Financial System Soundness
The financial crises of the late 1990s underscored the linkages between macroeconomic developments and financial system soundness. Indeed, weak financial institutions, inadequate bank regulation and supervision, and lack of transparency were at the heart of these crises. This is why the IMF has stepped up efforts to help countries identify and implement policies that build sound financial systems. |
Why are sound financial systems important?
Resilient, well-regulated financial systems are essential for macroeconomic and financial stability in a world of increased capital flows. A country's financial system includes its banks, securities exchanges, pension funds, insurers, central bank, and national regulators. These firms and institutions provide a framework for carrying out economic transactions and monetary policy. They also help to efficiently channel savings into investment. A sound financial system is therefore essential for supporting economic growth. Problems in financial systems can reduce the effectiveness of monetary policy, deepen or prolong economic downturns, and, in case of large scale problems, trigger capital flight or create large fiscal costs related to rescuing troubled financial institutions. Moreover, ample international financial and trade links imply that financial weaknesses in one country can rapidly spill over across national borders. Hence the soundness of a country's financial system is important both for the domestic economy, as well as for its trading partners and countries with which it has financial linkages.
How the IMF helps to promote financial system soundness
The IMF's main channels for promoting financial system soundness in member countries are through its ongoing multilateral and bilateral surveillance, the design of its lending programs, and the provision of technical assistance. A Financial Sector Assessment Handbook, published by the IMF and World Bank in September 2005, provides information for financial sector authorities on key issues and sound practices in the assessment of financial systems and in the design of policy responses.
Bilateral Surveillance is the process of regular dialogue and policy advice that the IMF is mandated to provide to its members, covering macroeconomic and financial developments and policies in their countries. The Fund has been working to improve the surveillance process by deepening its coverage of financial system issues and, in particular, by promoting the Financial Sector Assessment Program (FSAP) (see below). These efforts are intended to better identify financial system strengths and weaknesses, and thereby lessen the frequency and diminish the intensity of potential financial system problems.
Multilateral Surveillance introduces a multi-country or regional perspective to surveillance. As economies and financial systems are increasingly integrated across borders, many relevant issues span multiple jurisdictions. Spillovers from one country or financial system to another occur frequently. Examples of such spillovers range from the spread of prudent banking practices throughout multinational financial groups to cross-border financial crises. The IMF's Global Financial Stability Report takes a multilateral perspective on financial stability. It assesses key issues in financial market development with a view to identify systemic vulnerabilities. Other examples of regional financial sector surveillance include recent projects on financial integration in Central America and in the Nordic-Baltic region.
IMF-supported programs often include measures to strengthen member countries' financial systems. In addition to providing financial assistance, the IMF assists members in identifying and diagnosing financial system problems; designing—in conjunction with the World Bank—strategies for systemic reforms and bank restructuring; and ensuring that such strategies are consistent with, and supported by, appropriate macroeconomic and other structural policies.
Technical assistance provided by the IMF helps member countries to implement specific measures that will strengthen their financial infrastructure. This assistance may include training and advice on improving monetary and fiscal management; foreign exchange and capital market development; the design of payment systems and deposit insurance arrangements; the development of the legal framework for banking, as well as prudential regulations and supervisory capabilities; and strategies for systemic bank restructuring.
The Financial Sector Assessment Program
The Financial Sector Assessment Program (FSAP) is a joint IMF-World Bank initiative to provide member countries with a comprehensive evaluation of their financial systems. The program was launched in 1999, partly in response to the Asia crisis and calls by the international community for intensified cooperative efforts to monitor financial systems.
Objectives and tools: The FSAP aims to alert national authorities to likely vulnerabilities in their financial sectors—whether originating from inside the country or from outside sources—and to assist them in the design of measures that would reduce these vulnerabilities. The emphasis of the FSAP is on prevention and mitigation rather than on crisis resolution. At the same time, it ascertains the financial sector's development needs. Sectoral developments, risks, and vulnerabilities are analyzed using a range of financial soundness indicators and macrofinancial stress tests. Other structural underpinnings of financial stability—systemic liquidity arrangements; the institutional and legal framework for crisis management and loan recovery; transparency, accountability, and governance structures—are also examined as needed to ensure a comprehensive assessment of both stability and developmental needs. As part of the process, the FSAP provides assessments of observance of various internationally-accepted financial sector standards, set within the broader institutional and macroprudential context.
FSAP reports are designed to assess the stability of the financial system as a whole, and not that of individual institutions. Furthermore, FSAP reports represent the views of the assessment team, and not necessarily the authorities or the Executive Boards of the Fund or World Bank.
Implications for the work of the IMF and World Bank: The FSAP fosters consistent analysis and advice in the financial sector work of the Fund and Bank, optimizes scarce expert resources, and reduces duplication of efforts by involving broader cooperation and drawing on experts from national and international agencies. It informs the IMF's surveillance process and the Bank's other financial system activities. Both IMF-supported programs and technical assistance build on FSAP findings.
The IMF's focus in the FSAP is on the linkages between the soundness and operations of the financial sector and macroeconomic performance, and the support of policies that make financial systems more resilient to shocks or lessen the likelihood and severity of financial system crises. The World Bank's focus in the FSAP is on strengthening the financial sector to promote economic development and reduce poverty. For industrialized countries, FSAP work is entirely the responsibility of the IMF, although the World Bank may provide experts in specific fields.
Progress: As of end-April 2008, about 140 countries, three-quarters of the IMF's membership, have participated or are participating in the FSAP. About two-thirds of the countries that have completed the process agreed to post associated Financial System Stability Assessments (FSSAs) on the IMF's website. At end-April 2008, 32 FSAP updates have been completed, while an additional 26 updates have been requested or are ongoing.