Treatment of Risks in the Measurement of FISIM

Satoru HaginoDirector, Statistics Development and CoordinationResearch and statistics departmentBank of Japan

FISIM Task Force October 4-5 2010

1-1. Use of multiple reference rates FISIM are the productive services of

financial intermediaries measured indirectly.

In the estimation of FISIM, the choice of the reference rate (no service element) is important.

1-2. Problem of single reference rate In Japan, OFIs (e.g., consumer finance companies)

borrow large amounts of money from ODCs (e.g., banks). Interest payments by OFIs include the compensation for services provided by ODCs.

In the estimation of Japan’s FISIM, a single reference rate is used ( in Chart 1-a), based on interest payments a①mong financial institutions.

As a result, FISIM is double counted (E in Chart 1-a). As the reference rate is elevated, Japan’s FISIM is over-

estimated on the deposit side (B in Chart 1-a).

( Chart 1-a) Single Reference rate

Rate of interest received Rate of interest paid Rate of interest received Rate of interest paid

Reference rate

FISIM on the lendingside

D

Lending side

FISIM on the depositside

A

B

CE

Lending side

Other Financial Intermediaries Depository Corporations

Borrowing side Deposit side

Need to be subtracted

①

③

②

1-3. Solution

Multiple reference rates should be used.

→ The reference rate for ODCs (e.g., banks) should be based on the interest on claims among ODCs ( in Chart 1-b)② .

→ For OFIs (e.g., consumer finance companies), their reference rate should be based on their borrowing rates ( in Chart 1-b). ③

( Chart 1-b) Multiple reference rates

Rate of interest received Rate of interest paid Rate of interest received Rate of interest paid

Reference rate

Lending side

CFISIM of OFI onｓthe lending side

B

A

FISIM of ODC onｓthe lending side

FISIM of DC onＯ ｓthe deposit side

Depository CorporationsOther Financial Intermediaries

Borrowing side Deposit sideLending side

③

②

2-1-1. Treatment of interest rate risks As maturities of deposits and loans are different,

two different reference rates can be considered. The term premium of financial intermediaries refl

ects the margin between the reference rate for deposits and that for loans.

By deducting the term premium, Japan’s interest margins would decrease by approximately 20 percent, compared to the estimation method that uses a single reference rate (Chart 2).

( Chart 2) Japan’s Interest margin (Calculated by Bank of Japan)

2-1-2. Appropriateness of excluding term premium

Excluding term premium is appropriate as long as FISIM is limited to deposits and loans.

The scope of FISIM is limited to deposits and loans because of their unique function.

Transforming maturities is not a unique function of deposits and loans; it can be realized by means of securities other than shares.

2-1-3.Consistency with insurance service

For insurance companies, risks themselves are not considered as productive services; the amounts of insurance services in the national accounts are calculated as the sum of actual premiums plus property income, less expected claims.

For financial intermediaries, losses occurring through interest-rate risks should be deducted when measuring FISIM.

2-2-1. Treatment of credit risks If financial intermediaries increase their lending to hi

gh risk borrowers, the number of defaults will increase; the trend implies that monitoring services are not fully provided to high risk borrowers.

Losses caused by nonperforming loans, specifically the financial intermediaries’ credit costs, should be deducted from FISIM.

In Japan, interest margins are expected to decrease further by approximately 20 percent even before the recent financial distress (Chart 3).

( Chart 3) Japan’s Interest margin: Credit cost ratio is added to the reference rate for lending (Calculated by Bank

of Japan) --

2-2-2.Consistency with insurance service For insurance companies, risks themselves a

re not considered as productive services; the amounts of insurance services in the national accounts are calculated as the sum of actual premiums plus property income, less expected claims.

For financial intermediaries, losses occurring through credit risks, i.e., credit costs, should be deducted when measuring FISIM.

2-2-3. FISIM on the lending side FISIM on the lending side are defined as

monitoring services such as financial intermediaries’ advisory activities vis-à-vis borrowers, with a view to enable borrowers to repay on a regular basis.

Opportunity costs are hardly observed for small and medium-sized businesses as well as households ⇒ not always appropriate to treat FISIM on the lending side as opportunity costs of borrowers.

2-2-4. Why credit costs, rather than credit risk premiums When providing funds to high risk borrowers,

financial intermediaries strive to avoid default by strengthening monitoring and advisory activities; their lending rates include the compensation for monitoring services.

Credit risk premiums include the compensation for monitoring services inappropriate to e⇒xclude credit risk premiums from FISIM entirely.

3-1. Focus on consumer loans Credit costs of business loans are considered

to have little impact on the GDP because FISIM produced by business loans is treated as intermediate consumption.

Credit costs of consumer loans have a significant impact on the GDP because FISIM produced by consumer loans is treated as final consumption.

3-2. Japan’s case

FISIM produced from consumer loans represents more than half of the final consumption of the total FISIM.

If credit costs of consumer finance companies (see Chart 4), are deducted, the amount of final consumption expenditure for Japan’s FISIM is expected to decrease by 20 - 30 percent and (see Chart 5, moving average is deducted).

( Chart 4) Credit costs of consumer loans

Credit cost/ interest margin ratio

0

10

20

30

40

50

2003 2004 2005 2006 2007

Estimates based on P/ Lstatements

Backward moving averageof three years

％

Fiscal Year

( Chart 5) Impact of Credit costs of consumer loans on Japan’s FISIM

Estimation of final consumtion expenditure for J apan's FISIM

0

2,000

4,000

6,000

8,000

10,000

2003 2004 2005 2006 2007

After deducting movingaverage of credit costs(estimated by the BOJ )

Before deducting creditcosts (published by theESRI)

Billion of Yen（ ）

Fiscal Year

3-3. Expenses for the provision for losses on interest repayment Interest rates charged on some loans by

consumer finance companies have exceeded the interest rate ceilings specified in the Interest Rate Restriction Act.

Consumer finance companies have made provision for losses on interest repayment.

If such expenses as well as credit costs of consumer finance companies are deducted, the amount of final consumption expenditure for Japan’s FISIM will decrease further.

Conclusion

Deducting losses related to interest-rate risks of deposits and loans is appropriate but might not be practical.

Deducting credit costs—as opposed to the credit risk premium—from FISIM is appropriate and practical.

By doing so, the amounts of FISIM remain stable even during a boom or turmoil in the financial sector. An advantage could be further added by using past trends of credit costs.