The Use of Financial Accounts in Assessing Financial Stability 1

STD/NAES/FA(2003)4

1

STD/NAES/FA(2003)4

The Use of Financial Accounts in Assessing Financial Stability[1]

1.Introduction

The financial crisis in Asia in the late 1990s has highlighted the importance of identifying potential sources of financial risk and alternative approaches for assessing the vulnerabilities of national economies as well as of specific institutional sectors within national economies. It also stimulated detailed research on threats to macroeconomic financial stability in addition to microeconomic analyses in the context of financial supervision.

Since its creation in June 1998, the European Central Bank (ECB) has been involved via the European System of Central Banks’ (ESCB) Banking Supervision Committee (BSC) in the assessment of financial stability in the European Union, either from a euro area-wide or from an EU country perspective. Various reports have already been produced by the BSC on this subject[2], mainly based on data taken from balance sheet statistics of monetary financial institutions (MFI) or from corresponding statistics of available supervisory reports. One of the deficiencies mentioned in the reports was that the assessment of financial stability is based on rather incomplete and non-harmonised sets of financial data for the EU countries and for the euro area as a whole. This refers specifically to data for non-monetary financial institutions, but also applies to data for non-financial corporations and households.

Quarterly Monetary Union financial accounts (MUFA) provide a comprehensive set of financial data for the euro area and its main institutional sectors. Based on such euro area data, comparable sets of accounts can be provided for the euro area and the pre-in countries to assess financial stability. Quarterly MUFA as a framework within the System of National Accounts (SNA 93) focus on the compilation and analysis of financial flows between/ and stocks of/ the various sectors of the euro area economy.

Quarterly MUFA are still under construction at the ECB with the aim of increasing the coverage of sectors and financial instruments. However, the quarterly Tables on Financing and Investment (TFIs) of euro area non-financial sectors and of insurance corporations and pension funds already provide detailed information on financial transactions and balance sheets. They are used to evaluate the financial soundness of these sectors, for instance by assessing their degree of indebtedness.

The paper is organised as follows. Section two describes the methodological framework of the system of quarterly MUFA in the context of financial stability analysis, while Section three outlines the developments instigated by the ECB on macro-prudential analysis and financial supervision. Section four presents the work on quarterly MUFA currently being undertaken by the ECB and provides an outlook on how to use quarterly MUFA for purposes of financial stability analysis in the future. Finally, Section five makes some concluding remarks.

2.Quarterly Monetary Union financial accounts related to financial stability analysis

2.1.The methodological framework of quarterly Monetary Union financial accounts

There are essentially six conceptual elements in the design of a system of quarterly MUFA: its integration into the SNA 93 or into its European twin, the European System of Accounts (ESA 95); the selection of financial assets and liabilities; the breakdown of the economy into institutional sectors; the market valuation criterion; the accrual accounting principle; and the focus on the original maturity breakdown of financial assets.

The ESA 95 records flows and balance sheets in a sequential set of accounts describing the economic cycle from the generation of income through its distribution and redistribution and then finally to its accumulation in the form of assets. Flows are described as events that “create, transform, exchange, transfer or extinguish economic value”. The flows of the generation, distribution and redistribution of income and its use in the form of final consumption are shown in the “current accounts”.

A second group of flow accounts, the “accumulation accounts”, records the various changes in the assets and liabilities of the institutional units grouped into sectors and the change in their net worth, the difference between assets and liabilities. The stocks of assets and liabilities constitute the “balance sheet accounts.” The accumulation accounts comprise the “capital account” (transactions in non-financial assets) the “financial transaction account”, the “other changes in volume of assets account” and the “revaluation account”.

Table 1

Components of the system of quarterly Monetary Union financial accounts

1) Flow accounts (changes in financial assets and liabilities owing to transactions and other flows)

a) Financial transaction account

b) Other changes in the volume of assets account

c) Revaluation account

2) Financial balance sheets (outstanding amounts of financial assets and liabilities)

Financial accounts, as defined in the context of quarterly MUFA, cover the financial transaction account and the financial balance sheets account as well as the corresponding other changes in the volume of assets and the revaluation account as shown in Table 1.

Seven categories of financial assets or financial instruments are distinguished in the ESA 95. They are classified according to liquidity factors and legal characteristics (Table 2). Provision is also made for a further split of the list of financial assets, in particular according to maturity and market capacity.[3]

Table 2

Classification of financial assets according to the ESA 95

Monetary gold and special drawing rights (F.1)
Currency and deposits (F.2)
Currency (F.21)
Transferable deposits (F.22)
Other deposits (F.29)
Securities other than shares (F.3)
Securities other than shares, excluding financial derivatives (F.33)
Short-term (F.331)
Long-term (F.332)
Financial derivatives (F.34)
Loans (F.4)
Short-term (F.41)
Long-term (F.42)
Shares and other equity (F.5)
Shares and other equity, excluding mutual funds shares (F.51)
Quoted shares (F.511)
Unquoted shares (F.512)
Other equity (F.513)
Mutual fund shares (F.52)
Insurance technical reserves (F.6)
Net equity of households in life insurance reserves and in pension funds reserves (F.61)
Prepayments of insurance premiums and reserves for outstanding claims (F.62)
Other accounts receivable/payable (F.7)
Trade credits and advances (F.71)
Other (F.79)

ESA 95 codes in brackets.

In addition to the financial assets, balance sheets also comprise non-financial assets, which in turn can be broken down into produced and non-produced assets. Net worth is calculated as the difference between all assets (produced, non-produced and financial assets) and liabilities. Net worth has to be distinguished from net financial assets, which is defined as the difference between the stock of financial assets and liabilities.

The scope of an economy (the residency concept) or an economic area underlying the compilation of the system of accounts in the ESA 95 is based on the notion of a centre of economic interest. All institutional units that “have a centre of economic interest on the economic territory” should be considered residents. The ESA 95 groups the resident institutional units of an economy into five sectors according to their type of economic behaviour: non-financial corporations, financial corporations, general government, households, and non-profit institutions serving households. Most of the sectors may be further broken down by sub-sector. Financial corporations, for example, can be broken down into the central bank, other monetary financial institutions, other financial intermediaries (except insurance corporations and pension funds), financial auxiliaries, and insurance corporations and pension funds. The same applies for general government and for the rest of the world sector, which covers all cross-border flows and positions (see Table 3).

Table 3

Classification of an economy by institutional sector and sub-sector according to the ESA 95

Non-financial corporations (S.11)
Financial corporations (S.12)
Central bank (S.121)
Other monetary financial institutions (S.122)
Other financial intermediaries, except insurance corporations and pension funds (OFIs) (S.123)
Financial auxiliaries (S.124)
Insurance corporations and pension funds (S.125)
General government (S.13)
Central government (S.1311)
State government (S.1312)
Local government (S.1313)
Social security funds (S.1314)
Households (S.14)
Non-profit institutions serving households (S.15)
Rest of the world (S.2)
The European Union (S.21)
Third countries and international organisations (S.22)

ESA 95 codes in brackets.

Following ESA 95 principles, flows and stocks should be recorded at exchange value, i.e. the value at which the financial assets are or can be created, liquidated, exchanged or assumed between institutional units. Thus the ESA 95 recommends market prices as a general reference for valuation, especially when the exchange is made or can be made through a market. A transaction is generally recorded when the value is created, liquidated, exchanged or assumed, and not, for example, when the payment is made, thus following the accrual principle. Furthermore, the components of the balance sheets and of their associated flow accounts are shown in gross terms, without netting liabilities against assets and/or inter-sector positions.

The original maturity split – short versus long-term – is normally based on a one-year cut-off and, in exceptional cases, on a two-year cut-off. Short-term financial assets are those with an original maturity of up to one year and, in exceptional cases, of up to a maximum of two years, while long-term financial assets are those with an original maturity of more than one year and, in exceptional cases, of more than two years as a minimum.[4]

To compile quarterly MUFA, further amendments have to be made, as the classification of sectors as shown in Table 3 is seen from a national economy viewpoint. Modifications refer, for example, to the financial corporations sector, in which the ECB has to be included. Furthermore, detailed data have to be made available for the cross-border flows and positions to allow the compilation of a euro area rest of the world account.

2.2.Conceptual elements of financial stability analysis

Financial stability as understood by the ECB means “a condition whereby the financial system is able to withstand shocks without giving way to cumulative processes, which impair the allocation of savings to investment opportunities and the processing of payments in the economy”.[5] Therefore, the definition of financial stability is not only confined to banking stability, but actually refers to the whole financial system, whereby the financial stability of the banking sector is crucial for the soundness of financial corporations.

To successfully safeguard financial stability, the vulnerabilities of the financial sector and, as their counterpart, the non-financial sectors should be effectively identified and monitored, as well as the potential shocks to (financial and non-financial) markets. Typically, economists refer to this as macro-prudential analysis or surveillance. Such activities are usually part of the core competencies of central banks to promote financial stability and sound payment systems. These activities differ from financial supervision activities, as they are primarily focused on factors that may pose risks to the economy as a whole, with significant macroeconomic repercussions.

The measures of financial soundness and the methods to analyse them are usually called macro-prudential indicators (MPIs)[6] and analysis, respectively. MPIs “are indicators compiled to monitor the health and soundness of financial institutions and markets, and of their corporate and household counterparts”. Such indicators “include both aggregated information on financial institutions and indicators that are representative of markets in which financial institutions operate” as well as “other indicators that support the assessment and monitoring of the strengths and vulnerabilities of financial systems, notably macroeconomic indicators”.[7]

Therefore, macro-prudential analysis may be defined as the “assessment and monitoring of the strengths and vulnerabilities of financial systems. It encompasses quantitative information from both MPIs and indicators that provide a broader picture of economic and financial circumstances, such as GDP growth and inflation, along with information on the structure of the financial system, qualitative information on the institutional and regulatory framework – particularly through assessments of compliance with the international financial sector standards and codes – and the outcome of stress tests”, as well as scenario analysis to determine the sensitivity of the financial system to macroeconomic shocks.

As indicated in Chart 1, financial accounts play a major role in the compilation of certain MPIs – such as debt-to-GDP ratios and the financial health of the non-financial sectors – as well as in structural analysis, including the importance of the main instruments, ownership structure and concentration.

Taking into account the complexity of the global financial system, there is no single indicator that can be used to assess whether a financial system is stable or not. Instead, a wide array of concepts need to be considered when attempting to form an overall picture of the health of a financial system. Ideally, MPIs are based on long time series, enabling general trends that are believed to be key measures of the health of a financial system to be identified. They are then used to highlight sudden movements away from these trends, rather than necessarily the magnitude or direction of the change.

Chart 1
Components of macro-prudential analysis

Source: Sundararajan, V. and others (2002) – adapted.

The range of MPIs that should be followed and analysed depends very much on the characteristics of the country or of the economic area; however, their coverage typically follows the CAMELS framework (capital adequacy, asset quality, management soundness, earnings, liquidity, sensitivity to market risk).[8] After selecting the correct set of MPIs, it is important to discuss methods of analysing them. A variety of methods are available for deriving conclusions from MPIs about the stability of the financial sector – from a simple ratio analysis to more complex macro and microeconomic modelling. In recent years, the importance of stress testing has been growing in the context of its potential application to the analysis of strengths and vulnerabilities at the level of the aggregated system, as opposed to the individual institutions (for which it was originally developed). Stress tests add a dynamic element to the analysis of MPIs. They refer to the sensitivity, or probability distribution, of MPIs’ outcomes in response to a variety of (macroeconomic) shocks and scenarios.

Another concept that is usually associated with financial stability is peer group analysis. A peer group is a statistical set of individual institutions that have been grouped on the basis of specific analytically interesting criteria. A wide variety of meaningful peer groups can be created for comparison purposes and for the examination of the dispersion and concentration of the institutions in that group. Examples of criteria for creating peer groups are the size of assets or revenues, the type of activity (e.g. universal banking and investment banking), the type of ownership (public or private), the region of the economy (by country in the case of the euro area), and so on.

2.3.Methodological differences between financial accounts and indicators underlying financial stability analysis

Several methodological differences between financial accounts and indicators underlying financial stability analysis have to be taken into account when using both data sets in parallel for the assessment of financial stability.[9] Specifically, it has to taken into account which underlying methodological concepts are used. This refers specifically to the residency criterion, the applied methods of aggregation and consolidation, and the valuation of balance sheet components. Furthermore, the time of recording in the context of accrual accounting and the maturity definitions used are of utmost importance if financial accounts data are taken together with aggregated micro-prudential data, which are mainly derived from supervisory reports and are a useful measure of certain banking sector risks.[10]

The analysis of the MPIs is highly influenced by whether the underlying data are consolidated or not. Accordingly, special attention should be given to the method used to consolidate specific MPIs. For the time being, no single method is used for this consolidation process because of country-specific needs for analysis.

In compiling MPIs it is recommended, specifically for the banking sector, to use data collected on a ‘consolidated reporting’ or ‘home’ basis. This means that the data cover not only the business of the reporting institution, but also the business of its branches and subsidiaries. Such branches or subsidiaries might be resident or non-resident in the economy, with the consequence that all transactions between these entities and their positions are eliminated by consolidation.[11] In essence, consolidation is based on the concept of control by a parent enterprise over the other operating units.

Such an approach, i.e. of consolidation on a home basis, is essential in monitoring the integrity of capital in the banking sector as it eliminates double counting.[12] By contrast, the collection systems used for financial statistics, such as the MFI balance sheets statistics, are based on the so-called ‘host-country’ principle, in which reporting institutions provide data only on their business, without consolidating the activities of their branches and subsidiaries, whether resident or non-resident. In any case, such branches and subsidiaries are treated as ‘autonomous’ institutional units that are part of the reporting population of the country in which they are located.

Regarding valuation concepts, the data used to compile MPIs may also differ from the concepts underlying quarterly MUFA. As outlined above, the ESA 95 recommends measuring transactions and stocks “according to their exchange value, i.e. the value at which flows and stocks are in fact, or could be, exchanged for cash. Market price is thus ESA’s basic reference for valuation”. As for MPIs, the draft IMF Compilation Guide on Financial Soundness Indicators advocates that the valuation should be based on the “most realistic assessment at any point in time of the value of the variable”. Therefore, market values should be used for traded securities and shares, whereas nominal values are preferred for non-traded instruments. This proposal diverges from the ESA 95 and also from the proposed International Accounting Standards (IAS), which in principle advocate the application of fair value.