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INTERNATIONAL FINANCIAL PROGRAMS

Explore how international initiatives such as the Financial Sector Assessment Program address financial issues like money laundering, terrorist financing, and risk management, enhancing financial integrity and stability. Learn about key standards assessed and objectives achieved through these programs.

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INTERNATIONAL FINANCIAL PROGRAMS

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  1. INTERNATIONAL FINANCIAL PROGRAMS Overview of Financial Issues and Analysis May 31, 2002

  2. OUTLINE • Financial Sector Assessment Program • Money laundering and terrorist financing • Stress testing

  3. IMPLICIT THEMES • Crisis prevention • Risk assessment • Sound practices • Risk management • At policy level • At level of private institutions (financial and nonfinancial)

  4. FINANCIAL SECTOR ASSESSMENT PROGRAM

  5. 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.

  6. INTERNATIONAL INITIATIVES:Bodies • G-7 Economic Summits • G-22 Working Groups • Financial Stability Forum • Joint IMF/World Bank Financial Sector Liaison Committee (FSLC)

  7. INTERNATIONAL INITIATIVES:Instruments • Financial Sector Assessment Program (FSAP) • Reviews of Standards and Codes (ROSC) • Technical assistance and country follow-up

  8. WHAT IS THE FSAP? • A joint product of the IMF and the WorldBank (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

  9. 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

  10. 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.

  11. 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

  12. 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

  13. OTHER KEY STANDARDS • Accounting • Auditing • Insolvency and creditor rights • Corporate governance • Data dissemination (IMF) • Fiscal transparency (IMF)

  14. TECHNICAL ASSISTANCEandCOUNTRY FOLLOW-UP These are critical.

  15. MONEY LAUNDERINGandTERRORIST FINANCING

  16. 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

  17. MONEY LAUNDERING any transaction involving funds derived from criminal activity TERRORIST FINANCING Fundraising or supporting organizations engaged in terrorism.

  18. 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

  19. COMMON PREDICATE OFFENCES • Terrorism/terrorist financing • Drug trafficking • Bribery • Smuggling (arms, people, goods) • Theft • Embezzlement • Racketeering • Tax evasion • Gambling • Prostitution

  20. 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.

  21. 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

  22. 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.

  23. GOALS OF AML/CFTLAWS & 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.

  24. Basic FIU Concept (one example) Foreign FIU Financial Institution 3 Financial Institution 1 FIU Financial Institution Prosecutorial Authorities 4 Financial Institution 2 Law Enforcement

  25. 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?

  26. 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]

  27. STRESS TESTING A Review of the Issues and Methodologies

  28. 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.

  29. 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.

  30. 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.

  31. Stress Testing Decision Sequence

  32. 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).

  33. 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.

  34. 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.)

  35. 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:

  36. 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.

  37. 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.).

  38. Gap analysis • Objective: examine the change in the bank’s net interest income resulting from a change in interest rates. • 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.

  39. 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.

  40. Duration Analysis Given that : and since then, E as R if DA*A < DL*L

  41. 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.

  42. 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.

  43. 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.

  44. 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.

  45. 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.

  46. 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.

  47. 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.

  48. 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.

  49. 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.

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