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?
A country’s financial system includes its banks, securities exchanges, pension funds, insurers, central bank and national regulators—all of the firms and institutions that provide a framework for carrying out economic transactions and help to channel savings into investment. A sound financial system is therefore essential for supporting economic growth. Financial system problems can reduce the effectiveness of monetary policy, create large fiscal costs related to rescuing troubled financial institutions, trigger capital flight, and deepen economic recessions. Moreover, financial weaknesses in one country can rapidly spill over and contaminate others.
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.
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.
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-June 2005, about 120 countries, two-thirds 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. Thirteen FSAP updates have been requested and completed.