INTERNATIONAL FINANCIAL
PROGRAMS
Overview of Financial Issues and Analysis
May 31, 2002
OUTLINE
• Financial Sector Assessment Program
• Money laundering and terrorist financing
• Stress testing
IMPLICIT THEMES
• Crisis prevention
• Risk assessment
• Sound practices
• Risk management
– At policy level
– At level of private institutions (financial and
nonfinancial)
FINANCIAL SECTOR
ASSESSMENT PROGRAM
BACKGROUND
• Mexico (1994-95) and Asia (1997-98) highlighted
importance of:
– strong financial sectors,
– enhanced supervision and regulation,
– crisis prevention.
• Assessment of strength and capacity of financial
sectors is element of new international financial
architecture.
INTERNATIONAL INITIATIVES:
Bodies
• G-7 Economic Summits
• G-22 Working Groups
• Financial Stability Forum
• Joint IMF/World Bank Financial Sector Liaison
Committee (FSLC)
INTERNATIONAL INITIATIVES:
Instruments
• Financial Sector Assessment Program (FSAP)
• Reviews of Standards and Codes (ROSC)
• Technical assistance and country follow-up
WHAT IS THE FSAP?
• A joint product of the IMF and the World Bank
(the Financial Sector Liaison Committee) -- to
enhance coordination between the Bank and the
Fund
• An international cooperative effort using experts
from cooperating official institutions
• A program, begun in 1999, to generate
comprehensive assessments of national financial
systems
WHAT ARE ITS OBJECTIVES?
• Identify strengths, vulnerabilities and risks
• Ascertain development and technical assistance needs
• Assess observance and implementation of relevant
international standards and codes
• Help design appropriate policy responses
HOW DO THE BANK AND FUND USE
THE FSAP FINDINGS?
• FSAP provides the basis for:
-- A policy dialogue;
-- The formulation of financial sector development
strategies; and
-- Lending and non-lending services (TA)
• Financial Sector Assessments (FSAs) are given to
Bank Board for information.
• Financial System Stability Assessments (FSSAs)
are discussed by Fund Board.
WHAT ARE THE FSAP OUTPUTS?
• Main Report
– Overall assessment
– Stability issues
– Development priorities
– Key recommendations
• Selected Financial Sector Issues
• Detailed Assessments of Standards and Codes
WHICH STANDARDS ARE ASSESSED?
• Core Principles for Effective Banking Supervision, 1997
• IAIS Insurance Core Principles, 2000
• IOSCO Objectives and Principles for Securities Regulation,
1998
• IMF Code of Good Practices on Transparency in Monetary
and Financial Policies (MFP Code), 2000
• CPSS Core Principles for Systemically Important Payment
Systems, 2001
• AML/CFT
OTHER KEY STANDARDS
•
•
•
•
Accounting
Auditing
Insolvency and creditor rights
Corporate governance
• Data dissemination (IMF)
• Fiscal transparency (IMF)
TECHNICAL ASSISTANCE
and
COUNTRY FOLLOW-UP
MONEY LAUNDERING
and
TERRORIST FINANCING
WB & IMF BOARDS AGREE
 Money laundering is a global concern
 It affects financial systems & has development
costs
 To intensify global efforts in anti-money
laundering (AML) and in countering the
financing of terrorism (CFT) within respective
development mandates
MONEY LAUNDERING
any transaction involving funds
derived from criminal activity
TERRORIST FINANCING
Fundraising or supporting
organizations engaged in
terrorism.
GOALS
Money Launderers
 Inject & transfer dirty money so funds from
criminal activities appear to have come from
legal sources
 Ensure underlying criminal activity remains
invisible
Terrorists
 Fund raising
 Criminal act doesn’t always precede transfers








COMMON PREDICATE
OFFENCES
Terrorism/terrorist financing
Drug trafficking
Bribery
Smuggling (arms, people, goods)
Theft
Embezzlement
Racketeering
Tax evasion
o Gambling
o Prostitution
CONSEQUENCES OF MONEY
LAUNDERING
 Makes crime a profitable enterprise
 Damages market integrity
 Deters (honest) foreign investment
 Perpetuates corruption - undermines
good governance
 Contamination/contagion: B.C.C.I.
CONSEQUENCES OF MONEY
LAUNDERING (continued)
 Uneven playing field for honest businesses
 Laundered funds often untaxed income
 Risks for Financial Institutions
• Regulatory Risk
• Credit & Operational Risks
• Market risk
GOOD AML/CFT FRAMEWORK
 Enhances efficiency & capacity in:
 Detection of corruption & financial fraud;
 Preventing bribery of public officials;
 Discourages:
 tax evasion/avoidance;
 growth of underground economy
 Promotes legitimate private business sector;
 Enhances financial sector supervision;
 Avoid “name & shame” process.
GOALS OF AML/CFT
LAWS & POLICIES
• Know-Your-Customer (KYC)
• Report Suspicious Transactions
• Financial Intelligence Unit (FIU)
A central, national agency responsible for receiving,
requesting, analyzing and disseminating to the
competent authorities, disclosures of financial
information in order to counter money laundering.
Basic FIU Concept
(one example)
Financial
Institution
Financial
Institution
Financial
Institution
Financial
Institution
Foreign
FIU
3
1
FIU
4
2
Law
Enforcement
Prosecutorial
Authorities
AML/CFT METHODOLOGY





Money laundering properly criminalized?
KYC policies/procedures required?
Compliance officers & staff training required?
Financial Intelligence Unit (FIU) operational?
Sectors & entities are covered?
 Financial institutions
 Securities, insurance, leasing companies,
 Casinos, other entities, professions
 Cooperation permitted (domestic & international)?
 Penalties sufficient?
ORGANIZATIONS &
REFERENCES
 United Nations [www.un.org ]
 UN Global Program Against Money Laundering (Vienna)
 UN Security Council: Counter-Terrorism Committee (NYC)
 Model laws & regulations: [www.imolin.org ]
 Fin. Action Task Force Ag. Money Laundering
“FATF” [www1.oecd.org/fatf]
 40 AML Recommendations + 8 new CFT Recommendations
 Regional FATF organizations
 NCCT List [www1.oecd.org/fatf/NCCT_en.htm]
 Egmont Group [see FATF website]
 Quick ref: Country summaries by U.S. State Dept.
 [www.state.gov/documents/organization/8703.pdf]
STRESS TESTING
A Review of the Issues
and Methodologies
What Are Stress Tests?
• Range of techniques used to assess the
vulnerability of a portfolio to major changes in
the macroeconomic environment or to
exceptional events.
• In the case of banks, stress test are conducted to
evaluate vulnerability to credit (or default),
interest rate, foreign exchange, and liquidity
risks.
• Techniques were developed for individual
portfolio applications, but can be applied to
aggregate portfolios.
Why Conduct Stress Tests?
Reasons for banks:
• Make risks more transparent by estimating potential losses on a
portfolio in abnormal markets.
• Complement statistical models with information about losses
under extreme events.
• To comply with Basle recommendations.
– Basle states that banks that use internal models to measure market risk
must conduct stress tests.
Reasons for supervisors:
• To measure systemic risks.
• To understand tests undertaken by banks and ensure adequate
risk management.
Stress Tests Limitations
• They rely on judgment:
–
–
–
–
What risk factors to stress
How to combine factors stressed
Range of values to consider
Time frame to analyze
• They have no probabilities attached to them.
– Help answer “how much could be lost” but not “how
much is likely to be lost”.
• Generally, these tests do not integrate different
types of risks.
Stress Testing Decision Sequence
Type of risk model
Market risk
(interest rate risk,
exchange rate risk, etc.)
Credit Risk
Other
(liquidity, operational)
Type of stress test
Sensitivity single factor
Scenario
(multiple factors)
Other
(extreme value,
maximum loss)
Type of shock
Individual market variables
Underlying volatilities
Underlying correlations
Type of scenario
Historical
Hypothetical
Core assets to be shocked,
size of shocks, and
time horizons
Aggregation, comparison with present portfolio
Monte Carlo simulation
Aggregate Stress Testing of
Financial Systems
• Measure of the risk exposure of a group of
reporting firms (i.e., banks) to a specified stress
scenario.
• Objectives:
– Offer “forward-looking” rather than historical
information on aggregate risk-taking behavior.
– Help regulators identify structural vulnerabilities and
risk exposures that could lead to a disruption of
financial markets.
– Emphasis on potential externalities and market failures
(e.g., evaporation of liquidity).
Aggregate Stress Testing of
Financial Systems
• Challenges:
– Determine the scope (i.e., which institutions to
include?)
– How best to aggregate?
• Compile results of individual tests, report distribution of
results, dispersion?
• Test aggregate portfolio and report average?
• Limitations:
– There are no probabilities attached to the outcomes.
Data Requirements for the Conduct of
Banking Sector Stress Tests
• Balance sheet and income statement data (ideally
at high frequencies) covering at least 5 years.
• Information on banks’ (on and off-balance sheet)
exposure to exchange rate changes, specific
economic sectors, etc.
• Market indicators of bank performance if
available.
• Bank ratings by regulators or external auditors.
• Macro-indicators affecting the financial system
(e.g., GDP growth, real interest rates, stock prices,
exchange rates, etc.)
Credit Risk
• Risk that a counter-party or obligor will default on
their contractual obligations.
• Objective of stress tests: assess the extent to which
bank solvency is impacted by:
– (a) Better provisioning of existing bad loans (i.e., either reflecting
an adjustment in provisions to cover “true” NPLs or a rise in
provisions to more adequate levels).
– (b) Future losses arising from the impact of micro or macro
conditions on banks’ stock of bad loans.
– Given (a) and (b), the new capital-asset ratio will be:
revised capital asset ratio 
capital  extra provisions  un exp ected losses
risk weighted assets  extra provisions  un exp ected losses
Implementing Credit Risk Stress Tests
• How to estimate future losses:
– Examine default transition matrices.
– Examine past trends of NPLs and assume that past losses recur.
– Use regression analysis to estimate response of non-performing loans to
macroeconomic shocks like changes in interest rates, changes in real
GDP, changes in terms of trade, etc.
– Commercial products such as JP Morgan’s Creditmetrics, Credit Suisse’s
Creditrisk+, McKinsey’s Credit Portfolio View, and KMV’s Creditor
Monitor have been developed to help banks estimate the distribution of
potential future losses.
• What to do when data is limited:
– When no precise information exists on the extent of underprovisioning or
the behavior of NPLs, it might be useful to at least calculate the
maximum loss that banks could bear if capital is to remain above the
required level.
Interest Rate Risk
• Risk incurred by a financial institution when the
interest rate sensitivity of its assets and liabilities
are mismatched.
• Interest rate changes can affect:
– (a) the income of financial institutions
– (b) the market value of assets and liabilities
• Common approaches to analyze interest rate risk:
– Repricing gap model
– Duration model
– In both cases we need to identify interest rate sensitive
assets (e.g. loans, government bonds, etc.) and
liabilities (deposits, loans received, etc.).
Gap analysis
• Objective: examine the change in the bank’s net
interest income resulting from a change in
interest rates.
Maturity Interest Interest Size of
Buckets sensitive sensitive gap
assets (1) liabilities (1)-(2)
(2)
Next 15
days
Next 30
days
Next 30
years
• NII= interest income - interest expenses
• It follows that ΔNII=Δr*cumulative gap
– If gap is >0, then NII increases as r increases.
– If gap is <0, then NII drops as r increases.
Duration analysis
– Objective: Examine the impact of interest rate changes on
bank solvency measured at market values.
– Conceptual underpinnings:
• Market value of an asset or liability is the present value of its cash
flows. As interest rates rise, the market value drops.
– Market value of a bank is the difference between the market value
of its assets minus its liabilities.
• Duration:
– Weighted average time to maturity, using the present values
of the cash flows as weights.
– Measure of the interest rate sensitivity or elasticity of an asset
or liability to interest rate changes.
– Duration analysis consists of evaluating the dollar
weighted duration of assets vis-a-vis that for liabilities.
The market value of a bank will drop as interest rates rise,
if the former is larger than the latter.
Duration Analysis
Given that :
and since
then,
P
D P
R
1 R
R
P   D *
*P
1 R
E  A  L
R
R
E   DA *
* A  [ DL *
* L]
1 R
1 R
E as R if DA*A < DL*L
Implementing Interest Rate Risk Stress Tests
• Type and size of shocks:
– Simplest type of shocks: (a) parallel shift in yield curve, (b) change in
slope of yield curve, and (c) change in the spread between interest rates
with the same time horizon.
– Commercial bank examination manual of the U.S. Federal Reserve
recommends a 200 basis point parallel shift in the yield curve as a
plausible scenario.
– Alternatively, examine the impact of large interest rate changes observed
in the past either in the country in question or in neighboring countries.
• Time horizon:
– A longer time horizon allows for a greater variation and possibility of
larger shocks. Scenarios with shorter time horizons tend to be applied to
institutions with large trading portfolios subject to risk on a daily basis.
• What to do when data limitations exist:
– Make educated guesses of the duration of assets and liabilities to get
upper and lower bound estimates of changes in equity following changes
in interest rates.
Exchange Rate Risk
• Risk that exchange rate changes can affect the value
of an institution’s assets and liabilities.
• Exchange rate risk can be direct or indirect:
– Direct: where a financial institution takes or holds a
position in foreign currency
– Indirect: foreign exchange exposure of financial
institutions’ borrowers affect their creditworthiness
• Stress test objective: calculate the impact of a
devaluation on the solvency of banks.
• Net foreign exchange exposure (NFE)= foreign
assets - foreign liabilities
• If NFE<0 bank loses from a devaluation.
Implementing Exchange Rate Stress Tests
• Type of shock:
– Depending on their relevance, one or more exchange rates can be
shocked either separately or simultaneously.
• Type of scenario:
– If the exchange rate has suffered from sharp depreciations in the past,
historical scenarios could be used.
– Currency crises in other countries could be used as a yardstick.
– Hypothetical yet plausible scenarios can also be used.
• Recommended size of shocks:
– Derivatives Policy Group (1995) recommends shocks between 6-20%.
Commission of the European Communities (2000) suggests 10%
change.
• What to do when data limitations exist:
– If supervisors have defined hard limits on the net open foreign
exchange position of financial institutions, these could be used to
conduct stress tests.
Liquidity Risk
• Banks face constant liquidity pressures because of the
nature of their business.
– Banks fund longer-term loans with short-term liabilities.
– Imbalances between the maturity of assets and liabilities of
banks may imply that incoming cash flows from assets may
not match the cash outflows to cover liabilities.
– Liquidity problems may result from assets unexpectedly
becoming illiquid during period of stress.
• E.g., banks holding government bonds as liquid assets may find that
the market may disappear during times of crisis.
Liquidity Stress Tests
• Objective: examine the impact of changes in bank
liquid assets on the ability of banks to meet their liquid
liabilities. In particular, analyze:
– (1) What size deposit run could a bank endure, given its
liquid assets?
– (2) What if certain assets considered liquid become illiquid
at times of stress?
• Type and size of shocks:
– Use historical data.
• At the minimum, banks should be able to withstand shocks of a
similar magnitude to those observed in the past.
– Examine deposit withdrawals observed in other peer group
countries.
Market risk and Value-at-risk
• Market risk refers to the likelihood of losses on a
portfolio arising from movements in market prices
(commodity prices, exchange rates, interest rates,
stock prices, etc.).
• The value-at-risk (VAR) of a portfolio is a
statistical measure that summarizes the largest
expected loss that the portfolio is likely to suffer
over a specified time period for a given level of
confidence.
– E.g. a portfolio may have a ten-day VAR of $100
million at a 99% confidence. This implies that over the
next ten days there is less than 1% chance that the
portfolio will lose more than $100 million.
Drawbacks from Using VARs
• Not useful in providing information about
unlikely events.
• The accuracy of the loss threshold depends on the
specification and estimation of the underlying
statistical model of portfolio returns.
– If the true distribution of returns has fatter tails than the
assumed distribution, then the VAR may underestimate
the losses.
– If the estimation technique is inaccurate (e.g., because
of linear approximation) the model may under-predict
losses.
Stress Testing in the Context of the FSAPs
•
•
•
•
Mostly univariate tests have been conducted.
Scenarios tend to be historical or hypothetical.
Size of shocks varies by country.
Methodologies discussed above have been
implemented with the exception of VAR, which
has only been used in a few cases.
• Areas for improvements:
– Develop multivariate tests that account for changes in
correlations.
– Determine likely feedback of banking sector problems
to the macroeconomy and other areas of the financial
sector.
References
- Bank for International Settlements (2000), “Stress Testing by
Large Financial Institutions: Current Practice and Aggregation
Issues,” Committee on the Global Financial System.
- Bank for International Settlements (2001), “A Survey of Stress
Tests and Current Practice at Major Financial Institutions”
Committee on the Global Financial System.
- Blaschke, Winfrid, Matthew Jones, Giovanni Majnoni and
Maria Soledad Martinez Peria (2001), “Stress Testing of
Financial Systems: A Review of the Issues, Methodologies, and
FSAP Experiences,” IMF Working Paper, WP/01/88.