Systemic risks remain high and the adverse feedback loop between the financial system and the real economy has yet to be arrested, despite the wide range of policy actions and some limited improvement in market functioning. Further effective government action—particularly geared toward cleansing balance sheets and strengthening institutions—will be required to stabilize the global financial system and to provide the foundation for a sustainable economic recovery. The banking system needs additional equity to absorb further writedowns as credit deteriorates, and risks are broadening to encompass nonbank institutions. The crisis has spread to emerging markets with the collapse of international financing, posing challenges to corporates, households, and banks as well as raising sovereign risk. The global policy response, including the IMF’s enhanced lending framework, should help to mitigate crisis risks. There remains considerable scope for further public commitments in larger economies, but extensive provision of financing and the transfer of balance sheet risk from the private to the public sector have increased tail risks for certain mature market sovereigns.


Systemic risks remain high and the adverse feedback loop between the financial system and the real economy has yet to be arrested, despite the wide range of policy actions and some limited improvement in market functioning. Further effective government action—particularly geared toward cleansing balance sheets and strengthening institutions—will be required to stabilize the global financial system and to provide the foundation for a sustainable economic recovery. The banking system needs additional equity to absorb further writedowns as credit deteriorates, and risks are broadening to encompass nonbank institutions. The crisis has spread to emerging markets with the collapse of international financing, posing challenges to corporates, households, and banks as well as raising sovereign risk. The global policy response, including the IMF’s enhanced lending framework, should help to mitigate crisis risks. There remains considerable scope for further public commitments in larger economies, but extensive provision of financing and the transfer of balance sheet risk from the private to the public sector have increased tail risks for certain mature market sovereigns.

Against this backdrop, Chapter 1 first outlines the key financial stability risks that have materialized since the October 2008 Global Financial Stability Report. Then, it examines the deleveraging process and its effects on the real economy. The following section assesses the vulnerability of emerging markets to global stress, especially focusing on the refinancing risks facing corporates. The outlook for global credit markets is then evaluated, along with IMF staff estimates of potential global financial writedowns. The stability risks facing financial institutions are assessed and the effectiveness of the policy response evaluated. The chapter concludes with a discussion on sovereign risks.

Box 1.1. summarizes the key financial stability challenges and policy priorities detailed in the chapter.

A. Global Financial Stability Map

The global financial stability map (Figure 1.1) presents an overall assessment of how changes in underlying conditions and risk factors bear on global financial stability in the period ahead.1

Figure 1.1.
Figure 1.1.

Global Financial Stability Map

Source: IMF staff estimates.Note: Closer to center signifies less risk, tighter monetary and financial conditions, or reduced risk appetite.

Nearly all the elements of the map point to a degradation of financial stability, with emerging market risks having deteriorated the most since October 2008.

The economic downturn has gathered momentum, resulting in a deterioration in macroeconomic risks. The IMF’s baseline forecast for global economic growth for 2009 has been adjusted sharply downward to the slowest pace in at least four decades. The reduction in trade financing has exacerbated the slowdown in global trade, particularly affecting emerging economies. A raft of official measures that transfer risk from private sector financial institutions to the public sector has increased pressures on sovereign balance sheets and credit (see Section E).

Near-Term Financial Stability Challenges and Policy Priorities

Global financial stability has deteriorated further, with emerging market risks having risen the most since the October 2008 Global Financial Stability Report.

Notwithstanding some improvements in shortterm liquidity conditions and the opening of some term funding markets, other measures of instability have deteriorated to record or nearrecord levels.

The global credit crunch is likely to be deep and long lasting. The process ultimately may lead to a pronounced contraction of credit in the United States and Europe before the recovery begins. IMF analysis suggests that financing constraints have been a large contributor to the widening of credit spreads, making repairing funding markets imperative to help avert a deeper recession.

Credit cycles have turned sharply, with the deterioration moving to higher–rated credits and spreading globally. The deterioration in credit quality has increased our estimates of loan writedowns, which would put further pressure on financial institutions to raise capital and shed assets.

The deleveraging process is curtailing capital flows to emerging markets. On balance, emerging markets could see net private capital outflows in 2009, with slim chances of a recovery in 2010 and 2011. This decline is likely to slow credit growth, impairing corporate refinancing prospects.

Within emerging markets, European economies have been hardest hit, reflecting their large domestic and external imbalances, fueled by rapid credit growth prior to the crisis. Banks operating in emerging markets may face mounting writedowns and require fresh equity, while corporates face large refinancing needs, increasing risks for emerging market sovereigns. While authorities have been proactive in responding to the crisis, policies are being challenged by the scale of resources required.

Fiscal burdens are growing as a result of bank rescue plans and macroeconomic stimulus packages. Increased funding needs and illiquid capital markets have exerted pressure on sovereign credit spreads and raised concerns about the market’s ability to absorb increased debt issuance and about the crowding out of other borrowers. The United States faces some of the largest potential costs of financial stabilization, as do a number of countries with large banking sectors relative to their economies or concentrated exposures to the property sector or emerging markets (e.g., Austria, Ireland, the Netherlands, Sweden, and the United Kingdom).

Stabilizing the financial system requires further policy actions. The global policy response to date has been unprecedented, but has not prevented the onset of the adverse feedback loop with the real economy. It is thus necessary to undertake further forceful, focused, and effective policy action to stabilize the financial system. In particular, the public sector should ensure viable institutions have sufficient capital when it cannot be raised in the market, accelerate balance sheet cleansing and bank restructuring, and harmonize measures supporting funding markets. Public support measures also need to consider the risk of solvency pressures among other financial institutions (e.g., insurance companies, pension funds).

Uncertainty about the scale of the downturn and continued stress on the financial system has further increased credit risks. The core financial system remains fragile and public confidence low, as the credit deterioration has intensified and spread to higher–quality assets (Figure 1.2). The global financial system is facing a once–ina–century event, where credit risks have risen to extremely high levels. Activity has improved in credit markets receiving government support, but other sectors remain moribund (see Section D). Household balance sheets have come under pressure due to mounting job losses, falling net worth, and tight credit conditions. Expected credit writedowns by financials have ballooned, and, with private markets largely unwilling to provide capital to the banking system, the tail risk of more public sector ownership has increased.2 Estimates for U.S. and European banking systems suggest both are undercapitalized (see Section E).

Figure 1.2.
Figure 1.2.

Heat Map: Developments in Systemic Asset Classes

Source: IMF staff estimates.Note: The heat map measures both the level and one-month volatility of the spreads, prices, and total returns of each asset class relative to the average during 2004–06 (i.e., wider spreads, lower prices and total returns, and higher volatility). That deviation is expressed in terms of standard deviations. Dark green signifies a standard deviation under 1, light green signifies 1 to 4 standard deviations, light magenta signifies 4 to 7 standard deviations, and dark magenta signifies greater than 7 standard deviations. MBS = mortgage-backed security; RMBS = residential mortgage-backed security.

Our assessment is that emerging market risks have heightened the most since the last GFSR, moving out three notches. Cross–border bank lending to emerging markets has begun to contract. Capital market financing is sporadic, and limited to higher–quality borrowers. Emerging market corporates face falling revenues and large financing needs and household balance sheets are under pressure (see Section C). Emerging market banks face liquidity and solvency pressures. Financing conditions could tighten further as a number of mature market banks active in emerging markets may ration credit and sell subsidiaries to preserve capital for their home markets. These pressures are most pronounced in central and eastern Europe, given their higher reliance on cross–border and wholesale funding, weaker balance of payments positions, and higher degree of credit risk. By contrast, in Latin America and Asia, the bigger risks are related to the dramatic collapse in global trade (including trade financing) and domestic activity.

While government guarantees of bank debt have allowed some medium–term funding, market and liquidity risks remain elevated. Interbank markets have improved, but are still functioning only at very short maturities (see Section E). Monetary and financial conditions have tightened despite global policy easing as credit standards continue to be tightened (albeit at a more moderate pace). In addition, rising nonperforming loans and pressures to delever have weakened the monetary policy transmission mechanism, constraining the effect of lower policy rates on new lending. Risk appetite has diminished as confidence remains depressed and counterparty risks high, adding to the pressures to further unwind positions in riskier assets.

B. Global Deleveraging and Its Consequences

Previous GFSRs have highlighted that the global credit crunch will be deep and long lasting, as deleveraging accelerates in advanced economies and balance sheet adjustments take place over at least the next couple of years. This process has strongly negative global ramifications, raising crisis risks for emerging economies.

History suggests deep deleveraging will need to play out, although policies can lessen the economic consequences.

Financial institutions and households, in particular, had built up record levels of debt and are now seeking to reduce leverage (Figure 1.3). Deleveraging is being driven by mounting bank writedowns and the reversal of the intertemporal savings choices made by households and some corporates compared to the previous decade. Deteriorating credit quality has pushed up our estimates of bank writedowns, increasing pressures on banks and other financial institutions to raise capital and shed assets (see Section D and E). Recent quarters have shown that the assumed moderation in macroeconomic and financial volatility, which had given many confidence to lever up their balance sheets, was a mirage. Leverage increases the probability of bankruptcy if volatility is high, and it is natural for private economic agents to want to lower leverage as they recognize that their earlier volatility assumptions were overly optimistic. Previous GFSRs have shown that various instruments and sectors of the financial system–structured investment vehicles (SIVs), conduits, constantproportion debt obligations (CPDOs), auction rate securities (ARS), and hedge funds–were predicated on high leverage. To the extent that many of these elements of the “shadow banking system” have already collapsed or are in serious ofy, leverage is naturally declining.

Figure 1.3.
Figure 1.3.

Ratio of Debt to GDP Among selected Advanced Economies

(In percent, GDP-weighted, 1987 = 100)

Sources: Bank of Japan; Bureau of Economic Analysis; Federal Reserve; Office of National Statistics; and IMF staff estimates.

The buildup of leverage that preceded this crisis was substantial, and certainly on a par with other periods in history that have ended in a collapse in credit. Figure 1.4 compares the ratio of bank credit to GDP in the current crisis to that in Japan and Sweden in the run–up to their crises in the early 1990s. Three features are apparent. First, the rise in bank credit in the United Kingdom has been massive, and has been greater in the United States and European Union than in Japan in the years preceding its bubble. Second, the crises in Japan and Sweden both caused the bank–credit–to–GDP ratio to drop by around a quarter from its peak. Third, Sweden achieved its deleveraging rapidly, and then started to rebuild, while deleveraging in Japan continued over more than a decade. The current trajectories for the United States and Europe appear similar to the Japanese path, but policies discussed in Section E can lessen the economic impact and speed the recovery period.

Figure 1.4.
Figure 1.4.

Bank Credit to the Private Sector

(In percent of nominal GDP)

Sources: National authorities; and IMF staff estimates.Note: Dashed lines are estimates. Year of credit peak in parentheses.

The global credit crunch is likely to be deep and long lasting.

The October 2008 GFSR envisaged that, if there were a substantial in flow of capital to the banking system (then estimated at $675 billion) and some assets were sold to achieve higher capital ratios, credit would decelerate but not contract. That has proved optimistic; equity capital for banking has been very of to raise from the private sector, the forces driving deleveraging have strengthened as the depth of the economic downturn has become clear, and credit spreads in many cases remain at historic highs. We estimate U.S. and European private sector credit could contract at a 4 percent quarter–on–quarter annualized rate at its most negative (Figure 1.5), reinforcing the deleveraging process.3 A major element of the deleveraging process is the sale of bank assets, either to public sector entities or to nonbanks, and the maturing of other assets.4 This process still has a long way to go, as many illiquid assets have average remaining maturities of three to five years, although the adjustment of bank balance sheets is supported by purchases from governmentsponsored asset management corporations, of which $2.6 trillion in the United States and Europe is assumed in this scenario.

Figure 1.5.
Figure 1.5.

Private Sector Credit Growth

(Borrowing as a percentage of debt outstanding, quarter-on-quarter annualized, seasonally adjusted)

Source: IMF staff estimates.

Further pressures to deleverage come from heavy pastreliance on wholesale funding.

Much of the credit buildup was financed through wholesale funding, which has since diminished. Those markets are unlikely to return to their former size in the foreseeable future. There remains a risk that this could force a more rapid, disorderly deleveraging. Large–scale official funding support has replaced a substantial part of the wholesale market. While in many jurisdictions banks can now issue government–guaranteed longer–term debt, banks’ funding gaps remain large. Much of the earlier buildup in wholesale funding had occurred across borders, but the availability of cross–border funding has now contracted sharply (Figure 1.6).5 As long as banks need to rely on guarantees and short–term liquidity for funding, pressures for balance sheets to shrink will constrain lending (see Section E).

Figure 1.6.
Figure 1.6.

Bank for International Settlements Reporting Banks: Cross-Border Liabilities, Exchange-Rate-Adjusted Changes

(In billions of U.S. dollars)

Sources: Bank for International Settlements; and IMF staff estimates.

The retrenchment from foreign markets is outpacing the overall deleveraging process.

The proportion of cross–border assets in banks’ total assets fell again in the third quarter of 2008, as cross–border lending is falling at an even faster rate than overall credit (Figure 1.7). Three factors are likely driving the faster pace of cross–border deleveraging. First, increased credit risk concerns accentuate home bias in lending, as some banks perceive themselves less able to manage credit risk from a distance. Second, cross–currency and foreign exchange swap markets are impaired, and there are still some limits on the use of assets denominated in foreign currencies as collateral when accessing central bank facilities.6 Third, cross–border exposures typically involve a higher regulatory capital charge due to currency or country risk. So shedding these assets is a quick way to improve capital ratios.

Figure 1.7.
Figure 1.7.

Bank for International Settlements Reporting Countries: Cross-Border Assets as a Proportion of Total Assets

(Annual change in percentage points)

Sources: Bank for International Settlements; and IMF staff estimates.

These factors and risks are particularly strong in the case of lending to emerging markets, further accelerated as a result of sovereign downgrades in emerging markets. The collapse in cross–border funding has already been a critical element in the intensification of the crisis in several countries. A retreat of total crossborder lending to the levels seen as recently as 2004 would imply a contraction of a further 10 percent, or $3 trillion. Such a contraction would most likely hit emerging markets disproportionately.

Domestic official support programs for banks are accentuating home bias, which may be accelerating the pace of cross–border deleveraging. This applies to support by both mature and emerging market governments, which is often provided on the condition, or the understanding, that lending to the domestic economy be maintained.

As a result, capital flows to emerging markets are likely to reverse as foreign direct investment fails to offset bank and portfolio outflows.

Net private flows to emerging markets peaked at 4.5 percent of emerging market GDP in 2007 (Figure 1.8). However, the credit crunch in mature markets will likely cause significant outflows by banks in the coming years, as crossborder lending comes to a halt and a number of parent banks may begin curtailing financing to emerging market subsidiaries. An econometric analysis suggests outflows by banks could reach 5 percent of GDP in many emerging European countries, where cross–border bank inflows soared to unsustainable levels in recent years (see Annex 1.2). Such outflows would not be without precedent. Banking outflows of this magnitude were seen in some countries during the Latin American debt crisis in the early 1980s and again during the Asian financial crisis in 1997–98.

Figure 1.8.
Figure 1.8.

Emerging Market Net Private Capital Flows

(In percent of GDP)

Source: IMF, World Economic Outlook database.Note: FDI = foreign direct investment.

Emerging markets experienced large portfolio outflows at the end of 2008, and outflows are likely to continue over the coming years, given continued pressures for leveraged investors to shed assets, the risk of further redemptions from emerging market funds, and crowding out from government–guaranteed mature market bonds (Figure 1.9). We project annual portfolio outfl ows of around 1 percent of emerging market GDP over the next few years. Foreign direct investment in emerging markets is set to slow significantly, given diminished appetite from private equity firms, the lack of credit available to finance acquisitions, and sharply deteriorating cyclical growth prospects in emerging markets. On balance, emerging markets will likely see net private capital outflows in 2009, with slim chances of a recovery in 2010 and 2011. Moreover, risks to these projections appear to be to the downside, given how protracted the current global crisis is likely to be.

Figure 1.9.
Figure 1.9.

Net Foreign Equity Investment in Emerging Economies

(In billions of U.S. dollars)

Sources: Bloomberg L.P.; Emerging Portfolio Research; and IMF staff estimates.Note: “Other” includes Indonesia, the Philippines, Thailand, and Vietnam. EMEA = Emerging Europe, the Middle East, and Africa.

The global credit crunch has reduced the investor base for emerging market assets.

Emerging market assets under management by hedge funds have dropped by about half from their peak in early 2008 due to a combination of redemption pressures and negative performance (Figure 1.10). In the fourth quarter of 2008, withdrawals accounted for nearly onethird of the total $23 billion decline in assets under management. Retail investors have also withdrawn, with dedicated emerging market bond and equity funds experiencing substantial outflows, losing several years’ worth of inflows in the second half of 2008—a magnitude similar to the outflows seen in 1998.7 Surveys suggest crossover investors have shifted heavily away from emerging markets into mature market corporate bonds, including governmentguaranteed debt, amid a reevaluation of the diversification benefits from emerging markets as theories of “decoupling” proved wrong. Over the longer term, market participants believe emerging markets will retain a core of institutional investors committed to strategic allocations. The reduction in the number of investors, however, combined with the disappearance of some broker–dealers, is likely to impair the liquidity of emerging market assets for several years to come.

Figure 1.10.
Figure 1.10.

Emerging Market Hedge Funds: Estimated Assets and Net Asset Flows

(In billions of U.S. dollars)

Source: Hedge Fund Research.

C. The Crisis Has Engulfed Emerging Markets

Pressures on emerging markets intensified in September 2008, following the collapse of Lehman Brothers, as counterparty risks rose and as the credit crunch’s impact on economic activity became indisputable (Figure 1.11). A large set of interlinked risks has already pushed some emerging markets into crisis, and threatens many more, particularly in emerging central and eastern Europe. The severity of the crisis in emerging markets and the risks of spillovers call for a strong and coordinated response from policymakers at a global level to ensure that adequate liquidity is available. The decision taken at the recent G–20 summit to increase the resources available to the IMF can serve as an example in this respect. Policies should also be aimed at keeping mature market financial institutions engaged, through close cooperation between home and host authorities. Emerging market policymakers, inturn, need to strengthen their financial systems and policies for the more challenging global economic environment.

Figure 1.11.
Figure 1.11.

Heat Map: Developments in Emerging Market Systemic Asset Classes

Source: IMF staff estimates.Note: The heat map measures both the level and one-month volatility of the spreads, prices, and total returns of each asset class relative to the average during 2004–06 (i.e., wider spreads, lower prices and total returns, and higher volatility). That deviation is expressed in terms of standard deviations. Dark green signifies a standard deviation under 1, light green signifies 1–4 standard deviations, light magenta 4–7, and dark magenta greater than 7 standard deviations.

Crisis risks in emerging Europe have increased sharply…

Emerging Europe has been hit hard by global deleveraging. The impact has flowed through the same financial linkages with mature markets that previously allowed the region to build up a high degree of leverage through rapid foreign–financed credit growth (Table 1.1). Cross–border bank funding is now being disrupted as the banking crisis in western Europe intensifies.8 Growth in credit to the private sector is falling rapidly, intensifying the vicious circle between output declines and deteriorating asset quality (Figure 1.12).

Figure 1.12.
Figure 1.12.

Emerging Europe: Real Credit Growth to the Private Sector and Output

(In percent, year-on-year)

Sources: Bloomberg L.P.; IMF, International Financial Statistics database; and IMF staff estimates.Note: GDP-weighted average for emerging European countries shown inTable 1.1.

As a result, external debt spreads have risen sharply, stock markets have collapsed, and currencies have come under pressure, especially in those countries with large domestic and external imbalances (Figure 1.13). Households and corporates in a number of countries have built up large foreign exchange exposures in the run–up to the crisis, and further currency depreciation could result in severe loan writedowns across the region, eroding the capital and asset quality of banks, including parents of foreign–owned subsidiaries.9 In countries with tightly managed exchange rate regimes, the fear of currency and stock market collapse also risks capital flight, such as that experienced in Russia and Ukraine.

Figure 1.13.
Figure 1.13.

Emerging Market Performance of Credit Default Swap (CDS) Spreads and Equity Prices

(August 29, 2008–March 16, 2009)

Sources: Bloomberg L.P.; Datastream; and IMF staff estimates.Note: Figure uses countries in Table 1.1. State Bank of India for India’s CDS spreads. Regional average values are weighted by GDP. For Ukraine, changes in CDS spreads and equity prices are 3,119 bps and—62 percent, respectively.

…and financial interconnectedness within Europe increases the risk of adverse feedback loops.

Most emerging European countries are highly dependent on western European banks, which own the majority of banking systems in these countries (see Box 1.2.). The parents are largely concentrated in just a few countries (Austria, Belgium, Germany, Italy, and Sweden), and in some cases, the claims of the western European banks on emerging Europe are large relative to home country GDP as well (Austria, Belgium, and Sweden).

These interlinkages create feedback loops between emerging and western Europe that could exacerbate the crisis. For instance, the deteriorating financial condition of emerging European subsidiaries affects their parents’ liquidity and capital position. This has led to rating downgrades and higher funding costs for the parents, reducing their capacity to maintain funding to the subsidiaries, which further weakens the financial strength of the subsidiaries. Capital injections and wholesale funding guarantees to some parent banks by their home authorities have lessened risks to their subsidiaries, but raise other concerns, such as whether the parent banks will be pushed to divert credit to their home market. Sovereign credit default swap (CDS) spreads and bond yields of home countries with substantial exposures to emerging Europe have risen sharply on concerns about the potential costs of bailing out banks. Subsidiaries with loan–to-deposit ratios close to one (Table 1.1) can rely largely on their own funding sources to maintain lending, but, together with locally owned banks, face difficulties using local currency deposits to fund foreign currency loans owing to the dislocation in foreign exchange and cross–currency swap markets. Liquidity in these markets remains well below its level prior to September 2008, while the swap basis remains very wide for some currencies as global banks have scaled back dollar and euro liquidity (Figure 1.14). The Hungarian and Polish central banks recently introduced foreign exchange swap facilities to supplement private markets, which has contributed to a narrowing of crosscurrency swap spreads.

Cross–Border Exposures and Financial Interlinkages within Europe

Financial interlinkages within Europe have grown markedly with the rise in foreign ownership of banking systems in central, eastern, and southeastern Europe (CESE). Foreign ownership has brought important benefits to the host countries, including advanced technology and risk management techniques, increased access to cross-border funding, and rapid financial deepening. It has also brought important benefits to home countries in terms of income generation. At the same time, the growing financial links have raised susceptibility to negative spillovers for the hosts, as well as for the home countries.

Bank for International Settlements data show the interlinkages are substantial. Most CESE countries are highly dependent on western European banks, either through direct borrowing by their private nonbank sectors or through local banks. Many countries use large amounts of cross–border funding, in relation both to their GDP and to the size of their banking system assets (see first figure). CESE countries’ funding exposures are fairly concentrated, with Austria, Germany, and Italy accounting for the largest share of claims on the region (see table). The Baltics obtain their funding mainly from Sweden. Such concentration of funding sources makes a large number of CESE countries heavily exposed to potential adverse developments in parent banks.

Western European bank credit exposures to CESE are generally not large in terms of the size of their own economies, but there are important exceptions (see second figure). Austria has the largest exposure to CESE. The claims of its banks amount to over 70 percent of its GDP and 26 percent of its banking system assets. Belgian and Swedish bank exposures are also relatively high in terms of their GDP, though much less so in relation to banking system assets. Even where direct credit exposures are well diversified across the CESE region (e.g., in Austria) or economically negligible (e.g., France, Germany, and Italy), potential economic and financial spillovers within CESE and western Europe could increase the impact well beyond those direct exposures.

Cross–border exposures have important implications for regional contagion and the spillover of financial pressures to real economies:

  • Financial shocks could be transmitted by the “common lender channel,” in which a western European banking sector has a large exposure to a trigger CESE country while being an important source of credit for other countries in the region. A shock affecting the trigger country that pressures banks in the common lender country could thus spill over to other CESE countries.

  • CESE banks that are subsidiaries of foreign parents and are heavily dependent on parent funding to support credit growth could face a sudden shortfall of, or costly access to, credit, if the parent bank withdraws its lending to the subsidiary, or charges a much higher interest rate on its funding. While the reputational risk to the parent and the damage to its long–term business plans make this unlikely, Western banks have been facing increasing balance sheet pressure to slow lending and liquidity provision abroad as funding conditions in home countries become more of.

Some straightforward conclusions are that:

  • The greater the dependence of a CESE country on funds from a regional common lender, the higher is its exposure to problems triggered in the common lender’s banks.

  • The greater the dependence on a common lender, and the greater the latter’s exposure to a trigger country, the higher is the possibility of spillovers.

  • The risk of spillovers is highest when the common lender has activities substantially concentrated in the region (e.g., Austria). They are smaller when the common lender’s exposure to the CESE is small in terms of its own economic size (e.g., Italy), since exposures to any potential trigger country’s problems are economically too small to affect the funds available to others.


Borrower’s Funding Exposure

Source: Árvai, Driessen, and Ötker-Robe (2009).Note: CESE = Central, eastern, and southeastern Europe.

Lender’s Exposure to CESE, end-2007

Source: Árvai, Driessen, and Ötker-Robe (2009).Note: CESE = Central, eastern, and southeastern Europe.

Central, Eastern, and Southeastern Europe Exposure to Western Europe, December 2007

(In percent of total cross-border outstanding obligations)

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Source: Árvai, Driessen, and Ötker-Robe (2009).

This analysis does not represent an assessment of the financial or macroeconomic vulnerability of individual countries. It only gauges a country’s susceptibility to spillovers from problems in another country in the region, and helps identify the channels for such potential effects. The actual vulnerability of a country will depend on its macroeconomic fundamentals; the capitalization, liquidity, and general soundness of its banking systems and other key institutions; the maturity structure of its debt; and the nature of the regulations that affect financial relations between home and host institutions.

Note: This box was prepared by Inci Ötker-Robe, drawing heavily on Árvai, Driessen, and Ötker-Robe (2009).
Figure 1.14.
Figure 1.14.

Cross-Currency Basis Swap Spreads

(In basis points, one-year tenors)

Source: Bloomberg L.P.Note: All basis swaps are quoted against the euro, except the Turkish lira, which is quoted against the U.S. dollar.
Table 1.1.

Macro and Financial Indicators in Selected Emerging Market Countries

article image
Sources: Bank for International Settlements (BIS); Bloomberg L.P.; IMF, Direction of Trade Statistics, International Financial Statistics, and World Economic Outlook (WEO) databases; and IMF staff estimates.Note: The shaded boxes of the table point to areas of potential concern. Cut-off values are as follows: current account balance below ‒5 percent of GDP; refinancing needs in excess of 100 percent of reserves; net external liabilities to BIS reporting banks above 10 percent of GDP; average real growth of credit to the private sector greater than 30 percent year-on-year; loan-to-deposit ratio exceeding 1; and foreigncurrency-denominated loans exceeding 50 percent of total loans.

Projections of the current account balance and GDP for 2009 in dollar terms from the WEO.

Short-term debt at initial maturity at end-2008 plus amortizations on medium- and long-term debt during 2009, estimated by IMF staff. Care should be taken in interpreting the figures, as circumstances among countries differ. For instance, the figures include obligations resulting from lending by foreign parent banks to domestic subsidiary banks, so the stability of the relationship between parents and subsidiaries needs to be taken into account. In addition, some countries have sovereign wealth funds whose assets may not be included in reserves.

Data on external positions of reporting banks vis-áis individual countries and all sectors from the BIS, as of September 2008.

Average growth of credit to the private sector, adjusted for inflation.

Credit to the private sector relative to demand, time, saving, and foreign currency deposits.

In Latin America and Asia, the dramatic drop in trade and domestic activity is leading to a collapse in working capital available to corporates.

Cross–border funding risks are somewhat less acute in Asia and Latin America, given that countries in these regions entered the crisis with generally stronger external balances, larger international reserves, and deeper local funding markets (see Table 1.1). Still, Asian and Latin American asset prices have fallen substantially over the past three quarters.

The Asian corporate sector looks likely to be hit hard by extremely large drops in trade volumes. Sharp drops in export revenues are leading some companies to burn through cash reserves rapidly, implying that financing needs will pick up. However, foreign financing is increasingly scarce. Hedge funds that had been a major source of capital for Asia’s corporate expansion are now mostly trying to sell their largely illiquid assets, while foreign banks are deleveraging. Banks in Asia and Latin America are less impacted by the crisis than in emerging Europe, as they are mostly still well–capitalized and locally funded with low loan–to–deposit ratios, but are increasingly concerned about the quality of their loan books and are scaling back working capital financing to corporates.10 A concern is that funding of bigger corporates will squeeze out small and medium–sized enterprises and new entrants.

The abrupt fall in trade volumes in recent months appears to have been worsened by the disruption in the provision of finance for working capital, including trade finance. The cost of trade finance has increased significantly and its modalities have changed, returning from open–account trade financing to more traditional structures (see Box 1.3..).11 Many exporters have restricted the credit they are willing to provide their customers as a result of reduced access to capital and heightened concerns about customer creditworthiness.12 To address these concerns, the March 2009 G–20 summit committed up to $250 billion to support trade financing through export credit and investment agencies, and through multilateral development banks.

Credit growth in emerging markets is set to decelerate sharply as capital inflows come to a halt.

The econometric analysis presented in Annex 1.2 indicates that emerging markets that have been relying on foreign inflows to finance credit booms could see real credit contract by as much as 15 percent a year over the next couple of years, which would be similar to the magnitudes seen in previous episodes of “sudden stops” in emerging markets (Figure 1.15). The global policy response under way, with increased resources to the IMF and other international financial institutions, will help mitigate the drop in credit growth in emerging markets. However, large credit contractions are still likely to materialize in some countries in emerging Europe. Credit growth is set to slow considerably also in Asia and Latin America over the coming years, as banks in these regions are increasingly reluctant to lend with deteriorating economic conditions and rising loan writedowns.

Figure 1.15.
Figure 1.15.

Emerging Market Real Credit Growth

(In percent, year-on-year, average in panel)

Sources: IMF, World Economic Outlook database; and IMF staff estimates.
Figure 1.16.
Figure 1.16.

External Debt Refinancing Needs

(In billions of U.S. dollars)

Sources: Bloomberg L.P.; IMF, International Financial Statistics and World Economic Outlook databases; and IMF staff estimates.Note: Amortization of medium- and long-term debt on the year and short-term debt outstanding at the end of previous year. Corporate debt includes financials.

Emerging market corporates are vulnerable to financial distress, as they have high external debt refinancing needs…

Given the run–up in emerging market corporate external debt in recent years, a slowdownin financing will impair the ability of these corporates to meet their debt refinancing needs. IMF estimates suggest refinancing needs (calculated as short–term debt plus amortizations of medium–and long–term debt) faced byemerging markets will grow from an estimated$1.5 trillion in 2008, to $1.6 trillion in 2009, and $1.8 trillion by 2012 (Figure 1.16).13 The bulk of the increase is projected to come from corporates (including financial institutions). The requirements of emerging Europe are largenot only in absolute terms—estimated corporate refinancing needs in 2009 amount to $124 billion in Russia, $80 billion in Poland, and $62 billionin Turkey—but also in relation to official reserves, highlighting the region’s vulnerabilityto a continued seizing up of capital flows to emerging markets (see Table 1.11). As a share of GDP in each region, the estimated refinancingneeds in 2009 amount to 9 percent in Asia,19 percent in emerging Europe, and 8 percent in Latin America. Although substantial, cor-poraterefinancing needs are less alarming inrelation to official reserves and GDP in Asia and Latin America, and corporate debt spreads havenot increased as dramatically as in emerging Europe (Figure 1.17).

Currency depreciations are exacerbating the refinancing risk for corporates with high external indebtedness. In addition, corporates in a number of countries (such as Brazil, Indonesia, Korea, Mexico, and Poland) have suffered significant losses on currency derivative strategies that they took in anticipation of continued appreciation of domestic currencies that have, in fact, since depreciated sharply.

Effects of the Global Financial Crisis on Trade Finance: The Case of Sub–Saharan Africa

The global financial crisis has affected the cost, volumes, and modalities of trade finance. Reports from most regions indicate trade finance has become more expensive, volumes have been hit, and banks have moved away from funded open–account facilities, which had become most common in recent years, to more traditional forms of trade finance as counterparty risk rose rapidly. It has also become increasingly of to obtain trade finance insurance: trade insurers, like monolines, have had excessive amounts of troubled assets on their balance sheets, are now forced to deleverage, and, therefore, have cut back on their activities dramatically.

As elsewhere, trade finance in sub–Saharan Africa has become significantly more expensive, usually involves shorter maturities, and has contracted in scale, although in this stage of the global crisis declining volumes also reflect a drop in global demand. Spreads have reportedly increased from 100 to 150 bps to around 400 bps over LIBOR as country risk and counterparty concerns intensify, with much higher spreads reported in some cases.

Higher trade finance costs stem not only from higher spreads on borrowing and fees, but also from delays in payments and deliveries, foreign exchange shortages, and cash constraints. In Nigeria, importers are increasingly being asked by banks to pay in foreign exchange (obtained from the central bank against proof of imports) at the time when letters of credit are being opened, which pushes them to rely on more expensive funding in local currency and constrains their working cash balances. Ghanaian banks are charging more to facilitate import transactions (as are corresponding banks abroad) and see a significant shift toward the use of pre–paid letters of credit as foreign exchange shortages in the domestic market intensify. Alternatively, they charge for documentary collections (a fee–for–service option that does not bear a bank guarantee risk) and collateral management arrangements.

Trade finance has been increasingly routed through either the largest well–established local banks (with long–term relationships with correspondent international banks) or via local subsidiaries of international banks. International banks now often either do not roll over or cancel funded overdraft facilities without warning. The situation may be particularly difficult in some low-income countries, where even large domestic banks may have limited international reputation.1 And disruption may intensify as the macroeconomic shocks unfold.2 As a rule now, international banks do not confirm clients’ letters of credit unless they are prepaid, or have cash or other tangible collateral. They focus on longstanding relationships with known large local banks and have stopped doing business with second–tier banks, which are forced to seek access to trade finance through first–tier competitors.3

Note: This box reports on discussions with banks, corporates, regulators, and government officials in a number of sub–Saharan countries, and was prepared by Effie Psalida.1 International Finance Corporation staff have noted that even large domestic banks, with limited nostro balances to provide collateral, are encountering sizable difficulties in maintaining trade finance arrangements.2 Information on trade finance is normally proprietary between corporate customer and bank, between the two correspondent banks, or directly between corporates: data compilation is of and most evidence is anecdotal or impressionistic.3 A large South African bank, which intermediates much trade financing in sub–Saharan Africa, argues that foreign exchange is becoming harder to access in the region, that some larger banks have in recent months missed payment due dates, and that the bank itself is now extending trade credit in sub–Saharan Africa only on a case–by–case basis (evaluating both corporate and bank involved).
Figure 1.17.
Figure 1.17.

Emerging Market External Corporate Bond Spreads

(In basis points over treasuries)

Source: JPMorgan Chase & Co.

…that will be difficult to meet.

In light of the substantial challenges that emerging market corporates face, mature marketinvestment managers are loath toallocate resources toward the corporate debt market. Emerging market corporates had notyet become an established asset class prior to thecrisis, with relatively few funds benchmarked tothe main emerging market corporate indices. Now, most corporate bond funds have been sus-pended, with only a pool of fairly illiquid assetsremaining under management. The overhangof illiquid assets, combined with the general retrenchment from emerging market assets, will make it of to regenerate an investorbase for emerging market corporates that couldunderpin a revival of primary markets.

Domestic financing is not likely to be a sufficient substitute. In emerging Europe, corporate external refinancing needs for 2009 are especially large relative to the size of domestic credit markets. There are hardly any markets fordomestic corporate bonds in emerging Europe, and external private refinancing needs amount to more than 50 percent of domestic bank creditto the private sector on average in the region. In Asia and Latin America, local funding may beable to mitigate the drop–off in foreign inflowsto a greater extent, given that corporate external refinancing needs are in general smallerrelative to domestic bank credit, and that local corporate bond markets are more developed than in emerging Europe.14 However, small and medium-sized corporates in Asia and Latin America are still likely to run into difficulties rolling over their debt.

Emerging market banks face mounting writedowns and require fresh equity as economic conditions dete rioraterapidly.

Estimates of the potential scale of writedowns on loans and securities at emerging market banks have been rising sharply inrecent months. Writedowns in emerging market banking systems (including in the subsidiaries of foreign parent banks), could reach $800 billion or around 7 percent of assets (Table 1.2). While some systems have large capital buffers that could absorb writedowns of this scale, many emerging market banks (particularly in emerging Europe) will require fresh capital, possibly totaling $300 billion.15 Much of this will have to be financed by the official sector, as there is little prospect of atimely resurgence of private investor interestin these institutions. But some governments will themselves be hard pressed to providecapital to the banks operating in their countries, as their fiscal positions are stretched by the economic downturn and the need for stimulus spending. Foreign banks with subsidiariesin emerging market countries are facing mounting credit writedowns at home and will find it difficult to make up the capital shortfalls of their subsidiaries. Thus, it is likely that many emerging market banks will face challenges in repairing capital deficiencies.

Table 1.2.

Potential Writedowns and Capital Needs for Emerging Market Banks by Region

(In billions of U.S. dollars)

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Source: IMF staff estimates.

Emerging market sovereigns will suffer spillovers from banking and corporate distress.

Concern about the consequences for public finances of stimulus plans and bailout packages is raising market premia for sovereign risk. Our sovereign bond spreads model indicates that emerging market spreads have risen as a result of continued stress in core mature financial markets and deteriorating emerging market fundamentals (Figure 1.18).16 Given the likely length and depth of the credit crunch in core markets, there is a risk that spreads will remain elevated throughout 2009 and 2010. In addition, rating agencies have downgraded sovereign debt ratings or outlooks in many emerging European countries, attributed in part to the cost of financial support packages.

Figure 1.18.
Figure 1.18.

Aggregate Emerging Markets Bond Index Global Spread

(In basis points)

Sources: JPMorgan Chase & Co.; and IMF staff estimates.

Concerns about domestic banking conditions have also caused more volatile conditions for public sector debt, including some protracted interruptions in financing for emerging European sovereigns. Government issuers have had to shorten maturities as investors retreat from risk, increasing refinancing risks.

Hedging behavior has contributed another channel for spillovers from corporate and banking sector distress to sovereigns. In many cases, investors are hedging against risks on what are now illiquid holdings of emerging market corporate bonds by buying protection on sovereigns in CDS markets. This appears to have contributed to a rise in sovereign CDS spreads, above and beyond concerns about sovereign credit quality.

IMF analysis shows the extent to which CDS spreads have priced in concerns about spilloversto emerging market sovereigns from mature market banks (see Annex 1.3). Market estimates of risks for emerging market sovereigns and the mature market banks exposed to them increased in tandem up to September 2008. However, in the fourth quarter of last year, risks in emerging market sovereigns moved significantly higher than in mature market banks, as the latter received support from their own governments. The analysis shows that the risk of distress for emerging market sovereigns in the case of default by a parent bank has increased substantially in recent months across all regions (Figure 1.19).

Figure 1.19.
Figure 1.19.

Distress Dependence between Emerging Market Sovereigns and Advanced Country Banks

(Average conditional probabilities for the region)

Source: IMF staff estimates.Note: Probability of emerging market sovereign default in the event of default by a mature market bank exposed to the region.

Emerging market sovereigns may also face spillover risks from increased mature market issuance of government and government-guaranteed debt, which may crowd out emerging market sovereign borrowers to some extent (see Section F).

Emerging economies face unique policy challenges given the scale of resources required.

Emerging economies have introduced a range of policies to deal with the challenges of global deleveraging and risk aversion, but the scale of interventions needed in markets and banking systems will likely strain already limited resources.

Like their mature market counterparts, emerging market central banks have expanded liquidity provision to their banking systems, often by reducing relatively high reserve and liquid asset requirements and reversing the direction of open market operations in order to inject, rather than absorb, liquidity. However, the effect has been limited given that domestic interbank markets were often not a significant source of bank funding.

Many countries have introduced or expanded deposit insurance schemes to shore up confi-dence in local banks. The capacity to provide a credible deposit insurance safety net has sometimes been limited, particularly where the deposit base was highly dollarized. Some countries with additional resources have been able to extend guarantees to other bank liabilities.

Central banks have addressed the collapse in cross–border bank funding by providing dollars to local banks through swaps or outright sales of foreign currency. A few have been able to arrange swap lines with advanced economy central banks. In some cases, countries have imposed capital controls or measures to limit conversion of domestic currency to foreign exchange.

Some countries have directly supported credit for the corporate sector, including trade finance. This has been particularly important where local banks, facing their own pressures to deleverage, have been hard pressed to substitute for the drop in foreign financing.

Addressing the potential financing shortfalls facing emerging markets will require a significant coordinated response from the international community…

The international community will need to provide a large amount of resources and avoid measures that exacerbate existing deleveraging pressures on emerging markets. The decision by the G–20 to substantially increase the resources of the IMF and provide other forms of finance to emerging markets is an important step. The recent reforms of the IMF’s lending facilities, introducing a Flexible Credit Line and streamlining conditionality, will provide support to emerging markets in the face of the global crisis (Box 1.4). However, additional short–term liquidity support from major advanced economy central banks to emerging market central banks may be needed on a case–by–case basis to address immediate refinancing pressures. This will be particularly important in emerging Europe, where major banks active in the region have rolled over existing funding, but may curb new funding.

Substantial longer–term resources would help emerging market countries shore up their financial systems, replenish reserves that are being rapidly depleted to finance measures to alleviate the crisis, and ease macroeconomic adjustment. In this context, the pledge of up to 24.5 billion euros in 2009 and 2010 by the European Bank for Reconstruction and Development, the European Investment Bank, and the World Bank to support banking sectors and bank lending to enterprises in emerging Europe, and the decision by the European Union to increase crisis support to non–euro members, mark welcome initiatives. With the passage of time, the provision of such support will increasingly need to be conditioned on the adoption of a broader set of corrective policies.

…and from national policymakers. Policies for Europe will have to take into account the particular importance of cooperation given the especially close linkages between mature and emerging Europe.

Given the speed and intensity of the crisis, policy actions have at times not been sufficiently coordinated either globally, or between mature and emerging countries within regions. The various channels for spillovers in both directions imply that systemic and comprehensive approaches are needed. Indeed, one of the important lessons that policymakers, including those at the IMF, drew from the Asian crisis is the dangers inherent in pursuing a one–country-at–a–time approach, although policies should also take care to recognize relevant differences between countries.

Financial support measures for parent banks in mature markets should take into account the risk of introducing home bias that may stifle the timely resumption of banking inflows to emerging markets. Similarly, advanced country bank deposit guarantees may have caused deposit outflows from emerging market banks where local authorities do not have sufficient resources to match the mature market guarantees. These problems may be especially acute in emerging Europe, where links between mature market parent banks and emerging market subsidiaries are particularly strong. International financial support packages to emerging market countries may need to include elements that can offset such effects by providing financing for policy measures that can support continued capital inflows and funding of local banks by the private sector.

Joint action should be taken to clean up bank balance sheets and ensure that banking groups are addressed in a coherent and durable manner. Regional stress tests involving both parent and subsidiaries could help establish the level of impairment to assets and capital needs.

The absence of clear rules for cross–border crisis management and burden–sharing raises uncertainty about the costs the host country will bear, including the recapitalization needs of foreign–owned subsidiaries. There is also a need for clear rules on cross–border crisis prevention and mechanisms for the unwinding of public policy intervention. In the longer term, more harmonized prudential regulations and supervisory practices may enhance the effectiveness of supervision and regulation of cross–border banks, and reduce regulatory arbitrage. Joint supervisory analysis and inspections of systemically important banks should take into consideration the interconnectedness of risks and test for spillover risks that amplify the overall risk exposures of banks active in the region.17

Enhanced IMF Lending Capabilities and Implications for Emerging Markets

In response to the global credit crisis, the IMFoverhauled its lending framework and expanded its resources.1 Reforms were aimed at bolstering contingent lending instruments for crisis prevention, facilitating larger and more frontloaded financing and further streamlining conditionality. Markets have responded favorably to the reforms. This box discusses the key elements of the reforms and their implications for emerging markets.

In late March, the IMF overhauled its lending framework, with the intent of better tailoring IMF facilities to the varying needs of membercountries. This reform included the creation ofthe Flexible Credit Line (FCL), the modernizationof conditionality, and the simplification of (nonconcessional) lending terms. To bolster the IMF’s lending capacity, the G–20 group of leadingeconomies agreed to triple the resourcesavailable to the IMF to $750 billion. These measuresare intended to provide reassurance thatthe IMF has the tools and resources needed, inturn restoring confidence to emerging markets. In addition, the G–20 agreed to support ageneral allocation of the IMF’s Special Drawing Rights (SDRs) equivalent to $250 billion, in aneffort to boost global liquidity.

The FCL is geared toward making conditions for access to IMF resources more flexible for countries with very strong fundamentals andpolicies. The key design feature of the FCL isthe reliance on an ex ante screening process of qualification rather than the traditional ex post program conditions.2 The FCL is expected to domiperform a catalytic role by providing assurances to investors that resources would be available if needed and therefore helping ensure the country’s continued access to international capital markets.

Other key elements of the overhaul of the IMF’s lending toolkit included increased flexibility of high–access precautionary Stand–by Arrangements to ensure all members have access to effective insurance instruments; streamlined conditionality by discontinuing the use of structural performance criteria; the elimination of seldom–used facilities; and the simplification of repayment terms of nonconcessional loans. The IMF is also working on an overhaul of its concessional lending facilities.

To meet the additional demand for capital, the G–20 pledged up to $1.1 trillion, including (i) commitment to immediately increase bilateral financing to the IMF from members by $250 billion, subsequently incorporated into anexpanded and more flexible New Arrangementsto Borrow, increased by up to $500 billion;3 (ii) a $250 billion equivalent increase in SDRs tosupplement existing official reserves of membercountries;4 (iii) $100 billion in additional funds provided by multilateral development banks; and (iv) $250 billion in trade credit provided by the World Bank and national export credit agencies.


Sovereign Risk Premia and Share Prices

Sources: Bloomberg L.P.; JPMorgan Chase & Co.; and Morgan Stanley.Note: Share prices represent MSCI indices in dollar terms, March 31, 2009 = 100. CDS = credit default swaps; EM = emerging market.

Emerging Market Regional Asset Performance

(Change March 31–April 10, 2009)

Sources: JPMorgan Chase & Co.; Morgan Stanley; and IMF staff estimates.

The overhaul of the IMF’s lending toolkit and the expansion of international financial institutions’ resources are key elements of the global policy response, and its stabilizing effect has already been evidenced. By increasing access to external financing at favorable terms, risks of heightened balance of payment pressures have been reduced. To date, an FCL arrangement has been requested by Colombia (with access of $10.4 billion or 900 percent of quota), and approved for Mexico (with access of $47 billion or 1,000 percent of quota) and Poland ($20.5 billion or 1,000 percent of quota). Since the approval of the IMF’s reforms, external credit and credit default swap spreads on emerging market sovereigns have tightened about 80 basis points, while comparable corporate credit spreads have tightened 40 basis points, though both remain near mid–October 2008 levels (see first figure). Emerging market shares rebounded, outperforming mature market stocks. Cross–currency swaps also narrowed in several countries, reflecting an easing in foreign currency funding constraints. Emerging European assets—where refinancing concerns are most acute—especially benefited (see second figure). Default probabilities receded, while currency, equity, and debt markets outperformed assets in other regions. Economies outside the region that applied for FCL funding or were perceived as benefiting from potentially higher access to official financing experienced gains across a range of core local assets. Several sovereign and quasi–sovereign borrowers have taken advantage of the improving financing environment to issue debt, while others are planning new issues. Nonetheless, risk appetite remains lukewarm–as demonstrated by still tepid flows into emerging market assets–and funding and credit markets remain severely strained.

Note: The main author of this box is Rebecca McCaughrin.1 See detailed material on the reforms at www.imf.org/external/np/sec/pn/2009/pn0940.htm.2 The qualification criteria include a sustainable external position, a capital account position dominated by private flows, a track record of sovereign access to international capital markets at favorable terms, a relatively comfortable reserve position, sound public finances, low and stable inflation, a solvent banking system, effective financial sector supervision, and data transparency and integrity.3 Bilateral credit lines have already been committed by Japan ($100 billion), Europe ($100 billion), Norway ($4.5 billion), Canada ($10 billion), and Switzerland ($10 billion).4 The G–20–supported SDR allocation would raise the stock of SDRs nearly nine–fold to $282 billion at current exchange rates. Given that allocations are proportional to quotas, emerging markets will receive about $80 billion, which will directly augment their reserves, and which can be exchanged for reserve currencies.

Policymakers should also prepare for corporate and household distress, which will imply a need to plan for orderly debt restructurings in some cases.

Steps also need to be taken to prepare for wide–ranging corporate and household balance sheet stress. Some combination of public sector support and targeted corporate restructuring will likely be necessary in many countries.18 In countries such as Kazakhstan, Russia, and Ukraine, the systemic importance of some of the corporates and the size of their funding gaps suggest the need for a comprehensive approach that would help ensure that any large–scale restructurings take place in an orderly manner, including with consensual private sector involvement. There will likely be a need for national authorities to coordinate on debt restructuring, given the importance of cross–border exposures.

Household debt restructuring may be necessary where households took on foreignexchange-denominated liabilities, notably mortgages. In such cases, the authorities will need to assess whether the problem is large enough to require a generalized solution. Government–sponsored debt relief programs, perhaps with some form of risk–or loss–sharing between the government and banks (and possibly combined with bank recapitalization), may be needed to reduce the costs to the economy of widespread defaults, including costs associated with mortgage foreclosures, which could add further downward pressure on house prices and widen the problem.19

D. The Deteriorating Outlook for Household and Corporate Defaults in Mature Markets and Implications for the Financial System

Real estate, consumer, and corporate cycles have turned in a global synchronized fashion…

Credit cycles have turned sharply across asset classes and geographical areas, with the deterioration moving to higher–rated corporate credits and other assets that had previously escaped the worst of the problems. Previous GFSRs have documented the rise in delinquencies across a range of credit markets and provided scenarios for projected charge–off rates on credit. An update of that analysis using the latest World Economic Outlook forecasts of a deeper and more protracted recession, larger declines in house prices, and a longer period of tight lending conditions results in a higher projected rate of credit deterioration compared to the last GFSR (Figure 1.20).20

Figure 1.20.
Figure 1.20.

U.S. Loan Charge-Off Rates: Baseline

(In percent)

Sources: Federal Reserve; and IMF staff estimates.

Residential mortgage credit performance has continued to weaken in the United States and in Europe. Home prices in major advanced economies have already fallen roughly 10 percent from their peaks on average, with the sharpest declines in the United States (27 percent) and the United Kingdom (21 percent). Futures markets are pointing to substantial further declines. In the United States, delinquency and foreclosure rates have continued to rise on both prime and nonprime loans (Figure 1.21) and foreclosure moratoriums and other work–out efforts have failed to reverse the deterioration. In some cases, public interventions, including large–scale purchases of mortgage–backed securities (MBS), have helped reduce primary and secondary mortgage rates and contain or narrow spreads.21 Nevertheless, issuance of MBS has continued to decline, with U.S. and European originations down 40 percent year–to–date from already depressed levels during the same period last year.22

Figure 1.21.
Figure 1.21.

Delinquency Rate of U.S. Residential Mortgage Loans

(In percent of total loans, 90+ days)

Source: Bloomberg L.P.

Commercial mortgages are following the same pattern as residential mortgages. Until recently, the outlook for commercial mortgages had appeared slightly brighter, as occupancy rates remained high, and contractual arrangements looked more robust. However, this apparent resilience has disappeared–commercial real estate prices have already dropped 21 percent since the peak in the United States, 35 percent in the United Kingdom, and are starting to edge lower elsewhere in Europe. Commercial real estate loan performance has begun to deteriorate in the United States and the United Kingdom. Delinquencies have started to rise, and will doubtless accelerate as the economic cycle deteriorates further. U.S., U.K., and euro area commercial mortgage–backed security (CMBS) spreads have widened on average over 1,800 basis points, 800 basis points, and 800 basis points, respectively, since the last GFSR, though with significant differentiation across the capital structure (Figure 1.22). The supply of commercial mortgages remains weak, with interest rates high. U.S. and European CMBS securitizations both collapsed 90 percent last year, and have been nearly nonexistent so far this year.23

Figure 1.22.
Figure 1.22.

Spreads on Consumer Credit Asset-Backed Securities

(In basis points, 10-year tenor, spread to government securities)

Sources: Merrill Lynch; and Morgan Stanley.

…taking a toll on balance sheets.

Economic stress is also putting pressure on household balance sheets and debt servicing, in turn triggering deterioration in consumer credit markets. At the start of the crisis, U.S. households borrowed more heavily on credit cards and other forms of consumer credit as other credit channels began to close. That trend has since ceased, and consumer credit in Europe has also started to contract, as the financial condition of consumers has weakened sharply. This is illustrated by rising delinquencies, bankruptcies, and charge-off rates, while spreads have widened across most consumer credit sectors since the last GFSR (Figure 1.23).24 Rates remain high and securitization anemic, suggesting that supply–side constraints predominate.25 Since the peak, U.S. nonmortgage ABS issuance has fallen by more than 80 percent. European issuance, meanwhile, has continued to be supported by retained securitizations.26 In some countries, public programs are offering alternative funding sources, access to liquidity, and favorable capital treatment, but these have yet to revive securitization volumes.

Figure 1.23.
Figure 1.23.

Spreads on Consumer Credit Asset-Backed Securities

(In basis points, spread to swaps)

Sources: JPMorgan Chase & Co.; Markit; and Morgan Stanley.

The corporate credit cycle is turning.

Nonfinancial corporates entered the crisis with strong liquidity positions, relatively low leverage, and generally sound balance sheets. However, corporate credit quality has deteriorated rapidly amid the weakening economic backdrop, tight lending conditions, and increased funding costs. Leading indicators, such as purchasing manager indices and new industrial orders, suggest the outlook for corporate cash flows is grim, and corporate bankruptcies are set to rise. Bankruptcy filings are rising in the United States and the United Kingdom, and conditions for debtor–in–possession (DIP) financing have tightened sharply.27

Globally, corporate default rates have risen to 2.1 percent (and 4.8 percent on high–yield debt, in particular), and are set to rise further Figure 1.24.28 Various forward–looking credit indicators, such as downgrade–to–upgrade ratios, the proportion of borrowers on negative outlook, the proportion of lower–grade, high–yield issuers, and the share of distressed debt, have increased dramatically in recent months. In addition, borrowers are breaching covenants in their loans more frequently, and recovery rates on defaulted bonds continue to slide Figure 1.25.

Figure 1.24.
Figure 1.24.

Global Corporate Default Rates

(In percent)

Source: Moody’s.
Figure 1.25.
Figure 1.25.

Average Recovery Rates on Defaulted U.S. Bonds

(In percent, trailing 12 months)

Source: Moody’s.

As bank credit remains tight, corporates have been forced to turn to capital markets as an alternative, but at higher costs. Global corporate bond markets have seen a flurry of activity since the beginning of the year–nonfinancial corporate issuance has risen 68 percent year–to–date relative to the same period in 2008. Activity has favored large, liquid, high–quality borrowers in sectors considered less vulnerable to the recession, and has been mostly geared toward refinancing existing debt.29 New deals have been issued at considerably higher spreads than a year ago as investors have been worried about a deterioration in credit quality and possible future crowding out by sovereign and government–guaranteed debt. Corporates–even high–quality issuers–have been willing to pay punitive rates in order to replace bank financing or to hoard cash. Many still have untapped prenegotiated credit lines, but have preferred to keep those as a back–up in case bank lending remains scarce (and to improve their negotiating position vis–à–vis banks).

In secondary markets, a large share of global corporate debt is now trading at distressed levels Figure 1.26. Some 70 percent of the high–yield market and 12 percent of high–grade debt is currently trading at spreads above 1,000 basis points. At such elevated spreads, the cost of funding exceeds many borrowers’ hurdle rate or return on capital, threatening their viability. The rise in spreads has surprised many observers. Box 1.5., which seeks to disentangle the factors driving spreads, finds that the increase is being driven not just by worsening corporate profitability expectations and economic uncertainty, but also by financing constraints. Indeed, the analysis shows that financing constraints (as measured by total liabilities of issuers and London Interbank Offered Rate (LIBOR)–overnight index swap (OIS) spreads) have been the single greatest contributor to the widening in investment- grade spreads, particularly during the most recent period. This makes the repair of funding markets imperative to help avert an even deeper recession (see Section E).30

Figure 1.26.
Figure 1.26.

Corporate Credit Default Swap Spreads

(In basis points)

Sources: JPMorgan Chase & Co.

Even though corporate debt outstanding is not unusually high by historical standards, refinancing that debt as it matures may yet pose serious challenges if spreads remain wide.31 Cash flows at large U.S. and European companies are still generally ample to cover their interest payments, but this is less true for lower–quality and smaller corporates. High–yield borrowers are expected to need to refinance nearly 50 percent more debt this year than last year, and financing pressures will increase in 2011 and beyond as substantial amounts of debt issued during the leveraged buyout boom of 2005–07 matures.

Credit deterioration is feeding back to higher writedowns across all sectors.

As a result of continued pressures in credit markets, global financial institutions and other holders could face larger potential writedowns, according to our estimates Table 1.3. Looking at the range of assets originated in the United States over the same cumulative period (2007–10) as in prior GFSRs, expected write–downs have risen to some $2.7 trillion, up from the $2.2 trillion estimated at our interim update in January 2009, and from the $1.4 trillion estimated in October 2008.32 The rise represents the credit deterioration that the worsening economic cycle is creating Figure 1.27. Considering a much wider set of outstanding loans and securities to include European–originated loans and related securities as well as Japanese–originated assets (totaling some $58 trillion compared to earlier estimates based on $27 trillion of U.S.–originated loans and securities) provides a broader, albeit more uncertain, assessment of potential writedowns of some $4.1 trillion.33 While banks are expected to bear about two–thirds of the writedowns, other financial institutions including pension funds and insurance companies also have significant credit exposures.34 Among other market participants, hedge funds have suffered losses related to both mark–to–market declines and forced asset liquidations due to redemptions.

Figure 1.27.
Figure 1.27.

Estimates of Economic Growth and Financial Sector Writedowns

(In billions of U.S. dollars, end of period)

Source: IMF, Global Financial Stability Report, World Economic Outlook, various issues.Note: Estimates of potential writedowns for 2007–10 on U.S. originated assets as reported in the GFSR and GFSR quarterly updates. GDP growth (year-on-year) is average for 2007–10.
Table 1.3.

Estimates of Financial Sector Potential Writedowns (2007–10) by Geographic Origin of Assets as of April 2009

(In billions of U.S. dollars)

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Sources: Bank for International Settlements; European Securitization Forum; Federal Reserve, Flow of Funds (2008:Q3); national central banks; and IMF staff estimates.Note: See Annex 1.5 for details on writedown estimation methodology.

For banks in advanced countries, potential writedowns by origin of assets. For an estimate of writedowns by domicile of banks, see Table 1.15.

2Included in this category are estimated losses for U.S. government-sponsored enterprises of approximately $250 billion, as well as expected writedowns for hedge funds, pensions, and other nonbank financial institutions.

Europe includes the euro area and the United Kingdom.

E. Stability Risks and the Effectiveness of the Policy Response

Stability has proven elusive to attain.

The prior sections underscore that confidence in the international financial system remains fractured and systemic risks elevated. Policy actions have prevented an even deeper crisis, but the limited market improvement to date has been insufficient to prevent the onset of the adverse feedback loop with the real economy. Despite some recent tentative signs of improvement, bank equity prices, and to a lesser extent, senior debt prices, have continued to decline as writedowns mount and long–term earnings prospects remain uncertain. The impairment of financial institutions and core funding markets is curtailing credit to corporates, which have themselves also faced cash–flow pressures from the deteriorating economy. This section discusses stability risks to core financial institutions and assesses the effectiveness of policy measures in repairing financial sector balance sheets and reopening credit markets. The main message is that stabilizing the financial system remains a key priority and, although progress is being made, further policy efforts will be required.

Loss recognition is incomplete and capital is insufficient under a recession scenario.

Under the scenario of global recession and continuing credit pressures, we project banks could incur roughly $2.8 trillion in credit–related writedowns over 2007–10 Table 1.3, of which about one–third have already occurred. Credit deterioration could substantially deepen for European banks in particular, including through their exposure to emerging Europe (see Section C). The size of the losses may ultimately turn out lower to the extent that forceful and well targeted actions by authorities manage to restore confidence and establish a more virtuous cycle, giving support to credit markets. Authorities in several countries have already made substantial efforts to strengthen bank balance sheets and limit some of the downside risks faced by banks. Banks worldwide have raised about $900 billion in capital to date (half of which has come from public sources), but additional equity is still needed to cushion potential writedowns and to restore investor confidence.

Mounting writedowns are depleting equity, increasing investor concerns about the size of capital cushions protecting bank solvency.

Since the start of the crisis, market capitalization of global banks has fallen by more than half from $3.6 trillion to $1.6 trillion, while the value of preferred shares and subordinated debt has also fallen sharply, underscoring concerns about the size and quality of capital cushions Figure 1.28. Banks are increasingly being judged by markets on a contingent set of cash flows they could receive. Table 1.4 provides an illustration of banks’ equity needs under a number of assumptions about the future environment for banking, including earnings streams and capital adequacy measures asserted by the market. Accordingly, there is considerable uncertainty surrounding these approximate top-down scenarios.35 Moreover, the assessment of the needed recapitalization for specific banks should be done on the basis of the actual portfolio, prevailing capitalization, and expected revenues. In addition, the illustrations aggregate across banking systems and therefore do not show the substantial variation between banks within those systems. With those important caveats, if banks were to bring forward to today loss provisions for the next two years, before expected earnings, U.S. and European banks in aggregate would have tangible equity close to zero Table 1.4.36,37 This suggests equity cushions may need to be bolstered to sustain market confidence through the cycle.

Modeling Corporate Bond Spreads: A Capital Flows Framework

This box seeks to explain the widening in U.S. investment–grade corporate bond spreads, based on a combination of business cycle variables, volatility, and financial strains in the corporate, banking, other financial, and household sectors. The analysis suggests that financing constraints have played a pronounced role in driving spreads wider during the current period. As such, alleviating the pressures on funding markets is critical to improving the cost of financing for corporates. A 50 basis point reduction in the London Interbank Offered Rate (LIBOR)–overnight index swap (OIS) spread would translate into a roughly 100 basis point decline in corporate spreads.

This box attempts to model corporate bond spreads based on a cash–flows approach to explain the underlying key drivers. The equilibrium spreads are ultimately determined by cash flows or internal funds available to bond issuers and bond buyers. The analysis identifies factors affecting the cash flows from operating, investing, and financing activities across the major classes of bond issuers and bond holders. The drivers are intended to represent expected profitability, uncertainty, and liquidity constraints. The model displays linkages among financial strains in major sectors of the economy, asset returns, financial and economic risks, macroeconomic activity, and losses in the system.

Previous studies of corporate spreads have found it of to explain the sharp increase in spreads during the recent crisis. The conventional approach is to regress spreads on a broad range of macroeconomic and financial variables. Large residuals arising from these models are attributed to an unexplained component driven by illiquidity premia. In this box, spreads are modeled by explicitly accounting for illiquidity premia and funding strains.

The Capital Flows Approach

The analysis first introduces a new framework based on net cash flows for bond issuers and bond holders. Corporate spreads are modeled based on the supply–demand equilibrium conditions.

Three crucial sectors are identified from the supply side: nonfinancial corporates, commercial banks, and asset–backed securities (ABS) issuers, which are responsible for 33 percent, 7 percent, and 33 percent, respectively, of all corporate bond liabilities in the United States. The demand side is represented by households, commercial banks, life insurance companies, and mutual funds, which hold 16 percent, 8 percent, 17 percent, and 9 percent, respectively, of all corporate bonds.

The analysis models corporate spreads based on cash flows. Cash flows define the willingness of suppliers to issue bonds, and buyers to purchase bonds, and are generated and dispersed by three types of activities: operating, investing, and financing. For any given set of economic and financial conditions, each type of activity contributes to the decision of a supplier to sell, or a buyer to purchase, a bond, thus helping to determine the equilibrium price (spread over the risk–free rate).

For each sector and by type of activity, the analysis identifies the factors driving cash flows (see table). Operating cash flows are affected by either indicators of revenue, such as industrial production growth, or failure or loss rates, such as charge–offs for bank loans (see bottom figure). Cash flows from investing activities of bond issuers are driven by expected profitability proxied by GDP but hampered by uncertainty represented by the VIX. Cash flows from financing activities are affected by refinancing needs, represented by leverage, and cost of capital and funding, such as the cost of equity for corporates and the LIBOR–OIS spreads for banks. Variables that are highly correlated with others, such as personal income that is closely related to GDP, are omitted.


A separate model is developed for each of the three types of cash flows, each of which provides a good fit. The estimation is carried out over 1990–2008, with a quarterly frequency.

Operating cash–flows model: S(t)=6.0280.282*D(t)0.060*CapU(t)t5.*EQ(t)+0.005*D(t)*ABS(t),(1)4.613.9

where S(t) is the U.S. investment-grade corporate spread (in percent), D(t) is the dummy 0,1 to identify the period when ABS spreads become available (in 2006:Q1).

Investing cash–flows model:


where D1(t) is the dummy 0,1 to characterize the increased sensitivity of spreads to fundamentals during the last cycle (six years).

Financing cash–flows model:


Combined model:

Bringing these together gives the following combined cash–flows model that incorporates business cycle variables, a measure of volatility, equity prices, and indicators of financing constraints:


The model provides a very good fit (top figure) and the values of the coefficients indicate that the relationships are economically meaningful.

The combined model explains 93 percent of the variation in spreads, of which 57 percent is explained by the interaction of the factors, 7 percent is explained uniquely by capacity utilization, 10 percent uniquely by the VIX, 2 percent uniquely by equity prices, and 17 percent uniquely by the combination of the financing constraints indicators, particularly house price declines and growth in total liabilities of bond issuers.

List of Variables

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Note: CapU = capacity utilization rate (percent); IP = industrial production, yearly growth (percent); CH = charge-off rate for bank loans (percent); ABS = the ABS spread (bps); UR = unemployment rate (percent); EQ = equity prices, yearly growth (percent); GDP = gross domestic product, yearly growth (percent); VIX = the implied CBOE volatility index (percent); DR = the corporate default rate (percent); TL = total liabilities of bond issuers, yearly growth (percent); LOS = the LIBOR-OIS spread (bps); CDOR(t) is the spread between the one-month commercial deposit and the Fed funds rate (bps); HP = residential house prices, yearly growth (percent); FL = mutual funds’ net flows (percent of total assets).


The capital flows framework developed in this analysis allows one to capture explicitly the effects of stress in various economic sectors on corporate spreads. The analysis suggests that corporate spreads can be largely explained by the fundamentals and risks related to both uncertainty and financing constraints. Policy implications should be drawn with caution, since, as with any regression analysis, the equations display measures of correlation rather than causality. For example, if the LIBOR–OIS spread were to decline by 50 basis points–possibly as a result of some policy action–it would be associated with a roughly 100 basis point decline in corporate spreads. This provides some perspective on the scale of challenges and potential benefits for policymakers contemplating intervention in the market for corporate finance.


Actual and Fitted Spreads

(In percent)


Cash-Flow Drivers for Bond Holders and Bond Issues

Note: This box was prepared by Sergei Antoshin. Throughout this box, the data for the United States are used, but the analysis could be applied to Europe, for which the corresponding data are readily available.
Figure 1.28.
Figure 1.28.

U.S. and European Bank and Insurance Company Market Capitalization, Writedowns, and Capital Infusions

(In billions of U.S. dollars, end of period)

Source: Bloomberg L.P.
Table 1.4.

Bank Equity Requirement Analysis

(In billions of dollars, unless shown)

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Source: IMF staff estimates.Note: Tier 1 = Tier 1 capital; RWA = risk-weighted assets; TA = tangible assets; TCE = tangible common equity.

Excludes government-sponsored enterprises, which are expected to receive equity injections from the government of up to $250 billion to help support writedowns.

Denmark, Iceland, Norway, Sweden, Switzerland.

The approximate leverage assumed in the GFSR deleveraging scenario (a 4 percent TCE/TA ratio).

The approximate leverage of U.S. banks in the mid-1990s (a 6 percent TCE/TA ratio), prior to the buildup in leverage in the banking system that contributed to the crisis.

The focus on the quality of bank capital has also intensified. Broader measures of capital, such as Tier 1, are seen by investors as offering insufficient protection and are therefore currently viewed as a less reliable basis for investor valuation and counterparty assessment. Instead, markets have increasingly focused on tangible common equity (TCE) and attach less weight to other components of regulatory capital, such as Tier 2 capital, hybrid securities, preferred shares, deferred tax assets, and the value of intangible assets on the balance sheet. Furthermore, with expected writedowns mounting, common equity is being depleted, reducing its share in total capital relative to other components with weaker lossabsorbing characteristics. In cases of banks with still–sufficient Tier 1 capital, converting preferred equity–both public and private–into common equity would rebalance the capital structure by increasing loss–absorbing capital.38 More broadly, decisive and up–front policy implementation could alleviate the above scenario by bolstering confidence in banks and reducing credit strains, ultimately reducing the amount of public equity needed if private markets reopen. As confidence in valuation of assets improves, bank capital structures are seen to have been strengthened, and the economic outlook becomes less uncertain, market focus may return to the broader measures of capital adequacy. The use of TCE as a measure of capital adequacy in our scenarios should thus not be interpreted as a judgment regarding the appropriateness of this measure going forward, but rather as recognition of its present predominance in market assessments.

The long–term viability of institutions needs to be reevaluated to assess both prospects for further writedowns and potential capital needs. To provide a gauge for equity needs, the first calculation in Table 1.4 assumes that leverage, measured as TCE over tangible assets (TA), is reduced to 25 times (4 percent TCE/TA), consistent with the deleveraging scenario and toward levels that existed prior to the crisis.39 Even to reach these levels, capital injections would need to be some $275 billion for U.S. banks, about $375 billion for euro area banks, about $125 billion for U.K. banks, and about $100 billion for banks in the rest of mature Europe. The second calculation illustrates the potential impact of a return of leverage to levels of the mid–1990s (around 6 percent TCE/TA). To achieve this more demanding level would require about $500 billion for U.S. banks, about $725 billion for euro area banks, about $250 billion for U.K. banks, and about $225 billion for the banks in the rest of mature Europe. These rough estimates suggest that in addition to offsetting losses, the additional need for capital derives from the stringent leverage and capital requirements markets are now demanding, based on the uncertainty surrounding asset valuations and the quality of capital. The authorities in several countries have introduced schemes that “ring–fence” certain troubled assets on bank balance sheets, and allow for risk–sharing between the bank and the government against further declines in the prices of these assets.

This can hopefully remove some of the tail risk of large further declines in the prices of those assets, and thus help restore investor confidence in bank balance sheets. In some cases, it may play a useful complementary role alongside recapitalization and limit the additional capital required.

Near term, bank earnings offer only a partial cushion to writedowns.

Applying the model described in Section D, lower operating earnings going forward will reduce the cushion against further credit writedowns on capital. Under the stylized scenario, banks’ pre–provision earnings are forecast to drop by between a third and a half (Figure 1.29). This is less than the 50 percent drop experienced by U.S. banks during the Great Depression, but in line with the experience of Japanese banks during the 1990s.40

Figure 1.29.
Figure 1.29.

U.S. and European (including U.K.) Bank Earnings and Writedowns

(In billions of U.S. dollars)

Source: IMF staff estimates.

Charge–offs are forecast to peak at 4.2 percent in the United States, 3.4 percent in the United Kingdom, and 2.8 percent in the euro area Figure 1.30. In each case, these are levels that are well above those experienced during the 1991–92 recession, though below those estimated to have been experienced in the United States during the Great Depression.

Figure 1.30.
Figure 1.30.

Commercial Bank Loan Charge-Offs

(In percent of total loans)

Source: IMF staff estimates.

The resulting decline in net profit is expected to be severe, but not unprecedented. Under the scenario, banks would post losses in all three regions during 2008–10, make flat returns in 2010 and return to profitability subsequently, albeit at modest levels (due to less use of leverage, lower fee income from securitization, and heavier regulatory burdens). This is broadly consistent with the period of time it took banks to return to profitability during the Great Depression and in Sweden in the early 1990s (although the writedowns are less severe than either of those more extreme cases). Dividends and taxes are assumed to play a minor role in determining the future path of capital. Under the scenario, dividend payout ratios decline to 20 percent of pre–tax earnings (from 60 percent) in the period to 2010–partly reflecting greater government involvement in dividend policy–but then rebound to 40 percent at the end of the period. Deferred tax assets built up during the loss periods are all expected to be used promptly as banks return to profitability. In addition, the procyclicality of Basel II risk weightings is likely to mean risk-weighted assets (RWA) rise at a faster pace than total assets, as a decline in asset quality contributes to reduced credit ratings.41 As a base case, we assume RWA grow 8 to 10 percent faster than total assets through 2011, but less rapidly thereafter.

The public sector should ensure viable banks are sufficiently capitalized to restore market confidence.

Experience with addressing banking system crises suggests that the public sector should ensure viable institutions have sufficient capital when it cannot be raised in the market and to do so through a single up–front operation. 42 Market participants are less confident to transact and invest where they see the risk of further, as yet unspecified, major policy interventions.

A decision to use official resources to supply capital should not be taken lightly. In addition to taking due account of the cost to taxpayers, care should be exercised as fiscal balances are already under pressure around the world. Steps should be taken to encourage private sector participation in recapitalization to the extent possible under current market conditions. However, further bold steps are needed at this point to restore market confidence, including committing the necessary government funds, even where this may mean taking temporary majority or full government control of financial institutions.

Potential new providers of capital and funding are currently deterred by uncertainty over banks’ balance sheet health and the macroeconomic outlook, as well as by uncertainty over the treatment of their claims in the event of further government support. Thus, governments need to design capital injection programs that protect potential new investors from policy risk, both through the convincing size of the capital injection and through the seniority provided to new investments, which may require new legal protection for the investors in some countries. Government support could pose risks to fiscal sustainability in more indebted countries that need to be taken into account in deciding the extent of overcapitalization.

Addressing troubled assets remains a priority.

Authorities have used a variety of policies to address banks’ troubled assets. In so doing, they hope to mitigate the adverse feedback loop by reducing the pressure on banks to pare lending in order to delever. As well, they aim to reduce the risk premiums that investors and counterparties continue to place on banks as a result of the uncertainty about the scale of eventual writedowns stemming from troubled, often opaque, assets.

Policy measures taken so far in this domain have had only a limited effect in improving market confidence. Policies have assisted in offsetting, ring–fencing or providing additional clarity about troubled assets, but have generally not been sufficient in magnitude and have not been applied comprehensively. Table 1.5 summarizes specific measures and their effectiveness.

Table 1.5.

Policy Measures and Effectiveness

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Source: IMF staff estimates.

The recent U.S. Treasury announcement of the Public–Private Investment Program (PPIP) is an important development in this context. While the details are still being worked out, the initiative would give an impetus to price discovery and secondary trading in distressed mortgage/credit securities. This should provide greater clarity on the value of such securities on bank balance sheets. The PPIP provides incentives to encourage investor purchases of troubled assets through the provision of leverage while capping private sector investors’ losses at their original equity investment. By increasing the price that investors are prepared to bid for assets, it should facilitate sales by banks. However, it appears less likely to successfully bridge the gap between the price that investors are willing to pay and the price that banks are willing to accept for loans (which banks mostly hold at book value) than for securities (which banks mostly hold at fair value). It therefore remains to be seen whether the program, which provides funding initially to finance up to $500 billion of asset purchases, will make a significant dent in the total size of troubled assets on banks’ balance sheets. The findings of the U.S. regulators’ stress tests, including the assessment of impairments of loans and actions needed by banks to achieve satisfactory capital buffers, may prove an important element in banks’ incentives to participate in the program.

The “bad bank” approach has the advantage of being relatively transparent and leaving the “good bank” with a clean balance sheet. However, as the table illustrates, different approaches can work depending on country circumstances. The most important priority is to choose an appropriate approach, fund it adequately, and implement it clearly. With some national initiatives recently reinvigorated, measures to address troubled assets are accelerating, including private–public investor partnerships. As these gain traction, they have the capacity to significantly improve the outlook for banking systems and the global economy.

Bank funding markets will continue to need support.

There has been some modest thawing in borrowers’ ability to access capital markets since the October 2008 GFSR Table 1.6, but securitization markets remain impaired and interbank and cross–currency swap markets remain stressed.

Securitized loans have declined by $1.6 trillion in the United States since 2006, and by $534 billion in Europe (although securitizations retained on banks’ own balance sheets for use as central bank collateral have remained high) Figure 1.31. Given the previous importance of securitization in bank funding, impairment of the securitization process will continue to limit access to credit.

Figure 1.31.
Figure 1.31.

European Securitization Gross Issuance

(In billions of U.S. dollars)

Sources: Citigroup; and European Securitization Forum.Note: Retained securitization refers to securitizations that are generated because they are eligible as collateral for repo financing from the central bank.
Figure 1.32.
Figure 1.32.

Refinancing Gap of Global Banks

Source: IMF staff estimates.

Although LIBOR–OIS spreads have receded somewhat, they remain elevated compared to the pre–crisis period, and term funding is still available only on a small scale owing to liquidity hoarding and continuing concerns about counterparty credit risk. Some banks continue to shun term interbank markets entirely, instead depositing surplus liquidity with central banks. Until balance sheet concerns are eliminated through effective banking system measures, central banks are likely to remain major suppliers of term funding.

Table 1.6.

Tentative Easing in Credit Conditions

(In billions of U.S. dollars)

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Sources: Bloomberg L.P.; Merrill Lynch; national central banks; and IMF staff estimates.Note: For lending surveys, a positive/negative balance indicates that lenders reported credit availability to be higher/lower than over the previous three-month period MBS = mortgage-backed security. OAS = option-adjusted spread; OIS = overnight index swap.