Financial Sector Assessment

FSIs for Non-financial Sectors

Corporate sector indicators tend to focus on indicators of leverage (or gearing), profit­ability, liquidity, and debt-servicing capacity because of those indicators’ demonstrated usefulness in predicting corporate distress or failure.13 Four commonly used measures of corporate sector health are the debt-to-equity ratio, the return on equity, the cash ratio, and the debt service coverage (or interest coverage ratio). Total debt to equity measures leverage or the extent to which activities are financed out of other than own funds. High corporate leverage increases the vulnerability of corporations to shocks and may impair their repayment capacity. Return on equity is commonly used to capture profitability and efficiency in using capital. Over time, it can also provide information on the sustainability of capital positions. Profitability is a critical determinant of corporate strength, affecting the capital growth, the ability to withstand adverse events, and, ultimately, the repay­ment capacity. Sharp declines in corporate sector profitability, for example, as a result of economic deceleration, may serve as a leading indicator of financial difficulties.

The cash ratio is a measure of short-term assets held against short-term liabilities, after deductions for inventories and receivables. The cash ratio measures the capacity to absorb sudden changes in cash flows. Debt service coverage measures the capacity to cover debt service payments (interest and principal) and serves as an indicator of the risk that a firm may not be able to make the required payments on its debts. One commonly used measure of debt service coverage is the earnings before interest, taxes, depreciation, and amortization divided by debt servicing costs (principal plus interest). FSIs on the corporate sector can be compiled by aggregating data from the consolidated financial statements of publicly listed corporations and, thus, are a direct analog of the indicators used by shareholders and market participants to monitor the financial health of individual corporations. For the economy as a whole, domestically consolidated data (e. g., data based on National Income Accounts) can be used when corporate financial statements do not provide sufficient coverage.

Household sector indicators of leverage, liquidity, and debt servicing capacity can be useful in monitoring the health of the sector. Two common measures are used: the ratio of household debt to GDP, and the ratio of household debt burden to income. The house - hold-debt-to-GDP ratio measures the overall level of household indebtedness (commonly related to consumer loans and mortgages) as a share of GDP. High levels of borrowing increase the vulnerability of the household sector to economic and financial market shocks and may impair their repayment capacity. The ratio of household debt burden to income measures the capacity of households to cover their debt payments (interest and principal). It is also a potentially significant predictor of future consumer spending growth: a high debt-to-service ratio sustained over several quarters can affect the rate of growth of personal consumption.14

Monitoring of the real estate sector tends to focus on indicators of significant swings in prices or volumes of lending and construction because this information often signals future problems in credit quality and collateral. Rapid increases in real estate prices— often fueled by expansionary monetary policies or by large capital inflows—that are fol­lowed by a sharp economic downturn can have a detrimental impact on financial sector health and soundness.15 Ideally, a range of indicators should be analyzed to get a sense of real estate market developments (demand, supply, prices, and links to the business cycle) and to assess financial sector exposure to the real estate sector. If one is to determine the exposure of the banking sector to the real estate sector, it is important to have informa­tion on the size of the credit exposure and the riskiness of the exposure. Different types of loans related to real estate may have very different risk characteristics, so it may be useful to distinguish lending according to purpose (e. g., lending for commercial real estate or to construction companies and lending for residential real estate, including mortgages). The level of sophistication of the mortgage market (e. g., mortgage interest rate structure, availability of home equity release products) may also have implications for risk manage­ment and financial stability.