Technical Notes and Manuals

Diagnostic studies are essential to IMF programs in situations of significant bank weakness and when regular disclosures are not reliable. Restoring bank solvency is key to maintaining financial stability and, therefore, the ultimate policy objectives of a Fund-supported program. Bank diagnostics aim to ensure that existing potential losses and capital needs are identified in a timely manner and, in case public support is needed, the relevant cost is prudently incorporated in the program financing envelope. Diagnostic studies provide assurances that financial stability risks are reasonably quantified and provide information essential to: (i) understanding the scale and scope of banking sector problems; (ii) executing strategies for bank resolution and restructuring, including quantifying recapitalization needs; and (iii) estimating any financing needs with reasonable certainty. There is no single template for diagnostic studies that fits all cases. Though an asset quality review (AQR) will always be a central component, there are other aspects, such as stress tests or reviews of bank viability and funding structures, whose relevance depends on country circumstances. While a diagnostic exercise provides a point-in-time snapshot, it can go further and be seen as part of a process of discovery and remediation of the factors at the root of the banks’ problems. Diagnostics are undertaken by local authorities based on a robust governance structure that provides credibility and quality assurance through independent, external participation. Diagnostics should consider local conditions and, where resources are available and qualified, be performed with local participation to enhance ownership and political acceptance. Communication is a key consideration, with the level of information released publicly often being dictated by circumstances. This note provides practical guidance, drawing on experience. Rather than looking at diagnostics as a narrow capital compliance event, the note advocates a building block approach to assessing banking businesses, and to enable forming a view on long-term viability as a basis for action with respect to each institution reviewed. Features of observed international practice are also summarized, drawing on recent diagnostic studies in Europe, and on extensive earlier experiences in a range of emerging and developing country contexts.