Memorandum of Understanding on Cooperation between the Financial Supervisory Authorities, Central Banks and Finance Ministries of the European Union on Cross-Border Financial Stability/Annex 2

Section 1: Summary assessment

Note: The colour shading in the chart indicates the degree of impact (light=low; dark=high)

• The heat map and its key underlying assumptions (e.g. assessment time frame, with/without intervention)
• Overall assessment of the impact on the domestic financial system and the domestic real economy
• Uncertainty relating to the assessment; “worst case” assessment
• Most relevant policy issues if the overall disturbance is serious
• Key supporting elements for the assessment [Discussed in greater detail in the following sections]
• Main cross-border contagion channels [Discussed in greater detail in Section 6]

Section 2: Summary of events

• Characteristics of the crisis:

(i) size and nature (idiosyncratic or general) of the shock,
(ii) expected pace (fast-moving or slow-moving) of the crisis,
(iii) affected financial systems and their constituent components (institutions, markets, infrastructure)

• Present state of the financial system and the real economy

• Measures already taken or under consideration by:

(i) the private sector,
(ii) domestic authorities,
(iii) foreign authorities

Section 3: Financial institutions

• Most relevant policy issues if the disturbance is serious

• Supporting elements for the assessment of the critical nature of the affected parts

(see the table “Examples of indicators for assessing the critical nature of the financial system’s parts” – hereafter “Table”);
their extent of disturbance (possible indicators: shortage in liquidity, loss of capital, fall in future profits, market sentiment/depositor confidence);
and risk mitigants of a financial (e.g. capital buffers), legal (e.g. collateral, netting) or institutional nature (e.g. deposit insurance, shareholder structure)

Section 4: Financial markets

• Most relevant policy issues if the disturbance is serious

• Supporting elements for the assessment of the critical nature of the affected parts

(see Table); their extent of disturbance (possible indicators: bid-ask spreads, market turnover, price volatility, price information, liquidity risk premiums, market sentiment);
and risk mitigants of a legal (e.g. collateral, netting) or institutional nature (e.g. central counterparties, regulation/supervision)

Section 5: Financial infrastructure

• Most relevant policy issues if the disturbance is serious

• Supporting elements for the assessment of the critical nature of the affected parts

(see Table); their extent of disturbance (possible indicators: recovery time, pending transactions, critical dependency transactions);
and risk mitigants of a technical (e.g. back-up systems), legal (e.g. collateral, netting) or institutional nature (e.g. central counterparties, oversight)

Section 6: Contagion channels

• [Brings together the contagion elements discussed in Sections 3 to 5; see the overview table in the user guide for the main possible channels]
• Overall assessment of the contagion effects
• Main financial institutions, markets and infrastructures affected through real/exposure-based or information-based contagion channels and their vulnerability
• Cross-border dimension in the contagion channels

Section 7: Real economy

• Most relevant policy issues if the disturbance is serious
• Supporting elements for the assessment of the financial losses of non-financial economic agents (possible indicators: losses on uninsured deposits, market losses on assets) and the restricted access of non-financial economic agents to financial services (possible indicators: pay-out time for insured deposits, sector/regional lending concentrations for banks, market share of non-financial corporations in affected financial markets)

User guide

Policy background. In a crisis authorities will be confronted with two basic questions: whether to intervene, and if so how to intervene (e.g. through facilitating a private sector solution, public statements, liquidity support and recapitalisation). As a rule, the handling of a crisis and its resolution are primarily the responsibility of the institution(s) involved. Public intervention, in particular when public money is at risk, should only occur when there is a clear systemic risk, i.e. when there is a serious disturbance of the financial system that, as a result, may have a major impact on the real economy. The purpose of the template is to provide a common language to authorities when they discuss such systemic assessments and the possible effects of related policy measures in a cross-border context. In this way, it enables them to address more clearly any differences in their views on the impact of the crisis and reduces the risk that under the pressure of circumstances they might start discussing how to resolve a crisis before assessing its potential impact. A formal assessment, backed-up by supporting material, further enhances the authorities’ accountability for any recommendations made.

Scope assessment. The assessment should be made from the perspective of the domestic financial system, composed of financial institutions, markets and infrastructure, and the domestic real economy. The domestic financial system needs to be defined with reference to those parts that have the potential to disturb the domestic real economy. In defining the financial system’s three components, one should be wary of possible overlaps (resulting in double counting) and gaps. The real economy assessment should include and only include the effects of the crisis intermediated via the domestic financial system and via foreign financial systems (e.g. direct lending from abroad). In principle, all foreseeable effects should be taken into account, although the further away in time the effects are, the greater the uncertainty. Hence, it might be useful to differentiate between short-term and long-term effects.

Prioritisation in the assessment. In the case of a rapidly unfolding crisis, one may need to focus the assessment on the most critical parts of the financial system. These are likely to be the (major) banks, the markets they use for their daily funding and active balance sheet management, and the related infrastructure (e.g. large value payment systems). In such a situation, one may also need to place more reliance on qualitative judgements rather than on up-to-date quantitative information.

Factors influencing the assessment. The assessment of the financial system’s components should reflect

the critical nature of their affected parts and their extent of disturbance. For both factors, a number of possible indicators can be used. The extent of disturbance will be influenced by the presence of risk mitigants. Two main criteria are relevant for a part’s critical nature:

(i) its role in performing the key financial functions (executing payments, matching savings to investments, managing financial risks) and
(ii) its main users. Three additional criteria can be used to further differentiate the affected parts:

(i) the part’s activity level (“size”),
(ii) the availability of alternatives (“substitutability”) within a reasonable time/at a reasonable cost and
(iii) its linkages with other parts. For the real economy, relevant factors are the reduction in the financial wealth of non-financial economic agents and their restricted access to financial services.

Systemic impact score. The score is a decimal number that reflects the assessment of the impact of the crisis on the components of the financial system and the real economy relative to four base cases: 0 (no impact),1 (limited impact), 2 (serious impact), 3 (very severe impact).
The score should take into account both the state of the financial system and the real economy before the crisis and the additional impact of the crisis. For example, when the financial system is already in a weak shape, the effect of a crisis is likely to be bigger (higher score) than if the financial system is robust (lower score). The score should be supported as much as possible by quantitative information. The four separate scores are graphically represented in a “heat map”. The heat map is a snapshot in time and one may need to construct a series of maps over the life of a crisis. Moreover, an initial assessment that is relatively benign can quickly change if vulnerabilities are present in the financial system or the real economy. Authorities should therefore be careful not to overlook elements that are not fully captured by the map.

Range of the score. The score is a reflection of an assessment which involves a significant degree of uncertainty and discretion. A range can be defined for each score reflecting the uncertainty relating to the assessment, with the lower boundary corresponding to a “best case” scenario and the upper boundary to a “worst case” scenario. Authorities may try to attach a qualitative likelihood (e.g. “most likely”, “very unlikely”) to the scenarios. Given the large potential costs associated with a systemic financial crisis, authorities should pay particular attention to the worst case scenario.

Contagion channels. These are the real/exposure-based or information-based channels through which shocks can be transmitted between various parts of the financial system. They should be explicitly considered in the assessment, in particular their cross-border dimension, as they are often crucial in times of crisis. The following table might be helpful in identifying the main channels.

Main possible contagion channels

Note: This list of contagion channels is for illustrative purposes and is not exhaustive

Examples of indicators for assessing the critical nature of the financial system’s parts

Note: The indicators are for illustrative purposes only and may change depending on the type of financial institution, market, infrastructure or crisis under consideration,