FINANCIAL STABILITY

Monitoring and Identifying Risks

GROUP 5
Boyco, Jaizza Mae
Calang, Reyjoy
Claros, Daisy Keith
Delapena, Cherry
Edillor, Kenna Mariz
Florencio, Johanna Brigitte
Magagbologtong, Aila Marie
Malhin, Maria Christy
Tabar, Maridel
 11.2 Monitoring and Identifying Risks in the
Macroeconomy
What is Macroeconomy?
Macroeconomy is a large scale of economic
system.
Who are Involved?
 Household Sector
 Corporate Sector
 Government Sector
 External Sector
 Financial Imbalances in Macroeconomy Indicator

• Overindebtedness (Household, Firms, Government, • Balance Sheet

and External Sector)

• Asset Price Bubbles • Fast Rising of Asset Prices

 HOUSEHOLD SECTOR
• Individual
• Consumer
• Entrepreneur

How to Identify Risk?

1. Look at the growth rate of overall household debt

2. Examine composition of that debt

Indicators
• Household debt to GDP Ratio
Household debt to GDP = Household Debt
Gross Domestic Product
• Growth in various types of credit extended to household (credit card,
auto loans, and mortgage)
• Gap Measurement Approach
– proposed by Claudio Bario and Philip Lowe
– ratio of household to GDP might be compared to its historical
trend, a large gap between the current ratio of household debt to
GDP and the historical trend might warrant concern.
Where to get the data?
 From Survey
 Data from Financial Institution

Practical Example
 Global Financial Crisis
 CORPORATE SECTOR
Corporate Sector is a non-financial and financial corporation

How to identify Risk?

1. Look at the growth rate of corporate sectors debt
2. Examine components of corporate debt
Indicators
• Debt to Income Ratio
Debt to Income Ratio = Monthly Debt Payment
Gross Monthly Income
• Debt to Capital
Debt to Capital Ratio = Total Debt
Total Debt + Equity
• Gap Measurement Approach (same to household)
Where to get the data?
 Loans to corporate sector by Financial Institutions
 Bond issuance by corporate sector

Practical Example
 Dot-com Bubble
 GOVERNMENT SECTOR
• Local Government

How to identify the risk?

1. Need to assess the growth of public debt or debt for which the
government is liable.
2. Examine the composition of public debt.
3. Need to look at the growth of government contingent liability
4. Look at country sovereign debt rating
Indicators
 Public Debt to GDP
Public Debt to GDP = Total Debt of the Country
Total GDP of the Country
 Gap Measurement Approach
-How public debt to GDP ratio deviated from its historical trend
Practical Example
 European Sovereign Debt Crisis in 2010
 EXTERNAL SECTOR
• External Creditor

How to Identify risk?

1. Look on both the growth and level of external debt incurred by various
agent as well as currency and maturity profile of that debt.
2. Capital flow must be monitored
Indicators
 Fast rise in dent owed to external creditor
 Source of income to finance debt
 Degree of maturity mismatch of the debt

Practical Example
 Latin America Debt Crisis in 1980
 ASSET PRICE BUBBLE
Real estate, stocks, mortgage

How to identify the risk?

1. Look at the growth rate of real estate to stock market price
2. Increased in loans related to this market also need to be closely
monitored.
Indicator
 Fast- Rising Asset Prices
 Gap approach by comparing the real asset price to its historical
trend
 Price Earnings Ratio
Price Earnings Ratio = Share Price
Earning per share
 11.2 Monitoring and Identifying Risks to
Financial Institutions
Financial Institutions
 Encompass a broad range of business operations within the financial services sector
 Bank or non-bank financial institutions (nbfi)
• Example: Rural banks, trust companies, insurance companies, brokerage firms,
cooperative banks, and investment dealers.
Top 5 Stock Brockers in the Philippines
1. First Metro Sec Pro
2. COL Financial
3. BDO Securities
4. BPI Trade
5. Philstock
 Major Risks to Individual Institutions
 Credit Risk
• Risk that the bank’s debtors or counterparties might be unable to
repay their debts in the manner specified in the loan contracts, or
fulfill their obligations to the bank.
• Ex. A borrower defaults on a principal or interest payment of a loan.
 Market Risk
– Arises when movements in market rates and prices adversely affect the institution’s
financial position such as interest rates, foreign exchange rates, and equity prices.
 Operational Risk
– The risk of loss resulting from inadequate or failed internal processes, people, and
systems, or external event (BCBS, 2020).
– Ex. A teller mistakenly or accidentally gives an extra $50 bill.
 Liquidity Risk
– Arises from the possibility that an institution would not be able to meet its short term
obligations as they come due.
– Central Bank’s reserve requirements regulation.
 Systemic Risk
 Situation wherein the entire sector or industry stream gets
affected and suffers even by the downturn or collapse of a
single big entity in the sector/industry. And that will adversely
impact the entire financial system due to one single company.
– Ex. A large bank that provides large amounts of credit without
adhering to standards could lead to systemic risk.
– Collapse of Lehman Brothers
 CAMELS
• The CAMELS rating
system assesses the strength
of a bank through six
categories
• Proposed by the National
Credit Union Administration
(NCUA)
• FED
 Risk Distribution within the Financial Networks
 Also known as risk sharing, is a fundamental feature of
insurance.
 Financial institutions (banks and nonbanks) interact by
borrowing and lending among themselves.
 Help promote resiliency of individual institutions by enabling
those short of liquidity to tap funds from those with excess
liquidity.
 Risk Concentration in Systematically Important
Financial Institutions (SIFIs)
• Risk Concentration- is the
potential for a loss in value
of an investment portfolio or
a financial institution when
an individual or group of
exposures move together in
an unfavorable direction.
• “too-big-to-fail”
 CHAPTER 12 Financial Stability
Intervention Tools
 Intervention Tools are tools central banks might use to intervene, safeguard, and restore financial
stability
12.1 The Macroeconomy
 Sustaining Financial Stability: Dealing with Threats Against the Macroeconomy Ex Ante
 Sustaining Financial Stability: Dealing with Risks within Macroeconomy Ex Post
12.2 Financial Institutions
 Sustaining Financial Stability: Dealing with Threats to Financial Institutions Ex Ante
 Sustaining Financial Stability: Dealing with Threats to Financial Institutions Ex Post
12.3 Financial Markets
 Sustaining Financial Stability: Dealing with Threats to Financial Markets Ex Ante
 Sustaining Financial Stability: Dealing with Threats to Financial Markets Ex Post
 12.1 THE MACROECONOMY
2 Key Intervention Tools

1.) Monetary Policy

2.) Macroprudential Measures
– are designed to address risk buildups in specific areas that, if
remain
– unchecked, could affect systemwide stability.
●Limits on Loan-to-Value Ratios
-Limits on LTV ratios are used to address risk buildups in
the housing market. LTV ratios limit households’ borrowing
capacity through
the amount of the down payment required for a housing
purchase.
●Debt-to-Income Ratio
-ratio is a metric used by creditors to determine the ability of
a borrower to pay their debts and make interest payments.
The DTI ratio compares an individual’s monthly debt
payments to his or her monthly gross income. It is a key
indicator that lenders use to measure an individual’s ability
to repay monthly payments and accumulate additional debt.
●Ceiling Credit Growth
-A ceiling may be imposed on either total bank lending or
credit to a specific sector. The ceiling on aggregate credit or
credit growth may be used to dampen the credit/asset price
cycle—the time dimension of systemic risk. The ceiling on
credit to a specific sector, such as real estate, may be used
to contain a specific type of asset price inflation or limit
common exposure to a specific riskk—the cross-sectional
dimension of systemic risk
●Caps on Unhedged Foreign Currency Lending
-Caps on unhedged foreign currency lending are placed on
banks, which may borrow overseas to lend to domestic
borrowers in a foreign currency.15 Caps on foreign currency
lending can be used to limit exposure to the unhedged
foreign exchange rate risk that comes with external
borrowing.
Sustaining Financial Stability: Dealing with
Risks within the Macroeconomy Ex Post
 Once overindebtedness has started leading to chains of
defaults, or when asset pruce bubbles start to burst, the
central bank can also decide to intervene ex post, and
deal with threats to financial stability that might arise from
the macroeconomy.
 Such intervention could be done through (1) the easing of
monetary policy, and (2) the use of macroprudential
measures.
 Monetary Policy Easing
What is easing of monetary Policy?

Monetary Easing is the policy in which a central bank

lowers interest rates and deposit ratios to make credit more
easily available.
 Conventional Monetary Policy Easing
 Conventional monetary policy easing through a cut in
interest rates helps safeguard the macroeconomy and
financial stability by reducing risk among the agents within
the economy, particularly credit risk.
 Unconventional Easing
 Unconventional Monetary Policy occurs when tools other than
changing a policy interest rate are used. These tools include:

 Forward Guidance
 Asset Purchases
 Term Funding Facilities
 Adjustmenst to market operations
 Negative interest rates
 Macropudential Measures
 To help safeguard the macroeconomy and financial
stability ex post, the central bank can also loosen credit-
related macroprudential measures- such as caps on LTV,
DTI, or credit growth- that had previously been tightened
during the period of economic upturn.
12.2 FINANCIAL INSTITUTIONS
Sustaining Financial Stability: Dealing with
Threats to Financial Institutions Ex Ante
Microprudential Supervision - aim to ensure that individual banks do
have enough capital and liquidity to cover any emerging shocks,
and that the banks are managed in a safe and sound manner.
Onsite examinations - CAMELS rating
Offsite monitoring - checking corrective actions
- in case of serious breach of compliance, option to remove
directors or management of the bank for negligence or misconduct,
and install a temporary administration
- in case of insolvency, forced sale or liquidation of the bank to
prevent a bank run
Macroprudential Supervision - puts more emphasis on the resiliency of the banking system as a
whole.
Macroprudential measures -used to safeguard financial institutions against systemic risks.
 Capital-related macroprudential tools
- time-varying capital requirements
- dynamic provisioning
- extra capital buffers for SIFIs
 Liquidity-related macroprudential tools
- limits on net open positions
- limit on mismatches
- liquidity coverage ratios (LCR)
- net stable funding ratios (NSFR)

Capital-Related Macroprudential Measures

Capital requirements - used to guard against systemic risk that might arise from
(1) risk amplification through the business cycle, and
(2) risk concentration and distribution within the system
 CONCEPT: THE BASICS OF CAPITAL REQUIREMENTS: THE
RELATIONSHIP BETWEEN ASSETS, LIABILITIES, AND CAPITAL

ASSSET=LIABILITIES + OWNER’S EQUITY

If a bank’s assets decline in value, possibly because borrowers cannot repay their loans, the value
of the bank’s total liabilities must also decline for the balance sheet to remain balanced.

FIGURE 12.1 The Use of Bank Capital to Absorb Loan

Losses
Source: Adapted from Jorge A. Chan-Lau, "Balance
Sheet Network Analysis of TooConnected-to-Fail Risk
in Global and Domestic Banking Systems" (IMF
Working Paper WP/10/107, April 2010).
Capital -the part of the business that actually belongs to shareholders (as
opposed to creditors).
For banks, capital would normally include common equity, preferred equity,
retained earnings, and required reserves.

Classifications of Capital
1. Tier 1 - capital reflects the banks’ strength (or lack thereof)
2. Tier 2 - part of capital that might temporary rise or might be transformed into
Tier 1 capital under certain circumstances, includes changes in valuation of
fixed assets.
CAPITAL RATIO = CAPITAL/RWA

RWA- are types of assets that have different degree of riskiness

depending on the type of loan and the type of borrower.

In aggregate, how much capital the bank should hold against their
assets should thus be determined by how many different types of
assets are being held and the degree of riskiness of each type.
Capital Adequacy Requirements in the Macroprudential
Context
Capital adequacy should be adjusted to take account of risk
accumulation and risk-taking behavior by both banks and
borrowers over the business cycle.
Time-varying capital requirements
The gist of time-varying capital requirements is that capital
requirements should be raised during good times and
lowered during bad times to safeguard the stability of the
banking system from the vagaries of the business cycle.
A proposal made by Charles Goodhart, an economic consultant
to Morgan Stanley in 2009 in his 2013 paper entitled "An
Integrated Framework for Analyzing Multiple Financial
Regulations” also suggested the use of capital requirements as
an active tool to sustain financial instability.
According to Goodhart’s 2013 paper, there should also be “an
increasing ladder of penal sanctions” as a bank’s equity capital
falls. As the bank’s capital adequacy falls towards a “minimum
intervention point," official action should be taken to remove
management and shareholders, and to move to a resolution.
According to this view, rather than passively monitoring banks
to ensure that they comply with capital adequacy requirements,
capital adequacy requirements could be used by regulatory
authorities as an active tool to maintain financial stability ex
ante.
 CONCEPT: INTRODUCTION TO BASEL I, II,
AND III
G10 MEMBERS
Basel Accords Belgium Netherlands
 Set of international banking regulations Canada Sweden
 Established by the Basel Committee on France Switzerland

Banking Supervision (BCBS), a group Germany United Kingdom

of banking supervisors whose Italy United States

secretariat is based at the Bank for Japan

International Settlements in Basel,  Discusses to replace the recently

Switzerland. collapsed Bretton Woods system
 The Basel Committee’s main objective
was to create prudential rules for banks
with an initial focus on establishing
minimum capital requirements.
 BASEL I
Bank’s BANK’S ASSET
 Aimed to standardize the computation risk
Category
of risk-based capital across banks and
0% cash, central bank, and government debt, and any
across countries. Organisation for Economic Co-operation and
 Issued in 1988 by the Basel Committee Development (OECD) government debt, domestic
government bonds
on Banking Supervision.
10% public sector debt
 primarily focuses on credit risk and 20% development bank debt, OECD bank debt, OECD
risk-weighted assets (RWA). securities firm debt, non-OECD bank debt (under
one year of maturity), non-OECD public sector
 Banks were required to hold capital as debt, and cash in collection
reserves against the assets at 0, 10, 20, 50% mortgages
50, or 100% depending on the 100% debentures, private sector debt, non-OECD bank
perceived level of risk associated with debt (maturity over a year), real estate, plant and
equipment, and capital instruments issued at other
it. banks.
 BASEL I
 Banks had to hold capital of at least 8% of risk-
weighted assets
 Can be expressed as

Capital Adequacy Ratio = Capital/RWA ≥ 8%

where:
Capital = value of bank’s capital
RWA = value of the bank’s risk-
weighted assets
EXAMPLE:
Where: CAR : 4,000 / 25,000 = 16%
As Bank of BAFM3A has a CAR of 16%, it has enough
capital to cushion potential losses and protect depositors’
money.

 Aims to make capital
requirements more risk-
sensitive.
 Basel I only accounts for
credit risk and market risk
– Basel II includes
operational risk and other
risks.
 COMPARISON BETWEEN
BASEL 1 AND 2
BASEL II
AREAS OF BASEL I
DIFFERENCE
Basel Accords Basel I is the older of the Basel
Accords
Year of Basel I was initially published in
Implementation 1988, and was enforced by law in
the Group of Ten (G-10) countries.
Area of focus Basel 1, that is, the 1988 Basel
Accord, primarily focused on
credit risk
Scope of the The Basel I accord dealt with only
framework parts of each of these pillars. For
example, only one risk, credit risk,
was dealt with in a simple manner
while the market risk was an
afterthought; operational risk was
not dealt with at all.
BASEL II
Basel II is the second of the
Basel Accords
Basel II was initially published
in 2004.
Basel II focused on three
major components of risk that
a bank faces: credit risk,
operational risk, and market
risk.
Basel II uses a "three pillars"
concept; (1) minimum capital
(addressing risk), (2)
supervisory review
requirements, and (3) market
discipline.
 BASEL II
Improvements through the use of the three pillars approach.
Pillars Basel I
Capital requirements Under Basel I the risk-based capital
ratio is measured as follows:
Capital Adequacy Ratio =
Capital/RWA ≥ 8%
Supervisory Review Under Basel I individual risk weights
depend on a broad category of
borrowers.
Market Discipline This pillar doesn't exist in Basel I.
Basel II
In Basel II, the definition of capital will remain
the same and the ratio of capital to risk-weighted
assets will also be at 8% for total capital.
Under Basel II the risk weights are to be refined
by reference to a rating provided by an external
credit assessment institution or by relying on
internal rating-based approaches where the banks
provides the inputs for the risk weights.
The third pillar in Basel II aims to bolster market
discipline through enhanced disclosure by banks.
More detailed reporting requirements.
 BASEL III
• Basel II needed revisions by the time the global financial crisis became full-blown in 2008.
• Issued in late 2010
Shortcomings of Basel II Components of Basel III
Unclear and inconsistent Enhanced transparency,
capital definition consistency, and quality of
capital base
Exposure to some risk Risk-based capital
not addressed requirement
• Common equity must be
4.5% of risk-weighted assets.
• Capital conservation buffer is
2.5 percent of risk-weighted
assets.
• Total common equity
standard to 7%
• Minimum total capital ratio
remains at 8%
Nonrisk-based leverage ratio
 Dynamic Loan Loss Provisioning
 Raise their provisions for expected losses for the loans they
make during good times and lower their provisions for
expected losses during bad times.
 Liquidity-Related Macroprudential Tools
 Limits on banks’ net open positions
 Limiting the exposure of companies towards foreign exchange
risk that the company is exposed towards. The exposure of the
foreign exchange risk is defined as the difference between total
assets and total liabilities in the foreign currency.
 Limits on currency and maturity mismatches
 Assets and liabilities are denominated in different currencies
 The former is referred to as an asset-liability mismatch.
Sustaining Financial Stability: Dealing with
Threats to Financial Institutions Ex Post
 Micro and macroprudential measure and capital
aduquacy requirements such as those proposed in Bael I,
II, and III are used to ensure that financial institutions are
generally in a safe and sound conditions ex ante. In
practice, however, financial institutions often borrow short-
term and lend long-term, meaning that is very possible
that thay could experience unexpected liquidity shortages,
whether from internal or external factors, despite very well
capitalized.
 The Discount Window
 To prevent liquidity shortages from creating undue strain
on financial institutions and causing systemic failure, the
crentral bank can provide access to backup liquidity for
eligible financial institutions through a facility that is often
known as the discount window. In the early days of
central banking, the discount window was the principal
instrument of central banking operations where the
central bank provided funds to financial institutions that
needed them.
 Special Resolution for Troubled Financial
Institutions and Living Wills
 Despite various measure put in place, there is always a
possibility that a bank might still fail. to ensure financial
stability, the central bank and related authorities might
need special resolutions to ensure that a atroubled bank
does not fail in a disorderly manner.
 According to 2012 work from Claire McQuire, there are
four key types of special resolutions that regulatory
authorities might resort to when they want to ensure an
orderly reolution for troubled bank: (1) liquidation, or
closing of the bank; (2) coservatorship, or temporary
 Liquidation: Closing of a Bank. Liquidation is often
preferred option in cases in which regulatory authorities
feel that the closure of the bank would not lead to
contagion effects.
 Conservatorship: Temporary Administration. If regulatory
authorities feel that closing the troubled bank immediately
wuld create unnecessary disruption, regulatory authorities
might appoint a temporary administration team who would
take over from the bank’s own senior executives.
 Purchase and Assumption: Facilitating an Acquisition by
Another Party. To prevent unnecessary disruptions,
another alternative is for regulatory authorities to pursue
what is known as purchase and assumption (P&A).
 Nationalization: Assumption of Ownership by the
Government. In the environment in which the system is
already under a lot of stress and a more market-based
resolution might not be timely or effective, regulatory
authorities might nees to assume ownership of the
troubled bank.
 Living Wills. In the wake of the 2007-2010 crisis, it has
been recognized that modern financia institutions can be
very large with very complec ownership structures and
contractual obligations.
12.3 Financial Markets
 Three key reasons

• First is the growing importance of financial markets.

• Second, severe disruptions in the financial markets can
result in shortages of liquidity.
• Third, through its day-to-day monetary policy operations
in the financial markets.
Sustaining Financial Stability: Dealing with Threats to Financial

Markets Ex Ante
• Monetary Policy
• Regulatory power over banks (bank supervisor)
• Central bank has the ability to deal with threats to
financial markets ex ante.
• Using Monetary Policy to Address Risk Buildups in the
Financial Markets
– Tightened Monetary Policy
• raises the cost of funds
• Regulations on Market Players
– They are established to oversee the functioning and fairness of
financial market and the firms that engage in financial activity.
 List of Financial Regulatory Authorities
• Philippines
– Philippine Securities and Exchange Commission (SEC)
– Insurance Commission
– Bangko Sentral ng Pilipinas
– Philippines Deposit Insurance Corporation (PDIC)
– Department of Finance
– Philippine Stock Exchange
– Bureau of Treasury
Sustaining Financial Stability: Dealing with Threats to Financial

Markets Ex Post
• Control of Monetary Policy
• Lender of Last Resort
– Central bank also are in a good position to deal with threats to
financial markets ex post.
• Monetary Policy and Liquidity Risk
– As overindebtedness or bubbles start to materially affect
financial stability, it becomes more likely that players in the
financial markets would be wary of lending to each other, as
they become unsure of each other’s ability to fulfill their
transaction obligations.
• Liquidity Provision to Institutions Not Supervised by the
Central Bank
• Central bank provided liquidity to during the crisis
although they were not necessarily under its supervision
were:
– Primary Dealers
– Money Market Mutual Funds
– Commercial Paper Issuers
– Investors in the asset-backed securities market
– Foreign Central Banks
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