- International Monetary Fund. Monetary and Capital Markets Department
- Published Date:
- May 2010
© 2010 International Monetary Fund
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Global financial stability report–Washington, DC: International Monetary Fund, 2002 –
v. ; cm. — (World economic and financial surveys, 0258-7440)
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1. Capital market — Developing countries — Periodicals. 2. International finance — Periodicals. 3. Economic stabilization — Periodicals. I. International Monetary Fund. II. Title. III. World economic and financial surveys.
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[The following supplemental annexes to Chapter 1 are available online at http://www.imf.org/external/pubs/ft/gfsr/2010/01/index.htm]
Annex 1.6. Analyzing Nonperforming Loans in Central and Eastern Europe Based on Historical Experience in Emerging Markets
Annex 1.7. Credit Demand and Capacity Estimates in the United States, Euro Area, and United Kingdom
Annex 1.8. The Effects of Large-Scale Asset Purchase Programs
Annex 1.9. Methodologies Underlying Assessment of Bubble Risks
Annex 1.10. Euro Zone Sovereign Spreads: Global Risk Aversion, Spillovers, or Fundamentals?
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As used in this volume the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.
The boundaries, colors, denominations, and any other information shown on the maps do not imply, on the part of the International Monetary Fund, any judgment on the legal status of any territory or any endorsement or acceptance of such boundaries.
The Global Financial Stability Report (GFSR) assesses key risks facing the global financial system with a view to identifying those that represent systemic vulnerabilities. In normal times, the report seeks to play a role in preventing crises by highlighting policies that may mitigate systemic risks, thereby contributing to global financial stability and the sustained economic growth of the IMF’s member countries. Although global financial stability has improved, the current report highlights how risks have changed over the last six months, traces the sources and channels of financial distress, and provides a discussion of policy proposals under consideration to mend the global financial system.
The analysis in this report has been coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of José Viñals, Financial Counsellor and Director. The project has been directed by MCM staff Jan Brockmeijer, Deputy Director; Peter Dattels and Laura Kodres, Division Chiefs; and Christopher Morris, Matthew Jones and Effie Psalida, Deputy Division Chiefs. It has benefited from comments and suggestions from the senior staff in the MCM department.
Contributors to this report also include Sergei Antoshin, Chikako Baba, Alberto Buffa di Perrero, Alexandre Chailloux, Phil de Imus, Joseph Di Censo, Randall Dodd, Marco Espinosa-Vega, Simon Gray, Ivan Guerra, Alessandro Gullo, Vincenzo Guzzo, Kristian Hartelius, Geoffrey Heenan, Silvia Iorgova, Hui Jin, Andreas Jobst, Charles Kahn, Elias Kazarian, Geoffrey Keim, William Kerry, John Kiff, Annamaria Kokenyne, Vanessa Le Lesle, Isaac Lustgarten, Andrea Maechler, Kazuhiro Masaki, Rebecca McCaughrin, Paul Mills, Ken Miyajima, Sylwia Nowak, Jaume Puig, Christine Sampic, Manmohan Singh, Juan Solé, Tao Sun, Narayan Suryakumar, and Morgane de Tollenaere. Martin Edmonds, Oksana Khadarina, Yoon Sook Kim, and Marta Sanchez Sache provided analytical support. Shannon Bui, Nirmaleen Jayawardane, Juan Rigat, and Ramanjeet Singh were responsible for word processing. David Einhorn of the External Relations Department edited the manuscript and coordinated production of the publication.
This particular issue draws, in part, on a series of discussions with banks, clearing organizations, securities firms, asset management companies, hedge funds, standard setters, financial consultants, and academic researchers. The report reflects information available up to March 2010 unless otherwise indicated.
The report benefited from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussion of the Global Financial Stability Report on April 5, 2010. However, the analysis and policy considerations are those of the contributing staff and should not be attributed to the Executive Directors, their national authorities, or the IMF.
Joint Foreword to World Economic OutlookandGlobal Financial Stability Reporta
The global recovery is proceeding better than expected but at varying speeds—tepidly in many advanced economies and solidly in most emerging and developing economies. World growth is now expected to be 4¼ percent. Among the advanced economies, the United States is off to a better start than Europe and Japan. Among emerging and developing economies, emerging Asia is leading the recovery, while many emerging European and some Commonwealth of Independent States economies are lagging behind. This multispeed recovery is expected to continue.
As the recovery has gained traction, risks to global financial stability have eased, but stability is not yet assured. Our estimates of banking system write-downs in the economies hit hardest from the onset of the crisis through 2010 have been reduced to $2.3 trillion from $2.8 trillion in the October 2009 Global Financial Stability Report. However, the aggregate picture masks considerable differentiation within segments of banking systems, and there remain pockets that are characterized by shortages of capital, high risks of further asset deterioration, and chronically weak profitability. Deleveraging has so far been driven mainly by deteriorating assets that have hit both earnings and capital. Going forward, however, pressures on the funding or liability side of bank balance sheets are likely to play a greater role, as banks reduce leverage and raise capital and liquidity buffers. Hence, the recovery of private sector credit is likely to be subdued, especially in advanced economies.
At the same time, better growth prospects in many emerging economies and low interest rates in major economies have triggered a welcome resurgence of capital flows to some emerging economies. These capital flows however come with the attendant risk of inflation pressure and asset bubbles. So far, there is no systemwide evidence of bubbles, although there are a few hot spots, and risks could build up over a longer-term horizon. The recovery of cross-border financial flows has brought some real effective exchange rate changes—depreciation of the U.S. dollar and appreciation of other floating currencies of advanced and emerging economies. But these changes have been limited, and global current account imbalances are forecast to widen once again.
The outlook for activity remains unusually uncertain, and downside risks stemming from fiscal fragilities have come to the fore. A key concern is that room for policy maneuvers in many advanced economies has either been exhausted or become much more limited. Moreover, sovereign risks in advanced economies could undermine financial stability gains and extend the crisis. The rapid increase in public debt and deterioration of fiscal balance sheets could be transmitted back to banking systems or across borders.
This underscores the need for policy action to sustain the recovery of the global economy and financial system. The policy agenda should include several important elements.
The key task ahead is to reduce sovereign vulnerabilities. In many advanced economies, there is a pressing need to design and communicate credible medium-term fiscal consolidation strategies. These should include clear time frames to bring down gross debt-to-GDP ratios over the medium term as well as contingency measures if the deterioration in public finances is greater than expected. If macroeconomic developments proceed as expected, most advanced economies should embark on fiscal consolidation in 2011. Meanwhile, given the still-fragile recovery, the fiscal stimulus planned for 2010 should be fully implemented, except in economies that face large increases in risk premiums, where the urgency is greater and consolidation needs to begin now. Entitlement reforms that do not detract from demand in the short term—for example, raising the statutory retirement age or lowering the cost of health care—should be implemented without delay.
Other policy challenges relate to unwinding monetary accommodation across the globe and managing capital flows to emerging economies. In major advanced economies, insofar as inflation expectations remain well anchored, monetary policy can continue being accommodative as fiscal consolidation progresses, even as central banks begin to withdraw the emergency support provided to financial sectors. Major emerging and some advanced economies will continue to lead the tightening cycle, since they are experiencing faster recoveries and renewed capital flows. Although there is only limited evidence of inflation pressures and asset price bubbles, current conditions warrant close scrutiny and early action. In emerging economies with relatively balanced external positions, the defense against excessive currency appreciation should include a combination of macroeconomic and prudential policies, which are discussed in detail in the World Economic Outlook and Global Financial Stability Report.
Combating unemployment is yet another policy challenge. As high unemployment persists in advanced economies, a major concern is that temporary joblessness will turn into long-term unemployment. Beyond pursuing macroeconomic policies that support recovery in the near term and financial sector policies that restore banking sector health (and credit supply to employment-intensive sectors), specific labor market policies could also help limit damage to the labor market. In particular, adequate unemployment benefits are essential to support confidence among households and to avoid large increases in poverty, and education and training can help reintegrate the unemployed into the labor force.
Policies also need to buttress lasting financial stability, so that the next stage of the deleveraging process unfolds smoothly and results in a safer, competitive, and vital financial system. Swift resolution of nonviable institutions and restructuring of those with a commercial future is key. Care will be needed to ensure that too-important-to-fail institutions in all jurisdictions do not use the funding advantages their systemic importance gives them to consolidate their positions even further. Starting securitization on a safer basis is also essential to support credit, particularly for households and small and medium-size enterprises.
Looking further ahead, there must be agreement on the regulatory reform agenda. The direction of reform is clear—higher quantity and quality of capital and better liquidity risk management—but the magnitude is not. In addition, uncertainty surrounding reforms to address too-important-to-fail institutions and systemic risks make it difficult for financial institutions to plan. Policymakers must strike the right balance between promoting the safety of the financial system and keeping it innovative and efficient. Specific proposals for making the financial system safer and for strengthening its infrastructure—for example, in the over-the-counter derivatives market—are discussed in the Global Financial Stability Report.
Finally, the world’s ability to sustain high growth over the medium term depends on rebalancing global demand. This means that economies that had excessive external deficits before the crisis need to consolidate their public finances in ways that limit damage to growth and demand. Concurrently, economies that ran excessive current account surpluses will need to further increase domestic demand to sustain growth, as excessive deficit economies scale back their demand. As the currencies of economies with excessive deficits depreciate, those of surplus economies must logically appreciate. Rebalancing also needs to be supported with financial sector reform and growth-enhancing structural policies in both surplus and deficit economies.
Risks to global financial stability have eased as the economic recovery has gained steam, but concerns about advanced country sovereign risks could undermine stability gains and prolong the collapse of credit. Without more fully restoring the health of financial and household balance sheets, a worsening of public debt sustainability could be transmitted back to banking systems or across borders. Hence, policies are needed to (1) reduce sovereign vulnerabilities, including through communicating credible medium-term fiscal consolidation plans; (2) ensure that the ongoing deleveraging process unfolds smoothly; and (3) decisively move forward to complete the regulatory agenda so as to move to a safer, more resilient, and dynamic global financial system. For emerging market countries, where the surge in capital inflows has led to fears of inflation and asset price bubbles, a pragmatic approach using a combination of macroeconomic and prudential financial policies is advisable.
With the global economy improving (see the April 2010 World Economic Outlook), risks to financial stability have subsided. Nonetheless, the deterioration of fiscal balances and the rapid accumulation of public debt have altered the global risk profile. Vulnerabilities now increasingly emanate from concerns over the sustainability of governments’ balance sheets. In some cases, the longer-run solvency concerns could translate into short-term strains in funding markets as investors require higher yields to compensate for potential future risks. Such strains can intensify the short-term funding challenges facing advanced country banks and may have negative implications for a recovery of private credit. These interactions are covered in Chapter 1 of this report.
Banking system health is generally improving alongside the economic recovery, continued deleveraging, and normalizing markets. Our estimates of bank writedowns since the start of the crisis through 2010 have been reduced to $2.3 trillion from $2.8 trillion in the October 2009 Global Financial Stability Report. As a result, bank capital needs have declined substantially, although segments of banking systems in some countries remain capital deficient, mainly as a result of losses related to commercial real estate. Even though capital needs have fallen, banks still face considerable challenges: a large amount of short-term funding will need to be refinanced this year and next; more and higher-quality capital will likely be needed to satisfy investors in anticipation of upcoming more stringent regulation; and not all losses have been written down to date. In addition to these challenges, new regulations will also require banks to rethink their business strategies. All of these factors are likely to put downward pressure on profitability.
In such an environment, the recovery of private sector credit is likely to be subdued as credit demand is weak and supply is constrained. Households and corporates need to reduce their debt levels and restore their balance sheets. Even with low demand, the ballooning sovereign financing needs may bump up against limited credit supply, which could contribute to upward pressure on interest rates (see Section D of Chapter 1) and increase funding pressures for banks. Small and medium-sized enterprises are feeling the brunt of reductions in credit. Thus, policy measures to address supply constraints may still be needed in some economies.
In contrast, some emerging market economies have experienced a resurgence of capital flows. Strong recoveries, expectations of appreciating currencies, as well as ample liquidity and low interest rates in the major advanced countries form the backdrop for portfolio capital inflows to Asia (excluding Japan) and Latin America (see Section E of Chapter 1, and Chapter 4). While the resumption of capital flows is welcome, in some cases this has led to concerns about the potential for inflationary pressures and asset price bubbles, which could compromise monetary and financial stability. However, with the exception of some local property markets, there is only limited evidence of this actually happening so far.
Nonetheless, current conditions warrant close scrutiny and early policy action so as not to compromise financial stability. Chapter 4 notes that there are strong links between global liquidity expansion and asset prices in “liquidity-receiving” economies. The work shows that capital inflows in the receiving economies are less problematic if exchange rates are flexible and capital outflows are liberalized. Moreover, policymakers in these economies are encouraged to use a wide range of policy options in response to the surge in flows—namely macroeconomic policies and prudential regulations. If these policy measures are insufficient and the capital flows are likely to be temporary, judicious use of capital controls could be considered.
Main Policy Messages
To address sovereign risks, credible medium-term fiscal consolidation plans that command public support are needed. This is the most daunting challenge facing governments in the near term. Consolidation plans should be made transparent, and contingency measures should be in place if the degradation of public finances is greater than expected. Better fiscal frameworks and growth-enhancing structural reforms will help ground public confidence that the fiscal consolidation process is consistent with long-term growth.
In the near term, the banking systems in a number of countries still require attention so as to reestablish a healthy core set of viable banks that can get private credit flowing again. Policies need to focus on the “right sizing” of a vital and sound financial system. While deleveraging has occurred mostly on the asset side of banks’ balance sheets, funding and liability-side pressures are coming to the fore. Further efforts to address a number of weak banks are still necessary to ensure a smooth exit from the extraordinary central bank support of funding and liquidity. The key will be for policymakers to ensure fair competition consistent with a well-functioning and safe banking system. While certain central banks and governments may need to continue to provide some support, others should stand ready to reinstate it, if needed, to avert a return of funding market disruptions.
Looking further ahead, the regulatory reforms need to move forward expeditiously after being adequately calibrated, and be introduced in a manner that accounts for the current economic and financial conditions. It is already clear that the reforms to make the financial system safer will entail more and better quality capital and improvements in liquidity management and buffers. These microprudential measures will help remove excess capacity and restrict a build-up in leverage. While the direction of the reforms is clear, the magnitude is not. Furthermore, questions remain about how policymakers will deal with the capacity of too-important-to-fail institutions to harm the financial system and to generate costs for the public sector and its taxpayers. In particular, there will be a need for some combination of ex ante preventive measures as well as improved ex post resolution mechanisms. Resolving the present regulatory uncertainty will help financial institutions better plan and adapt their business strategies.
In moving forward with regulatory reforms to address systemic risks, care will be needed to ensure that the combination of measures strikes the right balance between the safety of the financial system and its innovativeness and efficiency. One way that is being considered to improve the safety of the system is to assign capital charges on the basis of an institution’s contribution to systemic risk. While not necessarily endorsing its use, Chapter 2 presents a methodology to construct such a capital surcharge based on financial institutions’ interconnectedness—essentially charging systemically important institutions for the externality they impose on the system as a whole—that is, the impact their failure would have on others. The methodology relies on techniques already employed by supervisors and the private sector to manage risk. Other regulatory measures, of course, are also possible, such as those discussed in Section F of Chapter 1, and merit further analysis.
As important as the types of regulations to put into place is the question of who should do it. Chapter 2 also asks whether some recent reform proposals that add the task of monitoring the build-up of systemic risks to the role of regulators would help to mitigate such risks. The chapter finds that a unified regulator—one that oversees liquidity and solvency issues—removes some of the conflicting incentives that result from the separation of these powers, but nonetheless if it is mandated to oversee systemic risks it would still be softer on systemically important institutions than on those that are not. This arises because the failure of one of these institutions would cause disproportionate damage to the financial system and regulators would be loath to see serial failures. To truly address systemic risks, regulators need additional tools explicitly tied to their mandate to monitor systemic risks—altering the structure of regulatory bodies is not enough. Such tools could include systemic-risk-based capital surcharges, levies on institutions in ways directly related to their contribution to systemic risk, or perhaps even limiting the size of certain business activities.
Another approach to improving financial stability is to beef up the infrastructure underling financial markets to make them more resilient to the distress of individual financial institutions. One of the major initiatives is to move over-the-counter (OTC) derivatives contracts to central counterparties (CCPs) for clearing. Chapter 3 examines how such a move could lower systemic counterparty credit risks, but notes that once contracts are placed in a CCP it is essential that the risk management standards are high and back-up plans to prevent a failure of the CCP itself are well designed. In the global context, strict regulatory oversight, including a set of international guidelines, is warranted. Such a set of guidelines is currently being crafted jointly by the International Organization of Securities Commissions and the Committee on Payments and Settlement Systems.
The chapter also notes that while moving OTC derivative contracts to a CCP will likely lower systemic risks by reducing the counterparty risks associated with trading these contracts, such a move will bring with it transition costs due to the need to post large amounts of additional collateral at the CCP. This calls for a gradual transition. Given these costs, however, the incentive to voluntarily move contracts to the safer environment may be low and it may need more regulatory encouragement. One way, for example, would be to raise capital charges or attach a levy on derivative exposures that represent a dealer’s payments to their other counterparties in case of their own failure—that is, their contribution to systemic risk in the OTC market.
In sum, the future financial regulatory reform agenda is still a work in progress, but will need to move forward with at least the main ingredients soon. The window of opportunity for dealing with too-important-to-fail institutions may be closing and should not be squandered, all the more so because some of these institutions have become bigger and more dominant than before the crisis erupted. Policy-makers need to give serious thought about what makes these institutions systemically important and how their risks to the financial system can be mitigated.