The Path Toward Greater Financial Stability:
By Naoyuki Shinohara, Deputy Managing Director,
Where Are We and What Needs to be Done?
International Monetary Fund
8th Conference on Risk, Banking and Financial Stability
Bali, Indonesia, September 25, 2013
As Prepared for Delivery
It is a great pleasure and honor to join you on the occasion of the 8th Conference on Risk, Banking and Financial Stability. I would like to express my gratitude to the organizers, particularly to Governor Agus of Bank Indonesia, to Universitas Sebelas Maret and the Journal of Financial Stability, and all who have contributed to the excellent organization of this Conference here in Bali. As always, it is a great pleasure to come to this beautiful island with its deep cultural traditions.
This conference is taking place at an important moment for the global economy and financial system. Policy makers have achieved a great deal in the aftermath of the Global Financial Crisis. Acute crisis risks in the euro area have been reduced by concerted efforts to stem contagion and re-address the region’s financial architecture. At the same time, regulatory authorities have strived to coordinate global policies to build a more harmonized regulatory structure that will help prevent the build-up of future excesses. Importantly, the United States appears to be moving into a more sustained growth phase and a gradual exit from unconventional monetary policy. Emerging markets have weathered the crisis well, although some concerns on the outlook of a number of them have emerged recently.
Nevertheless, important challenges lie ahead. This includes some residual legacy risks from the global crisis that remain unresolved. They stem from the unfinished bank repair and corporate debt overhang, particularly in the euro area. At the same time, new challenges are also beginning to unfold, arising from the side effects of prolonged monetary easing.
Five years have passed since the onset of the Global Financial Crisis, and banking systems are still at different stages of balance sheet repair. Banks in the U.S. have advanced the most in this process, but some European banks still require significant adjustment. Despite an increase in regulatory capital ratios, leverage and reliance on wholesale funding remain relatively high among the banks in core countries of the euro area. Strikingly, some large banks that report high Tier 1 capital ratios based on internally computed risk-weighted assets have weak leverage ratios. This raises concerns that capital levels may not be as strong as they seem. In countries outside the core euro area, banking systems continue to remain vulnerable as capital buffers are low relative to impaired loans. Furthermore, overall bank funding costs remain elevated, despite the easing of sovereign debt spreads. Weak economic growth will likely constrain earnings even further.
The unfinished bank repair in the euro area is very costly as it hinders credit transmission to the real economy. Healthy banks are needed to support economic recovery, so it is critical for the repair of the banking sector to be completed. In some cases, additional bank capital is needed, along with adequate provisioning to enhance overall buffers. It is important that the process of bank repair include a thorough asset quality review, stress tests, and supported by adequate capital backstops. If needed, state-backed asset management companies or other mechanisms could be established to warehouse and manage the stock of badly impaired assets to provide banks with incentive to value and write-down impaired and nonperforming loans.
Balance sheet repair is not only confined to banks. Another challenge from the crisis is the debt overhang in the nonfinancial corporate sector. Prior to the crisis, easy credit conditions and high profit expectations had caused firms to accumulate sizable leverage, for example in Italy, Portugal and Spain. Debt overhang at listed companies is significant in countries outside the core of the euro area – up to one-fifth of debt outstanding. Our analysis suggests that corporate leverage in these countries would have to be reduced by 6 to 11 percent of assets in the medium term to ensure sustainability.
As in the case of Japan during its banking crisis, weak banks in the euro area have continued to reinforce the problems of weak corporates. In turn, weak corporates have exacerbated the pressures on weak banks. This adverse bank-corporate feedback loop in the euro area needs to be disentangled to restore market confidence and ensure a lasting recovery. There is, therefore, a need for complementary measures to pare down corporate debts to sustainable levels, alongside banking reforms. These measures include further deleveraging, especially by larger firms, through the sale of foreign assets. There is also a need for equity swaps to reduce leverage. Other measures may be required such as reductions in operating costs, capital expenditures, dividend payouts, as well as loan principal reductions. Policies that facilitate corporate consolidation and restructuring will help support firms facing credit constraints.
As we speak, new challenges are beginning to emerge: in particular, those associated with the side effects of a prolonged period of monetary easing. Undoubtedly, at this stage of the global recovery, monetary policy needs to stay highly accommodative to meet macroeconomic goals—where appropriate. Exceptionally low interest rates have reduced the cost of debt for corporate borrowers. This has enabled firms to increase their debt maturity profiles and render debt servicing ratios more favorable, even at higher debt burdens. The down-side to easy credit, however, is a weakening of underwriting standards. In the U.S., for example, the issuance of covenant-lite loans once again has been on the rise over the last three years. In a number of emerging market countries, the combination of low borrowing rates, easy credit through bond financing and relative stagnation in equity issuance has led to a resurgence of corporate leverage. Macroprudential and other policy tools are employed in a measured manner to guard against undesirable credit excesses. Otherwise, the build-up of leverage over time may again usher in undesirable effects that could adversely affect financial stability.
In addition, there has been increasing concern recently about the challenges to macro-financial stability in some emerging market economies. The recent spikes in market volatility have unveiled pockets of fragility, particularly the susceptibility to shifts in portfolio flows. An escalation of global uncertainties, and a shift in expectations about tapering quantitative easing and an increase in U.S. long-term interest rates, could lead to a sharp reversal of portfolio flows to some emerging markets. This could re-test the resilience of emerging markets financial systems and macro frameworks. Indeed, the episodes of financial market turbulence in the second and third quarters of 2013 have focused more recently on countries with macroeconomic imbalances—high inflation and significant current account deficits—and weaker policy positions. It is therefore important for these countries to address underlying macroeconomic vulnerabilities, and ensure policy buffers are adequate to cushion risks emanating from external headwinds.
I would also like to underline the urgent need to reinvigorate the global regulatory reform agenda. Although much has been done to improve financial sector regulation at the global, cross-border and national levels, the reform process remains incomplete. Delays in completing the reform agenda are a source of continued vulnerability and are causing regulatory uncertainty that may affect banks’ willingness to lend. On this note banking reforms must consider several key features:
- First, the national regulatory reform priorities need to aim at achieving a stronger and more robustly capitalized banking system, and encouraging the buildup of liquidity buffers on an internationally consistent basis.
- Second, prudential supervision must be strengthened by securing sufficient resources and safeguarding the independence of supervisors. Robust enforcement of the new rules is required. This will call for sufficiently intrusive, skeptical, proactive, comprehensive, adaptive, and conclusive supervision.
- Third, as a complement to stronger supervision, enhanced disclosure will help improve market discipline and restore confidence in banks. To this end, improved financial reporting and disclosures are essential. This will promote better transparency, and prudent and consistent valuation of risk-weighted assets.
- And fourth, effective resolution regimes need to be established to allow for the orderly exit of non-viable banks. This includes effective agreements for winding down failing cross-border banks. In countries whose banks have been expanding rapidly across borders, cooperation between home and host supervisors should be fostered.
Finally, it is also important to recognize the potential risks associated with the rapid growth of shadow banking in some countries. Increasingly, credit intermediation involves entities and products that are outside the perimeter of banking supervision. No doubt, non-bank financial intermediation provides a valuable alternative to banks in providing credit to support economic activity. But, as the global financial crisis has shown, when a bubble bursts, uncontrolled leverage in the shadow banking sector can trigger a downward spiral in liquidity and solvency. Consequently, it is essential to put in place a prudent and holistic regulatory-supervisory approach that extends beyond banks to include the monitoring of shadow banking activities. This would prevent the build-up of the excessive leverage and risk-taking that can amplify financial sector risks.
To summarize, since the onset of the global financial crisis, commendable progress has been achieved in restoring stability and cementing recovery. Nonetheless, we must continue to work together to address old legacy risks and emerging new challenges, and to build a more robust foundation for our financial system to sustain growth and withstand shocks. This calls for the need to tackle existing imbalances, re-build buffers and embrace policies and changes that could strengthen our financial sector and lay a foundation for growth in the years to come.