## CHAPTER 1 GETTING ThE POLICY MIx RIGhT ## Source details **Canonical URL:** [CHAPTER 1 GETTING ThE POLICY MIx RIGhT](https://www.imf.org/-/media/files/publications/gfsr/2017/april/chapter-1/ch1.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2017/april/chapter-1/ch1.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2017/april/chapter-1/ch1.pdf.json) --- ### Global risks and market conditions - Macroeconomic risks have declined, driven by improving economic activity and lower inflation risks. - Emerging market risks remain elevated as higher inflation volatility offsets improvements in the corporate sector and external financing. - Credit risks have declined amid improvement in banks and the corporate sector. - Monetary and financial conditions are unchanged as tighter monetary policies are offset by easier financial conditions. - Risk appetite has strengthened because of improved confidence and gains in risk assets. - Market and liquidity risks have moderated from an elevated level against the backdrop of better liquidity conditions. - Asset and market indicators tracked include U.S. Treasuries (10-year), German Bund (10-year), JGB (10-year), EMBI global (yield), GBI-EM (yield), S&P 500 and sector indices, VIX, MOVE, FX 6-month volatilities, and commodity index. ### Reflation, market optimism, and financial market signals - Market expectations for the U.S. economy and monetary policy normalization have improved (Consensus Forecasts for End-2017 U.S. 10-Year Treasury Yield shown as probability density). - Ten-Year Inflation Compensation: cumulative breakeven yield change in basis points indicates rising hopes for reflation across advanced economies. - Financial Market Risk Dashboard: a compression in volatility across a number of global markets has accompanied market optimism. ### U.S. corporate sector — policy channels and balance-sheet dynamics - Policies under discussion: tax reform, deregulation, infrastructure spending, trade — could boost economic growth and corporate cash flow directly and indirectly via improved market sentiment. - Corporate tax channels: - Potential reduction in corporate tax rate. - Interest deductibility/expensing investment. - Incentives for repatriation. - Stylized uses of funds: - Economic risk taking = Capital spending (including R&D). - Financial risk taking = Acquisition of financial assets, M&A, and share buybacks/dividends. - Stylized sources of funds: - Internal funds (income, operating cash, buffers). - Equity markets (cost of equity finance and issuance). - Debt markets (cost of borrowing and leverage limits). - Banks (cost and availability of loans). ### Illustrative scenario estimates of proposed tax measures and corporate capex capacity - Scenario elements estimated using sector-level data include: - A boost to operating cash flow from a 10 percentage point reduction in effective corporate tax rates to proxy a lower statutory corporate tax rate. - Combined effect of expensing new capital expenditures and removing the tax deductibility of interest expenses (approximated by taking half of the product of effective interest expenses and the statutory tax rate for the stock transition). - Potential for a one-off repatriation of retained foreign earnings, including liquid funds held abroad. - Quantified impacts and capacities: - A cut to the statutory tax rate could provide a cash flow impetus to S&P 500 firms amounting to more than $100 billion a year, atop existing cash flow of more than $1 trillion. - Business sentiment improvements could help close a gap in corporate capital spending relative to higher historical growth by almost 2 percentage points of assets, or some $750 billion a year. - Repatriation: $2.2 trillion in unremitted foreign earnings held abroad; 60 percent concentrated in information technology and health care. - Cash and investments: ~$1.3 trillion reported for S&P 500 firms. - Full expensing of new capex and removal of interest deductibility produce net impacts varying by sector, with capital-intensive sectors (energy, real estate, utilities) benefitting more. ### Limits, distributional effects, and financing gaps - Energy, utilities, and real estate accounted for nearly half of overall capital spending among S&P 500 firms in recent years. - The cash flow boost from a cut to the statutory tax rate may be insufficient to spur the nearly $140 billion needed to boost capital expenditure to the level prevailing before 2000. - Adding expensing, removal of interest deductibility, and repatriation attenuates but likely does not eliminate financing needs in those sectors. - Cash windfalls from repatriation would likely accrue mainly to cash-abundant sectors and sectors that have engaged in substantial financial risk taking. ### Financial risk taking, leverage, and vulnerabilities in the U.S. corporate sector - Financial risk taking (purchases of financial assets, M&A, and net payouts) averaged $940 billion a year over the past three years for S&P 500 firms—more than half of free corporate cash flow. - Sector concentration: health care and information technology collectively accounted for nearly $500 billion a year of financial risk taking since 2012. - Corporate sector balance sheets: - $36 trillion economy-wide corporate sector balance sheet; S&P 500 firms collectively account for about one-third of that balance sheet. - $7.8 trillion in debt and other liabilities added since 2010. - Broader sample: nearly 4,000 firms account for about half of the economy-wide corporate sector balance sheet. - Leverage and asset-quality signals: - Median net debt across S&P 500 firms is close to a historic high of more than 1½ times earnings. - Debt is very high in energy, real estate, and utilities sectors, ranging between four and six times earnings. - Corporate credit fundamentals have started to weaken; asset quality (for example, share of deals with weaker covenants) has deteriorated; rising share of rating downgrades observed in industries including energy, capital goods, and health care. - Debt servicing and interest coverage: - The proportion of income devoted to debt servicing has risen by 4 percentage points, bringing it to its highest level since 2010. - Average interest coverage ratio has fallen sharply over the past two years; earnings have dropped to less than six times interest expense. ### Policy implications and financial stability considerations (U.S. corporate sector) - Tax policy reforms could support higher growth but should: - Maximize economic effectiveness while safeguarding against excesses of financial risk taking that could undermine financial stability. - Policymakers should be mindful that: - Cash flow boosts may disproportionately accrue to sectors engaged in financial risk taking. - High leverage combined with tighter borrowing conditions could materially affect financial stability. - Some sectors may continue to face financing gaps even after tax-related windfalls and repatriation measures. ### Corporate cash holdings, leverage, and the credit cycle - Corporate cash holdings are tapering. - Corporate profits are receding from a high level (percent of GDP). - Net equity financing has been falling the past four decades, as debt finance has continued to rise (percent of assets). - Negative net equity issuance (gross issuance minus share buybacks) has coincided with an increase in debt and other liabilities. - Deteriorating balance sheet fundamentals and credit conditions signal a late stage of expansion in the credit cycle (unweighted average in percentile rank, normalized to zero). - Median corporate leverage among big firms has grown steadily and is close to a historical peak (net debt to EBITDA). - Eight out of ten sectors witness an increase in leverage across a broad set of firms (net debt to EBITDA by sector). - The rise in "challenged" firms has been mostly concentrated in the energy sector, and broadened across real estate and utilities; these three industries currently account for about half of firms struggling to meet debt service obligations and higher borrowing costs. ### Debt service, interest coverage, and vulnerability metrics - Firms accounting for 10 percent of corporate assets appear unable to meet interest expenses out of current earnings (ICR < 1). - Firms accounting for 20 percent of corporate assets have 1 ≤ ICR < 2. - Under the assumed interest rate rise in the WEO adverse scenario, the share rises to 22 percent. - Under the adverse scenario in Scenario Box 1.1 of the WEO, the combined assets of challenged firms could reach almost $4 trillion. - Sensitivity exercise: assumes an interest shock passing through based on an assumed loan maturity of five years; the number of firms analyzed ranges from 1,800 to 4,000 depending on S&P Capital IQ data availability. ### Policy recommendations for advanced economies - Balance stimulus and tax reform benefits against financial stability risks; monitor rising leverage and deteriorating credit quality. - Tax measures that reduce incentives for debt financing could help attenuate risks of further leverage buildup. - Regulators should preemptively address excessive risk taking; deploy additional prudential and supervisory action if stimulus increases debt-financed investment and medium-term corporate vulnerabilities. - Use stress testing (for banks and potentially nonbank financial intermediaries) to assess impacts of severe losses in nonfinancial corporate debt, accounting for liquidity strains and correlated sector risks (such as commercial real estate). - Resist wholesale dilution or backtracking on global regulatory reforms. ### Emerging market resilience, risks, and transmission channels - Emerging market overall growth is projected to rise from 4.1 percent in 2016 to 4.5 percent in 2017 (driven mainly by gains in commodity exporters). - Emerging market corporate leverage has started to decline but remains elevated. - Countries most at risk include those with large external financing needs, high corporate foreign-currency indebtedness, or a large foreign presence in local bond markets; frontier market borrowers are also vulnerable. - A shift toward protectionism would raise risk premiums amid declining global trade and commodity prices, hurting corporate earnings—especially export-dependent firms—and straining leveraged firms and weaker banking systems. ### Quantified emerging market scenario impacts - Rising global risk premiums scenario: - The weak tail of emerging market economy firms (proportion of nonfinancial corporate debt issued by firms with ICR < 1) would increase to over 16 percent of total nonfinancial corporate debt, an increase of $135 billion. - This would exceed the 15 percent peak in 2015. - Brazil, China, and India would experience the greatest impact. - Rising protectionism scenario (assumption: global tariff and nontariff barriers raise the effective cost of imports by 10 percent): - The size of the weak tail of firms would increase to 17 percent of total nonfinancial corporate debt, an increase of $235 billion. - Greatest deterioration in corporate balance sheets would occur in China, India, and South Africa. ### Capital flows to emerging markets and investor concentration - Capital flows to emerging market economies have been subdued in recent years. - Retail investors represent a small source of financing but are a large source of volatility; most capital flow reversals are driven by retail investors. - Example: in 2016 the multisector bond funds of a single asset manager reduced combined emerging market bond exposure by $15 billion; almost $11 billion of that total was concentrated in a single country, representing an estimated 13 percent of that country’s total sovereign local and hard currency bonds. - Emerging market equities: manufacturing exporters with high U.S. trade exposure have underperformed other emerging market equities. - Emerging market currencies: currencies of manufacturing exporters have underperformed those of commodity exporters. ### Emerging market banks — asset quality and capital buffers - Bank-level data sample: 294 banks covering banks from 14 countries with $32 trillion in assets. - Aggregate Tier 1 capital ratios for the sample have been rising steadily and are at comfortable levels. - Lenders outside China increased capital by 20 percent since the end of 2014, compared with 15 percent growth in assets over the same period. - Provisioning and asset-quality pressures: - Nonperforming and problem loans have climbed in many countries due to economic weakness (Brazil, Russia), continued corporate leverage growth (China), and sector-specific downturns (India). - Provision needs exceed annual profits in 30 percent of emerging market banks outside China. - If provisions were deducted from equity, weak banks would rise to 35 percent of assets. - A large weak tail of banks has a high ratio of bad loans to buffers. ### Selected bank-level indicators (sample summary) - Sample summary: 294 banks; $32 trillion in assets. - India: Number of banks 64; Tier 1 Capital Ratio (sample) 10.6 percent; FSI 10.6; NPL and Problem Loan Ratio 11.3 percent. - Russia: Number of banks 24; Tier 1 Capital Ratio (sample) 11.6 percent; FSI 8.8; NPL and Problem Loan Ratio 15.6 percent. - South Africa: Number of banks 8; Tier 1 Capital Ratio (sample) 12.8 percent; FSI 14.2; NPL and Problem Loan Ratio 7.1 percent. - Brazil: Number of banks 22; Tier 1 Capital Ratio (sample) 12.9 percent; FSI 13.1; NPL and Problem Loan Ratio 9.5 percent. - Poland: Number of banks 14; Tier 1 Capital Ratio (sample) 14.8 percent; FSI 15.7; NPL and Problem Loan Ratio 7.6 percent. - Indonesia: Number of banks 32; Tier 1 Capital Ratio (sample) 19.5 percent; FSI 20.6; NPL and Problem Loan Ratio 8.0 percent. - Mexico: Number of banks 12; Tier 1 Capital Ratio (sample) 14.9 percent; FSI 13.2; NPL and Problem Loan Ratio 2.5 percent. - China: Number of banks 42; Tier 1 Capital Ratio (sample) 11.0 percent; FSI 11.1; NPL and Problem Loan Ratio 4.8 percent. - United Arab Emirates: Number of banks 22; Tier 1 Capital Ratio (sample) 17.1 percent; FSI 16.9; NPL and Problem Loan Ratio 6.6 percent. - Malaysia: Number of banks 12; Tier 1 Capital Ratio (sample) 14.2 percent; FSI 14.4; NPL and Problem Loan Ratio 3.7 percent. - Colombia: Number of banks 3; Tier 1 Capital Ratio (sample) 8.4 percent; FSI 11.9; NPL and Problem Loan Ratio 7.1 percent. - Saudi Arabia: Number of banks 12; Tier 1 Capital Ratio (sample) 17.6 percent; FSI 16.8; NPL and Problem Loan Ratio 3.0 percent. ### Bank provisioning shortfalls and resilience implications - Illustrative exercise: raise banks’ provision coverage ratios to at least 50 percent of nonperforming and problem loans, or to their country’s average provision-to-loan ratio. - Result: generates some $120 billion (5 percent of capital) in additional provisions that would need to be fulfilled through retained earnings, existing capital, or new equity. - For about 30 percent of emerging market bank assets (outside of China), additional provisions would exceed average annual net income. - In more than a third of the banking systems in India and Russia, provisioning needs would amount to at least three years of net income, unless profits recover from cyclical lows. - If provisioning needs were fulfilled with equity, the share of banks with Tier 1 capital ratios below 10 percent, excluding China, would jump from about 20 percent to 35 percent of total assets. - Policy implication: restoring provisioning coverage among the weakest banks is important to ensure the banking system has resilience to withstand further asset quality deterioration. ### China — credit growth, capital-flow pressures, and market strains - Credit continues to grow rapidly in China; total assets of China’s banks are now more than triple the size of its GDP. - Bank for International Settlements calculates the credit gap now stands at about 25 percent. - Capital outflows picked up again in the second half of 2016, moderated substantially in the first two months of 2017. - December market turbulence: - Tighter liquidity in interbank and repo markets pushed up repo rates, causing losses for financial institutions investing in bond market vehicles and prompting leveraged investors to sell bonds. - Falling bond prices, rising global interest rates, and surging repo rates caused distress in the informal “entrusted bond market.” - People’s Bank of China instructed several large, state-owned banks to provide broad-based liquidity support through X-repurchase agreements to calm markets and reduce bond yields. - Risks and vulnerabilities: - Many financial institutions are overly dependent on wholesale financing with sizable asset-liability mismatches; repo funding is very short-term while funded credit products have longer maturities. - China accounts for more than two-thirds of total emerging market bond issuance and a third of U.S. dollar issuance; maturities are shortening. - Policy implications for China: - Deleveraging is crucial and urgent; authorities have initiated regulatory measures to close loopholes for regulatory arbitrage, rein in leverage, and increase transparency of nonbank financial institutions and wealth management products. - Proactive recognition of losses combined with restructuring of overly indebted but viable firms is needed. - Supervisory attention should focus on fast asset growth among small unlisted local banks, increasing reliance on wholesale funding, risks packaged into shadow products, and possible contagion through the interbank market. ### European banking systems — structural challenges and profitability constraints - Progress: - Banks have higher levels of capital; regulations have been strengthened and supervision enhanced. - Recent recapitalizations occurred in Italy and Portugal. - Banks now make less use of short-term wholesale funding. - Steps being taken to address nonperforming loans; business models are being adapted and some consolidation has occurred. - Remaining challenges: - A cyclical recovery alone is unlikely to fully restore profitability of persistently weak banks. - Structural features—such as overbanking—vary by country and compound profitability challenges. - Sample and profitability metrics: - Total sample: $35 trillion in assets covered by 172 of the largest European banks. - October 2016 GFSR finding: after a cyclical recovery, a group of structurally weak banks representing about $8.5 trillion in assets (or about one-third of bank assets) would remain with a return on equity less than 8 percent. - Market analysts predict the asset-weighted average return on equity for about 80 European banks will remain below 8 percent until 2019. - Decomposition and remedies: - Return on assets decomposed into revenues, costs, and loan loss provisions. - Tackling structural impediments is essential: reduce overbanking, improve operational efficiency (branches and headcount rationalization), address high NPL stock through accelerated write-offs and market-based sales, and remove legal and informational barriers to distressed-asset transactions. ### Overbranching, NPLs, and country-specific progress - Insufficient buffers at banks to absorb additional losses recognized on sales of bad debts at market prices remains an impediment to resolving nonperforming loans. - Euro area progress: cumulative 2010–16 sales now total about 40 percent of the peak level of impaired loans in the euro area. - At current write-off rates and new bad debt formation rates, it could take about six years on average for countries across the euro area to resolve the burden of impaired assets. - Asset-quality table excerpts (verbatim formatting preserved in source) highlight cross-country variation in NPL peaks, declines, and cumulative write-offs. - Country examples of policy recommendations include: - Italy: more intensive use of out-of-court debt restructuring; strengthened supervision; systematic assessment of asset quality. - Portugal: comprehensive debt restructuring, increase in capital and loan loss provisions, appropriate pricing and selling of bad loans, reduce operating costs, improve governance. - Spain: continue provisioning, improve efficiency through mergers, boost non-interest income, increase high-quality capital. ### Sovereign-bank nexus, global liquidity, and offshore dollar funding - Weak bank profitability and unresolved problem loan stocks can lead to wider sovereign spreads and potential spillovers. - Global liquidity and cross-currency swap basis: - Some non-U.S. banks accumulated higher-yielding foreign-currency assets faster than funding in those currencies, especially U.S. dollar–denominated assets. - After widening over 2014–16, cross-currency swap bases narrowed considerably since late 2016. - Box 1.1 — Offshore dollar funding fragilities: - Many cross-currency swap bases remain negative, indicating unmet demand for dollars. - U.S. corporations hold abroad an estimated $2.2 trillion in cumulative reinvested earnings from overseas operations. - Roughly $1.3 trillion of that is in liquid assets. - Since 2007, advanced economy banks’ maturity gap—the difference between long-term foreign-currency assets and long-term foreign-currency liabilities—has nearly doubled to $2.9 trillion. - As a percentage of total assets, the maturity gap grew from 4.4 percent to a high of 6.1 percent in November 2015. - Policy recommendations include lengthening foreign-currency debt maturities, securing longer-term foreign-currency credit lines, and expanding bilateral and multilateral currency swap arrangements as extraordinary backstops. ### Brexit, regulatory uncertainty, and market liquidity - The United Kingdom and the European Union do not currently qualify as “third countries” vis-à-vis each other and hence cannot begin the formal application process to seek third-country regulatory equivalence. - Banks face uncertainty about how quickly internal risk models will be reviewed and accepted by new regulators after relocation. - Several U.K.-based banks provide critical primary dealer functions in sovereign debt markets; operating-cost and regulatory uncertainty during transition could lead banks to scale back primary dealer business, temporarily making markets costlier and less efficient. ### Policy priorities and supervisory actions (summary) - For corporate sectors: - Monitor and limit incentives for excessive financial risk taking. - Use stress testing and supervisory scrutiny to assess corporate and banking exposures. - For banks and authorities: - Ensure swift and transparent recognition of nonperforming assets. - Strengthen capital buffers to absorb increased corporate stress. - Restore provisioning coverage among weakest banks; consider private capital solutions first and public support as last resort. - Encourage development of markets for problem loans and accelerate NPL resolution. - Complete the regulatory reform agenda (including Basel III package and revisions to the standardized approach to risk-weighted assets). - For emerging markets: - Continue addressing corporate and bank vulnerabilities. - Monitor retail-driven portfolio flow volatility and corporate foreign-currency exposures. - Prepare contingency arrangements for capital flow reversals and tighter global financial conditions. *International Monetary Fund | April 2017 — Chapter 1: Getting the Policy Mix Right (figures and notes as provided)* ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### Global risks and market conditions (Global Financial Stability Map) - Macroeconomic risks have declined, driven by improving economic activity and lower inflation risks. - Emerging market risks remain elevated, as higher inflation volatility offsets improvements in the corporate sector and external financing. - Credit risks have declined amid improvement in banks and the corporate sector. - Monetary and financial conditions are unchanged, as tighter monetary policies are offset by easier financial conditions. - Risk appetite has strengthened as a result of improved confidence and gains in risk assets. - Market and liquidity risks have moderated from an elevated level against the backdrop of better liquidity conditions. ### Reflation, market optimism, and financial market signals - Market expectations for the U.S. economy and monetary policy normalization have improved (Consensus Forecasts for End-2017 U.S. 10-Year Treasury Yield shown as probability density). - Ten-Year Inflation Compensation: cumulative breakeven yield change in basis points indicates rising hopes for reflation across advanced economies. - Financial Market Risk Dashboard: a compression in volatility across a number of global markets has accompanied market optimism. - Asset and market indicators tracked include U.S. Treasuries (10-year), German Bund (10-year), JGB (10-year), EMBI global (yield), GBI-EM (yield), S&P 500 and sector indices, VIX, MOVE, FX 6-month volatilities, and commodity index. ### U.S. corporate sector: policy context and transmission - Policies under discussion (tax reform, deregulation, infrastructure spending, trade) could boost economic growth and corporate cash flow directly and indirectly via improved market sentiment. - Key policy channels considered: - Corporate sector taxation: potential reduction in corporate tax rate; interest deductibility/expensing investment; incentives for repatriation. - Other: infrastructure spending, deregulation, trade, and other policies. - Stylized corporate balance sheet dynamics: - Uses of funds: Economic risk taking = Capital spending (including R&D); Financial risk taking = Acquisition of financial assets, M&A, and share buybacks/dividends. - Sources of funds: Internal funds (income, operating cash, buffers); Equity markets (cost of equity finance and issuance); Debt markets (cost of borrowing and leverage limits); Banks (cost and availability of loans). ### Illustrative scenario estimates of proposed tax measures and corporate capacity to expand capex - Scenario elements estimated using sector-level data: - A boost to operating cash flow from a 10 percentage point reduction in effective corporate tax rates to proxy a lower statutory corporate tax rate. - Combined effect of expensing new capital expenditures and removing the tax deductibility of interest expenses (approximated by taking half of the product of effective interest expenses and the statutory tax rate for the stock transition). - Potential for a one-off repatriation of retained foreign earnings, including liquid funds held abroad. - Quantified impacts and capacities: - A cut to the statutory tax rate could provide a cash flow impetus to S&P 500 firms amounting to more than $100 billion a year, atop existing cash flow of more than $1 trillion. - Business sentiment improvements could help close a gap in corporate capital spending relative to higher historical growth by almost 2 percentage points of assets, or some $750 billion a year. - Repatriation: $2.2 trillion in unremitted foreign earnings held abroad; 60 percent concentrated in information technology and health care. - Cash and investments: ~$1.3 trillion reported for S&P 500 firms. - Full expensing of new capex and removal of interest deductibility produce net impacts varying by sector, with capital-intensive sectors (energy, real estate, utilities) benefitting more from expensing/removal of interest deductibility. ### Limits, distributional effects, and financing gaps - Even with tax-related windfalls, financing gaps may remain for cash-constrained sectors: - Energy, utilities, and real estate accounted for nearly half of overall capital spending among S&P 500 firms in recent years. - The cash flow boost from a cut to the statutory tax rate may be insufficient to spur the nearly $140 billion needed to boost capital expenditure to the level prevailing before 2000. - Adding expensing, removal of interest deductibility, and repatriation attenuates but likely does not eliminate financing needs in those sectors. - Cash windfalls from repatriation would likely accrue mainly to cash-abundant sectors and sectors that have engaged in substantial financial risk taking. ### Financial risk taking, leverage, and vulnerabilities in the U.S. corporate sector - Aggregate indicators and recent trends: - Financial risk taking (purchases of financial assets, M&A, and net payouts) averaged $940 billion a year over the past three years for S&P 500 firms—more than half of free corporate cash flow. - Sector concentration of financial risk taking has been strongest in health care and information technology, amounting collectively to nearly $500 billion a year since 2012. - Corporate sector balance sheets: $36 trillion economy-wide corporate sector balance sheet; S&P 500 firms collectively account for about one-third of that balance sheet. - Debt accumulation: $7.8 trillion in debt and other liabilities added since 2010. - Broader sample: nearly 4,000 firms account for about half of the economy-wide corporate sector balance sheet. - Leverage and asset-quality signals: - Median net debt across S&P 500 firms is close to a historic high of more than 1½ times earnings. - Leverage beyond the S&P 500: many sectors show leverage rises to levels exceeding those prevailing just before the global financial crisis. - Debt is very high in energy, real estate, and utilities sectors, ranging between four and six times earnings. - Corporate credit fundamentals have started to weaken; asset quality (for example, share of deals with weaker covenants) has deteriorated; rising share of rating downgrades observed in industries including energy, capital goods, and health care. - Debt servicing and interest coverage: - The proportion of income devoted to debt servicing has risen by 4 percentage points, bringing it to its highest level since 2010. - Average interest coverage ratio has fallen sharply over the past two years; earnings have dropped to less than six times interest expense. ### Policy implications and financial stability considerations - Tax policy reforms under discussion could lay the groundwork for the corporate sector to support higher economic growth, but: - Reforms should maximize economic effectiveness while safeguarding against excesses of financial risk taking that could undermine financial stability. - Given elevated leverage in several sectors and signs of weakening credit fundamentals, policymakers should be mindful that: - Cash flow boosts may disproportionately accrue to sectors engaged in financial risk taking. - High leverage combined with tighter borrowing conditions could materially affect financial stability. - Some sectors may continue to face financing gaps even after tax-related windfalls and repatriation measures. *Source: IMF staff estimates and figures from CHAPTER 1 GETTING ThE POLICY MIx RIGhT (International Monetary Fund | April 2017).* ### 1. Corporate Cash Holdings on Balance Sheet ### 1. Corporate Cash Holdings on Balance Sheet ### Corporate balance sheet and financing trends - Corporate cash holdings are tapering. - Corporate profits are receding from a high level (percent of GDP). - Net equity financing has been falling the past four decades, as debt finance has continued to rise (percent of assets). - Gross equity issuance has abated, despite favorable valuations (Billions of U.S. dollars, unless otherwise stated). - Negative net equity issuance (gross issuance minus share buybacks) has coincided with an increase in debt and other liabilities. ### Leverage and credit cycle signals - Deteriorating balance sheet fundamentals and credit conditions signal a late stage of expansion in the credit cycle (unweighted average in percentile rank, normalized to zero). - Median corporate leverage among big firms has grown steadily and is close to a historical peak (net debt to EBITDA). - Eight out of ten sectors witness an increase in leverage across a broad set of firms (net debt to EBITDA by sector). - Stages of a stylized credit cycle described include Expansion, Downturn, Repair, Recovery with past episodes: July 2004–August 2007 (excessive risk taking), August 2007–March 2009 (falling credit growth), March 2009–December 2009 (companies shore up balance sheets), December 2009–August 2010 (improving momentum). ### Valuations, fundamentals, and credit conditions - Panel measures: Valuation (distress ratio, deviation in high-yield bond spreads from fair value), Fundamentals (capital expenditures, interest coverage, leverage, liquidity, profit margins), Credit conditions (bank credit, lending conditions, net bond issuance). - Above zero represents improvement (high valuations, supportive credit conditions, rising profits, ample liquidity); below zero represents deterioration (excessive risk taking, reduced access to credit, high leverage, diminishing profits, falling valuations). ### Sectoral concentrations - The rise in "challenged" firms has been mostly concentrated in the energy sector, and broadened across real estate and utilities. These three industries currently account for about half of firms struggling to meet debt service obligations and higher borrowing costs. --- ### Debt service, interest coverage, and vulnerability - The debt service burden for the corporate sector as a whole has risen strikingly despite low rates. - Interest coverage ratios (ICR = EBIT or EBITDA divided by interest payments) have fallen, particularly for smaller companies. - Market pricing of corporate risk has decoupled from the decline in interest coverage ratios (high-yield spreads and average ICRs across firms). - Higher financing costs could significantly weaken firms’ interest coverage ratios and increase the percentage of “challenged” firms (ICR < 2). Key statistics and scenario outcomes: - Currently, firms accounting for 10 percent of corporate assets appear unable to meet interest expenses out of current earnings (ICR < 1). - This figure doubles to 20 percent of corporate assets when considering firms with slightly higher earnings cover for interest payments (1 ≤ ICR < 2). - Under the assumed interest rate rise in the WEO adverse scenario, the share rises to 22 percent. - Under the adverse scenario in Scenario Box 1.1 of the WEO, the combined assets of challenged firms could reach almost $4 trillion. - A partial sensitivity calculation assumes an interest shock passing through based on an assumed loan maturity of five years; the number of firms analyzed ranges from 1,800 to 4,000 depending on S&P Capital IQ data availability. --- ### Policy analysis and recommendations for advanced economies - Historical experience shows financial risk taking (asset acquisition, M&A, net payouts) often follows tax policy changes (examples: U.S. 1980s tax cuts; 2004 repatriation tax holiday). - Increased financial risk taking is associated with pronounced leverage cycles that can end abruptly in recessions (examples: 2001, 2008). - Policymakers must balance the economic benefits of stimulus and tax reform against broader financial stability risks; vigilance is needed regarding rising leverage and deteriorating credit quality. - Tax measures that reduce incentives for debt financing could help attenuate risks of further leverage buildup and encourage unwinding of tax-advantaged debt. - Regulators should preemptively address areas where risk taking appears excessive; deploy additional financial prudential and supervisory action if policy stimulus increases debt-financed investment and medium-term corporate vulnerabilities. - Stress testing: use exercises (for banks and potentially nonbank financial intermediaries) to assess impacts of severe losses in nonfinancial corporate debt, accounting for liquidity strains and correlated sector risks (such as commercial real estate). - Policymakers should resist efforts to weaken bank regulatory requirements that reduce resilience; while fine-tuning is possible, wholesale dilution or backtracking on global regulatory reforms should be avoided. --- ### Emerging market economies: resilience and external risk transmission - Emerging market economies have enhanced resilience: reduced external imbalances and strengthened policy buffers since the 2013 taper tantrum. - Corporate leverage in emerging markets has started to decline but remains elevated. - Emerging market overall growth is projected to rise from 4.1 percent in 2016 to 4.5 percent in 2017 (driven mainly by gains in commodity exporters). - Political and policy uncertainty in advanced economies opens channels for negative spillovers: faster normalization of the U.S. term premium would raise worldwide term premiums and could trigger higher emerging market risk premiums, asset price volatility, capital outflows, stronger U.S. dollar, and balance sheet stresses. Transmission channels and vulnerabilities: - Countries most at risk include those with large external financing needs, high corporate foreign-currency indebtedness, or a large foreign presence in local bond markets; frontier market borrowers are also vulnerable. - A shift toward protectionism would raise risk premiums amid declining global trade and commodity prices, hurting corporate earnings—especially export-dependent firms—and straining leveraged firms and weaker banking systems. Quantified scenario impacts: - In a scenario of rising global risk premiums, the weak tail of emerging market economy firms (defined as proportion of nonfinancial corporate debt issued by firms with ICR < 1) would increase to over 16 percent of total nonfinancial corporate debt, which is an increase of $135 billion. - This would exceed the 15 percent peak in 2015 when the collapse in commodity prices hit corporate balance sheets. - Brazil, China, and India would experience the greatest impact given sensitivities to changes in earnings and corporate interest rates. - Example of investor retrenchment: in 2016 the multisector bond funds of a single asset manager reduced combined emerging market bond exposure by $15 billion; almost $11 billion of that total was concentrated in a single country, representing an estimated 13 percent of that country’s total sovereign local and hard currency bonds. Policy guidance for emerging markets: - Continue addressing corporate and bank vulnerabilities to ensure resilience against an uncertain global policy mix. - Prepare for potential capital flow reversals and tighter global financial conditions by strengthening buffers and monitoring corporate foreign-currency exposures and external financing needs. --- *International Monetary Fund | April 2017 — Chapter 1: Getting the Policy Mix Right (figures and notes as provided)* ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### Capital flows to emerging market economies - Capital flows to emerging market economies have been subdued in recent years. - Retail investors represent a small source of financing but are a large source of volatility. - Most capital flow reversals are driven by retail investors. - Individual fund families often own large portions of emerging market bonds in selected markets. - Emerging market equity returns: equities of manufacturing exporters with high U.S. trade exposure have underperformed other emerging market equities (Figure 1.14, panel 5). - Emerging market exchange rates: currencies of manufacturing exporters have underperformed those of commodity exporters (Figure 1.14, panel 6). ### Rising protectionism: channels and projected corporate-sector effects - If protectionist pressures increase and start to affect global trade, emerging market economies closely integrated into global trade and capital markets will face lower external revenues and rising risk premiums. - Declining global trade and growth would increase corporate vulnerability, especially for firms with high leverage and large foreign exchange mismatches; higher corporate risk premiums and borrowing costs will increase financial stability risks. - Transmission channels include disruptions to principal trading partners; example: manufacturing exports account for some 25 percent of Mexico’s GDP, and 80 percent of all its goods exports are bound for the United States (Table 1.1). - A decline in Chinese exports would weaken China’s growth and weigh on demand for imported intermediate and capital goods, affecting exporters in Asia and commodity exporters. - Scenario assumptions: under rising protectionism, global tariff and nontariff barriers raise the effective cost of imports by 10 percent. Scenario outcomes for corporate debt: - In a scenario of rising protectionism, the size of the weak tail of firms would increase to 17 percent of total nonfinancial corporate debt, an increase of $235 billion. - The increase in the weak tail under rising protectionism is somewhat higher than under the case of rising global risk premiums (Figure 1.15, panel 1). - The greatest deterioration in corporate balance sheets would occur in China, India, and South Africa. - Commodity sectors would be especially pressured because metal and oil prices would fall as a result of the sharp decline in global growth. ### Emerging market banks: capital buffers and asset quality - Bank-level data sample: 294 banks covering banks from 14 countries with $32 trillion in assets. - Aggregate Tier 1 capital ratios for the sample have been rising steadily and are at comfortable levels (Table 1.2; Figure 1.16, panel 1). - Lenders outside China have increased capital by 20 percent since the end of 2014, compared with 15 percent growth in assets over the same period. - Shrinking risk weightings have contributed to higher reported capital ratios, particularly in Brazil, and banks in most markets have actively reduced leverage. - Asset quality concerns persist after several years of rapid lending growth. - Bank equity valuations are relatively weak in China and Turkey, where credit has grown rapidly relative to GDP (Figure 1.16, panel 2). - Profitability: while generally strong relative to the United States and Europe, heavy credit losses erode profits at many banks, notably in Russia and India (Figure 1.16, panel 3). - Nonperforming and problem loans have climbed in many countries due to economic weakness (Brazil, Russia), continued corporate leverage growth (China), and sector-specific downturns (India) (Figure 1.16, panel 4). - Banks have raised provisioning levels in response, but not quickly enough to keep pace with bad loan formation (Figure 1.17, panel 1). - Provision needs exceed annual profits in 30 percent of emerging market banks outside China (Figure 1.17, panel 3). - If provisions were deducted from equity, weak banks would rise to 35 percent of assets (Figure 1.17, panel 4). - A large weak tail of banks has a high ratio of bad loans to buffers (Figure 1.17, panel 2). ### Asset-quality and capital indicators (selected figures from Table 1.2 and text) - Sample summary: 294 banks; $32 trillion in assets. - India: Number of banks 64; Tier 1 Capital Ratio (sample) 10.6 percent; FSI 10.6; NPL and Problem Loan Ratio 11.3 percent. - Russia: Number of banks 24; Tier 1 Capital Ratio (sample) 11.6 percent; FSI 8.8; NPL and Problem Loan Ratio 15.6 percent. - South Africa: Number of banks 8; Tier 1 Capital Ratio (sample) 12.8 percent; FSI 14.2; NPL and Problem Loan Ratio 7.1 percent. - Brazil: Number of banks 22; Tier 1 Capital Ratio (sample) 12.9 percent; FSI 13.1; NPL and Problem Loan Ratio 9.5 percent. - Poland: Number of banks 14; Tier 1 Capital Ratio (sample) 14.8 percent; FSI 15.7; NPL and Problem Loan Ratio 7.6 percent. - Indonesia: Number of banks 32; Tier 1 Capital Ratio (sample) 19.5 percent; FSI 20.6; NPL and Problem Loan Ratio 8.0 percent. - Mexico: Number of banks 12; Tier 1 Capital Ratio (sample) 14.9 percent; FSI 13.2; NPL and Problem Loan Ratio 2.5 percent. - China: Number of banks 42; Tier 1 Capital Ratio (sample) 11.0 percent; FSI 11.1; NPL and Problem Loan Ratio 4.8 percent. - United Arab Emirates: Number of banks 22; Tier 1 Capital Ratio (sample) 17.1 percent; FSI 16.9; NPL and Problem Loan Ratio 6.6 percent. - Malaysia: Number of banks 12; Tier 1 Capital Ratio (sample) 14.2 percent; FSI 14.4; NPL and Problem Loan Ratio 3.7 percent. - Colombia: Number of banks 3; Tier 1 Capital Ratio (sample) 8.4 percent; FSI 11.9; NPL and Problem Loan Ratio 7.1 percent. - Saudi Arabia: Number of banks 12; Tier 1 Capital Ratio (sample) 17.6 percent; FSI 16.8; NPL and Problem Loan Ratio 3.0 percent. ### Policy implications and priorities highlighted in the chapter - Ensure the health of emerging market banking systems through swift and transparent recognition of nonperforming assets. - Strengthen capital buffers to absorb increased corporate stress arising from tighter global financial conditions or increased trade protectionism. - Monitor retail-driven portfolio flow volatility carefully given its outsized contribution to capital flow reversals. - Pay attention to trade-exposure vulnerabilities, especially for economies with large manufacturing exports to the United States or deep integration in global supply chains. *International Monetary Fund | April 2017* ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### Underprovisioning, capital needs, and bank resilience - Illustrative exercise: raise banks’ provision coverage ratios to at least 50 percent of nonperforming and problem loans, or to their country’s average provision-to-loan ratio. - Result: generates some $120 billion (5 percent of capital) in additional provisions that would need to be fulfilled through retained earnings, existing capital, or new equity. - Distributional impacts: - More profitable systems (example: Colombia and Indonesia) could absorb such costs. - For about 30 percent of emerging market bank assets (outside of China), additional provisions would exceed average annual net income. - In more than a third of the banking systems in India and Russia, provisioning needs would amount to at least three years of net income, unless profits recover from cyclical lows. - Using preprovision profits as comparator, some banks in India and Russia would still require more than one year of earnings to boost provisioning. - If provisioning needs were fulfilled with equity, the share of banks with Tier 1 capital ratios below 10 percent, excluding China, would jump from about 20 percent to 35 percent of total assets. - Policy implication: restoring provisioning coverage among the weakest banks is important to ensure the banking system has resilience to withstand further asset quality deterioration. ### Emerging market economy vulnerabilities and policy priorities - Emerging markets have become more resilient due to a recovery in global commodity prices and supportive external conditions, but face multiple challenges across channels. - Identified country vulnerabilities (examples listed in source): - Trade openness reliance: Hungary, Malaysia, Thailand, Vietnam, United Arab Emirates. - Large external financing needs: Malaysia, Poland. - Low reserve adequacy: South Africa, Vietnam. - Combination of factors: Turkey. - Corporate sector challenges: China, India, Indonesia, Turkey. - Banking sector challenges: China, India, Russia. - Risks: abrupt tightening in financial conditions and increased protectionism. - Policy recommendations (priorities for authorities): - Restoring the health of corporate balance sheets: - Improve corporate debt-restructuring mechanisms, including formal insolvency frameworks and out-of-court debt restructuring. - Develop an in-depth understanding of sources and composition of credit to nonfinancial firms and proactively monitor corporate vulnerability. - Monitor firms’ foreign exchange exposure and the extent to which foreign-currency debt is hedged naturally or via financial instruments. - Stand ready to provide additional foreign exchange hedging tools to help firms absorb sharp currency movements without causing financial distress (example actions: undertaken in Brazil and Mexico in recent years). - Strengthening the health of the banking system: - Bank supervisors in countries with weak-balance-sheet or rapidly expanded banks should carry out comprehensive asset quality assessments to gauge unrecognized credit losses. - Follow assessments with concrete steps to cover losses and, where applicable, ensuing capital needs. - Tackle capital needs promptly while global financial conditions are favorable, preferably via private channels including equity issuance and bail-ins. - Use public support as a last resort when issues are systemic and fiscal space is sufficient. - Bank regulators should monitor limits on foreign exchange open positions and assess offsetting effects of foreign exchange hedging. ### China: rising credit risks, capital flow pressures, and financial market strains - Credit growth and leverage: - Credit continues to grow rapidly in China; total assets of China’s banks are now more than triple the size of its GDP. - Fastest asset expansion from city commercial, joint-stock, and other smaller banks. - Other nonbank financial institutions have raised credit exposure and leverage with short-term wholesale funding; corporate bond issuance surged throughout 2016. - Bank for International Settlements calculates the credit gap now stands at about 25 percent. - Evidence suggests credit booms of this size are often dangerous; the likelihood of a financial crisis rises the longer and larger the boom, especially with very limited exchange rate flexibility. - Capital account and reserve dynamics: - Capital outflows picked up again in the second half of 2016, moderated substantially in the first two months of 2017. - People’s Bank of China continued foreign exchange interventions to maintain broad exchange rate stability. - Foreign asset purchases by Chinese residents account for most recent outflows; Chinese firms increased investments in foreign companies since late 2015. - Foreign direct investment by overseas firms into China declined markedly over past quarters. - Narrowing interest rate differentials and market expectations of bilateral depreciation versus the U.S. dollar have added to outflow pressures. - December market turbulence and mechanistic drivers: - Tighter liquidity conditions in interbank and repo markets pushed up repo rates, causing losses for financial institutions investing in bond market vehicles and prompting leveraged investors to sell bonds. - Falling bond prices, rising global interest rates, and surging repo rates caused distress in the informal “entrusted bond market,” increasing counterparty concerns in this largely unregulated market with weak documentation standards; segments of the repo market started to freeze up in mid-December. - To avoid systemic stress, the People’s Bank of China instructed several large, state-owned banks to provide broad-based liquidity support through X-repurchase agreements (counterparties anonymous), in some cases to institutions without central bank lending facility access, calming markets and reducing bond yields. - Financial system pressure points: - Many financial institutions are overly dependent on wholesale financing with sizable asset-liability mismatches; repo funding is very short-term while funded credit products have longer maturities, implying borrowers must roll over liabilities on average almost daily. - Liquidity and credit risks are sizable amid increased reliance on bond issuance and elevated redemption needs. - China now accounts for more than two-thirds of total emerging market bond issuance and a third of U.S. dollar issuance; maturities are shortening. - Investor composition is increasingly complex: banks remain the largest bond holders, but wealth management products and securities firms have significant exposure and, in some cases, are highly leveraged, often via informal markets with limited documentation and transparency. - Policy implications for China: - Deleveraging is crucial and urgent; authorities have initiated regulatory measures to close loopholes for regulatory arbitrage, rein in leverage, and increase transparency of nonbank financial institutions and wealth management products. - Proactive recognition of losses combined with restructuring of overly indebted but viable firms is needed. - Supervisory attention should focus on banks’ emerging risks: fast asset growth among small unlisted local banks, increasing reliance on wholesale funding, risks packaged into shadow products, and possible contagion through the interbank market. - Address policy tension between maintaining high growth and the need for deleveraging; persistent excessive credit growth sustains underpricing of credit risk and the search for yield, perpetuating leverage and financial risk build-up. ### European banking systems: structural challenges and profitability constraints - Progress to date: - Banks have higher levels of capital; regulations have been strengthened and supervision enhanced. - Recent recapitalizations occurred in Italy and Portugal. - Banks now make less use of short-term wholesale funding. - Steps being taken to address nonperforming loans; business models are being adapted and some consolidation has occurred. - Remaining challenges: - A cyclical recovery alone is unlikely to fully restore profitability of persistently weak banks. - Structural features—such as overbanking—vary by country and compound profitability challenges; until structural impediments are addressed, business model restructuring may not yield sufficient profitability. - Left unresolved, weak banks combined with lack of access to private capital and large bad debt burdens impede recovery and could reignite systemic risks. - Market and performance indicators: - European bank equity prices have increased, rising by about 40 percent on average since mid-2016. - Yield curve steepening has relieved some pressure on net interest margins in a low rate environment. - Despite improvements, market valuations (price-to-book ratios) continue to reflect concerns about banks’ ability to generate sustainable profits. - In a large sample of European banks, the 2016 return on equity was weak (source classifies ROE: Weak (ROE < 8%), Challenged (8% ≤ ROE < 10%), Healthy (ROE ≥ 10%)). - Structural factors weighing on profitability (excerpted indicators): - Overbanking (assets to GDP; concentration; number of banks; number of branches; headcount). - Bad debt overhang (NPL ratio; NPL coverage; NPL disposals). - Revenue, costs, loan loss provisions, leverage, return on assets, return on equity. *International Monetary Fund | April 2017* ### 1. European Bank Equity Prices and the Slope of the Yield ### 1. European Bank Equity Prices and the Slope of the Yield Curve ### Bank equity prices, market expectations, and profitability projections - Bank equity prices have increased (text note). - October 2016 GFSR finding: after a cyclical recovery, a group of structurally weak banks representing about $8.5 trillion in assets (or about one-third of bank assets) would remain with a return on equity less than 8 percent. - Market analysts predict the asset-weighted average return on equity for about 80 European banks will remain below 8 percent until 2019, and the majority will have a return on equity below that level over the next three years. ### Sample and classification used in the analysis - Total sample: $35 trillion in assets covered by 172 of the largest European banks. - Banks divided into three groups for analysis: global, Europe focused, and domestic. - Definition: domestic banks = home market > 70 percent of total; Europe-focused banks = Europe > 70 percent but home market < 70 percent; global banks = Europe and home market both < 70 percent. ### Profitability outcomes by bank type (2016) - Three-quarters of domestic banks in the sample had a weak return on equity in 2016. - About 65 percent of sample global banks had a weak return on equity in 2016. - Just 15 percent of Europe-focused banks in the sample had a weak return on equity in 2016. ### Country variation in domestic bank profitability (2016) - Sample domestic banks in Italy and Portugal suffered losses overall in 2016. - Sample domestic banks in Germany, Spain, and the U.K. were barely profitable in 2016. - Sample domestic banks in Ireland, Norway, and Sweden were able to generate much higher returns in 2016. - There is great variability in domestic banks’ profitability across countries, measured on either a return on equity or return on assets basis. ### Financial stability implications of weak profitability - Persistently weak profitability is a systemic stability concern: low profits impede organic capital build-up and increase vulnerability to shocks. - Sustained returns below the cost of equity can inhibit access to private capital and lead banks to take greater risks (higher-yielding assets, lending to less creditworthy borrowers, increasing maturity mismatch). - Weak returns limit banks’ ability to expand balance sheets and lend without depleting capital, placing a drag on recovery. --- ### Decomposition of profitability and drivers (2016) - Return on assets decomposed into: revenues, costs, and loan loss provisions. - Some domestic banks with weak return on assets had relatively high preprovision operating profit, implying provisioning for nonperforming loans is a key driver of weak profitability for those banks. - Other domestic banks with weak preprovision operating profits face structural challenges affecting revenues and costs. ### Sample scope for domestic-bank-focused panels - Panels 2 to 6 in the source are based on the 143 domestic banks in the sample (of the 172 total). --- ### System-wide operating environments and structural causes of weak profitability - Question addressed: Is weak profitability due to poor business models only, or do system-wide operating environments also play an important role? - Domestic banks—banks with more than 70 percent of revenues or assets in their home market—struggled especially with profitability in 2016. - Domestic banks have limited scope to improve profitability by shifting exposures across markets; their profitability more clearly reflects structural features of their home systems. ### Identified structural causes and mechanisms - Overbanking: an overly large banking sector that affects profitability through: - Revenue compression (too many banks chasing too few profitable lending opportunities). - Higher costs and lower operational efficiency (high number of branches or staff). - Overbanking can arise from: - Banking system assets large relative to the economy served. - A long weak tail of banks with low buffers. - Too many regionally focused banks with narrow mandates. - System structure effects: - High share of savings or cooperative banks, Landesbanken, and policy or state-owned banks may exert downward pressure on revenues. - In the sample, cooperative and savings banks, development and policy institutions, Landesbanken, and state-owned banks tended to have lower overall return on equity in 2016. ### Empirical indicators and metrics used to assess overbanking (Table 1.4) - System size: ratio of local bank claims to GDP (times). - System concentration: assets per credit firm (billions of euros); total number of credit firms; Herfindahl concentration index for credit institutions (index). - Operational efficiency: assets per branch (millions of euros); assets per headcount (millions of euros). - System structure: share of savings and cooperative banks (percent). --- ### Country examples of structural mixes - France: banking sector large relative to economy and high share of savings and cooperative banks. - Austria and Germany: large number of banks, low concentration, large share of savings and cooperative banks. - Italy, Portugal, Spain: large number of branches or staff relative to banking assets; Italy also has a large number of banks and low concentration. ### Progress and remaining challenges in reducing overcapacity and costs - Some systems have reduced costs by cutting excess capacity: Denmark, the Netherlands, and Spain showed larger percentage reductions in branches and employees. - Rationalizing branches to reach the European average deposits-per-branch ratio could reduce operating expenses by about $23 billion overall, equivalent to 23 percent of after-tax profits for the banks considered (calculation based on 159 banks out of the 172-bank sample, representing about 98 percent of sample assets). - Frictions to faster restructuring include high restructuring costs, operating leases on branches, labor market rigidities, and demographic preferences for in-person banking. --- ### Nonperforming loans (NPLs) and the debt overhang - Euro area progress: formation of new problem loans has slowed, write-offs have picked up, and sales of nonperforming loans have increased—cumulative 2010–16 sales now total about 40 percent of the peak level of impaired loans in the euro area. - Countries with notable progress: Ireland and Spain have reduced nonperforming loans substantially from peak levels through asset management companies, strategic bank restructuring, and government recapitalization support. - Countries with limited reduction relative to peak levels: Italy and Portugal—further progress needed. - At current write-off rates and new bad debt formation rates, it could take about six years on average for countries across the euro area to resolve the burden of impaired assets. - Structural barriers that impede NPL disposal include inefficient legal frameworks, poor information quality in distressed-asset markets (lowering buyers’ reservation prices), and structurally unattractive portfolio characteristics. --- ### Sample details by country (selected figures from Table 1.3) - Total sample assets: 34,929 (billions of U.S. dollars). - Total sample: 172 firms; domestic firms in sample: 143; Europe-focused firms: 20; global firms: 9. - Country sample assets (billions of U.S. dollars) and proportion of sample assets (percent) for top jurisdictions: - France: 7,785; 22.3 percent; Number of firms in sample: 7 (Domestic: 4; Europe-focused: 3; Global: 0). - United Kingdom: 6,697; 19.2 percent; Number of firms in sample: 13 (Domestic: 10; Europe-focused: 0; Global: 3). - Germany: 4,452; 12.7 percent; Number of firms in sample: 22 (Domestic: 17; Europe-focused: 4; Global: 1). - Spain: 3,767; 10.8 percent; Number of firms in sample: 15 (Domestic: 13; Europe-focused: 0; Global: 2). - Italy: 2,651; 7.6 percent; Number of firms in sample: 21 (Domestic: 20; Europe-focused: 1; Global: 0). - Switzerland: 2,476; 7.1 percent; Number of firms in sample: 20 (Domestic: 16; Europe-focused: 1; Global: 3). - Netherlands: 1,866; 5.3 percent; Number of firms in sample: 7 (Domestic: 5; Europe-focused: 2; Global: 0). - Sweden: 1,545; 4.4 percent; Number of firms in sample: 7 (Domestic: 4; Europe-focused: 3; Global: 0). - Denmark: 825; 2.4 percent; Number of firms in sample: 6 (Domestic: 5; Europe-focused: 1; Global: 0). - Austria: 733; 2.1 percent; Number of firms in sample: 14 (Domestic: 13; Europe-focused: 1; Global: 0). - Belgium: 543; 1.6 percent; Number of firms in sample: 5 (Domestic: 4; Europe-focused: 1; Global: 0). - Norway: 346; 1.0 percent; Number of firms in sample: 6 (Domestic: 6; Europe-focused: 0; Global: 0). - Portugal: 314; 0.9 percent; Number of firms in sample: 6 (Domestic: 5; Europe-focused: 1; Global: 0). - Ireland: 289; 0.8 percent; Number of firms in sample: 4 (Domestic: 4; Europe-focused: 0; Global: 0). - Greece: 340; 1.0 percent; Number of firms in sample: 5 (Domestic: 5; Europe-focused: 0; Global: 0). - Sample composition by institution type: Commercial banks represent 74 percent of sample assets; other institutions (savings, cooperative, development, policy, and state-owned banks) represent 26 percent of sample assets. --- ### Policy-relevant conclusions and implications - Cyclical recovery in profits is welcome but likely insufficient to resolve structural profitability challenges for a sizeable group of banks. - Tackling structural impediments is essential: reduce overbanking, improve operational efficiency (branches and headcount rationalization), address high NPL stock through accelerated write-offs and market-based sales, and remove legal and informational barriers to distressed-asset transactions. - The appropriate mix of structural actions will vary by country, depending on the specific combination of system-size, concentration, operational-efficiency, and system-structure factors affecting domestic bank profitability. *Italic: Source — ch1 - 1. European Bank Equity Prices and the Slope of the Yield Curve (PDF chapter).* ### 1. Overbranching and Reduction in Branches ### 1. Overbranching and Reduction in Branches ### Systemic challenges and nonperforming loans - Insufficient buffers at banks to absorb additional losses recognized on sales of bad debts at market prices remains an impediment to resolving nonperforming loans. - Lack of progress on resolving nonperforming loans reflects weak earnings and insufficient generation of capital and provisioning buffers. - Further action is needed to fully resolve the burden of nonperforming loans. Initiatives noted include: - European Central Bank guidance to banks on how to tackle nonperforming loans. - Italy: two Atlante funds set up by financial institutions and banking foundations; a public guarantee on senior tranches of securitized bad loans. - Reforms to legal frameworks in several countries to help alleviate the process of resolving problem loans. - Accounting standards (International Financial Reporting Standard 9) expected to ensure greater forward-looking provisioning when phased in. - Supervisors should ensure banks adopt ambitious, time-bound strategies for disposal of nonperforming loans and encourage development of a market for problem loans. ### Asset quality: Table 1.5 (Asset Quality Position and Recent Progress) - Table rows as shown in source: - Austria 3.1–1.01.30.53758–14 - Belgium 3.5–0.82.00.22344–4 - Denmark 3.3–2.61.90.14943–8 - France 3.9–0.62.00.25650–9 - Germany 2.0–0.71.20.273424 - Ireland 14.6–11.18.5–0.46142–3 - Italy 12.2–0.16.22.522499 - Netherlands 2.6–0.71.4–0.254444 - Portugal 12.6–0.24.30.8536611 - Spain 5.7–3.73.30.76343–14 - Sweden 1.0–0.20.70.54834–36 - United Kingdom 1.0–3.00.6–1.946424 - Notes accompanying the table (verbatim elements preserved): - Sources: Central banks; Haver Analytics; IMF, Financial Soundness Indicators database; SNL Financial; and IMF staff calculations. - Note: Red (green) shading denotes the four most (least) risky systems or those that have made the least (most) progress. The remaining four systems are shown in yellow. Data are for the dates shown, or latest available figures. The definition of NPLs is not harmonized across all countries. The peak in the second column is the maximum since 2008. Cumulative write-offs are for a broad sample of banks and are shown as a percentage of 2013 NPLs. NPL = nonperforming loan. ### Global systemically important banks (G-SIBs): profitability and business model challenges - Domestic business represents on average about half of European G-SIBs’ total assets and about 40 percent of total revenues. - European G-SIBs have strengthened capitalization and liquidity, cut balance sheets, reorganized businesses, and written off legacy assets; nevertheless: - Profitability remains a challenge for many European G-SIBs. - Virtually none of the European G-SIBs are currently able to approach the profitability of their U.S. peers. - Some European G-SIBs have comparable preprovision profitability but face continued high provisions lowering return on assets. - Many banks have poor preprovision profit margins and require further restructuring to improve core profitability. - Efforts to cut costs and reorganize businesses have had varying degrees of success. - Market pricing differences (investor perceptions): - Higher price-to-book ratios and lower credit default swap spreads indicate market conviction that business models are robust. - Lower equity market valuations and higher spreads suggest investors believe further progress is needed to strengthen business models. ### Sovereign-bank nexus and market spillovers - Combination of weak profitability in domestic banks and G-SIBs, lack of access to private capital, and large unresolved problem loan stocks could reignite systemic risks in some economies. - Weaknesses in the Italian and Portuguese banking systems led to a widening in bank credit default swap spreads in 2016; these banking risks led to rises in associated sovereign spreads through market concerns about contingent liabilities for the government. - Measures such as the EU Bank Recovery and Resolution Directive and Total Loss Absorbing Capacity rules should limit spillovers from banks to sovereigns, but building sufficient bail-inable liabilities will take time. - Recent movements: government bond spreads have risen in France and Italy and remain high in Portugal, reflecting concerns about political risks and government debt burdens. - Potential channels of spillback from sovereigns to banks: - Sovereign downgrades could increase bank wholesale funding costs and reduce the amount of assets acceptable as collateral. - Banks that hold significant local government bonds could face mark-to-market losses in trading books and available-for-sale portfolios. - These wholesale funding and trading risks would be especially problematic if financial conditions tightened sharply. ### Brexit and system efficiency - Brexit may cause London to lose some predominance as a global financial center, with attendant costs related to loss of economies of scale in financial activities; regulatory challenges and complexities may increase, although lower concentration in one center could bring diversification gains to financial stability. ### Policy recommendations and supervisory actions - Banks should: - Seek opportunities to increase weak revenues and reduce high operating costs. - Restructure business models to enhance returns and invest in technology to increase medium-term efficiency. - Develop sustainable earnings by tackling business model problems; there is no single model for all banks. - Supervisors and authorities should: - Encourage consolidation where appropriate, combined with governance reforms and avoidance of creating too-big-to-fail concerns. - Consider targeted asset quality reviews for banks that have not undergone such exercises. - Take action to resolve unviable institutions to remove excess capacity from banking systems. - Focus on removing system-wide impediments to profitability; prescriptions will vary across countries. - Consider macroprudential or other regulatory measures if banks react to profitability challenges by taking greater risks. - Encourage development of a market for problem loans. - Consider reducing thresholds for direct recapitalization of viable banks under the European Stability Mechanism and establishing a common deposit insurance scheme in the euro area. - Completing the regulatory reform agenda is vital, notably finalizing an agreement on the Basel III package of reforms, including revision of the “standardized” approach to risk-weighted assets and boundaries on internal model use. ### Selected IMF country recommendations (Table 1.6, summary) - France: - Ensuring profitability via further cost cutting, diversification, and possibly consolidation within the euro area. - Regulated savings rates in France should continue to be adapted to market interest rate conditions. - Progress: Banks adapting business models by diversifying into asset management, private banking, and insurance. - Germany: - Banking system faces structural headwinds; needs adaptation. Low profitability reflects crisis legacy issues, compliance provisions, business model adjustments to postcrisis regulation and technology, and structural inefficiencies. - Progress: Consolidation ongoing, German savings bank sector deleveraging; restructuring at large banks and cost cutting remain slow. - Italy: - Further steps: more intensive use of out-of-court debt restructuring; strengthened supervision; systematic assessment of asset quality for banks not subject to ECB comprehensive assessment; follow-up actions per regulatory requirements. - Effective use of framework for timely orderly resolution of failing banks to prevent costs from being borne by rest of system. - Progress: Monte dei Paschi applied for precautionary state recapitalization in December 2016; Unicredit raised almost €13 billion; Banco Popolare di Milano and Banco Popolare merged; mutual bank reform ongoing; authorities approved issuance of up to €20 billion in additional government debt to potentially support bank capital and liquidity. - Portugal: - Return to profitability via comprehensive debt restructuring, increase in capital and loan loss provisions, appropriate pricing and selling of bad loans, reduce operating costs, improve internal governance. - Progress: March 2017 final agreement on a €5 billion recapitalization of Caixa Geral de Depositos announced; negotiations to sell Novo Banco continue; Banco Comercial Portugues received private capital injection; Banco BPI takeover by CaixaBank concluded. - Spain: - Continue ensuring adequate provisioning, improve efficiency gains possibly through mergers, boost non-interest income, and increase high-quality capital. - Progress: System closer to putting most crisis legacies behind it; framework for savings banks and banking foundations fully in place requiring divestment or reserve funds. ### Global liquidity and cross-currency swap basis - Global liquidity risks could be amplified by currency mismatches between non-U.S. banks’ assets and liabilities, especially if U.S. interest rates increase sharply and the dollar appreciates. - Some non-U.S. banks accumulated higher-yielding foreign-currency assets faster than funding in those currencies, particularly U.S. dollar–denominated assets outpacing U.S. dollar funding via deposits, certificates of deposit, commercial paper, and other sources. - Regulatory changes and money fund reform have limited the supply of U.S. dollar funding. - The resulting imbalance led to a persistent premium in the price to swap local-currency funding into dollars via foreign exchange swaps, known as the cross-currency swap basis. - After widening over 2014–16, cross-currency swap bases narrowed considerably since late 2016. Factors potentially reducing dollar funding costs include: - Modest pickup in U.S. prime money fund assets. - Greater demand from investors less affected by regulatory balance sheet constraints (for example, corporations, offshore money funds, private liquidity funds). - Central bank efforts to provide larger backstops. - Figure note preserved verbatim: - Sources: Bank for International Settlements; Bloomberg L.P.; and IMF staff estimates. - Note: Weights are based on daily average foreign exchange swap turnover versus the U.S. dollar for the euro, Japanese yen, British pound, and Swiss franc. MMF = money market fund. *Source: ch1 - 1. Overbranching and Reduction in Branches (PDF chapter).* ### Box 1.1. Could Fragilities in Offshore Dollar Funding Exacerbate Liquidity Risk? ### Box 1.1. Could Fragilities in Offshore Dollar Funding Exacerbate Liquidity Risk? ### Evidence of strained offshore dollar funding - Many cross-currency swap bases remain negative, indicating unmet demand for dollars. - Dollar appreciation—such as may be expected if U.S. growth accelerates and the Federal Reserve continues to raise policy rates—is associated with more negative cross-currency swap bases. - Supply of offshore dollars could deteriorate with potential U.S. tax reform: - U.S. corporations hold abroad an estimated $2.2 trillion in cumulative reinvested earnings from overseas operations. - Roughly $1.3 trillion of that is in liquid assets, half of which is believed to be held in U.S. banks or U.S. investments. - After the 2004 repatriation tax holiday, U.S. companies repatriated $362 billion; similar incentives could lead to repatriation of a significant portion of U.S. dollar assets. - Administrative measures (for example, bank ring-fencing) could increase frictions in the supply of dollar funding, raise costs, and fragment the offshore dollar market. ### Banks’ foreign-currency maturity mismatches and liquidity implications - Advanced economy banks have become reliant on cheap short-term foreign-currency funding for long-term foreign-currency assets. - Since 2007, advanced economy banks’ maturity gap—the difference between long-term foreign-currency assets and long-term foreign-currency liabilities—has nearly doubled to $2.9 trillion. - As a percentage of total assets, the maturity gap grew from 4.4 percent to a high of 6.1 percent in November 2015. - Figure annotations note a smaller earlier maturity gap of $0.3 trillion (panel context retained from source). - Hedging via derivatives reduces interest rate and FX risk but introduces counterparty risk and does not eliminate rollover risk. - Local central banks can provide near-limitless liquidity for local-currency funding stress, but for foreign-currency-denominated assets they can provide liquidity only from finite foreign-currency reserves or by tapping foreign exchange swap facilities and credit lines with other official institutions. - If offshore dollars become scarcer, banks may reduce their global footprint or increase reliance on central banks as dollar providers of last resort. ### Emerging market banks and regional exceptions - Emerging market banks have a smaller and more stable maturity gap compared with advanced economy banks. - Banking systems in emerging European economies are an exception, exhibiting large foreign-currency maturity mismatches—likely due to extensive use of foreign-currency (mostly euro) deposit funding. - These deposits are relatively sticky and generally safer than other short-term funding forms. - Foreign exchange regimes, such as currency boards, further mitigate risks. - Nonetheless, this mismatch can present risk; if European short-term interest rates unexpectedly and rapidly rise, banks in these countries could be exposed to significant funding risk. ### Policy recommendations and contingency arrangements - Supervisors should encourage banks to reduce foreign-currency maturity mismatches by: - Lengthening foreign-currency debt maturities. - Securing longer-term foreign-currency credit lines. - Authorities should seek to expand bilateral and multilateral currency swap arrangements to backstop foreign currency liquidity. - Use of these facilities should be viewed as extraordinary, with access to official liquidity priced accordingly. - Attention to structural rigidities, the currency mismatch between non-U.S. banks’ assets and liabilities, and potential reductions in offshore dollar supply is important—especially if U.S. interest rates increase sharply and the dollar appreciates. *International Monetary Fund | April 2017* ### Box 1.3 (continued) ### Box 1.3 (continued) ### Regulatory status and equivalence - The United Kingdom and the European Union do not currently qualify as “third countries” vis-à-vis each other and hence cannot begin the formal application process to seek third-country regulatory equivalence. ### Banks’ uncertainty about new regulators - Banks have invested heavily to develop internal risk models that are accepted by their current regulators. - Relocation to a new jurisdiction will bring some uncertainty about how quickly these models can be reviewed and accepted by the new regulator. - Banks’ uncertainty about the requirements of their new regulators is likely to rise temporarily. ### Market liquidity in government debt markets - Several U.K.-based banks provide critical primary dealer functions in the sovereign debt market. - Because uncertainty and operating costs will likely increase during the transition period, many banks may opt to exit or scale back the primary dealer business. - This could lead to costlier and less efficient markets until new players enter. *Source: ch1 - Box 1.3 (continued), International Monetary Fund | April 2017* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2017/april/chapter-1/ch1.pdf_