IMF Working Paper No. 13/177
August 09, 2013
Summary: Developments during the global financial crisis have highlighted the importance of differentiating across financial systems and institutions. Assessments of financial stability have increasingly considered the characteristics of individual banks within a financial system, as well as those with significant international reach, to identify vulnerabilities and inform policy decisions. This paper proposes a simple measure of bank soundness, the Bank Health Index (BHI), to facilitate preliminary analyses of individual financial institutions relative to their peers. The evidence suggests that the BHI is useful for a first-pass identification of bank soundness conditions. Automated spreadsheet templates of the bank Health Assessment Tool (HEAT!) are provided for users with access to the BankScope, Bloomberg and/or SNL database(s).
The impact of the global financial crisis on individual banking systems and banks has highlighted the importance of differentiating across countries and among financial institutions. Traditionally, macroprudential surveillance of the financial sector has complemented the microprudential oversight of individual financial institutions by supervisors (The World Bank/IMF, 2005). However, the growing systemic importance of these institutions, notably banks, and their potential impact on policy and the public purse have underscored the need to extend any macroprudential analysis to include individual systemic institutions as well.
The depth and protracted nature of the current crisis have revealed vast divergences in the resilience of individual banks. This is, in large part, attributable to banks’ business models and management quality, sometimes mitigated by the various pre-emptive or supportive policy actions taken by country authorities. In many cases, specific knowledge of characteristics underpinning individual banks’ financial health has been crucial for identifying vulnerabilities and informing policy decisions for crisis prevention or management purposes. Looking ahead, lessons learned from this crisis suggest that more granular, bank-specific analysis will become increasingly more important in that it could:
- enable early identification of vulnerabilities in global systemically important banks (G-SIBs) and domestic systemically important banks (D-SIBs), which could help prevent widespread spillovers from any realization of tail risks if appropriate mitigation actions are put in place;
- inform system-wide reform strategies by differentiating the core, healthy banks from the very weak ones that require significant restructuring or even resolution, so that the strong banks are not burdened with a “one size fits all” solution for an entire system; and
- inform restructuring decisions, such as mergers and acquisitions, recapitalization and/or liquidity support, by highlighting banks’ weaknesses or identifying the weak banks.
To this end, this paper proposes a simple, broadly-based measure of bank soundness that would allow preliminary, first-pass analysis of the health of individual financial institutions and, consequently, financial systems. We develop a Bank Health Index (BHI) and provide automated spreadsheet templates, the bank Health Assessment Tool (HEAT!), to facilitate the exercise. We show that the BHI, albeit simple, can be useful for initial identification of relative bank soundness and is also able to identify more specific areas of vulnerability. However, we also note its limitations and acknowledge that such analyses would need to be complemented by more rigorous and robust quantitative (e.g., stress tests) and qualitative (e.g., supervisory and regulatory frameworks) assessments.
The global financial crisis has underscored the importance of individual banks to the stability of their own or even the global financial system. Thus, analyses of the health of individual banks, especially the systemic ones, are becoming a matter of course for surveillance purposes and for crisis management decisions. We have developed the BHI to enable simple, preliminary analyses of individual banks in financial systems around the world and introduced an Excel-based spreadsheet tool (HEAT!) to facilitate its calculation and presentation. Our back-test, based on actual developments in the Spanish banking system, suggests that the BHI is able to accurately differentiate banks according to their financial soundness.
That said, there are strong caveats attached to the use of the BHI and its components. Any representation about the health of individual banks using this method should be made with care. Specifically, the Index is an aggregation of ratios, so the performance of the individual components should also be considered in any analysis. Moreover, the associated z-scores do not provide an absolute assessment of the health of banks, but rather, their relative health within a sample, which means that the selection of the sample itself matters. The differences in banks’ business models at any point in time and their changing nature over time, as well as the definitions used in calculating the constituent components of the BHI should also be taken into account when interpreting the results. Last but not least, it is also important for the user to be familiar with the peculiarities of any banking system being analyzed and to ensure that any assessment is supplemented with other quantitative and qualitative information.