Summary



The April 2017 Global Financial Stability Report (GFSR) finds that financial stability has continued to improve since last October. Economic activity has gained momentum and longer-term interest rates have risen, helping to boost the earnings of banks and insurance companies. Despite these improvements, however, threats to financial stability are emerging from elevated political and policy uncertainty around the globe. If policy developments in advanced economies make the path for growth and debt less benign than expected, risk premiums and volatility could rise sharply. In addition, a shift toward protectionism in advanced economies could reduce global growth and trade, impede capital flows, and dampen market sentiment. Getting the policy mix right is crucial. In the United States, policymakers should provide incentives for economic risk taking while guarding against excessive financial risk taking. Emerging market economies should address domestic imbalances to enhance their resilience to external shocks. In Europe, domestic banking systems continue to face significant structural challenges. Furthermore, there should be no rollback of the postcrisis reforms that have strengthened oversight of the financial system. The April 2017 GFSR also includes a chapter that examines how a prolonged low-growth, low-interest rate environment can fundamentally change the nature of financial intermediation. In such an environment, yield curves would likely flatten. Combined with low credit demand, this would lower bank earnings, particularly for smaller, deposit-funded, and less diversified institutions, and presenting long-lasting challenges for life insurers and defined-benefit pension funds. Another chapter assesses the ability of country authorities to influence domestic financial conditions in a financially integrated world. It finds that, despite the significant impact on domestic financial conditions of global shocks, countries retain influence to achieve domestic objectives—specifically, through monetary policy.

Chapter 1 : Getting the Policy Mix Right

Chapter 1 finds that financial stability has continued to improve since the October 2016 Global Financial Stability Report. Economic activity has gained momentum and longer-term interest rates have risen, helping to boost earnings of banks and insurance companies and improving appetite for risk. Despite this improvement, new threats to financial stability are emerging from elevated political and policy uncertainty around the globe. If policy developments in advanced economies mean a less benign path for growth and debt than expected, risk premiums and volatility could rise sharply, undermining financial stability. In addition, a shift toward protectionism in advanced economies could reduce global growth and trade, impede capital flows, and dampen market sentiment. Getting the policy mix right is crucial. In the United States, policymakers should provide incentives for economic risk taking, while guarding against excessive financial risk taking that could undermine financial stability. Emerging market economies should address domestic imbalances while protecting themselves from external shocks. In Europe, banking systems face structural challenges that need to be tackled. The postcrisis reform agenda has strengthened oversight of the financial system, raised capital and liquidity buffers of individual institutions, and improved cooperation among regulators. Caution is needed when considering any rollback of this progress.

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Financial Stability Overview
Is the U.S. Corporate Sector Ready to Accelerate Expansion—Safely?
Emerging Market Economies Face Trying Times in Global Markets
European Banking Systems: Addressing Structural Challenges
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1.1. Could Fragilities in Offshore Dollar Funding Exacerbate Liquidity Risk?
Chart Data 1.3. Implications of Brexit for Financial Stability and Efficiency
 
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Data 1.1. Global Financial Stability Map: Risks and Conditions
Chart Data 1.2. Global Financial Stability Map: Assessment of Risks and Conditions
Chart Data 1.3. Reflation and Market Optimism
Chart Data 1.4. Assessments of U.S. Equity Valuations
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1.5. United States: Policies under Discussion and Financial Stability Risks
Chart Data 1.6. United States: Business Confidence and Economic Risk Taking
Chart Data 1.7. Policy Stimulus and Corporate Balance Sheets
Chart Data 1.8. United States: Corporate Internal Funds and External Sources of Finance
Chart Data 1.9. Corporate Leverage and the Credit Cycle
Chart Data 1.10. Debt Service, Interest Coverage Ratios, and Vulnerability to Higher Interest Rates

Chart Data  1.11. United States: A Retrospective on Economic versus Financial Risk Taking    
Chart Data  1.12. Emerging Market Economies: Asset Prices and Fundamentals     
Chart   1.13. Transmission of External Risks to Emerging Market Economies     
Chart Data  1.14. Capital Flows to Emerging Market Economies     
Chart Data  1.15. Emerging Market Corporate Debt under Rising Risk Premiums and Protectionism     
Chart Data 1.16. Emerging Market Bank Capital and Asset Quality     
Chart Data  1.17. Underprovisioning in the Weak Tail of Banks     
Chart   1.18. Emerging Market Economy Challenges     
Chart Data  1.19. China: Credit and Bank Balance Sheets     
Chart Data  1.20. China: Capital Flows and Foreign Exchange Reserves     
Chart Data  1.21. Recent Turmoil in Chinese Financial Markets     
Chart Data  1.22. Banking Sector Market Valuations and Return Performance     
Chart Data  1.23. European Bank Profitability, 2016     
Chart Data  1.24. European Banking System Actions to Reduce Costs     
Chart   1.25. Global Systematically Important Bank Business Model Challenges     
Chart   1.26. Bank and Sovereign Nexus     

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Chapter 2 : Low Growth, Low Interest Rates, and Financial Intermediation

Chapter 2 analyzes the potential long-term impact of a scenario of sustained low growth and low real and nominal rates for the business models of financial institutions and the products offered by the financial sector. Advanced economies have experienced low interest rates and growth since the global financial crisis. Despite recent signs of an increase in longer-term yields, an imminent exit from low rates is not guaranteed, given the prevalence of slow-moving structural factors, such as demographic aging and stagnation in productivity growth. The confluence of these factors could change the nature of financial intermediation. Credit demand would likely be lower whereas household demand for transaction services would likely rise. Consequently, banking in advanced economies may evolve toward fee-based services. Aging will increase demand for health and long-term-care insurance, and low asset returns would accelerate the transition to defined-contribution private pension plans. Demand is likely to weaken for long-term savings products offered by insurers in favor of passive index funds. Policies could help ease the adjustment to such an environment by providing incentives to ensure longer-term stability instead of merely attenuating short-term pain.

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Summary
Introduction
The Term Structure of Interest Rates
Banking with Low Natural Rates of Interest
 
Insurance and Pensions in a Low Natural Rate Economy
Asset Allocation, Market Finance, and Financial Stability
 
Policy Implications and Conclusions
 
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2.2 How Have U.S. Banks Reacted to the Low-Interest-Rate Environment?
Chart Data 2.3 Pension Fund Exit from Underfunding: Risk-Return Trade-off
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Data 2.1. Interest Rates, Term Spreads, and Volatility in Advanced Economies
Chart Data 2.2, Term Premiums in Economies with Normal versus Low Natural Rates
Chart Data 2.3. Banking under Low Natural Rates: Theoretical Predictions
Chart Data 2.4. Japan: Evolution of Bank Net Interest Margins in Normal and Low-for-Long Settings
Chart Data 2.5. Japan: Banks’ Adaptation to the Deposit Rate Lower Bound Period
Chart Data 2.6. Prolonged Low Interest Rates and Bank Profits
Chart Data 2.7. Impact of Forward Rate Surprises on Bank Equity Returns
Chart Data 2.8. Asset Allocation of Pension Funds and Insurers, 2015
Chart Data 2.9. U.S. Mutual Fund Expense Ratios and Growth of U.S. Index Funds




Annex Figures
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Annex Figure 2.1.1. Impulse Responses Outside of a Low-for-Long Scenario

Chart Data  Annex Figure 2.1.2. Impulse Responses in Low-for-Long Economies
   

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Chapter 3 : Are Countries Losing Control of Domestic Financial Conditions?

Chapter 3 examines whether countries still retain influence over their domestic financial conditions in a globally integrated financial system. The chapter develops financial conditions indices that make it possible to compare a large set of advanced and emerging market economies. It finds that global financial conditions account for 20 to 40 percent of the variation in countries’ domestic financial conditions, with notable difference among economies. The importance of this global factor does not, however, seem to have increased much over the past two decades. Despite the significant role of global financial shocks, countries seem to be able to influence their own financial conditions to achieve domestic objectives—specifically, through monetary policy. But because domestic financial conditions react strongly and rapidly to global financial shocks, countries may find it difficult to implement timely policy responses. Emerging market economies, which are more sensitive to global financial conditions, should prepare for tighter external financial conditions. Governments can promote domestic financial deepening to enhance resilience to global financial shocks. In particular, developing a local investor base, as well as fostering greater equity- and bond-market depth and liquidity, can help dampen the impact of such shocks.

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Summary
Introduction
 
An Overview of Financial Conditions
Financial Conditions around the World
Can Countries Manage Domestic Financial Conditions amid Global Financial Integration?
 
Conclusions and Policy Implications
 
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Data 3.1. United States: Financial Conditions Indices, 1991–2016
Chart Data 3.2. Selected Advanced and Emerging Market Economies: Financial Conditions Indices
Chart Data 3.3. Future GDP Growth and Financial Conditions: Quantile Regressions
Chart Data 3.4. Probability Distributions of One-Year-Ahead GDP Growth
Chart Data 3.5. Three-Factor Model Based on Financial Conditions Index, 1995–2016
Chart Data 3.6. Single Factor versus Principal Component Analysis, 1995–2015
Chart Data 3.7. Variance Accounted for by One-and Three-Factor Models
Chart Data 3.8. Variance Attributable to Global Financial Conditions, 1995–2016
Chart Data 3.9. Response of Domestic Financial Conditions to Shocks
Chart Data 3.10. Share of Domestic Financial Conditions Index Fluctuations Attributable to Global Financial and Monetary Policy Shocks

Chart Data   3.11. Share of Domestic Financial Conditions Index Fluctuations Attributable to Global Financial Conditions
   
Chart Data  3.12. Selected Advanced Economies: Response of Financial Conditions Index to Monetary Policy Shocks    
Chart Data   3.13. Share of Domestic Financial Conditions Index Fluctuations Attributable to Global Financial Shocks before and after the Global Financial Crisis    
Annex Figures

Data Annex 3.1 Financial Conditions Indicies for all 43 Countries    

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