I. Introduction

1. The Executive Board last reviewed the Fund's work on financial soundness indicators (FSIs) on June 2, 2003.¹ On that occasion, Executive Directors welcomed progress made in this area and underscored the importance of FSIs in assessing financial sector soundness, facilitating financial sector surveillance, increasing the transparency and stability of the international financial system, and strengthening market discipline.² They encouraged the work on the Compilation Guide on Financial Soundness Indicators (Guide), which they saw as a milestone in establishing a standard reference on inter alia the concepts and definitions, data sources, and techniques to be used in the compilation of cross-country comparable FSIs. In the context of the preparation of the Guide, Directors welcomed the planned regional outreach seminars and encouraged continued consultations with experts and comments from the public. Directors suggested that both the lists of core and encouraged FSIs be kept under review to ensure that they reflect the evolving priorities of Fund surveillance, the rapidly changing financial environment, and the relative capacity of countries to compile FSIs. They also made specific suggestions regarding modifications to the lists.

2. In the Executive Board meeting on June 2, 2003, nearly all Directors agreed that the Fund conduct a coordinated compilation exercise (CCE) for FSIs involving around 60 member countries to support country compilation efforts. Directors endorsed proposals for assessing countries' capacity to compile FSIs and helping them develop that capacity, including through the CCE, the Financial Sector Assessment Program (FSAP), Article IV and UFR missions, workshops, and technical assistance. They generally supported the further development of guidance on the use of FSIs and their expanded reporting and analysis in bilateral and multilateral surveillance, including Article IV reports and the Global Financial Stability Report. They encouraged work on the use of FSIs and stress testing and encouraged further analytic work to clarify macro-financial linkages and identify the data needed to assess them. Directors looked forward to reviewing progress on the FSI work program in about two years.³

3. This paper informs Executive Directors regarding the progress on the FSI work program discussed by the Board in its June 2, 2003 meeting. In particular, it reviews the steps taken leading to the finalization of the Guide, progress on the analytical work on FSIs, the work done so far in the CCE, and collaboration of Fund staff with the staff of regional and international institutions. The paper concludes by outlining the steps ahead in the Fund's work on FSIs.

II. Work on FSIs Since the Last Board Discussion

A. Regional Outreach Seminars on the Draft Guide

4. In 2003-2004, STA conducted eight regional outreach seminars in Europe (Joint Vienna Institute and the European Central Bank), Latin America (Brazil Training Center), the Caribbean (Eastern Caribbean Central Bank), the Middle East (Arab Monetary Fund), Africa (Joint Africa Institute), the Pacific (Reserve Bank of Australia), and Asia (Singapore Training Institute). In total, about 225 participants from 141 countries and several international and regional institutions attended the seminars. The purpose of the seminars was to promote awareness of the draft Guide and invite comments from the participants. Representatives of various international and regional institutions also participated in these seminars.

5. In general, participants in the regional seminars supported the recommendations in the Guide as well as the list of core and encouraged indicators. From the comments received, it was clear that many countries-beyond the ones that would eventually be invited to participate in the CCE-were considering or had already started to compile FSIs. In this context, they welcomed the preparation of the Guide. Some countries noted the high costs involved in collecting information for compiling FSIs fully in line with the Guide and therefore called for some flexibility in the implementation of the FSIs.

6. In the regional seminars, there were discussions about various aspects of the Guide and the work on FSIs. These discussions addressed the usefulness of some of the FSIs and of certain methodological recommendations in the Guide (such as the method of consolidation). Participants expressed interest in further analytical work on benchmarking FSIs, which they felt could increase their usefulness. There were also some discussions about potential problems associated with the dissemination of FSIs due to limitations on the cross-country comparability of data. Some participants noted that efforts would be needed to ensure inter-agency cooperation in compiling FSI data. Others noted the cost of addressing the weaknesses in data on nonfinancial corporations, household, and real estate necessary for the compilation of FSIs in these areas. At the same time, there was wide interest in the inclusion of additional FSIs for the nondeposit taking financial sector (especially insurance companies). Many participants in the seminars urged the Fund to provide technical assistance in compiling FSIs.

B. Expert Group Meeting in October 2003

7. The Executive Board, in its June 2003 meeting, encouraged consultation with experts prior to finalizing the Guide.⁴ Therefore, a meeting of experts⁵ was held in Washington D.C. during October 29-30, 2003 to review the modifications to the list of FSIs suggested by the IMF Executive Directors during their June 2003 meeting. The experts also considered specific issues that had arisen at the outreach seminars and during the public comment period (from March 2003 to July 2003) on the draft Guide.

8. The experts endorsed the need for flexibility in implementing the Guide due to technical difficulties and resource constraints, but stressed the advantages of compiling FSIs in accordance with generally agreed standards. They also noted that when foreign controlled deposit takers are important, compilation practices may need to be adapted to provide a broader measure of financial soundness. Therefore, the experts suggested the Guide could supplement the requirement that FSIs be compiled for domestic controlled deposit takers with a recommendation that FSIs also be compiled for foreign controlled deposit takers separately and for domestic and foreign controlled deposit takers together. There was consensus on the definition of nonperforming loans (NPLs) and, to take account of the potential for contagion, on the presentation on a gross basis of certain items such as intra-sector debt and derivative exposures.⁶

9. The expert group supported some modifications to the list of FSIs. The experts supported the proposal to move the large exposure to capital FSI from the core to the encouraged list of FSIs. In their view, this indicator is useful primarily in smaller financial systems where large exposures are more likely to be concentrated on the same borrowers and, hence, is not of high importance in all countries. There was no support among experts for introducing connected lending as a separate FSI at this stage because of the technical difficulties involved. The experts also recommended removing the duration of assets and duration of liabilities FSI from the list because it was difficult to interpret and compile. There was no support for moving the FSIs measuring foreign currency loans to total loans and foreign currency liabilities to total liabilities from the encouraged to the core list because, while important for some countries, these indicators were not viewed as critical for all countries.

10. Following the October 2003 expert group meeting, the modified lists of FSIs were circulated to the Executive Directors on January 12, 2004. The modified lists (Box 1), along with the other conclusions of the expert group, were incorporated in the draft Guide.

C. Finalization and Publication of the Guide

11. The final draft of the Guide was submitted to the Executive Board, which endorsed its posting on the Fund's external website on July 29, 2004. The paper form of the Guide is expected to be released later in 2005 and translations into Arabic, Chinese, French, Russian, and Spanish are under way.

D. Analytical Work on FSIs

12. FSIs continue to be further integrated into Fund financial sector surveillance. Countries typically provide core FSIs in the areas of capital adequacy, asset quality, earnings and profitability, and foreign exchange market risk in FSAPs and FSAP updates. However, definitions of these indicators have varied substantially across countries and in some cases countries have substituted closely related indicators. Provision of the encouraged FSIs varies significantly across countries depending upon the sophistication of the supervisory and statistical capacity of the country. Several encouraged indicators, such as the ratio of capital to assets and foreign currency denominated loans to total loans, were provided in a large share of FSAPs. Provision of FSIs for the corporate and household sectors and for the real estate markets was relatively low however. Inclusion of FSIs in Article IV consultations has been generally commensurate with the coverage of financial sector issues more broadly. The practice regarding the provision of FSIs in Article IV consultations should accordingly be considered in light of the prominence of financial sector issues in specific consultations and the resource constraints of member countries as well as Article IV missions. A pilot project currently under way on financial surveillance in the context of Article IV consultations should provide further information on the usage of FSIs, which could be reported in the planned 2007 Board paper on FSIs.

13. The ongoing monitoring of financial systems by staff also relies on FSIs. This has been facilitated by the Guide, which has made it easier for countries to compile the indicators. In addition, countries are increasingly undertaking their own financial stability analysis, as evidenced by the proliferation of financial stability reports, which promotes the compilation and dissemination of FSIs. FSIs are also being used increasingly in multilateral and regional financial sector surveillance activities, including in the presentation of trends in banking systems in emerging market countries in the Global Financial Stability Report. International and offshore financial centers participating in the Information Framework Initiative have been encouraged to provide a subset of the core FSIs to support monitoring of financial developments.⁷ Within the Fund, an internal training program is being undertaken for staff on the analysis and interpretation of FSIs.

14. Analytical work on the FSIs has focused on their macroeconomic linkages and relationship with other surveillance tools. Technical work is under way on the macroeconomic determinants of FSIs, identification of thresholds of key FSIs signaling heightened risk to financial stability, and benchmarking to facilitate inter-country comparisons. Efforts are also under way to relate FSIs to the analysis of gaps in regulatory, legal, and corporate governance frameworks identified in standards assessments that contribute to financial sector vulnerabilities. The staff is also devoting efforts towards developing stress testing methodologies. In this context, FSIs facilitate the identification of the vulnerabilities on which stress tests are focused. Stress tests add a forward-looking dimension to the analysis by illustrating the effects of plausible shocks on key FSIs, such as capital adequacy and NPL ratios. Stress test results thereby aid in the interpretation and benchmarking of FSIs.⁸ Another area of analytical work focuses on indicators that take into account financial market information and employ databases on the corporate sector.⁹ This includes, for example, "distance to default" measures derived from equity prices and option pricing models. Such analysis complements the FSIs by providing forward looking, early warning signals about potential shocks.

E. Coordinated Compilation Exercise (CCE)

Launching of the CCE

15. Following the finalization of the Guide, STA began preparation for the launching of a voluntary CCE for FSIs with a view to (1) developing the capacity of the member countries to compile FSIs important to the surveillance of their financial systems, (2) promoting cross-country comparability of FSIs, (3) coordinating efforts by national authorities to compile FSIs, and (4) disseminating the FSI data compiled in the CCE, along with metadata, to increase transparency and strengthen market discipline. Countries participating in the CCE would compile at least the core FSIs as of a reference date and provide them to the Fund for publication along with supporting information (the terms of reference of the CCE are described in detail below).

16. Countries were invited to participate in the CCE on the basis of broad guidelines provided by the Executive Board. In line with the Board's guidance, and following close collaboration among STA, MFD, and area departments, the Fund¹⁰ invited 71 countries, which comprised systemically important countries and also countries that had received an FSAP or were SDDS subscribers (or were close to subscribing). In the event, sixty-two countries/regions agreed to participate in the CCE (Box 2).

17. In the regional outreach seminars, countries not participating in the CCE were encouraged to compile FSIs on the basis of the recommendations in the Guide. However, because of resource constraints, support by STA for non-CCE countries' FSI compilation efforts will have to be limited during the period of the CCE. STA staff stands ready to provide countries with the necessary materials (such as the Guide, and the standard FSI data and metadata report forms) and provide advice from Headquarters on FSI compilation issues raised by non-CCE countries. STA staff could also participate, as resources permit, in technical assistance activities and other initiatives that may be organized by other international or regional agencies (including Technical Assistance Centers) to support FSI compilation efforts in non-CCE countries. Support by the Fund of FSI compilation efforts of non-CCE countries would be reexamined after the CCE.

Inventory Survey of Country FSI Compilation Practices

18. STA conducted an inventory survey in August-September 2004 to gather information from each country participating in the CCE on its starting point in the exercise. Information collected pertained to (1) current practices for compiling and disseminating the FSIs, (2) major departures from the Guide and thus areas where more work was needed, and (3) common issues in country practices that needed to be addressed for the purposes of the CCE. The inventory survey also allowed participating countries to focus attention on the Guide and on their own institutional arrangements for collecting, compiling, and disseminating FSIs. Main issues brought forth by countries in their responses to the inventory survey facilitated the exchange of views and experiences of participants in the meeting for CCE coordinators and FSI compilers in November 2004.

19. Of the 62 CCE participating countries, 55 responded to the inventory survey. ¹¹ The inventory survey's main findings were that (1) a large number of countries already compiled most or all core FSIs, but fewer countries compiled the encouraged FSIs for deposit takers, and even fewer countries compiled FSIs for the other sectors; (2) there was a diversity of consolidation approaches among countries for compiling the underlying data series for the core FSIs, with only few countries already following the Guide's recommended approach; (3) a significant number of countries assessed themselves as already fully conforming to the Guide regarding the compilation of many core indicators; (4) dissemination of FSIs was lagging behind their compilation; and (5) as expected, the framework for the data collection and compilation of encouraged indicators was much less developed than that for core indicators, thus making their compilation less common; dissemination of these indicators was even weaker.

Meeting of CCE Coordinators and FSI Compilers

20. To advance the implementation of the CCE, a meeting for coordinators and compilers of FSIs from the countries participating in the CCE was held during November 18-19, 2004 at Headquarters. The aim of the meeting was (1) to discuss the draft terms of reference (TOR) as well as the work program and timetable of actions for the CCE and (2) address FSI compilation issues in the context of the exercise. Representatives from 59 out of the then 61 countries participating in the CCE were joined by observers from ten international and regional financial institutions (Box 3), as well as from IMF's Regional Technical Assistance Centers (CARTAC, East AFRITAC, and West AFRITAC), Executive Directors' offices, and departments in the Fund.

21. The draft TOR for the CCE that had been provided in advance to participating countries were accepted in all their essential points. The staff received a few comments, which were subsequently incorporated in the finalized TOR. An important comment was to specify in the TOR that the post-CCE meeting for participating countries would be held in Spring 2007 before the Executive Board Meeting, so that the Board paper and discussion could benefit from countries' views on the CCE, the lessons learned in the process, and the way forward. Participants agreed on the CCE work program and timetable of actions for countries and Fund staff to ensure the timeliness of the CCE. Several participants made suggestions for strengthening communication among countries participating in the CCE. On that basis, STA with the assistance of TGS completed the development of an electronic discussion group for CCE participants, which is expected to be launched in the next few weeks.

22. The staff presented the draft standard report forms for FSI data and metadata that would be used to report this information to the Fund and subsequently to disseminate it to the public. The draft report forms, which had been sent to participants before the meeting, were accepted as appropriate. A number of suggestions were provided during the meeting while others were received in the weeks following the meeting. They were used to hone the usefulness of the data and metadata report forms, which were subsequently finalized and transmitted to countries.

23. A key objective of the meeting was to address issues raised by participating countries on FSI compilation and the CCE. The discussion indicated that the CCE could proceed using the recommendations of the Guide as a reference. There was consensus that, given differences in national practices, resource costs, and data availability constraints, countries compiling FSIs would use flexibly the recommendations of the Guide, while keeping in mind that there is a trade-off between flexibility and cross-country comparability of the data. It was emphasized that this flexibility raises the importance of the metadata that countries would prepare and disseminate along with the FSI data. In particular, departures from the recommendations in the Guide will be reported in the associated metadata.

24. A number of important issues were raised during the meeting. Some countries considered their approaches in certain areas more suitable than those in the Guide for assessing the soundness of their financial systems. For example, certain countries indicated that they will continue to use the domestically controlled cross-border and cross-sector approach for the deposit-taking sector for reporting FSIs in the CCE, instead of the domestically controlled cross-border basis recommended in the Guide.¹² A few countries raised broader methodological issues such as the implications of the adoption of Basel II and of the (revised) International Accounting Standards (IAS) for the recommendations in the Guide. Given the flexibility built into the CCE, the staff explained that countries could report their FSIs using their chosen approaches as long as they document in the metadata the ways in which their approaches differ from the Guide. Moreover, the staff indicated that the methodological issues raised by countries could potentially be reexamined after the completion of the CCE, in light of the experience gathered in the exercise.

Collaboration with International and Regional Institutions

25. On November 17, 2004, STA held a meeting with representatives of international and regional institutions (Box 3), who then joined the coordinators/compilers meeting as observers. The goal of the meeting was to ensure that there was appropriate coordination among the various institutions in FSI compilation efforts. In the discussion, these institutions expressed their strong support for the CCE as well as their willingness to help ensure the success of the exercise. They were particularly interested in the creation of a reference group that would provide views to Fund staff on FSI compilation issues arising in the CCE. The reference group would also serve as a sounding board when the Fund staff considers post-CCE strategies and issues. These institutions also expressed some interest in working with countries in their jurisdictions that are not participating in the CCE with a view to supporting them in their FSI compilation and dissemination efforts.

Box 3. International and Regional Financial Institutions that Participated in the November 2004 CCE Meeting
1.	African Development Bank
2.	Association of Supervisors of Banks of the Americas
3.	Central Bank of West African States (BCEAO)
4.	Bank of Central African States (BEAC)
5.	Bank for International Settlements
6.	European Central Bank
7.	Eastern Caribbean Central Bank
8.	Inter-American Development Bank
9.	Organization for Economic Co-operation and Development
10.	World Bank

III. The Finalized Terms of Reference for the CCE and Next Steps

26. Following the November 2004 meeting of CCE coordinators and FSI compilers, the terms of reference (TOR) for the CCE were finalized. In accordance with the TOR, participating countries in the CCE are required to compile the 12 core FSIs as of the end-2005 reference date and provide the Fund by end-July 2006, for publication, information using the standard report forms regarding data on the core FSIs, the underlying data series, and the related metadata. Countries are also required to nominate a single agency to act as the point of contact for Fund staff, prepare and provide to the Fund an inventory on their current (pre-CCE) FSI compilation and dissemination practices, and provide intermediate drafts of FSI metadata to Fund staff at appropriate intervals. Participating countries are also encouraged to compile some or all encouraged FSIs, and provide them to the Fund by end-July 2006 for publication along with the underlying data series and relevant metadata. They are also encouraged to provide for publication sectoral financial statements underlying FSIs, measures of dispersion and concentration, and historical data series. A timetable for implementing the CCE work program has also been finalized in consultation with CCE countries. The key actions and time for completion are as follows:

27. STA staff is providing technical assistance to countries in implementing the CCE. Given the staff resources available, such technical assistance comprises the following:

• For CCE participating countries as a whole, the staff is providing technical support by developing a standard format for reporting to the Fund and disseminating to the public FSI data and metadata, as well as by conducting regional meetings to discuss common issues in the implementation of the CCE.¹³
  
  
• For addressing country specific issues, the staff will provide technical assistance primarily by providing advice from Headquarters, and by conducting bilateral consultations with countries in the context of the envisaged regional meetings.

28. The outcome of the ongoing analytic work outlined in this progress report will be presented in the 2007 FSI Board paper. The paper will report methods for estimating thresholds for FSIs that signal heightened risk, while taking into account the contribution to financial system vulnerabilities of regulatory and supervisory gaps as revealed by standards assessments. It will also report on how the analysis of FSIs together with financial market indicators and other surveillance tools, such as stress testing, can enhance the forward-looking orientation of financial sector surveillance. Methods to assess macro-financial linkages that are being developed in the context of FSAPs and other Fund financial surveillance activities will also be reported. Analytical work will continue to be shared with Fund staff through seminars intended to strengthen IMF financial sector surveillance. Finally, the analytic work will look into potential new FSIs, which could, for example, cover nonbank financial institutions, and will review some existing FSIs to ensure that they can most effectively meet surveillance needs in the context of evolving Fund financial sector surveillance priorities.¹⁴ The results of this analysis will be combined with experience gained on FSAP and Article IV missions as well as in carrying out the CCE to determine the need for any modifications to the list of FSIs.

29. It is envisaged that in 2007 Fund staff will report back to the Board on the outcome of the CCE and on proposals for future work of the Fund in FSIs. By that time, data and metadata for the core FSIs for at least one period will have been prepared by countries completing the CCE and disseminated by the Fund. This is expected to set the stage for the regular compilation of FSIs by these countries. The report will reflect the CCE participating countries' views and experience in compiling FSIs and the lessons learned in carrying out the exercise. It will also reflect the conclusions of analytical work carried out by Fund staff on FSIs. The report will address whether the goals of the CCE were achieved and the potential for follow-up initiatives to the CCE. Issues related to follow-up initiatives could include (1) approaches to expanding the number of countries compiling FSIs, including modes of technical assistance; (2) the potential for greater convergence towards the Guide's recommendations and fostering greater FSI data comparability; (3) addressing the challenges of compiling FSIs in accordance with the Guide in the context of evolving accounting and supervisory standards; (4) modifications to the core and encouraged FSIs; (5) amendments to the advice provided in the Guide; and (6) the potential for inclusion of FSIs in the SDDS. The issues to be addressed in the report will be further defined by the experience gained in the CCE and Fund surveillance activities, as well as the results of analytical work relating to FSIs.