The 2009 FDS Index: Tipping the balance

06/10/2009 | Harinder Kohli

The global financial crisis snowballed from an imbalance of financial development over strength – which proved the undoing of the world’s traditional financial powerhouses

THE 2009 FDX INDEX:

The Centennial Group and Emerging Markets are proud to present the Index of Financial Development and Strength. The Index, developed over the past two years by a five-person Centennial team of three universally recognized, world-respected economists and two supporting expert economists, provides the most powerful assessment anywhere available of the relative development and strength of financial systems across the world and over time.

The Centennial team has intimate knowledge of the global and emerging economies’ financial systems in Asia, Africa, Europe and Latin America as well as the related work of multilateral institutions such as the IMF, World Bank, Asian Development Bank, IsDB, and CAF. The team also has significant expertise in data management and advanced statistical analysis.

A complete description of the approach and methodology developed and fuller results are given in the forthcoming Centennial Group paper Measuring and Comparing Financial Development and Stability Across Countries and Timeî by V. Sundararajan, Harpaul Alberto Kohli, Claudio Loser, Adina Goldstein and Harinder S. Kohli.

Changing Times, new tool

The current financial turmoil has like never before called attention to the fundamental interactions between the financial environment and real economic performance, thanks to its strong ripple effects on the global economy.

The financial crisis has also brought into sharp relief the importance of systematic analysis of financial sector development and strength within and across countries. But until now, policy-makers and business leaders have lacked the means readily to assess and compare the health and robustness of national financial systems and their development over time. The FDS Index fills this gap in the tools available to economic and financial decision-makers. It is the most comprehensive and sophisticated analysis anywhere available, as it:

Measures and compares separately the two related but very distinct aspects of a financial system: financial development and financial strength

Provides two apex indices – separately measuring financial development and financial strength – based on a cascading set of 15 sub-indices that measure relevant underlying attributes of the financial system. The indices and relations between them are shown in this chart:

Covers approximately 175 developed, emerging and low-income market countries

Analyses detailed data on 189 distinct indicators of financial development and strength

Provides time series for the period 1997-2008

Computes standard errors and confidence intervals for each country-year score to allow more meaningful and rigorous comparisons with other countries and years

Offers robust analysis and results by applying sophisticated statistical methodologies

Allows inter-country and inter-temporal comparisons for the two apex indices, the four sub-indices, the 15 sub-sub-indices, and the individual indicators.

Fills in gaps in cross-country data available from the usual sources by independently collecting data from reliable country-specific sources and by imputing data through advanced statistical techniques.

The pioneering FDS Index may be used for both public policy and private resource allocation decisions.

Data on a vector of attributes of a country’s financial system can be used to formulate national financial sector strategy and for setting financial reform priorities. Moreover, such information could prove valuable in making portfolio allocation and decisions on investments in and exposure to financial institutions and assets.

For example, the relationship between economic growth, financial development, and financial strength in the selected countries could be analyzed as input into sector strategy in the region. The movements in financial system attributes over time could provide information on shifts in the potential for financial strength, or on changes in financial constraints impacting real economic activity; in this way the data could serve as forward-looking indicators of macroeconomic and broad market developments.

Such information could prove valuable in making asset allocations as well as decisions on investments and exposure in financial institutions and assets. The composite indices of various attributes of the financial system may also be used to assess the interaction between financial development and financial stability, and how this interaction influences the level and pattern of economic growth.

TIPPING THE BALANCE

In the wake of the 1997/8 Asian financial crisis, many emerging market economies moved decisively to strengthen their financial and regulatory frameworks and improve the balance sheets of their financial institutions, in particular their banks.

Largely as a result of such efforts, the development and strength of the world’s financial systems in subsequent years (2000–05) progressed steadily upwards, with both indicators improving more or less in tandem. Indeed, at the global level, the two distinct parts of the 2009 FDS Index — financial development and financial strength – are correlated and closely track each other over the index’s 11-year period 1997/98–2008/9, albeit with a time lag.

Ignoring the signs

Then in 2004/5, both financial development and strength improved sharply, but this result cannot be fully explained by real improvements in the health and robustness of the world’s financial systems.

In retrospect, these unprecedented advances were clear warning signs of over-exuberance, that in turn fed the asset price bubbles and excessive risk taking that ultimately brought the entire global economy to the brink of a total meltdown.

Towards the end of 2004, an upturn in the Financial Development Index – which reflects the size and economic reach of financial systems – leap-frogged the improvements in the Financial Strength Index. The Financial Strength Index showed signs of stagnation as early as 2004, whereas the unprecedented growth in the size and reach of the global financial system – concentrated in North America and Europe – continued unabated.

This sharp jump in the size, complexity and risk appetite of the financial system – the Financial Development Index – over the regulatory, supervisory and other components of the system – as represented by the Financial Strength Index – may have sown the seeds of the financial crisis that reared its head in 2007, and reached its depth in March 2009.

Neither the top management of the global financial firms that were driving these developments nor their regulators or supervisors heeded the warning signals – until it was too late.

Now that the financial meltdown so feared by many just a year ago seems to have been averted, regulatory and supervisory agencies of all major western financial systems must ask themselves: did they have at their disposal tools similar to those laid out in the FDS Index and, if so, why did they fail to identify the warning signs that should have been apparent since 2004?

Moreover, if they lacked such tools, should they not acquire them now to prevent future disasters?



Strong regional variations

While at the global level there is a strong relationship between financial strength and development, there are significant differences in this dynamic at the regional and, even more so country, levels because of different risk and return preferences of the savers and investors in different parts of the world.

As expected, the most developed economies score the highest in terms of both financial strength and financial development. But there are some surprises among emerging market regions. In particular, the development and strength of financial systems are not necessarily linked to regions’ relative per capita income, but much more to domestic savings and investment rates.

While Latin America – the wealthiest emerging market region – has the second-highest regional scores in financial strength, its financial systems are relatively under developed, ranking just above sub-Saharan Africa (the poorest region) and well behind not only developing Europe, but also Asia and the Middle East.

After repeated financial crises in the 1980s and 1990s, authorities in Latin America (and also in Asia) redoubled their efforts to tighten prudential norms, and put in place stronger regulatory and supervisory regimes, measures that allowed the region to weather the current financial crisis relatively well (along with Asia).

Latin America’s relatively low scores in financial development reflect its poor savings rates as well as financial systems dominated by commercial banks; bond and equity markets are under developed relative to Latin America’s per capita income levels. This also partly explains the region’s respectable ranking in financial strength. The region’s smaller (relative to GDP) financial systems and underdeveloped capital markets engendered relatively conservative financial practices and reduced downside risks.

In contrast, Asia’s deeper and more developed financial systems reflect its high savings rates (the highest anywhere) and more developed capital markets. Accordingly, Asia’s Financial Development Index ranks the region highest amongst all emerging markets, despite its lower per capita income and a moderate ranking on the Financial Strength Index.

On the other hand, the Financial Development Index for Emerging Europe has dropped sharply since 2007, arguably because its financial strength remained relatively weak, low domestic savings rates and its financial system’s growth depended on foreign bank borrowings.

Finally, and perhaps unsurprisingly, sub-Saharan Africa as a whole has the weakest and least developed financial system, despite the emergence of a few countries – Botswana and South Africa – in the ranks of the world’s better-performing systems.



We’re all emerging markets now

As a parallel Centennial Group study published by Emerging Markets shows, the world suffered a massive loss in the global financial wealth exceeding $50 trillion (almost 100% of global GDP) – comprising losses in equity and bond markets and in other bank assets – as a result of the financial crisis.

These losses were incurred directly or indirectly by private households, institutional investors as well as by banks, insurance companies and other financial institutions. The net result has been an unprecedented shrinking since 2007 of financial assets (size and robustness of the financial systems) as well as weakening of the financial systems (e.g. drop in capital to asset ratios).

In addition to weakening individual financial institutions, these events led to a severe deterioration in both the Financial Development and Financial Strength Indices worldwide.

But this decline was not equal across regions and countries. The FDS Index clearly shows that different regions were affected differently. And, in sharp contrast to past financial crises, financial systems in emerging markets economies this time suffered relatively less than those in developed nations. Moreover, some of the largest and most “innovative” financial systems within developed countries appear to have suffered the most.

Our findings suggest that the latest financial crisis may have ended the reign of the old paradigm, under which financial systems in developed economies were considered safe, and those in emerging markets were considered to be more risky. Indeed, the initial signs of recovery in the second and third quarters of 2009 suggest that the financial systems in some Asian countries – such as China, India and Indonesia – are for at least the time being regarded as less risky than some developed countries, in particular Iceland and Ireland.



Country ranking upheaval

As a result of the phenomena described above, the relative country rankings under the FDS Index changed significantly from what many previous rankings may have shown. Tables, show how the latest financial crisis has toppled some traditional powerhouses from the top ranks in both Financial Development and Financial Strength Indices.

The countries with the biggest drops in the Financial Development Index include: Congo (DR), Ecuador, Cambodia, Lao and Ireland. Among the developed countries, Iceland and the UK have fallen from the ranks of the world’s strongest systems.

Conversely, even though the global financial crisis originated in the US, which suffered massive losses, it remains among the world’s top 10 because of the sheer size and depth of its financial system, not to mention the aggressive policy actions taken by the US authorities when the crisis broke.

Nevertheless, the jury is still out. The 2009 FDS Index draws on data through to end 2008. Until 2009 data becomes available in mid 2010, it would be imprudent to declare that the health of the US financial system has been restored.

Despite lingering questions about the US, most other countries in the 2009 top-10 list appear to belong there, among them Singapore, Switzerland, Kuwait, Norway and Taiwan. At the same time, this year’s list includes a number of surprise additions of emerging market economies with relatively small financial systems: Uruguay, Armenia and Botswana. It’s unclear whether they will remain there for long, or drop as countries with much larger financial systems, such as the UK, Germany and Japan, nurture their systems back to good health.



APPROACH AND METHODOLOGY

The approach and methodology developed by the Centennial Group:

Defines a range of core attributes that characterize the financial environment. These attributes — and their component indicators — together characterize the overall financial environment impacting on both private and public operations;

Identifies best available quantitative indicators of these attributes so as to measure depth and openness, structural and institutional characteristics, and stability properties of financial systems in individual countries;

Computes sub-indices of the different attributes of a financial system based on aggregation of the component indicators;

Computes a standard error and confidence interval for each sub-index value;

Examines the interrelationships among these sub-indices;

Calculates two apex indices — one measuring financial development and the other financial strength — based on a cascading set of sub-indices (see Chart on pages 5 and 6); and

Assesses the relative positions of a country and monitors shifts in these positions—in terms of the vector of financial attributes—taking into account the normal linkages among, and the determinants of, these attributes.



INDICATORS OF FINANCIAL DEVELOPMENT

Financial development refers to the system’s capacity to provide a wide range of financial services effectively, efficiently and widely.

Financial development is assessed by using indicators of: i) financial depth; and ii) financial structure (breadth/diversity, efficiency, competition, openness, role of public sector, and financial inclusion/access).

Financial depth measures the size of a country’s financial system relative to the size of its economy. Financial structure measures its breadth or diversity and range of financial institutions and services: openness; efficiency; concentration; public sector dominance; and financial inclusion or access.

Financial Development Index is thus based on two sub sets of indices — 11 indicators measuring financial depth, and 36 that best describe financial structure — for which credible and consistent data is readily available. (For a list of the specific indicators, please see below.)



INDICATORS OF FINANCIAL STRENGTH

Financial strength refers to the system’s capacity to manage stress, withstand shocks and avoid disruptions in the orderly provision of financial services.

Financial strength is comprised of two interrelated aspects of a financial system: i) the enabling environment, which includes the quality and efficiency of financial infrastructure; and ii) financial stability, which includes three components of financial soundness, in addition to the scope and quality of financial supervision and the macro-prudential environment. This conception of financial stability is based on the notion that financial stability depends not only on the extent of risks and vulnerabilities in the system as measured by the financial soundness indicators, but also on how well these risks are monitored and managed by effective supervision and good governance.

In constructing the overall indicator of financial strength, we have selected indicators in the two areas as below:

Indicators of the Enabling Environment for Finance: These financial infrastructure indicators measure the robustness of the infrastructure components that support the performance of financial institutions and markets, and the effectiveness of financial supervision. These infrastructure components are further classified into four groups: Policy Transparency; Private-Sector Governance; Legal and Safety net infrastructure; and Systemic Liquidity infrastructure. Systemic Liquidity infrastructure covers the functioning and efficiency of money markets and payment settlement systems, liquidity of private and public securities markets, and central bank operations to manage market liquidity.

Indicators of Financial Stability: Financial Stability is divided into five components, three of which are grouped together as Financial Soundness.

The first component of Financial Stability is the Macro-Prudential Environment, which gauges broader macroeconomic and systemic risks, including those outside the financial sector, that may threaten the health of the financial system.

The second component of Financial Stability comprises Financial Supervisions. Financial supervision indicators look at four core components of supervisory and regulatory environment, namely: Regulatory Governance; Regulatory Practice; Prudential Framework; and Financial Integrity, mixing them into one aggregate pool to derive the Supervision sub-index. Each of these attributes is best measured based on country specific information on the observance of Basel Core Principles (BCP), and other supervisory standards, in addition to the information derived from World Bank’s Bank Regulation Data Base.

The final three components of Financial Stability, namely, Asset Quality, Capital Base and Income Risk, also together comprise the sub-index of Financial Soundness. The three sets of financial soundness indicators measure financial health and vulnerability to shocks of both the financial and non-financial sectors. At this time, we use mainly the “core” indicators that broadly correspond to capital adequacy, asset quality, management efficiency, earnings quality, liquidity and sensitivity to market and other risks as well as some selected additional indicators of soundness to capture vulnerabilities to shocks.

Financial Development Index is thus based on two sub sets of indices — 39 measuring the Enabling Environment, and 103 that best describe Financial Stability, including its sub-index of Financial Soundness. (For a list of the specific indicators, please see below.)



AGGREGATION AND COMPUTATION OF SUB-INDICES

After detailed data for indicators selected for each attribute of financial environment for each country has been obtained, the next step is to calculate sub-indices for the 15 underlying sub-indices on which the broader indices are based: Depth, Openness, Efficiency, Concentration, Public-Sector Dominance, Access, Asset Quality, Capital Base, Income Risk, Supervision, Macro-Prudential Risk, Policy Transparency, Private-Sector Governance, Legal & Safety Net and Systemic Liquidity.

The sub-indices are calculated from the underlying indicators via maximum-likelihood factor analysis, a statistical model used to reduce a number of measurable variables into least-variance, latent composite variables, called factors.

These factors will account for the correlation between, and therefore the data behind, all of the indicators of a given sub-index. Missing observations in the underlying indicators that cannot be filled by alternate sources are estimated by the standard technique of automatically generated multiple best-subset regressions; for each missing data point, this statistical technique calculates quintillions of different possible regressions and, for that data point, chooses the regression with the best fit.

Finally, as depicted in the accompanying chart, the sub-indices are combined into the broader indices and two apex indices: the Financial Development Index – viewed as a composite indicator that combines its depth as well as its various structural characteristics – and the Financial Stability Index viewed as a combination of financial stability and the enabling environment for finance.

A high degree of financial stability should contribute to sustained financial development. Aspects of financial development – notably its efficiency, openness, and public-sector role—can impact on financial stability.

Further, the pace of financial development by itself can put pressures on financial soundness. Robustness of financial infrastructure influences both financial stability and financial development. Assessment of financial environment should therefore take into account these interrelationships.

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