Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
The Ability of Financial Soundness Indicators in Assessing the Health
of the Financial System: Evidence from Arab Banking
Saeed Al-Muharrami
This paper investigates the ability of Financial Soundness Indicators (FSIs) in assessing
the financial stability of Arab GCC deposit takers using the recommended measures of
FSIs by the IMF. The paper uses the dataset of 94 banks operating in Arab GCC
countries during the period from 1999 to 2013. The results show the ability of FSIs
related to asset quality, capital adequacy, and liquidity to assess the health of the
financial sector. Accordingly, its findings may assist and guide GCC policy makers and
regulatory authorities in ways to create stable banking systems. Nonetheless, GCC
governments should be cautioned against sole reliance on these indicators and they
should supplement them with other tools and techniques.
JEL classification: G21; G28
Keywords: Arab GCC banking; Financial soundness indicators; Financial risk; Banking
crises; Macro-prudential analysis
1. Introduction
Financial Soundness Indicators (FSIs) are statistical measures for monitoring the
financial health and soundness of a country‟s financial sector, and its corporate and
household counterparts. The development of these experimental indicators is being coordinated by the International Monetary Fund (IMF), with the support of other
international organizations, such as the World Bank, the Bank for International
Settlements, the Organization for Economic Co-operation and Development (OECD),
and the European Central Bank (ECB), plus IMF member countries in all geographic
areas.
Banking sector stability has received increased attentions in the last few decades. After
the recent global financial crisis in the banking systems, Macroprudential approach has
become more important to monitor the stability of the financial system as a whole
instead of focusing on individual financial institutions. The IMF compiled a set of
macroprudential indicators: “Financial Soundness Indicators”.
Many studies on macroprudential and financial stability have been conducted but, todate; few studies have referred to banks in Arab countries in general and few 1
specifically to Arab Gulf Cooperation Council (GCC) countries. Gulf Cooperation Council
__________________________________________
Dr. Saeed Al-Muharrami, Associate Professor, Department of Economics and Finance, College of
Economics and Political Science, Sultan Qaboos University, Sultanate of Oman,
Email: muharami@squ.edu.om
1
Rath et al. (2014) Concentration and Competition in Oman’s Banking Sector: Implications for Financial Stability.
CBO Working paper: 2014-1. This paper is discussing the relationship between market concentration and financial
stability in Oman.
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
(GCC) consists of six countries; namely Bahrain, Kuwait, Oman, Qatar, Saudi Arabia
and United Arab Emirates (UAE). This study is motivated by the researcher‟s aim to fill
the gap in the literature and also the fact that commercial banks play a vital role in the
economies of GCC countries. Evaluating and monitoring the financial performance and
condition of commercial and Islamic banks is important to depositors, owners, potential
investors, managers and, of course, regulators. In addition, much of the literature has
focused on theoretical aspects and very few studies have empirically explored their
usefulness. Therefore, by examining the practical and empirical aspects of
macroprudential and financial stability, this study makes two contributions. First, in
terms of empirical investigation, this is the first cross-country study investigate
macroprudential and financial stability of the banking sector in GCC countries by
analyzing data pooled from six countries for fifteen years from 1999-2013. Second, its
findings may assist and guide policy makers and regulatory authorities in ways to create
a financially stable environment in the banking sector in order to realize a number of
benefits.
In total, 39 FSIs have been established to be the ratios that should be used to give a
good indication about the financial stability in any country. These 39 FSIs are divided
into two categories: Core Set and Encouraged Set (See Appendix 1). The core set
provides data covering all main categories of bank risk, while the encouraged set
includes more indicators from the banking sector as well as other institutions and
markets which were considered important in financial stability assessments. These
include data on the corporate and household sectors, real estate developments and
non-banking financial institutions. By compiling two datasets, the IMF aimed to avoid
imposing too rigid a financial system, and instead to give respective countries the
opportunity to select the indicators that are most relevant to their circumstances.
Core FSIs are those judged to be relevant to all countries, and those that all countries
should be able to produce. Therefore, the aim of this study is to investigate the ability of
core set FSIs, as are defined in Appendix 1, to explain the financial soundness of the
banking industry in the six GCC countries by attempting to answer the following
questions:
1. Can Financial Soundness Indicators for risk assessment explain the financial
soundness of GCC countries, and, are FSIs useful in explaining the financial
soundness of these six countries?
2. Does one set of ratios (the same FSIs) fit all countries? Therefore, are these
indicators valid for GCC banking?
3. What is the ability of FSIs relating to asset quality, capital adequacy, liquidity and
profitability to assess the health of financial sector?
4. Should GCC governments pay close attention to the evolution of FSIs
measures?
This paper is structured as follows. Section 2 introduces the background to GCC
countries‟ banking and economies. Section 3 explains the dataset and presents the
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
methodological approach. Section 4 presents the empirical results. Section 5 concludes
the paper.
2. Background to GCC countries’ banking and economies
The Gulf Cooperation Council (GCC) was founded in 1981 with the aim of coordinating
political, economic, and social policies across the Gulf region.2 The economies of GCC
countries share a number of common features. These economies are characterized by
large oil producing sectors, dependency on oil exports, stable currencies and stable
price levels. Similarities also extend to geography, longstanding cultural and political
ties, a common language, high living standards and coordinated policies. These
similarities by far outweigh any differences (Al-Muharrami et al., 2006).
Gross Domestic Product (GDP) is widely used as an indicator to measure economic
development and growth in a country. Using this reference, it is clear that GCC
countries achieved significant economic development throughout the period from 1999
to 2012. According to the IMF data and statistics, the GDP of GCC countries grew by
510 per cent from $315.547 billion in 1999 to $1,603.342 billion in 2012. IMF Report in
Table 1 shows that the size of GDP and GDP per capita of GCC countries from 19992012. In 2012, Saudi Arabia accounted for 45.8% of the total GDP of GCC countries
followed by the UAE (23.9%) then Qatar (12.0%). Kuwait, Oman, and Bahrain came
fourth, fifth and sixth with 11.5%, 4.9% and 1.9% respectively. Table 1 also presents the
relative size of GDP per capita of GCC countries. In 2012, Qatar was the highest
country in the region in terms of GDP per capita and Saudi Arabia was the lowest.
2
GCC Secretariat General (http://www.gcc-sg.org/eng/).
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
Table 1: Development of GDP and GDP Per Capita in GCC Countries in US$
Subject
description
Country
GDP current prices
Bahrain
Kuwait
Oman
Qatar
Saudi
Arabia
UAE
Bahrain
GDP per capita
Kuwait
Oman
Qatar
Saudi
Arabia
1999
2002
2005
2008
2010
2012
7.581
9.591
15.965
25.705
25.708
30.355
30.123
38.135
80.807
147.402
119.932
184.54
15.532
20.048
30.905
60.742
58.814
78.29
12.393
19.364
44.53
115.27
125.122
192.402
167.053
194.878
328.461
519.796
526.811
733.956
82.865
11,486.0
2
13,358.1
3
109.816
13,702.1
4
15,759.0
7
8,070.48
21,660.4
5
30,748.5
4
8,359.73
9,067.84
315.475
32,983.0
2
42,827.1
3
21,807.7
5
74,189.2
9
20,157.2
8
39,074.8
4
287.422
23,233.2
0
33,481.3
6
23,350.8
4
76,413.2
0
19,112.7
0
34,778.0
5
383.799
6,579.94
180.617
21,739.3
0
27,014.7
7
11,805.5
8
54,228.8
3
14,079.1
5
43,988.5
6
27,321.0 32,790.7
4
1
Source: www.imf.org/external/pubs/ft/weo/2014/01/weodata
GDP in current prices in Billions US$; GDP per capita in US$
UAE
26,368.24
48,761.24
25,356.14
104,755.8
1
25,139.00
43,773.84
The financial sector in the GCC is generally dominated by the banking sector, which is
relatively concentrated with a few domestic players dominating the market. Table 2
presents the growth of the total assets, deposits and short term funding, equity, and net
income of local commercial banks in GCC countries. Overall, the period from 1999-2013
showed a yearly increase in these four financial data. The overall increase, in total
assets from 1999-2013, was 607%.
Table 2: Evolving Financial Profile of GCC banks (in million US$)
1999
Total Assets
Deposits & Short
term funding
Equity
Net Income
2002
2005
2008
2011
2013
236,089
292,553
482,554
1,074,465
1,319,601
1,669,516
195,557
239,243
369,479
838,736
1,016,156
1,303,251
28,274
36,027
72,605
141,134
195,031
240,006
1,584
4,971
15,330
17,192
22,016
28,053
Source: Bankscope (2013)
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
Financial soundness
The GCC countries have witnessed rapid credit growth in recent years. A breakdown of
credit growth during 1999–2013 into its contributing sources of funds confirms that client
deposits have been the main contributor to credit growth for the six countries over the
period. GCC banks are raising most of their funds at the lowest possible cost supported
by high savings of individuals and institutions. Table 3 summarizes the financial
soundness variables in the area of asset quality, capitalization, profitability and
operations, and liquidity.
Asset quality
The asset quality of GCC banks has improved significantly over the past fifteen years.
Nonperforming Loans (NPL) and Net Charge Offs (NCO) are excellent measures of the
asset quality. The ratio NPL to gross loans has been declining from a double digit figure
of 10.63% in 1999 to a single digit figure of 3.94% in 2013. Both NPL to gross loans and
NCO to gross loans stood at low levels in 2013 by international comparisons. However,
after the Global Financial Crisis of 2008, the Central Banks and Monetary Authorities in
the GCC have required commercial and Islamic banks to take significant loan loss
provisions in anticipation of rising amounts of NPL.
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
Table 3: The Evolution of Selected Aggregate Financial Ratio of GCC Banks
2013
2011
2008
2005
2002
1999
Assets Quality
NPL / Gross Loans
NCO / Gross Loans
NCO/ Net Income before Loan Loss
Provision
NPL / Equity
Capitalization
Equity / Tot Assets
Equity / Net Loans
Equity / Customer & ST Funding
Equity / Liabilities
Profitability and Operations
Net Interest Margin
ROA
ROE
Cost /Income
Liquidity
Net Loans / Tot Assets
Net Loans / Dep & ST Funding
Net Loans/Tot Dep & Bor
Liquid Assets / Dep & ST Funding
Liquid Assets / Tot Dep & Bor
3.94
0.71
4.90
0.68
2.30
0.13
2.49
0.48
8.27
0.56
10.63
0.39
19.07
17.56
17.00
20.91
3.44
11.46
6.95
10.65
12.78
39.40
9.99
50.97
14.38
23.45
14.78
24.72
13.14
20.95
15.05
26.65
12.31
26.15
11.98
26.58
17.54
16.93
18.12
17.61
15.64
15.24
17.83
17.78
12.79
14.07
12.17
13.62
3.04
1.78
12.31
36.80
3.15
1.74
11.86
36.10
3.18
1.74
13.02
35.07
3.45
3.55
24.77
28.76
3.01
1.78
14.47
40.23
2.96
0.71
6.25
44.78
60.87
59.50
61.81
56.28
47.10
45.06
76.87
76.19
78.22
72.20
56.10
53.49
73.07
72.64
73.63
67.56
54.31
51.81
19.05
21.55
21.04
27.10
47.95
52.39
18.17
20.26
18.90
24.91
46.44
52.16
Source: Bankscope (2013)
Capitalization
Raising sufficient capital and retaining enough capital to protect the interests of
depositors, borrowers, employees, owners, and the general public is one of the great
challenges in bank management and in the management of many competing financial
firms as well. When all else defenses fails, it is owners‟ capital that forms the ultimate
defence against risk. Owners‟ capital absorbs losses from bad loans, poor securities
investments, crime, and management misjudgement. Basel Agreement Capital requirements
set the ratio of total capital (Tier 1 and Tier 2) to risk weighted assets must be at least 8
percent. The GCC banking sectors are well capitalized with capital adequacy ratios (CAR) well
above the minimum capital adequacy rate set by Basel Agreement (see Table 3).
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
Profitability and Operations
Performance refers to how effectively a bank meets the objectives its stockholders
(owners), employees, depositors and other creditors, and borrowing customers identify.
At the same time, banks must find a way to keep government regulators satisfied that
their operating policies, loans, and investments are sound, protecting the public interest.
The success or lack of success of these banks in meeting the expectations of others is
usually revealed by a careful and through analysis of their profitability and earnings.
The GCC banks have stable profitability and earnings from traditional banking. Returns
on Assets (ROA) stood at comfortable levels by international comparisons. The GCC
banking sector has been little harmed by the global financial crisis. Before the Global
Financial Crisis, ROA reached the highest of 3.55 percent in 2005 declined to 1.78
percent in 2013 because of the Global Financial Crisis. GCC banks, following the
instructions of the regulatory authorities, became more cautious and conservative in
lending. Profitability was reduced by increasing provisions due to the continuing
slowdown in economic activity.
Liquidity
The availability of cash in the amount and at the time needed at a reasonable cost is
very essential for banks. The ratio Liquid Assets / Deposit & Short Term Funding has
been declining from 52.39 percent in 1999 to 19.05 percent in 2013. The ratio Liquid
Assets / Total Deposit & Borrowing is showing a similar trend from 52.16 percent in
1999 to 18.17 percent in 2013.
There are many reasons why GCC banks face significant liquidity problems. First,
imbalances between maturity dates of their assets and liabilities: banks borrow large
amounts of short term deposits and reserves from individuals, businesses, and from
other lending institutions and then turn around and make long term credit available to
their borrowing customers. Second, a high proportion of liabilities are subject to
immediate repayment: A high proportion of liabilities are subject to immediate payment,
such as demand deposits, negotiable order of withdrawal (NOW) accounts, and money
market borrowings. Thus, they must always stand ready to meet immediate cash
demands that can be substantial at times, especially near the end of a week, at the first
of each month, and during certain seasons of the year. Third, sensitivity to changes in
interest rates: when market‟s interest rates rise, some depositors of banks will withdraw
their funds in search of higher returns elsewhere. Many loan customers may postpone
new loan requests or speed up their drawings on those credit lines that carry lower
interest rates. Thus, changing interest rates affects both customer demand for deposits
and customer demand for loans, each of which has an impact on a bank‟s liquidity
position.
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
3. Data and Methodology:
Data presentation:
The Non-Bank Deposit Takers (NBDT) sector is an important component of the broader
financial system because it provides funding to sectors of the economy that the
mainstream banks often avoid, and provides alternative investment options for
individuals and organizations. However, this study concentrates on Deposit Takers
because the banking industry plays a major role in economies of all countries. Deposit
Takers are institutions which are licensed to receive funds on deposit from individuals
and institutions and to pay interest on these funds (e.g. commercial and Islamic banks).
This study focuses on core FSIs (on regulatory capital, asset quality, profitability, and
liquidity of deposit-taking institutions in GCC countries).
Data used in this study are compiled from Balance Sheets and Income Statements of
banks, their web pages on the internet, annual Central Bank Reports, and from the
Fitch-IBCA Ltd Bankscope CD Rom (Bankscope, 2013). Islamic banks have grown in
recent years to become a prominent source of financial intermediation in the GCC
countries. This study covers 94 privately held and domestically owned fully licensed
commercial and Islamic banks in the GCC- six member countries. The distribution of
these banks by GCC countries is shown in Table 4 for the period 1999 – 2013. Table 5
provides a snapshot of the data which are used to perform the empirical analysis.
Table 4: Number of Banks in the Sample
Types/Country Bahrain Kuwait Oman Qatar Saudi UAE
Commercial
10
7
6
7
9
17
Islamic
17
5
1
3
4
8
Total
27
12
7
10
13
25
Total
56
38
94
Table 5: Summary Statistics
Variable
RCRWA
T1RWA
NPLCAP
NPLGLN
ROA
ROE
IMGINC
NIXGINC
LIQTA
LIQSTL
Zscore
Max
0.839242
0.67929
1.868683
10.63
3.78
25.7
0.746264
44.9
0.443083
52.57
2.060262
Min
0.14086
0.129668
0.086634
1.9
0.72
6.33
0.392018
28.07
0.151555
19.09
0.440039
Average
0.297921
0.23828
0.400696
5.283333
2.044363
14.78067
0.587562
36.862
0.257757
31.94267
1.142315
Median
0.188599
0.153344
0.211718
4.62
1.77
14.02
0.617649
36.98
0.229114
29.21
1.002173
Std Dev. Skewness Kurtosis
0.216105 1.626211 1.598642
0.168238 1.795575 2.402852
0.478366 2.528952 6.534141
2.840922 0.667768 -0.70742
0.835012 0.927823 0.485785
5.398586 0.710757 -0.04814
0.119094
-0.29329 -1.36733
4.468982
-0.16348 0.036615
0.108544 0.967047 -0.78817
12.29194 0.910814 -0.84916
0.440411 0.930393 0.513737
Source: Compiled by the author from Bankscope (2013).
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
The Model:
This study tests the applicability of the subset of banking ratios for the identification of banking
crises using a log linear model for a pooled dataset of the GCC countries‟ economies in 1999–
2013. The justification for using the log linear form is typically to improve the
regression‟s goodness of fit and reduce simultaneity bias (De Bandt and Davis, 2000).
The basic model can be expressed as follows:
LnZscore= a0 + a1lnRCRWA +a2lnT1RWA +a3lnNPLCAP + a4lnNPLGLN + a5lnROA + a6lnROE +
a7IMGINC + a8lnNIXGINC + a9lnLIQTA + a10lnLIQSTL
(1)
The variables in Table 5 and the equation model are defined as follows:
ZScore
Z-Score as the measure of bank stability
RCRWA
Regulatory capital to risk-weighted Asset
T1RWA
Regulatory Tier 1 capital to risk-weighted Assets
NPLCAP
Non-performing Loans Net of provision to capital
NPLGLN
Non-performing Loans to total Gross loans
ROA
Return on Assets
ROE
Return on Equity
IMGINC
Interest Margin to Gross Income
NIXGINC
Non-interest Expenses to Gross Income
LIQTA
Liquid Assets to Total Assets
LIQSTL
Liquid Assets to short term Liabilities
Dependent Variable:
Following Laeven and Levine (2009) and Bai and Elyasiani (2013), the study uses the
Z-Score as the measure for the overall bank stability. Compared to the market-based
risk measures such as the standard deviation of the stock returns or the market beta,
the Z-Score directly measures the bank‟s distance from insolvency (the probability of
default), which is the primary concern of depositors and deposit insurers (Bai and
Elyasiani, 2013).
Zi,t represents the Z-score ratio as a measure of financial soundness. A key variable
used to measure financial stability is the Z-score, a variable that explicitly compares
buffers (capitalization and returns) with the potential for risk (volatility of returns). The Zscore has gained traction from previous studies as a measure of individual financial
institution‟s soundness. The Z-score is defined as Z = (k+μ)/σ, where k is equity capital
as a percentage of assets, μ is return as percent of assets, and σ is the standard
deviation of return on assets as a proxy for return volatility. The popularity of the Z-score
stems from the fact that it is inversely related to the probability of a financial institution‟s
insolvency, i.e. the probability that the value of its assets becomes lower than the value
of its debt. A higher Z-score therefore implies a lower probability of insolvency.
The Z-Score is defined as the distance to default. This measure is calculated as: Z =
(k+μ)/σ. Assuming profits are normally distributed; the Z-Score measures the probability
of a negative return that forces the bank to default, that is, the probability of insolvency
of a bank at a given time. A higher Z-Score indicates that the bank has relatively more
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
profits to cover its debt liability, that is, the bank has a lower default risk. Therefore, the
Z-Score is the proxy for the distance to default. Following Laeven and Levine (2009)
and Bai and Elyasiani (2013), this study uses the natural logarithm of the Z-Score to
measure bank stability. For brevity, the paper uses the LnZscore in referring to the
natural logarithm of the raw Z-Score in the remainder of this paper.
Explanatory Variables:
The independent variables are chosen to account for Bank specific risk factors. Bank
specific risk factors related to four areas relating to capital adequacy, asset quality,
earnings and profitability, and liquidity. The study uses ten FSIs out of twelve available
belonging to the core set. The fifth area of core FSIs, sensitivity to market risk, was
disregarded due to the non-availability of data. The ten FSIs are selected based on data
availability. The Survey on the Use, Compilation, and Dissemination of Macroprudential
Indicators, conducted by the IMF in 2000, revealed that all major categories of FSIs
were broadly useful. In particular, capital adequacy, asset quality and profitability
indicators were most widely deemed to be useful, followed by indicators of liquidity and
sensibility to market risk (Sundararajan et al., 2002). Table 6 presents the ten FSIs that
are used by this study.
Table 6: Financial Soundness Indicators
Category
Capital
adequacy
Asset quality
Earnings and
profitability
Indicator
Ratios
Regulatory capital to riskweighted Asset
Regulatory Tier 1 capital to riskweighted Assets
Non-performing Loans Net of
provision to capital
Non-performing Loans to total
Gross loans
Return on Asset
Return on Equity
Interest Margin to gross Income
Non-interest Expenses to Gross
Income
Liquidity
Liquid Assets to Total Assets
(liquid Assets Ratio)
Liquid Assets to short term
Liabilities
Source: IMF (2006).
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
4. Empirical results:
Since the Z-Score is the proxy for the distance to default risk, results show significant
coefficients for regulatory capital to risk-weighted asset (RCRWA), non-performing
loans net of provision to capital (NPLCAP), non-performing loans to total gross loans
(NPLGLN), liquid assets to total assets (LIQTA) and liquid assets to short term liabilities
(LIQSTL) which indicate a relevant impact of these variables on the default risk and
therefore on the financial soundness of the banking industry in GCC countries.
The study presents the results in Table 7. The coefficient of determination of the model,
denoted by R2 (R-squared), indicates how well data fit a statistical model. Adjusted Rsquared explained the model by 34.2%. The result shows the ability of some FSIs
related to asset quality, capital adequacy, and liquidity to explain the health of the GCC
financial industries.
The capital adequacy variable capital to risk-weighted asset (RCRWA), have
significantly positive effects on financial soundness. This relationship shows that an
increase of the percentage of regulatory capital would increase the capital quality of the
banking sector. Thus, banks that increased their regulatory capital are more financially
sound.
The other two asset quality variables of FSIs (NPLCAP and NPLGLN) have significantly
negative effects on financial soundness. Non-performing loans net of provision to capital
(NPLCAP), and Non-performing loans to total gross loans (NPLGLN) have a
significantly negative impact on financial soundness, so that an increase of the
percentage of non-performing loans reduces the asset quality of the banking sector and
causes a deterioration of GCC countries‟ financial health.
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Proceedings of 10th Annual London Business Research Conference
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ISBN: 978-1-922069-81-8
Table 7: Model Aggregate Results for the GCC Banking [„t‟ values in parenthesis]
Variable
Z-Score
Intercept
-30.31923
(-1.947744)*
RCRWA
1.422103
(2.210556)*
TR1RWA
0.075313
(0.369605)
NPLCAP
-2.560275
(-1.875450)*
NPLGLN
-2.405583
(-1.706578)*
ROA
2.186151
(1.227365)
ROE
2.245238
(1.190125)
IMGINC
1.216452
(1.445270)
NIXGINC
-0.200675
(-0.198110)
LIQTA
7.019283
(2.253868)*
LIQSTL
6.173448
(2.051118)*
Adjusted R-squared
0.342132
F-statistic
3.444288
SE of regression
0.814174
* Significant at 10%
The two liquidity variables of FSIs (LIQTA and LIQSTL) have significantly positive
effects on financial soundness. Liquid assets to total assets (LIQTA) and liquid assets to
short term liabilities (LIQSTL) have a significantly positive impact on financial
soundness. Thus, GCC banks are encouraged to have more liquid assets to have
stronger financial systems in these six countries.
Return on Assets (ROA), which is representing one variable of earnings and profitability
of the core set, is statistically not significant but it does show a positive relationship as
hypothesized. Return on equity (ROE), which is representing another variable of
earnings and profitability of the core set, is statistically not significant with a positive
relationship, implying that the higher the return on assets and a higher return on equity,
the more stable the financial system is. Even though these two variables are not
significant, it is required for banks to have a higher return on assets and a higher return
on equity to have a stable financial system.
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
As banks become more profitable, investors expect higher dividends because of
increased profitability; investor confidence is boosted, thereby attracting more capital in
addition to increased internally generated retained reserves, thus boosting capital
accumulation. This increases the safety and soundness of banks and, hence, the
stability of the financial system which means a reduction in the risk of bank failures and
the pertinent costs.
5. Summary and conclusions
The paper empirically analyses the ability of FSIs proposed by the IMF to explain the
financial soundness of the GCC banking industry. It examines the impact of the range of
indicators covering deposit takers (including capital adequacy, asset quality, liquidity,
earnings and profitability), on the financial strength of GCC banking systems from 1999
to 2013. Published research, to date, has not empirically examined to what extent FSIs
proposed by IMF explain the financial soundness (or lack of risk) of Arab GCC
countries. This study attempts, at least partially, to fill this gap in the literature.
This paper reveals that some core FSIs related to the banking sector are useful in
explaining the risk of GCC financial banking systems. These ratios can therefore,
contribute to macroprudential analysis. However, these ratios need to be interpreted
with caution and we should remember that these indicators are only one of many tools
for macroprudential assessment. They should be used along with other instruments
(such as banks stress testing, early warning systems, or supervisory assessment) for a
reliable and complete assessment of the financial soundness of banking in each
country. All in all, GCC governments should give close attention to the progress of these
measures.
References
Al-Muharrami, S., Matthews, K, and Karbahri, Y. (2006) Market Structure and
Competitive Conditions in the Arab GCC Banking System, Journal of Banking and
Finance, Vol. 30, Issue No. 12, pp. 3487-3501.
Bai, Gang and Elyasiani, Elyas (2013), Bank Stability and Managerial Compensation,
Journal of Banking and Finance, vol.37, pp. 799–813.
Capital Intelligence, Bankscope CD Rom Databases (2013).
De Bandt, O. and Davis, E.P. (2000), Competition, contestability and market structure in
European banking sectors on the eve of EMU, Journal of Banking and Finance, Vol. 24,
pp. 1045-66.
IMF (2002), Financial Soundness Indicators compilation Guide 2002. Washington, DC.
Laeven, Luc, and Ross, Levine (2009), Bank governance, regulation, and risk taking,
Journal of Financial Economics 93, pp. 259 - 275.
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
Rath, P., Misha, R., and Al-Yahyaei, Q. (2014), Concentration and Competition in
Oman‟s Banking Sector: Implications for Financial Stability. CBO Working Paper: 20141, Central Bank of Oman.
Sundararajan, V., Enoch, C., San Jose, A, Hilbers, P., Krueger, R., Moretti, M., and
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Practices, IMF Occasional Paper No. 212.
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Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK
ISBN: 978-1-922069-81-8
Appendix 1: Financial Soundness Indicators: The Core and Encouraged Sets
Core Set
Deposit-taking institutions
Capital adequacy
Regulatory capital to risk-weighted assets
Regulatory Tier I capital to risk-weighted assets
Asset quality
Nonperforming loans to total gross loans
Nonperforming loans net of provisions to capital
Sectorial distribution of loans to total loans
Large exposures to capital
Earnings and profitability
Return on assets
Return on equity
Interest margin to gross income
Noninterest expenses to gross income
Liquidity
Liquid assets to total assets (liquid asset ratio)
Liquid assets to short-term liabilities
Sensitivity to market risk
Duration of assets
Duration of liabilities
Net open position in foreign exchange to capital
Encouraged Set
Deposit-taking institutions
Capital to assets
Geographical distribution of loans to total loans
Gross asset position in financial derivatives to capital
Gross liability position in financial derivatives to capital Trading
income to total income
Personnel expenses to noninterest expenses
Spread between reference lending and deposit rates
Spread between highest and lowest interbank rate
Customer deposits to total (non-interbank) loans
Foreign currency-denominated loans to total loans
Foreign currency-denominated liabilities to total liabilities
Net open position in equities to capital
Other financial corporations
Assets to total financial system assets
Assets to GDP
Nonfinancial corporate sector
Total debt to equity
Return on equity
Earnings to interest and principal expenses
Net foreign exchange exposure to equity
Number of applications for protection from creditors
Households
Household debt to GDP
Household debt service and principal payments to income
Market liquidity
Average bid-ask spread in the securities market
Average daily turnover ratio in the securities market
Real estate markets
Real estate prices
Residential real estate loans to total loans
Commercial real estate loans to total loans
Source: IMF (2006).
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