Global Financial Stability Report (GFSR)

Potent Policies for a Successful Normalization

April 2016

The current report finds that global financial stability risks have risen since October 2015. The report finds that the outlook has deteriorated in advanced economies because of heightened uncertainty and setbacks to growth and confidence, while declines in oil and commodity prices and slower growth have kept risks elevated in emerging markets. These developments have tightened financial conditions, reduced risk appetite, raised credit risks, and stymied balance sheet repair. A broad-based policy response is needed to secure financial stability. Advanced economies must deal with crisis legacy issues, emerging markets need to bolster their resilience to global headwinds, and the resilience of market liquidity should be enhanced. The report also examines financial spillovers from emerging market economies and finds that they have risen substantially. This implies that when assessing macrofinancial conditions, policymakers may need to increasingly take into account economic developments in emerging market economies. Finally, the report assesses changes in the systemic importance of insurers, finding that across advanced economies the contribution of life insurers to systemic risk has increased in recent years. The results suggest that supervisors and regulators should take a more macroprudential approach to the sector.


Executive Summary and Preface

Chapter 1: Potent Policies for a Successful Normalization

Chapter 1 finds that risks to global financial stability have increased since the October 2015 Global Financial Stability Report. In advanced economies, the outlook has deteriorated because of heightened uncertainty and setbacks to growth and confidence. Disruptions to global asset markets have added to these pressures. Declines in oil and commodity prices have kept risks elevated in emerging market economies, while greater uncertainty about China’s growth transition has increased spillovers to global markets. These developments tightened financial conditions, reduced risk appetite, raised credit risks, and stymied balance sheet repair, undermining financial stability. A broad-based policy response is needed to secure financial stability.

Chart Data 1.1   Developments in Financial Conditions
1.2   Brazil: Financial System Risks
Data 1.3   Impact of Low and Negative Rates on Banks
1.4   Euro Area Financial Architecture—Progress, but Gaps Remain
1.1   The Effects of Energy Commodities on Emerging Market Economies and Other Economies and Their Buffers and Policy Indicators
Data 1.2   Loss-of-Market-Access Indicators
Data 1.3   Selected Indicators of Advanced Economy Banks
Chart Data 1.1   Global Financial Stability Map: Risks and Conditions
Chart Data 1.2   Global Financial Stability Map: Components of Risks and Conditions
Chart Data 1.3   Recent Market Developments
Chart Data 1.4   Equity Risk Premiums and Earnings Decompositions
Chart Data 1.5   Global Oil Prices, Equity, and Bond Markets
Chart Data 1.6   U.S. High-Yield Markets and Lending Conditions
Chart Data 1.7   Deterioration of Inflation Expectations
Chart Data 1.8   Interest Rate Expectations and Bond Term Premiums
Chart 1.9   Simulated Peak Effects under Global Market Disruption Scenario
Chart Data 1.10   China and Emerging Market Economies: Credit and Profitability
Chart Data 1.11   Chinese Listed Companies: Leverage, Interest Coverage, and Debt-at-Risk
Chart Data 1.12   Chinese Listed Companies’ Performance
Chart Data 1.13   China: Corporate Bond Issuance and Pricing
Chart Data 1.14   China: Equity Markets and Exchange Rates
Chart Data 1.15   The Global Commodity Crisis
Chart Data 1.16   Corporations, Sovereigns, and Their Nexus
Chart Data 1.17   Banking System Health
Chart Data 1.18   Oil Prices and Economic Links in the Caucasus and Central Asia, and Middle East and North Africa Regions
Chart Data 1.19   Performance of the Banking System in the Caucasus and Central Asia, and Middle East and North Africa Regions since June 2014
Chart Data 1.20   Falling Bank Valuations Reflect Weakening Outlook
Chart Data 1.21   Valuations Reflect Legacy and Business Model Challenges
Chart 1.22   Simulated Peak Effects under Successful Normalization Scenario
Annex Figures
Chart 1.1.1   China: Reported NPL + SML Ratio, and Debt-at-Risk Ratio
Chart 1.1.2   Sensitivity of Variations in Interest Coverage Threshold
Chart 1.1.3   Corporate Sector Loans Potentially at Risk
Chart 1.2.1   Successful Normalization Scenario Simulation Results
Chart 1.2.2   Global Market Disruption Scenario Simulation Results

Chapter 2: The Growing Importance of Financial Spillovers from Emerging Market Economies

Chapter 2 finds that spillovers from emerging equity and foreign exchange markets have risen substantially, and now explain more than a third of the variation in asset returns in other countries. This underscores the importance for policymakers of taking account of economic and policy developments in emerging market economies when assessing domestic macrofinancial conditions. More than economic size and trade integration, the degree of financial integration matters for a country’s importance as receiver and emitter of financial spillovers. The level of integration explains, for example, why purely financial contagion from China remains less significant even as the impact of Chinese growth shocks is increasingly important for equity returns in both emerging market and advanced economies. As China’s role in the global financial system continues to grow, clear and timely communication of its policy decisions and transparency about its policy goals and strategies consistent with their achievement will be ever more important. Given the evident relevance of corporate leverage and mutual fund flows in amplifying spillovers of shocks, it will also be important to shape macroprudential surveillance and policies to contain systemic risks arising from these channels.

Data 2.1   Spillover Channels from China—From Real to Financial Linkages?
2.2   Bilateral Cross-Border Exposure through Mutual Funds
Chart Data 2.1   Trade between Advanced and Emerging Market Economies
Chart Data 2.2   Global Financial Integration
Chart Data 2.3   Global Gross Exports and Domestic Value-Added Exports
Chart 2.4   Example of Shock Transmission through Common Lenders
Chart Data 2.5   Advanced Economies' Financial Exposures to Emerging Market Economies
Chart Data 2.6   Spillover Indices for Various Asset Classes and Components
Chart 2.7   Spillovers before and after the Global Financial Crisis
Chart Data 2.8   Average Equity Spillovers from Selected Emerging Market Economies
Chart Data 2.9   Contribution to Variation in Emerging Market Economy Equity Spillovers,
Chart Data 2.10   Emerging Market Economy Outward Equity Spillovers by Sector
Chart Data 2.11   Chinese Industrial Sector: Equity Market Spillovers to Advanced Economy Sectors
Chart Data 2.12   Emerging Market Economy Equity Market Spillovers: Role of Firm-Level Factors
Chart Data 2.13   Contribution to Variation in Emerging Market Economy Foreign Exchange Spillovers, 1995–2014
Chart Data 2.14   Foreign Exchange Spillovers of Selected Emerging Market Economies, 2011–15
Chart 2.15   Spillover of Growth Surprises in Major Emerging Market Economies
Chart Data 2.16   Financial Interdependence on Emerging Market Economies through Global Funds
Chart Data 2.17   Contributions to Variation in Bond and Equity Returns in Advanced and Emerging Market Economies

Chapter 3: The Insurance Sector—Trends and Systemic Risk Implications

Chapter 3 shows that across advanced economies, the contribution of the insurance sector, particularly of life insurers, to systemic risk has increased, although it is not yet to the level of the banking sector. This increase is largely a result of growing common exposures to aggregate risk, partly because insurers’ interest rate sensitivity has risen and partly because of higher correlations across asset classes. In the event of an adverse shock, therefore, insurers are unlikely to fulfill their role as financial intermediaries at a time when other parts of the financial system are also struggling to do so. These findings suggest that a more macroprudential approach to supervision and regulation of insurance companies should be taken. Measures could include regular macroprudential stress testing or the adoption of countercyclical capital buffers. Steps that would complement a push for stronger macroprudential policies include the international adoption of capital and transparency standards for the sector. In addition, the different behavior of smaller and weaker insurers warrants attention by supervisors.

Chart Data 3.1   Insurance Models
Data 3.2   Designation of Global Systemically Important Insurers
Chart Data 3.3   Reinsurance, Retrocession, and Financial Stability
Chart Data 3.4   Insurance in China
Chart Data 3.5   Inward and Outward Spillovers and Centrality of European Insurers
Chart Data 3.1    Selected Countries: Relative Size of Financial Intermediaries
Chart 3.2   Systemic Risks in Insurance
Chart Data 3.3   Global Insurance Sector Size and Market Structures
Chart Data 3.4   Changing Insurance Business Models and Systemic Risk Factors
Chart Data 3.5   Time-Series Clustering of Life Insurers on Equity Returns
Chart Data 3.6   Variation of Insurers’ Equity Return Due to First Principal Component
Chart Data 3.7   CoVaR Indices
Chart Data 3.8   Conditional Capital Shortfall
Chart Data 3.9   Forward-Looking Default Correlation Networks
Chart Data 3.10   Spillovers between Insurance and Other Financial Sectors
Chart Data 3.11    Life Insurers' Investments
Chart Data 3.12   Sensitivity of Life Insurers' Risky Assets to Firm-Level Factors
Chart Data 3.13   U.S. Life Insurers' Higher Risk Assets
Chart Data 3.14   U.S. Insurance Sector Bond Holdings and Turnover
Chart Data 3.15   Insurers' Interest Rate and Market Return Sensitivity
Chart Data 3.16   Compliance with Insurance Core Principles