Attachment 1

Recommendation for Design of an Early Warning System Model

For Commercial Banks with Head Offices in Shanghai, PRC
Presented below for the consideration of the staffs of the People’s Bank of China (PBC)
and the Asian Development Bank (ADB) is an outline for the design of an early warning
system (EWS). This EWS could be developed for use by the Shanghai branch of the
PBC as one tool for identifying potential liquidity problems at the eleven commercial
banks whose head office reports to the Shanghai branch of PBC. The proposed EWS
can be set up to identify banks showing probable signs that their financial condition may
deteriorate over a period of three, six, or twelve months into the future, thus establishing
the potential for them to suffer serious liquidity problems.

It is important to emphasize that the EWS is a complement to, and not a substitute for,
on-site examinations. An EWS is dependent upon timely and accurate financial data,
and on-site examinations are necessary to ensure that the financial statements filed by
a bank accurately reflect the bank’s true condition. With timely and accurate financial
data, bank supervisors can use an EWS to monitor the financial condition of a bank
during the period between on-site examinations. Given limited supervisory resources,
individual banks can only be examined infrequently.

At the heart of the proposed EWS is a statistical model that uses advanced econometric
techniques to forecast a bank’s future financial condition based upon the financial
information it provides to the PBOC. The model is used to estimate the historical
relationship between bank solvency and a large set of financial ratios. Once this
relationship has been estimated, it is used with current financial data to derive a
forecast of future solvency for each bank. Currently, such forecasting models are used
by central banks in only three countries: the U.S., France, and the Philippines.

The focus of the proposed EWS is on the consolidated bank rather than the regional
branch. There are a number of reasons for this focus. First, senior management at the
bank level typically makes strategic decisions regarding a bank's investment policy,
funding policy, and capital structure. Second, a bank branch cannot become insolvent
unless the consolidated bank is insolvent. Otherwise, the consolidated bank is
responsible for transferring funds from other branches to a branch without sufficient
funds to meet its obligations. An advantageous feature of the system is that it could be
easily adapted by the PBC to provide forecasts for banks whose head offices report to
other branches of PBC, if and when the PBC chooses to do so.

In the sections below, the design of the proposed EWS is outlined. Section A describes
the methodology that would be used to generate an early warning forecast. Section B
outlines the procedures for generating the early warning forecast. Section C provides
one method for assessing the accuracy of the early warning forecast. Section D
concludes with an explanation of how the early warning forecast might feed into the off-
site and on-site supervision process.

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A. Methodology

There are three major decisions that must be made when specifying a forecasting
model. The first is specification of the variable we wish to forecast; the second is
specification of the explanatory variables that we will use to predict the variable we wish
to forecast; and the third is specification of the length of the forecast horizon, i.e., how
far into future we wish to forecast.

The first decision that must be made in the design of an EWS is the choice of a
summary measure of financial condition that is to be forecasted. Typically, regulators in
most countries have relied upon some variation of the capital-to-asset ratio as the single
most important measure of a commercial bank’s financial health. Capital, of course,
provides the “cushion” for absorbing losses that flow from bad assets. The measure to
be used in the proposed EWS would not deviate from this basic approach. However,
the proposed system would use a variation of the capital-to-assets ratio that takes into
account differing levels of booked, loan-loss reserves and differing levels of non-
performing assets that banks may have. The logic is: a bank with a relatively high level
of booked reserves has a greater “cushion” against losses while a bank with a higher
level of bad assets has a smaller “cushion” against losses than other banks similarly
situated with respect to all other key variables. We would adjust for differing levels of
these variables at each bank adding loan-loss reserves and subtracting non-performing
assets from the numerator of its capital-to-asset ratio. We call this ratio the Non-
performing Asset (NPA) Coverage Ratio, which is more formally defined as:

(Capital + Loan-Loss Reserves - Non-performing Assets) / Total Assets,

where non-performing assets is a flexible metric that can be defined as the sum of
whatever variables that measure non-performing assets and are available from
regulatory reports.1 Intuitively, this ratio measures the capital ratio of a bank under the
assumption that its non-performing assets are written down to zero. (In practice, the
loss rate on non-performing assets can be varied from zero to 100 percent in order to
stress test a bank’s capital adequacy. The 100% loss rate is a worst-case scenario.

Of course, the NPA coverage ratio is not the only indicator of a bank’s financial
condition that might be used in an EWS. But, in our experience this ratio has proven to
be by far the most efficient such indicator, one that reflects the impact of a number of
factors that can affect the condition of a bank. Moreover, it should be noted that the
purpose of the EWS is to single out banks that have higher than normal probabilities of
encountering serious problems. Once the EWS has identified these high-risk banks,
supervisory analysts should conduct a far more comprehensive analysis of the financial
statements of each of these banks. The proposed surveillance software for domestic
banks, which is to be adapted from the foreign-bank surveillance software, will provide a

1
Researchers at the International Monetary Fund also have proposed the NPA coverage ratio as a means of ranking
banks by financial condition. The World Bank has funded an EWS in the Philippines that uses the NPA coverage
ratio as its primary measure of financial condition.

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valuable complement to the proposed EWS.

The NPA coverage ratio observed during period (t) would be modeled as a function of a
vector of explanatory variables observed during period (t - 1). The parameter estimates
from this model can then be used in combination with the values of the explanatory
variables observed during period (t) to produce a forecast of the NPA coverage ratio
that would be observed during period (t + 1). Effectively, this produces a one-period-
ahead forecast of the NPA coverage ratio. The analyst using the model can specify this
period to be three months, six months, twelve months, or even longer and, through a
series of separate estimations, derive forecasts for each of these future periods. It
should be noted that forecasting accuracy deteriorates as the length of the forecast
period increases.

Because there are to be very few (11) commercial banks for which data will be available
at the outset of the use of the model, it would be difficult to obtain accurate cross-
sectional estimates of an early warning score for commercial banks. To improve the
accuracy of the early warning model, one can take advantage of the fact that there are
multiple time-series observations for each bank. This approach is commonly referred to
in econometrics as a “pooled, cross-sectional and time series” analysis, in that both
cross-sectional (different banks) and time-series (different points in time for each bank)
observations are utilized. In addition to improved accuracy, this approach also enables
us to incorporate macroeconomic variables into the model. In a simple cross-sectional
model, the values of macroeconomic variables would be constant across all
observations and therefore collinear with the model’s intercept term, so that the model
could not be estimated.

More formally, the EWS model can be written as:

NPACR i, t = ?
0+?
1 * X1 i, t - 1 + . . . + ?
K * XK i, t - 1 + ?i, t

where:

NPACR i, t is the Non-performing Asset Coverage Ratio observed at bank (i) during
period (t);

X1 i, t - 1, . . . , XK i, t - 1 are the K explanatory variables observed at bank (i) during

period (t-1);

?
0, . . . , ?
k are the K coefficient estimates for the K explanatory variables; and

?i, t is a randomly distributed error term.

The second major decision is specification of the explanatory variables. The

explanatory variables to be considered for inclusion in the model should be chosen
based upon past experience in developing early warning models for other countries,
including the U.S. These variables would include numerous measures of capital, asset

3
quality, earnings, liquidity, and market risk. A backwards-selection method can be used
to trim this list down to include only those variables that are statistically significant in
explaining variation in the dependent variable.

All RMB-denominated variables should be divided by total assets. This ensures that the
model will be valid for banks of all sizes, and heteroskedasticity will not be a problem.
We also should include (the natural logarithm of) total assets as a measure of bank size
to control for systematic differences in the NPACRs of large and small banks.

As is often the case with time-series variables, the single best predictor of the NPACR
observed during period (t) is likely to be the NPACR observed during period (t-1).
Consequently, we should include NPACR t - 1 as an explanatory variable in the EWS
model.

With regard to macroeconomic variables, we should test the RMB-dollar exchange rate,
the overnight inter-bank borrowing rate, the Treasury Bill Rate, the CPI rate of inflation,
the return on the stock index, and whatever other macro variables the PBC might
suggest. Because many of these variables are highly correlated, using several of these
variables at once is likely to result in multicollinearity and render all of them statistically
insignificant. We can try to include them one-by-one, to determine whether or not this is
a problem. (Technically, multicollinearity does not affect the forecast, but affects
analysts’ ability to determine what variables are driving the forecast.)

To obtain our one-period-ahead forecasts of NPACR, we simply multiply the coefficient

estimates (?0, . . . , ?
k) by the values of the explanatory variables (X1 i, t , . . . , XK i, t)
observed during period (t) instead of those observed during period (t - 1) and sum up
the resulting products:

Forecast of NPACR i, t + 1 = ?
0+?
1 * X1 i, t + . . . + ?
K * XK i, t

The third and final decision that must be made is specification of a forecasting horizon.
This decision is best made by testing the forecasting model’s accuracy using differing
lead times. Availability of historical data may limit the forecasting horizon if there is not
a sufficiently long time-series of data to test longer lead times. International experience
indicates that accuracy falls off rapidly when the forecasting horizon exceeds two years.
According to PBOC Statistics Department staff, computerized records are available as
early as 1996, so there should be sufficient data available to test forecasting horizons
from three months to one year.

B. Forecasting Procedures

The procedures for producing this forecast are as follows:

1. Create EWS database

a. Manually collect and enter consolidated balance sheet and income statement

4
 data from hard-copy records of the Department of Supervision at the Shanghai
Branch of PBC into an Excel spreadsheet.

Mr. Zhang Hai says that the Shanghai Branch of PBC has records going
back to first quarter 1999, for a total of eight quarters of data for each of
the 11 banks with head offices under jurisdiction of PBC Shanghai.
Therefore, there are 88 observations for which data should be collected
(11 banks times 8 quarters).

b. Manually collect and enter macroeconomic data from hard-copy records into
Excel spreadsheet.

c. Merge macroeconomic data with financial data by date.

d. Manually enter bank structure data (e.g., city bank vs. share bank) into Excel
spreadsheet.

e. Merge bank structure data with financial data by bank.

2. Import the EWS database into a statistical software package.

3. Transform the raw banking data into the variables needed to estimate the NPA
coverage ratio, e.g., transform the numeric RMB-values of the capital, reserves, non-
performing assets, and total assets accounts into the NPA coverage ratio; transform the
numeric RMB-values of the net income and total assets accounts into the profitability
ratio “return on assets,” etc.

4. Use the statistical modeling capabilities of the statistical software to estimate an

empirical model of the NPA coverage ratio. The NPA coverage ratio in the current
period is estimated as a function of a broad set of independent variables measured one
period prior to the current period.

5. Use the coefficient estimates of this empirical model to generate a one-month-ahead

forecast of NPA coverage ratio. Substituting current-period values of the independent
variables into the estimated model does this. The resulting values are one-period-
ahead forecasts of the NPA coverage ratio.

C. Validation of the Model’s Forecasting Accuracy

Once a bank early warning model has been estimated, it is important to assess the
model’s accuracy in identifying high-risk banks. To assess our model’s forecasting
accuracy, we should apply it to historical data where the forecast can be compared to
the realized values of the NPA ratio. For example, one-quarter-ahead forecasts are
generated using June 2000 data, and these forecasts are then compared to actual
values realized one quarter later September 2000.

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D. How an EWS Fits into the Supervision Process

Once the early warning forecast has been produced, it is used to rank order banks from
worst to best. In our case, we would sort banks by the predicted NPA coverage ratio.
We would then set a cutoff value, and all banks with predicted NPA coverage ratios
worse than the cutoff value would be flagged for more intensive off-site analysis using
the proposed off-site surveillance software and other tools. If this analysis confirms the
EWS forecast that a bank is deteriorating, then supervisors would contact the bank for
an explanation. If this explanation does not satisfy supervisors, then additional
supervisory actions would be taken. One such action might be to accelerate the bank’s
next on-site examination. Another use of the EWS forecast is in scheduling bank
examinations. Other factors being equal, banks with worse EWS forecasts should be
examined earlier than other banks.

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 Bank
Financial
Data
Overview of Liquidity EWS On-Site
Targeted
Examination

Detailed Contact
Liquidity Bank
Microsoft Analysis
Access

EWS PC EWS Yes

Database Statistical Liquidity Liquidity
Software Score Problem

Microsoft
Access
No
Action
Required

Macro-
Economic
Data

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 Liquidity EWS Input Data
Monthly Macro-
Balance- Economic
Sheet Quarterly Data
Data Income- Bank
Statement Structure FX Rate
Data Inter-bank
Total Assets Data
Loan Rate
Total Deposits Net Income Stock Index
Location
Total Loans Net Interest Income Number of GDP
Total Capital Non-Operating Branches
Expense

Data Data
Entry Data Entry
Data
Entry
Entry

MS
MS MS
MS Access
Access Access
Access Data File
Data Data File
Data File
File

Merge MS Merge MS Merge MS Access

by Access by Access by EWS
Bank/D Bank Date
Data Data File Data File
File