There’s one thing all countries learned in the recent crisis: problems in the financial system can have devastating consequences for economic health.

In the wake of the crisis, the IMF has strengthened its surveillance of countries’ financial systems. Since 1999 the IMF has monitored countries’ financial sectors on a voluntary basis through a joint review process with the World Bank called the Financial Sector Assessment Program.

In September 2010, in response to the global crisis, the IMF’s Executive Board agreed the world’s top 25 financial sectors would undergo a mandatory financial check-up every five years.

2012 will be a busy year as the IMF plans to evaluate 18 countries’ financial health—ranging from France and Spain to Argentina and Armenia— to spot any potential trouble on the horizon. The IMF then produces a detailed report that includes recommendations for the country on how to strengthen its financial stability.

Amid a gloomy global economic outlook, the IMF will focus its attention on potential risks in large, interconnected financial sectors including some G-20 countries, such as Australia, Brazil, and Japan (see box).

“Our larger shareholders have agreed to submit themselves to more extensive, regular, and mandatory surveillance and the Financial Sector Assessment Program is proof,” said Dimitri Demekas, an assistant director in the IMF’s Monetary and Capital Markets Department, which manages the program.

Goal is financial stability

The IMF’s Financial Sector Assessment Program assesses three key components in all countries: the soundness of banks and other financial institutions, including through stress tests; the quality of bank, insurance, and financial market supervision; and the ability of supervisors, policymakers, and financial safety nets to respond effectively in case of a crisis.

One size does not fit all in these assessments, and the IMF tailors its focus in each of these areas to a country’s individual circumstances and takes into account the potential sources that might make the country in question vulnerable.

The objective is to assess countries’ crisis prevention and management frameworks, with the goal of supporting both national and global financial stability.

While the emphasis will be on larger countries, especially those required to undergo assessments under the IMF’s new policy, the smaller jurisdictions the IMF plans to visit in 2012 face their own challenges.

Given the growing reach of global banks, the IMF closely examines cross-border supervisory cooperation arrangements. In countries where foreign-owned banks are systemically important, it is essential that the host country supervisor has enough tools and good communications with the parent banks’ regulators.

Specific, actionable recommendations

The IMF’s financial assessments provide countries with specific, actionable recommendations on how to reduce risks, improve supervision, and strengthen crisis management. Each report has a table with key recommendations, and rates them according to priority and time-frame for implementation.

Countries are free to implement or not, but the IMF follows up and monitors countries’ implementation.

Demekas said roughly 60 percent of the IMF’s recommendations in the Financial Sector Assessment Program are found to be either fully or partially implemented in subsequent assessments.

New methods for new risks

The IMF learned a number of lessons from the crisis that began in 2008, and has expanded its risk assessments to cover a broader range of potentially vulnerable elements in the financial sector. New tools for stress testing both capital adequacy and liquidity risk have been developed, stress testing is being applied to financial institutions other than banks, and models are being designed that can be applied consistently in all assessments under the program.

The IMF is also more focused on how problems in one country can affect others, along with the connections between financial institutions. The IMF, among others, is developing what are known as network models to try and understand how events in one financial institution, market, or country will impact others.

“Evaluating the potential for regional and global spillovers is now given much greater emphasis in our assessments,” said Demekas.

Under the microscope

In the wake of the collapse of U.S. investment bank Lehman Brothers in 2008, crisis management arrangements are also under the microscope, along with how countries can prepare for a crisis.

The experience of the United States and other big financial sectors as they coped with the massive shock to their funding markets during the crisis holds a number of lessons for other countries, which the IMF is now using in its assessments.

The IMF’s financial assessments identify gaps and provide advice to countries on how to fix them. Often specific legal tools don’t exist, and need to be written into domestic legislation.

Getting all the financial supervisors and regulators to cooperate if something does go wrong is key.

“Countries need a protocol of cooperation, data and information exchange, as well as a game plan if a crisis occurs, and a key part of our assessments is to try and make sure that governments have the essential ingredients,” said Demekas.