THE EARLY WARNING SYSTEM
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PRESENTED BY:
PETER GATERE
MANGER, BANK SUPERVISION CENTRAL BANK OF KENYA
PRESENTATION
Definition
Background
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Objectives of an early warning system
Role of qualitative information
Current supervisory tools
Steps in developing an early warning system
DEFINITION
• An Early Warning System (EWS) is a systemic process for evaluating and measuring risks early in order to take pre-emptive steps to minimize its
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impact on the financial system
• An EWS allows policy-makers to detect economic weaknesses and vulnerabilities-off-site monitoring tool.
• Gives the supervisors hints for bad/good events to the financial system at an early stage and contributes significantly to the process of on-going supervision of the financial institutions.
DEFINITION
Built on the premise that there is a link between the performance of financial institutions and the real sector
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institutions and the real sector
Major disruptions in the banking system typically stem from changes in the macroeconomic environment
Supervisors need to understand the environment in order to adequately assess the risk profile of banking institutions
BACKGROUND
The cost of financial instability can be very high and can easily run into double digits of GDP.
Severe financial distress can numb the effectiveness of standard macroeconomic tools such as monetary
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of standard macroeconomic tools such as monetary and fiscal policies.
Improvement of the safeguards against financial instability is anchored on strengthening the macro- prudential orientation of the current prudential frameworks.
The ability to monitor financial soundness presupposes the existence of indicators that can be used as a basis for analyzing the health and stability of any financial system.
BACKGROUND Cont…..
• Supervisory approaches should no longer focuses on the micro-prudential aspect to supervision but on the macro-prudential aspect to supervision through the use of macro-prudential
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supervision through the use of macro-prudential indicators (MPIs).
• Macro-prudential indicators comprise both micro prudential indicators of the health of individual financial institutions and the macroeconomic variables associated with financial system soundness.
BACKGROUND Cont….
• Hitherto, supervisors have concentrated on aggregating indicators of the health of individual financial institutions in order to determine the
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health of the financial system.
• Macro-prudential analysis provides an early warning system to supervisors, which can assist them to be more proactive to impending problems in the banking sector.
OBJECTIVES OF THE EWS
The EWS seeks to predict the possibility of a crisis occurring within a specific time horizon, which may be set at three months, six months or
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twelve months.
In other words, the EWS, through the use of various models, attempts to asses whether a crisis will occur during a particular period.
The EWS seeks to predict the possibility of a crisis occurring within a specific time horizon, which may be set at three months, six months or twelve months.
OBJECTIVES OF THE EWS Cont…
• Introduce a forward-looking aspect to risk-based supervision.
• This EWS is complementary to, and not substitute
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y for on-site examinations.
• On-site examinations ensure that the financial statements filed or submitted by the financial institutions accurately reflect the condition of the institutions, and the EWS can be used to monitor the financial condition in between the examination cycles.
THE EARLY WARNING SYSTEM
For the EWS to be effective it has to fulfil the following criteria
Have capacity to signal distress within an acceptable margin of error
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margin of error
Monitor internal and external environment
Must be a systemic way of coordinating information from the diverse sources
Account for any recent developments in the financial sector
Have a response procedure for the revision and updating of information when required
CURRENT SUPERVISORY PROCESSES
Supervisory authorities have several processes which have been used as some form of early warning system
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form of early warning system
Supervisory bank rating system
Financial ratio and peer group analysis system
Comprehensive bank risk assessment systems
SUPERVISORY BANK RATING SYSTEMS
Makes use of information from on-site examinations and off-site surveillance
Assessments made against given
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Assessments made against given benchmarks that represent the foundation of the assessments
Examiner considers other factors
Normally makes use of the CAMELS
Covers issues of compliance
FINANCIAL RATIO AND PEER GROUP ANALYSIS
Heavily relies on regulatory reporting data
Setting up of industry benchmarks
Provides an early warning system where the ratios of
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Provides an early warning system where the ratios of a particular institution comes out as an outlier to peer group benchmarks or past performance
Measures performance of an institution against performance of other institutions
Systemic changes or deterioration of the peer group is not accounted for though the banks in the peer group may have become more risky
COMPREHENSIVE BANK RISK ASSESSMENT SYSTEM
Involves a comprehensive assessment of both qualitative and quantitative risk factors
Applied on both solo and consolidated basis
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Applied on both solo and consolidated basis
Allows supervisors to track an institution’s risk profile over time
In areas where risk increases, provides a warning system which may entail an investigation or on-site examination
CURRENT EWS USED BY THE CENTRAL BANK OF KENYA
The Central Bank of Kenya uses the standard CAEL framework for identifying banks that are financially vulnerable and are
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banks that are financially vulnerable and are therefore in need of increased supervisory attention.
C-Capital Adequacy.
A-Asset quality.
E-Earnings.
L-Liquidity
CAPITAL ADEQUACY
Capital adequacy is measured in terms of :
Absolute minimum core capital.
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Core capital exposure limits as prescribed by the Banking Act and prudential regulations.
Capital adequacy ratios.
CORE CAPITAL EXPOSURE LIMITS
Credit Exposure Limits-Single Borrowings should not exceed 25% of core capital. In case of insiders this limit is set at 20% of core capital and aggregate insider borrowing is limited to 100% of core capital
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insider borrowing is limited to 100% of core capital.
Foreign Exchange Exposure Limit-Should not exceed 20% of an institution’s core capital.
Investment Exposure limit-Investment in non-core business should not exceed 20% of core capital.
Fixed Assets Exposure Limit-Fixed assets should not exceed 20% of core capital.
CAPITAL ADEQUACY RATIOS (CARS)
Core Capital/Deposits (Gearing Ratio)- Minimum 8%.
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Core Capital/Total Risk Weighted Assets (TRWA)-Minimum 8%.
Total Capital/TRWA-Minimum 12%.
For rating purposes the ratio of total capital to TRWA is used.
CAPITAL ADEQUACY RATING BANDS
Rating/Performance Category
Total Capital/TRWA (%)
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1-Strong >=19.5
2-Satisfactory <19.5 and =15.5
3-Fair <15 and =12
4-Marginal <12 and =8.3 5-Unsatisfactory <8.3
CAPITAL ADEQUACY CONT’D
All institutions with problems with any of the indicators of capital adequacy are flagged and necessary corrective action is
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and necessary corrective action is recommended.
Institutions that meet all the capital adequacy ratios but whose minimum core capital is below the prescribed core capital are automatically rated fair at best.
ASSET QUALITY
Asset Quality is measured in terms of non- performing loans less provisions as a percentage of gross loans
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percentage of gross loans.
Non performing loans are those facilities whose performance does not conform with the terms and conditions in the letter of offer (agreement). These are facilities classified as substandard, doubtful and loss in
accordance with the prudential regulation on loan classification and provisioning.
ASSET QUALITY RATING BANDS
Rating/Performance Category
Net NPLs/Gross Advances (%)
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1-Strong <=5
2-Satisfactory >5 and = 10
3-Fair > 10 and = 15
4-Marginal > 15 and = 20 5-Unsatisfactory > 20
ASSET QUALITY RATING CONT’D
An increase in the percentage of non performing loans to gross advances is an indicator of declining asset quality This
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indicator of declining asset quality. This prompts remedial action, which includes requiring an institutions’ management to enhance recovery efforts on non-performing loans and enhancing credit appraisal and administration procedures.
MANAGEMENT
In 2002, CBK incorporated management in the rating parameters. The rating is based on a questionnaire that incorporates aspects of
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a questionnaire that incorporates aspects of corporate governance and puts emphasis on risk management systems.
The parameters used are :
Role of shareholders.
Board and Senior Management oversight.
Financial performance indicators.
MANAGEMENT RATING
Scores ranging from 1 denoting strong to 5 denoting unsatisfactory are assigned to the rating parameters
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rating parameters.
The composite rating is derived by aggregating the parameters. The weights allocated are :
The role of shareholders-10%.
Board and senior management oversight- 70%.
Financial performance indicators-20%
EARNINGS
Earnings/profitability is measured in terms of return on assets (ROA) expressed as profit before tax as a percentage of gross assets
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before tax as a percentage of gross assets including off-balance sheet assets.
Other profitability ratios used include :-
• Net Interest Income/Average Earning Assets.
• Non-Interest Expenses/Operating Income.
• Total Expenses/Total Income.
Institutions with declining or negative ROA’s are flagged and appropriate remedial action is recommended.
EARNINGS RATING BANDS
Rating/Performance Category
Return on Assets (ROA)
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1-Strong >=3
2-Satisfactory <3 and = 2
3-Fair < 2 and = 1
4-Marginal <1 and = 0 5-Unsatisfactory < 0
LIQUIDITY
Liquidity refers to the ability of a financial institution to meet its’ maturing obligations.
Liquidity is measured in terms of net liquid
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Liquidity is measured in terms of net liquid assets as a percentage of net deposit liabilities.
The minimum statutory liquidity is 20%.
Institutions whose liquidity ratio falls below 20% are flagged for remedial action.
The liquidity ratio is supplemented by gap analysis of maturity mismatches between assets and liabilities within specified maturity
LIQUIDITY RATING BANDS
Rating/Performance Category
Liquidity Ratio
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1-Strong >=34
2-Satisfactory <34 and = 25
3-Fair < 25 and = 20
4-Marginal < 20 and = 15 5-Unsatisfactory < 15
WEAKNESSES IN CAMEL RATING SYSTEM
It is reactive as it is based on historical financial data.
The composite rating attaches equal
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The composite rating attaches equal weighting to each of the parameters.
Ignores other but significant micro and macro-economic indicators of financial instability.
Excludes sensitivity analysis.
STRESS TESTING
Stress testing is used to identify events or influences that could greatly impact on the bank’s performance or bank’s capital, by anticipating the potential impact of specified events on selected indicators of bank
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of specified events on selected indicators of bank performance
Scenario analysis which seeks to asses the resilience of financial institutions/sector to unexpected but plausible economic scenarios, e.g.
changes in interest rates
Stress testing gaining significance as a risk management tool
STRESS TESTING
Financial system is dynamic, stress testing adds a dynamic element to the supervision of the financial system
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the financial system
By anticipating the potential impact of specified events on selected indicators, stress testing help focus on financial system vulnerabilities arising from particular banking system and macroeconomic shocks
RATIOS THAT CAN BE USED
Capital ratio- leverage ratio - Tier 1 capital ratio - capital adequacy ratio
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Capital red flags
• Equity growth versus asset growth
• Performance ratios that are significantly different from peer ratios
• Dividend payout is significantly higher than peer ratios
• Significant growth in balance sheet activities
RATIOS THAT CAN BE USED
Asset quality – NPL/Total loans Asset quality red flags
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• Loan growth
• Loans to equity ratios
• Loans to assets
• NPLs (net provisions)/capital
RATIOS THAT CAN BE USED
Earnings: focus on the quantity, trend, quality and sustainability of earnings
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NIM
Return on Assets
Return on Equity
Earnings red flags
• Significant increase in non-interest income
RATIOS THAT CAN BE USED
Significant variance in ROE,ROA and NIM with prior periods and compared with peer group averages
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group averages
Significant variance from budgeted amounts on income and expenses and balance sheet accounts
RATIOS THAT CAN BE USED
Liquidity ratios
Loans to deposit ratios
Liquidity red flags
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Liquidity red flags
• Loans to deposit ratio
• Net short-term liabilities
• Funding concentration from a single source or multiple sources with common credit or rate sensitivity
• Declining levels of core deposits
RATIOS THAT CAN BE USED
Long term assets to total assets
Changes in interest income
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EARLY WARNING SYSTEM FORWARD
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QUESTIONS
