Financial crises are hardly rare. Since 1980 they have flared up in about three fourths of the world's countries, including many industrialized nations. The 1997 Asian financial crisis, however, highlighted how critical a nation's financial sector is to its macroeconomic stability and -- in an increasingly integrated world -- how important sound financial systems are for maintaining orderly international financial conditions.

In the wake of the financial crises of the late 1990s, the International Monetary Fund and the World Bank launched an initiative, known as the Financial Sector Assessment Program (FSAP), to assess members' financial systems. Financial systems include the whole range of financial institutions, such as banks, mutual funds, and insurance companies, as well as the financial markets themselves (e.g., securities, foreign exchange, and money markets). They also include the payments system and the regulatory, supervisory, and legal framework that underlies the operations of the financial institutions and markets. The FSAP seeks to identify financial system strengths and vulnerabilities and to reduce the potential for crisis, thereby contributing to efforts to promote national and international financial stability and growth.

The FSAP draws heavily on the Fund's and the Bank's earlier financial sector work. The IMF has traditionally focused on the two-way linkages between financial sector soundness and macroeconomic performance, on the one hand, and support for policies that reduce the likelihood of financial crises and lessen the severity of those that do occur, on the other. These include policies to improve the national authorities' oversight of financial institutions and markets to reduce excessive risk, improve these institutions' risk management, and promote sound intermediation of financial flows. They also involve improvements in macroeconomic policies, such as monetary and fiscal policy, with the aim of making the macroeconomic environment more stable and hence more conducive to financial sector stability.

The Bank has focused on the importance of the financial sector to development and poverty reduction. A well-functioning financial system has been shown to be important for economic growth, which is a key element for poverty reduction. In this connection, the Bank has traditionally supported the development and strengthening of countries' financial sectors.

The FSAP seeks to alert countries to likely financial sector vulnerabilities and to assist the Bank and the Fund -- and the international community more broadly -- in designing appropriate assistance. The quality of the assessments relies importantly on the analytical capability and judgment of the joint team of Bank and Fund staff that conducts them. The staff members draw on their own experience and that of experts from a range of cooperating central banks, national supervisory agencies, and international standard-setting bodies (e.g., the Basel Committee on Banking Supervision, the International Association of Insurance Supervisors, and the International Organization of Securities Commissions) and other institutions. These outside experts provide a valuable element of peer review to the analysis, especially with regard to the observance of financial sector standards and codes.

The FSAP program was launched in May 1999 on a trial basis. It initially involved a dozen countries that ranged widely in the degree of development of their financial systems, including industrialized countries (such as Canada and Ireland), emerging markets (such as South Africa), and developing economies (such as Cameroon and El Salvador). The program has found strong support in the participating countries and the international community; it is now likely to become a permanent feature of the work of the Fund and the Bank.

COMPONENTS OF THE FSAP

The FSAP teams' examination of the strengths, risks, and vulnerabilities of a country's financial system has three main components: (1) an assessment of stability of the financial system, including macroeconomic factors that could affect the performance of the system and conditions in the system that could affect the macroeconomy; (2) an assessment of the extent to which relevant financial sector standards, codes, and good practices are observed; and (3) an assessment of the financial sector's reform and development needs. The team identifies actions that would strengthen the financial system, together with any needed contingency plans, and provides a detailed evaluation of the monetary and fiscal implications of these actions.

For example, an asset price bubble in a country (in real estate or equity prices, perhaps) could leave banks or other lenders exposed to potentially severe losses if those assets were the main security backing a significant proportion of loans. In such a case, the FSAP team would first try to determine whether there was indeed a price bubble, what caused it, and whether the authorities could and should act to address it. At the same time, the team would examine whether lending institutions were unduly reliant on collateral when making lending decisions, whether they had adequately considered the possibility of a fall in asset prices when valuing collateral, and whether they have adequate levels of capital. The team would also examine whether official supervisors were adequately monitoring these risks and advising lending institutions on their practices. If weaknesses in any of these areas were identified, then the team would make recommendations for dealing with them.

Sustained financial system health depends in large part on an adequate regulatory environment and incentive structure. An FSAP assessment will look at the financial sector's legislative underpinnings to evaluate regulatory capacity and practice. This will include a systematic assessment of compliance with the Basel Core Principles for Effective Banking Supervision, transparency practices in monetary and financial policies, and -- if relevant -- standards for securities markets, insurance, and payment systems. Other legal and institutional issues that bear on the financial sector may also be reviewed.

In addition to judging the system's present economic performance, the authorities' strategic vision for system development may need to be considered. In developing countries with underdeveloped financial markets, special attention may need to be given to the potential for development of capital markets and contractual savings (including insurance and pension funds). These parts of the financial system will contribute to the health of the whole system, as well as supporting economic growth.

These various components of an FSAP assessment require examination of a broad range of areas. In each of these areas, the assessment must take into account the structure of the country's financial industry and draw on international standards, best practices, and accumulated experience of the Bank, the Fund, and other international institutions, as well as on market information. While this range of areas is extensive, Bank and Fund staff have substantial background knowledge gained from working for national governments or private sector institutions, as well as from the two institutions' previous work. This permits an identification of those issues that are most significant in a given country, so as to focus the work under the FSAP.

METHODOLOGIES AND TOOLS

Some of the FSAP teams' methodologies and tools have been developed especially for the program. In particular, macroprudential analysis, including stress tests and scenario analysis, coupled with improved methods for judging observance of standards and codes, have supported and strengthened the consistency and quality of analysis for this program.

Macroprudential analysis aims to highlight the linkages between macroeconomic performance and financial sector soundness. Macroprudential indicators comprise both aggregated microprudential indicators of the health of individual commercial banks and other financial institutions (such as capital adequacy, earnings, and solvency) and macroeconomic indicators associated with financial system soundness (such as volatility in exchange rates and interest rates). Aggregated microprudential indicators have been found to be primarily contemporaneous or lagging indicators of financial sector soundness. Macroeconomic variables, on the other hand, can signal imbalances that affect financial systems, and they tend to be leading indicators. Practice has shown that financial crises usually occur when both types of indicators point to vulnerabilities, that is, when financial institutions are weak and face macroeconomic shocks.

Stress tests and scenario analysis help in determining the impact of macroeconomic shocks, structural changes, and financial sector innovations on the profitability and solvency of financial institutions. They provide a useful and flexible framework for the identification and analysis of financial sector vulnerabilities. Under the FSAP, the kinds of tests and models used vary depending on the structure and characteristics of the financial system in the country being examined and the availability of data. For example, a country that mostly exports primary commodities may be more prone to suffer from volatility in export prices and earnings. In such a situation, it may be appropriate to focus more on possible external shocks than on other shocks. Further, the scale of the potential external shock that is used as the basis for a stress test may be greater for such a country. Conducting stress tests and scenario analysis in cooperation with the authorities has also proven valuable in helping to build risk management capacity in member countries and to encourage routine stress testing by country officials of their financial systems.

Assessments of the observance and implementation of relevant financial sector standards and codes in the FSAP serve to identify gaps in financial sector regulation and transparency practices, and hence reform and development needs in the area covered by the standard. In addition, standards assessments provide input for the overall stability assessment of the financial system and help countries evaluate their own system against international benchmarks.

Experience to date confirms that standards assessments are an important part of the FSAP. High-quality supervision and monitoring of financial institutions and markets is critical to the stability of financial systems that are integrated into global markets and that face a variety of financial innovations and shocks. Standards assessments are also helpful in identifying and implementing regulatory and operational reforms needed for the development of countries' financial systems over time and their integration into global financial markets. On the other hand, standards assessments play a more limited role in identifying immediate financial systems vulnerabilities, since these are influenced by a host of macroeconomic and structural factors. Such assessments need to be combined with a broader range of information and analysis to obtain a complete picture of relevant risks and vulnerabilities required for an overall stability assessment, as is the case under the FSAP.

Assessments conducted under the FSAP are not ends in themselves. The results of this diagnosis must be integrated into the work of the Bank and the Fund. In the case of the Fund, a Financial System Stability Assessment (FSSA) is prepared based on the FSAP findings. FSSAs focus on strengths, risks, and vulnerabilities in the financial system in a broader macroeconomic and macroprudential context than previously, resulting in an overall stability assessment. They are passed to the Fund's Executive Board as part of the documentation for the Article IV consultations -- the annual discussions on macroeconomic policies that the Fund holds with its member countries. Thus, the FSSAs link the FSAP and the monitoring of financial systems under Fund surveillance. Analyses conducted in the context of the FSSAs serve to focus on the likely consequences of alternative macroeconomic policy mixes and exogenous shocks and the implications of financial sector reforms for financial sector profitability, solvency, and liquidity.

From the Bank's perspective, the FSAP is part of the ongoing policy dialogue between bank staff and national authorities. The FSAP's diagnostic work provides a comprehensive assessment of a country's financial sector, which serves as the basis for the Bank's country assistance strategy and the provision of technical assistance. In addition, Bank staff produce Financial Sector Assessments (FSAs), which summarize the main points identified in the FSAP, with emphasis on those related to developing and strengthening institution-building in a country's financial system. Authorities can decide to publish the FSSAs and the FSAs. They may separately decide to publish summaries of the assessments of compliance with financial sector standards as part of the so-called Reports on Observance of Standards and Codes (ROSCs).

LOOKING AHEAD

So far, experience with the FSAP has been positive. The FSAP has helped ensure that financial sector analysis becomes part of the core of economic policy discussions and has provided national authorities with a strategic framework for strengthening and further developing their financial systems. For instance, in some cases the linkages between high interest rates and nonperforming loans have been highlighted, which has allowed a more considered analysis of the sustainability of high interest rates. In other cases, the FSAP has highlighted the need to reinforce banking supervision, improve financial sector legislation, reduce risks in payment and securities settlement systems, and strengthen sovereign debt management. Follow-up assistance has been provided, for example, with regard to the design of deposit insurance and the development of credit registries.

It is important to realize that the FSAP will not protect countries against all financial crises. Macroprudential indicators, stress tests, and standards assessments can identify vulnerabilities, but they are not foolproof. Nonetheless, over time, the FSAP can reduce the incidence of crises by providing the authorities with a thorough and objective review of their financial sectors, by identifying weaknesses at an earlier stage, and by suggesting effective and timely policy responses.

(Note: The opinions expressed in this article do not necessarily reflect the views or policies of the U.S. government.)