## 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/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2017/april/chapter-1/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2017/april/chapter-1/text.pdf.json) --- ### Financial stability: current assessment and near-term outlook - Financial stability has continued to improve since the October 2016 GFSR; growth is gaining momentum and risk premiums and volatility have declined. - Equity markets in the United States hit record highs in March on investors’ hopes for tax reform, infrastructure spending, and regulatory rollbacks. - Market and liquidity risks have eased as risk premiums have fallen and volatility remains subdued, but elevated political and policy uncertainty is a major downside risk. - Key downside scenarios and channels: - U.S. policy disappointment (tax reforms/deregulation not delivering benign growth/debt paths) could trigger sharp rises in risk premiums and volatility. - A shift toward protectionism in advanced economies could reduce global growth and trade, impede capital flows, and dampen market sentiment. - A broad rollback of financial regulations or loss of global cooperation could undermine gains in financial stability. - The GFSR analysis reflects information available as of March 31, 2017. ### U.S. corporate sector: capacity to expand and vulnerabilities - Balance-sheet capacity and potential effects of tax reform: - The cash flow boost from a statutory tax cut could amount to more than $100 billion a year for S&P 500 firms, atop existing cash flow of more than $1 trillion. - Repatriation: $2.2 trillion in unremitted foreign earnings held abroad, with 60 percent concentrated in the information technology and health care sectors. - A cut to the statutory tax rate may be insufficient to close a capital spending gap of nearly $140 billion needed to reach pre-2000 capital spending levels; expensing and removal of interest deductibility would attenuate but likely not eliminate financing needs for cash-constrained sectors. - Financial risk taking and leverage: - Financial risk taking has averaged $940 billion a year over the past three years for S&P 500 firms, more than half of free corporate cash flow. - Health care and information technology sectors together have accounted for nearly $500 billion a year in financial risk taking since 2012. - Aggregate corporate balance-sheet observations: $7.8 trillion in debt and other liabilities added since 2010. - Median net debt across S&P 500 firms is close to a historic high of more than 1½ times earnings. - Sectoral leverage extremes: debt between four and six times earnings in energy, real estate, and utilities. - Debt service and asset-at-risk metrics: - Proportion of income devoted to debt servicing has risen by 4 percentage points, bringing it to its highest level since 2010. - The average interest coverage ratio has fallen sharply over the past two years; earnings have dropped to less than six times interest expense. - 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 when considering firms with slightly higher earnings cover, and rises to 22 percent under an assumed interest rate rise. - Under an adverse scenario, the combined assets of challenged firms could reach almost $4 trillion. ### Policy implications for the U.S. corporate sector - Vigilantly monitor increased leverage and deteriorating credit quality and preemptively address excessive financial risk taking. - Deploy prudential and supervisory actions if policy stimulus leads to increased debt-financed investment and rising corporate vulnerabilities. - Tax reforms that reduce incentives for debt financing could help attenuate leverage buildup and encourage firms to lower existing tax-advantaged leverage. - Use stress testing to assess risks to nonbank financial intermediary balance sheets from 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 postcrisis regulatory progress. ### Emerging market economies: resilience, external risks, and scenario impacts - Resilience and growth: - Emerging market growth projected to rise from 4.1 percent in 2016 to 4.5 percent in 2017. - Corporate leverage in many emerging markets has started to decline, and policy buffers have been strengthened since the 2013 taper tantrum. - China-specific vulnerabilities: - Credit continues to rise rapidly; China’s bank assets are now more than triple its GDP. - BIS credit gap estimated at about 25 percent; evidence suggests credit booms of this size are often dangerous. - Many Chinese financial institutions remain overly dependent on wholesale financing with sizable asset-liability mismatches; repo funding is very short-term while funded credit products have much longer maturities. - Recent money-market turbulence illustrated vulnerabilities in an increasingly large, opaque, and interconnected system. - Scenario estimates for emerging markets: - A scenario of rising global risk premiums would increase the weak tail of emerging market firms to over 16 percent of total nonfinancial corporate debt, an increase of $135 billion (exceeding the 15 percent peak in 2015). - A scenario of rising protectionism would increase the size of the weak tail of firms to 17 percent of total nonfinancial corporate debt, an increase of $235 billion. - These scenarios indicate greatest deterioration in corporate balance sheets in China, India, and South Africa; commodity sectors would be pressured by falling metal and oil prices. - Banking sector indicators and provisioning: - Bank sample: 294 banks from 14 countries with $32 trillion in assets. - Lenders outside China increased capital by 20 percent since end-2014 versus 15 percent asset growth. - Provision needs exercise: raising provision coverage ratios to at least 50 percent of nonperforming and problem loans or to country average would generate some $120 billion (5 percent of capital) in additional provisions. - For about 30 percent of emerging market bank assets (outside China), additional provisions would exceed average annual net income. - 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 recommendations for emerging markets: - Strengthen supervision and bank governance while maintaining robust macroprudential toolkits. - Swift and transparent recognition of nonperforming assets; comprehensive asset quality assessments where warranted. - Prioritize improving corporate debt-restructuring mechanisms, including formal insolvency frameworks and out-of-court restructuring. - Strengthen capital buffers and stand ready to provide foreign exchange hedging tools where needed. - Use private channels (equity issuance, bail-ins) to meet capital needs where possible; use public support only as last resort when systemic and fiscal space exists. ### European banking systems: structural challenges, profitability, and policy actions - Profitability and structural facts: - Almost three-quarters of domestic banks had weak returns in 2016 (defined as return on equity of less than 8 percent). - A group of structurally weak banks represents about $8.5 trillion in assets (about one-third of bank assets) and would be stuck with ROE < 8 percent even after a cyclical recovery. - Sample of 172 large European banks: total 2016 assets amount to $35 trillion. - Three bank classifications by assets: Domestic 40 percent; Europe-focused 31 percent; Global 29 percent. - Structural impediments: - Overbanking, large banking-system assets relative to the economy, a long weak tail of banks, many banks with regional focus or narrow mandate, leading to limited lending opportunities, higher costs, and reduced operational efficiencies. - Nonperforming loan (NPL) challenges: time to resolution at current rates could be about six years on average for euro area countries; country heterogeneity—Italy and Portugal have seen little reduction relative to peak NPL levels; Ireland and Spain have made more progress. - Selected country metrics (sample statistics): - Total sample assets: 34,929 (billions of U.S. dollars). - Country examples (assets, proportion of sample assets, number of firms): - France: 7,785; 22.3 percent; 7 firms. - United Kingdom: 6,697; 19.2 percent; 13 firms. - Germany: 4,452; 12.7 percent; 22 firms. - Spain: 3,767; 10.8 percent; 15 firms. - Italy: 2,651; 7.6 percent; 21 firms. - Provisioning and branch rationalization: - Rationalizing branches to reach the European average deposits-to-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 representing about 98 percent of sample assets). - Illustrative asset-quality provisioning exercise across emerging market banks generates $120 billion in additional provisions (5 percent of capital). - Policy recommendations for Europe: - Address NPL burdens via improved legal frameworks, information quality, asset-management companies, and loan-sale markets. - Tackle overbanking and excess capacity through consolidation, branch rationalization, and governance reforms. - 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. - Supervisors should emphasize business-model examinations and consider targeted asset-quality reviews for banks without such assessments. - Complete regulatory reform agenda (including Basel III package) and resist broad regulatory rollback. ### Low-for-long interest-rate environment: implications for financial intermediation - Long-run observations: - Advanced economies have experienced prolonged low interest rates and low growth; real interest rates have been on a steady decline over the past three decades. - Recent increase in longer-term yields (notably in the United States) does not guarantee exit from low rates; Japan’s experience highlights persistent structural factors. - Key findings in sustained “low-for-long” scenario: - Yield curves likely flatter, lowering bank earnings—particularly for smaller, deposit-funded, and less diversified institutions. - If bank deposit rates cannot drop (significantly) below zero, bank profits would be squeezed further. - Long-lasting challenges for life insurers and defined-benefit pension funds; guaranteed-return long-term savings products become less attractive. - As banks reach for yield, new financial stability challenges would arise in home and host markets. - Quantitative empirical findings from cross-country bank panel: - Sample: almost 17,000 banks in eight advanced economies, annual data 1990–2015; daily equity analysis covers 2000–2016 for 16 advanced economies. - On average, sampled banks earn a 10½ percent return on equity, but in periods with prolonged low rates this falls to 7.8 percent. - During periods of prolonged low interest rates: - A 1 percentage point drop in three-month rates is estimated to reduce bank profits by 31 percent below average estimated bank profits. - A 1 percentage point drop in term premiums is estimated to reduce bank profits by 8 percent below average estimated bank profits. - Bank business-model heterogeneity: - A one-standard-deviation increase in bank size raises bank profits an estimated 67 percent relative to the sample average during prolonged low-rate periods. - A one-standard-deviation increase in the share of deposit funding is associated with estimated bank returns lower by 14 percent than the sample average in such periods. - A one-standard-deviation increase in the share of loans in the asset portfolio is associated with estimated bank returns higher by 22 percent than the sample average in such periods. - Insurance, pensions, and asset management implications: - Liability-duration mismatches create solvency pressure; asset-allocation changes alone are unlikely to restore solvency without taking potentially unacceptable risk. - Defined-contribution plans likely to grow; guaranteed-return products decline; insurers may shift toward protection and unit-linked products. - Growth of asset managers and index funds raises issues for price discovery and liquidity management; fees for active funds remain higher than index funds. - Policy recommendations for low-for-long environment: - Prudential frameworks should incentivize longer-term stability and resist deregulation pressures aimed at short-term relief. - For banks: facilitate smooth consolidation and exit of nonviable institutions; limit excessive risk taking and incentives to widen maturity mismatches. - For insurers: adopt economic solvency requirements that encourage necessary business-model adjustments. - Strengthen surveillance and regulation of asset management, close data gaps, and adopt macroprudential rules to address liquidity-mismatch risks. ### Global financial conditions and domestic influence (financial conditions indices) - Measurement and stylized facts: - Financial conditions indices (FCIs) constructed for 43 advanced and emerging market economies (1990–2016) using domestic financial variables (spreads, equity & house prices, volatility, credit growth). - A single global financial factor accounts for about 20 to 40 percent of the variation in countries’ domestic FCIs; the one-factor TSFA explains about 30 percent of variance while a three-factor TSFA explains about 41 percent. - The global factor moves in tandem with the U.S. FCI and global risk measures (for example, VIX); average correlation between the U.S. FCI and global measures is 82 percent. - No conclusive evidence that the global factor’s influence has risen markedly over the past two decades; the share displays cyclical patterns but is broadly stable. - Predictive power and policy relevance: - A one standard deviation increase in the FCI (tighter financial conditions) is associated with a 0.4 percentage point decrease in median future GDP growth at a one-year horizon. - FCIs improve forecasts of future growth and particularly flag downside risks: at the second quarter of 2006 the model with FCIs attributed approximately a 45 percent probability to the actual 6 percent growth outturn—more than twice the probability from a model using only growth rates. - Transmission, heterogeneity, and policy tools: - Domestic FCIs react faster and more strongly to global financial shocks than to domestic policy rate changes, implying that timely and effective monetary responses may need to be “very quickly and strongly,” which can have undesirable side effects. - For small open economies with flexible exchange rates (panel VAR): - About 21 percent of the variation in domestic FCIs is attributed to global financial shocks; domestic monetary policy shocks account for about 15 percent. - Alternative country-by-country VARs: global financial conditions and monetary policy account for, on average, about 40 percent and 12 percent of domestic FCI variations, respectively. - In a subset of four small open advanced economies (Australia, New Zealand, Norway, Sweden) using Gertler and Karadi identification, global financial conditions and domestic monetary policy explain, on average, 15 percent and 33 percent of FCI variation, respectively. - Country characteristics affecting sensitivity to global FCI: - Greater financial linkages (especially FDI) and trade openness increase sensitivity. - Greater financial development and stronger rule of law tend to attenuate sensitivity. - Policy recommendations to preserve influence over domestic financial conditions: - Promote domestic financial deepening and develop a local investor base (banks and nonbanks) to dampen external shocks. - Use macroprudential measures to contain vulnerability buildups that increase sensitivity to external shocks. - Consider temporary capital flow management measures where disruptive outflows threaten stability, consistent with IMF guidance. - Strengthen multilateral cooperation and resist inward-looking policies that would reduce global integration and financial stability. ### Offshore dollar funding and global liquidity risks (Box 1.1) - Key metrics and concerns: - Advanced economy banks’ foreign-currency maturity gap has nearly doubled since 2007 to $2.9 trillion; the foreign-currency maturity gap as a percentage of total assets grew from 4.4 percent to a high of 6.1 percent in November 2015. - Many cross-currency swap bases remain negative, indicating persistent unmet demand for dollars. - U.S. corporations hold abroad an estimated $2.2 trillion in cumulative reinvested earnings; roughly $1.3 trillion of that is in liquid assets. - Historical precedent: after the 2004 repatriation tax holiday, $362 billion was repatriated. - Amplification scenarios: - A sharp increase in U.S. interest rates combined with a strong dollar could produce more negative cross-currency swap bases and reduce offshore dollar supply. - A U.S. repatriation incentive could materially reduce offshore dollar supply. - Administrative measures (for example, bank ring-fencing) could fragment dollar funding markets and raise costs. - Policy guidance: - Supervisors should encourage banks to reduce foreign-currency maturity mismatches by lengthening debt maturities and 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 such facilities should be treated as extraordinary and priced accordingly. ### Executive Directors’ policy priorities (summarized) - Directors welcomed stronger activity and financial market sentiment but emphasized downside risks, urging use of all policy tools nationally and multilateral cooperation to: - sustain recovery, - ward off downside risks, - safeguard global integration and financial stability, - promote inclusion. - Specific recommendations: - Advanced economies: boost potential output via fiscal and structural reforms (upgrade public infrastructure, improve labor force participation and skills, eliminate product market distortions, reform corporate income taxation); design inclusive fiscal policies balanced with debt sustainability. - Where core inflation is persistently low, unconventional monetary policies remain appropriate but their financial stability consequences should be monitored. - Emerging market and developing economies: maintain sound policies, including exchange rate flexibility and robust macroprudential toolkits; consider temporary capital flow management measures where warranted. - Country-specific vigilance: United States—monitor leverage and credit quality amid potential tax reform; Europe—adjust bank business models and dispose of NPLs; China—focus on rapid asset growth among smaller banks and interconnections between shadow products and interbank markets. - Cross-cutting principle: resist broad rollback of financial regulations and maintain global cooperation; complete postcrisis regulatory reform and avoid uncoordinated opt-outs that could fragment standards. *International Monetary Fund. Global Financial Stability Report: Getting the Policy Mix Right (Chapter 1, April 2017).* ### Preface ### Preface ### Financial Stability Has Improved - Financial stability has continued to improve since the October 2016 Global Financial Stability Report (GFSR). - Economic activity has gained momentum, as outlined in the April 2017 World Economic Outlook (WEO), amid broadly accommodative monetary and financial conditions, spurring hopes for reflation. - Longer-term interest rates have risen, helping to boost earnings of banks and insurance companies. - Equity markets in the United States hit record highs in March on investors’ hopes for tax reform, infrastructure spending, and regulatory rollbacks. - Risk premiums and volatility have declined. ### Policy Uncertainty Is a Key Downside Risk - Elevated political and policy uncertainty around the globe is a major downside risk to financial stability. - In the United States, if anticipated tax reforms and deregulation deliver paths for growth and debt that are less benign than expected, risk premiums and volatility could rise sharply. - A shift toward protectionism in advanced economies could reduce global growth and trade, impede capital flows, and dampen market sentiment. - In Europe, political tensions combined with a lack of progress on structural banking challenges and high debt levels could reignite financial stability concerns. - A broad rollback of financial regulations—or a loss of global cooperation—could undermine gains in financial stability. - Markets have so far taken a relatively benign view of these downside risks, leaving the potential for a swift repricing of risks in the event of policy disappointment. ### Are U.S. Companies Strong Enough to Accelerate the Expansion Safely? - Many nonfinancial firms have the balance sheet capacity to expand investment; reductions in corporate tax burdens could positively affect cash flow. - Reforms could spur increased financial risk taking and, in some sectors, raise leverage from already-elevated levels. - The sectors that have invested the most have the highest leverage; financing additional investment with debt will increase vulnerabilities. - Under a scenario of rising global risk premiums, higher leverage could have negative stability consequences. - In such a scenario, the assets of firms with particularly low debt service capacity could rise to nearly $4 trillion, or almost a quarter of corporate assets considered. ### Emerging Market Economies Face Trying Times in Global Markets - Emerging market economies have continued to enhance resilience by lowering corporate leverage and reducing external vulnerabilities. - Growth is expected to continue improving, driven by gains for commodity exporters and prospects for positive growth spillovers from advanced economies. - Global political and policy uncertainties create new channels for negative spillovers, keeping overall financial stability risks elevated. - A sudden reversal of market sentiment or a global shift toward inward-looking protectionist policies could reignite capital outflows and hurt growth prospects. - Countries with strong international financial and trade links could be challenged by tighter global financial conditions or adverse trade measures. - These risks could increase the debt at risk of the weakest firms by $130–$230 billion. - A sharp turn away from the current supportive external environment could reinforce risks in countries whose weakest banks are challenged to maintain asset quality and adequately provision for bad loans after long credit booms. - China: credit continues to rise rapidly; China’s bank assets are now more than triple its GDP, and other nonbank financial institutions also have heightened credit exposure. - Many Chinese financial institutions remain overly dependent on wholesale financing, with sizable asset-liability mismatches and elevated liquidity and credit risks. - Recent turbulence in money markets in China illustrates vulnerabilities in an increasingly large, opaque, and interconnected system. ### European Banking Systems Must Address Structural Challenges - Considerable progress has been made in the European banking sector, and cyclical upturn optimism has helped boost European banks’ equity prices. - A cyclical recovery alone will likely be insufficient to restore profitability of persistently weak banks. - Almost three-quarters of domestic banks had weak returns in 2016 (defined as return on equity of less than 8 percent). - Structural challenges include overbanking, large banking-system assets relative to the economy, a long weak tail of banks, and too many banks with a regional focus or narrow mandate. - These features can lead to limited lending opportunities, high numbers of branches relative to assets, higher costs, and reduced operational efficiencies. - System-wide headwinds also affect large, systemically important banks in Europe, hindering their ability to compete globally. - Until structural impediments are addressed, simple restructuring of business models is unlikely to yield sufficient profitability. - Left unresolved, weak profits, lack of access to private capital, and large bad debt burdens could impede recovery and reignite systemic risks. ### It Is Crucial to Get the Policy Mix Right - Policymakers should adjust the policy mix to deliver a stronger path for long-term and inclusive growth while avoiding inward-looking policies that could be counterproductive. - In the United States: - Vigilantly monitor increased leverage and deteriorating credit quality. - Regulators should preemptively address excessive financial risk taking. - Prudential and supervisory actions should be taken if policy stimulus leads to an increase in debt-financed investment and rising corporate vulnerabilities. - Tax reforms that reduce incentives for debt financing could help attenuate risks of further leverage buildup and possibly encourage firms to lower existing tax-advantaged leverage. - In Europe: - Further actions should be taken to address bank profitability and legacy challenges. - Banks bear primary responsibility for developing sustainable earnings by tackling business model problems through consolidation, branch rationalization, and investment in technology to increase medium-term efficiency. - Supervisors are increasingly engaged in addressing these challenges. - The analysis in this GFSR reflects information available as of March 31, 2017. *International Monetary Fund. Global Financial Stability Report: Getting the Policy Mix Right (Preface).* ### exeCutIve suMMary ### exeCutIve suMMary ### Banking system vulnerabilities and supervision - Supervisory frameworks should emphasize examination of bank business models to detect weak links in systems with significant asset quality challenges. - Consider targeted asset quality reviews for banks that have not undergone such an exercise. - Regulators should take action to resolve unviable institutions to remove excess capacity. - Authorities should focus on removing system-wide impediments to profitability, including: - addressing nonperforming loans, and - developing frameworks that accelerate recovery. - In emerging market economies: - strengthen supervision and bank governance while maintaining a robust macroprudential toolkit; - monitor countries with wide net foreign-currency positions or foreign-currency maturity gaps; - proactively monitor and reduce corporate and banking sector vulnerabilities and improve restructuring mechanisms. - In China: - supervisory attention should concentrate on banks’ emerging risks, especially fast asset growth among smaller banks, increasing reliance on wholesale funding, and risks from interconnections between shadow products and interbank markets; - authorities have recognized the urgent need to deleverage and have undertaken substantive corrective measures, but addressing the policy tension between maintaining high growth and deleveraging is necessary to avoid market and macro instability. ### Postcrisis regulatory reform and risks of rollback - The postcrisis reform agenda has: - strengthened oversight of the financial system, - raised capital and liquidity buffers of individual institutions, - improved cooperation among regulators. - Caution is needed when considering any future regulatory rollback: - weakening regulatory standards increases financial stability risks; - uncoordinated or unilateral opt-outs could cause financial fragmentation and a race to the bottom in regulatory standards. - Completing the regulatory reform agenda is vital; reviews of reforms should avoid unraveling broad improvements in global financial resilience. ### Long-term low growth and low interest rates: implications for financial intermediation (Chapter 2) - Advanced economies have experienced a prolonged episode of low interest rates and low growth since the global financial crisis; real interest rates have been on a steady decline over the past three decades. - Recent signs of increase in longer-term yields (particularly in the United States) do not guarantee an imminent and permanent exit from low rates; Japan’s experience highlights persistent structural factors (for example, demographic aging). - Key findings on a sustained “low-for-long” scenario: - yield curves would likely flatten, lowering bank earnings—particularly for smaller, deposit-funded, and less diversified institutions; - long-lasting challenges would arise for life insurers and defined-benefit pension funds; - if bank deposit rates cannot drop (significantly) below zero, bank profits would be squeezed further; - as banks reach for yield, new financial stability challenges would arise in home and host markets. - Broader structural effects: - lower credit demand, higher household demand for transaction services; - bank business models in advanced economies may shift toward fees-based and utility banking services; - demographic changes would increase demand for health and long-term-care insurance; - low asset returns would accelerate the transition to defined-contribution private pension plans; - demand would weaken for guaranteed-return, long-term savings products offered by insurers and strengthen for passive index funds offered by asset managers. - Policy implications: - prudential frameworks need to provide incentives for longer-term stability and resist pressures for deregulation aimed at short-term relief. ### Influence over domestic financial conditions amid global integration (Chapter 3) - Countries can retain influence over domestic financial conditions in a globally integrated financial system; greater financial integration complicates management but need not result in a loss of control. - Financial conditions indices show global financial conditions account for "20 to 40 percent" of the variation in countries’ domestic financial conditions, with notable differences among economies. - The importance of the global factor does not appear to have increased much over the past two decades. - Despite strong and rapid domestic reactions to global financial shocks, countries can influence domestic financial conditions—specifically through monetary policy. - Emerging market economies are more sensitive to global financial conditions and should prepare for tighter external financial conditions. - Policy recommendations to enhance resilience: - promote domestic financial deepening; - develop a local investor base; - foster greater equity- and bond-market depth and liquidity. ### Executive Directors’ assessment and policy priorities - Directors welcomed positive developments since the second half of 2016: accelerated global activity, generally rising headline inflation, and strengthened financial market sentiment. - Global growth is expected to pick up further in 2017–18, reflecting stronger-than-expected advanced-economy recoveries and projected higher growth in many emerging market and developing economies. - Downside risks dominate, with heightened policy uncertainty and persistent structural headwinds. - Directors emphasized using all policy tools nationally and strengthening multilateral cooperation to: - sustain recovery, - ward off downside risks, - safeguard global integration and financial stability, and - promote inclusion. - Specific concerns and policy guidance: - risks from faster-than-expected interest rate normalization, rollback of financial regulation, and potential rise in protectionism; - advanced economies: boost potential output via fiscal and structural reforms (upgrade public infrastructure, improve labor force participation and skills, eliminate product market distortions, reform corporate income taxation); - design inclusive fiscal policies (transfer and tax instruments) that balance redistribution with incentives to invest and work; - where core inflation is persistently low or deflation risk remains tangible, unconventional monetary policies remain appropriate but their financial stability consequences should be monitored; - fiscal policy should be countercyclical, growth friendly, promote inclusion, and be anchored in a credible medium-term framework ensuring debt sustainability; - emerging market and developing economies should maintain sound policies (including exchange rate flexibility and robust macroprudential toolkits) and may use capital flow management measures temporarily where warranted; - priorities include monitoring vulnerabilities, addressing corporate and banking sector weaknesses, improving corporate governance, reducing infrastructure bottlenecks, developing local investor bases, fostering market depth and liquidity, and upgrading tax systems. - Country-specific vigilance: - United States: be vigilant to increases in leverage and deterioration in credit quality, and take preemptive measures against excessive risk taking amid potential tax reform and deregulation; - Europe: adjust bank business models, facilitate disposal of nonperforming loans, and remove structural impediments to bank profitability; - China: pay special attention to rapid asset growth among smaller banks, reliance on wholesale funding, and interconnections between shadow products and interbank markets. - For commodity-exporting low-income developing countries: - intensify efforts to mobilize revenue, improve tax administration, enhance spending efficiency, and contain debt buildup; - for diversified countries: build fiscal buffers while growth remains relatively strong and balance social/developmental needs with debt sustainability; - maintain progress toward sustainable development goals. ### Financial stability overview and near-term outlook - Financial stability has improved since the October 2016 GFSR: - growth gaining momentum, reducing macroeconomic risks and rekindling reflation hopes; - rising equity prices and steeper yield curves have mitigated some negative side effects of low interest rates for banks and insurers. - Emerging market risks remain elevated but unchanged, as recovering commodity prices and modest corporate deleveraging are offset by higher external financing risks and rising vulnerabilities in China. - Market indicators: - market and liquidity risks have eased as risk premiums have fallen and volatility remains subdued; - reflexive global trends began last September and accelerated after the U.S. elections; - expectations for policy stimulus contributed to a stronger dollar and higher nominal and real U.S. Treasury security yields, spilling over to other advanced economy bond markets. - Risks ahead: - U.S. policy imbalances could lead to tighter-than-expected financial conditions, higher volatility, and increased risk aversion; - a global shift toward protectionism could harm trade, global growth, capital flows, and market sentiment, with adverse spillovers to emerging markets. - Sectoral observations: - U.S. nonfinancial corporate sector is well positioned to benefit from proposals aimed at increasing business confidence and investment, but rising corporate leverage may constrain safe expansion; - stretched valuations and outperformance in sectors exposed to potential fiscal stimulus raise risks of overestimation of benefits and underestimation of downside risks. - European banking systems: - cyclical recovery alone unlikely to restore profitability of persistently weak banks; - system-wide structural impediments—operational inefficiencies, weak business models, inefficient credit allocation, excess capacity, and large legacy bad debt—require systematic and comprehensive policies in addition to business model restructuring. ### Getting the policy mix right - Securing improvements in financial stability and validating market expectations requires: - concerted, careful national and global policy efforts to deliver stronger long-term and inclusive growth; - avoidance of inward-looking policies that are politically expedient but counterproductive; - resistance to broad rollback of financial regulations and maintenance of global cooperation. - Policy trade-offs must aim to enhance effectiveness of proposed measures while safeguarding against financial risk excesses and market instability. *Source: exeCutIve suMMary (text - exeCutIve suMMary), Global Financial Stability Report: Getting the Policy Mix Right, April 2017.* ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### Global risk and market conditions: key assessments - 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. - Note: Overall notch changes are the simple average of notch changes in individual indicators. The number in parentheses next to each category indicates the number of individual indicators within each subcategory. ### Reflation, market optimism, and asset-price moves - Market expectations for the U.S. economy and monetary policy normalization have improved. - Ten-year inflation compensation has moved higher across a range of sovereign bond markets. - Financial market risk dashboard: a compression in volatility and stronger price moves across a number of global markets was observed between September 30, 2016, and March 31, 2017. - Key market series referenced: 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, V2X, MOVE, and major FX six‑month implied vols. ### U.S. equity valuations and policy-linked sectoral effects - Despite greater policy uncertainty, implied equity volatility has declined to multiyear lows. - U.S. equity valuations have become increasingly overvalued (Shiller price-to-earnings ratio and S&P 500 discussed). - Some industry subsectors have benefited disproportionately from anticipated policy changes (percent changes since U.S. election shown for multiple subsectors). - Valuations in sectors exposed to potential policy shifts are being driven more by expectations than by actual earnings. ### Is the U.S. corporate sector ready to accelerate expansion—safely? - Policy intent and transmission: - Tax policy reforms under discussion (including cuts in the statutory tax rate, incentives for repatriation, and changes to interest deductibility and expensing) could boost corporate internal funds and encourage capital spending. - Other proposed policies include infrastructure spending, deregulation, and trade measures. - Stylized 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, and buffers); Debt markets; Equity markets; Banks. ### Illustrative scenario estimates and numeric impacts - Scenario elements modeled: - A boost to operating cash flow from a 10 percentage point reduction in effective corporate tax rates (proxy for a lower statutory corporate tax rate). - Combined effect of expensing new capital expenditures and removing the tax deductibility of interest expenses (approximated given gradual stock effects). - Potential for a one-off repatriation of retained foreign earnings, including liquid funds held abroad. - Quantified illustrative results and sectoral impacts: - The cash flow boost from a statutory tax cut could amount to more than $100 billion a year for S&P 500 firms, atop existing cash flow of more than $1 trillion. - Tax-related windfalls could cover higher capital spending in seven of the ten main S&P 500 nonfinancial sectors. - Repatriation: $2.2 trillion in unremitted foreign earnings held abroad, with 60 percent concentrated in the information technology and health care sectors. - A cut to the statutory tax rate may be insufficient to close a capital spending gap of nearly $140 billion needed to reach pre-2000 capital spending levels. - Additional measures (expensing and removal of interest deductibility) would attenuate but likely not eliminate financing needs for cash-constrained sectors. - Financial risk taking has averaged $940 billion a year over the past three years for S&P 500 firms, more than half of free corporate cash flow. - Health care and information technology sectors together have accounted for nearly $500 billion a year in financial risk taking since 2012. ### Sectoral cash constraints and financing composition - Cash-constrained sectors: Energy, utilities, and real estate account for almost half of overall capital spending among S&P 500 firms in recent years. - Cash and financing aggregates (illustrative, as presented): - Cash and investments: ~ $1.3 trillion (aggregate depiction). - Breakdown of uses and sources of financing by sector shown in figures (operating cash, increase in debt, etc.). ### Corporate vulnerabilities, leverage, and credit-cycle signals - Aggregate corporate balance-sheet observations: - Corporate cash flow has tapered as corporate profits have come off peaks. - $7.8 trillion in debt and other liabilities added since 2010. - Median net debt across S&P 500 firms is close to a historic high of more than 1½ times earnings. - S&P 500 firms collectively account for about one-third of the $36 trillion economy-wide corporate sector balance sheet. - Broader sample of nearly 4,000 firms (about half of the economy-wide corporate sector balance sheet) shows leverage rising across almost all sectors to levels exceeding those prevailing just before the global financial crisis. - Sectoral leverage extremes: debt between four and six times earnings in energy, real estate, and utilities. - Credit-cycle and asset-quality signals: - Corporate credit fundamentals have started to weaken, consistent with a maturing credit cycle. - Asset quality deterioration evidenced by a rising share of deals with weaker covenants and a rising share of rating downgrades in industries including energy, capital goods, and health care. - Debt-servicing and interest coverage: - Proportion of income devoted to debt servicing has risen by 4 percentage points, bringing it to its highest level since 2010. - The average interest coverage ratio has fallen sharply over the past two years; earnings have dropped to less than six times interest expense. - These developments leave firms vulnerable to tighter borrowing conditions. ### Implications for policy and financial stability (implicit policy guidance) - Policy stimulus through tax reform and repatriation could materially increase corporate cash flows and support higher capital spending but may not fully eliminate financing gaps in cash-constrained sectors. - Stimulus that disproportionately accrues to sectors with elevated financial risk taking could amplify systemic risks if corporate balance-sheet vulnerabilities and elevated leverage coincide with tighter borrowing conditions. - Monitoring and policy design should consider sectoral heterogeneity in cash positions, leverage, and prior financial risk taking to maximize economic effectiveness while safeguarding financial stability. *Source: IMF staff estimates (April 2017).* ### 1. Corporate Cash Holdings on Balance Sheet ### 1. Corporate Cash Holdings on Balance Sheet ### Corporate liquidity and profits - Corporate cash holdings are tapering. - Corporate profits are receding from a high level (percent of GDP). ### Financing patterns and equity issuance - Net equity financing has been falling the past four decades, while 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) is associated with an increase in debt and other liabilities. ### Balance sheet fundamentals, valuations, and credit conditions - Asset valuations, balance sheet fundamentals, and credit conditions show deteriorating balance sheet fundamentals and credit conditions (unweighted average in percentile rank, normalized to zero). - Stages of a stylized credit cycle signal a late stage of expansion in the credit cycle (Downturn, Repair, Recovery, Expansion described; examples: August 2007–March 2009, July 2004–August 2007, March 2009–December 2009, December 2009–August 2010). - Median corporate leverage among large firms (S&P 500) has grown steadily and is close to a historical peak (ratio of net debt to EBITDA). - Eight out of ten sectors witness an increase in leverage across a broad set of firms (net leverage by sector, ratio of net debt to EBITDA). ### Debt service, interest coverage, and vulnerability to higher interest rates - The debt service burden for the corporate sector as a whole has risen strikingly despite low rates. - Interest coverage ratios (ICR = ratio of EBIT to 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 vs. average ICRs). - Under an adverse scenario (Scenario Box 1.1 of the WEO), an unproductive fiscal expansion could lead to a sharp rise in borrowing costs, further compromising firms’ ability to service debt. - Under this scenario, the combined assets of challenged firms could reach almost $4 trillion. - 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. - The share rises to 22 percent under the assumed interest rate rise. - The rise in challenged firms has been concentrated in the energy sector and broadened to real estate and utilities; together these three industries account for about half of firms struggling to meet debt service obligations and higher borrowing costs. ### Interest rate sensitivity and stressed assets - Declines in ICRs historically correspond with eventual widening in credit spreads for risky corporate debt. - Higher financing costs could significantly weaken firms’ ICRs and increase the percentage of “challenged” firms (percent of total assets). ### Policy recommendations and regulatory actions - Policymakers must balance economic benefits of stimulus and tax reform against financial stability risks; be vigilant to the increase in leverage and deteriorating credit quality. - Tax measures that reduce incentives for debt financing could help attenuate risks of further leverage buildup and may encourage unwinding of tax-advantaged debt. - Regulators should preemptively address areas where risk taking appears excessive; additional financial prudential and supervisory action could be deployed should policy stimulus increase debt-financed investment and medium-term corporate vulnerabilities. - Use stress testing to assess risks to nonbank financial intermediary balance sheets from 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; there is room to fine-tune existing regulations but avoid wholesale dilution or backtracking on regulatory progress. ### Emerging market economies: resilience and external risks - Emerging market economies have strengthened policy buffers and reduced external imbalances since the 2013 taper tantrum; corporate leverage has started to decline but remains elevated. - Emerging market growth is projected to rise from 4.1 percent in 2016 to 4.5 percent in 2017. - Political and policy uncertainty in advanced economies could trigger negative spillovers: faster normalization of U.S. term premium, higher worldwide term premiums, rising risk premiums, asset price volatility, capital outflows, stronger U.S. dollar, and balance-sheet stresses. - Countries with large external financing needs, high corporate foreign-currency indebtedness, or large foreign presence in local bond markets would be most at risk. - A shift toward protectionism would hurt emerging markets with high trade openness via declining global trade and commodity prices, depressing corporate earnings—especially for exporters—and straining leveraged firms and weaker banking systems. ### Scenario: rising global risk premiums and impact on emerging markets - In a scenario of rising global risk premiums: - The weak tail of emerging market economy firms 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 when commodity price collapse hit corporate balance sheets. - Brazil, China, and India experience the greatest impact given sensitivities to changes in earnings and corporate interest rates. - A sustained reversal of capital inflows would put pressure on countries with high external financing requirements and/or low reserve adequacy. *International Monetary Fund | Global Financial Stability Report: Getting the Policy Mix Right, April 2017* ### 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 and exchange rates: - Equities of manufacturing exporters with high U.S. trade exposure have underperformed other emerging market equities (Figure 1.14, panel 5). - Currencies of manufacturing exporters have underperformed those of commodity exporters in recent months (Figure 1.14, panel 6). - Data and samples: - IIF country sample encompasses 25 emerging market economies (used in panels 1, 2, and 3). - EPFR country sample encompasses about 85 emerging and developing economies (used in panels 2 and 3). - EM = emerging market; FDI = foreign direct investment. ### Rising Protectionism and Trade Exposure - 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. - The combination of declining global trade and growth would increase corporate vulnerability, especially for firms with high leverage and large foreign exchange mismatches, raising corporate risk premiums and borrowing costs. - Transmission channels include disruptions to principal trading partners and lower demand for imported intermediate and capital goods. - Country trade exposures highlighted: - 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. - Some emerging market economies in Asia (for example, Malaysia, Thailand, and Vietnam) have high manufacturing exports as a share of GDP. - A decline in Chinese exports would weaken China’s growth and reduce demand for imported intermediate and capital goods, affecting exporters in Asia and commodity exporters. - Scenarios used in analysis include rising global risk premiums and rising protectionism. ### Corporate Debt under Rising Risk Premiums and Protectionism - Scenario outcomes: - 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 under protectionism is somewhat higher than under the case of rising global risk premiums. - Greatest deterioration in corporate balance sheets would occur in China, India, and South Africa. - Commodity sectors would come under pressure because metal and oil prices would fall as a result of a sharp decline in global growth. - Figure 1.15 visuals: - Panel 1: Corporate debt with interest coverage ratio < 1 — the weak tail of corporate debt rises significantly under rising global risk premiums and rising protectionism. - Panel 2: Emerging market corporate debt with interest coverage ratio < 1 (Percent of total nonfinancial corporate debt). ### Emerging Market Banking Sector: Capital Buffers and Asset Quality - Bank sample and coverage: - Banking sector data in this section are based on a 294-bank sample covering banks from 14 countries with $32 trillion in assets. - Bank-level data are used for granularity and cross-sectional analysis. - Capital and leverage developments: - A sample of about 300 emerging market banks shows aggregate Tier 1 capital ratios now 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 been a contributing factor to rising capital ratios, particularly in Brazil. - Profitability and asset quality: - Bank equity valuations are relatively weak in China and Turkey, where credit has grown rapidly relative to GDP (Figure 1.16, panel 2). - Profitability is generally strong relative to the United States and Europe, but 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). - Provisioning and the weak tail: - Banks have raised provisioning levels in response, but not quickly enough to keep pace with bad loan formation (Figure 1.17, panel 1). - There is a large weak tail of banks with a high ratio of bad loans to buffers. - 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 jump up to 35 percent of assets (Figure 1.17, panel 4). ### Policy Implications and Recommendations - Ensure the health of emerging market banking systems through: - Swift and transparent recognition of nonperforming assets. - Strengthening capital buffers to absorb increased corporate stress. - Monitor and address underprovisioning and the weak tail of banks to reduce systemic vulnerability. - Consider the trade-exposure channels when assessing country vulnerability to rising protectionism, with attention to manufacturing exporters highly integrated with the United States and to economies with substantial links to Chinese demand. *Source: CHAPTER 1 GETTING ThE POLICY MIx RIGhT, International Monetary Fund | April 2017* ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### CHAPTER 1 GETTING ThE POLICY MIx RIGhT ### Asset quality and bank provisioning - Restoring provisioning coverage among the weakest banks is important to ensure the banking system has resilience to withstand further asset quality deterioration. - 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. - This exercise generates some $120 billion (5 percent of capital) in additional provisions, which would have 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 (Figure 1.17, panel 3). - 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. - Comparing provision needs with preprovision profits: 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 (Figure 1.17, panel 4). - More profitable banking systems such as those in Colombia and Indonesia would be well positioned to absorb such costs. - Many large banks could raise capital by tapping the equity market given generally favorable valuations. ### Policy recommendations for emerging market economies - Emerging market economies have become more resilient, benefiting from a recovery in global commodity prices and still-supportive external conditions, but face challenges along several channels (Figure 1.18). - Key vulnerabilities identified: reliance on trade openness (Hungary, Malaysia, Thailand, Vietnam, United Arab Emirates), large external financing needs (Malaysia, Poland), low reserve adequacy (South Africa, Vietnam), or combinations of these (Turkey); corporate-sector challenges (China, India, Indonesia, Turkey); banking-sector challenges (China, India, Russia). - Risks: abrupt tightening in financial conditions and increased protectionism. - Recommended policy actions: - Restoring the health of corporate balance sheets: - Prioritize improving 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 extended to nonfinancial firms and proactively monitor corporate vulnerability. - Continue to monitor firms’ foreign exchange exposure and the extent to which foreign-currency debt is hedged, either naturally or through financial instruments. - Stand ready to provide additional foreign exchange hedging tools to help firms absorb sharp currency movements without causing financial distress (as 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 the extent of 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 through 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 the offsetting effect of foreign exchange hedging. ### China: rising risks and financial vulnerabilities - Credit continues to grow at a rapid pace in China (Figure 1.19, panel 1); total assets of China’s banks are now more than triple the size of its GDP. - Bank asset growth fastest among city commercial, joint-stock, and other smaller banks (Figure 1.19, panels 3 and 4). - Other nonbank financial institutions have raised credit exposure and leverage with short-term wholesale funding, raising counterparty concerns; issuance of corporate bonds surged throughout 2016. - A large credit overhang has built up; the Bank for International Settlements calculates that the credit gap now stands at about 25 percent, and there is evidence that credit booms of this size are often dangerous (Figure 1.19, panel 2). - Capital account pressures: outflows picked up again in the second half of 2016, moderated substantially in the first two months of 2017; the People’s Bank of China has continued foreign exchange interventions to maintain broad exchange rate stability (Figure 1.20, panels 1 and 2). - Recent market episode following late-2016 tightening: - Tighter liquidity conditions in interbank and repo markets pushed up repo rates, causing losses for financial institutions investing in bond market vehicles and leading leveraged investors to sell bonds, pushing up bond yields sharply (Figure 1.21, panels 1–3). - Distress occurred in the informal “entrusted bond market,” characterized by 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, calming markets and helping reduce yields in bond markets. - System pressure points: - Many financial institutions remain overly dependent on wholesale financing with sizable asset-liability mismatches; China’s repo funding is very short-term, requiring borrowers to roll over liabilities on average almost daily, while funded credit products have much longer maturities. - Liquidity and credit risks are sizable amid increased reliance on bond issuance and elevated redemption needs. - China 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 are largest bond holders, but wealth management products and securities firms also have significant exposure and, in some cases, are highly leveraged; leverage is often established through informal markets with limited documentation and transparency. - Policy implications: - Deleveraging the system is crucial and urgent. - Authorities have started new regulatory initiatives 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 the policy tension between maintaining high growth and the need for deleveraging; if credit growth remains excessive and underpricing of credit risks persists, leverage and financial risks will continue to grow. ### European banking systems: structural challenges and profitability - Considerable progress: banks have higher capital levels; regulations strengthened; supervision enhanced; business model adaptation continues; recent bank equity price gains linked to cyclical upturn optimism. - Challenges remain: cyclical recovery unlikely to fully restore profitability of persistently weak banks; system-wide structural features compound profitability challenges and may affect international institutions. - Structural challenge: overbanking, with features varying by country; until structural impediments are fully addressed, business model restructuring alone may not yield sufficient profitability. - Risks of leaving issues unresolved: weak banks, lack of access to private capital, and large bad debt burdens impede recovery scope and could reignite systemic risks. - Developments and metrics: - European bank equity prices have increased, rising by about 40 percent on average since mid-2016 (Figure 1.22, panel 1). - Yield curve steepening has relieved building pressures on bank net interest margins. - Market valuations (price-to-book ratios) continue to reflect concerns about banks’ ability to generate sustainable profits (Figure 1.22, panel 2). - In a large sample of European banks, the 2016 return on equity was weak (Figure 1.22, panels 3–4), with distinctions made between Weak (ROE < 8%), Challenged (8% ≤ ROE < 10%), and Healthy (ROE ≥ 10%). - Policy focus: - Continue efforts to address nonperforming loan burdens and adapt business models. - Progress on resolving overbanking and structural impediments is necessary to restore sustainable profitability and reduce systemic risk. *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 ### Profitability challenges and market expectations - Market and staff findings: - A group of structurally weak banks represents about $8.5 trillion in assets (or about one-third of bank assets) and would be stuck with a return on equity less than 8 percent even after a cyclical recovery. - Market analysts predict that 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. - Systemic implications of persistently weak profitability: - Low profits reduce banks’ ability to organically build buffers against unexpected losses. - Sustained returns below the cost of equity inhibit access to private capital and can lead to future dilution if recapitalization is required. - Profit pressures can induce risk-taking: seeking higher yields, lending to less creditworthy borrowers at higher spreads, or increasing maturity mismatch. - Weak returns constrain balance sheet expansion and lending without depleting capital, dragging on recovery. ### Sample, classification, and benchmark metrics - Sample and classification: - Sample contains 172 of the largest European banks with required data; total 2016 assets in the sample amount to $35 trillion (Table 1.3). - Banks are classified into three types: - Domestic bank: Home market > 70 percent of total. - Europe-focused bank: Europe > 70 percent, but home market < 70 percent of total. - Global bank: Europe and home market < 70 percent of total. - The analysis focuses on $35 trillion in assets of 172 large European banks, and additional breakdowns use the 143 domestic banks in the sample. - Profitability benchmark and data treatment: - An 8 percent return on equity benchmark is used (investor surveys suggest banks’ cost of equity is at least 8 percent; some investors indicated cost of equity is above 10 percent). - Much of the analysis is based on 2016 profit data; where 2016 was unavailable, 2016 figures were annualized or 2015 profits used. ### Variation by bank type and country - By bank type (sample of 172 banks, by assets): - About half of the banks (by assets) had return on equity less than 8 percent. - Three-quarters of domestic banks in the sample had a weak return on equity (ROE < 8 percent), compared with about 65 percent of sample global banks and just 15 percent of Europe-focused banks in the sample. - Country-level variability (143 domestic banks sample): - Sample domestic banks in Italy and Portugal suffered losses overall in 2016. - German, Spanish, and U.K. domestic banks in the sample were barely profitable in 2016. - Sample domestic institutions in Ireland, Norway, and Sweden generated much higher returns in 2016. - There is great variability in domestic banks’ profitability measured by ROE and ROA; variation in ROA within countries is highlighted in Figure 1.23, panel 6. ### Structural drivers of weak profitability - Decomposition and drivers: - Return on assets can be decomposed into revenues, costs, and loan loss provisions; some domestic banks with weak ROA have relatively high preprovision operating profit, implying provisioning against nonperforming loans is a major drag. - Other domestic banks with weak preprovision operating profits face revenue and cost structural challenges. - Overbanking (definition and effects): - “Overbanking” is used to describe structural factors that lead to an overly large banking sector that affects profitability through: - Revenue compression: too many banks chasing too few profitable lending opportunities. - Cost and operational inefficiency: high numbers of branches or staff relative to assets. - Causes of overbanking vary by country: banking systems large relative to the economy, long weak tail of banks with low buffers, many regionally focused banks, or many branches increasing costs. - System structure and institution types: - Banking systems with a high proportion of savings or cooperative banks, Landesbanken, and policy or state-owned banks tend to face additional pressure on revenues. - In the sample, domestic cooperative and savings banks, development and policy institutions, Landesbanken, and state-owned banks tended to have lower overall ROE in 2016. ### Operational efficiency and cost reduction potential - Observed actions and potential savings: - Banking systems in Denmark, the Netherlands, and Spain showed larger percentage reductions in branches and employees. - Rationalizing branches so that the ratio of deposits to branches of each sample bank at least reaches the European average 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). - Barriers to restructuring: - High restructuring costs reduce up-front earnings and can deter cuts needed for efficiency. - Operating leases, labor market rigidities, and demographic preferences for in-person banking limit speed and extent of branch rationalization. ### Nonperforming loans (NPLs) and resolution progress - Euro area aggregate 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. - Country differences and remaining challenges: - Ireland and Spain have made good progress reducing nonperforming loans from peak levels through asset management companies, bank restructuring, and government recapitalization support. - Little reduction relative to peak levels has occurred in Italy and Portugal, two countries with among the highest NPL ratios. - Time to resolution and structural impediments: - 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—though loan sales could pick up, particularly in Italy. - Structural barriers slowing NPL disposal include inefficient legal frameworks, poor information quality in distressed asset markets, and structurally unattractive portfolio characteristics that lower buyer reservation prices. ### Country- and system-level metrics (selected sample statistics) - Total sample and composition (Table 1.3 summary): - Total sample assets: 34,929 (billions of U.S. dollars). - Proportion of sample assets by bank type: Domestic 40 percent; Europe-focused 31 percent; Global 29 percent. - Number of firms in sample: 172 total; 143 domestic; 20 Europe-focused; 9 global. - Commercial banks account for 74 percent of sample assets; others account for 26 percent. - Examples of country sample assets (billions of U.S. dollars) and proportion of sample assets: - France: 7,785; Proportion of Sample Assets 22.3 percent; Number of firms 7. - United Kingdom: 6,697; Proportion of Sample Assets 19.2 percent; Number of firms 13. - Germany: 4,452; Proportion of Sample Assets 12.7 percent; Number of firms 22. - Spain: 3,767; Proportion of Sample Assets 10.8 percent; Number of firms 15. - Italy: 2,651; Proportion of Sample Assets 7.6 percent; Number of firms 21. - Switzerland: 2,476; Proportion of Sample Assets 7.1 percent; Number of firms 20. - Netherlands: 1,866; Proportion of Sample Assets 5.3 percent; Number of firms 7. - Sweden: 1,545; Proportion of Sample Assets 4.4 percent; Number of firms 7. - Denmark: 825; Proportion of Sample Assets 2.4 percent; Number of firms 6. - Austria: 733; Proportion of Sample Assets 2.1 percent; Number of firms 14. - Belgium: 543; Proportion of Sample Assets 1.6 percent; Number of firms 5. - Norway: 346; Proportion of Sample Assets 1.0 percent; Number of firms 6. - Greece: 340; Proportion of Sample Assets 1.0 percent; Number of firms 5. - Portugal: 314; Proportion of Sample Assets 0.9 percent; Number of firms 6. - Ireland: 289; Proportion of Sample Assets 0.8 percent; Number of firms 4. - Others: 299; Proportion of Sample Assets 0.9 percent; Number of firms 14. ### Policy-relevant implications and suggested actions - Structural impediments require country-specific actions: - No single structural factor explains profitability concerns across countries; each country has a unique mix of structural features (system size, concentration, operational efficiency, system structure) that can be targeted. - Policy responses should focus on resolving NPL burdens, improving legal and information frameworks for distressed asset markets, encouraging consolidation where appropriate, and improving operational efficiency (branch and staff rationalization). - Priorities for systems with the biggest challenges: - Reduce overbanking and excess capacity to improve revenue prospects and lower costs. - Address NPL resolution with targeted measures (asset management companies, legal reform, attracting investors by improving information quality and portfolio standardization). - Facilitate consolidation and governance strengthening where needed, including reforms to cooperative, savings, Landesbanken, and state-owned bank segments. - Consider measures to lower restructuring frictions (labor and lease rigidities) to realize cost savings earlier. *Source: IMF — GLOBAL FINANCIAL STABILITY REPORT: GETTING THE POLICY MIX RIGHT (April 2017), Chapter 1, “European Bank Equity Prices and the Slope of the Yield Curve.”* ### 1. Overbranching and Reduction in Branches ### 1. Overbranching and Reduction in Branches ### Nonperforming Loans, Buffers, and Asset Quality - Insufficient buffers at banks to absorb additional losses recognized on sales of bad debts at market prices is an impediment to bad-debt disposal. - Lack of progress on resolving nonperforming loans also reflects weak earnings and insufficient generation of capital and provisioning buffers. - Further action is needed to fully resolve the burden of nonperforming loans. - The European Central Bank has published guidance to banks on how to tackle nonperforming loans. - Accounting standards (International Financial Reporting Standard 9) should ensure greater forward-looking provisioning when phased in and may change the dynamics of loss recognition by making banks more proactive. - Supervisors should ensure that banks adopt ambitious, time-bound strategies for the disposal of nonperforming loans and encourage the development of a market for problem loans. - Consideration should be given to reducing the thresholds for the direct recapitalization of viable banks under the European Stability Mechanism and establishing a common deposit insurance scheme in the euro area. ### System-wide Problems and Global Systemically Important Banks (G-SIBs) - 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, are cutting back balance sheets and reorganizing businesses, and have made progress writing off legacy assets; however, profitability remains a challenge for many. - Virtually none of the European G-SIBs are currently able to approach the profitability of their U.S. peers. - Of those European G-SIBs with comparable preprovision profitability, several continue to be hampered by continued high provisions, lowering return on assets. - Many banks have poor preprovision profit margins and thus require further restructuring of business models to improve core profitability. - Efforts to cut costs by reorganizing businesses have had varying degrees of success. - Market pricing differences: higher price-to-book ratios and lower credit default swap spreads indicate investor conviction that business models are robust; lower valuations and higher spreads suggest investors believe further progress is needed. ### Sovereign–Bank Nexus and Spillovers - Weak profitability in domestic banks and G-SIBs, lack of access to private capital, and a large stock of unresolved problem loans can 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; banking risks led to a rise 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 up sufficient bail-inable liabilities will take time. - Higher sovereign spreads could spill back to the banking sector via: - Increased bank wholesale funding costs and reduced acceptable collateral. - Mark-to-market losses on government bonds held in trading books and available-for-sale portfolios. - To help erode bank-sovereign links, authorities should consider: - Reducing thresholds for direct recapitalization of viable banks under the European Stability Mechanism. - Establishing a common deposit insurance scheme in the euro area. ### Brexit and Global Liquidity Risks - Brexit creates uncertainty about London losing some predominance as a global financial center, with attendant costs related to the loss of economies of scale; lower concentration in one center may bring diversification gains to financial stability. - Global liquidity risks could be amplified by currency mismatches between non-U.S. banks’ assets and liabilities, especially if U.S. interest rates were to increase sharply and the dollar were to appreciate. - Some non-U.S. banks accumulated higher-yielding foreign-currency assets at a pace that exceeded their funding in those currencies; U.S. dollar–denominated assets have outpaced the supply of U.S. dollar funding via deposits, certificates of deposit, commercial paper, and other sources. - The imbalance in the supply and demand of offshore dollars has 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 having steadily widened over 2014–16, cross-currency swap bases have narrowed considerably since late 2016; the reduction may reflect greater availability of dollar funding (modest pickup in U.S. prime money fund assets, greater demand from other investors, and central bank backstops). ### Policy Recommendations and Regulatory Actions - Banks should seek opportunities to increase weak revenues and reduce high operating costs; consolidation should be accompanied by governance reforms and avoid creating too-big-to-fail concerns. - Consider targeted asset quality reviews for banks that have not undergone such an exercise; regulators should take action to resolve unviable institutions to remove excess capacity. - Banks are primarily responsible for developing sustainable earnings by tackling business model problems and investing in technology to increase medium-term efficiency. - Supervisors should emphasize examination of bank business models and take forward-looking approaches to assessing sustainability (examples: Single Supervisory Mechanism Supervisory Review and Evaluation Process; U.K. Prudential Regulation Authority). - If banks respond to profitability challenges by taking greater risks, authorities should consider macroprudential or other regulatory measures to reduce probability of future problems. - Completing the regulatory reform agenda is vital, including finalizing an agreement on the Basel III package of reforms (revision of the “standardized” approach to risk-weighted assets and boundaries to the use of internal models). ### Selected Asset Quality Indicators (Table 1.5) - Note: 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. - Austria: Gross NPL Ratio (percent) 3.1; Change from the Peak (percentage points) –1.0; Net NPL Ratio (percent) 1.3; Change in the Net NPL Ratio (percentage points) 0.53; Cumulative Write-offs to NPLs (percent) 75; Coverage Ratio (percent) 58; Change in Coverage Ratio (percentage points) –14 - Belgium: Gross NPL Ratio (percent) 3.5; Change from the Peak (percentage points) –0.8; Net NPL Ratio (percent) 2.0; Change in the Net NPL Ratio (percentage points) 0.22; Cumulative Write-offs to NPLs (percent) 34; Coverage Ratio (percent) 44; Change in Coverage Ratio (percentage points) –4 - Denmark: Gross NPL Ratio (percent) 3.3; Change from the Peak (percentage points) –2.6; Net NPL Ratio (percent) 1.9; Change in the Net NPL Ratio (percentage points) 0.14; Cumulative Write-offs to NPLs (percent) 94; Coverage Ratio (percent) 43; Change in Coverage Ratio (percentage points) –8 - France: Gross NPL Ratio (percent) 3.9; Change from the Peak (percentage points) –0.6; Net NPL Ratio (percent) 2.0; Change in the Net NPL Ratio (percentage points) 0.25; Cumulative Write-offs to NPLs (percent) 65; Coverage Ratio (percent) 50; Change in Coverage Ratio (percentage points) –9 - Germany: Gross NPL Ratio (percent) 2.0; Change from the Peak (percentage points) –0.7; Net NPL Ratio (percent) 1.2; Change in the Net NPL Ratio (percentage points) 0.27; Cumulative Write-offs to NPLs (percent) 34; Coverage Ratio (percent) 24; Change in Coverage Ratio (percentage points) (blank) - Ireland: Gross NPL Ratio (percent) 14.6; Change from the Peak (percentage points) –11.1; Net NPL Ratio (percent) 8.5; Change in the Net NPL Ratio (percentage points) –0.46; Cumulative Write-offs to NPLs (percent) 142; Coverage Ratio (percent) 42; Change in Coverage Ratio (percentage points) –3 - Italy: Gross NPL Ratio (percent) 12.2; Change from the Peak (percentage points) –0.1; Net NPL Ratio (percent) 6.2; Change in the Net NPL Ratio (percentage points) 2.52; Cumulative Write-offs to NPLs (percent) 249; Coverage Ratio (percent) 99; Change in Coverage Ratio (percentage points) (blank) - Netherlands: Gross NPL Ratio (percent) 2.6; Change from the Peak (percentage points) –0.7; Net NPL Ratio (percent) 1.4; Change in the Net NPL Ratio (percentage points) –0.25; Cumulative Write-offs to NPLs (percent) 44; Coverage Ratio (percent) 44; Change in Coverage Ratio (percentage points) (blank) - Portugal: Gross NPL Ratio (percent) 12.6; Change from the Peak (percentage points) –0.2; Net NPL Ratio (percent) 4.3; Change in the Net NPL Ratio (percentage points) 0.85; Cumulative Write-offs to NPLs (percent) 36; Coverage Ratio (percent) 61; Change in Coverage Ratio (percentage points) 11 - Spain: Gross NPL Ratio (percent) 5.7; Change from the Peak (percentage points) –3.7; Net NPL Ratio (percent) 3.3; Change in the Net NPL Ratio (percentage points) 0.76; Cumulative Write-offs to NPLs (percent) 343; Coverage Ratio (percent) 43; Change in Coverage Ratio (percentage points) –14 - Sweden: Gross NPL Ratio (percent) 1.0; Change from the Peak (percentage points) –0.2; Net NPL Ratio (percent) 0.7; Change in the Net NPL Ratio (percentage points) 0.54; Cumulative Write-offs to NPLs (percent) 83; Coverage Ratio (percent) 48; Change in Coverage Ratio (percentage points) 34–36 - United Kingdom: Gross NPL Ratio (percent) 1.0; Change from the Peak (percentage points) –3.0; Net NPL Ratio (percent) 0.6; Change in the Net NPL Ratio (percentage points) –1.94; Cumulative Write-offs to NPLs (percent) 64; Coverage Ratio (percent) 24; Change in Coverage Ratio (percentage points) (blank) ### Country-Specific Recommendations (selected) - France: Ensure profitability by further cost cutting, diversification, and possibly consolidation within the euro area; adapt regulated savings rates to reflect market interest rate conditions. - Progress: Banks are adapting business models by further diversifying into asset management, private banking, and insurance activities. - Germany: System faces structural headwinds and needs to adapt; low profitability reflects crisis legacy issues, provisions for compliance violations, need to adjust business models to postcrisis regulation and technological change, and long-standing inefficiencies. - Progress: Consolidation is ongoing, albeit gradually; savings bank sector is deleveraging; restructuring at large banks still needs to bear fruit and cost cutting remains slow. - Italy: Further steps to advance balance sheet repair, including more intensive use of out-of-court debt restructuring mechanisms; strengthened supervision; systematic assessment of asset quality for banks not subject to ECB comprehensive assessment; effective use of framework for timely and orderly resolution of failing banks. - Progress: Monte dei Paschi applied for a precautionary state recapitalization in December 2016. Unicredit raised almost €13 billion in capital. Banco Popolare di Milano and Banco Popolare merged after conversion into joint-stock companies. Mutual bank reform is ongoing. Authorities approved issuance of up to €20 billion in additional government debt to potentially support bank capital and liquidity. - Portugal: Clean up balance sheets through comprehensive debt restructuring, increase capital, loan loss provisions, and impairment provisions; appropriately price and sell bad loans; reduce operating costs and improve governance. - Progress: Final agreement on a €5 billion recapitalization of Caixa Geral de Depositos announced in March 2017. Negotiations to sell Novo Banco continue. Banco Comercial Portugues received a private capital injection and Banco BPI’s takeover by CaixaBank has been concluded. - Spain: Ensure adequate provisioning, improve efficiency gains (possibly through mergers), boost non-interest income, and increase high-quality capital. - Progress: The system is closer to putting most crisis legacies behind it. Framework for savings banks and banking foundations is fully in place and requires banking foundations either to divest relevant credit institutions or to set up reserve funds. *Source: International Monetary Fund, Global Financial Stability Report: Getting the Policy Mix Right, April 2017 (chapter text).* ### 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 and key metrics - Many cross-currency swap bases remain negative, indicating persistent unmet demand for dollars. - Research finds dollar appreciation is associated with more negative cross-currency swap bases. - U.S. corporations hold abroad an estimated $2.2 trillion in cumulative reinvested earnings from overseas operations. - Roughly $1.3 trillion of that $2.2 trillion 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; a comparable tax incentive could trigger significant repatriation of offshore dollar assets. - Advanced economy banks’ foreign-currency maturity gap has nearly doubled since 2007 to $2.9 trillion. - The foreign-currency maturity gap as a percentage of total assets grew from 4.4 percent to a high of 6.1 percent in November 2015. - Figure annotations indicate a prior maturity gap milestone of $0.3 trillion and later $2.9 trillion (labels preserved). ### Drivers and transmission channels of liquidity risk - Dollar appreciation (for example, if U.S. growth accelerates and the Federal Reserve continues to raise policy rates) could increase negative swap bases and tighten offshore dollar conditions. - Potential U.S. tax reform creating repatriation incentives could reduce the supply of offshore dollars. - Administrative measures such as bank ring-fencing could increase frictions in the supply of dollar funding and fragment the offshore dollar market. - Advanced economy banks have become reliant on cheap short-term foreign-currency funding to finance long-term foreign-currency assets, increasing rollover risk. - Hedging via derivatives mitigates interest rate and FX exposures but introduces counterparty risk and does not eliminate rollover risk. - Local central banks can provide almost limitless liquidity in their own currency but are limited in foreign-currency liquidity provision to finite reserves or foreign exchange swap facilities and official credit lines. - If offshore dollars become scarcer, banks may reduce their global footprint or increase reliance on central banks as dollar providers of last resort. ### Differences across jurisdictions - Advanced economy banks: pronounced increase in foreign-currency maturity mismatch since 2007 (maturity gap nearly doubled to $2.9 trillion; mismatch rose from 4.4 percent to 6.1 percent of total assets at peak). - Emerging market banks: smaller and more stable maturity gaps overall, with the exception of banking systems in emerging European economies that show large foreign-currency maturity mismatches due to extensive use of foreign-currency (mostly euro) deposit funding. - In emerging European economies, deposit funding tends to be relatively sticky and safer than other short-term funding, and foreign exchange regimes (such as currency boards) can further mitigate risks; nevertheless, sharp rises in short-term European rates could expose these banks to significant funding risk. ### Potential scenarios that could amplify global liquidity risk - A sharp increase in U.S. interest rates combined with a strong dollar leading to: - More negative cross-currency swap bases. - Reduced supply of offshore dollars. - Amplified frictions from structural rigidities in the offshore dollar market. - U.S. corporate tax reform introducing repatriation incentives similar to the 2004 holiday, prompting sizable repatriation of offshore dollar assets (historical comparison: $362 billion repatriated in 2004). - Administrative or regulatory actions (e.g., bank ring-fencing) that fragment dollar funding markets and raise costs. ### Policy recommendations and supervisory guidance - 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 such facilities should be treated as extraordinary, with access to official liquidity priced accordingly. *International Monetary Fund | April 2017* ### Box 1.3 (continued) ### Box 1.3 (continued) ### Banks and market functioning - Banks’ uncertainty about the requirements of their new regulators is likely to rise temporarily because relocation to a new jurisdiction will bring uncertainty about how quickly internal risk models can be reviewed and accepted by the new regulator. - Market liquidity in government debt markets could be temporarily curtailed: several U.K.-based banks provide critical primary dealer functions in the sovereign debt market, and uncertainty and higher operating costs during transition may lead many banks to exit or scale back primary dealer business, leading to costlier and less efficient markets until new players enter. - Interest rate volatility has declined; low-for-long periods are identified where the 10-year yield was less than 2 percent. ### Main findings of the low-for-long scenario - The yield curve would be flatter compared to an equilibrium with higher rates and growth. - Although lower interest rates may boost banks’ earnings in the short term, they hurt profitability in the steady state once they fall below a particular positive threshold. - Smaller, geographically undiversified, deposit-funded banks would be hurt most in such a scenario. - Tail risk exposure could increase: banks adopt different strategies in reaching for yield depending on business models (smaller deposit-funded banks increase duration of bond portfolios; large banks increase risk exposures in foreign countries and rely more on wholesale funding). - Life insurers and pension funds would face a long-lasting transitional challenge to profitability and solvency, likely requiring additional capital because existing liabilities contracted in past periods of higher interest rates may be difficult to meet by altering asset portfolios alone. - Major long-term changes are likely to household demand for financial products, the menu of services offered, and the relative role of institutions versus markets in financial intermediation. ### Implications for financial institutions and products - Banks: - Pressure on smaller banks would lead to consolidation among themselves or with larger banks. - Domestic banking would likely evolve toward provision of fee-based and utility services; lending would likely shrink and focus more on small businesses and less on households and large firms. - Insurers and pension funds: - Insurers and pension funds face profitability and solvency pressures; guaranteed-return, long-term savings products would be less attractive. - Insurers may switch toward unguaranteed savings products but would face competition from asset managers. - Health and long-term care businesses would likely grow strongly as people age and live longer. - Employers likely to move away from defined-benefit toward defined-contribution pension plans, though pace and extent vary across advanced economies. - Asset management: - Retail demand for asset management products would continue to grow, particularly for passive index investing targeted at minimizing management fees. - Insurers would likely cede some of their savings business to asset managers and banks over the long term. - Household behavior: - Population aging and rising longevity likely to reduce household demand for credit and increase demand for transaction services and liquid bank deposits. - Rising longevity likely boosts demand for health and long-term care insurance; implications for life annuities are ambiguous. - Pooled management of household life cycle risks likely to decline more rapidly. ### Policy challenges and recommendations - Prudential frameworks should provide incentives to ensure longer-term stability and resist demands for deregulation to ease short-term pain. - For banks: - Provide a legal and regulatory framework that facilitates smooth consolidation and exit of nonviable institutions. - Limit excessive risk taking in an environment with lower expected returns and avoid worsening the too-big-to-fail problem. - Contain incentives to increase exposure to tail risk from widening maturity mismatches, higher wholesale funding, and foreign exposures. - For insurers: - Implement economic solvency requirements that encourage life insurers to undertake necessary adjustments to their business models. - For the broader financial sector: - Surveillance and regulation of asset management activities should become more important as this industry’s share in the financial sector grows. _International Monetary Fund | GLOBAL FINANCIAL STABILITY REPORT: GETTING ThE POLICY MIx RIGhT | April 2017_ ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### The Term Structure of Interest Rates - The slope of the yield curve equals market expectations of the short rate path plus the bond’s term (risk) premium. - Around a steady state with the short rate at its long-term equilibrium, the slope is driven entirely by the sign and magnitude of (nominal) bond term premiums. - Term premium intuition: - If bond returns increase when economic shocks reduce other income, investors pay for the bond (negative term premium). - If bond returns decline with other income, investors require a premium (positive term premium). - In a “normal economy” with higher equilibrium growth and nominal/real rates not close to zero, the model implies an upward-sloping nominal yield curve. - In a low-for-long economy the zero lower bound on short-term nominal interest rates prevents central banks from cutting rates in response to negative (noninflationary) real-income shocks, making bond returns more resilient to such shocks, producing lower term premiums and flatter yield curves. - Decline in term premiums at the zero lower bound also reflects investors perceiving lower risk in holding long-term securities because central banks’ reaction functions are constrained and short rates’ sensitivity to macroeconomic news drops. - Robustness and modeling notes: - Results correspond to a parameterization described in Annex 2.1 and are robust when calibrating endowment and inflation shocks using VARs based on Germany, Japan, the United Kingdom, or the United States. - It suffices for there to be an effective, possibly negative, lower bound on nominal short-term interest rates so long as it is close to zero. - Flattening of yield curves due to compression in term premiums is robust across term structure models with a zero lower bound. ### Banking with Low Natural Rates of Interest - Two augmentations to literature: - With an unchanged yield curve, permanently lower interest rates need not affect banks’ earnings. - A zero lower bound on deposit rates generates pressure on bank interest margins and profits in an equilibrium with a low natural rate. - Existing empirical findings summarized: - Negative interest rate shocks increase bank profits in the immediate future, but favorable impact dissipates as low rates persist. - Banks lose profitability from longer-lasting drops in interest rates proportional to their maturity transformation and reliance on deposit funding. - Falling interest rates boost short-term bank profits via collateral valuation gains, mark-to-market asset gains, and lower default risk on repriced loans. - Banks tend to increase risk taking through higher leverage when rates fall. - Questions addressed: long-term impact on profits in a low-for-long environment, sensitivity as rates go lower, heterogeneity across bank business models, and likely market-structure changes. ### Insights from Theory - A simple banking model shows: - Bank profits fall significantly in a low-for-long economy if deposit interest rates are subject to a zero lower bound. - Banks’ interest margins are (almost) independent of market interest rate levels if they can flexibly adjust loan and deposit rates with changes in steady-state market rates. - Once deposit rates hit the zero lower bound, banks cannot maintain spreads between loans and deposits, reducing net interest income under lower equilibrium market rates. - Business model implications: - Internationally operating banks increase exposure to countries with favorable returns, notably emerging market economies, and increase reliance on wholesale funding in foreign currency (within regulatory limits). - Banks with more capital markets funding are less susceptible to a squeeze in interest margins induced by the zero lower bound. - Scale efficiencies in deposit management incentivize consolidation; scale efficiencies in wholesale funding management incentivize larger banks to seek market funding. ### Lessons from Japan - Japan approximates a steady state with low growth and natural rates; short-term rates near zero since the Bank of Japan adopted zero interest rate policy in the early 2000s (exception 2007–08). - Long-term rates low since early 2000s, with further declines after quantitative and qualitative easing in 2013 and negative interest rates in 2016. - Econometric evidence: - Analysis using an error-correction model (in the spirit of Gambacorta 2008) shows Japanese banks’ net interest margins fell primarily from narrowing funding spreads once deposit rates hit the zero lower bound in the mid-2000s. - Deposit rates first approached the zero lower bound in the mid-2000s despite market interest rates near zero since the 1990s. - Differential bank responses and outcomes: - Major banks: - Almost all asset growth accounted for by increases in international loans and securities via foreign branches and M&A. - Increased share of income from international businesses and expanded fee businesses outside Japan, including emerging markets. - Use of cross-product customer connections to increase noninterest income (fees and commissions on investment trusts and life insurance products). - Source about one-third of funding from capital markets, easing domestic funding-compression effects. - Maintained operational cost ratios almost flat for past two decades. - Maintained margins/profits at the cost of higher cross-border market and counterparty risk, with rising reliance on wholesale foreign currency funding. - Regional and shinkin banks: - Deposits constitute over 90 percent of their nonequity financing. - Focused on expanding domestic loan portfolios and extending sovereign bond maturities; gains from extending bond maturities were relatively limited due to compression in term premiums. - Responded with cost cutting and consolidation (branch rationalization) as margin compression persisted. - Increased interest-rate risk by extending bond maturities; risk-adjusted returns increased modestly given unusually low inflation and interest rate volatility. - Consolidation: - Enhanced effectiveness of strategies to maintain profits by cutting fixed operational costs and increasing monopolistic power in deposit and loan markets. - Regional banks have pursued consolidation via forming financial groups. ### Cross-Country Experience with Prolonged Low Interest Rates - Empirical approach to identify low-for-long periods: - Short-term yield below 1 percent. - The “on-the-run,” 10-year nominal bond yield lower than the historical average of short-term policy [rates] (criterion described; full empirical framework in Annex 2.2). - Empirical aim: compare bank profitability during low-and-expected-to-remain-low periods with other periods to assess impact on profits and heterogeneity across bank business models. *International Monetary Fund | April 2017* ### 1. Average Asset Maturity, 2000–15 ### 1. Average Asset Maturity, 2000–15 ### Key empirical observations from figures and data sources - Time series and cross-sectional evidence drawn from Bank of Japan; Fitch Connect; Japanese Bankers’ Association; and IMF staff calculations. - Figures depicted: - Average asset maturity trends (Years) for 2000–15. - Fee and commission income versus net interest income on loans (plotted across 2006–15). - Share of foreign business of major banks, 2006–15 (Percent). - Number of branches, 2005–15 (Index; 2005 = 100). - Operational cost ratios, 2000–15 (Percent of total earning assets). - Summary observations stated in figures and captions: - Large banks have expanded abroad. - Smaller banks have taken more interest rate risk. - Smaller banks have also cut costs ...... in part, by closing branches. ### Prolonged low interest rates — effects on bank profitability - On average, sampled banks earn a 10½ percent return on equity, but in periods with prolonged low rates this falls to 7.8 percent. - During periods of prolonged low interest rates: - A 1 percentage point drop in three-month rates is estimated to reduce bank profits by 31 percent below average estimated bank profits. - A 1 percentage point drop in term premiums is estimated to reduce bank profits by 8 percent below average estimated bank profits. - In normal times, a drop in interest rates tends to increase bank profits; in prolonged low-rate periods the reverse holds. ### Sensitivity of impacts to bank business models and characteristics - Table 2.1 classification of bank business models (labels preserved exactly): - Business Model 1 Business Model 2 Business Model 3 - Wholesale funded, diversified geographically and by business line - Deposit funded domestic credit intermediary - Deposit funded, diversified by business line, domestic bank - Average Size (billions of U.S. dollars)4232 - Average Loan-to-Asset Ratio (percent)477343 - Average Deposit Funding Ratio (percent)258892 - Average Share of Foreign Income (percent) 1 1724 - Sources: Bloomberg L.P.; Fitch Connect; and IMF staff calculations. - 1 Data available for a significantly smaller subset of banks. - Estimated sensitivity results (periods of prolonged low rates): - A one-standard-deviation increase in bank size raises bank profits an estimated 67 percent relative to the sample average for such periods. - A one-standard-deviation increase in the share of deposit funding is associated with estimated bank returns lower by 14 percent than the sample average for such periods. - A one-standard-deviation increase in the share of loans in the asset portfolio is associated with estimated bank returns higher by 22 percent than the sample average for such periods. - Clustered results: - Large, internationally more diversified, wholesale-funded banks tend to outperform other types of banks when interest rates are low for a long time. - Their estimated average profit is 2.2 percentage points higher than that of deposit-funded domestic banks with small lending portfolios in such episodes. ### Bank equity values and forward-rate surprises - Method: linear factor model using daily stock returns around monetary policy announcement dates to estimate impact of changes in forward interest rates in normal and prolonged low-rate periods. - Main findings: - Monetary easing surprises boost bank equity returns in normal times but lower equity returns during episodes of prolonged low interest rates. - Larger, more diversified, and more-wholesale-funded banks are less sensitive to monetary policy news during periods of prolonged low rates. - Smaller, deposit-funded, domestically oriented banks show greater negative sensitivity in equity returns to bad news about the domestic economy during prolonged low rates. - Table 2.2 (signs preserved as in source) — key coefficient signs reported: - Dependent Variable: Return on Equity - Three-Month Interest Rate (prolonged low rates) + - Term Premium (prolonged low rates) + - Dependent Variable: Equity Price Return - Term Structure (normal period) n.s. - Surprise on Monetary Policy Announcement Dates in Normal Times + - Surprise on Monetary Policy Announcement Dates in Prolonged-Low-Rate Periods – - Bank Characteristics (prolonged low rates): - Size + - Leverage – - Deposit Funding Share – - Loan-to-Asset Ratio + - Controls: Macro Controls; Market Return - Estimation Method: Bank FE, time FE; Bank FE ### Long-term structural implications for banking - Expected industry adjustments in a low natural-rate scenario: - Consolidation: small deposit-funded banks that are less internationally diversified tend to suffer the largest hit to profitability, leading to mergers or exit and potential increases in industry concentration. - Tail-risk exposure may increase as banks search for longer asset maturities and greater wholesale funding shares, making them vulnerable to large positive interest rate shocks and volatile funding. - Larger banks face incentives to use capital market financing for international expansion. - Demographics, productivity, and financial technology effects: - Aging populations and low productivity imply lower household loan demand and rising deposits. - Financial technology threatens banks’ preeminence in payment services and may enable nonbanks to price corporate credit risk, potentially reducing banks’ market share in corporate debt financing. - Business models may shift toward fee-based and utility banking services; larger internationally active banks may increase exposure abroad. ### Insurance and pensions in a low-for-long economy - Main challenges: - Life insurance and pension sectors face large transitional challenges due to existing liabilities with guaranteed returns amid lower interest rates and flatter yield curves. - Life insurers and defined-benefit pension plans may require additional capital. - The market for traditional guaranteed-return savings products is likely to shrink; insurers may focus more on protection products, particularly health insurance. - Defined-contribution pension plans will likely continue to grow in importance. - Long-term implications for benefits and plan types: - Life insurers and sponsors of defined-benefit pension plans may need to significantly reduce benefits; guaranteed rates of return are possible only if reset significantly lower. - Pension arrangements: a continued transition from defined benefits toward defined contributions is likely as lower population growth, aging, and prolonged low interest rates pressure retirement benefit levels and favor portability. - Country variation: hybrid approaches and multiemployer defined-benefit plans (for example, traditional industry-level arrangements in the Netherlands) may be more resilient and slow the transition. *Italic: Source — text - 1. Average Asset Maturity, 2000–15 (from the supplied IMF PDF content).* ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### Shifts in demand and product mix - Population aging and rising longevity may raise demand for life annuities, but the combined effect on annuity demand is ambiguous. - Countervailing forces: increased demand for precautionary savings and liquid assets to cover out-of-pocket health expenses in retirement; at very low rates of interest, administrative costs of managing annuity portfolios may tip relative returns in favor of bonds and demand deposits. - A continuing switch from defined-benefit to defined-contribution pensions may reduce annuity demand if very low take-up rates of voluntary annuitization continue to prevail. - Example: In Chile, pension reform resulted almost exclusively in defined-contribution plans starting in the early 1980s, and the annuity industry subsequently expanded as workers in the new system reached retirement age—about 60 percent of retired workers opt for an annuity instead of a phased withdrawal option. - Insurers may expand into unit-linked products, where investors bear asset-price volatility; these products are a significant share of insurer business in Australia, Belgium, Canada, Ireland, Sweden, the United Kingdom, and the United States. - It is unclear what fundamental advantages insurers have in offering unit-linked products; competition with asset managers and potential loss of tax advantages could shift household savings to funds offered by asset managers. - Demand for health and long-term care insurance and for new life-cycle–replicating products may increase; Koijen, Van Nieuwerburgh, and Yogo (2016) find that as households age, the value of life insurance falls, the value of health insurance peaks only at a very advanced age, and the value of long-term care insurance progressively rises. ### The transitional challenge for insurers and pension funds - Core problem: Assets often have significantly shorter duration than liabilities; in a low-for-long environment, institutions must reinvest assets at much lower rates earlier than fixed-rate obligations terminate, creating negative duration gaps and solvency pressure. - Insurance companies: - Non–life insurance businesses with short liability duration are relatively unaffected. - Long-term, guaranteed-payout businesses are especially vulnerable: a negative duration gap boosts the present value of long-term liabilities much more than assets. - Other vulnerabilities: policyholder options that increase losses when interest rates are low; difficulty raising premiums due to competition and high price elasticity of demand for savings products. - Defined-benefit pensions: - Defined-benefit pension funds with substantial vested obligations suffer most in a low-for-long environment. - Projected pension obligations resemble a large portfolio of long-term nominal bonds (or real bonds, if indexed) with coupon payments corresponding to normal interest rates; sponsors will be hard-pressed to find duration-matched risk-free bond portfolios. - Sponsors of defined-benefit plans with a majority of actively employed, younger participants have other adjustment options (raising retirement age, grandfathering current arrangements, reducing replacement rates, removing indexation). ### Can asset-allocation changes restore solvency? - Liability-driven investment (finding a bond portfolio whose duration matches liabilities) is recommended for life insurers and mature/closed defined-benefit pension plans. - Life insurers and defined-benefit pension plans often enter low-rate periods with reduced economic capital buffers or higher funding gaps, complicating risk management: - Need to minimize market risk (future interest rate volatility) by holding bonds matching cash outflows. - But wider funding gaps create incentives to seek returns exceeding liabilities, pushing toward riskier portfolios (equities, alternative assets). - Simulation results: - Recovering adequate solvency margins by changing asset allocation appears feasible only by taking potentially unacceptable levels of risk. - The volatility risk required would either deter institutions from such portfolios or conflict with regulatory capital constraints. - Prudential regulation often prevents significant reach for yield; risk-based capital requirements impose high capital charges for risky investments, which may not be compensated by expected returns. - Public defined-benefit pension plans in the United States are an exception where regulatory and accounting rules may encourage gambling-for-resurrection incentives in a low-return environment. - Conclusion: Asset-allocation changes alone cannot adequately address solvency challenges; institutions will likely need fresh equity capital to cover part of losses. ### Options to address funding shortfalls and business-model adjustments - Potential institutional responses: - Expand scale of nonlife and protection businesses to generate earnings to offset savings-business losses; achieving necessary business growth may be difficult in a low-growth, aging environment. - Transfer pension obligations or their financial risk to insurers after recapitalizing plans to close funding gaps—pension risk transfers can be market-efficient and insurers’ mortality-risk business provides a hedge against longevity risk; regulation could facilitate such transactions. - Expect lower and less flexible guarantees on long-term savings products; insurers may be allowed to adjust guarantees at regular intervals to reflect market conditions. - Regulatory and accounting regimes requiring economic valuation and full recognition of the economic costs of long-term guarantees would encourage sustainable business-model shifts. ### Asset allocation by households, rise of asset managers, and market impacts - Household asset-allocation shifts in a low-for-long environment: - Demand for bank deposits should rise, especially once deposit rates hit the zero lower bound, because deposits offer liquidity premium and guarantees. - Population aging may increase the share of bonds at the expense of equities for several reasons, including a rising equity risk premium with age and annuitization behavior (older households tend to reduce equity exposure). - Growth of asset managers and market finance: - Changes to pension arrangements could increase investment via asset managers (defined-contribution plans intermediated into mutual funds). - Insurers may lose clients to investment funds. - Financial technology could expand market funding for nonfinancial firms, with banks focusing more on small businesses. - Countries with deep corporate bond markets and well-developed retail investment products may transition faster to market finance. - Mutual funds, index funds, and financial stability: - Prolonged low rates may promote growth in average mutual fund size and relative importance of index funds; low asset returns and fee competition make it harder for smaller active funds to survive. - Indexing increases access and diversification but may raise the role of nonfundamental factors in asset returns and comovement, potentially detaching prices from fundamentals and thwarting price discovery. - Benchmarking can motivate investors to overweight high-beta assets. - Key financial stability concerns from larger asset-manager share and index funds: - Need for stronger oversight and liquidity risk management of mutual funds, especially if investors seek exposure to illiquid assets. - Larger fund sizes and increasing passive investing reduce buy-side diversity and increase propensity for herding and correlated responses to shocks. - Herd behavior among fund managers remains a concern. ### Empirical observations on asset allocations (2015) - Figure 2.8 summary points: - Excluding Japan and the Netherlands, pensions place less than a third of funds in bonds. - Life insurers consistently invest a majority of their portfolios in bonds. - Figure 2.9 summary points: - U.S. mutual fund expense ratios and index fund growth: index funds have grown significantly and expense ratios differ across actively managed and index bond/equity funds; competition and low returns pressure active managers. ### Prudential and policy implications - Prudential frameworks should incentivize longer-term stability and resist short-term deregulation pressures. - Policymakers should enable smooth adjustment of financial institutions’ business models: - For banks: do not hinder, and where feasible actively facilitate, consolidation for smaller institutions and liquidation of nonviable businesses when desirable for efficiency and financial stability. - For life insurers: support transition to regulatory and accounting regimes requiring more economic valuation to recognize economic costs of long-term guarantees. - Policy can guide better household financial planning in retirement: - Encourage more annuitization at retirement where appropriate, including clearer communication of benefits and exploring options to increase take-up. *International Monetary Fund | April 2017* ### 1. Expense Ratios of Actively Managed Funds and Index Funds ### 1. Expense Ratios of Actively Managed Funds and Index Funds ### Findings on fees and market structure - Fees charged by active funds are significantly higher than those charged by index funds. - The share of index funds has increased dramatically over the past two decades. - If passive index investing becomes preeminent, price discovery could be hampered and markets could become more prone to swings in sentiment. - Further strong growth of the asset management sector can contribute to financial stability, but also entails new challenges that require enhanced surveillance and regulation. ### Risks and implications for financial stability - Growth of the asset management industry increases the importance of closing significant data gaps and implementing adequate macroprudential rules to address risks such as liquidity mismatches. - Passive investing dominance could reduce price discovery and amplify sentiment-driven market moves. - Prudential authorities need to contain incentives in a low-for-long scenario that may increase exposure to tail risk; banks may respond by widening maturity mismatches, increasing leverage, or using more wholesale funding (within regulatory limits). - Insurance and pension regulators that have not introduced economic solvency requirements should implement such regulations as soon as practical. - Public pension funds that discount liabilities at expected portfolio returns have invested aggressively in risky assets, producing negative financial results (Andonov, Bauer, and Cremers 2016). Aligning liability discounting rules with those for corporate pension plans in the United States would safeguard solvency positions. ### U.S. bank responses to prolonged low interest rates (illustrative evidence) - Bank profitability in the United States returned to precrisis levels after a significant dip around the Lehman Brothers bankruptcy. - A common adaptation strategy has been increased focus on fee-based businesses and trading; the share of noninterest income in banks’ total income has risen by 5 to 10 percentage points depending on bank size and business model, with the largest increase for global systemically important banks. - Banks have also increased the maturity of their assets; smaller banks increased the ratio of loans maturing in more than five years to total loans by more than 25 percent between 2011 and 2016. - In securities portfolios, both domestic systemically important banks and smaller banks have lengthened average maturity by increasing the share of longer-term securities. ### Pension fund risk-return trade-offs for exiting underfunding (simulation results) - The simulation considers three strategies: high bonds, high equity, and balanced, calibrated with actual 2016 data. - A fixed return of 4 percent is assumed for liabilities; initial funding ratio set at 80 percent. - The low-risk, high-bond portfolio cannot achieve fully funded status under these assumptions. - The portfolio allocation most tilted toward equity would require about four and a half years to reach full funding, with annual risk equal to 8 percent of the asset portfolio value. - Potential one-year losses at a 95 percent confidence level: - High-equity strategy: up to 24 percent of market value of assets. - Balanced strategy: up to 20 percent of market value of assets. - A fund with an initial funding ratio of 90 percent can achieve fully funded status in just two years with an asset portfolio whose return volatility is 7 percent a year, but would take more than four years with the same portfolio and a funding ratio of 80 percent. - High-equity strategies entail very high levels of risk, which can result in insolvency. ### Policy recommendations - Strengthen surveillance and regulation of asset management activities as the industry grows. - Close significant data gaps to enable effective monitoring of systemic risks from asset management. - Implement adequate macroprudential rules to address liquidity-mismatch risks in asset managers. - Insurance and pension regulators should adopt economic solvency requirements where absent. - Align liability discounting rules for public pension funds with corporate pension plan standards to safeguard solvency. *International Monetary Fund | April 2017* ### 1. Inflation ### 1. Inflation ### Annex 2.2 — Cross-Country Evidence of Prolonged Low Interest Rates’ Impact on Banks: scope and data - Sample: unbalanced panel of almost 17,000 banks in eight advanced economies, using annual data from 1990 through 2015. Only banks with end-of-year statements are included. - Countries (annual profit analysis): Canada, Finland, France, Germany, Japan, the Netherlands, the United Kingdom, and the United States. - Daily equity-price analysis sample period: 2000 through 2016, covering banks in 16 advanced economies: Australia, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. - Data sources: Fitch Connect (bank-level), Thomson Reuters Datastream, IMF staff calculations, Haver Analytics, IMF (International Financial Statistics and World Economic Outlook), Bank for International Settlements, Bloomberg L.P., central bank websites. ### Empirical strategies - Profitability regression (bank i, country j, year t): - Profitijt = αi + β Macrojt + θ lowjt + γ1 Shortratejt + γ2 Shortratejt × lowjt + γ3 TPjt + γ4 TPjt × lowjt + φ1 Businessmodelijt + φ2 Businessmodelijt × lowjt + εijt - Profit measured by return on equity. - Macro is a vector including consumer price index inflation, credit growth, and GDP growth. - low is a dummy for periods with prolonged low rates of interest, defined as years when: - the 10-year, on-the-run spot rate on government bonds is less than the historic in-sample average of the monetary policy interest rate (for Japan, the threshold for the 10-year spot rate is 2 percent), and - the three-month government bond or bill interest rate is less than 1 percent. - Shortrate is the three-month interest rate. - TP denotes the term premium, based on Wright 2011. - Businessmodel represents indicators of banks’ business models. - Equity price return regression (daily, bank i, country j, day t): - EquityPriceReturnijt = α + β marketreturnjt + γ0 surprisejt + γ1 surprisejt × MP_normaltimejt + γ2 surprisejt × MP_lowjt + θ conditioningvariablejt + εijt - EquityPriceReturn is the daily change in equity prices (in logarithm). - marketreturn denotes the daily change in country-specific stock market indices (in logarithm). - surprise denotes the unexpected change in market expectations of future short-term interest rates, defined as the change in the country-specific nine-year-ahead one-year-forward rate. - MP_low is the dummy for monetary policy announcement dates in periods with prolonged low rates; MP_normaltime represents announcement dates in other periods. - The period of prolonged low rates is defined as the time when the 10-year government bond yield is less than 2 percent (in this regression the short-term threshold used in the profit regression is not applied). ### Business-model characterization - Two approaches: 1. Individual balance-sheet indicators: size (total assets), leverage (assets-to-equity ratio), deposit funding ratio, loans-to-total-assets ratio, share of trading assets in total assets. 2. Clustering method: business models constructed using three features — size, deposit funding ratio, and loan-to-asset ratio — following Roengpitya, Tarashev, and Tsatsaronis 2014. Three group-types of business models are estimated and assigned one bank at a time. - Note: Data on the geographic distribution of bank incomes were not included because available only for a small subsample and skewed distributions. ### Identification and robustness - Profit regression estimation incorporates bank-level and time-level fixed effects. - Baseline results are robust to: - alternative definitions of bank profits (return on assets), - inclusion of other bank business characteristics, - alternative definitions of periods of prolonged low interest rates, - lagged values of bank business model characteristics, - controlling for scope and intensity of macroprudential policies, - controlling for concentration in the banking industry, - incorporating a lagged dependent variable (dynamic panel yielded insignificant year-to-year persistence of bank returns, leading to reporting cross-country panel results). - Endogeneity concerns in equity-price regressions: - Additional checks: event study regression covering only monetary policy announcement dates; daily-frequency regression using an alternative surprise measure orthogonal to market return (surprise orthogonal = residual of regression of surprise on market return). Both checks confirm robustness. ### Variable definitions (selected, from Annex Table 2.2.1) - Low: Dummy for period with low interest rates. Thresholds: - 10-year government bond yield threshold = historical average of country-specific policy rates (for Japan set to 2 percent). - Three-month interest rate threshold = 1 percent. - Sources: Thomson Reuters Datastream and IMF staff calculations. - Surprise (9-year forward): Daily change in the forward rate of the one-year government bond yield, based on a no-arbitrage assumption and the spot rate of the 10-year and 9-year government bond yield; source Thomson Reuters Datastream and IMF staff calculations. - Surprise (9-year-forward orthogonal): Surprise orthogonal to market return, measured by the residual of the regression of surprise on market return; source IMF staff calculations. - Monetary Policy in Low (2 percent): Dummy for period in low period and with monetary policy announcements. Low period defined as 10-year government bond yield below 2 percent; sources: Thomson Reuters Datastream, central bank websites, and IMF staff calculations. - Bank characteristics (source: Fitch Connect unless noted): - Return on Equity: Earnings before interest and taxation divided by equity. - Size: Logarithm of banks’ total assets. - Loan-to-Asset Ratio: Gross loans divided by total assets. - Deposit Funding Ratio: Customer deposits divided by total liabilities. - Trading Asset, Trading Asset Ratio, Leverage Ratio: defined as in Annex Table. - Macroeconomic variables: - Consumer Price Index Inflation: Year-over-year growth of consumer price index, percent (IMF, International Financial Statistics database). - Credit-to-GDP Ratio: Private sector credit in percent of GDP (Bank for International Settlements). - Real GDP Growth: Year-over-year growth of GDP, constant prices (IMF, World Economic Outlook database). - Three-Month Interest Rate: Typically central bank bill/Treasury bill yield or interbank offered rate (Haver Analytics). - Term Premium: Term premium estimated based on Wright 2011 (IMF, Global Financial Stability Report, October 2016). - Ten-Year Government Bond Yield: On-the-run 10-year government bond yield (Thomson Reuters Datastream). - Financial market controls: Equity Price Return, Market Return, VIX (Chicago Board Options Exchange Market Volatility Index, Bloomberg L.P.), Oil Price (West Texas Intermediate crude oil spot price, Bloomberg L.P.). ### Main analytical focus and interpretation (as described) - The analysis studies how periods of low interest rates affect: - bank profitability as measured by realized profits (return on equity) and - expected future profits as reflected in banks’ equity price returns. - Low-rate periods are defined with explicit numeric thresholds (10-year yield relative to historical policy-rate average or 2 percent for Japan; three-month rate < 1 percent). - The daily equity-price analysis uses surprises in forward rates around monetary policy announcements to isolate shocks to expected future short-term rates, distinguishing announcement-date effects in low-rate periods (10-year yield < 2 percent) from normal periods. - Robustness exercises address omitted-variable and endogeneity concerns using orthogonalized surprises and event-study frameworks. *Source: IMF staff calculations, Annex 2.2, Global Financial Stability Report: Getting the Policy Mix Right (April 2017).* ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### Summary and Key Findings - The chapter develops financial conditions indices (FCIs) comparable across a large set of advanced and emerging market economies. - A single factor, “global financial conditions,” accounts for about 20 to 40 percent of the variation in domestic FCIs across countries, with notable heterogeneity across countries. - The global factor moves in tandem with the U.S. FCI and measures of global risk, such as the Chicago Board Options Exchange Volatility Index (VIX). - There is no conclusive evidence that the global factor has gained significant influence over the past two decades. - Monetary policy shocks account for about 15 percent of the variation in domestic FCIs across countries with flexible exchange rates. - The new FCI measures appear to signal downside risks to GDP well; economic contractions are more clearly associated with a preceding change in financial conditions than expansions. - Domestic factors account for the remainder of FCI variation not explained by the global factor. ### Measurement and Conceptual Framework - Financial conditions are defined as the ease of obtaining financing, encompassing price and nonprice costs of credit, asset price valuations, risk appetite, and willingness to hold illiquid assets. - FCIs constructed in the chapter include domestic financial variables such as corporate, interbank, and term spreads; equity and house price returns; equity return volatility; and credit growth. - The FCIs attempt to purge contemporaneous macroeconomic conditions to assess how much “unwarranted” global financial shocks affect domestic financial conditions. - FCIs are useful for: - Capturing transmission channels through which monetary policy influences inflation and output. - Predicting future economic activity, including flagging future economic contractions. ### Transmission Channels and International Linkages - Monetary policy transmits via two broad categories: - The “traditional,” or New Keynesian, channels—changes in short-term policy rates, expectations, longer-term rates, consumption, investment, and exchange rate effects. - Imperfections in credit supply—balance sheet channels, bank capital channel, risk-taking channels—arising from institutional constraints and informational asymmetries. - Financial conditions spill across countries through multiple mechanisms: - Cross-border credit volumes and capital flows. - Comovements in risk premiums affecting collateral valuations and borrowing constraints. - Exchange rate movements that induce changes in domestic financial conditions. - Financial linkages (such as cross-country investments) are the most reliable indicator of the influence of global financial conditions on local FCIs. - Greater financial development can reduce the sensitivity of domestic FCIs to global financial shocks. ### Policy Implications and Recommendations - Despite a sizable impact from global financial shocks, on average countries still appear to be able to influence their own financial conditions—specifically, through monetary policy. - However, domestic financial conditions react more rapidly to global financial shocks than to changes in domestic policy rates, making timely policy responses often difficult. - Emerging market economies, where global financial conditions tend to account for a greater fraction of FCI variability, should prepare for the implications of global financial tightening. - Policies to enhance resilience to global financial shocks: - Promote domestic financial deepening to lessen sensitivity to external shocks. - Develop a local investor base (both banks and non-banks) to help dampen the impact of external financial shocks. - Use macroprudential measures to contain lingering vulnerabilities that make domestic financial conditions sensitive to external shocks. - Consider capital flow management measures as a temporary tool when disruptive outflows threaten financial stability, consistent with IMF 2016 guidance. *Prepared by Selim Elekdag (team leader), Adrian Alter, Nicolas Arregui, Luis Brandão-Marques, Lucyna Gornicka, Romain Lafarguette, Dulani Seneviratne, and Kai Yan, under the general guidance of Gaston Gelos and Dong He.* ### CHAPTER 3 ARE COuNTRIES LOSING CONTROL OF DOMESTIC FINANCIAL CONDITIONS? ### CHAPTER 3 ARE COuNTRIES LOSING CONTROL OF DOMESTIC FINANCIAL CONDITIONS? ### Global drivers and policy challenge - Global financial integration can make it harder for domestic policymakers to control domestic financial conditions by: - Hampering transmission of monetary policy and limiting effectiveness of prudential policies. - Increasing the speed at which foreign shocks affect local financial conditions, complicating timely and effective reaction. - Global “push factors,” such as the VIX, are emphasized as drivers of financial variables; prices of risky assets across countries can be summarized by a single global factor, the “global financial cycle,” driven by U.S. monetary policy shocks. - Distinction between fundamentals-driven comovement (potentially optimal) and spillovers not driven by fundamentals (potentially undesirable). Empirically separating these is difficult; this chapter focuses on measures of financial conditions purged of macroeconomic fundamentals. ### Constructing Financial Conditions Indices (FCIs) - Methodology: - Latent FCIs are extracted using a time-varying parameter factor-augmented vector autoregression model (TVP-FAVAR) based on Koop and Korobilis (2014). - The model jointly considers dynamic interactions of the FCI and macroeconomic fundamentals and allows parameters to change over time. - Two notable advantages: - Aims to purge the FCI of the effects of current macroeconomic conditions so estimated FCIs primarily reflect exogenous shifts in financial conditions. - Time-varying parameters account for evolving relationships between macroeconomic and financial variables and changing (policy) regimes. - Purging caveats: - Initially purged only of the effect of current macroeconomic conditions; FCIs are not purged of expectations of future macroeconomic developments in baseline estimations. - Robustness check with professional forecasts for the United States did not result in material changes to the FCI. ### Variables, sample, and practical choices - Conceptual exclusion: - Variables measuring ease of access to international finance and the exchange rate are excluded to focus on indirect global influences on domestic financial conditions. - Financial segments included to capture policy channels: - Equity markets, housing, bond, and interbank markets. - Typical financial variables used: - Various interest rates and spreads (changes in longer-term interest rate, corporate, interbank, and term spreads). - Asset price returns (equity and house price returns). - Equity return volatility. - Credit growth. - Where available, survey-based information (lending standards). - Sample and coverage: - Comparable monthly FCIs estimated for 43 advanced and emerging market economies during 1990–2016, depending on data availability. ### Key empirical findings on FCIs - U.S. FCI performance: - The U.S. FCI developed in this chapter closely tracks counterparts developed by the IMF and other institutions (Federal Reserve Banks of Chicago and Kansas City) during 1990–2016. - The FCI captures major U.S. financial events: Long-Term Capital Management collapse (1998), dot-com crash (2000), events around 2002 (Arthur Andersen, WorldCom), the global financial crisis (2008), and a gradual uptrend more recently while still indicating broadly accommodative conditions. - Country-level patterns: - Russia: FCI tightened dramatically during 1998, outpacing tightening during the global financial crisis. - Korea: Financial conditions tighter during the global financial crisis than during the Asian financial crisis (1997–98). - Chile: The global financial crisis represents the sharpest spike in the FCI over the past two decades. - Netherlands: Financial conditions tightened to almost the same extent during the euro area crisis and the global financial crisis. - Variables contributing most to country FCIs: - Interbank and corporate spreads, equity return volatility, and changes in house prices are consistently among the top contributors for both advanced and emerging market economies. ### FCIs and GDP growth (predictive power) - FCIs are significant predictors of future GDP growth across countries. - The inverse relationship between FCIs and future GDP growth depends on the state of the business cycle: - Stronger negative relation during economic contractions (lower percentiles of growth distribution) than during expansions (upper percentiles). - At the one-year-ahead horizon: - The negative coefficient at the 10th percentile (when growth is well below –½ percent) is about three times as large in absolute terms relative to the coefficient corresponding to the median (when growth is about 3½ percent). - Quantitative summary: A one standard deviation increase in the FCI (tighter financial conditions) is associated with a 0.4 percentage point decrease in median future GDP growth at a one-year horizon. - Historical illustrative dates: - Second quarter of 2006 (precrisis expansion) and third quarter of 2008 (onset of the global financial crisis) highlight the conditional distribution of growth and the predictive power of FCIs for future downturns. *Source: CHAPTER 3 ARE COuNTRIES LOSING CONTROL OF DOMESTIC FINANCIAL CONDITIONS?, International Monetary Fund | April 2017* ### CHAPTER 3 ARE COuNTRIES LOSING CONTROL OF DOMESTIC FINANCIAL CONDITIONS? ### CHAPTER 3 ARE COuNTRIES LOSING CONTROL OF DOMESTIC FINANCIAL CONDITIONS? ### FCIs improve forecasts of future growth and flag downside risks - Two forecasting models for one-year-ahead GDP growth are compared: one using current and past growth rates only; the other augmenting that model with FCIs. - Based on information as of the second quarter of 2006: - The model with the FCIs attributes approximately a 45 percent probability to the actual growth outturn (6 percent). - This is more than twice the probability generated by the model that uses only growth rates. - Using information up to the third quarter of 2008: - The conditional distribution from the model with FCIs displays a long left tail, assigning a higher probability to economic downturns and more starkly signaling the actual GDP contraction in the third quarter of 2009. - Interpretation: - FCIs contain valuable information about the future state of the economy and can be particularly useful in flagging downside risks to economic activity. ### Global structure of financial conditions - Statistical dynamic factor model findings: - Financial conditions around the world can be summarized by three latent factors: - “Emerging market” factor - “Euro area” factor - “Global financial crisis” factor - Although each factor spikes during the global financial crisis, the emerging market and euro area factors also depict markedly tighter financial conditions during the late 1990s and around 2012, respectively. - A single global factor (global financial factor or global financial conditions) also adequately summarizes financial conditions across countries and closely tracks movements in the U.S. FCI and the VIX. - The average correlation between the U.S. FCI and the two measures of global financial conditions and the VIX is 82 percent. - This supports the view that global financial conditions are strongly driven by the United States. ### Share of country FCI variability attributable to global factors - On average, global financial conditions account for about 30 percent of the variation in financial conditions across countries. - In several economies, the share reaches almost 70 percent. - The proportion of FCI variability explained by the three-factor model is larger than its single-factor counterpart and is greater than 40 percent. - Relative differences: - Financial conditions in small open advanced economies are more synchronized with global financial conditions than those in emerging market economies. - Trend over time: - No clear evidence of a pronounced upward trend in the importance of global financial conditions over the past two decades; the share displays cyclical patterns (especially during the global financial crisis) but is broadly flat when viewed over the past 20 years. ### Country characteristics that influence sensitivity to global financial conditions - Country characteristics considered include: - Financial linkages with the United States (foreign direct investment, banking, and portfolio) - Financial openness and development - Institutional quality - Exchange rate regime - Empirical findings (summary of Table 3.1): - Direct effect of U.S. FCI: positive and highly significant (notation: ++***). - Interactions that strengthen sensitivity (positive estimated sign and significance): - FDI linkages with the United States: ++** (positive, p < 0.05) - Trade openness: ++** (positive, p < 0.05) - Interactions with mixed or less robust effects: - Portfolio linkages with the United States: +– (mixed sign/significance) - Banking linkages with the United States: +– (mixed) - Trade linkages with the United States: ++ (positive but not always significant) - Financial openness: ++ (positive but not uniformly significant) - Exchange rate flexibility: –+ (expected negative, estimated positive or mixed) - Interactions that attenuate sensitivity (negative estimated sign and significance): - Financial development: ––** (negative, p < 0.05) - Rule of law: –– (negative, not always significant) - Interpretation: - Financial linkages (especially proxied by FDI) are most closely associated with greater synchronization of domestic FCIs with global financial conditions. - Greater financial development (deeper equity and bond markets) and stronger institutional/policy frameworks are associated with an attenuated impact of global financial shocks on domestic FCIs. - Trade linkages with the United States do not seem to matter, though trade with the rest of the world may capture indirect financial linkages. - No clear pattern emerges for exchange rate regime and capital account openness. ### Quantifying the roles of global financial shocks and domestic monetary policy - Econometric approach: - Several complementary VAR-based approaches are used, jointly modeling output, consumer prices, policy rates, and domestic financial conditions for each country, and including a measure of global financial conditions proxied by the U.S. FCI. - Baseline panel VAR ordering: U.S. FCI, industrial production growth, inflation, domestic FCI, and the change in the domestic monetary policy rate. Shocks identified using a Cholesky decomposition. - Results are robust to using levels of variables, adding exchange rate terms, inclusion of global industrial production growth, commodity prices, and measures of global interest rates as exogenous controls, and to averaging country-level VARs. - Key finding: - Both global financial conditions and policy rates influence domestic financial conditions. - Despite the importance of global financial shocks, evidence suggests that monetary policy still accounts for a notable share of the variation in domestic financial conditions. - Impulse response evidence (panel VAR for sample countries with flexible exchange rates): - The chapter displays impulse response functions of domestic FCIs to global financial shocks and to domestic monetary policy shocks (with 90 percent confidence bands), indicating meaningful responses from both types of shocks over time. *International Monetary Fund | April 2017* ### Annex 3.4 for details. ### text - Annex 3.4 for details. ### Response of domestic financial conditions to shocks - Global financial and domestic monetary policy shocks appear to affect local financial conditions. - Local policy rate changes have an appreciable effect on local FCIs, but: - Local financial conditions react faster and more strongly to global financial shocks than to changes in domestic policy rates. - As a consequence, timely and effective monetary policy reactions to offset unwelcome global shocks may need to be “very quickly and strongly,” with potentially undesirable side effects. ### Quantitative contributions to FCI fluctuations - On average, for small open economies with flexible exchange rates (panel VAR): - About 21 percent of the variation in domestic FCIs is attributed to global financial shocks. - Domestic monetary policy shocks account for about 15 percent of the fluctuations in FCIs. - In alternative estimations (country-by-country VARs): - Shocks to global financial conditions and to monetary policy account for, on average, about 40 percent and 12 percent of countries’ domestic FCI variations, respectively. - The variance decompositions are statistically significant at the 10 percent level. - For a subset of four small open advanced economies (Australia, New Zealand, Norway, Sweden) using better-identified monetary policy shocks (Gertler and Karadi methodology): - The share of FCI variation characterized by fluctuations in global financial conditions and domestic monetary policy is, on average, 15 percent and 33 percent, respectively. - The impulse responses and variance shares are statistically significant at the 5 percent level. ### Cross-country heterogeneity - The importance of global financial shocks for domestic financial conditions varies considerably across countries: - Global financial conditions generally tend to account for a greater proportion of FCI variability in emerging market economies. - In a few cases, the proportion exceeds 60 percent. - Fluctuations in global financial conditions are associated with a greater share of FCI variability in countries that are relatively more financially integrated with the rest of the world; these differences are greater for emerging market economies. - Complementary analysis controlling for global growth and commodity prices and various lag lengths yields broadly similar results. ### Stability of the global influence over time - Repeating panel VAR exercises for precrisis (2001–07) and postcrisis (2010–16) periods: - The share of domestic financial conditions attributed to global financial conditions appears to be broadly stable over the two periods. - The 2001–07 and 2010–16 variance decompositions are not statistically different at the 95 percent level. ### Case studies and identification of monetary policy shocks - Identification of monetary policy shocks is challenging in VARs; using unexpected changes in bond yields on central bank policy announcement dates (Gertler and Karadi 2015 approach) for selected countries yields similar results to Cholesky-identified shocks. - Selected advanced economies’ impulse response functions (Australia, New Zealand, Norway, Sweden) display domestic FCI responses to monetary policy shocks consistent across identification methods (GK and Cholesky). ### Conclusions and policy implications - A single factor — global financial conditions (which move in tandem with the U.S. FCI and measures such as the VIX) — summarizes a significant share of global financial condition dynamics. - The fraction of fluctuations in countries’ domestic financial conditions attributed to global financial conditions does not appear to have increased markedly over the past two decades. - Despite the significant influence of global financial conditions, countries on average remain able to steer their domestic financial conditions. - Policy implications: - Timely and effective monetary policy reactions to global shocks may be difficult because domestic FCIs respond faster and more strongly to global shocks than to domestic policy rate changes. - Emerging market economies should prepare for the implications of global financial tightening, given a greater fraction of FCI variability attributable to global factors. - Other policy tools are available: - Macroprudential measures can limit risks from vulnerability buildups that increase sensitivity to external shocks (IMF 2014b). - There may be circumstances warranting a temporary role for capital flow management measures (IMF 2016). - Governments should prioritize domestic financial deepening to enhance resilience: - Develop a local investor base encompassing bank and nonbank financial intermediaries. - Foster greater equity and bond market depth and liquidity to help dampen the impact of external financial shocks. ### Methodology notes (Annex 3.1 summary) - FCIs are estimated for 1990–2016 at monthly frequency for 43 advanced and emerging market economies using a set of 10 financial indicators. - The vector of financial variables includes: corporate spreads, term spreads, interbank spreads, sovereign spreads, the change in long-term interest rates, equity and house price returns, equity return volatility, the change in the market share of the financial sector, and credit growth. - Estimation approach: - Builds on Koop and Korobilis 2014, Primiceri (2005) time-varying parameter VAR, and dynamic factor models of Doz, Giannone, and Reichlin (2011). - Advantages: can purge financial conditions of current macroeconomic conditions and allows dynamic interactions between FCIs and macroeconomic conditions that evolve over time. - Model form (as specified in the text): - x_t = λ_t^y Y_t + λ_t^f f_t + u_t - [Y_t f_t]' = B_{1,t} [Y_{t–1} f_{t–1}]' + B_{2,t} [Y_{t–2} f_{t–2}]' + ... + ε_t - f_t is the latent factor interpreted as the FCI. *Source: IMF staff estimates.* ### Annex 3.2. Factor Model Analysis ### Annex 3.2. Factor Model Analysis ### Methodology - Panel: 43 countries. - Sample period: 1995 to 2016. - Objective: extract common latent factors from the financial conditions indices (FCIs) across countries to represent unobserved common dynamics in financial conditions. - Estimation method: time series factor analysis (TSFA) methodology described in Gilbert and Meijer 2005, which does not require independent and identically distributed observations. - Models fitted: one-factor TSFA model and three-factor TSFA model. - Factor model (equation A3.2.1): - FCI_{c,t} = λ_{1,c} x_{1,t} + λ_{2,c} x_{2,t} + λ_{3,c} x_{3,t} , (A3.2.1) - where x_{1,t}, and λ_{1,c}, for example, represent the first common time-varying factor and the country-specific loading associated with it (c and t denote country and time, respectively). - Purpose of three factors: allow more accurate decomposition of common dynamics across countries and recognize regional dynamics apart from global financial conditions. ### Empirical results and key statistics - Variance explained: - One-factor model explains about 30 percent of the variance of the FCIs in the sample. - Three-factor model explains about 41 percent of the variance of the FCIs in the sample. - Cross-country variation: the explained variance can vary notably across countries. - Contribution of regional factors: - Over the full sample, the variance gain offered by the two regional factors is limited (about 10 percentage points on average). - Dominant driver: - The largest share of common dynamics across countries is driven by a single global factor, which moves in lock-step with the U.S. FCI. ### Interpretation and implications - A substantial portion of cross-country co-movement in financial conditions can be captured by a single global factor (linked to U.S. financial conditions). - Adding two regional factors improves decomposition but yields a limited average variance gain (about 10 percentage points), indicating global synchronization dominates. - Heterogeneity in country loadings (λ_{i,c}) implies that country-specific sensitivity to common factors differs and can lead to notable cross-country variation in how much of domestic FCI variance is explained by common factors. *The author of this annex is Romain Lafarguette. 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