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Research Journal of Finance and Accounting www.iiste.org
ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)
Vol.6, No.16, 2015
Prudential Bank Solvency Framework and Specific Solvency
Stress Test for Transition in Uzbekistan
Sevara Abdullayeva
Tashkent Finance Institute
60 A, Amir Temur Street, 100000, Tashkent, Uzbekistan
E-mail: finansistsevara@mail.ru
Abstract
This paper studies the applicability of globally recognized solvency measures for banking system solvency
framework of developing and transition economy of Uzbekistan through theoretical concepts and pure practical
evidences from several countries. Besides, it clearly indicates the differences and inherent aspects of banking
systems of transition economies that should be on account in solvency stress tests. Theoretical recommendations
in this article can be used in bank solvency frameworks or setting minimum requirements in other transition
economies with similar banking system characteristics.
1. Introduction
Implications of global financial crisis demonstrate the importance of having an effective and appropriate
financial system regulations and safety nets (BIS, 2012). The design of appropriate regulatory strategy to foster
financial system stability and development has become a key area of focus in all countries to withstand the
implications of the crisis which still have negative effects e.g. tensions and pressures in economy originated from
banking and financial market disorders. Responses of economies to the impact of the crisis on banking system
stability were derived from main weaknesses of financial sector and lessons from economywide downturn. For
example, the United States enacted Comprehensive Dodd-Frank Act stress testing and Capital Analysis and
Review (CCAR) to ensure the solvency by holding the capital of large banks above minimum requirements.
Euro area banks are required to have more transparent balance sheets and better quality of assets as outlined in
Comprehensive Assessment Exercise for one year period. Indonesia, the Netherlands, Sweden, Switzerland and
the United Kingdom imposed lower debt-to-income ratio for banks. Russia and Turkey raised the risk weights
and provisioning rates for consumer loans in order to strengthen loss-absorbing buffers. China raised bank
provisioning requirements and risk weights and tightened regulation of non-standard credit products, and
restricted off-balance-sheet funding (IMF, 2014).
However, main focus of this paper is directed for issues of creating an appropriate bank solvency
framework for transition economies which are vulnerable to any macroeconomic shocks and systemic
imbalances. Ongoing economic reforms and formation of market based economic relations among population,
relentless efforts for stability and growth consolidate the importance of banking system soundness in resilient
transition. These aspects are common for nearly all post-Soviet countries that have strictly relied on national
banking system stability policies targeted to cope with bank failures. In recent years the need to ensure bank
solvency has dominated banking sector reforms in these economies. Banks’ financial strength deteriorated after
the global financial crisis and many post-Soviet economies entered a bank solvency panics. Unsound profile of
financial intermediaries revealed the growing need to keep bank solvency and profitability in condition of
transition and systemic weaknesses. Bank solvency measures involved the recognition of profit losses, the
disposal of impaired assets, and the build-up of robust capital buffers which led to significant fall in banks’
activeness in economic growth (Kan, 2011). However, some banking system stability policies have been
strengthened through special frameworks to support failing banks based on international best practices. For
instance, being a transition economy, Uzbekistan’s banking system has been took measures for keeping the
sound solvency positions of commercial banks. Although those measures cushioned the crisis waves, concern of
the policymakers from unexpected implications caused further actions. Studies accomplished in this article are
built around banking system profile and indicators of Uzbekistan to analyse the responsiveness of banking
system of transition economies which facilitates proposing recommendations common for all post-Soviet
economies.
2. Literature review
Solvency of banking system has in the centre of debates among policymakers and academia for several decades.
They have offered different solvency procedures, mechanisms, facilities, theoretical models and even strategies.
Banking systems of most economies, both advanced and developing, have structural weaknesses in terms of
stability and flexibility. Solvency and liquidity provision is the hottest point of banking system in economic
crisis. Because as Diamond and Dybvig (1983) stressed, the primary function of banks is to ensure solvency by
offering funding that is more liquid than their asset holdings. From this statement, a bank is found insolvent if
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, Research Journal of Finance and Accounting www.iiste.org
ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)
Vol.6, No.16, 2015
the value of its assets falls below the value of its debt and loses the ability to meet minimum regulatory capital
requirements – solvency frameworks. This solvency mismatch makes commercial banks vulnerable to asset
shocks. The reason for studying the solvency framework of banks in transition economies is based on the
literature explaining bank failures based on the strength of the bank’s fundamentals. As Gorton (1988) proves
that bank failure is systematic responses to the perceived risk of banks. Diamond and Rajan (2005) found that
insolvent banks deteriorates liquidity and profitability stance in the entire banking system. In condition of
transition economy, banks responses to solvency risk are not so sufficiently strong that they cannot mitigate the
probability of losses or crisis. Therefore, in line with developing and emerging counterparts, transition
economies (they may be emerging or developing) need more prudent and flexible bank solvency regimes and
policies. As IMF and World Bank joint research group found developing economies must strengthen the legal,
regulatory, and supervisory frameworks of banks for keeping solvent banking system (2009).
Responsiveness of banking system to insolvency shocks is often evaluated through stress test with
different scenarios. Solvency stress testing models are large in number but different in fitting with the profile of
banking systems. They devise a variety of approaches to examine the ability of banks to respond financial
shocks. Mostly used and widespread stress testing model is forward looking model offered by European Central
Bank which considers all conditions that banks may face. Other models assume only limited types of financial
conditions and provide conclusions in a limited scope. For instance, balance–sheet approach assumes that
balance sheet of poorly operating banks indicates the probability of insolvency and even bank crisis (Sahajwala
and Van den Berg, 2000; Jagtiani, 2003). One cannot reject that balance sheet of banks clearly shows the
financial stance of banks, but it can be said that it is a common fact and all solvency models rely on bank
balance-sheet data. Market indicators approach assumes that equity and debt structure of banks can provide data
on banks’ financial condition along with bank-balance sheet (Bongini, Laeven, and Majnoni, 2002; Gropp,
Vesala, and Vulpes, 2002). Because market based early-warning systems contain the data on future prices of
underlaying bank assets and can signal the probability of default.
3. Case for bank solvency framework
Bank solvency frameworks and insolvency regimes are not new term in international banking. As systemic
banking failures occur, requirements for early warning systems – preliminary sets of signalling parameters for
banking system performance are introduced in international experience. Benchmarking and standardization of
bank performance in the scope of an entire banking system work as solvency requirements. In 1988 Basel
Committee for Banking Supervision enacted Basel Accord for bank performance which was the first milestone
for international banking system regulatory and supervisory framework. Then, countries began launching a
country-specific set of requirements for soundness of bank profiles based on the indicators of the Basel Accord
in 1991. The last boom, after global financial crisis of 2008, most countries launched macroprudential policies
for exiting and recovering the broken financial system from the waves and long term implications of the crisis.
Macroprudential policies have been working on mainly rescuing the banking systems as a set of counter-crisis,
post-crisis recovery and stabilization measures in most suffered economies from the crisis. In this period,
vulnerable banking systems lost value of bank assets because of improper solvency frameworks and early-
warning systems or lack of flexibility to modifications. As a result, system-wide failures in financial sector led to
the loss of power not only in many systemic important banks and too big to fail banks of advanced economies
but also in second-tier commercial banks of developing and transition economies. Because risk measurement and
management is comparatively difficult in banking systems of transition economies due to regular legislations and
reforms which raises the exposure to external shock and their hidden effects.
Most developing and transition economies are manipulating solvency frameworks in limited scope
focusing on measurement and management of internal risks only. They often rely on minimum requirements of
leverage ratio, despite the ratio of regulatory capital to risk weighted assets. Although leverage ratio ensures
simplicity and transparency, it cannot ensure the power of the banking systems how to capture insolvency.
Moreover, in case of uncertainties in risk measurement, risk-sensitive parameters and shifting the minimum
requirements risk assessment may improve solvency risk capture.
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