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Time to Fix Causes of Financial Crisis, Says IMF

Commuters walk past a bank: not enough has been done to fix the financial sector, according to the IMF’s latest report (photo: Fabrice Coffrini/AFP)

GLOBAL FINANCIAL STABILITY REPORT

Time to Fix Causes of Financial Crisis, Says IMF

IMF Survey online

April 13, 2011

  • Global financial stability improving, but risks remain
  • Advanced economies need to tackle high debt and weak balance sheets
  • Emerging markets need to guard against overheating and financial imbalances

The global financial system remains vulnerable to further shocks, and policymakers need to tackle the root causes of the recent crisis, the IMF said.

Policymakers have to strike the right balance and shift their focus away from policies that were put in place to treat the symptoms of the crisis toward measures that will treat the underlying causes. The challenge will be to repair the banking system and deal with high debt levels without jeopardizing financial stability and the nascent global economic recovery.

“The legacy of high debt burdens is weighing on economic activity and balance sheets, keeping risks to financial stability elevated,” said José Viñals, Financial Counsellor and head of the IMF’s Monetary and Capital Markets Department.

The latest Global Financial Stability Report gives policymakers a roadmap to focus their work on several fronts.

• Reduce high government debt burdens and strengthen balance sheets

• Clean banks’ balance sheets by resolving bad assets and increasing capital

• Write down distressed mortgage loans and reduce principal on mortgages that could benefit from modification

• Guard against overheating and the buildup of financial imbalances in emerging economies

The two-speed economic recovery—with advanced economies slowly gaining strength while emerging economies risk overheating—means governments face different challenges.

Unfinished business

High debt levels and excessive leverage, which is money borrowed to finance investments, are evident in a number of advanced economies—including among (i) banks lacking adequate capital to absorb losses and poor-quality assets, (ii) governments facing debt sustainability problems, and (iii) households whose houses are worth less than their mortgages.

Nearly four years after the start of the global crisis, confidence in the banking system has yet to be fully restored. Despite improvements to balance sheets, some banks—particularly in Europe—remain insufficiently capitalized, and subject to rising funding costs. To deal with these problems, a comprehensive set of policies is needed, including

• Increased transparency through more credible, rigorous stress tests

• Higher capital buffers

• Concrete plans to restructure or resolve failing banks, where necessary.

Government balance sheets also remain under strain in several advanced economies. Certain countries in Europe are especially at risk, as financial market concerns about the sustainability of public debt have raised funding costs, which in turn is harmful to a country’s economy.

Household indebtedness also remains a key challenge in the United States and several other advanced economies, in turn posing risks to bank balance sheets, credit availability, and house prices. The U.S. shadow housing inventory—which represents the potential additional supply of homes for sale—stands at approximately 6.3 million, or 16 months of additional housing supply.

More structural policies, including debt renegotiation or principal writedowns may be needed to reduce negative equity and the shadow inventory. IMF analysis shows that banks in the United States are sufficiently strong to withstand fairly sizeable reductions in the principal of risky mortgages.

Too much of a good thing

The main challenge for emerging economies is to combat overheating and the accumulation of financial imbalances in order to maintain financial stability and avoid future crises. Emerging markets are receiving an increased flow of foreign capital at a time when their output gaps are closing and inflation rates are rising. These capital inflows are complicating efforts to manage local demand through tighter monetary policy and are straining the absorptive capacity of some local financial markets.

Emerging economies need to rebalance their policy mix by relying more on economic policies, for example, tighter monetary policies in a number of countries, while a judicious use of macroprudential policies, including, in some cases, capital controls, can play a supportive role in managing capital flows and their effects.