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Global Financial System Risks Escalate

A stockbroker in Germany: anxious financial markets in Europe are concerned about government debt levels (photo: Thomas Lohnes/AFP/Getty Images)

GLOBAL FINANCIAL STABILITY REPORT

Global Financial System Risks Escalate

IMF Survey online

September 21, 2011

  • Weak growth, balance sheets and political resolve cause crisis of confidence
  • Large number of countries affected by government debt risks
  • Policymakers need to act to repair household, government and financial balance sheets

Financial stability risks have risen sharply in recent months, as slower economic growth, market turbulence in Europe, and the credit downgrade of the United States have weighed on the global financial system, according to new analysis by the IMF.

Financial markets have begun to question the ability of policymakers to command broad political support for needed policy actions, the IMF said in its latest Global Financial Stability Report.

“We are in the middle of a crisis of confidence, which is taking its toll on both the economy and the financial system” said José Viñals, Financial Counsellor and head of the IMF”s Monetary and Capital Markets Department, which produced the report. Improvements in financial stability over the past three years have been partly reversed, said Viñals.

The report said balance sheets—a snapshot of the assets and liabilities held by a government, financial institution or household—are strained by mounting debt or assets that have lost value.

The Global Financial Stability Report was released the day after the IMF issued its outlooks on global growth and government debts and deficits, which show a weak and bumpy recovery from the crisis.

Global challenges

The lack of progress to repair balance sheets has raised concerns about the financial health of governments in advanced economies, banks in Europe, and households in the United States.

In Europe, concerns about government debt levels have spilled over to the region’s banking system, raising the cost of borrowing for many banks and reducing their market value.

The IMF estimates the sovereign credit risk experienced by banks in a number of European countries has increased since the start of 2010 by about €200 billion. This figure is not a measure of banks’ capital needs, but rather it approximates the increase in sovereign credit risk experienced by banks over the past two years.

In the United States, there have been increased concerns about the longer-term sustainability of U.S. government debt. These concerns, if left unaddressed, could potentially reignite sovereign risks, with serious global consequences. At the same time, U.S. households are still repairing their balance sheets—a process that has weighed on economic growth, house prices, and U.S. banks.

Low interest rates

The IMF said low interest rates, while necessary to help advanced economies support growth, can carry longer-term threats to financial stability. The search for higher investment returns is pushing some sectors in advanced economies, such as carry traders and hedge funds, to borrow more money to invest. This raises the risk of greater deterioration in asset quality in the event of new financial or economic shocks.

At the same time, many emerging markets are experiencing rapid loan growth and borrowing more money to finance their investments. This could result in overheating pressures, a progressive buildup of financial imbalances, and worsening credit quality. Should global stability risks further intensify, emerging markets could face sudden capital outflows and financial strains.

Time for action

To stem the current crisis, policymakers need to act swiftly and decisively on a series of policies:

• Public balance sheets in the United States, Europe, and Japan need to be bolstered through credible strategies to reduce government debts and deficits over the next few years.

• Banks in the European Union need to continue to build adequate capital buffers to help them cope with the spillovers from riskier governments. They also need to have stronger balance sheets to support the economic recovery. Some banks heavily reliant on wholesale funding and exposed to riskier public debt may need more capital, while weaker banks should be either restructured or resolved.

• Overstretched U.S. household balance sheets might benefit from a more ambitious program of mortgage modifications involving principal writedowns.

• Emerging economies should limit the buildup of financial imbalances to maintain resilience to future financial shocks, and continue to build solid financial systems that will help develop their economies. Macroprudential policies can help contain system-wide risks in the financial sector.

• Global financial regulatory reforms need to be concluded and implemented consistently across countries. This includes the treatment of systemically important financial institutions and market infrastructures, and addressing the challenges posed by the shadow banking sector.

A lack of decisive policy action to fix the causes and legacy of the financial crisis that began in 2008 has led to the current situation. While the path to a sustained recovery has narrowed, it has not disappeared, the IMF said.

The report was released just ahead of the IMF’s annual meetings, which bring together global policymakers in Washington, D.C. for a series of discussions on the global economy.