Early warning systems:can more be done to averteconomic and financial crises?
Access Economics has a long established reputation for                                   The Institute of Chartered Accoun...
ForewordThis paper is part of a thought leadership series dedicated to helping Australian society and our nextgeneration o...
Early warning systems: can more be done to avert economic and financial crises?
ContentsExecutive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...
Executive summaryFinancial crises typically have two components: a trigger                         Considerable obstacles ...
1 IntroductionBefore the Global Financial Crisis (GFC) there were some                         renewed interest in identif...
frequent enough for there to be a rich literature on the                          Yet the systemic risk of non-financial c...
2 Macroeconomic indicators of a crisisTypically, an EWS has an empirical structure with indicators                        ...
The aim of an EWS is to identify indicators that are able                         has been found to be associated with ban...
The bursting of a bubble typically results in a contraction          Financial soundness indicators (FSIs) were determined...
2.2 Finding the appropriate policy responseEmpirical tests of EWSs have found that while they are ableto predict financial...
3 Microeconomic indicators of a crisisIndicators at the individual company level provide important      Moreover, changes ...
3.3 Credit rating agencies                                                        In more recent years, some analysts have...
> The distress dependence matrix – examining the  probability of distress of pairs of institutions, taking into  account a...
4 Bridging the gapThe macroeconomic and the microeconomic indicators                                 4.2 Reforming the cre...
5 Addressing obstacles to an effective EWSMany of the suggestions in Chapter 4 may make sense in                          ...
Broad Based Business Reporting (BBBR), sometimesdescribed as integrated reporting, is an enhanced reportingmechanism being...
6 ConclusionThe economics literature has struggled to produce aneffective EWS. This is because statistical models capturet...
References Altman, E 1984, ‘The success of business failure prediction models: an international survey’, Journal of Bankin...
Appendix ATable A.1: Variables commonly use in EWS modelsIndicator              DescriptionReal economyGDP growth         ...
Appendix A (continued) Indicator                           Description Financial markets Change in share price            ...
AcronymsAbbreviation/acronym         NameAPRA            Australian Prudential Regulation AuthorityBBBR            Broad B...
Contact detailsAccess Economics                                             The Institute of Chartered Accountants in Aust...
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Early warning systems: can more be done to avert economic and financial crises?

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This paper sets out the context of financial crises with the aim of stimulating discussion on developing early warning systems.

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Early warning systems: can more be done to avert economic and financial crises?

  1. 1. Early warning systems:can more be done to averteconomic and financial crises?
  2. 2. Access Economics has a long established reputation for The Institute of Chartered Accountants in Australia (theproviding in-depth research and impartial analysis to aid Institute) is the professional body representing Charteredthe development of sound public policy. Accountants in Australia. Our reach extends to moreFounded in 1988, Access Economics is Australia’s than 67,000 of today’s and tomorrow’s business leaders,premier economic consulting firm, specialising in both representing more than 55,000 Chartered Accountantsqualitative and quantitative economic analysis. Access and 12,000 of Australia’s best accounting graduatesEconomics’ team of highly qualified and experienced currently enrolled in our world-class Chartered Accountantsconsultants provides expert economic advice to postgraduate program.business, government and industry groups. Our members work in diverse roles across commercewww.accesseconomics.com.au and industry, academia, government and public practice throughout Australia and in 109 countries around the world. We aim to lead the profession by delivering visionary leadership projects, setting the benchmark for the highest ethical, professional and educational standards, and enhancing and promoting the Chartered Accountants brand. We also represent the interests of members to government, industry, academia and the general public by engaging our membership and local and international bodies on public policy, government legislation and regulatory issues. The Institute can leverage advantages for its members as a founding member of the Global Accounting Alliance (GAA), an international accounting coalition formed by the world’s premier accounting bodies. With a membership of over 800,000, the GAA promotes quality professional services, shares information, and collaborates on international accounting issues. Established in 1928, the Institute is constituted by Royal Charter. For further information about the Institute, visit charteredaccountants.com.auDisclaimerThis discussion paper presents the opinions and comments of the author and not necessarily those of the Institute of CharteredAccountants in Australia (the Institute) or its members. The contents are for general information only. They are not intended asprofessional advice – for that you should consult a Chartered Accountant or other suitably qualified professional. The Instituteexpressly disclaims all liability for any loss or damage arising from reliance upon any information contained in this paper.While every effort has been made to ensure the accuracy of this document and any attachments, the uncertain nature of economicdata, forecasting and analysis means that Access Economics Pty Limited is unable to make any warranties in relation to theinformation contained herein. Access Economics Pty Limited, its employees and agents disclaim liability for any loss or damagewhich may arise as a consequence of any person relying on the information contained in this document and any attachments.CopyrightA person or organisation that acquires or purchases this product from the Institute of Chartered Accountants in Australia mayreproduce and amend these documents for their own use or use within their business. Apart from such use, copyright is strictlyreserved, and no part of this publication may be reproduced or copied in any form or by any means without the written permissionof the Institute of Chartered Accountants in Australia.All information is current as at December 2010First published February 2011Published by:The Institute of Chartered Accountants in AustraliaAddress: 33 Erskine Street, Sydney, New South Wales, 2000Access EconomicsSuite 1401, Level 14, 68 Pitt Street, Sydney, New South Wales, 2000Early warning systems: can more be done to avert economic and financial crises?First editionEarly warning systems: can more be done to avert economic and financial crises?ISBN: 978-1-921245-79-4ABN 50 084 642 571 The Institute of Chartered Accountants in Australia Incorporated in Australia Members’ Liability Limited. 1210-10ABN 82 113 621 361 Access Economics.
  3. 3. ForewordThis paper is part of a thought leadership series dedicated to helping Australian society and our nextgeneration of business, political and social leaders remain ‘fit for the future’.Entitled Early warning systems: can more be done to avert economic and financial crises?, the paper isthe third in our series which contributes broad economic thinking and valuable insights on a range ofbusiness and social issues impacting Australia now and in the future.As a leader in the Australian accounting profession, the Institute of Chartered Accountants in Australia(the Institute) strives to influence and shape the public policy agenda. It is in this regard that we haveteamed up with Access Economics to produce this paper.Early warning systems: can more be done to avert economic and financial crises? broadly sets out thecontext for timely warning signals of impending financial crises, and examines how new or unexploredindicators may help improve our understanding of the stability of the economy. These are considered atboth the macro- and microeconomic levels.Our aim is to stimulate discussion around how to strengthen our policy settings and regulatory systemsand contribute to the process of improvement in the aftermath of the global financial crisis.The Institute is pleased to have worked with Access Economics on this paper and I trust that you willfind it both interesting and thought provoking. We will continue to challenge and provoke thinking onkey business issues for the benefit of Australia.Rachel Grimes FCAPresidentThe Institute of Chartered Accountants in Australia 3
  4. 4. Early warning systems: can more be done to avert economic and financial crises?
  5. 5. ContentsExecutive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6Macro- and microeconomic indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6Bridging the gap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 Macroeconomic indicators of a crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92.1 Design methods and issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92.2 Finding the appropriate policy response . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 Microeconomic indicators of a crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133.1 Financial ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133.2 The evolution of the audit committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133.3 Credit rating agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143.4 Analysts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143.5 Systemic risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 Bridging the gap. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164.1 An expanded role for auditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164.2 Reforming the credit ratings process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164.3 Collaboration across institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Addressing barriers to an EWS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175.1 Proprietary information and company burden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175.2 Timely information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175.3 The cost of collecting new information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21Acronyms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23ChartsChart 1.1: The cost of financial crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7FiguresFigure 2.1: Past financial crises: triggers and underlying vulnerabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9Figure 2.2: Global financial stability map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11TablesTable A.1: Variables commonly use in EWS models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21Table A.2: Indicators of corporate distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 5
  6. 6. Executive summaryFinancial crises typically have two components: a trigger Considerable obstacles do exist, however, to theand an underlying vulnerability. Although the trigger and achievement of an effective EWS – namely, the need totiming of a crisis are difficult to predict, the underlying protect companies’ proprietary information, the difficultyvulnerability should be detectable. of providing timely information, and the sheer cost ofThis paper sets out the context of financial crises with the collecting information.aim of stimulating discussion on developing an effective Conclusionearly warning system (EWS). It looks first at macro- andmicroeconomic indicators of a crisis (Chapter 2 and 3). There is no shortage of indicators of a potential economicIt then makes suggestions for bridging the gap between crisis. The problem lies in making the best use of thesethese (Chapter 4) and addressing obstacles to achieving indicators, and there are a number of ways in which financialan effective EWS (Chapter 5). information could be managed to achieve this. But in the end, gathering information is no substitute for action.Macro- and microeconomic indicators Having regulators with the independence and courage toThe macroeconomics literature has struggled to produce an call a looming disaster and take evasive action is required –effective EWS. Macroeconomic (whole economy) indicators a strong culture of regulatory independence is an essentialcommonly associated with crises include low growth in aspect of any effective EWS.Gross Domestic Product (GDP), rapid growth in privatesector debt, and prolonged periods of low interest rates.Indicators at the microeconomic (individual company) levelmay provide useful information that the macroeconomicindicators fail to capture. Microeconomic indicators includefinancial ratios (liquidity, solvency, profitability), auditcommittee information, credit ratings, financial analysis(e.g. trends, forecasts), and measures of systemic risk(links between companies). However, better informationcould be disclosed by corporates to assist regulators’understanding of the corporate sector’s financial positionand attitude to risk.Bridging the gapBoth macro- and microeconomic indicators provide importantinformation, yet there is no defined channel by which thesecan be linked to give a broader perspective of potentialcrises. Ways in which this could be achieved include:> Expanding the role of auditors to provide insights on the longer-term viability of companies and report on the effectiveness of business models used> Reforming the credit ratings process to encourage agencies to undertake broader risk analysis and report major financial changes to regulators> Collaborating across institutions to promote information-sharing among governments, regulators and others, and to find new sources of information.Early warning systems: can more be done to avert economic and financial crises?
  7. 7. 1 IntroductionBefore the Global Financial Crisis (GFC) there were some renewed interest in identifying and remedying weaknessesclear warning signs of impending problems, including in the financial system.bubbles in credit growth and house prices in many International institutions such as the Basel Committee oncountries, and there were reputable voices warning of Banking Supervision (BCBS) are currently developing reformsthese developments.1 Policy-makers and regulators may not to strengthen the resilience of financial institutions in thehave seen these warning signs but were likely putting less event of shocks to the economy and financial system:weight on them, or were wary of intervening in financialmarkets because of uncertainty about the effect theiractions might have had. Indeed, some policy experts were The BCBS reforms are intended to be forward looking, making the system more resilient to future crises,supportive of Alan Greenspan’s approach − that is, leave whatever their source ... While we cannot withthe market to its own devices and intervene only when certainty predict the source of the next crisis, wesomething has gone wrong. can however lay the groundwork to help mitigate orThe purpose of this paper is to broadly set out the context minimise the impact. (Walter 2010)of EWS, to identify potentially new or unexplored sourcesof information, and to stimulate further discussion on Policy-makers and regulators would not just rely on newhow to improve our policy settings and regulatory systems. regulation to prevent future crises. Regulation is only able toIt is not intended to provide a complete solution – rather, address areas of weakness that have already been identified.to make a contribution to the process of improvement However, the financial system is constantly changing;post-GFC. new financial products and increasingly sophisticatedFinancial crises occur when there is an underlying weakness technologies alter the way in which trade is conductedin the economy or financial system (IMF 2010). Although and the risks that are faced. The need for different or newthe weakness itself does not start the crisis – a trigger event regulation will not always be identified or implemented inis required – the extent and spread of the crisis are results time to prevent the emergence of weakness in the financialof this weakness. The huge cost of the damage caused by system. Re-examining early warning signs of financialthe GFC and past crises (Chart 1.1), even if only measured distress or an impending crisis is thus essential if authoritiesin terms of job losses and increased government debt, has are to react early and appropriately. Financial crises areChart 1.1: The cost of financial crisesWhile crises are more common in emerging economies, advanced economies are not immune.Frequency of crises across countries 1972 – 2007 Average cost of banking crises 1970 – 2007%* % of GDP 6 30 5 4 20 3 2 10 1 0 0 Banking Currency Debt Advanced Emerging Advanced Emerging Fiscal cost Output cost * Frequency of crises measured by number of crises episodes in per cent of the total number of country years in respective group samples. Source: Ghosh et al (2009).1. For example, Bezemer (2009) provides a list of well-known commentators who anticipated the housing bubble bursting and leading to recession, distinguishing ‘the lucky shots from insightful predictions’. 7
  8. 8. frequent enough for there to be a rich literature on the Yet the systemic risk of non-financial companies shouldpredictive power of various economic and financial variables. still be considered. There may also be important signs ofIn the wake of the GFC, authorities may be more willing to pressure in the economy to be extracted from the activitiesconsider reacting to such warning signs. and risk-taking behaviour of companies across industries andThis paper aims to collate information and raise questions sectors in the economy. The audit committee and auditorto facilitate discussion on what more can be done to make are well positioned to assist in expanding understanding ofimprovements to early warning systems. In particular, a company’s financial position and attitude to risk, and thisthere is a focus on two areas of literatures on early warning is explored further in Chapter 5. We also briefly explore insignals of financial stability: the economic and the financial. Chapter 5 the importance of non-financial broad informationIn addition to being important sources of information about and indicators.the state of the economy and the financial system, they also We turn now to a discussion of potential indicators of aprovide indicators from different perspectives: financial crisis, beginning in Chapter 2 with macroeconomic> The economic literature explores ‘macro’ or economy- indicators – those at the systemic level. wide indicators of financial distress and the state of the economy. These may not be the most timely indicators and may not fully reveal the extent to which the financial sector is exposed to unexpected changes in the state of the macro economy> The financial indicators that are, or potentially could be, provided by a publicly listed company are valuable for understanding some aspects of the financial position of that company. However, the financial distress of a single company is not sufficient to indicate a financial crisis. This depends on the company’s contribution to systemic risk. A link between these two areas of literatures could improve policy-makers’ understanding and knowledge of the stability of the economy. Moreover, there may be other sources of information available, or that could be made available, to further this knowledge. A list of alternative sources could include: > Greater company disclosures via the audit committee with an expanded role for auditors > Greater use of tax information > Broader regulation of systemic risk > Greater or different collaboration between regulators and all the groups involved in the capital market.As with any change to policy, there are practicalconsiderations in implementing any of these ideas.Early warning signals of a financial crisis are usually searchedfor in the real economy. However, this may not provide atimely indication of vulnerability if it occurs on the financialside of the economy. Although there exist indicators ofcorporate distress for individual companies, regulatorsmostly focus on the trends in deposit-taking and financialinstitutions to inform their broader view of the economy.Early warning systems: can more be done to avert economic and financial crises?
  9. 9. 2 Macroeconomic indicators of a crisisTypically, an EWS has an empirical structure with indicators considerable implications if policies are to be designed,that contribute to a country’s vulnerability to a future crisis implemented and allowed to take effect.and may forecast the likelihood of a financial crisis. The Early warning systems based on macroeconomic indicatorsindicators of an EWS could reveal a country’s vulnerability have previously focused on banking crises caused byto a future crisis and forecast the likelihood of a financial financial institutions underestimating their exposure tocrisis. The literature has identified indicators using EWS economy-wide systemic risk. Borio, Furfine and Lowe (2001)models based on reduced-form relationships linking a set consider the exposure of the banking industry as a wholeof explanatory variables to a financial crisis measure. EWS to macroeconomic shocks rather than the exposure ofmodels differ widely according to the definition of a financial individual institutions. Consequently, they do not considercrisis, the time span over which it may happen, the selection indicators for crises caused by counterparty exposure,of indicators, and the statistical or econometric method used. be it actual exposure or perceived exposure.2In general, they have not been found to work well.These models are sensitive to changes in specification 2.1 Design methods and issuesand definition of variables, and as a result findings vary There are two components of a financial crisis: an underlyingsubstantially across the literature. The design of an EWS vulnerability and a trigger (IMF 2010). The trigger determinesrequires consideration of how indicators combine − a the timing of the crisis and is difficult to predict − it mayvariable may not be an indicator of financial crisis risk by be a one-off unexpected event. However, the underlyingitself but would be if observed in conjunction with other vulnerability has often been present in the economy forfactors. Moreover, although empirical models of financial some time and should be predictable. Figure 2.1 showscrises are able to identify indicators retrospectively, there some examples of past crises and the associated triggersare doubts about their ability to pre-empt a crisis – this has and vulnerabilities.Figure 2.1: Past financial crises: triggers and underlying vulnerabilitiesCrises have been caused by a variety of vulnerabilities and triggers Crisis Vulnerability Triggers Norway (1988) Credit and house price booms, overheating, Tightening of monetary policy, collapse of trade thin capitalisation of banks, concentrated loan with the Council for Mutual Economic Assistance; Finland (1991) exposures, domestic lending in foreign currency, exchange rate depreciation financial deregulation without strengthening of Sweden (1991) prudential regulation and supervision; weaknesses in risk management at the individual bank level Mexico (1994) Government’s short-term external (and foreign- Tightening of US monetary policy, political shocks exchange-denominated liabilities) Thailand (1997) Financial and non-financial corporate sector Terms of trade deterioration; asset price deflation external liabilities; concentrated exposure of finance companies to property sector Indonesia (1997) Corporate sector external liabilities; concentration Contagion from Thailand’s crisis; banking crisis of banking system assets in real estate/property- related lending; high corporate debt-equity ratio Turkey (2000) Government short-term liabilities; banking system Widening current account deficit, real exchange foreign exchange and maturity mismatches rate appreciation, terms of trade shock; uncertainty about political will of the government to undertake reforms in the financial sector United States Credit and house price boom; weaknesses in Collapse of the subprime mortgage market (2007) financial regulation resulting in a buildup of leverage and mispricing of risk Source: Ghosh et al (2009)2. If agents are unable to distinguish between ‘good’ and ‘bad’ institutions the failure of one institution can result in the failure of others as agents treat the ‘good’ institutions as if they are about to fail – a self-fulfilling belief. 9
  10. 10. The aim of an EWS is to identify indicators that are able has been found to be associated with bank crises when lowto provide both a timely predictor of an impending crisis (Demirgüc-Kunt & Detragiache 2005). Yet the difficulty withand minimal false signals. These indicators are selected using it as an early warning indicator is that it is not timely.by examining their historical predictive power. A major It is typically released with a one-quarter lag, and by the timeobstacle in this exercise is that the underlying vulnerability the slowdown is occurring it may be too late to identify andin the economy may be a result of a combination of correct underlying vulnerabilities in the economy before afactors, including time- and country-specific factors such crisis begins.as institutional structure, government policy and prevailing Rapid growth in private sector debt is one of the few robusteconomic sentiment. These differences across countries and indicators found in the literature on early warning signs oftime zones may make it difficult to identify suitable warning a financial crisis (Borio & Lowe 2002; Kaminsky et al 1997).signs for future crises based on experience. Increases in the ratio of private sector credit to GDP duringThere are also different types of financial crises. Broadly pre-crisis periods, along with rapid real credit growth,speaking, a financial crisis can be categorised as a: indicate credit risk accumulation (Davis & Karim 2008)> Banking crisis – when there is a failure of, or run on, a bank and may signal the under-pricing of risk.> Currency crisis (balance of payments crisis) – when Growth in credit stimulates aggregate demand relative there is a speculative attack in the foreign exchange to potential output, overheating the economy. As inflation market causing the value of a currency to rapidly change, and interest rates rise, economic activity slows. If this was thereby undermining its ability to serve as a medium of not taken into account by borrowers, it may leave them exchange or a store of value unmanageably indebted and put the financial stability of> Wider (real) economic crisis – when there is a recession the economy at risk (Hilbers et al 2005). or prolonged downturn in economic activity. Prolonged periods of low interest rates may be a leading indicator of financial crises. During such periods, typicallyOne type of crisis can lead to another, or they can occur associated with economic booms, banks may use low-costsimultaneously; for example, currency and banking crises are deposit financing to invest heavily in particular sectors whichcommonly referred to as the ‘twin crisis’ when they occur appear profitable and where collateral values are high. Thetogether. Kaminsky and Reinhart (1999) found that problems banking industry may be exposed to increased interest ratein the banking sector typically precede a currency crisis but risk by investing in higher-risk long-term projects withoutthat the currency crisis deepens the banking crisis. correctly pricing the probability of future interest rises.Early warning systems require indicators with a sufficient Positive correlations between real interest rates and bankinglead time. This has been identified as a major obstacle crises have been found in numerous studies (e.g. Demirgüc-in EWS design (Kaminsky & Reinhart 1999). Many Kunt & Detragiache 2005; Kaminsky & Reinhart 1999).macroeconomic indicators often have a short forecast Excessive growth in asset prices may indicate a bubble inhorizon, and data is often not available until months after the asset market. A bubble occurs when rapid growth inthe period it refers to. This is crucial because policy the price of a class of asset is followed by a sharp fall. Theresponses, particularly once the trigger has occurred, take fall occurs because the asset price growth was not basedtime to design, implement and have an effect. For example, on ‘fundamentals’ − the intrinsic value of the asset − buta large unexpected expansionary change in monetary policy on some other factor.may have some immediate effect as expectations adjust andsentiment rises, but it will take months before the full effectof the policy is realised. Likewise, a fiscal stimulus package There are a number of theories for the cause ofneeds to be designed, receive parliamentary approval and bubbles in asset prices:be implemented – and those receiving funding from the > The ‘greater fool’ − people knowingly buy anpackage must spend the money for the consequential overvalued asset hoping to sell it to someone elseeffect. The aim of an EWS would, therefore, be to identify who is also willing to do thisunderlying vulnerabilities in the economy and correct them > Herding − it is better to act in the same way asbefore a crisis is triggered. your counterparts and eventually lose than appear to be missing out on gains now2.1.1 Macroeconomic variables of interest > Extrapolation − price growth should continue asVariables that are commonly found as predictors in EWS it has done in the pastmodels are shown in the Appendix (Table A.1). These > Moral hazard − not fully exposed to the risk sovariables are selected for their theoretical appeal. For the expected value of the asset to the buyer isexample, Gross Domestic Product (GDP) growth, which is higher that the true expected value.used widely as an indicator of the health of the economy,Early warning systems: can more be done to avert economic and financial crises?
  11. 11. The bursting of a bubble typically results in a contraction Financial soundness indicators (FSIs) were determined or slowdown of the economy. This can be due to asset through discussions with international agencies and member price bubbles fuelling demand through the consumption countries. In total, 39 FSIs have been agreed on. These are of perceived wealth; balance sheets being undermined split into core FSIs (those relevant to all countries and which with the collapse of the assets value, particularly if there is are producible given current data collection) and encouraged debt secured against it; and confidence being undermined, FSIs (only included if the country is able to produce the resulting in a contraction in activity. relevant data). Many of these indicators are financial ratios, House price growth in particular is an important indicator derived from the aggregated balance sheets of individual of financial crises. Barrell et al (2010), for example, found financial companies. that this was an important predictor of financial crises in 2.1.3 Proposed new IMF indicators countries of the Organisation for Economic Co-operation A potential solution to some of the problems posed by and Development (OECD). Davis (1998) also sights over- econometric-based EWSs might be found in designing a investment in real estate (particularly commercial) as a system that aims to identify changes in the exposure of the well-documented feature of banking crises. economy to risk, rather than precisely predict the occurrence 2.1.2 IMF financial soundness indicators of a crisis. The IMF (2010) has recently proposed such a type The International Monetary Fund (IMF) uses a composite of EWS, based on an analysis of six broad types of risk: indicator of macroeconomic and prudential indicators of > Macroeconomic risk the soundness of financial institutions (Worrell 2004). > Credit risk These include variables which have: > Market and liquidity risk > Direct impact on the balance sheets and profit and loss > Monetary and financial risk of financial institutions − interest rate changes > Risk appetite, and > Indirect effect − reduced collateral values or reduced > Emerging market risks. ability of borrowers to service their obligations to banks > Prudential indicators – of the adequacy of bank capital, These risks are calculated using a number of indicator the quality of bank assets, the efficiency of management, variables and are combined to form a global financial the robustness of earnings, the adequacy of liquidity, stability map (see Figure 2.2 below). and the coverage of market risk (the CAMELS ratios) > Measures of exposure to interbank contagion > Measures of exposure to contagion from abroad (Worrell 2004). Figure 2.2: Global financial stability map Risks April 2009 GFSR Emerging market risks Credit risks October 2009 GFSR April 2010 GFSR Note: Closer to centre signifies less risk, tighter monetary and financial conditions, or reduced risk appetite. Source: IMF (2010)Macroeconomic Market and liquidity risks risks Monetary and financial Risk appetite Conditions 11
  12. 12. 2.2 Finding the appropriate policy responseEmpirical tests of EWSs have found that while they are ableto predict financial crises they also lead to a large number offalse predictions. From a policy perspective this is a relevantissue: policy-makers and regulators need to decide whetherit is worse to fail to respond to vulnerability, or to react tofalse signals and try to correct problems that do not exist.Reacting to false signals is costly. It could be costly tobusiness in terms of complying with stricter regulation, orthere could be efficiency costs if the operation of marketsis restricted. For example, a policy response that aimsto restrict access to personal credit, because the EWSincorrectly indicates that credit growth is posing a threat tostability, would result in fewer people being able to accesscredit than is optimal. Formulating a policy response to afalse positive is also costly in terms of the administrativecost of designing and implementing the policy.A related question is whether or not monetary policy shouldrespond to asset price inflation that is potentially a bubble,for example, in the housing market. Asset price bubblesare difficult to detect until they have burst. In respondingto bubbles, central banks would need to make a judgmenton whether the growth in asset prices was based onfundamentals or not. Gruen et al (2003) found that centralbank intervention in a bubble was only optimal if the bubblewas identified in its early stages and if there was lessprobability of the bubble bursting of its own accord. Whetheror not monetary policy is able to curb a sustained upwardmovement in asset prices driven by excessively low riskaversion is another question. Borio and Lowe (2002) haveproposed that it can, as long as the central bank is credibleand is able to send a signal to the market that it is concernedabout the state of the economy.The final question for policy-makers is whether or notasset price booms and busts are in fact bad for the long-term growth of the economy. There is a trade-off betweenenduring periods of financial instability and exploiting growthpotential, because the reduction of financial constraintsduring a boom allows greater investment to occur, potentiallyimproving growth possibilities in the future.Having now looked at a number of macroeconomicindicators, Chapter 3 examines a range of microeconomicindicators – those at the individual company level.Early warning systems: can more be done to avert economic and financial crises?
  13. 13. 3 Microeconomic indicators of a crisisIndicators at the individual company level provide important Moreover, changes in attitudes to risk, and the existence ofinformation about the resilience of the corporate and financial businesses with an unsustainable business model, increasesector to economic shocks. While there are macroeconomic the vulnerability of the economy to shocks.indicators of this, an examination of micro-level information A limitation of financial ratios is that they do not capturemay provide important details that the aggregated this business model risk. This type of information is difficultinformation fails to capture. to capture using a single metric. Instead it requires eitherMuch of the micro-level information concerns what a comprehensive framework for assessment or substantialauditors examine when undertaking an audit. An auditor’s judgment of the information reported, in which case anunderstanding of the market places them in a good position external assessment would be required.for assessing the risk appetite and risk model of thecompanies they audit. Credit ratings agencies are likewise 3.2 The evolution of the audit committeeable to provide an assessment of the systemic exposure of An independent audit committee is a fundamental componentindividual companies. of a sound corporate governance structure. Importantly, it brings together non-executive directors, management,3.1 Financial ratios external audit, internal audit and advisors.Financial ratios are useful indicators of a company’s The role of the audit committee has evolved significantly inperformance and financial situation. Ratios can typically be the last 10 years and will continue to evolve. It has movedcalculated from information provided by financial statements. from having a fairly limited function primarily focusedIn their seminal research, Altman (1966), Beaver (1968) and on completion of audited financial statements to havingBlum (1969) identified a number of financial variables that a much broader and integrated focus of responsibilities.were significant predicators of corporate failure. Although Drivers of this evolution include regulatory expectations,financial indicators are not able to capture everything abouta company, they provide a basis on which to assess some market expectations, and the ‘better practice’ skills thatof the core requirements for a company to be reasonably audit committee members and auditors gain throughexpected to continue as a going concern. Some of these working closely together. It is clear, though, that furtherindicators are described in greater detail in the Appendix enhancements can and should be made to the role of the(Table A.2). audit committee. For example, an essential element of the audit committee’s role is to interact effectively with theThe three types of indicators identified in the literature external auditor in order to achieve a quality audit.are liquidity, solvency and profitability measures: Communication between auditors and the audit committee is> Liquidity ratios provide information about a company’s important, as is communication between the audit committee ability to meet its short-term financial obligations and the company’s stakeholders. There is merit in exploring> Solvency ratios indicate a company’s ability to pay an enhanced role for the audit committee, including better its obligation to creditors and other third parties in disclosures of key information in the annual report, and an the long term improved understanding of the role of audit.> Profitability indicators suggest whether or not a Greater disclosure of key information in the annual report company will be able to improve its liquidity and solvency through the audit committee could be achieved by including: position. If a company is profitable there is a good chance that it will be able to meet its obligations, but if not then > Indicators of the company’s future financial performance it is unlikely that it will be able to continue as a going (e.g. main assumptions, key sensitivities) concern for long. > The components of the company’s business model(s) and significant inherent risks to the success of the model(s)These types of indicators are often found in companies’annual reports and are used by shareholders or potential > Uncertainties and judgments that underlie its set ofshareholders to inform their investment decisions. In terms financial statements – these are typically the topicsof informing a regulator’s broader view of the economy, at of greatest discussion between auditors and auditmost the focus would be on deposit-taking and financial committees and attract the highest degree of audit focus.institutions rather than the whole of the corporate sector. These disclosures could substantially add to the value ofHowever, the behaviour of other types of companies may key forward-looking information and be a valuable source ofstill be informative for regulators. If there is change in the input into EWSs. The primary challenge, though, will lie innumber of companies not doing well, particularly in the same aggregating these disclosures at different levels to assist insector or industry, it may suggest an impending problem. broader analysis of EWSs. 13
  14. 14. 3.3 Credit rating agencies In more recent years, some analysts have become moreCredit rating agencies provide ratings to companies that engaged with the global financial reporting standard-setters,want to issue debt, both for the company and the instrument. providing input into their deliberations. The CorporateThese ratings are used by investors to evaluate the relative Reporting Users’ Forum (CRUF) has developed guidingrisk of different securities. During the recent financial crisis, principles on good financial reporting standards.credit ratings agencies were heavily criticised for rating Consideration should be given to whether there is scopestructured products, which were ultimately defaulted on, for greater involvement with the analyst community, andas AAA-rated. whether the substantial levels of information they collectA problem with the current ratings system is agencies could assist with EWSs.providing a company with a poor rating or a downgradecan result in the so-called ‘death spiral’. The downgrade 3.5 Systemic riskadversely affects the company’s contracts with financial An institution’s systemic risk is the risk it poses to theinstitutions, increasing expenses and making it more difficult stability of the financial system as a result of its links withto obtain finance. This in turn can reduce its credit ratings. other institutions. During the GFC, a number of largeDebt covenants may be breached if creditworthiness companies deemed ‘too big to fail’ were bailed out byfalls below a certain point, with loans due in full and the governments (e.g. American International Group, Inc. (AIG)company unable to refinance. The company may then be and Royal Bank of Scotland (RBS)). This has raised theforced into administration. question: how should such institutions be regulated in the future, given their importance in the stability of the economy?Ratings agencies have a standard process of forming ratings– they avoid using judgment or information outside of scope. Financial institutions have a strong incentive to becomeThis improves transparency, as companies know how the systemically relevant because they have a higher probabilityratings work and are less likely to take legal action against a of being bailed out in the case of financial distress. Thenegative credit rating. However, this also allows companies consequence of this is that institutions will take on moreto modify their behaviour to meet the minimum standard risk than is socially optimal because they are able to passrequired to receive their desired credit rating, and this could on some of this risk to society instead of bearing it allresult in areas of weakness if the credit rating framework is themselves. A number of proposals to mitigate this moralin any way deficient. hazard have been proposed, but the ones that have received the greatest attention are systemic-based capital surcharges.3.4 Analysts The IMF (2010) has outlined two approaches to computingAnalysts perform a range of activities for external and such surcharges:internal clients. They can be classified into different points > A standardized approach – regulators assess aof focus, such as financial or industry, buy-side or sell-side capital surcharge based on a rating of systemic riskinstitutions, and equity or fixed-income markets. Usually > A risk-budgeting approach – capital surcharges arefinancial analysts study an entire industry, assessing current determined in relation to an institution’s additionaltrends in business practices, products and competition. contribution to systemic risk and its own probabilityThey must keep abreast of new regulations or policies that of distress.may affect the industry, as well as monitoring the economyto determine its effect on earnings. One of the difficulties associated with implementing suchFinancial analysts use spreadsheet and statistical software surcharges is identifying the degree of systemic risk.packages to analyse financial data, spot trends and develop The IMF (2009) outlined four of the most common methodsforecasts. On the basis of their results, they write reports and for assessing systemic risk:make presentations, usually making recommendations to buy > The network approach – using direct links in theor sell a particular investment or security. Financial analysts interbank market to track the progression of a creditin investment banking departments of securities or banking event or liquidity squeeze throughout the banking systemfirms analyse the future prospects of companies that want > The co-risk model – using market data to assess linksto sell shares to the public for the first time. among financial institutions and test the progression of an extreme event through the systemEarly warning systems: can more be done to avert economic and financial crises?
  15. 15. > The distress dependence matrix – examining the probability of distress of pairs of institutions, taking into account a set of other institutions> The default intensity model – using historical data on defaults to measure the probability of failure of a large fraction of financial institutions due to both direct and indirect systemic links.All of these methods rely on the selection of appropriateinstitutions for inclusion in the model. However, it is possiblethat small institutions may carry large systemic risk. Apotential direction for regulators would be to develop a seriesof systemic risk indicators, similar to the concept of FSIs,and require all institutions to report on these indicators.3This is, however, easier said than done − it would bedifficult to monitor reporting of indicators and, like allfinancial reporting, there is a large amount of professionalinterpretation involved. Chapter 4 examines how this may beattempted, by drawing the together both the macroeconomicindicators from the previous chapter and the microeconomicindicators from this chapter.3. Qualitative assessments of systemic impact are made in APRA’s supervisory framework, using the PAIRS/SOARS system, for the institutions that it regulates. 15
  16. 16. 4 Bridging the gapThe macroeconomic and the microeconomic indicators 4.2 Reforming the credit ratings processdiscussed in the previous chapters all provide important Reforming the credit rating process could potentially provideinformation to policy-makers and regulators. However, if more accurate information about the risk of a companythe information gaps could be filled there is not an explicit or debt instrument. If ratings agencies were required tochannel by which these indicators are linked to form a undertake a broader analysis of risk, or report to regulatorsbroader perspective of the state of the economy.4 This changes in the complexity of financial instruments, therechapter discussed potential new links, while the following may be a greater understanding of the stability of financialchapter outlines some practical considerations. markets. Moreover, credit ratings could be commissioned on behalf of companies by a single body, such as the4.1 An expanded role for auditors Australian Securities Exchange (ASX) in Australia, removingIn 3.2 above there was a discussion of the evolution of the the incentive for the credit ratings agency to satisfy theaudit committee function and the potential forward-looking expectations of the issuer of the debt in order to securedisclosures that they could make in the annual report. repeat business.These disclosures could be highly valuable to investors andstakeholders but will require some form of assurance by the 4.3 Collaboration across institutionsauditor. This type of function would expand the auditor’s There may be scope for government agencies and regulatorscurrent role. to share more information or different information. AnThe current role of the auditor is focused on the completed example might be making use of information collected,financial statements provided by the Board of Directors and or that could be collected, by the Australian Tax Office.management. The role of audit is primarily guided through A sign of the financial distress of a company could bethe framework of auditing standards. changes in the timeliness of its GST or payroll tax payment. If this information was aggregated, a change overall couldHowever, auditors are well positioned to provide insights indicate a weakening of the corporate sector; this couldinto disclosures on the longer-term viability of a company. be done on an industry or sector basis to provide moreIn addition to considering whether the specific requirements detailed information.of accounting standards are satisfied, auditors could forexample consider whether certain limited objectives behind There are other agencies besides government with accessthe requirements have been met. This might be achieved to large amounts of information about the corporate sector.by auditors reporting on the audit committee disclosures For example, Genworth, an underwriter of mortgages,on the business model(s) of a company and its risks. may have access to information about credit growth and changing risk profiles. Information collected by searchMuch of corporate Australia is audited by one of ‘the big engines, in particular Google, may become or already befour’ accounting firms – KPMG, Ernst & Young, PwC and a valuable source of information about a variety of issues,Deloitte. These firms have large amounts of information because Google records information about search terms.and data on the state of corporate Australia. In the UK, An example already in use is Google’s ‘flu trends’ (developedthe Financial Services Authority (FSA) and Financial after Ginsberg et al 2009), which has found that certainReporting Council (FRC) (2010) have recommended greater search terms are good indicators of flu activity in a region.collaboration between auditors and regulators, with both Using the frequency of certain search terms, Google is ableparties providing information to each other rather than just to map flu trends around the world virtually in real time (seeauditors having to report to the regulators. In Australia, www.google.org/flutrends). By extension, there may besignificant communication already occurs between auditors information contained in search term databases on consumerand regulators such as Prudential Standard APS 310 however expectations, risk appetite and numerous other questionsthe merits of expanding two-way dialogues between that could be useful for regulators.regulators and auditors could be explored. Although there are many potentially interesting sources of information that may be useful, consideration needs to be given to both collecting and sharing this information. Chapter 5 looks at these and other practical considerations in relation to early warning systems.4. The FSB-IMF (2009) report to the G20 on information gaps that need to be filled recommended better capture of the build up of risk, improving data on international financial links, monitoring the vulnerability of economies and communicating of official statistics.Early warning systems: can more be done to avert economic and financial crises?
  17. 17. 5 Addressing obstacles to an effective EWSMany of the suggestions in Chapter 4 may make sense in 5.2 Timely informationtheory but may be difficult in practice. This chapter considers Designing an EWS requires timely information. This is aaspects of the obstacles lying in the way of developing an big problem with macroeconomic data. Once data iseffective EWS. collected the signals need to be interpreted correctly. Many of the early warning signals discussed in Chapter5.1 Proprietary information and company burden 2 need to be considered in the context of the rest of theA key difficulty with sharing information is that much of it is economy. Predicting financial crises requires considerationproprietary. Even if the information is not proprietary or can of the relationship between the variables, which can bebe aggregated to a level so as to maintain confidentiality, difficult to process without a model – and designing athere is little incentive for private companies to provide this model that works is yet to be achieved.information freely to regulators – after all they have borne In practice, designing an EWS is difficult because statisticalthe cost of collecting and collating it. Regulators would models have proven ineffective, meaning that judgment mustneed to be willing to purchase this information, or to compel be applied when interpreting information. The large amountscompanies to report it. of information available make this quite difficult. There is aAnother consideration when obtaining information from plethora of information at the disposal of decision-makers;private institutions is whether or not they have the capability the problem is that they do not necessarily know what theyto collect and collate information that would be relevant to should be looking for.regulators. If new training is required or collection is a large The qualitative information that auditors have at theirburden on business operations, private institutions will want disposal as a profession might be very useful to regulators.to be compensated. One way of decreasing the burden on However, careful consideration would need to be given tocompanies is through more effective use of technology, how that information can be collated and passed on. Whilesuch as XBRL. a simple statistical measure such as a Lickert scale might be employed, this might also remove much of the useful eXtensible Business Reporting Language information.5 The conundrum of predicting a crisis is that eXtensible Business Reporting Language (XBRL) was it is the information we do not know we need that may be introduced in Australia in July 2010 as part of the the most important for us to receive. Standard Business Reporting (SBR) project. XBRL is Another potential barrier is whether or not individual auditors a language that allows electronic business reporting. will be able to rate the activities of an individual company Its benefits include cost savings and efficiency to against some sort of perception of ‘normal’. A common business because it removes the duplication that occurs in providing specialised financial reports to problem during crises is that expectations adjust, normalising exchanges, regulators and government (Deloitte 2009). what would previously have been perceived as excessively Instead, a single report is produced electronically from risky behaviour. Moreover, an individual auditor only sees which these stakeholders are able to easily draw the a small portion of the picture. Will they be able to assess information that they require. companies against a central measure without a big Although the use of XBRL is still in its infancy, and picture view? has been introduced to reduce the reporting burdens on business, it is expected to rapidly improve the 5.3 The cost of collecting new information timeliness of financial information. As it develops Increasing the reporting requirements of companies would there may be scope to expand the type of information be costly to the company and, therefore, the shareholders. that is provided, at a lower cost than would currently A consideration of whether or not there is support for such be possible. changes would need to be made. Designing a framework for reporting non-financial information would also require careful consideration. While aiming to provide a more expansive picture of the viability of the company, it could easily result in the company being able to put a positive spin on negative financial results or further disguise potential weaknesses by allowing spin to be given greater credibility.5. A Lickert scale is a method of collating ratings scale answers commonly used in surveys. Respondents are asked to specify their level of agreement to a statement on a scale, such as 1 to 5 possibly with verbal interpretations attached to the numbers such as strongly agree for 5 and strongly disagree for 1. Each question can be analysed separately or the responses can be combined. 17
  18. 18. Broad Based Business Reporting (BBBR), sometimesdescribed as integrated reporting, is an enhanced reportingmechanism being implemented by some businesses tobetter meet the needs of their key stakeholders. BBBRdemonstrates how a business effectively manages anduses its limited resources to deliver on its defined strategies.Analysis of this type of reporting gives investors accessto more relevant information, enabling comparisons betweenbusinesses within industries and across industries, aswell as enabling more informed, forward-looking capitalallocation decisions.It is clear, globally, that there will be continuing developmentswith BBBR, and as the model matures it should be seenas an important source of information, particularly forpredictive trends and themes. The International IntegratedReporting Committee (IIRC) was launched in August 2010to create a globally accepted framework for accounting forsustainability, a framework which brings together financial,environmental, social and governance information in a clear,concise, consistent and comparable format.As this integrated framework matures it will contain valuableinformation not previously available that could be used inEWSs. There would, however, need to be some form ofassurance on this integrated information.Organising cross-institutional sharing of information isadministratively costly and time consuming. It may notresult in timely collation of all available information andcoordination of response is not always easy – not everyinstitution will interpret information in the same way.Early warning systems: can more be done to avert economic and financial crises?
  19. 19. 6 ConclusionThe economics literature has struggled to produce aneffective EWS. This is because statistical models capturethe relationship between indicators and the start date ofthe crisis, but are largely unable to identify the factors thatcontributed to vulnerability in the economy.Indicators at the macroeconomic level are plentiful, yetdifficult to integrate in practice. They are also subjectto change, as indicated by the IMF’s proposal for newfinancial soundness indicators to keep up with a changingand increasingly interlinked world economy.Indicators at the individual company level provide importantinformation about the resilience of the corporate and financialsectors to economic shocks, and examination of micro-level information reveals important detail that aggregatedinformation fails to capture. Yet here too there is difficultyin applying information in a timely and reliable way topredict crises.There is, however, considerable scope for discussion ofan effective EWS. Better information could be disclosedby corporates to assist regulators’ understanding of thecorporate sector’s financial position and attitude to risk.Credit rating agencies are also able to assess the systemicexposure of individual companies.Another area worth exploring is the inclusion of prospective(as opposed to retrospective) information in annual reports.Companies would be required to report or disclose anassessment of their business model and potential risks.Auditors could reflect on this assessment as part of anexpanded audit process. Globally this idea has begun toachieve some traction already. Furthermore, corporatesmay be able to contribute to policy-makers’ and regulators’understanding of the corporate sector through the disclosureof key assumptions, judgments and sensitivities underlyingfinancial statements.Of course, just gathering information is no substitute foraction. The political will to act in light of persuasive evidencemust be present. Having regulators with the independenceand courage to call a looming disaster and take evasiveaction is required if a better EWS model is to be found.A strong culture of regulatory independence is an essentialaspect of any effective EWS. 19
  20. 20. References Altman, E 1984, ‘The success of business failure prediction models: an international survey’, Journal of Banking and Finance, (8), 171-198. Barrell, R, Davis, EP, Karim, D and Liadze, I 2010, Bank regulation, property prices and early warning systems for banking crises in OECD countries, NIESR Discussion Paper No 330. Beaver, W 1966, ‘Financial ratios as predictors of failure’, Empirical Research in Accounting: Selected Studies, supplement to Journal of Accounting Research, (4):71-127. Bezemer DJ 2009, ‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models, Munich Personal RePEc Archive Paper No. 15892. Borio, C and Lowe, P2002, Asset prices, financial and monetary stability: exploring the nexus, BIS Working Papers No 114, Monetary and Economic Department, Bank for International Settlements. Borio, C, Furfine, C and Lowe, P 2001, Procyclicality of the financial system and financial stability: issues and policy options, BIS Papers No 1. Blum, M 1974, ‘Failing Company Discriminant Analysis’, Journal of Accounting Research, Spring, pp.1-25. Davis, EP 1998, Financial data needs for macroprudential surveillance – what are the key risks to financial stability?, Handbooks in Central Banking Lecture Series No 2, http://www.bankofengland.co.uk/education/ccbs/ls/pdf/lshb02.pdf, accessed 20 October 2010. Davis, EP and Karim, D 2008, Comparing early warning systems for banking crises, Journal of Financial Stability, 4(2):89:120. Deloitte 2009, eXtensible Business Reporting Language: moving to a global standard for electronic business reporting, http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/us_assurance_XBRL%20Moving%20to%20 a%20Global%20Standard040809.pdf, accessed 11 November 2010. Demirgüç-Kunt, A and Detragiach, E 2005, Cross-country empirical studies of systemic bank distress: a survey, International Monetary Fund Working Paper, WP/05/96. Financial Services Authority & Financial Reporting Council 2010, Enhancing the auditor’s contribution to prudential regulation, Discussion paper 10/3. Ghosh, A, Ostry, J, Tamirisa, N 2009, Anticipating the next crisis: what can early warning systems expect to deliver?, Finance & Development, 46(3): 35-37. Gruen, D, Plumb, M and Stone, A 2003, How should monetary policy respond to asset-price bubbles?, Reserve Bank of Australia, Research Discussion Paper, RDP 2003-11. Hilbers, P, Otker-Robe, I, Pazarbasioglu, C and Johnsen, G 2005, Assessing and managing rapid credit growth and the role of supervisory and prudential policies, International Monetary Fund Working Paper No WP/05/151. IMF 2010, The IMF-FSB early warning exercise: design and methodological toolkit, International Monetary Fund. IMF 2009, Global Financial Stability Report: responding to the financial crisis and measuring systemic risks, International Monetary Fund. IMF 2004, Compilation guide on financial soundness indicators, http://www.imf.org/external/np/sta/fsi/eng/2004/guide/index.htm, accessed 13 September 2010. IMF-FSB 2009, The Financial Crisis and Information Gaps, Report to the G-20 Finance Ministers and Central Bank Governors. International Monetary Fund-Financial Stability Board Kaminsky, G, Lizondo, S and Reinhart, C, 1997, Leading indicators of currency crises, Policy Research Working Paper Series 1852, The World Bank. Kaminsky, G and Reinhart, C 1999, ‘The twin crises: the causes of banking and balance of payments problems’, The American Economic Review, 89(3): 473–500. The Audit Office of NSW 1994, Appendix 1: Guidelines for Auditors & Managers on Fraud Control, http://www.audit.nsw.gov.au/publications/better_practice/1994/fraud_vol2/append.htm, accessed 29 October 2010. Walter, S 2010, Basel II and revisions to the capital requirements directive, Bank for International Settlements, http://www.bis.org/speeches/sp100503.htm, accessed 29 October 2010. Worrell, D 2004, Quantitative assessment of the financial sector: an integrated approach, International Monetary Fund Working Paper WP/04/153.Early warning systems: can more be done to avert economic and financial crises?
  21. 21. Appendix ATable A.1: Variables commonly use in EWS modelsIndicator DescriptionReal economyGDP growth Reflects the ability of the economy to create wealth and large deviations from trend indicate overheating or unsustainable growth (positive deviations) while negative deviations suggest a slow down.Inflation High inflation may signal policy mismanagement, in the form of lax monetary policy or expansionary fiscal policy. It may also indicate asset price inflation, itself an indicator of an asset price bubble, a frequent precursor to a financial crisis.Government’s fiscal A high budget deficit relative to GDP be an indicator of policy mismanagement and risk of governmentposition default. The size of the deficit will impact on the government’s ability to respond to the crisis, or signs of the crisis, potentially exacerbating the impact.CorporateTotal debt to equity Total corporate debt to corporate equity indicates the aggregate leverage of corporations, highlighting the extent to which activities are financed through liabilities rather than own funds (IMF, 2004). Excessively high levels of leverage may signal difficulties in meeting debt obligations.Net foreign exchange Excessive borrowing in foreign currency can increase the risks of corporate default. Large currencyexposure movements — themselves a potential indicator of financial crises — could have a substantial negative impact on the value of debt, assets or the value of a trade.Corporate defaults Insolvencies in the corporate sector can signal future problems in the banking sector, if insufficiently provisioned to accommodate the losses resulting from default on loans.Household sectorPrivate sector debt Rapid growth in private sector debt is an indicator of instability in the economy. Growth in credit stimulates aggregate demand relative to potential, overheating the economy.External sectorReal exchange rate Adverse movements in exchange rates, whether driven by fundaments such as movement in termsand commodity prices of trade or driven by an attack by speculators on a currency can be indicators of an impending financial crisis.Foreign exchange The level of foreign exchange reserves held by a government or central bank can be important forreserves the ability of a country to resist severe external shocks. With a shortfall of reserves policy makers may be unable to defend the currency. Currency and maturity mismatches have also been associated with financial crisis.Current account/ Increased international capital mobility tends to be followed by a domestic banking crisiscapital flow (Reinhart and Rogoff, 2008). A large current account deficit is usually cited as an important indicator of an impending currency crisis because as the current account deficit increases, the economy becomes more vulnerable to a decline in foreign lending.Financial sectorInterest rates Positive correlation between real interest rates and banking crises have been found in numerous studies.Capital adequacy Liquidity risk is measured by bank cash plus reserves as a proportion of total bank assets;and liquidity the lower this ratio the higher the systemic liquidity risk. Continued overleaf > 21
  22. 22. Appendix A (continued) Indicator Description Financial markets Change in share price Sudden collapses in equities prices can lead to a chain of events ending in financial crises in some cases. Households lose wealth and cut back spending leading to lower economic growth and subsequent job losses. Consumer confidence is hurt by falls in share prices. Corporate bond Corporate borrowing rates significantly above market rates can signal the loss of confidence by market spreads participants in the ability of each other to repay loans. Market liquidity Market liquidity was a key determinant of the most recent financial crisis. With companies hoarding cash and unwilling to borrow, the problem can be self-fulfilling. Volatility Periods of substantial volatility can also signal future economic or financial upheaval. Volatility clustering is an empirical regularity in financial markets. It is a proxy measure of uncertainty. Asset price (including Excessive growth in asset prices may indicate a bubble in the asset market. Bubbles have been house price) growth associated with many past financial crises. Source: Access Economics.Table A.2: Indicators of corporate distress Indicator Description Liquidity Working Capital/ A measure of the net liquid assets of the company relative to the total capitalisation. This indicates the Total Assets liquid reserve available to satisfy contingencies and uncertainties. The ratio indicates the short-term solvency of a business and in determining if a company can pay its current liabilities when due. Cash Flow/Total Debt This ratio provides an indication of a company’s ability to cover total debt with its yearly cash flow from operations. Solvency (financial leverage) Market value of This ratio shows how much the company’s assets can decline in value before the liabilities exceed the equity/book value assets and the company becomes insolvent. of debt Total Debt / Provides information about the company’s financial risk by determining how much of the company’s Total Assets assets have been financed by debt. Profitability Earnings before This is a measure of the productivity of the company’s assets, independent of any tax or leverage interest and tax/ factors. The earning power of its assets is the basis of all profit and this ratio is thus a fundamental total assets indicator of credit risk. Rate of return Return on equity measures the rate of return on the ownership interest (shareholders’ equity). to common It shows how well a company uses investment funds to generate earnings growth and thus measures shareholders a company’s efficiency at generating profits from every unit of shareholders’ equity. Retained earnings Retained earnings measures the cumulative profitability of the company over time. It is the total amount of reinvested earnings and/or losses of a company over its entire life. Retained earnings divided by total assets measures the leverage of a company and highlights the use of low risk funds (internally generated funds) versus riskier capital (debt) to grow the business. Total asset turnover Total asset turnover is the ratio of net sales to total assets. It compares the turnover with the assets that the business has used to generate that turnover indicating the company’s efficiency in generating a profit. Net operating margin A measure of the operating income generated by each dollar of sales, therefore indicating the profitability of the company. Source: Access Economics.Early warning systems: can more be done to avert economic and financial crises?
  23. 23. AcronymsAbbreviation/acronym NameAPRA Australian Prudential Regulation AuthorityBBBR Broad Based Business ReportingBCBS Basel Committee on Banking SupervisionCAMELS ratio Capital, Asset Quality, Management, Earnings, Liquidity, and Social Impact of an organization ratioCRUF Corporate Reporting Users’ ForumEWS Early warning systemFSA Financial Services AuthorityFSB Financial Stability BoardFSI Financial Soundness IndicatorGDP Gross domestic productGFC Global Financial CrisisIMF International Monetary FundIIRC International Integrated Reporting CommitteeOECD Organisation for Economic and Co-operation and DevelopmentSBR Standard Business ReportingXBRL eXtensible Business Reporting Language 23
  24. 24. Contact detailsAccess Economics The Institute of Chartered Accountants in AustraliaCanberra National OfficeLevel 1, 9 Sydney Avenue 33 Erskine StreetBarton ACT 2600 Sydney NSW 2000Phone +61 2 6175 2000 GPO Box 9985, Sydney, NSW 2001Fax +61 2 6175 2001 Service 1300 137 322Melbourne Phone +61 2 9290 1344 Fax +61 2 9262 1512Level 27, 150 Lonsdale Street Email service@ charteredaccountants.com.auMelbourne VIC 3000Phone +61 3 9659 8300 charteredaccountants.com.auFax +61 3 9659 8301SydneySuite 1401, Level 1468 Pitt StreetSydney NSW 2000Phone +61 2 9376 2500Fax +61 2 9376 2501www.accesseconomics.com.au Printed on ecoStar – a 100 per cent recycled paper supporting responsible use of forest resources.

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