Towards an Early Warning System for the Paraguayan Banking System

ANA-MARIA FUERTESa and ZULMA ESPINOLAb*

a
Cass Business School,106 Bunhill Row, London EC1Y 8TZ
b
Central Bank of Paraguay

Firts Draft: 30 August, 2004

Last Revision: May 2006

Abstract
This paper seeks to develop an Early Warning System (EWS) for banking crises. The goal is to
provide a mechanism which can anticipate increases in the fragility of the Paraguayan banking
system. A high Non-Performing Loan Ratio (NPLR) is taken as an indicator of inefficiency of the
institutions and hence, as a warning signal for regulators and other agents. We stress that the
EWS is not a substitute for the regulator and supervision tasks but instead, a complementary
instrument to the mandatory roles that they should perform on a day-to-day basis. The empirical
results based on a panel data model reveal that, for a set of 32 banks (at the end of 1995) and just
14 banks (at the end of 2003), the increment in the banks fragility are immediate results of a
economic recession in the real sector and/or of a deficit in the current account. Moreover, all
microprudential indicators selected (such as the simple capital ratio, liquidity, expenses and
returns on asset) have a very short-term impact in the NPLR. These findings have important
policy implications. In order to strengthen the health of the Paraguayan financial system, it
appears that both macroeconomic and microeconomic policy actions must be taken. The former
include urgent policies of economic reactivation and competitiveness of the real sector whereas
the main micro factor is a good credit risk management.

JEL classification: Early Warning System; banking crisis prediction; fixed effects; random
effects.

Keywords: G1, F3

* This paper was written while Zulma Espnola was a visiting scholar at the Faculty of Finance of Cass
Business School. The authors gratefully acknowledge the comments of Shellagh Heffernan, Walter Sosa-
Escudero, Carlos Fernandez-Valdovinos. They are also grateful to all Central Bank Officers of the Office of
Economic Studies and the Superintendency of Banks of the Central Bank of Paraguay for providing the
data. Zulma Espinola gratefully acknowledges partial financial support for this research from the British
Chevening Scholarships of the Foreign and Commonwealth Office.
 1

1. Introduction

Monetary and financial stability have become two basic goals of central banks during the
1990s and to that effect, it is crucial to obtain early warning information to prevent crises in the
financial system. Mainly after the Asian banking and currency crises, the so-called called Early
Warning Systems (EWS) emerge as new tools for policy makers and, for regulators and
supervisors of the financial system in their effort to strength the surveillance process. The aim of
an EWS is the anticipation of whether and when some country or economic sector may suffer a
financial crisis. In general, the empirical models that underlie existing EWS include both macro-
and microeconomic variables. Currently, there are a number of such models developed by public
and private sector companies. Institutions like the International Monetary Fund (IMF) and other
worldwide regulators are leading the race in the development of EWS for emerging economies.
A large amount of the past and current literature on EWS refers to exchange rate crises.
The purpose of the present paper is to develop an EWS to measure for the fragility of the
Paraguayan banking system. The Non Performing Loan Ratio (NPLR) is taken as a proxy for the
inefficiency of the banking system. In fact, the weakness of the institutions, in this case signalled
by a high NPLR ratio, is a warning signal for regulators and other agents. On the other hand, the
idea is to demonstrate that an increasing NPLR can be dangerous for the financial soundness and
monetary stability not only in the short term but also in the medium and long term. Moreover,
according to Thorne (1993), countries with a high number of new private banks, new regulation
and supervision and enhanced bank competition have experienced an improvement in credit
allocation and loss minimization.
Most of the financial crises in the last decades have had an impact not only in economic
terms but also in social, cultural and political terms. For a developing country, such as the case of
Paraguay, it is important to get warning signals as early as possible so that regulators and
policymakers can take proactive and preventive actions. This is not to say, however, that the EWS
is a substitute for the regulator and supervision role but a complementary tool of the mandatory
roles that they perform.
The paper is organised as follows. Section 2 reviews the literature with a brief description
of EWS models of some regulators. Section 3 introduces some features of the Paraguayan
financial system. Further, Section 4 describes the data and discusses the methodology. Section 5
presents the empirical results and a final section concludes.

2. Background literature
The approaches that have been followed to anticipate financial crises can be grouped as:
i. Qualitative comparisons. Including graphical comparisons of the economic fundamentals
immediately preceding a financial crisis with those in normal times or with those in a control
group of countries which did not suffer a crisis.
ii. Econometric modeling. This method uses qualitative (logit, probit or multinomial) regressions
to investigate which indicators are associated with a higher probability of a financial crisis.
iii. Non-parametric estimation. This approach uses the classification (clustering or neural
network) techniques to assess the usefulness of different variables in signaling a pending or
potential crisis.
Although these approaches have shortcomings, they are useful in providing a good
starting point for the anticipation of a pending crisis. The econometric and non-parametric
approaches are by and large the most frequent type of EWS for banking crises. They provide
signals (crisis probability estimates) on the basis of several economic and financial indicators.
The resulting EWS can incur two types of errors. A Type I Error when a weak bank is classified
as sound. A Type II Error when a strong bank is flagged as weak. The former is more worrisome
from a supervisory viewpoint.
 2

Gonzalez-Hermosillo (1999) considers the impact of market, credit and liquidity risks
alongside contagion and moral hazard factors in explaining bankrupcies. The study shows that the
increment in the NPLR ratio and the fast deterioration of the capital adequacy are the leading
factors. On the other hand, a previous study by Rojas-Suarez (1998) based on data for Colombia,
Mexico and Venezuela concludes that the spread rate and interbank debt growth are the main
factors to identify weak banks; and traditional ratios such as capital adequacy ratio, liquidity,
operative cost and earning ratios are not so useful in this case. Dabos and Sosa-Escudero (2000)
use the Cox proportional hazard model to characterize the dynamic of bank failures and
concludes that the bank financial situation (rather than government or external factors) played a
key role in the Argentina banking crisis. Estrella, Park and Peristiani (2000) examined the
relationship between different capital ratios and bank failure and found that the simple capital to
assets ratio (leverage ratio) predicts bank failure as well as more complex risk-weighted capital
ratios over one-year or two-year horizons. Crockett (2000) emphasizes that supervisory
perspectives must include macro and micro prudential elements. This is an important statement in
front of a generalized point of view, because in most cases, supervisors` analysis are just
associated in a micro-prudential dimension avoiding the macro perspective.
Bussiere and Fratzscher (2002), develop an EWS for currency crises based on a
multinomial logit model approach which corrects the post-crisis bias using three regimes a
tranquil, a pre crisis and post-crisis recovery periods.1 The analysis is based on a set of 32 open
emerging markets over years 1993-2001. The vulnerability indicators tested in the model was
arranged in 6 groups: i) external competitiveness measured by the Real Effective Exchange Rate
(REER) overvaluation, current account (% GDP), trade balance (% GDP) and export and import
growth; ii) external exposure measured by short-term debt/reserves, total debt/reserves, debt
composition (loans/bonds), foreign direct investment (FDI), portfolio investment, total net capital
inflows, foreign exchange reserves (level and growth rate); iii) domestic real & public sector
measured by the real GDP growth rate, fiscal stance, public debt (% GDP), inflation rate,
domestic investment ratios, real estate sector (level and growth rate), deposit/lending interest rate
spreads, M1, M2 (%GDP), equity market indices, bank deposits; iv) domestic financial sector by
domestic credit to private and to the government sector (level and growth rate), deposit/lending
interest rate spreads, M1, M2 (%GDP), equity market indices, bank deposits; v) global factors (to
come) by GDP growth rate in G3, US, EU interest rates, equity market performance in G3,
commodity/oil price; and vi) contagion with values of the trade channel and financial
interdependence.
Jagtiani et al (2003), have found evidence of a strong relationship between on-site exams
and Call Report revisions in a EWS model that focused in the identification of banks that will
have inadequate capital in the following year. To that effect, they choose the capital to asset ratio
as proxy, based on a sample period 198890, and considering banks with assets of less than US$
1 billion with the purpose of and early identification of capital inadequacy, that would enable
supervisors to identify risky firms and manage timely supervisory interventions. They tested three
models, from a simple logit model that includes only the lagged capital ratio and lagged change in
capital ratio, to a more complete logit stepwise model and a non-parametric Trait Recognition
Analysis (TRA) model. The in-sample results indicated that all three models are able to predict
banks with inadequate capital levels, but in the original sample period, the TRA models record
was superior when it predicts all adequately capitalized banks. In the out-of-sample tests the
simplest logit model was superior.

2.1. Formal approaches of regulators

The main features of the formal EWS employed by regulators are outlined below. Even
though, they have some limitations regarding to the application and usefulness in predicting

1
This bias is due mainly to failing to distinguish between a tranquil and post crisis/recovery period.
 3

banking crisis, currently they are recognised as key tools for regulators and supervisors. One of
the main constraints for the accuracy of these models is the high and direct level of dependence
on the accuracy of the inputs or the financial information of the regulated companies. Another
limitation is the absence of some qualitative factors behind banking crisis, with the exception of
the French approach and the introduction of the management ratio in the CAMELS2 for the
Federal Reserve (FED).

The Federal Reserves model3

The Federal Reserve System uses an econometric based approach called SEER (System
to Estimate Examination Ratings), which is an off-site early warning system for monitoring the
financial condition of banks during periods between on-site examination. The SEER system
consists of two models that provide complementary surveillance scores: the SEER Risk Rank
and the SEER Rating. The SEER Risk Rank is the probability, ranging from 0 to 100 percent,
that a bank will become critically undercapitalized within the next two years. The SEER rating is
an estimate of a bank' s composite CAMELS rating based upon Call Report data and examination
rating information. The prediction is the result of applying a multinomial logit analysis.
For that purpose, in a first stage, a bank is assigned each of five possible ratings. Then, the
SEER rating is calculated as the sum of the five rating levels multiplied by their respective
probabilities and classifying all banks into satisfactory (1- or 2-rated) and unsatisfactory (3-, 4-,
or 5-rated) categories. The model utilizes two previous quarters of Call Report and examination
data and includes approximately 45 financial and non-financial variables in the analysis. One of
the set of variables is proxy for, among other things, capital adequacy, asset quality, earnings
performance, and liquidity. In addition, the prior composite CAMELS rating is also included in
the SEER rating model. The economic variables such as: unemployment, income per capita, and
permits per capita are usually not statistically significant. The banks go to a Watch List if they
have a SEER1 Risk Rank greater than or equal to 2 percent; SEER rating worse than or equal to
3, among other factors.

The Office of Comptroller Currency (OCC) model

The OCC uses a monitoring system called CANARY4 organized into four components
(benchmarks, credit scope, market barometers and predictive models). The current set of
benchmarks consists of 15 financial ratios, 6 of them relate to credit risk; 4 to interest rate risk;
and 5 to liquidity. One example of particular benchmark is that credit quality problems often
increase when a banks loan-to-asset ratio exceeds 70 percent5.
The model uses various economic indicators, including interest rates, prices, wages,
unemployment rates and bankruptcy. Bank-specific financial variables include nonperforming
loans, provisions for loan and lease losses, asset growth rate, growth in equity, loan growth rate,
CAMELS rating, portfolio risk. In addition, specific financial and economic factors that are likely
to impact banks in certain peer groups are included, such as: farm incomes and farm output prices
for those of the agricultural peer group.

The Federal Deposit Insurance Company ( FDIC) model

2
All banks are analyzed and rated under CAMELS rating. "C" stands for Capital. "A" stands for asset
quality. "M" stands for management. "E" stands for earning. "L" stands for liquidity. And "S" is sensibility
to the market. Each of the components represent different aspects of a bank'
s operations.
3
http://fedweb.frb.gov/fedweb/bsr/surveil/home.htm
4
The name of CANARY is related to a EWS used in the mining industry. In the past, miners brought canaries in
cages into the mines with them, with the purpose to get a early warning system because the canaries stopped singing in
the presence of methane, a deadly gas. (Sprayregen, 2002)
5
http://occ.treas.gov.ftp/release/2000-71.doc
 4

The FDIC insures all savings and checking accounts of depositors, in banks throughout
the United States. The FDICs model: SCOR (Statistical CAMELS Off-Site Ratings) is based on
the information provided by the Call Report data to identify banks likely to experience a
downgrade at the next on-site examination, using step-wise ordered logit analysis to estimate
downgrade of 1 or 2-rated banks comparing one-year prior call report. The SCOR model predicts
the probability that a bank will be assigned a specific rating (1, 2, 3, 4, or 5, where 1 is best and 5
is worst) and the probability that a banks rating will be downgraded with current CAMELS
rating 1 or 2. The following financial variables are included: total equity capital, loan loss reserve,
3089 days past due loans, 90+ days past due loans, non-accrual loans, other real estate owned,
net charge-offs, provision for loan losses, net income pre-tax, cash dividends declared, volatile
liabilities, liquid assets, and loans and long-term securities. All variables are in ratios as a
percentage of total assets. In addition to SCOR, the FDIC uses the Growth Monitoring System
(GMS) and Real Estate Stress Test (REST) as its primary tools for offsite monitoring.
An audit report6 (2002) had conclude the unproductiveness of the SCOR due to the lag up
to 4 months existing between the date of the processing the Call Report date and the subsequent
offsite review and the dependence of the accuracy and integrity of the Call Reports. Further, there
was a recommendation to include the management factor.

Deutsche Banks Alarm Clock (DBAC) approach7

This approach estimates the probabilities of exchange rate and local interest rate crisis
events for 19 emerging markets on a monthly basis. To that purpose, there is a clear definition of
interest rate event as depreciation greater than a certain threshold (estimated separately for
levels ranging from 5 to 25 percent) and a monthly increase in the money market interest rate
above 25 percent. These two types of events are jointly modeled (simultaneous equations)
allowing for the probability of an interest rate crisis to influence the probability of an exchange
rate crisis and vice versa.

The Bank of England (BoE) approach

Even though the Bank of England has not developed a formal EWS as such, it pursues
stability in the financial sector by the Financial Stability Review (FSR) and the Risk Assessment,
Tools and Evaluation (RATE). The FSR is published by the BoE semi-annually with a summary
assessment of current and prospective risks to financial stability in the UK and internationally.
Several techniques are used to identify and evaluate these risks which include credit, market and
liquidity risk. The probability of banking crisis is mitigated if the institutional infrastructure is
robust.
Also, the Risk Assessment, Tools and Evaluation (RATE) is a framework to gather a
comprehensive bank risk assessment system. using key ratio trends and peer group analysis
during the formal risk assessment phase of a banking institution. All factors are converted in a
numerical factor indicating the level (high, medium or low) and direction (increasing, stable or
decreasing) of business and control risk are discussed with the bank, its parent company and other
regulators concerned. (Sahajwala and Van den Bergh, 2002).

French Banking Commission

The French Comission apply a model titled as SAABA (Support System for Banking
Analysis) based on a loss model using loans adjustment for an expected loss amount on a
probability of default. They use several data bases. It is one of the models that includes qualitative
factor, such as the assessment of management and shareholders commitments. It classifies banks
into 1 to 5 categories depending on anticipated solvency ratio. The primary indicators are credit

6
FDIC (2002), Audit report No. 02-033 available in http://www.fdicoig.gov/2002_a_reports.asp
7
IMF Survey (2001)
 5

analysis using internal and external rating data sources and it is run each six months. Judicial
events (liquidation) and extra-judicial events (striking from the Commerce Register) are taken
into account as "fatal" events if they indicate the failure of the firm and their default probability is
set to 100%.
There are three main use of the SAABA: a credit portfolio analysis, forecasting the
solvency of the bank for the next 3 years and a guide of global supervision of the banking system.

Models of Multilateral Organizations

EWS Models at the International Monetary Fund (IMF)8

As part of its surveillance activities, the IMF maintains two core EWS models: the
Developing Countries Studies Division (DCSD) model and the Kaminsky, Lizondo, and Reinhart
(KLR) Crisis Signals model. The core models attempt to forecast a countrys vulnerability to a
foreign exchange crisis defined as a large depreciation of the exchange rate and/or extensive
losses of foreign exchange reserves over a 24-month forecast horizon. In this context, a crisis is
said to have occurred when the exchange market pressure indexa weighted average of one-
month changes in the exchange rate and foreign exchange reservesis more than three (country-
specific) standard deviations above the country average value. In addition, the DCSD model
includes only five explanatory variables: real exchange rate overvaluation, current account,
foreign exchange reserve losses, export growth, and the ratio of short-term debt to foreign
exchange reserves. In contrast, the KLR Crisis Signals model uses twice as many variables (the
first four variables used in the DCSD model as well as the ratio of foreign exchange reserves to
M2, the growth of the ratio of reserves to M2, domestic credit growth, change in the money
multiplier, real interest rate, and excess M1 balancesdefined as actual M1 less an estimated
demand for money). The output of the core model is complemented by monitoring the results
from three investments banks models: Credit Suisse First Boston Emerging Markets Risk
Indicator (CSFB-EMRI), Deutsche Bank Alarm Clock (DBAC), and Goldman Sachs GS-Watch.
The forecasting horizon is one month for CSFB-EMRI and DBAC and three months for GS-
Watch. There are some methodological estimation differences among the three models but the
mayor one is the definition of a crisis event. CSFB-EMRI defines a crisis as an exchange rate
depreciation that exceeds 5 percent and it is at least double to the preceding months depreciation.
In contrast, DBAC defines exchange rate and interest rate events as currency devaluations and
interest rate increases exceeding exogenous thresholds (typically a depreciation of more than 10
percent).

ASEAN+3 Framework for the Development of Early Warning Systems

The model of regional EWS developed by the Asian Development Bank has four
components: (i) a set of macroprudential indicators (MPIs); (ii) a nonparametric EWS model; (iii)
a parametric EWS model; and (iv)a set of economic leading indicators of business cycles (LIBC).
The goals of the four components are different. Indeed, MPIs try to assess the health and stability
of financial system in a less formal and more qualitative way, while the other three components
using statistical techniques have more specific focuses. The nonparametric and parametric EWS
are designed to assess the probability of currency crisis within a 24-month time horizon, while the
LIBC focus in the prediction of turning points of business cycles. The latter three components
require high frequency data and long time series. Therefore, they can only be applied to countries
where such data are available, including Indonesia, Republic of Korea, Malaysia, the Philippines,
Singapore and Thailand.

i) Leading indicators.

8
IMF (2001) and IMF (2002)
 6

All macro indicators are classified by source of their impacts in the financial crisis in
several groups of current account, capital account, financial sector, fiscal account, real sector and
global economy. The proposed indicators for each group are as follows:
Current account indicators: real exchange rates, export growth, import growth, ratios of
the trade account balance to GDPand ratios of the current account balance to GDP.
Capital account indicators: ratios of short-term debt to foreign reserves, ratios of M2 to
foreign reserves, ratios of banks foreign liabilities to foreign assets, ratios of residents deposits
in the Bank of International Settlement banks to foreign reservesand growth of foreign reserves.
Financial sector indicators: ratios of domestic credit to GDP, M2 money multipliers,
excess real M1 balances, domestic real interest rates and lending-deposit rate spreads.
Fiscal account indicators: ratios of the fiscal balance to GDP, ratios of government
consumption to GDP and ratios of public debt to GDP.
Real sector indicators: growth of industrial production, changes in stock prices.
Global economy indicators: growth of world oil prices, the US real interest rate.

ii) A Nonparametric EWS Model

The nonparametric EWS model follows the signaling approach pioneered by Kaminsky
and Reinhart. Most of these indicators are among the MPIs of the first component described early.
Some MPIs, such as nonperforming loan ratios, capital adequacy ratios, ratios of government debt
to GDP, although important, are not part of the model, because they are available only for more
recent years and do there is not a long time series. Each indicator is examined to determine
whether it has crossed its threshold value that has historically been associated with heightened
probability of currency crises. When an observed outcome of an individual leading indicator
crosses its threshold value, it is considered as issue of a warning signal. A warning signal is
associated with a certain conditional probability. Composite leading index contains more
information than individual leading indicators and are considered to be more reliable. In the
model, there are six sector-specific composite leading indexes and two overall composite leading
index.

iii) Leading Indicators of Business Cycles.

The last component of the regional EWS prototype is leading economic indicators of
business cycles. Leading indicators are arguably the chief forecasting tools used to predict
recessions and recoveries. They can provide advance warning of a sharp economic upturn
(overheating) or downturn (recession) and thus enable policymaker to initiate preemptive action.
As be appreciated in all these EWS described in this section, there is a combination of
on site and off site supervision factors, where the financial adjustment of capital as well as simple
ratios are fundamental tools. However, just after the Asian crisis, starts the consideration of
macro variables that can affect the financial stability.

3. Stylised Facts of the Paraguayan Banking Industry

Previous to the design of the model for the Paraguayan case, it is important to see some
characteristics of the Paraguayan financial system as well as the restructuring process following
the banking crisis of 1995 and 1997.

a. Structure of the banking system

In Paraguay, banks are the main players of the financial system. Most of all financial
transactions taking place in Paraguay are conducted by banks, which have been key instruments
of the government financial policies. At the end of December 2003, the banking system
comprised 13 private commercial banks, 1 state bank, 20 finance companies, 23 Exchange
Houses, 4 Deposit Receipts Warehouses and 1 Trust Company, as we see in Table 1. The number
of banks in the market has been falling since the banking crisis of 1995.
 7

Table 1
Structure of the Paraguayan Financial System
As of December 31, 2003.
Regulated by the Banking Law Others
Banks 14 Representative Offices 1 2
Foreign Banks (including subsidiaries and 11 Credit Cooperatives2 556
branches)
Private Domestic Banks 2 Crdito Agrcola de Habilitacin 1
State Banks 1 Fondo Ganadero 1
Banco Nacional de la Vivienda 3 1
Finance Companies 20 Fondo de Desarrollo Campesino 1
Exchange Houses 23
Deposit Receipts Warehouses 4
Trust Company 1
Total 62 Total 562
Source: Superintendency of Banks, Central Bank of Paraguay.
Note: 1 Those Offices do the promotion and ads of the banking services and business and these can not receive
any deposit from the public.
2
According to the Census of Cooperatives at the end of 1999. The Credit Cooperatives are subject to oversight
by the Instituto Nacional de Cooperativismo (INCOOP) of the Ministry of Agriculture under the term of Law
2157/03.
3
The Banco Nacional de Ahorro y Prstamo para la Vivienda (BANAVI), a public owned housing bank is the
Superintendency of Societies that supervises the Savings and Loans Association.

As shown in Table 2, the number of banking institutions declined to 14 (at the end of
December, 2003) from 35 (at the end of 1995) mainly due to the banking crisis of a magnitude
not seen in the country. How large was the problem? 18 banks were closed; 12 banks were closed
after the intervention of the Central Bank and just 6 banks were closed and exit the market due to
merger or voluntary liquidation (Those banks were: BANESPA, REAL DEL PARAGUAY,
CORPORACION, ING. BANK S.A., BANCO ASUNCION S.A., REPUBLICA ORIENTAL
DEL URUGUAY). Prior the crisis there was a boom in the amount of domestic banks (from 1993
to 1997) and at that time, the total assets had growth by a positive rate of more than 20 per cent.

Table 2
The evolution of Banking system in Paraguay

At the end # Foreign Domestic Private Public Total Assets In Growth

of Year Banks Banks Banks Banks Billions Gs. In %
1989 26 14 10 2 988.01
1993 29 13 14 2 3,643.89 268.8
1994 34 13 19 2 4,872.55 33.7
1995 35 13 20 2 5,979.99 22.7
1996 32 14 16 2 7,679.55 28.4
1997 30 18 10 2 8,485.98 10.5
1998 23 17 5 1 8,625.85 1.6
1999 22 17 5 1 9,687.63 12.3
2000 22 17 4 1 10,331.96 6.7
2001 20 16 3 1 11,788.92 14.1
2002 18 14 3 1 12,030.06 2.0
2003 14 11 2 1 11,712.69 (2.6)
Source: Superintendency of Banks, Central Bank of Paraguay.
 8

Table 3 illustrates some features of the Paraguayan banking system from 2000 to 2003,
periods in which the real sector had been influenced by internal and external shocks with
recession signals in the country. In that period, there was a decreasing number of banks, branches
and agencies and, thus in the number of people employed, decrease in the loan to the private
sector, increment of the non performing loan ratio (NPLR) a stable and significant presence of
international banks.

Table 3
The Development of the Banking Industry in Paraguay during Years 2000-2003
In Billions of Paraguayan Guaranes and %
2000 2001 2002 2003
I Deposit and Loans
Deposits 7,689.20 9,252.00 9,302.20 9,886.38
Net Loans 6,628.90 7,547.30 5,812.58
7,025.70
II Assets and Liabilities
Total Assets 10,331.90 11,788.90 11,712.69
12,030.10
Total Liabilities 8,986.10 10,286.90
10,615.10 10,516.62
Net Worth 1,345.90 1,502.00 1,196.07
1,414.90
III Participation of the Foreign Banks (%)
In Total Deposits 86.2 87 84.5 86.1
In Total Net Loans 82.9 84.4 79.9 85.1
IV Participation of State Bank (BNF) (%)
In Total Deposits 6.9 6.3 5.8 6.6
In Total Net Loans 9.1 8.2 8 8.0
V Number of Banks and Employment
Number of Banks 22 20 18 14
Total Branches and Agencies inside Paraguay 180 173 164 127
Total Number of people employed 3,433 3,286
3,188 2,680
VI Solvency, Efficiency and Size
Assets / Number of people employed 3.1 3.6 3.8 4.4
Assets / Number of Banks 469.7 589.4 668.4
836.6
Deposits / Number of Banks 349.5 462.6 516.8
706.2
Deposits / Number of Branches and Agencies 42.7 53.5 56.7 77.8
Deposits / Number of people employed 2.2 2.8 2.9 3.7
Non Performing Loan Ratio (private banks) 11.8 12.1 14.5 15.0
Source: Superintendency of Banks, Central Bank of Paraguay.

b. Stages in the Paraguayan Financial Restructuring

The Paraguayan financial system has been involved in a restructuring process since 1989,
which will be detailed in four main stages:
i) The first stage, prior to 1989: The Paraguayan financial system and all economic
activities had supported excessive regulations and restrictions in the operations. For example,
there was a ceiling to the loans for each economic sector, high level of reserve requirements,
credit lines of the Central Bank loans (rediscounts) and ceiling to the interest rate. Indeed, most
of the prices (interest rates, exchange rates) were overregulated.
ii) Initial period of liberalization in 1989, without financial legal reform. After 1989,
coincident with a new government macroeconomic policy there was a introduction of substantial
improvements in the macroeconomics field beginning with the one of the most important reform:
the unification of the multiple exchange rate system and its liberalization. By 1991, the interest
 9

rates were liberalized and completely free with the exception for the Central Bank discount rate.
Further, foreign exchange deposits were liberalized and reserve requirements were reduced.
Selective credit controls were abolished for the private sector with the exception to some lines of
public credits. Other key event was the promulgation of a new Constitution Law in 1992 which
assigned a new role for the Paraguayan Central Bank. In the first stage of the liberalization, the
financial macroeconomic framework had not displayed important imbalances and, however, in
the financial sector there was a remarkable increment in the new financial firms, mainly locally
owned capital.
Indeed, Paraguay had undertaken a premature and indiscriminate financial liberalization
since 1989 in the absence of suitable mechanisms of regulation and supervision for the financial
sector. As mentioned, such liberalization included the deregulation of the national financial
system, price liberalization and the elimination of barriers to the entry in the financial market. All
those new events was developed in a context of inadequate and poor supervision and financial
regulation, mainly due to legal constraints. Furthermore, during the crisis, more than 50 per cent
of the total financial intermediaries were intervened and closed down. The cost of the banking
crisis is estimated in a sum around 7 to 12 per cent of the GDP. Insfrn (2000) pointed out that the
leading causes of the serious upheaval of the sector were the poor banking management, lack of
specialists in the credit risk management (including the concentration of loans and the poor
performancein the credit-risk analysis), the incomplete information systems, the informal
economy and the problem of not transparency (double accountancy because most of the balance
sheets disclosed did not reflect the real situation of the entity) of the financial institutions. Taken
together, these factors demonstrate clearly that the absence of a strong and sound management of
financial risks is one of the main feature of the crisis. Moreover, many analysts blame the lack of
skill as bankers for most of the managers of those entities. On the other hand, a second feature of
the Paraguayan crisis was on the side of the supervisor due the lack of efficiency and the poor
control that could not prevent fraudulent practices of some bankers.
iii) Period of introduction of a new legal framework with the promulgation of the new
banking laws. 1995 and 1996 saw the introduction of extensive new legislation with important
effects for the Paraguayan financial system. The Central Bank of Paraguay has a new Law at the
end of December 1995. And the heart of all legal reforms was the new banking law promulgated
in May 1996. In fact, the main provisions governing banking, its regulation and supervision, are
contained in the Banking Law. From the events of 1995, the Paraguayan financial system has
experienced very deep changes in its organizational structure. The main chapters of the banking
law set the licence process, entry and exit of the market, capital adequacy ratios and credit risk
measurement. Other features of the banking law is the mandatory task for the Superintendency of
Banks to rate all financial entities under their supervision based on capital adequacy, assets
quality, earning, liquidity and management, which are disclosed in a quarterly term. This is a
controversial duty for the supervisor because they play a dual role: as supervisor and rating
agency; but was necessary by the time the Banking Law was issued due to the lack of
transparency and disclosure of financial data .
iv) Period 1998 - 2003, characterized by the dynamic adjustments of the domestic legal
framework to international standards; opening a stage for the Paraguayan Financial System to the
strengthening and soundness of the Superintendency of Banks. One of the main features was the
institutional restructuration of the Superintendency of Banks. Currently, there are new Deposit
Insurance Law and also a project of law in resolution banks is in the Congress waiting the
approval.

c. Regulation and Supervision approach in Paraguay

In Paraguay, the principal government agencies responsible for the regulation and
supervision of financial institutions are the Central Bank of Paraguay and the Superintendency of
Banks. The Central Bank of Paraguay was the leading institution engineering the restructuring of
 10

the financial sector after the 1995s events. Paraguays approach to restructuring has focused on
two main players (banks and finance companies). Broadly speaking, the approaches adopted in
Paraguay for financial restructuring have been similar to those who face those types of crisis, and
have involved the injection of Central Bank liquidity, regulatory forbearance, closure of deeply
insolvent financial institutions, selling and transferring assets among other alternatives.
The main tool for off site examination is the rating instrument titled CAUA-G which
includes the rating of capital adequacy, asset quality, management, earnings, liquidity to evaluate
the banks in Paraguay. This system relies on various financial ratios obtained from quarterly
reports of the entities under their jurisdiction.
After the financial crisis experience, all main agents of the economy agree about the need
for strengthening the Superintendency of Banks. In carrying out its operations, the
Superintendency of Banks is guided by the provisions of the banking law, circulars and other
resolutions and its supervisory methods includes off-site and on-site examinations. The first of
them is in charge of the analysis of the main variables keep tracking of the operations of each
financial institution. Onsite examinations provide the checking on the banks operations and
conditions. The purpose of on-site inspection is to evaluate the financial soundness of each
institution with special emphasis on capital adequacy, asset quality, earnings performance and
liquidity. Also, the organizational reform of the Superintendency of Banks included the openness
of a new department: the Intendency of Special Supervision that is in charge of all non-banking
institutions and all entities that had been intervened or are in process of liquidation due to the
financial crisis. Recall that the current supervisory approach in Paraguay focuses more in the
compliance with all legal resolutions rather than focusing into assessing the management of
financial risk and the quality of the management. By end of year 2002, there is a new Deposit
Insurance Law for the Paraguayan financial system and also new standards in the asset quality
will be implemented by year 2007.

4. Data and Methodology

4.1 Data description
This paper relies on panel data models based on the two groups of indicators: micro and
macroprudential indicators. In fact, the deterioration of worsening of macro indicators could
affect the stability of financial systems and lead to banking crises. The main purpose to include
those indicators is to measure the lags in which those macro factor impact in the efficiency of the
banks. On the other hand, financial ratios are basic tool in the supervision system. For that the set
of micro variables includes ratios on balance sheet structure, profitability, capital, credit risk,
liquidity.
We have gathered monthly data over the period December 1995 to December 2003 for a
starting sample of 32 banks at the end of 1995, and 14 at the end of 2003. The list of banks and
closing date are illustrated in Table 1 of the Appendix. It is well known that systems with a large
number of variables have poor statistical properties. To start the case study, we carry out the
process of selection of the variables starting with the correlation matrix and unit root test. All
macro variables were provided by the Central Bank of Paraguay; and the monthly bulletin of
banking published by the Superintendency of Banks was the input for set of micro variables.
Indeed, the monthly balance sheet of each bank is the input for this statistical information
disclosed by the Superintendency of Banks.
The set of domestic variables included originally 17 macro variables and 15 micro variables,
try to capture the impact of all economics agents. Following the ASEAN+3 classifications, the
set of macro variables (further details of these variables can be found in Table 2 of the Appendix)
include the following group of indicators:
Current account indicators: real and nominal exchange rates depreciation, export growth,
import growth, growth of the trade account balance.
Capital account indicators: ratio of external debt to exports, growth of foreign reserves.
 11

Financial sector indicators: real credit growth in domestic money, real credit growth in
foreign money, lending-deposit rate spreads.
Fiscal account indicators: growth of public external debt.
Real sector indicators: Monthly Indicator of Economic Activity (IMAE) growth.
Global economy indicators: growth of world oil prices, the US T-bill nominal nterest
rate.
On the other hand, the micro variables were selected based on approaches used by regulator
worldwide, which was explained in Section 2. For the Paraguayan case, we had selected leading
financial ratios reflecting the feature and traditional activity of the banks. To that effect, we
include ratios such as: simple capital ratio, asset quality, management soundness, earnings,
liquidity, size and participation in the market. Besides, we have the non-performing loan (NPL)
ratiowhich is the dependent variable in the model. The detailed of these micro variables is
included in Table 3 of the Appendix.

5. Empirical results
5.1 Summary statistics and preliminary analysis
The advantages of using panel data relies on the increasing number of the sample size,
which allow to take into account different and complicated behavioural model and to control
time-constant unobserved features.
The panel data model will estimate the fragility of the bank as signal for problem in the
financial system. In this model, the Non Performing Lon Ratio (NPL) is the dependant variable.

Yit = +yit-1 + xMit +xmit + it i=1,...N t= 1,...T

Yit : dependant variable of bank i in month t (Non performing loan ratio (NPL)
xMit: a vector of de macroprudential variables
xmit: a vector of de microprudential variables.
We have N banks i={1,2,N} that we observe during T periods t={1,2,T}.

Stationarity properties of the variables

Considering the set of macro variables as time-serie data we use two tests: the Dickey
Fuller Augmented test and the Kwiatkowski, Phillips, Schmidt, and Shin (KPSS) Test. This later
differs from the other unit root tests due to its assumption that the variable is (trend-) stationary
under the null hypothesis. The summary of the results with optimal lags is shown in Table 4. The
real rate of Instrument of Regulatory Monetary (IRM) is stationary and for that reason is the first
variable to be excluded from the set.

Table 4
Unit root test for macroprudential data

Series Lag ADF KPSS Lag

Inflation Rate 0 -6.1941 0.146757 1
Growth of Import 0 -16.61312 0.169442 32
Growth of Exports 11 -4.492283 0.046033 8
Growth of Current Account Deficit 8 -4.495735 0.137894 3
Growth of international reserves 0 -9.83211 0.173584 9
Nominal exchange rate depreciation 0 -7.048959 0.137882 5
Real exchange rate depreciation 0 -7.90924 0.179602 4
Growth Monthly Indicator of Economic Activity (IMAE) 11 -9.760403 0.353556*** 62
Growth of External Debt 0 -9.744775 0.107067 3
 12

External debt/ exports 12 -1.112393 0.530171** 6

Real Credit growth in domestic money 0 -6.349046 0.07828 2
Real Credit growth in foreign money 0 -7.022414 0.143451 5
Growth of UST-bill 1 year 2 -3.919529 0.266305 6
Growth of Oil price 0 -8.928905 0.081811 0
Lending deposit rate spreads 0 -4.04164 0.325166 8
Real interest Rate (Central Bank IMR) 0 -2.097729 0.0588 8
* At 5%; ** At 5% (with trend); *** At 10%
Note: The sample period is from January 1995 to December 2003. ADF is the augmented Dickey-Fuller statistic and
the KPSS. The critical value for the ADF test statistics is -2.88 at 5% significance level and -2.58 at 10% significance
level and for the KPSS is: 0.463 at 5% and 0.347 a 10%.
The unit root test of the microeconomics variables were performed following the test of
In, Pesaran and Shin, IPS, (2002). IPS proposes a standardized t-bar test statistic based on the
ADF t-statistic averaged across groups. Where T differs across groups we have that:

Z t bar =
{
N t barNT N 1
N
i =1
}
E (tTi )
N
N 1 i =1
Var (tTi )

N
1
t barNT = tiTi
N i =1

Where E (tTi ) and Var (tTi ) are the asymptotic values of the mean and variance,
respectively, of the average ADF statistic which is tabulated for various lags and periods.
t barNT is the t-bar statistics formed as a simple average of the individual t statistic for testing
i = 0. When the errors are serially uncorrelated, independently and normally distributed across
individuals, the resulting "t-bar" test statistics is distributed as standard normal for large N
(number of individuals) and finite T (number of time periods). When the errors are serially
correlated and heterogeneous across individuals, the test statistics are valid as T and N go to
infinity (both N and T should be sufficiently large). The tests are consistent under the alternative
hypothesis that the fraction of the individual processes that are stationary is non-zero. The Monte
Carlo results showed that these tests perform very well even when T = 10. When the ADF
regressions has different lags (Li) for each group in finite samples, the term E (tTi ) and Var (tTi )
are replaced by the corresponding groups averages of the tabulated values of E (tTi , Li )
and Var (tTi , Li ) .
For this effective sample size, the unit root is rejected for most of the variables with the
exception of the variables G4 and G5 at IPS statistic at 1.65% at 5% (Table 5).

Table 5
Unit root test for microprudential data
Variables Ztbar
G1 -9.756049494
G2 -11.77451921
G3 -22.94271811
G4 1.614290617
G5 -0.516591617
K1 -3.508902381
K2 -2.615026794
L1 -5.306661401
 13

L2 -5.81472137
L3 -5.656880313
L4 -6.335294367
ROE -7.852453597
ROA -7.093386245
NPLFC -29.33881533
NPLLC -79.06401112
NPLT -45.856957
GASSER -839.866255
GDEPRE -573.0638032

Regressors correlation matrix

Tables 5 and 6 of the Appendix show the results of the correlation matrix, based on the
correlation coefficient and their results are a number between 1.0 and -1.0. If there is a perfect
positive linear relationship between two holdings, the correlation will be 1.0 and if there is a
perfect negative linear relationship between the two holdings, the correlation coefficient is -1.0. A
correlation coefficient of zero means that there is no linear relationship between the funds. The
correlation matrix for the micro variables is based on the simple annual average, which results in
the selection of G1, G2, G3, GDEPRE, K1, L1, L4 and ROE.

The inclusion of institutional and structural factors

In the period analysed the Paraguayan banking industry has been restructured. To that
effect, we introduce some dummies related to the introduction of new legal framework and the
institutional reorganization of the supervisor. On the other hand, there are 10 dummies regarding
the exit of the market of the banks for all who were intervened and close down and for those who
went into merger or voluntary dissolution. Also, there is a dummy represent the regional shock
like the Argentina tango effect in the Paraguayan banking industry. The detailed list of the
dummies variables are desribed in Table 4 of the Appendix.

4.2 Pooled estimates

Working with all variables selected after the unit root test and the correlation matrix, we
had performed the process of the selection of the model for the Paraguayan case. Taking the
whole sample we reject POLS relative to Fixed Effect (FE) Model with a LR statistic of
518.26(0.00); and the Hausman test statistic equal to 65.72 (0.00027) rejects the Random Effect
(RE) model relative to the FE. We performed the same procedure excluding the outliers9 and the
removal of outliers did not greatly affect them.
Running the first regression in FE approach we can see the most significant variables are
EDEX, GCAD, GDEB, GIMAE, GRIN, GUSTB for the macro set; and G1, K1, L4, LI1 and
ROA for the micro set. Then, we try several plausible lags (from 1 to a maximum of 12) for each
variable, and we select the optimal model, on the basics of the AIC and SBC criteria.
The selected model (Table 6) includes the following variables (lags are in parenthesis):
GCAD(4), GIMAE, LI1(6), K1(2), and ROA(12). All other variables including all dummies are
not relevant. The selected model estimated for the Paraguayan case has a deterministic time trend.
Table 6
Regression
Period: 1995:12-2003:12
Coefficient t-ratio
Growth rate of Current Account Deficit GCAD4 2.02E-02 2.758

9
The outliers were defined as any amount higher o lower than 1.96 standard deviation for each variable.
 14

Growth Monthly Indicator of Economic Activity GIMAE -8.84E-02 -2.638

(GIMAE)
Time trend T 0.165403 5.784
Total Equity/ Total Assets + Contingencies K1_2 0.75497 5.029
Liquid funds/total deposits LI1_6 -4.26E-02 -3.112
Return on Assets ROA_12 -0.24434 -2.008
Notes: The regression is estimated for the whole sample period and
including the whole sample. The method of estimation is FE model.

In a FE model the intercept differs among banks in recognition of the fact that each bank
may have some special characteristics on its own. Comparing to the average result of the whole
sample (see Table 7) we found that 62% of the banks are below of the average and from this
group: 23% are closed banks and 39% are operating banks. On the other hand, 38% of the banks
are over the average, in which 28% are closed bank. The 77% of current operating banks are in
the group below the average as we saw below.

Table 7
Intercepts of FE model
Bank Coefficient t-ratio
Parana S.A. 104.1409 17.89229
Amambay S.A. 28.29651 7.46418
Busaif S.A. 37.67574 6.86024
Unin S.A. 62.68663 6.30867
Paraguayo Oriental S.A. 27.60279 5.00153
Nacional de Fomento 4.65054 1.3699
ABN-AMRO Bank 4.605 1.05604
Finamerica S.A. 3.29062 0.78721
BANESPA 5.97057 0.63347
Inversiones S.A. 0.8074 0.14258
Real del Paraguay S.A. 0.59027 0.13883
Desarrollo S.A. 0.53996 0.09214
Bancoplus S.A.I.F. -1.63783 -0.34672
Citibank N.A. -1.78283 -0.49446
Itabank S.A. -3.42824 -0.60524
Corporacin S.A. -3.87813 -0.63781
Lloyds Bank PLC -2.26993 -0.63817
Asuncin S.A. -2.67306 -0.64602
Integracin S.A. -4.16591 -1.13577
I.N.G. Bank -6.54237 -1.3191
China Trust Commercial Bank -5.3003 -1.54247
Do Brasil S.A. -7.63466 -1.66654
BBVA Banco -6.43296 -1.70754
Aleman Paraguayo S.A -7.70996 -1.80786
Regional S.A. -7.46063 -1.99532
Nacin Argentina -7.46263 -2.00957
Multibanco S.A.E.C.A. -29.0737 -2.42259
Repub. Oriental del Uruguay -10.9655 -2.51013
Continental S.A. -9.48998 -2.62423
Interbanco S.A. -16.9223 -3.26348
Sudameris S.A. -15.9034 -3.91245
Average 0.53101968
 15

Heterogeneity issues
Performing the LR Test for the significance of unobserved FE effect in which the null
hypothesis states that there are not unobserved FE, against the alternative that there are
unobserved FE we have a LR equals to 577.674 (0.00), which indicates that there is a significant
unobserved fixed effects in the model. On the other hand, the RCM Homogeneity Test strongly
rejects equality of coefficients across all banks (individual banks are significantly different); the
test statistic is 41.71 (0.000001).

Marginal effects
Among the macro indicators the selected one include, lags are in parenthesis: the Growth
rate of Current Account Deficit (GCAD-4) and the Growth Monthly Indicator of Economic
Activity (GIMAE). Those two factor are illustrative to measure the impact the external and real
sector of the Paraguayan economy in the banking system. It is expected the negative signs of
these variables because a decreasing economic activity will affect in the increasing ratio of the
Non Performing Loans. Further, in this case we have the external sector has impact with 4 lags
while the real sector has an immediate impact. For each 100 increment in growth of the increment
of the current account deficit, there is a increase of 20.2% in the NPL ratio, and each time that the
decreasing activity is by 1%, the NPL tends to increase in 88.4%.
The set of micro variables selected includes the simple capital ratio K1(-2), the liquidity
ratios measured as Liquid funds/total deposits LI1(-6) and the Return on Assets ROA(-12). In
general, it is expected a negative sign for K1 and ROA and a positive sign for the liquidity ratio.
The increment of capital and earnings should make banks more conservative in the credit risk
allocation. Also, banks with more funds to borrow tend to increment their credits to the market
with the consequences of the increase in the NPLR.
In the model, the signs of the liquidity ratio and the one of the ROA are corrects. A
remarkable fact is the case of the capital ratio, as we see in the Paraguayan case, there was not a
better process of credit risk management during this period. And even with the increment of
capital adequacy ratio stated by the Superintendency of Banks, such increment was one of the
factor that make NPLR increase.

6. Policy implications

As we see in the preceding section, the model selected for the Paraguayan case reflects
that the fragility of each entity is more related to the behaviour of the financial company; in other
words, this implies that is mainly concerned to the microprudential variables. Considering the
traditional banking system in the Paraguayan case, there should be a reengineering of the
management of the credit risk, not only from the supervisor side but also from the banking
industry. Besides, most of the actions plans must encourage to minimise the fragility of the
banking system; and for that they must emphasise the market discipline and to strength all
policies of credit management.
By the side of the macrovariables, there is a negative impact of the real sector and the
Current Account Deficit. Therefore, the macroeconomics policies need to point out to the
economic reactivation and to increase of the competitiveness. The shock of these macro variables
are immediate when there is recession and with a lag of very short term (4 months) from the loss
of competitiveness.
To that effect, the policies to strength the health of the financial system must combine
macro and micro actions inside a local market that must be featured by discipline and
transparency. These policies must lead to a proactive action of all agents involved in the financial
sector.
 16

7. Concluding remarks
This paper has assessed the potential macro and micro impacts in the fragility of the
Paraguayan banking system to draw a EWS based on a panel data. Like mentioned, there is a very
short term impacts of the macro and micro indicators. In the selected model of this paper, which
can be a starting point for a dynamic models of early warning in the Paraguayan case, there are
some key finding such as: the return in equity (ROE) has 1 year lag, nevertheless all the other
variables such as GCAD(4), GIMAE, LI1(6), K1(2) demonstrated to impact in the NPLR in a
period equal or less than 6 months of lags. In summary, the empirical evidence in the Paraguayan
case address to the conclusion that the bank fragility increases (due to the increment of the
NPLR) when the country faces a recession in the real sector and the shock is immediate; also, the
schock of the deficit in current account is a increment of the NPLR after four months lags.
Besides, the increase of liquidity measured as the ratio of liquidity/deposits has an impact after 6
months, whereas the simple ratio of capital with 2 lags.
As suggestions for future researches, in the field of EWS for the Paraguayan financial
system, is the inclusion of qualitative factors and information of the on site inspection besides the
macro indicators and the financial ratios. On the other hand, the elaboration of a EWS for each
financial intermediary, or at least by peer groups, can help to the robustness of a more complete
EWS. Further, a dynamic model that constantly updates the data base and the results is another
detail to consider in the matter of elaboration of the EWS for Paraguay.

References

Berg, A. and C. Pattillo, 1999a. Are Currency Crises Predictable? A Test, IMF Staff Papers
46, 107-38.
Berg, A. and C. Pattillo, 1999b. Predicting Currency Crises: The Indicators Approach and an
Alternative, Journal of International Money and Finance 18, 561-86.
Berg, A., E. Borensztein and C. Pattillo, 2001. Assessing Early Warning Systems: How Have
They Worked in Practice?, IMF mimeo.
Berger, A. N., Sally M. D. and M. J. Flannery, 2000. Comparing Market and Supervisory
Assessments of Bank Performance: Who Knows What When? Journal of Money, Credit,
and Banking 32 , 64167.
Brewer, E., W. Jackson, J. Jagtiani, and T. Nguyen, 2000. The price of bank mergers in the
1990s, Economic Perspectives, Federal Reserve Bank of Chicago, 223.
Bussiere, M. and C. Mulder, 1999. External Vulnerability in Emerging Market Economies:
How High Liquidity Can Offset Weak Fundamentals and the Effects of Contagion, IMF
Working Paper 88.
Bussiere M., and M. Fratzscher, 2002, Towards a New Early Warning System of Financial
Crises, European Central Bank Working Paper 145..
Calvo, G. A., and E. Mendoza, 2000. Rational Contagion and the Globalization of Securities
Markets. Journal of International Economics 51, 79-113.
Christiano, L., C. Gust and J. Rolds, 2004. Monetary Policy in a Financial Crisis, Journal of
Economic Theory, forthcoming.
Cohen, D., 1991 Private Lending to Sovereign States: A Theoretical Autopsy (Cambridge,
Massachusetts: MIT Press).
Cole, R., and J. Gunther, 1998. Predicting bank failures: A comparison of on- and off-site
monitoring systems, Journal of Financial Services Research 13, 102117.
Cole, R., B. Cornyn, and J. Gunther, 1995. FIMS: A new monitoring system for banking
institutions, Federal Reserve Bulletin, Board of Governors of the Federal Reserve System,
January, pp. 115.
Credit Suisse First Boston, 2001. Emerging Market Risk Indicator: Re-estimated Version
September 2000, by Amlan Roy and Maria M. Tudela, February 2001.
 17

Crockett, Andrew, 2000. Marrying the micro- and macro-prudential dimensions offinancial
stability, Eleventh International Conference of Banking Supervisors, Basel, September
2000.
Dabos, M. and Sosa-Escudero, W., 2000. Explaining and Predicting Bank Failure in Argentina
using Duration Models. Universidad de San Andres, Mimeo.
Demirguc-Kunt, A., and E. Detragiache, 1998. The Determinants of Banking Crises in
Developing and Developed Countries, IMF Staff Papers 45.
Demirguc-Kunt, A. and E. Detragiache, 2000. Monitoring Banking Sector Fragility: A
Multivariate Logit Approach, World Bank Economic Review 14, 287-307.
Deutsche Bank (2000). Deutsche Bank Alarm Clock: Forecasting Exchange Rate and Interest
Rate Events in Emerging Markets, by Peter Garber, Robin L. Lumsdaine, and Marco van
der Leij.
Dornbusch and Reynoso, 1989. Financial factors in economic development. American
Economic Review 79, 204209
Edison, H. J., 2000. Do Indicators of Financial Crisis Work? An Evaluation of an Early
Warning System, International Finance Working Paper No. 675, Board of Governors of the
Federal Reserve System.
Eichengreen, Barry, Andrew Rose and Charles Wyplosz, 1995. Exchange Market Mayhem:
The Antecedents and Aftermaths of Speculative Attacks, Economic Policy, 21, pp. 249-
312.
Estrella, A., S. Park, and S. Peristiani, 2000. Capital ratios as predictors of bank failure,
Economic Policy Review, Federal Reserve Bank of New York, Vol. 6, No. 2, July, pp. 33
52.
FDIC, 2002. Audit Report No. 02-033 . Statistical CAMELS Offsite Rating
Review Program for FDIC-Supervised Banks. Office of General Inspector September 26,
2002. Available in http://www.fdicoig.gov/2002_a_reports.asp.
Flood, Robert P., Nancy P. Marion. 1998. Perspectives on the Recent Currency Crises
Literature. NBER Working Paper No. 6380..ECB Working Paper No 145 May 2002
Flood, Robert, and Nancy Marion, 2001. A Model of the Joint Distribution of Banking and
Exchange Rate Crises, IMF Working Paper No. 01/213 (Washington: International
Monetary Fund).
Forbes, Kristin and Roberto Rigobon, 1999. No Contagion, only Interdependence, NBER
Working Paper No. 7267.
Frankel, Jeffrey and Andrew Rose, 1996. Currency Crashes in emerging Markets: an
Empirical Treatment, Journal of International Economics, 41, pp. 351-66.
Fuertes, Ana Maria and Coakely Jerry, 1997. New panel unit root test of PPP. Economics
Letter 57 (1997) 17-22.
Gilbert, A., A. Meyer, and M. Vaughan, 1999. The role of supervisory screens and
econometric models in off-site surveillance. Review, Federal Reserve Bank of St. Louis,
November/December, pp. 3156.
Goldman Sachs, 1998. GS-Watch: A New Framework for Predicting Financial Crises in
Emerging Markets, by Alberto Ades, Rumi Masih, and Daniel Tenengauzer, December
1998.
Goldstein, Morris, Graziela L. Kaminsky and Carmen M. Reinhart, 2000. Assessing Financial
Vulnerability, An Early Warning System for Emerging Markets, June 2000, Institute for
International Economics.
Gonzalez-Hermosillo, Brenda, 1999. Determinants of Ex-Ante Banking System Distress: A
Macro-Micro Empirical Exploration of Some Recent Episodes,IMF Working Paper No.
99/33 (Washington: International Monetary Fund).
 18

Gunther, J., and R. Moore, 2000. Early warning models in real time, Federal Reserve Bank of
Dallas, Financial Industry Studies, working paper, No. 1-00, October.
Herrera, Santiago and Garcia Conrado, 1999. A Users guide to an Early Warning System of
Macroeconomic. Vulnerability for LAC Countries. Paper presented in the XVII LA
meeting of the Econometric Society.
Hunter, W. C., J. Verbrugge, and D. Whidbee, 1996. Risk taking and failure in de novo
savings and loans in the 1980s, Journal of Financial Services Research, Vol. 10, pp. 235
272.
IMF Survey, 2001. Economic Forum. Early warning systems: fad or reality?, Volume 30.
Number 21. November 12, 2001. Page 347
IMF, 2002 Early Warning Systems Models: The Next Steps Forward Current EWS models at
the IMF. EWS: A Way Forward. Chapter 4 in Global Financial Stability Report. A
Quarterly Report on Market Developments and Issues. March 2002. Page 48-64
J.P. Morgan, 1998. Event Risk Indicator Handbook, by Avinash D. Persaud, May 1998.
Kamin, Steven, 1999, The Current International Financial Crisis: How Much Is New ?,
Journal of International Money and Finance; 18(4), August 1999, pp. 501-514.
Jagtiani, Julapa, James Kolari, Catharine Lemieux, and Hwan Shin. 2003. Early Warning
Models for Bank Supervision: Simpler Could Be Better. Federal Reserve Bank of
Chicago Economic Perspectives (Quarter 3): 4960
Kamin, Steven and Oliver Babson, 1999. The Contribution of Domestic and External Factors
to Latin American Devaluation Crises: An Early Warning Systems Approach, Board of
Governors of the Federal Reserve System.
Kamin, Steven, John Schindler, and Shawna Samuel, 2001. The Contribution of Domestic and
External Factors to Emerging Market Devaluation Crises: An Early Warning Systems
Approach, International Finance Working Paper No. 711, Board of Governors of the
Federal Reserve System.
Kaminsky Graciela L., Saul Lizondo and Carmen M. Reinhart, 1998. Leading Indicators of
Currency Crises, IMF Staff Papers, 45, No. 1, pp. 1-48..ECB Working Paper No 145
May 2002 42
Kaminsky, Graciela L. and Carmen M. Reinhart, 1999. The Twin Crises: The Causes of
Banking and Balance-of-Payments Problems, American Economic Review; 89(3), June
1999, pp. 473-500.
Kaminsky, Graciela L. and Carmen M. Reinhart, 1998. Financial Crises in Asia and Latin
America: Then and Now, American Economic Review, Papers and Proceedings; 88(2),
May 1998, pp. 444-48.
Kaminsky, Graciela L. and Carmen M. Reinhart, 2000. On Crises, Contagion, and Confusion;
Journal of International Economics; 51(1), June 2000, pp. 145-68.
Kolari, J., D. Glennon, H. Shin, and M. Caputo, 2002. Predicting large U.S. commercial bank
failures, Journal of Economics and Business, Vol. 54, No. 4, July/August, pp. 361387.
Kolari, J., M. Caputo, and D. Wagner, 1996. Trait recognition: An alternative approach to
early warning systems in commercial banking, Journal of Business, Finance, and
Accounting, Vol. 23, pp. 14151434.
Krainer, J., and J. Lopez, 2003. Using equity market information to monitor banking
institutions, Economic Letter, Federal Reserve Bank of San Francisco, January 24.
Krugman, Paul, 1979. A Model of Balance-of-Payments crises, Journal of Money, Credit and
Banking, Vol. 11 (August), pp. 311-25.
Milesi-Ferretti, Gian-Maria and Assaf Razin, 1996. Persistent Current Account Deficits: A
Warning Signal ?, International Journal of Finance and Economics, 1, pp. 161-181 (1996).
Morgan Stanley Dean Witter, 2001. An Early Warning System for Currency Crises, by Karin
Kimbrough and Stephen Li Jen, July 2001.
Number 634, April 1999.
 19

Office of the Comptroller of the Currency, 2001. Examiners Guide to Problem Bank
Identification, Rehabilitation, and Resolution, Washington, DC.
Im, Kyung So, Pesaran Hashen and Shin Yongcheol, 2002. Testing for Unit Roots in
Heterogeneous Panels.
Rojas-Suarez, L., 1998. Early Warning Indicators of Banking Crises: What Works for
Emerging Markets? Paper presented at the January 1998 Meetings of the Allied Social
Sciences Association, Chicago. Inter-American Development Bank, Washington D.C.
Sachs, Jeffrey, Aaron Tornell and Andres Velasco, 1996. Financial Crises in Emerging
Markets: The Lessons from 1995, Brookings Papers on Economic Activity; 10(1), 1996:
147-98.
Sachs, Jeffrey, Aaron Tornell and Andres Velasco, 1996. The Mexican Peso Crisis: Sudden
Death Or Death Foretold ?, Journal of International Economics 41 (1996), pp. 265-283.
Sahajwala, Ranjana and Van den Bergh, Paul, 2002. Supervisory Risk Assessment and Early
Warning Systems. Bank for International Settlement, Working Papers No. 4 December
2000
Schnatz, Bernd, 1998. Macroeconomic Determinants of currency turbulences in emerging
markets, Discussion paper 3/98, Economic Research Group of the Deutsche Bundesbank,
September 1998.
Schnatz, Bernd, 1999. The Sudden Freeze of the Asian Miracle: The Role of Macroeconomic
Fundamentals, Asia Pacific Journal of Finance, Volume 2, Issue 1, May 1999.
Sprayregen, Richard, 2002. Predicting the Future for Fun and Profitability. In Banking Point
View. Financial Institutions Moss Adams LLP, Los Angeles. Spring 2002
Thomson, J., 1991, Predicting bank failures in the 1980s, Economic Review, Federal Reserve
Bank of Cleveland, Vol. 27, First Quarter, pp. 920.
Thorne, A., 1993. Eastern Europes' s experience with banking reform: Is there a role for banks
in the transition. Journal of Banking and Finance 17 (1993), pp. 9591000
Tornell, Aaron, 1999. Common Fundamentals in the Tequila and Asian Crises, National
Bureau of Economic Research Working Paper, 7139, May 1999.
Van Rijckeghem, Caroline, and Beatrice Weder, 1999. Sources of Contagion: Finance or
Trade? International Monetary Fund Working Paper No. 146.
Weber, Axel A., 1997. Sources of Currency Crises: An Empirical Analysis, Universitaet
Bonn, Discussion Paper No. B-418.
Wentzler, N., S. Hiemstra, and K. Jacques, 2001. Contagion effects, macroeconomic
conditions and the probability of bank failure, Office of the Comptroller of the Currency,
working paper.
Whalen, G., 1991. A proportional hazards model of bank failure: An examination of its
usefulness as an early warning tool, Economic Review, Federal Reserve Bank of
Cleveland, First Quarter, pp. 2131.
Wheelock, D., and P. Wilson, 2000. Why do banks disappear? The determinants of U.S. bank
failures and acquisitions, Review of Economics and Statistics, Vol. 82, pp. 127138.
Zanello, Alessandro and Dominique Desruelle, 1997. A Primer on the IMF' s Information
Notice System, IMF Working Paper, WP 97/71.ECB.
 20

Table 1
Sample of banks and period*
N Bank Start End T
1 Citibank N.A. Dec-95 Dec-03 97
2 Lloyds Bank PLC Dec-95 Dec-03 97
3 ABN-AMRO Bank Dec-95 Dec-03 97
4 Do Brasil S.A. Dec-95 Dec-03 97
5 Nacin Argentina Dec-95 Dec-03 97
6 Interbanco S.A. Dec-95 Dec-03 97
7 Integracin S.A. Dec-95 Dec-03 97
8 Continental S.A. Dec-95 Dec-03 97
9 Regional S.A. Dec-95 Dec-03 97
10 Amambay S.A. Dec-95 Dec-03 97
11 Nacional de Fomento Dec-95 Dec-03 97
12 Sudameris S.A. Dec-95 Dec-03 97
13 BBVA Banco Dec-95 Dec-03 97
16 China Trust Commercial Bank** Oct-96 Dec-03 87

14 Aleman Paraguayo S.A Dec-95 May-02 77

15 Asuncin S.A. Dec-95 Aug-03 92
17 Multibanco S.A.E.C.A. Dec-95 Apr-03 89
18 Repub. Oriental del Uruguay May-97 May-02 61
19 I.N.G. Bank Dec-95 Jun-03 89
20 Real del Paraguay S.A. Dec-95 Apr-99 41
21 Bancoplus S.A.I.F. Dec-95 May-01 66
22 BANESPA Dec-95 May-01 65
23 Unin S.A. Dec-95 Jun-97 19
24 Inversiones S.A. Dec-95 Jun-97 19
25 Corporacin S.A. Dec-95 Jul-98 32
26 Itabank S.A. Dec-95 Jun-98 31
27 Paraguayo Oriental S.A. Dec-95 Sep-98 34
28 S S Bank Dec-95 Sep-98 34
29 Desarrollo S.A. Dec-95 Sep-98 34
30 Finamerica S.A. Dec-95 Jul-98 32
31 Parana S.A. Dec-95 Nov-03 90
32 Nacional de Trabajadores Dec-95 Aug-98 33
*This sample excludes some banks with problem before 1995 such as: Bco. General,
Bancopar, Bancosur, Bco. Mercantil, Corfan.
** It is an operating banking.
 21

Table 2
List of Macroprudential Variables

External Sector
GIMP Growth rate of Import
GEXP Growth rate of Exports
GCAD Growth rate of Current Account Deficit
DEPNER Nominal exchange rate depreciation
DEPRER Real exchange rate depreciation
EDEX External debt/ exports
GRIN Growth rate of international reserves
Fiscal Sector
GDEB Growth rate of External Debt
Monetary Sector
GCMLR Real Credit growth rate in domestic money
LDRAR Lending deposit rate spreads
GCMER Real Credit growth rate in foreign money
World Economy Indicators
GUSTB Growth rate of US T-bill 1 year
GOILP Growth rate of Oil price
Real Sector
INFM Inflation Rate
GIMAE Growth Monthly Indicator of Economic Activity (IMAE)
 22

Table 3
List of Microprudential variables

Variables
Earnings ratio
ROA Return on Assets
ROE Return on Equity
Liquidity and size ratios
L1 Liquid funds*/total deposits
L2 Liquid funds*/total liabilities
L3 Total Assets/ Liabilities
L4 Total Assets/ Liabilities + Contingencies
Capital ratios
K1 Total Equity/ Total Assets + Contingencies
K2 Total Assets + Contingencies/ Total equities
Overhead expenses
G1 Personnel Expense/ Overhead Expense**
G2 Personnel Expense/ Operative Margin
G3 Overhead Expense** / Operative Margin
G4 Personnel Expense/ Total Deposits
G5 Overhead Expense / Total Deposits
Structure and market
GASSER Growth of real assets
GDEPRE Growth of real deposits

*Liquid funds includes Cash + short term Investment

**Overhead expense includes salaries & benefits, occupancy expense and other
operating expenses
 23

Table 4

Dummies Variables
Dummies for banks exit of the market
du1 Jun-97 Intervention of Banks: UNION, BIPSA,
du2 Jul-98 Intervention of Banks: ITABANK, ORIENTAL, FINAMERICA
du3 Aug-98 Exit of Bank: CORPORATION
du4 Sep-98 Intervention of Banks: DESARROLLO, SSB
du5 Feb-00 Exit of Bank: REAL DEL PARAGUAY
du6 Jul-01 Exit of: BANESPA
du7 Jun-02 Intervention of Bank: ALEMAN and exit of BROU
du8 Jul-03 Exit of ING. BANK S.A.
du9 Sep-03 Exit of MULTIBANCO SAECA
du10 Oct-03 Exit of BANCO ASUNCION S.A.
Dummies for structural changes
du12 May-96 Change in legal framework. New banking law
du13 Feb-98 Reorganization of the SIB
du14 April - Dec 2001 Monitoring of IMF
Dummies for regional shocks
du15 Jan- 2002 Argentina tango effect
24
Table 5
Correlation Matrix for Macro Data
INFM GIMP GEXP GCAD GPDG GRIN DEPNER DEPRER GIMAE
INFM 1.00 - 0.03 0.32 - 0.25 0.12 - 0.11 0.15 - 0.02 0.20
GIMP - 0.03 1.00 0.29 0.46 - 0.14 0.08 - 0.11 - 0.06 0.03
GEXP 0.32 0.29 1.00 - 0.26 - 0.05 - 0.05 - 0.07 - 0.16 0.15
GCAD - 0.25 0.46 - 0.26 1.00 - 0.04 0.06 - 0.10 0.02 - 0.07
GPDG 0.12 - 0.14 - 0.05 - 0.04 1.00 - 0.03 0.30 0.27 - 0.06
GRIN - 0.11 0.08 - 0.05 0.06 - 0.03 1.00 - 0.09 - 0.11 0.19
DEPNER 0.15 - 0.11 - 0.07 - 0.10 0.30 - 0.09 1.00 0.93 - 0.18
DEPRER - 0.02 - 0.06 - 0.16 0.02 0.27 - 0.11 0.93 1.00 - 0.22
GIMAE 0.20 0.03 0.15 - 0.07 - 0.06 0.19 - 0.18 - 0.22 1.00
GDEB - 0.11 0.02 - 0.15 0.02 0.00 0.63 0.18 0.15 0.13
EDEX 0.14 - 0.27 - 0.33 - 0.07 - 0.08 - 0.14 0.13 0.13 0.16
GCMLR - 1.00 0.02 - 0.32 0.24 - 0.13 0.11 - 0.14 0.03 - 0.20
GCMER - 0.15 0.11 0.07 0.10 - 0.30 0.09 - 1.00 - 0.93 0.18
GUSTB 0.02 - 0.02 0.17 - 0.17 - 0.13 0.04 - 0.13 - 0.10 - 0.02
GOILP 0.14 0.14 0.06 0.11 - 0.15 0.01 - 0.08 0.01 0.14
LDRAT - 0.02 - 0.09 0.05 - 0.09 0.14 0.00 0.27 0.23 - 0.11
IRM 0.24 - 0.04 0.07 - 0.04 0.20 0.03 0.28 0.20 0.05
b. Correlation among selected variables
GDEBT EDEX GCMLR GCMR GUSTB GOILP LDRAT IRM
INFM - 0.11 0.14 - 1.00 - 0.15 0.02 0.14 - 0.02 0.24
GIMP 0.02 - 0.27 0.02 0.11 - 0.02 0.14 - 0.09 - 0.04
GEXP - 0.15 - 0.33 - 0.32 0.07 0.17 0.06 0.05 0.07
GCAD 0.02 - 0.07 0.24 0.10 - 0.17 0.11 - 0.09 - 0.04
GPDG 0.00 - 0.08 - 0.13 - 0.30 - 0.13 - 0.15 0.14 0.20
GRIN 0.63 - 0.14 0.11 0.09 0.04 0.01 0.00 0.03
DEPNER 0.18 0.13 - 0.14 - 1.00 - 0.13 - 0.08 0.27 0.28
DEPRER 0.15 0.13 0.03 - 0.93 - 0.10 0.01 0.23 0.20
GIMAE 0.13 0.16 - 0.20 0.18 - 0.02 0.14 - 0.11 0.05
GDEB 1.00 0.09 0.11 - 0.18 - 0.08 0.19 0.02 - 0.03
EDEX 0.09 1.00 - 0.14 - 0.13 - 0.02 0.08 - 0.01 0.08
GCMLR 0.11 - 0.14 1.00 0.14 - 0.02 - 0.14 0.01 - 0.25

* This paper was written while Zulma Espnola was a visiting scholar at the Faculty of Finance of Cass Business School. The authors gratefully acknowledge the
comments of Shellagh Heffernan, Walter Sosa-Escudero, Carlos Fernandez-Valdovinos. They are also grateful to all Central Bank Officers of the Office of
Economic Studies and the Superintendency of Banks of the Central Bank of Paraguay for providing the data. Zulma Espinola gratefully acknowledges partial
financial support for this research from the British Chevening Scholarships of the Foreign and Commonwealth Office.
 1

GCMER - 0.18 - 0.13 0.14 1.00 0.13 0.08 - 0.27 - 0.28

GUSTB - 0.08 - 0.02 - 0.02 0.13 1.00 0.18 0.04 - 0.20
GOILP 0.19 0.08 - 0.14 0.08 0.18 1.00 - 0.03 0.03
LDRAT 0.02 - 0.01 0.01 - 0.27 0.04 - 0.03 1.00 0.23
IRM - 0.03 0.08 - 0.25 - 0.28 - 0.20 0.03 0.23 1.00
 2

Table 6
Correlation Matrix of Microprudential Data
G1 G2 G3 GASSR GDEP K1 K2 L1 L2 L3 L4 RNPL ROA ROE
RE
G1 1.000 0.255 0.240 0.044 0.005 0.417 -0.428 0.059 0.001 0.532 -0.274 -0.628 0.313 0.368
G2 0.255 1.000 0.999 0.114 0.166 0.577 -0.646 0.165 0.144 0.490 0.139 -0.093 -0.109 0.031
G3 0.240 0.999 1.000 0.139 0.190 0.560 -0.633 0.189 0.170 0.468 0.149 -0.068 -0.139 0.002
GASSRE 0.044 0.114 0.139 1.000 0.996 -0.513 0.420 0.997 0.997 -0.563 0.093 0.653 -0.892 -0.891
GDEPRE 0.005 0.166 0.190 0.996 1.000 -0.498 0.404 0.996 0.999 -0.552 0.100 0.681 -0.901 -0.898
K1 0.417 0.577 0.560 -0.513 -0.498 1.000 -0.980 -0.472 -0.500 0.935 0.185 -0.735 0.460 0.603
K2 -0.428 -0.646 -0.633 0.420 0.404 -0.980 1.000 0.373 0.406 -0.903 -0.177 0.698 -0.366 -0.530
L1 0.059 0.165 0.189 0.997 0.996 -0.472 0.373 1.000 0.998 -0.518 0.069 0.626 -0.890 -0.879
L2 0.001 0.144 0.170 0.997 0.999 -0.500 0.406 0.998 1.000 -0.553 0.088 0.670 -0.907 -0.903
L3 0.532 0.490 0.468 -0.563 -0.552 0.935 -0.903 -0.518 -0.553 1.000 -0.157 -0.870 0.627 0.748
L4 -0.274 0.139 0.149 0.093 0.100 0.185 -0.177 0.069 0.088 -0.157 1.000 0.323 -0.388 -0.340
RNPLT -0.628 -0.093 -0.068 0.653 0.681 -0.735 0.698 0.626 0.670 -0.870 0.323 1.000 -0.779 -0.860
ROA 0.313 -0.109 -0.139 -0.892 -0.901 0.460 -0.366 -0.890 -0.907 0.627 -0.388 -0.779 1.000 0.978
ROE 0.368 0.031 0.002 -0.891 -0.898 0.603 -0.530 -0.879 -0.903 0.748 -0.340 -0.860 0.978 1.000

G1 G2 G3 GDEPRE K1 L1 L4 RNPLT ROE

G1 1.000 0.255 0.240 0.005 0.417 - 0.274 - 0.628 0.368
0.059
G2 0.255 1.000 0.999 0.166 0.577 0.139 - 0.093 0.031
0.165
G3 0.240 0.999 1.000 0.190 0.560 0.149 - 0.068 0.002
0.189
GDEPRE 0.005 0.166 0.190 1.000 - 0.498 0.100 0.681 - 0.898
0.996
K1 0.417 0.577 0.560 - 0.498 1.000 - 0.472 0.185 - 0.735 0.603
L1 0.059 0.165 0.189 0.996 - 0.472 0.069 0.626 - 0.879
1.000
L4 - 0.274 0.139 0.149 0.100 0.185 1.000 0.323 - 0.340
0.069
RNPLT - 0.628 - 0.093 - 0.068 0.681 - 0.735 0.323 1.000 - 0.860
0.626
ROE 0.368 0.031 0.002 - 0.898 0.603 - 0.879 - 0.340 - 0.860 1.000
3