Indicators of Financial System Soundness - Essay Example

? BUSINESS FINANCIAL SYSTEM ANALYST and Business Financial System Analyst Introduction In the assessment of the module scene setting, one of the major elements when carrying out the assessment is the building of the financial system analysis model. The business analysts who are majorly responsible for the assessment develop this model that will be used to establish the principles that govern the analysis of investment opportunities that happen within the choice security and the investment instrument. The aim of this essay is to outline the business model that the business analyst develops in an effort to determine the projects potential success or failure or whether the risk free rate should be used as the alternative of the financial model. The investment sector chosen is the financial sector. Choice of Investment Financial sector can be defined as the stock category that contains the firms whose main job is the provision of services relating to finance to the commercial, as well as the retail customers. The sector comprises of entities ranging from banks, insurance companies, and investment funds to the real estate. As a business analyst, the choice to invest the 100 million United States dollars in the real estate and the investment funds was inevitable (Kolb, 2010). When making an investment choice, a number of items are considered to ensure that the investment will be profitable. The investor has to analyze the extent of risk that he or she can handle. For instance in choosing to buy bonds or shares, the risk is high since the funds are not insured. The investor has to choose the best investment mix or portfolio. Considering an investment mix is beneficial especially when the investor is protecting or guarding against unanticipated losses. The assets allocation should be carried out in a way that the risk is spread and high to ensure higher returns. The investor has to consider diversifying the investments to ensure that the risk of losses is not extreme. For instance, it is advised that the investor should not make hug investments in one sector of the economy. Otherwise should the sector fail, all his or her investment s would be submerged. With this knowledge, the investor decided to make the following decision. Money's 60 % was invested in the building of a prominent rental building in the outskirts of Chicago while the remaining 40 million dollars were invested in purchases of bonds of the Microsoft and the Unilever companies (Lockie, 2013). Having chosen the investment portfolio, it is significant to note that financial stability is therefore, crucial when it comes to sustaining economic growth. Economic growth in this case refers to the growth of the investment. In an effort to detect the vulnerability that exists in the financial system, macroprudential analysis model is recommended to be the best in analyzing the situation of a financial system. The analysis involves the identification of the financial soundness indicators and some of the methods that are used in their analysis (Robert, 2006). Macroprudential Analysis This is defined as the analysis of the economy that seeks to evaluate and examine the soundness of the financial system while taking into consideration the vulnerability and of a given financial system. The analysis involves the use of quantitative information mostly involving FSIs. The use of other indicators of the economy that give a broader picture in matters of financial and the economy is also recommended. Using this model I shall establish and investigate the linkages that exist between the real economic sector and the financial system (Mesonnier, 2012). The model will also assist in the scenario analysis and also in the testing of the stresses that may occur in this business investment field. Through the model, I will be able to note the system's sensitivity to the various economic shocks together with the resilience to the shocks. In a broader perspective, macroprudential analysis in this sector will help in the analysis of qualitative information which relate to the financial system structure, its institutional and also regulatory framework so as to get additional sense to make the financial system architecture strong (Philip, 2002). In this work, qualitative analysis will be done using the assessment that involves the standards of the international sector of finance and also the codes together with the assessment program of the financial sector. In summary, macroprudential analysis is a component of five elements. The five elements include the data that are based on the market. This data could include the bonds, the stocks or shares or the prices of real estates. The other component is the financial soundness indicators. One of the common indicators used is the CAMEL which represents adequacy of capital, quality of asset, soundness of the management, the earnings, the liquidity and finally the sensitivity of the firm to the market risk (Evans, 2000). The other component of the macroprudential analysis is the macroeconomic data that relate to the rates of growth of the economy and the exchange and interests rates. The other component is the qualitative information. This is what will be relied upon in this case. It includes the compliance of the firm with the standards set by the financial sector. The last component of this analysis is the structural information that relates to the structure of ownership as well as the size of the firm (Evans, 2000). Macroprudential Indicators Identification Using this model I will use three approaches to identify the financial system indicators. The first approach that I will use is the international best practice approach as suggested by the international institutions which include IMF, BIS and the Central banks. Some of the financial soundness indicators that this approach advocates are the financial indicators that define the five components of camel. The capital adequacy ratios include the capital ratios and the frequency distribution of those ratios. The asset quality ratios include the leverage ratios, the risk profile of the assets and the investment, the lending rate of the institution. The management soundness component comprises of the expenses ratios and earnings per the employees. The earnings and the profitability ratios include the return on the real estate, the return on the investment, the expense versus the income ratios and the profitability indicators (Mesonnier, 2012). According to Sundararajan (2002) the liquidity component comprises of the rates of the bonds across the various institutions or firms, the maturity structure of the bond, the market liquidity and the central bank policies in relation to the credit disbursement. Other market based indicators are the credit ratings, the excess yields indicators on investments and the yield spread. In the second approach, everything is based on the economic theories of the financial instability. Emphasis here is put on the sourcing of the requirements of data for the macroprudential analysis from the theories that outline and define the financial instability. Amongst these theories are the monetary approach theory and the theory based on the uncertainty concept and also the ones that are based on the agency costs and the asymmetrical information (Sundararajan 2002). The 3rd approach concentrated on the relationship between all other economy's and financial sector. The relationship can be aided through the inclusion of a diagram that depicts a circular flow of both the income and expenditure. When using the three approaches mentioned above, the indicators chosen for carrying out the analysis should be empirically valid and relevant. This signifies that they have to be proven either currently or in the past that they are suitable for analysis of the financial soundness (Mesonnier, 2012). Methods of Assessment Currently, individuals apply many techniques that are used by the central banks to assess the extent of exposure of the financial systems to the different types of market risks and shocks. The macroprudential analysis identifies the stress testing and the scenario analysis as the key determinants of the sensitivity of the financial system to the shocks relating to the economy. Stress testing has to do with the techniques that are employed by a firm to measure the degree of potential vulnerability of the firm in relation to the occurrence of the possible events (Quagliariello, 2009). When undertaking the stress testing, a number of issues are considered. This includes the type of risks that will be faced the range of factors that will be considered and the type of the macroeconomic shock anticipated, the assets that are likely to be included and the decision on whether to use historical data or one based on the hypothesis. The stress tests measure the exposure of the investment to a given stress scenario. For instance, the real estate market faces risks that will be different from the bonds market but related in a way (Quagliariello, 2009). The other method involves identification of a number of sources that generate a certain indicator. After identification, the indicator is monitored to in an effort to investigate whether there are many patterns of indicators that suggest imbalances in the financial systems that definitely leads to the instability. There is a benchmark or a standard that is usually set to measure the extents of the indicators. The interpretation is made on the basis of breach of this indicator relative to the benchmark set. Any breach made by the indicator on the benchmark translates to the warning signal of the firm’s potential vulnerability to the risk. Some of the risks that are involved in this sector are the credit risks, the market risk that is denoted as the risk free rate, the inflation rate risk, the exchange rate risk and the bond rate and the price of the real estate. The commodity price risk is a major factor in this analysis. These risks will both affect the real state as well as the investment on the bond (Nicolo, et al, 2012). Data The data to be used will be risk free rate of the United States as determined by the treasury bonds rate, the current inflation rate of the country, the current spot exchange rate and the bond rates. This data will be retrieved from the websites namely FT.com and Bloomberg.com. The idea is to use the financial model to evaluate the appropriateness of the investment. This will determine the success or failure of the investment and the alternative of it if the expectations are not met. The data will also be inclusive of the financial indicators selected. These are the capital adequacy, the liquidity, the earnings and profitability and the asset prices (Lim 2011). Analysis The indicators selected will be analyzed using the various formula put in place. This will apply to the ratios and the market risk analysis. The five CAMEL indicators will be analyzed to according to the projected returns from the investment. A scenario analysis will be carried out to determine the effects some of the macroeconomic events on the indicators. Some of those events include the prime lending rate that could affect the bond rate, the GDP of the country and the gross fixed capital formation that relates to the residential constructions. These factors are also considered in the preparation of the worst cases scenarios in the results obtained after stress testing (Lim 2011). The integration of the risks that may affect the success or failure of the investment will be done through the application of the statistical packages. This will involve analyzing the financial data and the financial trends of the historical data. Some of things to considered aiding in the analyzing of the financial stability theories are the debt accumulation, the conditions of entry of the firm to the financial markets and the risk concentration as well as the capital adequacy. Forecast will then be made using this analysis to facilitate making a prominent decision regarding the investing of the 100 million dollars in the real estate, as well as the bonds market (Lim 2011). Conclusion This paper has generally covered part of the assessment of the module scene setting. The paper has achieved this through developing a model that will be used in the analysis of the financial model. The model has been identified as the macroprudential analysis model. The paper has identified that the 100 million dollars previously allocated for investment have been invested in the financial industry sector. The components of the investments are the bonds from the Unilever and Microsoft companies and the real estate. The paper has identified use of the economic theories, use of the international best practices and the interactions of the economy's sectors as the methods used to identify the macroprudential indicators. The paper has also identified the methods to be used in analyzing the indicators. These are the stress testing and he scenario testing techniques. The paper has identified the various risks that are likely to impact the success ro the failure of the investments. Bibliography Evans, O., 2000. Macroprudential Indicators of Financial System Soundness. Washington USA: IMF graphics section. Kolb, R., 2010. Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. New Jersey: John Wiley and sons Inc. Lim C., N., 2011.Macroprudential Policy: What Instruments and How to Use Them? Washington USA: IMF graphics section. Lockie, J., 2013. What investors should consider when choosing an investment fund Retrieved on April 2013 http://www.theaic.co.uk/aic/news/press-releases/what-investors-should-consider-when-choosing-an-investment-fund Mesonnier, J, S., 2012. Macroprudential analysis of financial institutions. Retrieved from http://jsmeson.pagesperso-orange.fr/pageensae.html Nicolo, G., D., Giovanni, F. and Ratnovski, L., 2012. Externalities and Macro-Prudential Policy. Washington USA: IMF Graphics Section. Philip D., E., 2002. Macroprudential Analysis and Financial Soundness Indicators. Retrieved on April 2013 https://docs.google.com/viewer?a=v&q=cache:MuLB9hVV1nIJ:www.ephilipdavis.com/IMF1-2002.pdf+&hl=en&pid=bl&srcid=ADGEESijCpdheLHFtYHsaxtwOCTwz8JwQb_7Oxh_2Pw_s63IQM9Fd8claLx_b4HPB5xpara2YaZuu0UzhrOxEk4eOffdfB_IMpEZHhl1HjwaveCa-2vYWvFUPc-JL1t3l_LpdmrOhh_R&sig=AHIEtbSvAsUOrx7yUdVGjOMeNAcrRNKEhw Quagliariello, M., 2009. Stress-testing the Banking System: Methodologies and Applications. United Kingdom: Cambridge University Press. Robert, S., U., 2006. Financial Institutions and Services. New York: Nova Science Publishers Inc. Sundararajan, V., 2002. Financial Soundness Indicators: Analytical Aspects and Country Practices. Washington USA: IMF graphics section. Read More