banking union and policy measures to leverage the banks for adequate capital level maintenance need to be watched out for its impact on the interconnected economies. In light of the above concerns hovering presently, MIFF has drawn up a Global Financial Stability Map incorporating the changes in various risks. Market and Liquidity risks are expected to increase because of anticipated impact on asset prices of Feeds decision.

Emerging market risk will increase due to weak domestic growth prospects in emerging economies exacerbated further by external volatility. Credit risk would remain more or less enhanced due to slow recovery in global banking system. Monetary and financial conditions remain stable overall due to return stabilization in advanced and premium demand in emerging economies.

Figure : Global Financial Stability Map Measurement of financial stability Considering the importance of having a model to predict financial instabilities, many researchers have attempted to compute stress indices by using a set of financial indicators considered suitable to aggregately represent the overall macroeconomic condition – signal extraction approach (Skinny and Reinhardt, 1999), financial debility condition index (Van den End, 2006 for Netherlands), aggregate stability index (Lobules, 2010 for Romania). To understand the 2008 crisis, MIFF developed ME-IFS (financial stress index for emerging economies).

This is based on the weighted average methodology adopted by Cardinally, Alleged and All (2008). It uses financial indicators like banking system profitability, risk, sovereign debt spreads, reserves, stock market and foreign exchange volatility. Upon, verifying the applicability of ME- IFS on a retrospective basis, it indicates the burgeoning of crisis at the historic events South African Reserve Banks view on Financial Stability South African Reserve Bank defines Financial Stability as ‘smooth operation of the system of financial intermediation between households, firms and government through a range of financial institutions’.

South Africa is a member of the FSP and is actively involved in promoting the 12 key financial and economic standards. Though the onus of ensuring financial stability mainly rests with SARA, it opines that the support of government to ensure stable fiscal and structural environment stability, regulatory self sufficiency in the financial markets is eminent. Post the global crisis, SARA has received mandate from the constitution in 2010 to be responsible for ensuring financial stability.

Under its ambit, SARA evaluates the domestic and global macro-economic aspects to identify possible risks, work closely with respective agencies to design/restructure policies to mitigate to ensure long term stability. In the Financial Stability report released for Mar’13, Sara’s views align with that of MIFF on the external variables signaling instability. Additionally, high unemployment and mining sector difficulties pose internal vulnerabilities. To understand the possible instability threats, SARA assigns risk intensity rating (probability of occurrence and possible impact measured on scale of 0-8).

As per the recent analysis, labor unrest and high domestic unemployment are major cause of concerns, besides externalities. ‘Twin peak model of oversight – To make the economy resilient as well as participative for investor, SARA will be the prudential regulator and FSP will be Market Conduct Regulator (as proposed in Feb.’13). This consolidates all activities relating to enhancing soundness of financial intermediation process with SARA, while he responsibility for promoting and protecting consumer confidence will rest with FSP.

Both regulators will complement and also be a check on each other’s activities. Though the intention is to create a more resilient financial sector and increased investor confidence aiming at development and employment generation, increased regulation is likely to result in exorbitant compliance costs. IV. Historical Trend of Offs in South Africa In this section we look at the historical trends of the various Financial Soundness Indicators prescribed by the MIFF. These indicators are classified as follows by MIFF

Core Set – These indicators apply to deposit taking institutions Capital Adequacy Asset Quality Earnings and Profitability Liquidity Sensitivity to market risk Encouraged Set – These include indicators for Deposit Takers Other Financial Corporations Nonofficial corporations sector Households Market liquidity Real Estate Markets The trends for the core indicators are mentioned below Figure : Capital Adequacy Offs The Capital – both total and Tier 1 – to risk weighted assets ratio has increased in accordance with gradual revisions and adoption of the Basel Standards. However, the

Non Performing Loans Net of Provisions trended upwards since 2008 and reached uncomfortable levels of 45% of capital during the second half of 2009; it has started to trend downwards and is back to pre-crisis levels. Asset Quality Figure : Asset Quality Offs The Non Performing Loans to Total Gross Loans ratio has trended sharply upwards since 2008, reaching uncomfortable levels of 6%, while it has started to come down, it is still as high as 4% which is much higher than the pre-crisis levels of 2%. Earnings and Profitability Figure : Earnings and Profitability Offs The earnings and profitability ratios have remained at healthy levels.

Liquidity Figure : Liquidity Offs While the liquidity ratios have come down a bit, they have remained stable and at healthy levels. Overall, on the core Financial Soundness Indicators the only concerning aspect is the level of Non Performing Loans, all other indicators appear to be sound and healthy. V. Plan of Action Post Mid-Term We would look at identifying a set of macroeconomic variables that can be used to statistically predict financial sector stability. To model financial market stability we would use proxy variables like volatility in the stock market, bond market and FIX racket.