## EXECUTIVE SUMMARY

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### Financial Stability Has Improved
- Financial stability has continued to improve since the October 2016 Global Financial Stability Report (GFSR).
- Economic activity has gained momentum 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.
- Gains in many asset prices reflect a more optimistic outlook; U.S. equity markets 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 new threat to financial stability.
- U.S. tax reforms and deregulation could, if they deliver less benign paths for growth and debt than expected, cause risk premiums and volatility to rise sharply.
- A shift toward protectionism in advanced economies could reduce global growth and trade, impede capital flows, and dampen market sentiment.
- Political tensions in Europe, combined with slow progress on structural challenges in banking systems 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 and risk a swift repricing of risks if markets view policy outcomes as disappointing.

### Are U.S. Companies Strong Enough to Accelerate the Expansion Safely?
- Many nonfinancial firms have balance sheet capacity to expand investment; reductions in corporate tax burdens could improve cash flow.
- Reforms could also spur increased financial risk taking and raise leverage in some sectors.
- The sectors that have invested the most also 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:
  - 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 reduced corporate leverage and external vulnerabilities and their growth is expected to continue improving, driven by commodity exporters and positive spillovers from advanced economies.
- Financial stability risks remain elevated because global political and policy uncertainties open new channels for negative spillovers.
- A sudden reversal of market sentiment or a global shift toward protectionism could reignite capital outflows and hurt growth, testing resilience.
- 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.
- China faces mounting risks as credit continues to rise rapidly:
  - China’s bank assets are now more than triple its GDP.
  - Many financial institutions remain overly dependent on wholesale financing, with sizable asset-liability mismatches and elevated liquidity and credit risks.
  - Recent turbulence in money markets illustrates vulnerabilities in China’s increasingly large, opaque, and interconnected system.

### European Banking Systems Must Address Structural Challenges
- Considerable progress has been made, and cyclical optimism has helped boost European banks’ equity prices.
- A cyclical recovery alone is likely 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).
- System-wide structural features compounding profitability challenges include overbanking in various forms:
  - Banking systems with assets large relative to the economy.
  - Long weak tails of banks.
  - Too many banks with a regional focus or a narrow mandate.
- These features can result in limited lending opportunities, high numbers of branches relative to assets, added costs, and reduced operational efficiencies.
- System-wide headwinds can affect large, systemically important banks, impeding competitiveness versus global peers.
- 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 stronger long-term and inclusive growth while avoiding inward-looking policies that are 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 debt-financed investment and rising corporate vulnerabilities.
  - Tax reforms that reduce incentives for debt financing could help attenuate risks and possibly encourage firms to lower existing tax-advantaged leverage.
- In Europe:
  - Banks should tackle business model problems through consolidation, branch rationalization, and investment in technology to increase medium-term efficiency.
  - Supervisors are increasingly examining bank business models in their frameworks.
  - Consideration could be given to targeted asset quality reviews for banks that have not undergone such an exercise; regulators should then take action to resolve unviable institutions and 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.
  - Bank regulators should closely monitor vulnerabilities in countries with wide net foreign-currency positions or foreign-currency maturity gaps.
  - Policymakers should proactively monitor and reduce corporate and banking vulnerabilities and improve restructuring mechanisms.
  - In China, supervisory attention should concentrate on fast asset growth among smaller banks, increasing reliance on wholesale funding, and risks from interconnections between shadow products and interbank markets.
  - Addressing the policy tension between maintaining high growth and the need for deleveraging is necessary to avoid market and macro instability.
- On regulatory rollback:
  - Caution is needed; weakening regulatory standards comes at the cost of higher financial stability risks.
  - Decisions to opt out of mutually established regulations in an uncoordinated or unilateral manner could result in financial fragmentation and risk a race to the bottom.
  - Completing the regulatory reform agenda is vital; reviews should not unravel broad improvements in global financial resilience.

### A Long Period of Low Growth and Low Interest Rates Would Challenge Financial Intermediation
- Advanced economies have experienced prolonged 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 increases in longer-term yields, particularly in the United States, do not guarantee a permanent exit from low rates.
- Chapter findings:
  - Yield curves would likely flatten, lowering bank earnings—particularly of smaller, deposit-funded, and less diversified institutions—and presenting long-lasting challenges for life insurers and defined-benefit pension funds.
  - If bank deposit rates cannot drop (significantly) below zero, bank profits would be squeezed further.
  - Smaller, deposit-funded, and less diversified banks would be hurt most.
  - As banks reach for yield, new financial stability challenges would arise in home and host markets.
- A “low-for-long” environment driven by population aging, rising longevity, and stagnating productivity could:
  - Lower credit demand and raise household demand for transaction services.
  - Push bank business models in advanced economies toward fees-based and utility banking services.
  - Increase demand for health and long-term-care insurance.
  - Accelerate transition to defined-contribution private pension plans.
  - Weaken demand for guaranteed-return, long-term savings products offered by insurers and strengthen demand for passive index funds offered by asset managers.
- Prudential frameworks should provide incentives for longer-term stability to avoid pressures for deregulation that ease short-term pain.

### Policymakers Challenged to Effectively Steer Domestic Financial Conditions amid Increased International Financial Integration
- Countries can retain influence over domestic financial conditions despite global integration; greater integration complicates but does not eliminate control.
- Developed financial conditions indices show that 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 seem to have increased much over the past two decades.
- Domestic monetary policy remains a tool to influence domestic financial conditions, but:
  - Domestic financial conditions react strongly and rapidly to global financial shocks, making timely policy responses difficult.
  - Emerging market economies, being more sensitive to global financial conditions, should prepare for tighter external financial conditions.
  - Governments can promote domestic financial deepening—developing a local investor base and fostering greater equity- and bond-market depth and liquidity—to help dampen the impact of global shocks.

*International Monetary Fund | April 2017*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2017/april/front-matter/execsummary.pdf_