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

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

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Early warning systems: can more be done to avert economic and financial crises?
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Foreword
This paper is part of a thought leadership series dedicated to helping Australian society and our next
generation 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 is
the third in our series which contributes broad economic thinking and valuable insights on a range of
business 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 have
teamed up with Access Economics to produce this paper.
Early warning systems: can more be done to avert economic and financial crises? broadly sets out the
context for timely warning signals of impending financial crises, and examines how new or unexplored
indicators may help improve our understanding of the stability of the economy. These are considered at
both the macro- and microeconomic levels.
Our aim is to stimulate discussion around how to strengthen our policy settings and regulatory systems
and 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 will
find it both interesting and thought provoking. We will continue to challenge and provoke thinking on
key business issues for the benefit of Australia.

Rachel Grimes FCA
President
The Institute of Chartered Accountants in Australia

3

Contents
Executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Macro- and microeconomic indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Bridging the gap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2 Macroeconomic indicators of a crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.1 Design methods and issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2 Finding the appropriate policy response . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

3 Microeconomic indicators of a crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.1 Financial ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.2 The evolution of the audit committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.3 Credit rating agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.4 Analysts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.5 Systemic risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

4 Bridging the gap. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4.1 An expanded role for auditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4.2 Reforming the credit ratings process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4.3 Collaboration across institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

5 Addressing barriers to an EWS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
5.1 Proprietary information and company burden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
5.2 Timely information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
5.3 The cost of collecting new information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Acronyms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Charts
Chart 1.1: The cost of financial crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Figures
Figure 2.1: Past financial crises: triggers and underlying vulnerabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Figure 2.2: Global financial stability map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Tables
Table A.1: Variables commonly use in EWS models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Table A.2: Indicators of corporate distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

5

Executive summary
Financial crises typically have two components: a trigger Considerable obstacles do exist, however, to the
and an underlying vulnerability. Although the trigger and achievement of an effective EWS – namely, the need to
timing of a crisis are difficult to predict, the underlying protect companies’ proprietary information, the difficulty
vulnerability should be detectable. of providing timely information, and the sheer cost of
This paper sets out the context of financial crises with the collecting information.
aim of stimulating discussion on developing an effective
Conclusion
early warning system (EWS). It looks first at macro- and
microeconomic indicators of a crisis (Chapter 2 and 3). There is no shortage of indicators of a potential economic
It then makes suggestions for bridging the gap between crisis. The problem lies in making the best use of these
these (Chapter 4) and addressing obstacles to achieving indicators, and there are a number of ways in which financial
an 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 to
The 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 essential
commonly associated with crises include low growth in aspect of any effective EWS.
Gross Domestic Product (GDP), rapid growth in private
sector debt, and prolonged periods of low interest rates.
Indicators at the microeconomic (individual company) level
may provide useful information that the macroeconomic
indicators fail to capture. Microeconomic indicators include
financial ratios (liquidity, solvency, profitability), audit
committee information, credit ratings, financial analysis
(e.g. trends, forecasts), and measures of systemic risk
(links between companies). However, better information
could be disclosed by corporates to assist regulators’
understanding of the corporate sector’s financial position
and attitude to risk.

Bridging the gap
Both macro- and microeconomic indicators provide important
information, yet there is no defined channel by which these
can be linked to give a broader perspective of potential
crises. 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.


1 Introduction
Before the Global Financial Crisis (GFC) there were some renewed interest in identifying and remedying weaknesses
clear 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 on
countries, and there were reputable voices warning of Banking Supervision (BCBS) are currently developing reforms
these developments.1 Policy-makers and regulators may not to strengthen the resilience of financial institutions in the
have 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 financial
markets because of uncertainty about the effect their
actions 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 with
the market to its own devices and intervene only when certainty predict the source of the next crisis, we
something has gone wrong. can however lay the groundwork to help mitigate or
The purpose of this paper is to broadly set out the context minimise the impact. (Walter 2010)
of EWS, to identify potentially new or unexplored sources
of information, and to stimulate further discussion on Policy-makers and regulators would not just rely on new
how to improve our policy settings and regulatory systems. regulation to prevent future crises. Regulation is only able to
It 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 sophisticated
Financial crises occur when there is an underlying weakness technologies alter the way in which trade is conducted
in the economy or financial system (IMF 2010). Although and the risks that are faced. The need for different or new
the weakness itself does not start the crisis – a trigger event regulation will not always be identified or implemented in
is required – the extent and spread of the crisis are results time to prevent the emergence of weakness in the financial
of this weakness. The huge cost of the damage caused by system. Re-examining early warning signs of financial
the GFC and past crises (Chart 1.1), even if only measured distress or an impending crisis is thus essential if authorities
in terms of job losses and increased government debt, has are to react early and appropriately. Financial crises are

Chart 1.1: The cost of financial crises
While 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

frequent enough for there to be a rich literature on the Yet the systemic risk of non-financial companies should
predictive power of various economic and financial variables. still be considered. There may also be important signs of
In the wake of the GFC, authorities may be more willing to pressure in the economy to be extracted from the activities
consider reacting to such warning signs. and risk-taking behaviour of companies across industries and
This paper aims to collate information and raise questions sectors in the economy. The audit committee and auditor
to facilitate discussion on what more can be done to make are well positioned to assist in expanding understanding of
improvements to early warning systems. In particular, a company’s financial position and attitude to risk, and this
there is a focus on two areas of literatures on early warning is explored further in Chapter 5. We also briefly explore in
signals of financial stability: the economic and the financial. Chapter 5 the importance of non-financial broad information
In 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 a
provide 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 practical
considerations in implementing any of these ideas.
Early warning signals of a financial crisis are usually searched
for in the real economy. However, this may not provide a
timely indication of vulnerability if it occurs on the financial
side of the economy. Although there exist indicators of
corporate distress for individual companies, regulators
mostly focus on the trends in deposit-taking and financial
institutions to inform their broader view of the economy.


2 Macroeconomic indicators of a crisis
Typically, 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 indicators
indicators of an EWS could reveal a country’s vulnerability have previously focused on banking crises caused by
to a future crisis and forecast the likelihood of a financial financial institutions underestimating their exposure to
crisis. 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 whole
of explanatory variables to a financial crisis measure. EWS to macroeconomic shocks rather than the exposure of
models differ widely according to the definition of a financial individual institutions. Consequently, they do not consider
crisis, 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.2
In general, they have not been found to work well.
These models are sensitive to changes in specification 2.1 Design methods and issues
and definition of variables, and as a result findings vary There are two components of a financial crisis: an underlying
substantially across the literature. The design of an EWS vulnerability and a trigger (IMF 2010). The trigger determines
requires consideration of how indicators combine − a the timing of the crisis and is difficult to predict − it may
variable may not be an indicator of financial crisis risk by be a one-off unexpected event. However, the underlying
itself but would be if observed in conjunction with other vulnerability has often been present in the economy for
factors. Moreover, although empirical models of financial some time and should be predictable. Figure 2.1 shows
crises are able to identify indicators retrospectively, there some examples of past crises and the associated triggers
are doubts about their ability to pre-empt a crisis – this has and vulnerabilities.

Figure 2.1: Past financial crises: triggers and underlying vulnerabilities
Crises 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

The aim of an EWS is to identify indicators that are able has been found to be associated with bank crises when low
to provide both a timely predictor of an impending crisis (Demirgüc-Kunt & Detragiache 2005). Yet the difficulty with
and 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 time
obstacle in this exercise is that the underlying vulnerability the slowdown is occurring it may be too late to identify and
in the economy may be a result of a combination of correct underlying vulnerabilities in the economy before a
factors, 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 robust
economic sentiment. These differences across countries and indicators found in the literature on early warning signs of
time 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 during
There 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, typically
One type of crisis can lead to another, or they can occur
associated with economic booms, banks may use low-cost
simultaneously; for example, currency and banking crises are
deposit financing to invest heavily in particular sectors which
commonly referred to as the ‘twin crisis’ when they occur
appear profitable and where collateral values are high. The
together. Kaminsky and Reinhart (1999) found that problems
banking industry may be exposed to increased interest rate
in the banking sector typically precede a currency crisis but
risk by investing in higher-risk long-term projects without
that 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 banking
lead 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 in
horizon, and data is often not available until months after
the asset market. A bubble occurs when rapid growth in
the period it refers to. This is crucial because policy
the price of a class of asset is followed by a sharp fall. The
responses, particularly once the trigger has occurred, take
fall occurs because the asset price growth was not based
time to design, implement and have an effect. For example,
on ‘fundamentals’ − the intrinsic value of the asset − but
a large unexpected expansionary change in monetary policy
on some other factor.
may have some immediate effect as expectations adjust and
sentiment rises, but it will take months before the full effect
of the policy is realised. Likewise, a fiscal stimulus package There are a number of theories for the cause of
needs 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 an
package must spend the money for the consequential overvalued asset hoping to sell it to someone else
effect. The aim of an EWS would, therefore, be to identify who is also willing to do this
underlying vulnerabilities in the economy and correct them > Herding − it is better to act in the same way as
before a crisis is triggered. your counterparts and eventually lose than appear
to be missing out on gains now
2.1.1 Macroeconomic variables of interest > Extrapolation − price growth should continue as
Variables that are commonly found as predictors in EWS it has done in the past
models are shown in the Appendix (Table A.1). These > Moral hazard − not fully exposed to the risk so
variables are selected for their theoretical appeal. For the expected value of the asset to the buyer is
example, Gross Domestic Product (GDP) growth, which is higher that the true expected value.
used widely as an indicator of the health of the economy,


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

2.2 Finding the appropriate policy response
Empirical tests of EWSs have found that while they are able
to predict financial crises they also lead to a large number of
false predictions. From a policy perspective this is a relevant
issue: policy-makers and regulators need to decide whether
it is worse to fail to respond to vulnerability, or to react to
false signals and try to correct problems that do not exist.
Reacting to false signals is costly. It could be costly to
business in terms of complying with stricter regulation, or
there could be efficiency costs if the operation of markets
is restricted. For example, a policy response that aims
to restrict access to personal credit, because the EWS
incorrectly indicates that credit growth is posing a threat to
stability, would result in fewer people being able to access
credit than is optimal. Formulating a policy response to a
false positive is also costly in terms of the administrative
cost of designing and implementing the policy.
A related question is whether or not monetary policy should
respond to asset price inflation that is potentially a bubble,
for example, in the housing market. Asset price bubbles
are difficult to detect until they have burst. In responding
to bubbles, central banks would need to make a judgment
on whether the growth in asset prices was based on
fundamentals or not. Gruen et al (2003) found that central
bank intervention in a bubble was only optimal if the bubble
was identified in its early stages and if there was less
probability of the bubble bursting of its own accord. Whether
or not monetary policy is able to curb a sustained upward
movement in asset prices driven by excessively low risk
aversion is another question. Borio and Lowe (2002) have
proposed that it can, as long as the central bank is credible
and is able to send a signal to the market that it is concerned
about the state of the economy.
The final question for policy-makers is whether or not
asset price booms and busts are in fact bad for the long-
term growth of the economy. There is a trade-off between
enduring periods of financial instability and exploiting growth
potential, because the reduction of financial constraints
during a boom allows greater investment to occur, potentially
improving growth possibilities in the future.
Having now looked at a number of macroeconomic
indicators, Chapter 3 examines a range of microeconomic
indicators – those at the individual company level.


3 Microeconomic indicators of a crisis
Indicators at the individual company level provide important Moreover, changes in attitudes to risk, and the existence of
information about the resilience of the corporate and financial businesses with an unsustainable business model, increase
sector 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 capture
may provide important details that the aggregated
this business model risk. This type of information is difficult
information fails to capture.
to capture using a single metric. Instead it requires either
Much of the micro-level information concerns what a comprehensive framework for assessment or substantial
auditors examine when undertaking an audit. An auditor’s judgment of the information reported, in which case an
understanding of the market places them in a good position external assessment would be required.
for assessing the risk appetite and risk model of the
companies they audit. Credit ratings agencies are likewise 3.2 The evolution of the audit committee
able to provide an assessment of the systemic exposure of An independent audit committee is a fundamental component
individual 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 in
performance and financial situation. Ratios can typically be
the last 10 years and will continue to evolve. It has moved
calculated from information provided by financial statements.
from having a fairly limited function primarily focused
In their seminal research, Altman (1966), Beaver (1968) and
on completion of audited financial statements to having
Blum (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 about
a company, they provide a basis on which to assess some market expectations, and the ‘better practice’ skills that
of the core requirements for a company to be reasonably audit committee members and auditors gain through
expected to continue as a going concern. Some of these working closely together. It is clear, though, that further
indicators 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 the
The 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 of
shareholders to inform their investment decisions. In terms financial statements – these are typically the topics
of informing a regulator’s broader view of the economy, at of greatest discussion between auditors and audit
most 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 of
However, the behaviour of other types of companies may key forward-looking information and be a valuable source of
still be informative for regulators. If there is change in the input into EWSs. The primary challenge, though, will lie in
number of companies not doing well, particularly in the same aggregating these disclosures at different levels to assist in
sector or industry, it may suggest an impending problem. broader analysis of EWSs.

13

3.3 Credit rating agencies In more recent years, some analysts have become more
Credit 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 Corporate
These ratings are used by investors to evaluate the relative Reporting Users’ Forum (CRUF) has developed guiding
risk 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 scope
structured products, which were ultimately defaulted on, for greater involvement with the analyst community, and
as AAA-rated. whether the substantial levels of information they collect
A problem with the current ratings system is agencies could assist with EWSs.
providing a company with a poor rating or a downgrade
can result in the so-called ‘death spiral’. The downgrade
3.5 Systemic risk
adversely affects the company’s contracts with financial An institution’s systemic risk is the risk it poses to the
institutions, increasing expenses and making it more difficult stability of the financial system as a result of its links with
to obtain finance. This in turn can reduce its credit ratings. other institutions. During the GFC, a number of large
Debt covenants may be breached if creditworthiness companies deemed ‘too big to fail’ were bailed out by
falls 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 the
forced 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 become
This improves transparency, as companies know how the systemically relevant because they have a higher probability
ratings work and are less likely to take legal action against a of being bailed out in the case of financial distress. The
negative credit rating. However, this also allows companies consequence of this is that institutions will take on more
to modify their behaviour to meet the minimum standard risk than is socially optimal because they are able to pass
required to receive their desired credit rating, and this could on some of this risk to society instead of bearing it all
result in areas of weakness if the credit rating framework is themselves. A number of proposals to mitigate this moral
in 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 computing
Analysts perform a range of activities for external and such surcharges:
internal clients. They can be classified into different points > A standardized approach – regulators assess a
of focus, such as financial or industry, buy-side or sell-side capital surcharge based on a rating of systemic risk
institutions, and equity or fixed-income markets. Usually
> A risk-budgeting approach – capital surcharges are
financial analysts study an entire industry, assessing current
determined in relation to an institution’s additional
trends in business practices, products and competition.
contribution to systemic risk and its own probability
They must keep abreast of new regulations or policies that
of distress.
may affect the industry, as well as monitoring the economy
to determine its effect on earnings. One of the difficulties associated with implementing such
Financial 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 methods
forecasts. 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 the
or sell a particular investment or security. Financial analysts interbank market to track the progression of a credit
in investment banking departments of securities or banking event or liquidity squeeze throughout the banking system
firms analyse the future prospects of companies that want > The co-risk model – using market data to assess links
to sell shares to the public for the first time. among financial institutions and test the progression of
an extreme event through the system


> 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 appropriate
institutions for inclusion in the model. However, it is possible
that small institutions may carry large systemic risk. A
potential direction for regulators would be to develop a series
of systemic risk indicators, similar to the concept of FSIs,
and require all institutions to report on these indicators.3
This is, however, easier said than done − it would be
difficult to monitor reporting of indicators and, like all
financial reporting, there is a large amount of professional
interpretation involved. Chapter 4 examines how this may be
attempted, by drawing the together both the macroeconomic
indicators from the previous chapter and the microeconomic
indicators 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

4 Bridging the gap
The macroeconomic and the microeconomic indicators 4.2 Reforming the credit ratings process
discussed in the previous chapters all provide important Reforming the credit rating process could potentially provide
information to policy-makers and regulators. However, if more accurate information about the risk of a company
the information gaps could be filled there is not an explicit or debt instrument. If ratings agencies were required to
channel by which these indicators are linked to form a undertake a broader analysis of risk, or report to regulators
broader perspective of the state of the economy.4 This changes in the complexity of financial instruments, there
chapter discussed potential new links, while the following may be a greater understanding of the stability of financial
chapter outlines some practical considerations. markets. Moreover, credit ratings could be commissioned
on behalf of companies by a single body, such as the
4.1 An expanded role for auditors Australian Securities Exchange (ASX) in Australia, removing
In 3.2 above there was a discussion of the evolution of the the incentive for the credit ratings agency to satisfy the
audit committee function and the potential forward-looking expectations of the issuer of the debt in order to secure
disclosures that they could make in the annual report. repeat business.
These disclosures could be highly valuable to investors and
stakeholders but will require some form of assurance by the 4.3 Collaboration across institutions
auditor. This type of function would expand the auditor’s There may be scope for government agencies and regulators
current role. to share more information or different information. An
The 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 be
the framework of auditing standards. changes in the timeliness of its GST or payroll tax payment.
If this information was aggregated, a change overall could
However, auditors are well positioned to provide insights
indicate a weakening of the corporate sector; this could
into disclosures on the longer-term viability of a company.
be done on an industry or sector basis to provide more
In addition to considering whether the specific requirements
detailed information.
of accounting standards are satisfied, auditors could for
example consider whether certain limited objectives behind There are other agencies besides government with access
the 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 search
Much of corporate Australia is audited by one of ‘the big
engines, in particular Google, may become or already be
four’ 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’ (developed
the Financial Services Authority (FSA) and Financial
after Ginsberg et al 2009), which has found that certain
Reporting 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 able
parties providing information to each other rather than just
to map flu trends around the world virtually in real time (see
auditors having to report to the regulators. In Australia,
www.google.org/flutrends). By extension, there may be
significant communication already occurs between auditors
information contained in search term databases on consumer
and regulators such as Prudential Standard APS 310 however
expectations, risk appetite and numerous other questions
the 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.


5 Addressing obstacles to an effective EWS
Many of the suggestions in Chapter 4 may make sense in 5.2 Timely information
theory but may be difficult in practice. This chapter considers Designing an EWS requires timely information. This is a
aspects of the obstacles lying in the way of developing an big problem with macroeconomic data. Once data is
effective EWS. collected the signals need to be interpreted correctly.
Many of the early warning signals discussed in Chapter
5.1 Proprietary information and company burden 2 need to be considered in the context of the rest of the
A key difficulty with sharing information is that much of it is economy. Predicting financial crises requires consideration
proprietary. Even if the information is not proprietary or can of the relationship between the variables, which can be
be aggregated to a level so as to maintain confidentiality, difficult to process without a model – and designing a
there 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 statistical
the cost of collecting and collating it. Regulators would
models have proven ineffective, meaning that judgment must
need to be willing to purchase this information, or to compel
be applied when interpreting information. The large amounts
companies to report it.
of information available make this quite difficult. There is a
Another 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 they
to 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 their
burden 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 to
companies is through more effective use of technology,
how that information can be collated and passed on. While
such 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

Broad Based Business Reporting (BBBR), sometimes
described as integrated reporting, is an enhanced reporting
mechanism being implemented by some businesses to
better meet the needs of their key stakeholders. BBBR
demonstrates how a business effectively manages and
uses its limited resources to deliver on its defined strategies.
Analysis of this type of reporting gives investors access
to more relevant information, enabling comparisons between
businesses within industries and across industries, as
well as enabling more informed, forward-looking capital
allocation decisions.
It is clear, globally, that there will be continuing developments
with BBBR, and as the model matures it should be seen
as an important source of information, particularly for
predictive trends and themes. The International Integrated
Reporting Committee (IIRC) was launched in August 2010
to create a globally accepted framework for accounting for
sustainability, 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 valuable
information not previously available that could be used in
EWSs. There would, however, need to be some form of
assurance on this integrated information.
Organising cross-institutional sharing of information is
administratively costly and time consuming. It may not
result in timely collation of all available information and
coordination of response is not always easy – not every
institution will interpret information in the same way.


6 Conclusion
The economics literature has struggled to produce an
effective EWS. This is because statistical models capture
the relationship between indicators and the start date of
the crisis, but are largely unable to identify the factors that
contributed to vulnerability in the economy.
Indicators at the macroeconomic level are plentiful, yet
difficult to integrate in practice. They are also subject
to change, as indicated by the IMF’s proposal for new
financial soundness indicators to keep up with a changing
and increasingly interlinked world economy.
Indicators at the individual company level provide important
information about the resilience of the corporate and financial
sectors to economic shocks, and examination of micro-
level information reveals important detail that aggregated
information fails to capture. Yet here too there is difficulty
in applying information in a timely and reliable way to
predict crises.
There is, however, considerable scope for discussion of
an effective EWS. Better information could be disclosed
by corporates to assist regulators’ understanding of the
corporate sector’s financial position and attitude to risk.
Credit rating agencies are also able to assess the systemic
exposure 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 an
assessment of their business model and potential risks.
Auditors could reflect on this assessment as part of an
expanded audit process. Globally this idea has begun to
achieve some traction already. Furthermore, corporates
may be able to contribute to policy-makers’ and regulators’
understanding of the corporate sector through the disclosure
of key assumptions, judgments and sensitivities underlying
financial statements.
Of course, just gathering information is no substitute for
action. The political will to act in light of persuasive evidence
must be present. Having regulators with the independence
and courage to call a looming disaster and take evasive
action is required if a better EWS model is to be found.
A strong culture of regulatory independence is an essential
aspect of any effective EWS.

19

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Appendix A
Table A.1: Variables commonly use in EWS models

Indicator Description

Real economy
GDP 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 government
position 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.

Corporate
Total 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 currency
exposure 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 sector
Private 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 sector
Real exchange rate Adverse movements in exchange rates, whether driven by fundaments such as movement in terms
and 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 for
reserves 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 crisis
capital 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 sector
Interest 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

Appendix A (continued)


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


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.


Acronyms
Abbreviation/
acronym Name

APRA Australian Prudential Regulation Authority

BBBR Broad Based Business Reporting

BCBS Basel Committee on Banking Supervision

CAMELS ratio Capital, Asset Quality, Management, Earnings, Liquidity, and Social Impact of an organization ratio

CRUF Corporate Reporting Users’ Forum

EWS Early warning system

FSA Financial Services Authority

FSB Financial Stability Board

FSI Financial Soundness Indicator

GDP Gross domestic product

GFC Global Financial Crisis

IMF International Monetary Fund

IIRC International Integrated Reporting Committee

OECD Organisation for Economic and Co-operation and Development

SBR Standard Business Reporting

XBRL eXtensible Business Reporting Language

23

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www.accesseconomics.com.au

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