## CHAPTER 1 IS GROwTh AT RISk?

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### Global risk and financial conditions: summary assessments
- Macroeconomic risks have fallen, and macroeconomic conditions have improved.
- Emerging market risks are lower, driven by improved fundamentals and external financing conditions.
- Credit risks are unchanged, with improvements in the banking sector contrasting with increasing corporate and household sector risks.
- Monetary and financial conditions remain accommodative, as slightly higher real rates are offset by easier lending conditions and financial conditions.
- Risk appetite continues to increase, as reflected in robust capital flows to emerging markets and increased performance and allocations to risk assets.
- Market and liquidity risks are unchanged, as compressed risk premiums and low volatility offset less-extended market positioning and improved trading liquidity conditions.

### Search for yield, valuations, and volatility
- The global search for yield has compressed risk premiums across some assets.
- Volatility remains near precrisis lows; realized volatility heatmap uses three-month realized volatility percentiles since 2003.
- Asset valuation indicators and historical windows:
  - CAPE, forward P/E, equity risk premiums, term premiums: historical window from 1990.
  - EM term premiums: historical window from 1999.
  - House-price-to-income ratio: historical window from 2000.
  - Corporate spreads: historical window from 2007.
- Market-size and yield shifts:
  - Bank of America Global Bond Market Index: about $19.5 trillion in 2007 to $45.7 trillion in 2017.
  - In 2007, about 80 percent of the fixed income index ($15.8 trillion) yielded over 4 percent; by 2017, less than 5 percent ($1.8 trillion) did so.

### Global Systemically Important Banks (GSIBs): scale, structure, and trends
- Scale and systemic role:
  - The 30 GSIBs collectively hold more than $47 trillion in assets.
  - They hold more than one-third of the total assets and loans of thousands of banks globally.
  - They comprise 70 percent or more of certain international credit markets and international financial infrastructure.
- Business models and composition:
  - Business models: universal banks, consumer banks, transaction banks, investment banks, corporate banks, wealth managers.
  - About half of GSIBs, by assets, are universal banks.
  - Almost a third of GSIBs, by assets, are largely domestic businesses (mostly in China and the United States).
  - GSIB list (based on November 2016 publication) includes 4 Chinese, 3 Japanese, 11 continental European, 4 UK, and 8 US banks (names cited in source).
- Strategic reorientation phases since the crisis:
  1. Legacy cleanup (ongoing for most banks).
  2. Strategic reorientation of lines of business and geographic scope.
  3. Focus on resolution regimes and reconfiguration of international group structures.
- Capital, liquidity, and legacy-charge progress:
  - Additional $1 trillion in capital since 2009 while reducing assets.
  - Loan-to-deposit ratios are down from elevated levels a decade ago; reliance on short-term wholesale funding has fallen.
  - About two-thirds of GSIB noncore assets have been disposed of; US GSIBs are most advanced.
  - Charges for past misconduct totaled an estimated $220 billion between 2011 and 2016:
    - Equivalent to 27 percent of underlying net income for European banks over the period and 19 percent for US banks.
  - Restructuring charges in 2016 for continental European and UK banks amounted to $13 billion, equivalent to 25 percent of their underlying net income.
- Market-activity shifts and implications:
  - FICC revenue pool labels in source: $132 bn and $87 bn (aggregate trading revenue pools shown).
  - Home-region shares examples: United States (47% and 52% in different panels), Continental Europe (27% and 23%), United Kingdom (23% and 17%), Others (3% and 8%).
  - Reduced market-related functions and cutbacks in investment banking; concentration of FICC activity among fewer high-volume/high-margin players.
  - Potential trade-off: lower GSIB market exposure reduces bank risk but may reduce market liquidity, especially in stress, and concentrate supply of risk-management services.
- International operations and subsidiarization:
  - GSIB degree of internationality remained stable between 2010 and 2016.
  - Aggregate share of GSIB lending via foreign subsidiaries rose from 40 percent to 60 percent of international lending since 2009.
  - Subsidiarization shifted funding toward local deposits and away from cross-border funding.
  - Implications: improved resolvability and funding resilience but potential costs—higher local capital, reduced mobility of capital and liquidity, lower returns on equity, and constraints on responding to solvency/liquidity shocks.
- Profitability and capital outlook:
  - US bank profitability reached levels in line with or exceeding an 8 percent cost of equity.
  - About half of GSIBs by asset size remain below an 8 percent return on equity.
  - Analysts expect one-third of GSIB assets (about $17 trillion) to generate below-sustainable returns in 2019.
  - Definitions in analysis for 2019 expected ROE:
    - "Weak" = expected ROE below 8 percent.
    - "Challenged" = expected ROE between 8 and 10 percent.
    - "Healthy" = expected ROE more than 10 percent.
  - Cost-of-equity observations:
    - Investor surveys suggest cost of equity at least 8 percent.
    - Current cost of equity, inferred from market prices using a Gordon Growth model, is almost 11 percent for GSIBs as a whole.
    - Individual bank estimates range from 8 to 15 percent.
  - Management medium-term targets: 11 of 21 GSIBs target ROE above 10 percent; remaining 10 target between 8 and 10 percent.
- Risks and supervisory priorities:
  - Banks with thin capital buffers relative to future regulatory requirements and weak profitability may struggle to build buffers.
  - European investment banks face fundamental model and execution challenges.
  - Low domestic interest rates motivate Japanese GSIBs’ international expansion, raising currency and maturity mismatch risks.
  - Supervisory focus should prioritize business-model risks and sustainable profitability as problems in even a single GSIB could generate systemic stress.

### Policy recommendations for GSIBs and regulators
- Strengthen national resolution regimes and develop cross-border resolution plans with adequate loss-absorbing capacity.
- Ensure close coordination between home and host-country regulators and resolution authorities.
- Maintain strong focus on risks from weak business models to ensure weaker banks can achieve sustainable profitability.
- Euro area-specific:
  - More concerted effort to reduce nonperforming assets and improve business models.
  - Continued progress toward completing banking union is essential.
- Finalize Basel III to strengthen the financial sector and create a more level international playing field.
  - Any national proposals to substantially ease capital, liquidity, or prudential standards should be considered carefully for potential damage to global regulatory harmonization.

### Life insurers: adaptation, vulnerabilities, and simulation results
- Sample and profitability:
  - Analysis based on more than 80 life insurers from Belgium, France, Germany, Italy, Japan, the Netherlands, Norway, Spain, Sweden, the United Kingdom, and the United States; sample covers almost two-thirds of total assets of life insurers in Europe, Japan, and the United States.
  - Profits tumbled during the global financial crisis, particularly in the United States; insurers have rebuilt capital buffers since the crisis.
  - Half of US and European insurers in the sample, by assets, now have price-to-book ratios below precrisis levels and below one.
- Business-model and asset adaptations to low yields:
  - Reduced guaranteed returns on new policies.
  - Product-mix shifts:
    - European insurers: more unit-linked policies.
    - US insurers: moved from variable to fixed annuities.
    - Japanese insurers: favored certain products and increased foreign bond holdings.
  - Asset allocation shifts:
    - US and European insurers increased holdings of lower-rated bonds.
    - Japanese life insurers increased duration and holdings of foreign bonds.
- Risk-taking and balance-sheet changes:
  - At least one-third of US and European insurers’ bond portfolios now have a BBB rating or lower.
  - US portfolio durations increased from about five to eight years overall over the past five years.
  - In the United Kingdom, about 25 percent of annuities are currently backed by illiquid investments, with plans to increase to 40 percent by 2020.
  - Examples of illiquid investments: commercial property, infrastructure financing, private placements, structured securities, mortgage loans.
- Interest-rate risk and negative spreads:
  - If low interest rates persist, investment returns could continue to decrease for the next decade, leaving life insurers in the Netherlands, Germany, Sweden, and Norway facing negative spreads within a few years.
  - Even a 100 basis point increase in interest rates would not eliminate negative-spread risk for many insurers.
- Valuation and reporting concerns:
  - Discount rates used to value future liabilities often higher than market risk-free rates, understating liabilities.
  - Regulatory gaps and inadequate disclosure complicate cross-country comparisons.
  - Embedded options are hard to value, complicating balance-sheet risk assessment.
- Mark-to-market shock simulation (upper-bound, cash flows fixed, derivatives and loss absorption by policyholders/taxes/regulatory adjustments not taken into account):
  - Shock parameters on aggregate sector balance sheets (solo life insurers as of 2016:Q3 Europe, 2016:Q1 Japan, 2015:Q4 United States):
    - equity (–10 percent)
    - real estate (–6 percent)
    - sovereign debt yield AAA–A (–50 bps), BBB (+100 bps), < BBB (+100 bps)
    - corporate bond yields AAA–A (+50 bps), BBB (+150 bps), < BBB (+200 bps)
    - risk-free rates (–50 bps)
  - Results: life insurers in Italy, Spain, and the United States would be affected by lower-rated sovereign and corporate bond holdings; insurers in Germany, the Netherlands, Norway, and Sweden would be affected by long liability durations.
- Policy recommendations for insurer resilience:
  - Strengthen regulatory frameworks and increase reporting transparency to prevent excessive risk-taking.
  - Increase public disclosure of guaranteed returns and duration mismatches to motivate model adaptation and capital buffer building.
  - Address valuation and comparability issues across jurisdictions.
  - Close regulatory gaps:
    - United States: no consolidated capital requirement; sector-wide stress tests not regularly undertaken.
    - Europe: lack of loss-absorbing capacity in some regulatory-capital-eligible instruments harms solvency credibility.
  - Encourage the International Association of Insurance Supervisors to accelerate efforts to establish a global insurance capital standard.

### Monetary policy normalization, central bank balance sheets, and portfolio rebalancing
- Central bank holdings of outstanding government securities increased to 37 percent of GDP, up from 10 percent before the global financial crisis.
- Portfolio-balance and signaling channels of normalization:
  - Releasing assets will increase net supply to the public and may increase term and risk premiums (portfolio-balance channel).
  - Normalization will be associated with higher future short rates (signaling channel).
- Uncertainty on term-premium adjustment:
  - Federal Reserve estimates: gradual unwinding and fall in maturity of securities holdings would increase the term premium by about 15 basis points by end-2017; QE still holding down term premiums by about 85 basis points, with portfolio-balance channels accounting for two-thirds of the impact.
- Risk trade-offs:
  - Too-quick normalization could cause market turbulence and international spillovers.
  - Prolonged low rates and low volatility could encourage further buildup of financial excesses and medium-term vulnerabilities.

### International spillovers, emerging market flows, and vulnerabilities
- Push of unconventional Federal Reserve policies since 2010 attributed about $260 billion in portfolio inflows; expected Fed normalization could reduce portfolio flows by about $35 billion a year over the next two years.
- Countries likely to see the largest moderation in inflows relative to economy size: Chile, Mexico, and South Africa—estimated cumulative decline of 1.0 to 1.5 percent of annual GDP over the next two years.
- Nonresident portfolio inflows estimated $205 billion in the year through August and on track to reach $300 billion for 2017.
- Primary beneficiaries of portfolio inflows include Colombia, Mexico, South Africa, and Turkey.
- Emerging market sovereign and corporate issuance trends:
  - Sovereign gross and net issuance at record levels; corporate gross issuance back to 2013–14 levels, net issuance subdued.
  - Low-income-country bond issuance rose sharply in 2017; total volume $7.4 billion close to record level in 2014.
  - Many low-income-country issuers face a significant repayment hump after 2021; increased vulnerability to decompression of global risk premiums.
- Modelled portfolio flow impacts under normalization and risk-off:
  - Baseline: Fed normalization reduces flows by about $35 billion a year.
  - Scenario estimates for a rapid asset-market correction (see Global Financial Dislocation Scenario below) show large additional retrenchment.

### Credit and market risk mispricing, leverage, and liquidity concerns
- Low yields, compressed spreads, and abundant financing encouraged increased corporate leverage and equity buybacks.
- Share of lower-rated companies increased in US, European, and global bond indices; estimated default risk for high-yield and emerging market bonds remained elevated.
- Compensation for credit risk has fallen despite declining credit quality.
- For bond yields to return to 2000–2004 averages:
  - Market risk and term premiums would need to rise about 200 basis points for investment-grade bonds, about 450 basis points for high-yield bonds, and about 375 basis points for emerging market bonds.
- Volatility-targeting funds and liquidity risks:
  - Size of US equity holdings by volatility-targeting strategies may be larger than $0.5 trillion (less than 2.5 percent of US market capitalization).
  - Such strategies contributed between 9 and 16 percent of S&P 500 futures trading volume during August 24–26, 2015.
  - VIX spiked to 40.7 percent on August 24, 2015, from 13.0 a week earlier.
- Mutual-fund liquidity mismatches:
  - Mutual funds hold a greater share of the high-yield bond market; losses exceeding 5 percent on US high-yield benchmarks are identified as typical triggers for stop-loss strategies.

### Global Financial Dislocation Scenario: structure, shocks, and impacts
- Scenario phases:
  - Phase 1: Continuation of low volatility and compressed spreads; equity and housing prices climb; collateral values rise; favorable lending conditions continue through 2019.
  - Phase 2: Rapid decompression of risk premiums leading to asset repricing starting at the beginning of 2020.
- Shock magnitudes:
  - Equity prices decline up to 15 percent.
  - House prices decline up to 9 percent.
- Macroeconomic and policy outcomes by 2022:
  - Global output falls by 1.7 percent relative to the WEO baseline.
  - The Federal Reserve reverses hikes and cuts the policy rate by 150 basis points to 1.75 percent by 2022 in the scenario.
  - Scenario described as about one-third as severe as the global financial crisis.
- Cross-country impacts:
  - Euro area suffers larger output loss due to effective lower bound and renewed financial fragmentation.
  - Emerging market economies disproportionately affected: equity and bond outflows, currency pressure, constrained monetary policy.
  - Corporate and household defaults rise to prior cyclical peaks but do not reach global financial crisis levels.
  - Chinese banks suffer outsize declines in capital, though strong policy buffers could mitigate impacts.
- Portfolio flow dynamics in scenario:
  - Phase 1: Net reduction in portfolio inflows to emerging markets of about $25 billion a year (vs $35 billion under baseline).
  - Phase 2: Asset-market correction triggers retrenchment of about $65 billion over first four quarters, in addition to the $35 billion reduction — combined reduction of about $100 billion during the first four quarters (about $65 billion during the subsequent four quarters).
  - Country-level inflow reductions during first two years range from 1.6 to 2.3 percent of GDP for most affected countries.
  - Countries with projected current account deficits of 3 to 4½ percent of GDP in 2019 would be particularly challenged (examples in source: Colombia, South Africa, Turkey).

### Emerging market policy guidance for capital-flow pressures
- Manage primarily with macroeconomic, structural, and financial policies; responses depend on available policy space.
- Exchange rate flexibility should be a key shock absorber where appropriate.
- With sufficient international reserves, foreign exchange intervention can prevent disorderly conditions.
- Liquidity provision may be needed to support orderly market functioning during stress.
- Capital flow management measures should be used only in crisis situations or when a crisis is imminent; they should be transparent, temporary, nondiscriminatory, and lifted when conditions abate.

### Broad debt trends, sectoral leverage, and China-specific challenges
- Aggregate G20 nonfinancial sector debt rose to more than $135 trillion, about 235 percent of aggregate GDP.
  - G20 advanced economies: total nonfinancial sector debt now more than 260 percent of GDP.
  - G20 emerging market economies: leverage growth accelerated, driven largely by a huge increase in Chinese debt since 2007.
- About 80 percent of the $60 trillion increase in G20 nonfinancial sector debt since 2006 has been in the sovereign and nonfinancial corporate sectors.
- Debt drivers, distributional issues, and vulnerabilities:
  - Household leverage increases linked to lower borrowing costs and house-price movements.
  - Corporate debt increases occurred during loose financing conditions, reducing model-based default probabilities but masking reversal risks.
  - Debt-service ratios (annualized interest plus amortizations as percent of income) increased in many G20 economies despite low interest rates.
  - Countries/sectors with notable debt-service pressure: nonfinancial private sector in Australia, Canada, China; household sector in Korea.
- China — derisking to deleveraging:
  - Banking sector assets are 310 percent of GDP, up from 240 percent at end-2012 and nearly three times emerging market average.
  - Shadow credit significant driver of bank growth; shadow credit definition includes on-balance-sheet nonloan/nonbond credit and off-balance-sheet items like wealth management plans.
  - For sample of 32 large Chinese banking groups, shadow credit expansion outpaced loan growth over past three years.
  - Shadow credit accounted for large shares of new credit in scenario panels: 41%, 53%, 51% (years shown in source).
  - Shadow credit growth assumption in scenario analysis: 27 percent year over year; with 27 percent shadow growth, retained earnings support total credit growth of 17 percent year over year; with 0 percent shadow growth, retained earnings support credit growth of 11 percent.
  - New common equity announced for 2017: RMB 66 billion, about 2 percent of end-2016 common equity at small and medium-sized banks.
  - Nondeposit funding maturing in less than one year rose to about 34 percent of assets from 22 percent in 2011; over half of nondeposit funding now matures in less than three months.
  - Short-term nondeposit funding exceeds similar-maturity nonloan assets by about 6 percent of assets, or RMB 2.8 trillion.
- Policy recommendations for China and bank-sector repair:
  - Improve banks’ risk management and reduce maturity and liquidity transformation risks in shadow credit activities.
  - Strengthen regulation to reduce shadow-credit risks and regulatory arbitrage.
  - Target reducing balance-sheet vulnerabilities at weak banks, including dividend restrictions.
  - Restructure or resolve nonviable institutions to support corporate debt restructuring and strengthen governance/risk incentives.
  - Raise new equity paired with reforms to improve risk management and governance.
  - On borrower side, build on commitments to reduce corporate leverage and improve credit efficiency.

### Leverage, liquidity, and regulatory recommendations
- Aggregate measures:
  - Increased corporate leverage and G20 debt accumulation require vigilance; much increase concentrated in China and the United States.
- Regulatory, supervisory, and market-policy recommendations:
  - Maintain robust risk management across credit, business, and interest-rate cycles.
  - Monitor exposures to asset classes where search-for-yield has pressured valuations.
  - Endorse a clear, common definition of financial leverage in investment funds.
  - Improve data transparency, especially on derivatives.
  - Strengthen supervisory frameworks on liquidity risk management:
    - Include greater flexibility in redemption and dealing frequency.
    - Mark illiquid assets to market.
    - Address treatment of institutional investors.
    - Provide guidance on risk-management tools and enhanced disclosure.
  - Borrowers in frontier and low-income countries should develop institutional capacity for marketable debt, comprehensive debt-management strategies, liability-management operations, efficient public investment management, and investor relations programs.

### Cyberthreats to financial stability
- Increasing sophistication and economic impact of cyberthreats in 2016–2017; hypothetical major global cyberattack estimate up to $53 billion (Lloyds 2017).
- NotPetya (June 2017) caused global losses around $850 million; two multinationals estimated losses exceeding $130 million each.
- Cyberattack channels threatening financial stability:
  1. data breach
  2. disruption of business
  3. integrity attack
  4. malicious activities for financial gain
- Trends:
  - Number of stolen identities rose 95 percent year over year in 2016 (Symantec).
- Regulatory and supervisory actions cited:
  - European Parliament directive on security of network and information systems.
  - European Banking Authority guidelines on ICT risk assessment.
  - Bank of England vulnerability testing framework and supervisory statement on cyberinsurance underwriting risk.
  - US federal agencies’ notice of proposed rulemaking for enhanced cyberrisk standards.
  - CPMI and IOSCO cyberguidance for financial market infrastructures.
  - New York State Department of Financial Services Cybersecurity Requirements for Financial Services Companies.
  - EU General Data Protection Regulation effective May 2018 with fines up to 4 percent of yearly turnover or €20 million, whichever is greater.
- Policy needs:
  - Global and coordinated policy response to ensure resilience and combat cybercrime.
  - Harmonization of minimum standards to smooth cross-border implementation.
  - Tackle cybercrime by attacking its business model and raising engagement risks.
  - Focus on prevention, identification, timely recovery, information sharing, penetration and resilience tests, and harmonized minimum standards.

*Source: CHAPTER 1 IS GROwTh AT RISk?, International Monetary Fund | October 2017*

### CHAPTER 1 IS GROwTh AT RISk?

### CHAPTER 1 IS GROwTh AT RISk?

### Global risk and financial conditions: summary assessments
- Macroeconomic risks have fallen, and macroeconomic conditions have improved.
- Emerging market risks are lower, driven by improved fundamentals and external financing conditions.
- Credit risks are unchanged, with improvements in the banking sector contrasting with increasing corporate and household sector risks.
- Monetary and financial conditions remain accommodative, as slightly higher real rates are offset by easier lending conditions and financial conditions.
- Risk appetite continues to increase, as reflected in robust capital flows to emerging markets and increased performance and allocations to risk assets.
- Market and liquidity risks are unchanged, as compressed risk premiums and low volatility offset less-extended market positioning and improved trading liquidity conditions.

### Search for yield, valuations, and volatility
- The global search for yield has compressed risk premiums across some assets.
- Volatility remains near precrisis lows.
- Asset valuation indicators cited include: CAPE (cyclically adjusted price-to-earnings ratio), forward P/E, equity risk premiums (three-stage dividend discount model), term premiums (Wright 2011 methodology), corporate spreads (spreads per turn of leverage), and house-price-to-income ratio (income proxied using nominal GDP per capita).
- Percentile calculations use historical windows: from 1990 for CAPE, forward P/E, equity risk premiums and term premiums; from 1999 for EM term premiums; from 2000 for house-price-to-income ratio; and from 2007 for corporate spreads.
- Heatmap of realized volatility uses the percentile of three-month realized volatility since 2003 at a monthly frequency.

### GSIBs: systemic role and composition
- The 30 GSIBs collectively:
  - Hold more than $47 trillion in assets.
  - Hold more than one-third of the total assets and loans of thousands of banks globally.
  - Comprise 70 percent or more of certain international credit markets (for example, syndicated trade finance), market services, and the international financial infrastructure.
- GSIBs vary by business model and geographic reach:
  - Business models include universal banks, consumer banks, transaction banks, investment banks, corporate banks, and wealth managers.
  - About half of GSIBs, by assets, are universal banks.
  - Almost a third of GSIBs, by assets, are largely domestic businesses (mostly in China and the United States).
- GSIB list (based on November 2016 publication): China (4)—Agricultural Bank of China (ABC), Bank of China (BOC), China Construction Bank (CCB), Industrial and Commercial Bank of China (ICBC); Japan (3)—Mitsubishi UFJ Financial Group (MUFG), Mizuho Financial Group (MFG), Sumitomo Mitsui Financial Group (SMFG); Continental Europe (11)—Banco Santander (SAN), BNP Paribas (BNP), Crédit Agricole (CA), Credit Suisse (CS), Deutsche Bank (DB), Groupe BPCE (BPCE), ING Groep (ING), Nordea Bank (NDA), Société Générale (SG), UBS Group (UBS), Unicredit Group (UCG); United Kingdom (4)—Barclays (BARC), HSBC Holdings (HSBC), Royal Bank of Scotland (RBS), Standard Chartered (STAN); United States (8)—Bank of America (BOA), Bank of New York Mellon (BNY), Citigroup (C), Goldman Sachs (GS), JP Morgan Chase (JPM), Morgan Stanley (MS), State Street (STT), Wells Fargo (WFC).

### GSIB business model transitions and strategic phases
- Three overlapping phases of reorientation since the crisis:
  1. Legacy cleanup (ongoing for most banks).
  2. Strategic reorientation affecting lines of business and geographic scope.
  3. Focus on resolution regimes and reconfiguration of international group structures.
- These multiyear adjustments aim to support resilience and achieve more sustainable profitability; progress is positive but uneven and challenges remain.

### Capital, liquidity, and legacy-challenge progress
- GSIBs have strengthened balance sheets:
  - Additional $1 trillion in capital since 2009 while reducing assets.
  - Adjusted capital ratios (incorporating reserves against expected losses) have risen steadily since the precrisis period.
- Liquidity improvements:
  - Loan-to-deposit ratios are down from elevated levels a decade ago.
  - Reliance on short-term wholesale funding has fallen.
- Legacy cleanup and conduct-related charges:
  - About two-thirds of GSIB noncore assets have been disposed of; US GSIBs are the most advanced.
  - Charges for past misconduct (fines and private litigation) totaled an estimated $220 billion between 2011 and 2016.
    - This $220 billion is equivalent to 27 percent of underlying net income for European banks over the period and 19 percent for US banks.
  - Restructuring charges in 2016 for continental European and UK banks amounted to $13 billion, equivalent to 25 percent of their underlying net income.

### Reduction in market-related business and implications
- GSIBs have reduced market-related functions; investment banks have made significant cutbacks.
- Drivers include earlier overexpansion, increased risk-asset weighting and capital charges, and declining profitability in market businesses.
- FICC (fixed income, currencies, and commodities) businesses have become less attractive except for a few high-volume or high-margin players, leading to concentration of market activity.
- Potential implications:
  - Reduced GSIB market exposure lowers bank risk but may have costs for market liquidity, especially in stress.
  - Supply of risk management services that require GSIB balance sheet capacity may be reduced or concentrated among fewer providers.
- The balance between reduced GSIB riskiness and potential costs to liquidity during stress requires ongoing consideration.

### International operations and subsidiarization trends
- GSIBs have remained central to international credit and services (syndicated lending, trade finance, project finance), with international balance sheet commitments and revenue mix remaining quite stable across most GSIBs.
- During 2009–13, non-GSIB banks shrank international loans aggressively, but GSIBs as a group maintained international lending volume.
- Profitability of foreign banking operations (sample of 724 banking subsidiaries):
  - Foreign operations have been more profitable than domestic business for Japanese and continental European and UK GSIBs.
  - Japanese banks have pivoted aggressively toward international markets, maintaining reliance on potentially volatile wholesale foreign currency funding and expanding corporate loans and foreign securities investments.
  - US GSIBs, with highly profitable domestic operations, have maintained or slightly pulled back the international proportion of their loan portfolios.
- Subsidiarization:
  - Largely in response to national regulatory pressures, several GSIBs reliant on branching have begun shifting international lending from direct cross-border models to lending via subsidiaries, presenting a structural challenge for some banks.

*Source: IMF staff estimates and analysis, CHAPTER 1 IS GROwTh AT RISk? (October 2017).*

### CHAPTER 1 IS GROwTh AT RISk?

### CHAPTER 1 IS GROwTh AT RISk?

### Global Systemically Important Banks: Market Activity
- FICC revenue pool has shrunk with a shift in market share toward US banks (Figure 1.6, panel 3).
- Visual indicators in the source show aggregate trading revenue pools of:
  - $132 bn (label associated with one panel)
  - $87 bn (label associated with another panel)
- Home-region shares shown in the source:
  - United States (47%) in one panel; United States (52%) in another panel.
  - Continental Europe (27% and 23% in different panels).
  - United Kingdom (23% and 17% in different panels).
  - Others (3% and 8% in different panels).

### GSIB International Activity and Subsidiarization
- GSIBs’ market intensity has declined sharply between 2010 and 2016 (Figure 1.6, panel 1).
- Degree of internationality has remained stable overall between 2010 and 2016 (Figure 1.7, panel 1).
- The aggregate share of GSIB lending extended through foreign subsidiaries has risen from 40 percent to 60 percent of international lending since 2009.
- Subsidiarization has motivated banks to shift funding from cross-border (interbank and intragroup) funding toward local deposits (Figure 1.7, panel 4).
- Implications noted:
  - Improvements in resolvability and funding resilience.
  - Potential costs: lower returns on equity due to higher local capital, reduced mobility of capital and liquidity, and possible constraints on banks’ capacity to respond to solvency or liquidity shocks.
  - More significant effects for banks with globally integrated capital and liquidity models (most investment banks) than for consumer banks.
  - Regulatory impediments to liquidity and fund deployment within the euro area contribute to higher costs and reduced activity.

### GSIB Profitability and Capital: Uneven Progress and Outlook
- Progress in addressing legacy charges, business model adaptations, and group structure is uneven across GSIBs (Figure 1.8, panel 1).
- US bank profitability has reached levels in line with or exceeding an 8 percent cost of equity and approaches management-stated targets.
- European banks’ 2016 profitability was more mixed; several banks generated low returns, in part due to slower progress on legacy issues.
- About half of GSIBs by asset size remain below an 8 percent return on equity.
- Analysts expect one-third of the GSIB assets (about $17 trillion) to generate below-sustainable returns in 2019 (Figure 1.8, panel 3).
- Definitions used in the analysis:
  - "Weak" = expected ROE below 8 percent in 2019.
  - "Challenged" = expected ROE between 8 and 10 percent in 2019.
  - "Healthy" = expected ROE more than 10 percent in 2019.
- Cost-of-equity observations:
  - Investor surveys suggest the cost of equity is at least 8 percent.
  - The current cost of equity—inferred from current market prices using a Gordon Growth model—is almost 11 percent for GSIBs as a whole.
  - Individual bank estimates for the cost of equity range from 8 to 15 percent.
- Management medium-term profitability targets:
  - Target for 11 out of 21 GSIBs is a return on equity above 10 percent.
  - For the remaining 10 banks, the target is between 8 and 10 percent.
- Drivers expected to improve profitability:
  - Arresting revenue declines as weak and challenged banks’ assets increase following restructuring.
  - Expected cyclical improvement in net interest margins.
  - Cost-ratio dynamics improving with restructuring and balance sheet reflation.
- Risks requiring heightened attention:
  - Banks with thin capital buffers relative to future regulatory requirements and relatively weak profitability to build those buffers.
  - European investment banks facing fundamental problems defining and executing profitable business models.
  - Low domestic interest rates affecting Japanese GSIBs, motivating international expansion that raises currency and maturity mismatch risks.
- Systemic risk note: Problems in even a single GSIB could generate systemic stress; supervisory action should focus on business model risks and sustainable profitability.

### Policy Recommendations for Banks and Regulators
- Further work needed to make cross-border resolution frameworks operational:
  - Strengthen national resolution regimes.
  - Develop cross-border resolution plans with adequate loss-absorbing capacity.
  - Ensure close coordination between home and host-country regulators and resolution authorities to provide comfort to host countries regarding centralized resolution strategies.
- Regulators should maintain a strong focus on risks from weak business models to ensure weaker banks can achieve sustainable profitability.
- Euro area-specific recommendations:
  - More concerted effort to reduce nonperforming assets and improve business models; high nonperforming loan ratios remain in some countries.
  - Continued progress toward completing banking union remains essential.
- Finalize Basel III to further strengthen the financial sector and create a more level international playing field.
  - Any proposals by national regulators to substantially ease capital, liquidity, or prudential standards should be considered carefully because of potential damage to global regulatory harmonization.

### Life Insurers: Profitability and Business Model Adaptation
- Life insurers were hit hard by the global financial crisis; profits tumbled particularly in the United States (Figure 1.9, panel 1).
- Insurers have rebuilt capital buffers since the crisis (Figure 1.9, panel 2).
- The analysis is based on a sample of more than 80 life insurers from Belgium, France, Germany, Italy, Japan, the Netherlands, Norway, Spain, Sweden, the United Kingdom, and the United States; the sample covers almost two-thirds of total assets of life insurers in Europe, Japan, and the United States.
- Drivers of improved insurer finances:
  - Bullish equity and bond markets have raised the value of marked-to-market assets, boosting earnings, dividend payouts, and capital.
- Business model adaptations to low-yield environment:
  - Insurers have reduced guaranteed returns on new policies (Figure 1.10, panel 1).
  - Changes in product mix:
    - European insurers have gradually sold more unit-linked policies (Figure 1.10, panel 2).
    - US insurers have moved from variable to fixed annuities.
    - Japanese insurers have favored certain products (source shows shifts in gross written premiums and sales across regions).
  - Asset allocation shifts:
    - US and European life insurers have invested more in lower-rated bonds (Figure 1.10, panel 3).
    - Japanese life insurers have increased duration and holdings of foreign bonds (Figure 1.10, panel 4).

*Source: CHAPTER 1 IS GROwTh AT RISk?, International Monetary Fund | October 2017*

### CHAPTER 1 IS GROwTh AT RISk?

### CHAPTER 1 IS GROwTh AT RISk?

### Insurer risk-taking and balance-sheet adjustments
- Product and asset shifts have been gradual because of a large amount of legacy policies.
- Insurers have adjusted asset mixes to higher-yielding and less liquid assets, moving out of their natural investment habitat in search of yield.
- Credit risk:
  - At least one-third of US and European insurers’ bond portfolios now have a BBB rating or lower.
  - Additional risk taking has occurred in the United States using unregulated subsidiaries that do not face the same capital requirements as insurers.
- Market risk:
  - Japanese and US insurers have extended the maturity of domestic bond holdings; portfolio durations in the United States have increased from about five to eight years overall over the past five years.
  - Japanese life insurers have invested in higher-yielding foreign bonds, partly exposing them to currency risk.
- Liquidity risk:
  - Examples include commercial property, infrastructure financing, private placements, structured securities, and mortgage loans.
  - In the United Kingdom, about 25 percent of annuities are currently backed by illiquid investments, and insurers have plans to increase that proportion to 40 percent by 2020.

### Market concerns, profitability, and valuation
- Profitability pressures persist (see Figure 1.11 references).
- Valuation:
  - Half of the US and European insurers in the sample, by assets, now have a price-to-book ratio both below precrisis levels and below one.
- Guaranteed returns and duration mismatches remain elevated for a significant part of the sector.
- Interest-rate risk and negative spreads:
  - If low interest rates persist, investment returns could continue to decrease for the next decade, leaving life insurers in the Netherlands, Germany, Sweden, and Norway facing negative spreads within a few years.
  - Even if interest rates were to increase by 100 basis points, many insurers would still face this risk.
- Risk assessment deficiencies:
  - Discount rates used to value future liabilities differ between insurers and are often higher than market risk-free rates, resulting in an underestimation of liabilities.
  - Regulatory gaps and inadequate disclosure make cross-country risk comparisons difficult.
  - Options embedded in some insurance contracts are hard to value, complicating balance sheet risk assessment.

### Life insurers’ vulnerability under a mark-to-market shock (simulation)
- Business-model adjustments on the asset side increase vulnerability to decompression of risk premiums and asset-price falls.
- A simulated scenario assumes assets and liabilities are fully marked to market; current accounting/regulatory rules often exempt insurers from marking liabilities to market.
- In the simulation, life insurers in Italy, Spain, and the United States would be affected by lower-rated sovereign and corporate bond holdings; insurers in Germany, the Netherlands, Norway, and Sweden would be affected by long liability durations.
- Shock parameters applied to aggregate sector balance sheets (solo life insurers as of 2016:Q3 Europe, 2016:Q1 Japan, 2015:Q4 United States):
  - equity (–10 percent)
  - real estate (–6 percent)
  - sovereign debt yield AAA–A (–50 bps), BBB (+100 bps), < BBB (+100 bps)
  - corporate bond yields AAA–A (+50 bps), BBB (+150 bps), < BBB (+200 bps)
  - risk-free rates (–50 bps)
- Note: Cash flows are fixed. Derivative positions and loss absorption by policyholders and by taxes and regulatory adjustments are not taken into account; results are an upper-bound impact.

### Policy recommendations for insurer resilience
- Strengthen regulatory frameworks and increase reporting transparency to prevent excessive risk-taking as insurers adapt to a low-rate environment.
- Increase public disclosure of timely information on key metrics to assess interest-rate risk, namely guaranteed returns and duration mismatches, to motivate model adaptation and capital buffer building.
- Address valuation and comparability issues:
  - Liabilities often are not valued using current market prices (Japan, United States) or are understated by country- and firm-specific adjustments (Europe).
- Close regulatory gaps:
  - In the United States, there is no consolidated capital requirement, and sector-wide stress tests are not regularly undertaken.
  - In Europe, lack of loss-absorbing capacity in some instruments eligible as regulatory capital harms the credibility of reported solvency positions.
- Encourage the International Association of Insurance Supervisors to accelerate efforts to establish a global insurance capital standard that addresses these vulnerabilities.

### Monetary policy normalization, central bank balance sheets, and portfolio rebalancing
- Large-scale asset purchase programs increased central bank holdings of outstanding government securities to 37 percent of GDP, up from 10 percent before the global financial crisis.
- Central bank purchases altered private-sector portfolio allocations across advanced economies; effects varied by jurisdiction:
  - Bank of Japan’s QE led domestic banks and pension funds to reduce Japanese government bond holdings.
  - ECB’s QE led foreigners, domestic banks, and pension funds to reduce government debt holdings.
  - US QE had a more muted rebalancing; foreigners reduced Treasury holdings, while other investors (banks, households, mutual funds) increased holdings.
- In the euro area and Japan, official demand absorbed 100 percent or more of the supply of government bonds at times.
- Portfolio-balance and signaling channels:
  - Releasing assets via balance-sheet normalization will increase net supply to the public and may increase term and risk premiums (portfolio-balance channel).
  - Normalization will be associated with higher future short rates (signaling channel).
- Uncertainty on term-premium adjustment:
  - Historical policy-rate and term-premium movements are not always aligned; past tightening cycles show mixed outcomes.
  - In the United States, the Federal Reserve estimates that market expectations of a gradual unwinding and fall in the maturity of its securities holdings would increase the term premium by about 15 basis points by the end of 2017, at which point QE would still be holding down term premiums by a total of about 85 basis points. The portfolio-balance channels account for two-thirds of the impact.
- Risk trade-offs:
  - Too-quick normalization could cause market turbulence and international spillovers.
  - A prolonged period of low interest rates and low volatility could foster further buildup of financial excesses and medium-term vulnerabilities.

### International spillovers and implications
- Balance-sheet normalization in major advanced economies could tighten financial conditions in other countries by raising long-term rates and inducing capital outflows because global financial markets are highly integrated.
- Term premiums show a high degree of comovement, particularly if shocks originate from the largest global bond markets, amplifying potential international spillovers.

*Source: CHAPTER 1 IS GROwTh AT RISk?, International Monetary Fund | October 2017*

### 1. Federal Funds Rate and Term Premiums during Previous

### 1. Federal Funds Rate and Term Premiums during Previous

### Policy rates, term premiums, and cross-border dynamics
- Policy rates and term premiums have diverged during recent monetary policy tightening cycles.
- Term premiums are near historical lows in several major economies.
- Diverging monetary-policy cycles and paths for normalization pose the risk of a large simultaneous increase in global rates.
- Differences in balance sheet repair across countries could create additional sources of financial stress as monetary policy normalizes; euro area sovereign term spreads could increase as the prospect of reduced monetary accommodation moves closer.
- European Central Bank (ECB) net asset purchase reductions could partly reflect rising inflation expectations or signal increased credit risks in countries with high debt burdens.

### Emerging market portfolio flows and exposure to US monetary normalization
- Model estimates attribute about $260 billion in portfolio inflows since 2010 to the push of unconventional policies by the Federal Reserve.
- The expected steady pace of Federal Reserve policy normalization over the next two years could reduce portfolio flows by about $35 billion a year.
- Countries that benefited most during the boom period could see the largest moderation in inflows; Chile, Mexico, and South Africa are expected to experience the greatest decline in inflows relative to the size of their economies, estimated at a cumulative 1.0 to 1.5 percent of annual GDP over the next two years.
- Emerging market economies with previously large inflows generally have deeper and more liquid markets and thus are better able to withstand outflows.
- A rapid increase in investor risk aversion would have a more severe impact on portfolio inflows and be particularly challenging for countries with greater dependence on external financing.
- Examples of countries projected to have sizable external financing needs through 2020 include Malaysia, Poland, South Africa, and Turkey.
- Large external asset holdings of domestic investors and banks can mitigate pressures from external shocks.

### Policy communication and balance sheet normalization guidance
- Monetary policy changes should be well communicated to prevent excessive market volatility.
- The baseline foresees continued support from accommodative monetary policies, since inflation rates are expected to recover only slowly.
- Monetary authorities should provide and follow well-communicated plans on unwinding holdings of securities and, if needed, provide guidance on prospective changes to the framework to anchor market expectations and avoid undue market dislocations or excessive volatility.
- Central banks with still-expanding balance sheets need to take appropriate measures to alleviate collateral scarcity pressures to support liquidity resilience and efficient market functioning.
- For the European Central Bank:
  - Subdued inflation points to the need for monetary policy to remain accommodative for an extended period.
  - The ECB has committed to keeping policy rates at their current levels until well past the horizon of net asset purchases; adhering to this commitment is important for credibility of forward guidance and maintaining accommodation even if supply constraints necessitate scaling back net asset purchases next year.
  - Reinvesting proceeds from maturing assets would keep the central bank balance sheet from shrinking.
- For the Bank of Japan:
  - Low inflation underscores the importance of maintaining sustained accommodation through its “quantitative and qualitative easing with yield curve control” framework.
  - The Bank of Japan should carefully calibrate its yield curve policy in the event of downside risks, including by considering lowering the yield curve, in coordination with appropriate fiscal support and with consideration to the profitability of financial institutions and the functioning of the Japanese government bond market.
  - The Bank of Japan should continue to monitor market liquidity and functioning of the Japanese government bond market and consider measures to alleviate shortages in the event of liquidity stress.

### Search for yield: market structure and investor behavior
- Extended low-interest-rate environment has driven a search for yield, pushing investors beyond traditional risk mandates; this has compressed spreads, reduced compensation for credit and market risk in bond markets, contributed to low volatility, and facilitated financial leverage.
- The global fixed income market size (Bank of America Global Bond Market Index) increased from about $19.5 trillion in 2007 to $45.7 trillion in 2017.
- In 2007, about 80 percent of the fixed income index ($15.8 trillion) yielded over 4 percent.
- By 2017, this portion had shrunk to less than 5 percent ($1.8 trillion).
- In the United States:
  - Dearth of higher-yielding securities and portfolio rebalancing effects of QE shifted foreign investors from US Treasury bonds and agency securities into higher-yielding US corporate bonds.
  - Non-US investors now hold nearly 30 percent of outstanding US corporate bonds, up from 12 percent in 1990 and one quarter before the start of quantitative easing policies.
  - Marginal demand has been pronounced among Asian investors, with flows from insurance and pension funds from Japan and Taiwan Province of China accounting for almost two-thirds of all foreign institutional flows into US investment-grade credit over the past three years.

### Emerging market and low-income country issuance, vulnerabilities
- Nonresident inflows of portfolio capital reached an estimated $205 billion in the year through August and are on track to reach $300 billion for 2017.
- Primary beneficiaries of portfolio inflows include Colombia, Mexico, South Africa, and Turkey.
- Some emerging markets have used inflows to enhance policy buffers in the form of higher international reserves.
- Emerging market sovereign gross and net issuance is at record levels; corporate gross issuance is back to 2013–14 levels, but net issuance remains subdued.
- Low-income countries have expanded access to international bond markets; bond issuance has risen sharply since the start of 2017, with the total volume $7.4 billion close to the record level in 2014.
- Low-income countries face less favorable borrowing conditions due to less liquid markets, weaker credit profiles, and lack of an issuance track record; borrowing has been used to fund infrastructure projects, refinance debt, repay arrears, and increase budgetary flexibility.
- This borrowing has been accompanied by an underlying deterioration in debt burdens.
- Many low-income-country issuers face a significant repayment hump after 2021; annual principal and interest repayments (as a percent of GDP or international reserves) have risen above levels observed in regular emerging market economy borrowers.
- Greater reliance on foreign borrowing leaves low-income countries vulnerable to a decompression of global risk premiums, reflecting higher total debt stocks, greater debt servicing needs, and high exposure to flight-prone foreign asset managers and hedge funds.

### Credit and market risk mispricing
- Low yields, compressed spreads, abundant financing, and high equity costs have encouraged a buildup of financial leverage as corporations have bought back equity and raised debt levels.
- The share of lower-rated companies in major US, European, and global bond indices has increased.
- Estimated default risk for high-yield and emerging market bonds has remained elevated.
- Despite declining credit quality, compensation for credit risk in key corporate bond markets has fallen.
- For every increase in the leverage multiple (debt/EBITDA), the spread received has declined sharply for both US dollar–denominated and emerging market bonds.
- Decomposition of bond yields suggests the amount of spread left for market risk has fallen, particularly for high-yield bonds.
- Market risk and term premiums would need to rise about 200 basis points for investment-grade bonds and about 450 basis points for high-yield bonds to reach average levels from 2000 to 2004.
- Market risk and term premiums would need to rise about 375 basis points for emerging market bonds.

*Source: Chapter 1, GLOBAL FINANCIAL STABILITY REPORT: IS GROWTH AT RISK?, International Monetary Fund, October 2017.*

### 1. International Sovereign Issuance of Low-Income

### 1. International Sovereign Issuance of Low-Income

### Sovereign issuance trends and market access
- Low-income sovereign bond issuance has risen sharply in 2017, nearing previous peaks.
- Market access conditions improved recently, but remain less favorable compared with other issuers.
- Low-income sovereign coupons at issuance and secondary emerging market yields show that issuance occurred despite relatively higher yields.

### Debt burden and servicing needs
- Debt burden indicators have deteriorated: interest to revenues and public debt measures for 2012–18 show worsening pressure.
- Sovereign international bond servicing needs: tighter external financial conditions would affect those with large rollover needs.
- Authorities in frontier markets and low-income countries should:
  - develop institutional capacity to manage risks associated with increased issuance of marketable debt securities;
  - formulate a comprehensive debt management strategy that incorporates exchange rate, interest rate, and liquidity risks associated with issuance of external debt;
  - explore liability management operations to mitigate refinancing risk;
  - ensure efficient use of borrowed funds by strengthening public investment management;
  - enhance investor relations programs to better understand and inform the international investment community regarding their debt issuance strategy.

### Bond market structure and risk decomposition
- Default risk compensation is estimated monthly by breaking down each index’s holdings into Standard & Poor’s (S&P) ratings buckets and deriving average cumulative default probability from S&P’s ratings transition tables; results are weighted by duration and ratings distribution of the corresponding index.
- Loss given default is assumed to remain constant at 60 percent.
- Index data sources: JPMorgan JULI ALL ex-EM index for investment-grade; JPMorgan Developed Market High Yield index for high-yield; JPMorgan EMBI Global index for emerging markets.

### Volatility, leverage, and liquidity mismatches
- Volatility is compressed: equity volatility touched record lows in 2017.
- Three main drivers of lower equity volatility:
  - stable macroeconomic fundamentals and accommodative monetary policy;
  - accommodative funding and liquidity conditions provided by monetary policy that leave volatility lower than in previous cycles;
  - stable corporate performance supporting steady investor earnings expectations.
- Large-cap companies have materially contributed to low realized volatility via stronger and more stable earnings, and increased payouts through dividends and stock repurchases.
- Low volatility can increase sensitivity to market risk by enabling investors to increase exposure and leverage.
- Volatility-targeting investment strategies:
  - Lower market volatility requires greater financial leverage to meet volatility targets.
  - During volatility spikes, these strategies can trigger substantial asset sales to reduce leverage.
  - A representative volatility-targeting investment strategy cut its global equity exposure drastically in August 2015.
  - The size of US equity holdings held by volatility-targeting investment strategies may be larger than $0.5 trillion today.
  - This is less than 2.5 percent of the market capitalization of all US publicly traded equities.
  - Estimates suggest selling from volatility-targeting funds accounted for between 9 and 16 percent of all trading volume in S&P 500 futures during August 24–26, 2015.
- Low-interest-rate environment increased bond market duration and sensitivity to interest rate changes:
  - Simulation of an immediate 100 basis point shock on long-term interest rates shows increasing impacts over time as duration has increased.
  - Projected losses to fixed-income mutual funds following a 100 basis point shock to interest rates are measured in billions of US dollars and vary across jurisdictions.
  - The Chicago Board Options Exchange Volatility Index (VIX) increased sharply to 40.7 percent on August 24, 2015, from 13.0 a week earlier.
- Liquidity mismatch concerns:
  - Mutual funds hold a greater share of the high-yield bond market than in the past.
  - Periods when cumulative losses on US high-yield bond benchmarks exceeded 5 percent are identified as typical triggers for stop-loss strategies.

### Regulatory, supervisory, and market-policy recommendations
- Regulators, supervisors, and firm management should:
  - maintain robust risk management standards across credit, business, and interest rate cycles;
  - closely monitor and assess financial institutions’ exposure to asset classes where search-for-yield has contributed to valuation pressure;
  - endorse a clear and common definition of financial leverage in investment funds;
  - improve data transparency, particularly with respect to derivatives;
  - strengthen supervisory frameworks relating to liquidity risk management by building on recent initiatives and recommendations to:
    - include greater flexibility in redemption and dealing frequency;
    - mark illiquid assets to market;
    - address the treatment of institutional investors;
    - provide better guidance on the use of particular risk management tools and enhanced disclosure requirements.
- For borrowers in frontier markets and low-income countries, specific actions include those listed under the "Debt burden and servicing needs" subsection above.

### The rise in leverage and G20 nonfinancial sector debt
- Aggregate G20 nonfinancial sector debt has risen to more than $135 trillion, or about 235 percent of aggregate GDP.
- Aggregate G20 debt-to-GDP ratios:
  - In G20 advanced economies, total nonfinancial sector debt now amounts to more than 260 percent of GDP.
  - In G20 emerging market economies, leverage growth has accelerated in recent years, driven largely by a huge increase in Chinese debt since 2007.
- About 80 percent of the $60 trillion increase in G20 nonfinancial sector debt since 2006 has been in the sovereign and nonfinancial corporate sectors.
- Much of the increase has been in China (largely in nonfinancial companies) and the United States (mostly from the rise in general government debt); each country accounts for about one-third of the G20’s increase.
- Average debt-to-GDP ratios across G20 economies have increased in all three parts of the nonfinancial sector.
- Net debt developments in G20 advanced economies since 2006:
  - General government net debt rose along with gross debt.
  - Nonfinancial private sector net debt fell as savings and higher asset prices built up financial assets more quickly than liabilities.

*International Monetary Fund | October 2017*

### CHAPTER 1 IS GROwTh AT RISk?

### CHAPTER 1 IS GROwTh AT RISk?

### Broad debt trends and composition
- Debt has been rising more quickly than GDP across the G20.
- Aggregate gross private nonfinancial debt has increased, with differing drivers across sectors (households, nonfinancial companies, general government).
- Distributional issues matter: aggregate data do not capture differences in the distribution of assets and liabilities across age groups or across firms.
- Sample and data notes:
  - Panel 6 analysis is based on a sample of more than 2,600 nonfinancial companies in continental Europe, Japan, the United Kingdom, and the United States.
  - Corporate credit model statistics are based on a sample of more than 41,000 companies.
- Figure observations (described in text):
  - Firms with higher debt tend to have lower cash holdings, and vice versa.
  - Advanced-economy private sector financial assets have risen, but cash is unevenly distributed among firms.

### Change in sectoral leverage and regional patterns
- Household leverage increases are broadly associated with lower borrowing costs and house price movements.
- Corporate debt increases occurred during loose financing conditions (low interest rates, buoyant market valuations, low volatility), which reduced contemporaneous model-based default probabilities but may mask risks if conditions reverse.
- Countries and sectors with notable debt-service pressure (text highlights):
  - Nonfinancial private sector: Australia, Canada, China.
  - Household sector: Korea.
- Debt accumulation and debt-to-GDP ratios are above precrisis levels in many regions and sectors.

### Debt servicing capacity and vulnerabilities
- Debt service ratios are defined as annualized interest payments plus amortizations as a percentage of income (Bank for International Settlements methodology).
- Despite low interest rates, nonfinancial private sector debt service ratios increased in many G20 economies.
- There are several major economies where debt servicing pressure in the private nonfinancial sector is already high; weaker households and companies in these countries could have trouble repaying debt if interest rates rise or incomes fall.
- Evidence on distributional pressures:
  - U.S. corporate sector: deterioration in interest coverage ratios for the most indebted, particularly in the energy sector (April 2017 GFSR referenced).
  - Emerging market economies: commodity companies and industrials comprised a significant proportion of firms with weak interest coverage ratios.
  - ECB 2017: distribution of household debt service ratios reveals greater vulnerability among more recent mortgage borrowers than aggregate figures indicate.
- Credit boom comparisons:
  - Australia’s boom resembles the average of past credit booms that did not lead to a financial crisis.
  - Canada’s boom has been longer than the average of benign past booms.
  - China’s boom has been steeper than the average of past credit booms that did coincide with a financial crisis.
- House-price link:
  - Chapter 2 finds the relationship between future GDP growth and household debt is driven mostly by mortgage debt.

### Policy recommendations to reduce private nonfinancial sector vulnerabilities
- Use an appropriate mix of macroprudential and microprudential policies, preemptive regulatory measures, and close monitoring of balance sheets.
- Household sector measures:
  - Reduce higher household debt burdens where debt servicing pressures are already high.
  - Prevent further growth where debt servicing is currently manageable but debt levels are elevated.
  - Possible tools: limits on debt-service-to-income and loan-to-value ratios, and measures to restrict loan contracts.
  - Policies should balance medium-term financial stability risks with not harming long-term financial inclusion and development.
- Corporate sector measures:
  - Vigilantly monitor nonfinancial corporate leverage.
  - Consider macroprudential measures extended through banks (for example, sectoral capital requirements or risk weights on foreign currency credit).
  - Tax reforms to reduce incentives for debt financing to attenuate further leverage buildup and encourage lowering existing tax-advantaged leverage.
  - Foster smooth corporate deleveraging, including strengthening corporate restructuring mechanisms.

### China — from derisking to deleveraging: challenges ahead
- Rapid rise in nonfinancial sector leverage and the size, complexity, and pace of growth in China’s financial system point to continued financial stability risks.
- Banking-sector metrics:
  - Banking sector assets are now 310 percent of GDP, nearly three times the emerging market average and up from 240 percent at the end of 2012.
- Drivers and risks:
  - Rapid increases in intrafinancial-system credit have been an important factor.
  - Growing use of short-term wholesale funding to boost leverage and profits has increased sensitivity to liquidity stress.
  - Shadow credit to firms and other nonfinancial borrowers—particularly by small and medium-sized banks—has increased opacity of intermediation and instability risks.
  - Shadow credit definition (from text): banks’ nonloan, nonbond credit to nonfinancial borrowers, including on-balance-sheet items (trust beneficiary rights, specialized asset management plans, and other structured assets) and off-balance-sheet items (bank-sponsored wealth management plans). Off-balance-sheet bank credit estimates equal 65 percent of outstanding wealth management plans after deducting portions that are claims on financial or public sector counterparties (as reported in China Bank Wealth Management Market Annual Report 2016).
- Recent policy actions and effects:
  - China introduced prudential and administrative measures (including the Macroprudential Assessment, MPA) to slow growth in banks’ supply of shadow credit, reduce dependence on interbank funding, and contain regulatory arbitrage.
  - Examples of measures include inclusion of wealth management products in MPA, counting negotiable certificates of deposit toward prudential limits on interbank liabilities, and tightening corporate bond collateral requirements for exchange-traded repurchase agreements.
  - On-balance-sheet shadow credit products at small and medium-sized banks declined sharply in late 2016 and early 2017.
  - Growth in off-balance-sheet shadow credit (wealth management products) recently reversed by the largest amount in the post-crisis period, coinciding with rising interbank and bond market interest rates and stalling corporate bond issuance.
- Policy trade-offs:
  - Curbing shadow credit could substantially reduce banks’ capacity to increase credit; authorities face a delicate balance between tightening financial sector policies and slowing credit growth.

*International Monetary Fund | October 2017*

### 1. Contribution to Bank Asset Growth

### 1. Contribution to Bank Asset Growth

### Intrafinancial System Credit and Shadow Credit Driving Bank Growth
- Intrafinancial system credit has driven bank growth, with shadow credit accounting for a large share of total new credit: 41%, 53%, 51% (year series shown in source).
- Shadow credit definition used: banks’ nonloan, nonbond credit to nonfinancial private borrowers, both on and off balance sheet.
- For a sample of 32 of China’s largest banking groups, shadow credit expansion outpaced loan growth over the past three years.
- Key figures and indicators:
  - Shadow credit growth assumption in scenario analysis: 27 percent year over year.
  - If banks expanded shadow credit by 27 percent, projected retained earnings would support total credit growth of 17 percent year over year.
  - If shadow credit growth were 0 percent (keeping shadow credit constant and increasing only loans), the same retained earnings would support credit growth of 11 percent (2017 total credit growth capacity figures shown as 11%, 8%, 7% under different assumptions).
  - New common equity announced for 2017: RMB 66 billion, about 2 percent of end-2016 common equity at small and medium-sized banks.

### Trade-offs Between Credit Growth and Financial Stability
- Banks face a trade-off: use retained earnings to support credit growth versus addressing vulnerabilities (increasing loss recognition, capital, and provisions).
- Projected effects of addressing vulnerabilities:
  - Increasing capital/provisions against a modest portion of existing shadow products would reduce credit capacity further.
  - Balance sheet vulnerabilities would recede only gradually at smaller banks and remain elevated relative to the biggest banks.
  - A 25 bps fall in ROA is noted in scenario schematics when shadow credit assumptions change.

### Derisking, Profitability, and Business Model Implications
- Shifting away from shadow credit products and interbank funding improves balance sheets over time but can decrease short-term profitability and weaken buffers at vulnerable banks.
- Bank earnings dynamics:
  - Net interest income from loans and deposits fell from 1.7 percent of assets in 2011 to 1.0 percent of assets in 2016.
  - Provision expenses have upticked, compressing earnings.
- Small and medium-sized banks
  - Have sustained profitability partly by shifting toward shadow credit activities; shadow-related income has grown and net fee and commission income has doubled since 2011 at smaller banks.
  - Shadow-credit-related income levels (illustrated in panels): values include negative and positive contributions (examples in source: –0.75, 0.63, 0.82, 1.05, etc. by year).
- Funding and liquidity mismatches:
  - Nondeposit funding maturing in less than one year rose to about 34 percent of assets, from 22 percent in 2011.
  - Over half of nondeposit funding now matures in less than three months.
  - Short-term nondeposit funding exceeds similar-maturity nonloan assets by about 6 percent of assets, or RMB 2.8 trillion.
  - Resultant maturity mismatch would require liquidating longer-term assets if short-term market funding materially reduces.

### Regulatory Actions, Reform Needs, and Policy Recommendations
- Regulatory tightening on lenders must be accompanied by reforms to reduce the economy’s vulnerability to slower credit growth.
- Recommended policy directions from the source:
  - Deepen efforts to improve banks’ risk management and reduce maturity and liquidity transformation risks in shadow credit activities.
  - Strengthen regulation to reduce shadow credit risks and regulatory arbitrage.
  - Target reducing balance sheet vulnerabilities at weak banks, including restricting dividend payouts.
  - Restructure or resolve nonviable financial institutions to support corporate debt restructuring and strengthen governance and risk management incentives.
  - Raise new equity to allow banks to strengthen provisions and capital without slowing credit growth, but pair recapitalization with reforms to improve risk management and governance.
  - On the borrower side, build on commitments to reduce corporate leverage, resolve nonviable firms, and improve credit efficiency.

### Global Financial Dislocation Scenario: Transmission and Macrofinancial Impacts
- Scenario structure:
  - Phase 1: Continuation of low volatility and compressed spreads; equity and housing prices climb; collateral values rise; favorable lending conditions continue.
  - Phase 2: Rapid decompression of risk premiums leading to asset repricing starting at the beginning of 2020.
- Scenario shock magnitudes and outcomes:
  - Equity prices decline up to 15 percent; house prices decline up to 9 percent (starting 2020).
  - The level of global output falls by 1.7 percent by 2022 relative to the WEO baseline.
  - The Federal Reserve reverses hikes and cuts the policy rate by 150 basis points to 1.75 percent by 2022 in the scenario.
  - The scenario is described as about one-third as severe as the global financial crisis.
- Cross-country and sector implications:
  - Euro area suffers larger output loss due to effective lower bound on policy rate and renewed financial fragmentation.
  - Emerging market economies are disproportionately affected: equity and bond outflows, currency pressure, and constrained monetary policy.
  - Corporate and household defaults rise but do not reach global financial crisis levels; default rates return to prior cyclical peaks.
  - Chinese banks suffer outsize declines in capital, though strong policy buffers could mitigate impacts.
  - Higher credit and trading losses reduce bank capital ratios to varying degrees worldwide.
- Portfolio flow and emerging market financing impacts:
  - Phase 1: Net reduction in portfolio inflows to emerging market economies of about $25 billion a year, compared with $35 billion under the baseline.
  - Phase 2: Asset market correction triggers retrenchment of about $65 billion over the first four quarters, in addition to the projected $35 billion reduction from Fed balance sheet normalization — combined reduction of about $100 billion during the first four quarters of the correction (and about $65 billion during the subsequent four quarters).
  - Country-level portfolio inflow reductions during the first two years range from 1.6 to 2.3 percent of GDP for the most affected countries.
  - Countries with projected current account deficits in the range of 3 to 4½ percent of GDP in 2019 (examples cited in the source) would be particularly challenged (source cites Colombia, South Africa, and Turkey as examples).

*Source: IMF staff; Global Financial Stability Report (October 2017), Chapter 1.*

### CHAPTER 1 IS GROwTh AT RISk?

### CHAPTER 1 IS GROwTh AT RISk?

### Emerging Market Capital Flows and Corporate Vulnerabilities
- US monetary normalization and a global asset market correction would increase capital outflow pressures.
- Estimated Cumulative Reduction in Emerging Market Portfolio Flows (Billions of US dollars) — referenced as Figure 1.31.
- Estimated Peak Reduction in Emerging Market Portfolio Flows (Percent of GDP, reduction over four quarters) — numeric values shown in source: 1.0, 4.0, 3.0, 3.5, 2.0, 1.5, 2.5, 4.5, 5.0, 5.5, 6.0.
- Countries that previously received large inflows may see sizable outflows.
- Current Account Balances (Percent of GDP) — outflows could be challenging for countries with large current account deficits.
- Corporate Leverage (Total debt to EBITDA, multiple) — high corporate leverage in some economies could amplify pressure.
- Country labels shown in source (ISO codes and names): ARG, IND, MEX, ZAF, TUR, ARG, BRA, CHN, IDN, RUS, BRA, CHN, IDN, RUS; and listed countries: Turkey, South Africa, Chile, Colombia, Indonesia, Brazil, Mexico, India, Poland, Russia, China, Malaysia, China, India, Brazil, Indonesia, Turkey, Poland, Colombia, Malaysia, Chile, Mexico, South Africa.
- Policy guidance for managing outflow pressures:
  - Handle primarily with macroeconomic, structural, and financial policies, with responses differing across countries depending on available policy space.
  - Where appropriate, exchange rate flexibility should be a key shock absorber.
  - In countries with sufficient international reserves, foreign exchange intervention can be useful to prevent disorderly market conditions.
  - In periods of stress, liquidity provision may be needed to support orderly functioning of financial markets.
  - Capital flow management measures should be implemented only in crisis situations, or when a crisis is considered imminent, and should not substitute for needed macroeconomic adjustment.
  - When used on outflows, such measures should be transparent, temporary, nondiscriminatory, and lifted once crisis conditions abate.
- Sources cited for figures and data: Bank of America Merrill Lynch; Bloomberg Finance L.P.; Capital IQ; Haver Analytics; and IMF staff calculations.
- Note: EBITDA = earnings before interest, taxes, depreciation, and amortization.

### Divergence Between Financial and Economic Cycles
- Prolonged monetary accommodation has contributed to a widening divergence between financial and economic cycles: rapid asset price inflation, gathering credit growth, rising leverage, and only slowly dissipating negative output gaps.
- Box 1.1 key country observations:
  - United States: A maturing financial cycle expansion combined with a slowly closing output gap. The combined growth of asset prices (equity, bond, property) since the recent recession has produced one of the longest and largest cyclical expansions since 1970. Credit growth has been gathering momentum.
  - Euro area: Strong asset price boom only slightly off recent peaks; credit growth slowly recovering; persistently large negative output gap—implying need for continued accommodative macroeconomic policies and tighter financial sector policies, as warranted.
  - Japan: Financial cycle more muted with weak economic recovery; asset price inflation volatile; recently stronger credit growth and narrowing of the negative output gap.
  - Other economies with high private nonfinancial sector debt service ratios (Australia, Brazil, Canada, China, Korea) require strong financial sector policy vigilance.
- Figure 1.1.1 components referenced:
  - Asset Cycle (Quarterly index, deviation of filtered real growth from its historical average)
  - Credit Cycle (Quarterly index, deviation of filtered real growth from its historical average)
  - Output Gap (Percentage points)
- Historical framing: US cycles compared to historical since 1970; cycles dated using National Bureau of Economic Research recession dates; methodology references Schüler, Hiebert, and Peltonen 2017.
- Data sources: Bank for International Settlements; IMF, World Economic Outlook database; national sources; and IMF staff estimates.

### Cyberthreats as a Financial Stability Risk
- Cyberthreats to financial institutions have grown in impact and sophistication in 2016 and 2017, with perpetrators adopting operational models that replicate legitimate businesses.
- Economic loss estimates: a hypothetical major global cyberattack estimated as high as $53 billion (Lloyds 2017).
- Notable incident: June 2017 “NotPetya” attack — information technology systems in Ukraine, including automatic teller machines, were rendered unusable; problems spilled across borders at a total global cost of some $850 million.
  - Example losses: two multinational companies estimated losses from NotPetya exceeding $130 million each.
- Cyberattack channels threatening financial stability:
  1. data breach
  2. disruption of business
  3. integrity attack (modifications to internal data)
  4. malicious activities (financial gain)
- Financial sector vulnerabilities:
  - Banks and financial market infrastructures (payment, clearing, and settlement systems) harbor potential for contagious cyberrisk due to interconnection.
  - Insurance companies are less exposed through connectedness but face indirect exposure through cyberinsurance underwriting risk.
- Trends and metrics:
  - Number of stolen identities rose 95 percent year over year in 2016 (Symantec).
- Regulatory and policy responses noted:
  - European Parliament adopted the directive on security of network and information systems.
  - European Banking Authority issued guidelines on information and communications technology risk assessment.
  - Bank of England launched a vulnerability testing framework and set out a supervisory statement on cyberinsurance underwriting risk.
  - Board of Governors of the Federal Reserve System, OCC, and FDIC jointly published a notice of proposed rulemaking regarding enhanced cyberrisk management standards.
  - Committee on Payments and Market Infrastructures and IOSCO issued cyberguidance for financial market infrastructures.
  - New York State Department of Financial Services issued Cybersecurity Requirements for Financial Services Companies.
  - EU General Data Protection Regulation, effective May 2018, will have significant global impact; fines can be up to 4 percent of yearly turnover or €20 million, whichever is greater.
- Policy recommendations and needs:
  - A global and coordinated policy response is needed to ensure resilience and combat cybercrime.
  - Harmonization of minimum standards is needed to smooth implementation for cross-border institutions.
  - Tackle cybercrime by attacking its business model and raising the risks of engagement in cybercrime, underpinned by stronger international coordination.
  - Regulation increasingly focuses on prevention, identification, timely recovery, information sharing, penetration and resilience tests, and harmonized minimum standards.
- Box prepared by Tamas Gaidosch and Chris Wilson.

*Source: CHAPTER 1 IS GROwTh AT RISk?, International Monetary Fund | October 2017*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2017/october/chapter-1/documents/c1.pdf_