Financial Stability Report a toll road to Transparency and Policy Direction

Financial Stability Report a toll road to Transparency and Policy Direction

By Tesfaye Boru (PHD)

A financial stability report (FSR) is a publication issued by a central bank, regulatory authority, or other financial institution to assess and analyze the stability and soundness of a country's financial system. The report provides an overview of the current state of the financial system, identifies potential risks and vulnerabilities, and offers recommendations or policy measures to mitigate those risks.

Financial stability reports are typically published periodically, such as annually, semi-annually, or quarterly, depending on the jurisdiction and the specific requirements of the organization issuing the report. The aim is to enhance transparency and promote a better understanding of the overall health of the financial system among policymakers, market participants, and the general public.

With such backdrop, the National Bank of Ethiopia (NBE) issued the inaugural FSR 2023 comprising three major areas of discussions: Economic and financial conditions, financial sector stability and risk , financial system infrastructure development and risks. ?Basically, the long stayed FSR of countries often includes the following elements:

Assessment of the macroeconomic environment: An analysis of the economic conditions and trends that may impact financial stability, such as GDP growth, inflation, interest rates, and employment levels.

Overview of the financial system: A description of the structure and composition of the financial system, including banks, non-bank financial institutions, capital markets, and insurance companies. It may also cover the interconnectedness among different sectors and institutions.

Identification of risks and vulnerabilities: An assessment of potential risks to financial stability, such as excessive credit growth, high levels of debt, asset price bubbles, liquidity risks, or weaknesses in risk management practices. The report may also analyze vulnerabilities in specific sectors or institutions.

Stress testing and scenario analysis: The use of stress tests and scenario analysis to evaluate the resilience of the financial system to adverse shocks. This involves simulating hypothetical scenarios, such as economic downturns or changes in market conditions, to assess the potential impact on financial institutions and the overall system.

Policy recommendations and actions: Based on the findings of the analysis, the report may provide recommendations for policymakers and regulators to address the identified risks and vulnerabilities. This could include suggestions for macro prudential measures, regulatory reforms, or changes in supervisory practices.

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International perspectives: In some cases, financial stability reports may also assess global or regional developments and their potential implications for domestic financial stability. This can include an analysis of cross-border risks, contagion effects, or the impact of international regulatory frameworks.

The content of a financial stability report can vary, but it can be said that the first report of NBE adequately covers the major elements a financial report.?

It has covered both global and domestic economic conditions- a thorough analysis of the major and pertinent developments in the global and local economic context that had a direct impact on the well being of the economy are well addressed. Economic factors affecting the economy in general and specifically of the financial system are professionally evaluated and explained. GDP growth, inflation, current account balance, fiscal operations were cited as hot issues having material impact in the current? and forthcoming soundness and efficiency of the financial system.

Major players in the financial system are well addressed with special focus on the banking sector, holding 96% of the financial asset- the Ethiopian financial system consists of few players that recently increased in their number and types. For long time this system consisted of only three types of financial institutions banks, insurance and micro finances. Recently, the system integrated additional players such as capital leasing and mobile operators. In the near future, the capital market will be part of the financial system. The change in the structure is not yet eminent as the banking sector by far dominating the financial system taking the lion share of the financial assets in the system. Other players in the system were addressed in the report accordingly but little attention is provided to fin techs and mobile operators that remained to be the future game changers of the financial system.

Banking structural related matters were addressed through asset and deposit based classification but required structural reforms were not indicated- the report classified the banks in the sector in to three categories as large, medium and small banks. Even if it remains difficult to exactly determine the threshold applied, from the context of the report it seems that asset and deposit amount were taken as matrices to classify the banks in the sector into various groupings. This arguably might affect the basis of competition and customer preferences in bank selection but positively might contribute towards encouraging banks to aspire upgrading themselves towards a higher category. The categorization has accepted the fact that there is a large bank which was named as ‘systemic’ admitting the skewed market structure in the banking system. Policy measure to address "too big to fail” scenario and measures to reduce the systemic risks posed by large financial institutions were not presented in detail. Policy measures in such regard usually may involve imposing higher capital requirements (which the report indicated it partially), enhancing resolution frameworks, or promoting competition in the sector. ?The classification used (1 large and 5 medium banks) might also indicate the expected number of banks to operate in the financial arena in the forthcoming given the long spoken bank merger and acquisition scenarios are implemented.

?It seeks to identify weaknesses in the Ethiopia’s financial system and stress tested the identified key risks- after careful analysis, the report endorsed the stability and soundness of the financial system. In fact, concerns were identified in key areas of the banking business but the stress test revealed the capacity of the system to absorb shocks, such as economic downturns, rather than make them worse. Concentrations remained a key risk element in almost all players of the financial system. For instance, the report indicated prevalence of concentration in the credit, deposit, insurance, leasing activities/sectors. ?In other areas like liquidity stress test revealed vulnerabilities to be applied shocks in considerable number of banks. Policy suggestions however, mainly targeted addressing issues of specific banks. In such regard, macroeconomic indicators such as declined broad money supply support the fact that liquidity shock is systemic and need policy flexing to provide long term solution.

Policy directions were indicated here and there in the report but were? mainly focused on prudential and regulatory issues- ?the report boldly indicated the required action for some of the identified weaknesses in the report so that the system is able to absorb negative shocks effectively. The recommended measures mostly are prudential measures implemented by regulators to address systemic risks and vulnerabilities in the financial system. Examples of prudential measures indicated include: Increasing the minimum capital requirements for financial institutions to enhance their resilience against potential losses and increasing the intensity and effectiveness of supervisory activities and enforcement actions, to ensure compliance with regulations and identify potential risks at an early stage. Fiscal and monetary policy related measures were assumed to persist and applied in the forthcoming without any major alterations or amendments, to some extent revealing policy rigidity and against some facts in the report demanding for such interventions. This seems impacted by the recent policy due focus on the risk of persistent inflationary pressures leading to a more restrictive monetary policy stance.

Technology remains a top agenda of discussions - ?as part of the financial system infrastructure, technology usage and risks were adequately analyzed. It clearly portrays the steadfast growth of technologies and financial products in the banking system. The required precautions and safety measures are also indicated very well.

Geopolitics related issues were indicated as part of the global economic assessment but not as a separate agenda- global vulnerabilities can also amplify economic shocks in foreign economies and lead to spillovers to the Ethiopian economy. For example, the recent year performance in export is affected by lower demand for exports abroad, red sea incident etc. Heightened geopolitical tensions such as access to port continue to pose important risks to our economic activity. In addition, transmission channels through which shocks originating abroad can transmit back to the Ethiopian financial system need detail assessment as our current framework is moving towards an open door policy .

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Near Term risks demanding quick fix actions were not segregated from risks to be addressed in the long term- most cited potential risks seems to have long term nature demanding for new supervisory approach or gradual reduction of exposures. Identified near term risks (within 12 to 18 months) shall be separately analyzed and need to be supported by quick fix actions and clear policy directions. This will enhance the practicality of the FSR and ensures its role of providing early warning signals to eminent risk exposures.

Reports were mainly based on secondary data and primary data collection like survey which has chance to involve key stakeholders were not applied- ?Primary data collection is one of the strongest approach to identify salient risks to Financial Stability. The involvement of key stakeholders like professionals in each sector, research and advisory firms, academics, bank customers, supervisors and others provides a rich input and adds credibility to the report. Even if this is not expected to be done in the eye opening reports, future FSR’s are hopefully expected to participate key stakeholders.

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Overall, Financial stability reports offer several benefits to policymakers, regulators, market participants, and the general public. ?It contribute to the maintenance of a sound and resilient financial system by promoting transparency, early risk detection, informed decision-making, and effective policy responses. FSR serve as a valuable tool in safeguarding financial stability and reducing the likelihood and impact of financial crises. The NBE’s report in such regard is fit to purpose and much comprehensive to point out the existent status of the financial system, its vulnerabilities and required measures to address it. Future reports hopefully will have much wider content involving clear policy directions, well developed risk analysis tools and involving inputs from key stakeholders so that Financial Stability Report remains a toll road to Transparency and Policy Direction.

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