## Preface

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---

### Outlook for Financial Stability
- Global financial conditions have tightened somewhat since the October 2017 Global Financial Stability Report (GFSR), reflecting the spike in equity market volatility in early February and investors’ jitters in late March about a wider escalation of trade tensions.
- Despite some tightening, global financial conditions remain broadly accommodative relative to historical norms across both advanced and emerging market economies.
- Easy financial conditions have supported the global economic recovery since the global financial crisis but continue to facilitate a buildup of financial fragilities that increase risks to global financial stability and economic growth over the medium term.

### Still‑Easy Financial Conditions Continue to Support Economic Growth
- Monetary policy authorities in advanced economies have started to, or are gearing up to, normalize their monetary policy stance; however, inflation has been “well below target” historically and market sentiment has been buoyant.
- The recent firming of inflation has provided policymakers with more leeway to address financial vulnerabilities through micro‑ and macroprudential tools.
- Growth‑at‑Risk (GaR) approach:
  - GaR identifies severely adverse growth outcomes as those that occur with a 5 percent probability (the “tail” of the distribution).
  - The model estimates output growth as a function of current economic and financial conditions, forecasts conditional distributions for different horizons, and compares changes in forecasted severely adverse outcomes across horizons.

### Short‑Term Risks Have Increased Somewhat; Medium‑Term Vulnerabilities Remain Elevated
- Under current financial conditions, the GaR model forecasts that, under the severely adverse outcome, global growth will fall to about 3 percent or less over the following year.
- The estimated three‑year‑ahead growth distribution has a much fatter left tail compared with the one‑year‑ahead distribution; given current conditions, GaR forecasts that, under the severely adverse scenario, global growth will be negative three years from now.
- Continued easing of financial conditions over the past two years has:
  - Improved near‑term economic prospects while
  - Worsening the medium‑term growth outlook (the intertemporal trade‑off illustrated by a downward‑sloping curve in GaR analysis).
- Comparison of GaR severely adverse medium‑term growth forecasts since the 1990s suggests that risks to medium‑term growth stemming from current easy financial conditions are well above historical norms.

### Key Near‑Term Shock Scenarios and Transmission Channels
- Faster‑than‑expected inflation in the United States (possibly owing to recent fiscal expansion) could prompt central banks to tighten monetary policy more forcefully, leading to:
  - Sharp tightening in financial conditions,
  - Adverse spillovers to other advanced and emerging market economies, and
  - Adverse effects on internationally active banks that rely on dollar funding.
- A wider escalation of protectionist measures would:
  - Reduce global output and welfare directly and indirectly by raising geopolitical tensions,
  - Shift the distribution of global growth outcomes to the left, and
  - Exert negative implications for global financial stability even before material trade impacts through reduced confidence and tightened financial conditions.

### Balance Sheet Vulnerabilities and Sectoral Developments
- High leverage and balance sheet mismatches amplify shocks to the financial system and economy.
- Leverage in the nonfinancial sector has been rising in many major economies and remains high, implying aggregate debt‑service ratios could deteriorate quickly once financial conditions tighten.
- Some economies with already‑high nonfinancial sector debt are experiencing faster house price growth.
- Banks have increased capital and liquidity buffers since the global financial crisis, indicating greater resilience, but they may still be vulnerable to funding shocks.
- Use of financial leverage outside the banking sector is rising.

_International Monetary Fund | April 2018 — Preface (c1)_

### Preface                                                                                                                 

### Preface

### Outlook for Financial Stability
- Global financial conditions have tightened somewhat since the October 2017 Global Financial Stability Report (GFSR), reflecting the spike in equity market volatility in early February and investors’ jitters in late March about a wider escalation of trade tensions.
- Despite some tightening, global financial conditions remain broadly accommodative relative to historical norms across both advanced and emerging market economies.
- Easy financial conditions have supported the global economic recovery since the global financial crisis but continue to facilitate a buildup of financial fragilities that increase risks to global financial stability and economic growth over the medium term.

### Still-Easy Financial Conditions Continue to Support Economic Growth
- Monetary policy authorities in advanced economies have started to, or are gearing up to, normalize their monetary policy stance; however, inflation has been “well below target” historically and market sentiment has been buoyant.
- The recent firming of inflation has provided policymakers with more leeway to address financial vulnerabilities through micro- and macroprudential tools.
- The Growth-at-Risk (GaR) approach links financial conditions to the distribution of future GDP growth outcomes:
  - GaR identifies severely adverse growth outcomes as those that occur with a 5 percent probability (the “tail” of the distribution).
  - The model estimates output growth as a function of current economic and financial conditions, forecasts conditional distributions for different horizons, and compares changes in forecasted severely adverse outcomes across horizons.

### Short-Term Risks Have Increased Somewhat, while Medium-Term Vulnerabilities Remain Elevated
- Under current financial conditions, the GaR model forecasts that, under the severely adverse outcome, global growth will fall to about 3 percent or less over the following year.
- The estimated three-year-ahead growth distribution has a much fatter left tail compared with the one-year-ahead distribution; given current conditions, GaR forecasts that, under the severely adverse scenario, global growth will be negative three years from now.
- Continued easing of financial conditions over the past two years has:
  - Improved near-term economic prospects while
  - Worsening the medium-term growth outlook (the intertemporal trade-off illustrated by a downward-sloping curve in GaR analysis).
- Comparison of GaR severely adverse medium-term growth forecasts since the 1990s suggests that risks to medium-term growth stemming from current easy financial conditions are well above historical norms.

### Key Near-Term Shock Scenarios and Transmission Channels
- Faster-than-expected inflation in the United States (possibly owing to recent fiscal expansion) could prompt central banks to tighten monetary policy more forcefully, leading to:
  - Sharp tightening in financial conditions,
  - Adverse spillovers to other advanced and emerging market economies, and
  - Adverse effects on internationally active banks that rely on dollar funding.
- A wider escalation of protectionist measures would:
  - Reduce global output and welfare directly and indirectly by raising geopolitical tensions,
  - Shift the distribution of global growth outcomes to the left, and
  - Exert negative implications for global financial stability even before material trade impacts through reduced confidence and tightened financial conditions.

### Balance Sheet Vulnerabilities and Sectoral Developments
- High leverage and balance sheet mismatches amplify shocks to the financial system and economy.
- Leverage in the nonfinancial sector has been rising in many major economies and remains high, implying aggregate debt-service ratios could deteriorate quickly once financial conditions tighten.
- Some economies with already-high nonfinancial sector debt are experiencing faster house price growth.
- Banks have increased capital and liquidity buffers since the global financial crisis, indicating greater resilience, but they may still be vulnerable to funding shocks.
- Use of financial leverage outside the banking sector is rising.

_International Monetary Fund | April 2018 — Preface (c1)_

### 1. Percentiles of One-Year-Ahead Growth Forecast Densities

### 1. Percentiles of One-Year-Ahead Growth Forecast Densities

### Growth-at-Risk and Horizon Differences
- Supportive financial conditions tend to dampen near-term risks; growth-at-risk forecasting the severely adverse outcome (for example, with 5 percent probability) for global growth at about 3 percent or less one year ahead.
- The three-year-ahead growth distribution has a much fatter left tail than the one-year-ahead growth distribution.
- Medium-term risks to growth have increased in recent years and are well above historical norms, given the current financial conditions.

### Financial Conditions, Monetary Normalization, and Vulnerabilities
- A prolonged period of low interest rates has fueled search for yield and compressed market risk measures.
- Central banks must strike a balance between gradually withdrawing monetary policy accommodation and avoiding disruptive volatility in financial markets; clarity in central bank communications is important.
- The buildup of financial vulnerabilities over the past few years has left financial markets exposed to the risk of a sharp tightening of financial conditions as central banks withdraw accommodation.
- Decompression of term premiums may cause an abrupt tightening of financial conditions when central banks raise short-term interest rates and shrink balance sheets.

### Term Premiums, Signaling, and Model Assessment
- In the United States, the Federal Reserve has increased the federal funds rate six times since December 2015; yet the term premium remains near historical lows, and financial conditions have continued to ease.
- Factors that may explain muted effects on term premiums include:
  - Liquidity considerations: the first asset purchase program had a larger effect than subsequent programs.
  - Central bank purchase programs may have “structurally” lowered term premiums, especially in the current environment of lower equilibrium policy rates.
  - The signaling channel of balance sheet reduction may be muted compared with the signaling effects of asset purchases.
- Model estimates suggest that term premiums are not too low: term premiums are broadly in line with investors’ expectations for growth, inflation, and the current stance of monetary policy.
- The estimated term premium has remained near the lower bound of fitted model values over the past few years, in line with the large-scale monetary accommodation needed to support the economic recovery.
- The gap between the estimated and the model-based weighted-average estimated term premiums has been closing recently, but term premiums are significantly vulnerable to revisions in expectations about inflation, growth, or the path for monetary policy.

### Inflation Risks and Market Pricing
- Uncertainty about future inflation outcomes has diminished in tandem with declining term premiums.
- Markets are not pricing in a risk of sharply higher inflation over the next few years.
- An upside surprise to inflation (for example, faster-than-expected inflation in the United States) could lead the Federal Reserve to withdraw accommodation faster, potentially causing term premiums to decompress, risk premiums to rise, and global financial conditions to tighten sharply.

### Emerging Market Vulnerabilities and Spillovers
- Emerging markets are vulnerable to spillovers from an abrupt tightening in global financial conditions.
- Under realistic assumptions, portfolio flows to emerging markets could fall by at least one-quarter in a tightening cycle accompanied by a rise in investor risk aversion, increasing rollover risks and the cost of funding.
- Correlations among sovereign term premiums of major economies (Canada, Germany, Japan, United Kingdom, United States) indicate they move very closely together even as investors’ expectations for policy rate paths have diverged.
- Model estimates indicate elevated spillovers between G4 (Germany, Japan, United Kingdom, United States) term premiums, with spillovers from the United States to the other countries mainly dominating.
- Rapid decompression of term premiums could quickly spill over to global markets; spillovers from a faster withdrawal of US Federal Reserve accommodation following an inflation surprise could tighten US and global financial conditions and force other major central banks to respond through additional accommodation.

*Source: c1 - 1. Percentiles of One-Year-Ahead Growth Forecast Densities (PDF chapter/section).*

### 1. Term Premiums and Expected Rate Correlations

### 1. Term Premiums and Expected Rate Correlations

### Continued Clear Monetary Policy Communication Is Essential to Avoid Market Disruptions
- Gradual removal of monetary accommodation and clear communications will help anchor market expectations and prevent undue volatility.
- To support the recovery and ensure inflation objectives are met, monetary authorities should maintain accommodation, as needed.
- When normalizing policy, central banks should do so in a gradual and well-communicated manner.
- Central banks should provide guidance on prospective changes to policy frameworks if such changes are warranted.
- Gradualism and clear communications are crucial given the confluence of still relatively low inflation, easy global financial conditions, and rising financial vulnerabilities.
- To address the buildup in financial vulnerabilities and avoid putting growth at risk, policymakers should also deploy and develop appropriate micro- and macroprudential tools.

### Term premiums and expected rate correlations (figure notes)
- Panels referenced include Spot US Dollar Exchange Rate Betas: Euro and Spot US Dollar Exchange Rate Betas: British Pound (figures show betas across sample periods).
- Percent explained by first principal component is shown for "Term Premiums and Expected Rate Correlations."

### Sensitivity of currencies
- "the sensitivity of currencies to expected short rate differentials has remained elevated in recent years (Figure 1.6, panels 3 and 4)."
- "This finding holds both on average over the past 20 years and for estimates for the latest sensitivity."

### Note on methodology
- "Based on estimated dynamic correlations following Cappiello, Engle, and Shepphard (2006)."

---

### Financial Vulnerabilities: Reach for Yield or Overreach in Risky Assets?

### Overview and policy dilemma
- "Against a backdrop of mounting vulnerabilities, risky asset valuations appear overstretched, albeit to varying degrees across markets, ranging from global equities and credit markets, including leveraged loans, to rapidly expanding crypto assets."
- "The increasing use of financial leverage to boost returns and the growing influence of some passive investment vehicles, particularly exchange-traded funds (ETFs) in less liquid underlying markets, could amplify the impact of asset price moves on the financial system."
- Key questions posed:
  - "the extent to which financial vulnerabilities have increased since the previous GFSR"
  - "how the constellation of current accommodative financial conditions and vulnerabilities compares with past episodes of financial stress"
  - "whether asset valuations appear stretched, given current cyclical conditions"
- Policy implication:
  - If valuations are not significantly out of line, "policymakers can continue to normalize monetary policy gradually and to implement macroprudential and other regulatory measures aimed at lessening financial stability risks."
  - If asset misalignments are significant and may put growth at risk, "a more forceful policy response may be needed."

---

### Equity Valuations Remain Expensive

### Key findings
- "The ongoing global economic recovery, strong corporate performance, and still-low interest rates have supported equity prices, on balance, since the previous GFSR (Figure 1.7, panel 1)."
- United States equity market capitalization:
  - "has risen from 95 percent of GDP in 2011 to 155 percent of GDP in March 2018."
- "Rising global equity prices have supported a moderate rebound in new issuance, especially in emerging markets (Figure 1.7, panel 2)."
- Valuation metrics:
  - "Standard price-to-earnings and price-to-book valuation metrics remain elevated in most regions (Figure 1.7, panel 3)."
  - "For the United States, these measures remain relatively high compared to both historical levels and current valuations in other countries."
  - "Cyclically adjusted price-to-earnings, continue to support this assessment, even after the volatility spike in February and the slide in equity prices in March on concerns about trade tensions (Figure 1.7, panel 4)."
- Equity risk premium considerations:
  - "Some measures of the US equity risk premium, in which equity valuations are conditional on the level of interest rates, suggest that shares have been closer to fair value."
  - "Strong near-term earnings expectations, as well as historically low interest rates, sustain comparatively wide equity risk premiums (Figure 1.7, panel 5)."
  - "This approach is highly sensitive to profit forecasts as well as to different assumptions about the discount factor."
  - "Equity valuations deteriorate under alternative, less sanguine proxies for earnings, such as longer-term averages or nominal GDP growth."
  - "Higher projected paths for interest rates similarly narrow the equity premium and imply richer valuations (Figure 1.7, panel 6)."

---

### Corporate Bond Valuations Are Stretched and Credit Quality Is Deteriorating in Risky Segments

### Key findings
- "With central banks in advanced economies continuing to lift policy rates from the nominal lower bound or signaling a not-too-distant commencement of the normalization process, the share of negative-yielding global bonds has dipped lower since the October 2017 GFSR."
- "This ratio, however, remains significant (Figure 1.8, panel 1)."
- "Against a backdrop of low default rates, corporate spreads remain at very low levels, even in the riskiest segments (Figure 1.8, panel 2)."
- "Favorable financial conditions have boosted corporate bond issuances. Issuance of riskier bonds has surged, and the share of lower-grade bonds (BBB-rated) in the investment-grade universe has been rising (Figure 1.8, panel 3)."
- Profitability and leverage:
  - "Strong economic growth and corporate restructuring efforts, particularly in the energy sector, have supported corporate profitability; and debt ratios—while still high—have edged lower, especially in China and other emerging markets (Figure 1.8, panel 4)."
  - "Effective interest rates paid by the corporate sector moved higher, particularly outside the United States. As a result, interest coverage ratios have dipped everywhere except China and the United States (Figure 1.8, panel 5)."
- US tax reform implications:
  - "Most US companies will gain from the reform."
  - "The cap on the tax deductibility of interest expense will reduce incentives for debt financing, which tends to affect highly leveraged companies disproportionately (Figure 1.8, panel 6)."
  - "These firms may face funding pressures because of higher interest expenses, more volatile earnings, and a more compressed schedule for adapting their funding structure to the new tax code."

---

### Signs of Overheating in the Leveraged Loan Market

### Market size and issuance
- "Global leveraged loan issuance hit a record high in 2017 of $788 billion, surpassing the precrisis high of $762 billion in 2007."
- "Most issuance occurred in the United States, amounting to $564 billion (Figure 1.9, panel 1)."
- "Since 2007, US institutional leveraged loans outstanding have doubled to almost $1 trillion, compared with $1.3 trillion in US high-yield bonds outstanding."

### Use of proceeds and deal structure
- "While refinancing volumes have been significant given the low-interest-rate environment, borrowing to fund mergers and acquisitions, leveraged buyouts, dividends, and share buybacks still accounts for half of total issuance amid improving global growth (Figure 1.9, panel 2)."
- Covenant quality and recovery:
  - "Covenant protections have weakened over time ...... leading to potentially lower recovery rates in the next default cycle."
  - "Loan issuance reached record highs in 2017 ..."
  - "Covenant-lite percent of new issuance (left scale) and Moody’s loan covenant quality index score (right scale) are tracked; a higher Covenant Quality Index score represents weaker covenant protections."
  - "Average Annual First Lien US Loan Implied Recovery Rates (Percent) are shown, with implied recovery rates based on loan prices one month after default."
- Market structure shifts:
  - "Highly leveraged loan deals have increasingly been arranged by nonbank lenders ..."
  - "Fraction of US deals with a nonbank entity as lead agent (Percent) is shown."
  - "Percent of US deals with EBITDA adjustments: 69% average; 82% average." 

---

*Italic line: c1 - 1. Term Premiums and Expected Rate Correlations — c1.pdf, Chapter 1 excerpt*

### CHAPTER 1 A BuMPY ROAd AhEAd

### CHAPTER 1 A BuMPY ROAd AhEAd

### Leveraged Loan Market: issuance, terms, and credit quality
- Strong issuance and lofty valuations have loosened price and nonprice terms and weakened credit quality.
- Percentage of new loan issuance in the United States rated single-B or lower increased from about 25 percent in 2007 to 65 percent in 2017.
- Covenant-lite loans made up 75 percent of new institutional loan issuance in 2017.
- Average debt cushion of first-lien covenant-lite loans is now only 15 percent, down from about 33 percent before the financial crisis.
- Average recovery rate for defaulted loans in the current cycle is 69 percent, compared with the precrisis average of 82 percent.
- Weakening investor protections include looser covenants, thinner subordination, EBITDA add-backs and adjustments that conceal deteriorated leverage metrics; new loans with EBITDA add-backs or adjustments have reached new highs.
- Regulatory actions in the United States and Europe have aimed at curbing market excesses; an unintended consequence appears to be migration of activity away from banks toward institutional investors (for example, collateralized loan obligations, bank loan mutual funds, private equity firms, and other private funds).
- Institutional leveraged loans outstanding have grown rapidly, with institutional investors increasingly playing an important role in highly leveraged loan deals.

### The price of volatility and correlations
- Implied volatilities derived from equity options spiked sharply during the February equity market turmoil; the VIX term structure shifted higher and briefly inverted.
- Near- and longer-term equity options appear close to, if not below, levels consistent with volatility forecasts, implying the premium investors require to compensate for volatility risks was little changed.
- Correlations have rebounded from subdued levels:
  - Within the US stock market, correlations between individual stocks and across sectors picked up after major tax legislation and increased further after the February 2018 spike in volatility.
  - Global equity market correlations rebounded in recent months, even before the drop in global share prices.
  - Broader correlations across asset classes have increased, suggesting global diversification has become somewhat more difficult.
- Market turnover has been relatively low, especially for high-yield bonds, which may compound price discovery distortions and illiquidity in the future.
- Structural changes in the investment management industry (decline in broker-dealer intermediation and greater role for non-bank sector) have not been tested during a significant market downturn.

### Increasing use of financial leverage: measures and trends
- Synthetic collateralized debt obligations (CDOs):
  - Synthetic CDO issuance estimated to have surged to between $80 billion and $100 billion in 2017, up from about $20 billion a year in 2014–15.
- Margin debt:
  - Margin debt from stock borrowing stands at a record $580 billion in the United States, about 2 percent of overall market capitalization as of the end of 2017.
  - Current net exposure of investors involved in stock margin borrowing is at record negative highs relative to overall market capitalization compared with the past 25 years.
- Use of financial leverage by investment funds:
  - Assets under management of large regulated bond investment funds that actively use derivatives have increased to more than $1.5 trillion, about 17 percent of the world’s bond fund sector.
  - Average derivatives leverage (gross notional exposure as a percentage of net asset value) of an asset-weighted sample of more than 200 US- and European-domiciled bond funds has risen from 215 percent to 268 percent of assets over the past four years.
  - Distribution of embedded derivatives leverage across funds: bottom 25th percentile in the 100 to 150 percent range; top 25th percentile between 300 and 2,800 percent.
- Data and oversight gaps:
  - No disclosure requirements for detailed leverage information for regulated investment funds in the United States; requirements exist only on a selected basis in some European countries.
  - Implementing comprehensive and globally consistent reporting standards across the asset management industry is recommended to give regulators better data to locate leverage risks; reporting standards should include enough information on derivatives to show funds’ sensitivity to large moves in underlying rate and credit markets.

### Growth in less liquid bond ETFs and liquidity-mismatch risks
- Assets under management of ETFs invested in less liquid assets—bank loans and high-yield and emerging market bonds—have risen rapidly to more than $140 billion.
- The share of high-yield bond and emerging market bond ETF assets is still small (less than 5 percent of the total market value of underlying bond markets) but more than tripled from 2010 to 2017.
- ETFs can enhance price discovery, provide exchange-traded liquidity, facilitate hedging and diversification, and charge lower fees; about one-fifth of transactions in high-yield and emerging market bond ETFs prompt a corresponding transaction in the underlying market.
- Potential risks from ETFs investing in less liquid bonds:
  - Frequent trading: ETF flows are very volatile; monthly ETF outflows often exceed 3 percent (of assets), compared with a maximum monthly outflow of 2.5 percent (of assets) from high-yield bond investment funds in October 2008.
  - Sensitivity to changes in risky asset prices: High-yield and emerging market bond ETFs show higher sensitivity to S&P 500 returns than their underlying indices, suggesting ETFs investing in illiquid assets may increase contagion risk and amplify price moves during stress.
  - Greater investment in passive strategies, such as ETFs, may be related to the rise in cross-asset correlations during periods of stress, increasing the likelihood that benchmark-focused investors are driven by common shocks rather than idiosyncratic fundamentals.

_International Monetary Fund | April 2018 — CHAPTER 1 A BuMPY ROAd AhEAd_

### 1. Assets under Management of ETFs Invested in Global High-Yield,

### 1. Assets under Management of ETFs Invested in Global High-Yield, Bank Loan, and Emerging Market Bonds

### ETFs, market liquidity, and investor behavior
- Finding: "ETFs invested in less liquid bond markets are receiving strong inflows ... and ETFs are owning a growing share of the underlying markets."
- Finding: "their investor base is significantly more flight prone ... Although ETFs can provide additional liquidity to the less liquid bond markets ... and their greater sensitivity to major liquid markets increases contagion risks."
- Statistic: "3 percent (of NAV) outflows" (presented in the source as an annotated observation).
- Finding: "Ratio of Average Trading Volume to Shares Destroyed or Created for US High-Yield and EM Bond ETFs (Six-month moving average)" is discussed in the charts (dates shown 2008–2018), indicating increased trading activity relative to creations/redemptions over the sample period.

### Policy recommendations on financial vulnerabilities and macroprudential response
- Regulators and market participants should "avoid complacency and be mindful of the risk of sudden bouts of extreme volatility."
- Regulators should ensure financial institutions "maintain robust risk management standards, including through the close monitoring and assessment of exposures to asset classes deemed to be overvalued."
- Given "signs of late-stage credit cycle dynamics, policymakers should use the macroprudential tools at their disposal more actively."
- Regulators should "improve credit risk monitoring, also focusing on deterioration of nonprice terms and investor protection."
- Regulators should "be mindful of the unintended consequences of regulatory measures, including migration of activity toward more opaque segments of the financial system."
- Macroprudential toolkit expansion recommendations for the nonbank financial sector:
  - "Endorse a clear and common definition of financial leverage in investment funds: This definition would improve transparency, particularly for derivatives positions."
  - "Continue to strengthen supervisory frameworks for liquidity risk management in investment funds" and monitor "the effectiveness of existing liquidity risk management tools used by fund managers."
  - Authorities "across different jurisdictions agree on a harmonized and coherent macroprudential approach to the financial stability risks stemming from investment fund activities, including the possibility of conducting stress test exercises."

### Crypto assets: size, characteristics, and observed metrics
- Finding: "crypto assets have erupted onto the financial landscape and their prices have skyrocketed."
- Finding: "Some of the technological advances behind them have the potential to increase the efficiency of payment systems and the financial infrastructure."
- Finding: "At present, crypto assets do not appear to pose macrocritical financial stability risks."
- Statistic: "Their total market value is less than 3 percent of the combined G4 central bank balance sheets."
- Statistic: "Bitcoin alone accounts for 47 percent of crypto assets’ market value, while the next two largest crypto assets, Ethereum and Ripple, account for 15 percent and 8 percent, respectively."
- Statistic: "More than 180 CEs are transacting in thousands of different coins across jurisdictions, adding up to an average daily volume of $30 billion."
- Statistic: "The top 14 CEs account for more than 80 percent of reported volume."
- Statistic: "The top 10 crypto assets account for 82 percent of the total reported volume."
- Statistic: "Among currency pairs with fiat currency on one side, the US dollar dominates with 71 percent of volume, followed by the yen and the euro with about 14 percent and 11 percent, respectively."
- Statistic: "Futures volumes ... only 2.3 percent of reported trading in the Bitcoin cash market on CEs (Figure 1.14, panel 4)."
- Finding: "Even after accounting for recent price corrections, crypto assets have experienced spectacular appreciation over the past year."
- Finding: "After accounting for price volatility, risk-adjusted returns have not dramatically exceeded those of mainstream assets over the medium term, though they have in the most recent year."
- Finding: "The unconditional correlation between Bitcoin and other asset classes was close to zero between September 2015 and March 2018."
- Finding: "Pairwise correlations between different crypto assets are comparatively subdued" (see covariance matrices reported).

### Financial stability risk assessment for crypto assets
- Current assessment: "At present, crypto assets do not appear to pose risks to financial stability."
- Monitoring priorities highlighted in the source:
  - Leveraged trading:
    - "CEs have set generous limits on leveraged positions, in some cases reportedly 15 times, 25 times, and even 100 times (Deutsche Bank 2017)."
    - Industry contacts indicate "actual average leverage tends to be between 3 and 8 times."
    - Concern: "sudden depreciations prompt margin calls and amplify price moves."
  - Integration into mainstream financial products:
    - "The proliferation of crypto-asset-related investment funds, ETFs, and futures contracts increases the opportunities for mainstream investors to incorporate these assets into their portfolios."
    - Risk: "this broadening of the investor base could result in increased correlation between crypto assets and traditional assets over time, increasing the potential for transmission of shocks."
  - Partial disintermediation of the banking system:
    - Risk: "A large shift away from fiat money toward crypto assets could add challenges to banks’ business models" and could curtail "the ability of central banks to function as a lender of last resort."
  - Cross-border considerations:
    - "The lack of transparency in the markets and the rapid pace of growth could cause market disruptions. Those disruptions could be transmitted across national boundaries given the borderless nature of the underlying transaction mechanisms."
- Additional operational and market risks:
  - "Crypto assets have been afflicted by notorious cases of fraud, security breaches, and operational failures and have been associated with illicit activities."
  - "Dedicated crypto-asset exchanges (CEs) provide liquidity, leverage, and custodial services" but "CEs are a major source of risk for investors, given their opaque and often unregulated nature."
  - Data and reporting caveat: "Data on trading volumes can be unreliable, especially since CEs operate under heterogeneous rules with different fee structures, investor bases, and levels of regulatory oversight."

### Key statistics and figures (as reported)
- "3 percent (of NAV) outflows"
- "less than 3 percent" (crypto assets' total market value as share of combined G4 central bank balance sheets)
- "47 percent" (Bitcoin share of crypto assets’ market value)
- "15 percent" (Ethereum share)
- "8 percent" (Ripple share)
- "$30 billion" (average daily volume across CEs)
- "more than 180 CEs"
- "top 14 CEs account for more than 80 percent of reported volume"
- "top 10 crypto assets account for 82 percent of the total reported volume"
- "71 percent" (USD share among fiat pairs)
- "about 14 percent" (yen share)
- "about 11 percent" (euro share)
- "2.3 percent" (futures volumes as share of reported trading in the Bitcoin cash market on CEs)
- "15 times, 25 times, and even 100 times" (reported leverage limits on some CEs)
- "3 and 8 times" (industry contacts indicate actual average leverage tends to be between these values)

*Source: IMF Global Financial Stability Report: A BuMPY ROAd AhEAd (April 2018), Chapter 1.*

### 2. Reported Volumes by Cryptocurrency, March 2018

### 2. Reported Volumes by Cryptocurrency, March 2018

### Composition of reported volumes and market concentration
- Cryptocurrency market shares (percent):
  - Bitcoin 39%
  - Tether 14%
  - Ethereum 11%
  - Ripple 4%
  - Litecoin 3%
  - EOS 3%
  - Bitcoin Cash 3%
  - Ethereum Classic 2%
  - TRON 2%
  - Storm 1%
  - Others 19%
- Exchange concentration milestones:
  - 95 percent volume = 36 exchanges (20 percent of total)
  - 80 percent volume = 14 exchanges (8 percent of total)
  - 60 percent volume = 7 exchanges (4 percent of total)
- Noted development: Composition of reported volumes has shifted away from the Chinese exchanges.

### Bitcoin volumes by fiat currency and futures activity
- Reported fiat currency composition for Bitcoin highlights major trading currencies, including:
  - Chinese renminbi
  - Korean won
  - Euro
  - Japanese yen
  - US dollar
  - Others
- Bitcoin futures:
  - Bitcoin futures volumes remain low.
  - Charted measure: Ratio of volumes traded in futures versus cash; average ratio shown with low values across December 2017–March 2018 dates.
  - Policy/regulatory actions (context): People’s Bank of China crackdown on cryptoexchanges noted as a market development.

### Investor protection and anti–money‑laundering (AML) concerns
- Investor protection risks identified:
  - Heightened potential for fraud, especially around ICOs targeted to retail investors by parties located outside the investor’s home jurisdiction.
  - Cross-border distribution risks due to heterogeneous regulatory regimes.
  - Information asymmetries, technological flaws, and liquidity risks partly caused by lack of reliable market makers and opaque trading practices.
- AML and countering financing of terrorism (CFT) concerns:
  - Crypto‑asset transactions entail a high degree of anonymity, creating a potentially major new vehicle for money laundering and the financing of terrorism.
  - Preventive measures recommended include reporting requirements, customer due diligence, and transaction monitoring to provide safeguards comparable to traditional money.

### Policy responses, regulatory divergence, and recommended actions
- Regulatory divergence noted across jurisdictions:
  - United States: Commodity Futures Trading Commission sees crypto assets as a commodity; Internal Revenue Service considers them property; Securities and Exchange Commission (SEC) has acted on a case‑by‑case basis, including by halting some ICOs.
  - Switzerland: Guidelines issued to regulate ICOs based on economic function and token purpose, tradability, and transferability.
  - China and Korea: Have cracked down on some trading activities.
- Recommendations for future policymaking:
  - Policymaking should be nimble, innovative, and cooperative.
  - IMF’s role: offer advice and serve as a forum for discussion and international collaboration.
  - National authorities and international standard setters encouraged to intensify cooperation on monitoring crypto assets and on the consistency of regulatory approaches.
  - Immediate action needed to close data gaps that inhibit effective monitoring of potential risks and their links to the core financial system.
  - Support systemic risk assessment and timely policy responses; underpin measures to protect consumers, investors, and market integrity.
  - Draw out common elements of effective regulatory approaches to facilitate consistent international cooperation. Suggested common elements include good practices and regulatory requirements to:
    - promote the transparency and integrity of ICOs;
    - strengthen risk management and robustness of crypto‑asset exchanges.

### Contextual link to broader financial stability themes
- Crypto‑asset risks are presented alongside broader vulnerabilities in emerging markets, low‑income countries, and China, where financial stability risks persist and national regulatory approaches differ, creating potential channels for cross‑border spillovers and regulatory arbitrage.

*International Monetary Fund | April 2018*

### CHAPTER 1 A BuMPY ROAd AhEAd

### CHAPTER 1 A BuMPY ROAd AhEAd

### Rising Debt Vulnerabilities and More Complex Creditor Composition
- More than 45 percent of LICs are at high risk or in debt distress.
- Composition shifts:
  - Increase in Eurobonds and commercial loans with shorter maturities exposes issuers to higher rollover and interest rate risk.
  - New private-sector creditors include investors who may not specialize in sovereign debt and may withdraw if higher-yielding opportunities in traditional hard-currency assets (for example, US high yield) arise.
  - Use of collateralized debt (including pledging commodity shipments or issuing senior loans through state-owned enterprises) can grant holders of collateralized debt favorable treatment, impair renegotiation of unsecured debt, and require larger haircuts on remaining debt.
- Recent debt distress cases highlighted with collateralized lending include Chad, Republic of Congo, and Venezuela; details on collateralized deals remain scant.
- Findings from studies cited:
  - Bräutigam, Gallagher, and Hwang (2016) find that one-third of Chinese loans to Africa are secured by commodity exports.
  - Bräutigam and Gallagher (2014) find that roughly half of the $132 billion in Chinese financing to Latin America and Africa is commodity backed.
- Sovereign protections:
  - Sovereign states typically have immunity for noncommercial activities in international courts; the United States (Foreign Sovereign Immunities Act) and the United Kingdom (State Immunity Act) formalize this immunity.

### Policy Recommendations to Address Rising Debt Vulnerabilities
- Reduce vulnerabilities related to debt structure and attract a stable investor base, including through local bond market development.
- Debt managers should minimize risks from:
  - rollovers,
  - potential foreign exchange mismatches,
  - collateralization.
- Explore state-contingent debt instruments to offer protection against unforeseen shocks such as natural disasters, assuming reasonable pricing by investors (IMF 2017b).
- Official creditors should:
  - emphasize timely resolution of debt distress cases to avoid spillovers and minimize costs for issuer and creditors,
  - encourage transparent and broad creditor coordination when lenders are diverse,
  - consider adopting sustainable lending rules, such as those endorsed by the Group of 20.
- Borrowers and official creditors should ensure transparency of contractual terms for new debt, including debt issued by entities related to the sovereign.

### Shadow Banking Reform and Systemic Risk in China
- Size and linkages:
  - China’s banking system: RMB 250 trillion (300 percent of GDP).
  - Investment products outstanding: RMB 75 trillion.
  - Investment products are largely funded through issuance, with roughly half sold to multiple investors as high-yielding alternatives to bank deposits and half held by single investors, including banks.
- Investment vehicles:
  - Invest in bonds, bank deposits, nonstandard credit assets, and other investment products.
  - Insurance companies have considerable exposure by investing in these products and using them as funding sources.
  - Investment vehicles are little-regulated and create a complex web of exposures across financial institutions.
- Bank exposures and implicit guarantees:
  - Banks are exposed as investors, creditors, borrowers, guarantors, and managers.
  - Small and medium-sized banking institutions: investment products account for one-fifth of their assets.
  - Insurance companies: investment products account for one-third of their assets.
  - About one-quarter of investment vehicle assets are invested in other vehicles, creating opaque cross-holding and leverage structures.
  - Banks are seen as implicitly guaranteeing RMB 25 trillion in investment products they manage.
- Regulatory response:
  - Since summer of 2016, regulators have incorporated bank-sponsored investment vehicles in the macroprudential framework and taken steps to curb financial sector leverage and interconnectedness.
  - Proposed asset management rules beginning in 2018 would:
    - limit investment vehicle leverage and complexity,
    - gradually restrict banks from investing in or providing financial support to these vehicles,
    - effectively convert roughly half of the market from deposit-like products into mutual funds.
  - Insurance regulator has clamped down on sale of short-term investment products by life insurers.

### Chinese Banks: Deleveraging Progress and Remaining Risks
- Regulatory tightening outcomes:
  - Growth of banks’ exposure to other financial institutions fell from about 80 percent on an annual basis in 2016 to less than 20 percent at the end of 2017.
  - Banks’ holdings of investment products issued by other banks have declined sharply.
- Remaining vulnerabilities:
  - Bank buffers continue to thin for many commercial banks.
  - Core Tier 1 capital ratios are declining and remain near minimum levels for many small and medium-sized banks.
  - Preprovision profitability continues to weaken.
- Funding and liquidity:
  - Money market rates have risen sharply, leading to wider corporate bond spreads, particularly for weaker borrowers.
  - Reliance on short-term nondeposit funding remains high for small and medium-sized banks.
  - Short-term wholesale liabilities at smaller banks are still more than double available liquidity buffers.
- Specific metrics and observations:
  - Eight banks (including four of the Big Five lenders) disclose active direct lending to their investment vehicles, accounting for nearly half of the bank-managed investment product market (more than RMB 10 trillion in non-principal-guaranteed wealth management products).
  - This lending was equivalent to 15 percent of these banks’ core Tier 1 capital as of mid-2017.

### Reforming China’s Investment Product Market and Adjustment Challenges
- Role of investment vehicles in repo and bond markets:
  - Investment vehicles are the largest net borrower in China’s repurchase market, often using relatively illiquid collateral.
  - Direct lending by large banks to their sponsored vehicles amounts to about 10 percent of banks’ investment product liabilities, on average.
- Asset allocation trends:
  - Allocations to safer, more liquid assets by bank-sponsored investment vehicles decreased to one-third in 2017 from about half in 2015.
  - Investment vehicles hold 70 percent of corporate and financial bonds outstanding (they have bought nearly all the net increase in such bond issuance in the past three years).
- Implications of removing implicit guarantees:
  - Without bank-guaranteed fixed yields on investment products, retail investors would likely shift toward less risky instruments, reducing net demand for illiquid corporate bonds.
  - Banks will need to recognize some portion of corporate credit exposure held through investment vehicles as loans or bonds, incurring capital and provisioning costs that will reduce loan growth capacity.
  - For small and medium-sized banks, absorbing half of these exposures over two years would reduce net new loan growth from 17 percent to 6 percent, unless banks raise new capital.
- Policy conclusion:
  - Reducing risks in the investment product market requires further slowing of credit growth in the near term to ensure financial stability and sustainable medium-term growth.

### China’s Insurance Sector: Rapid Growth and Elevated Risk Profile
- Growth and products:
  - Insurers’ assets have more than tripled in size over the past seven years.
  - Growth fueled by “universal life insurance” (flexible savings products) in 2015 and 2016, and more traditional life policies in 2017.
- Guarantees and returns:
  - Many long-term policies carry guaranteed returns of 4 percent.
  - To attain high guaranteed returns amid a small and illiquid corporate bond market, insurers have shifted investments toward equity, funds, and “other assets.”
- Concentration and credit risks:
  - “Other assets” include asset and wealth management products, debt and equity products, and participations in joint ventures.
  - Large investments in infrastructure, real estate, and loan portfolios concentrate credit risks, including for insurers with limited credit-assessment expertise.
- Market signals:
  - Insurers’ share prices have risen sharply with increased volatility, reflecting perceived elevated risks.
  - The regulator recently took control of a large insurance group that had financed rapid expansion with short-term high-guarantee investment products.

*International Monetary Fund | April 2018*

### 3. China Bond Market: Corporate and Non-Policy-Bank Financial Bonds

### 3. China Bond Market: Corporate and Non-Policy-Bank Financial Bonds

### Chinese insurers: growth, asset allocation, and vulnerabilities
- Insurers have grown rapidly, driven by life insurance sales; insurers’ shares have risen sharply, accompanied by high volatility.
- Increased revenues have been invested in higher-risk assets while capital has not been raised.
- Other assets are mainly portfolios of infrastructure projects, real estate, and loans provided by asset managers.
- Variation of alternative investments and capital buffers within the sector is large.
- Decomposition of investment allocations (panel listing in source):
  - Asset management products and wealth management products: 30%
  - Debt schemes: 27%
  - Equity funds and schemes: 25%
  - Associates and joint ventures: 12%
  - Real estate: 6%
- Findings on balance and risk:
  - Increased illiquid assets covered by deposit-like insurance products raise exposure to redemptions at short notice.
  - When faced with net cash outflows, insurers may need to sell illiquid assets, potentially adding to market volatility.
  - Insurers are sometimes parts of financial conglomerates encompassing several sectors, creating spillover risks.
  - Whether all insurers have sufficient resilience against these vulnerabilities is uncertain.
- Prudential treatment and capital concerns:
  - Current regulations require relatively low capital charges for infrastructure investments, joint ventures, and real estate compared with corporate bonds.
  - Capital requirements for investments in funds are fixed and not based on risks of underlying assets.
  - Despite elevated risks, capital levels have remained unchanged.
  - Medium-sized and smaller insurers have invested more heavily in alternative assets and have weaker capability to manage related risks.
  - Risk assessments are clouded by complex and opaque company structures and uncertainty about the exact nature and credit quality of underlying investments, including implicit guarantees.
- Specific numeric regulatory risk factors:
  - Risk factor applied to infrastructure equity plans: 12 percent
  - Risk factor applied to real estate: 8 to 12 percent
  - Risk factor for 10-year AA-rated corporate bonds: 15 percent
  - Risk factor applied to bond funds: 6 percent
- Liability profile and liquidity signal:
  - About one-fifth of life insurers’ liabilities are deposits and policyholders’ investments, which are presumed to be more easily withdrawn by policyholders than traditional life insurance products.
  - One-third of the consolidated balance sheets of the five largest insurance groups consists of banking, asset management, or other activities.

### Policy recommendations for insurers and the investment product market
- Authorities should continue to reform the investment product market and enhance the insurance supervisory regime.
- Specific recommendations:
  - Further limit leverage for lower-risk products.
  - Eventually require that implicitly guaranteed off-balance-sheet business carry the same capital and liquidity buffers as on-balance-sheet business.
  - Careful sequencing of reforms is critical.
  - Prioritize strengthening policy frameworks and financial institutions’ liquidity and capital buffers to prevent dismantling implicit guarantees from inadvertently bringing forward stability risks.
  - Address nonregulatory factors that have driven proliferation of risky investment products and excessive demand for credit more broadly (for instance, GDP growth targets).
  - Evolve the insurance supervisory regime toward a transparent, market- and risk-based regime with close cooperation across authorities.
  - Increase transparency on nature, credit quality, and valuation of “other assets.”
  - Conduct a thorough review of prudential treatment to adequately reflect risks of underlying assets.
  - Closely monitor liability profiles—including duration and surrenders—and consider further action to curb unusual liquidity risks.
  - Enhance group supervision, strong cross-sector coordination, and create a framework for recovery and resolution for the largest life insurers.
- Regulatory steps already noted:
  - Authorities have curtailed the sale of “universal life” policies and addressed duration mismatches.
  - Introduction of China Risk-Oriented Solvency System in 2016 was an important step.
  - The recently announced merger of the China Insurance Regulatory Commission and the China Banking Regulatory Commission should facilitate closer cooperation with respect to insurance and banking supervision.

### Funding challenges and dollar liquidity vulnerabilities for internationally active banks
- Dollar balance sheet liquidity remains a source of vulnerability despite strengthened consolidated balance sheets over the past decade.
- International dollar lending continues to increase, dominated by non-US banks operating through international branch networks.
- Most such banks rely heavily on short-term wholesale dollar funding and, at the margin, on volatile foreign exchange swap markets.
- A sharp tightening of financial conditions could expose structurally vulnerable liquidity positions and trigger forced asset sales or defaults, amplifying and transmitting market turbulence.
- Structural features of the international dollar banking system:
  - Demand for US dollar–denominated assets from outside the United States continues to grow rapidly; loans remain the largest form of credit.
  - Non-US banks occupy a dominant position in provision of US dollar credit.
  - Non-US banks’ branches in the United States have been dollar borrowers from overseas, on net, since 2011, though gross flows in each direction remain considerable.
  - US subsidiaries of foreign banks gather retail dollar deposits but have limited flexibility to transfer funds intragroup and thus play little role in the international dollar system.
- Assessment metrics and findings:
  - Non-US banks’ international US dollar balance sheets rely more on short-term or wholesale dollar funding than their consolidated balance sheets.
  - Short-term wholesale instruments and relatively unstable deposits are prone to outflows and can generate refinancing risk under stressed conditions.
  - Two indicators assess this vulnerability: a liquidity ratio (approximating the Basel Liquidity Coverage Ratio) and a stable funding ratio.
  - The aggregate stable funding ratio is lower for US dollar international balance sheets than for consolidated balance sheets.
  - The international US dollar liquidity ratio is lower than reported LCRs for banks’ consolidated positions.
  - US dollar liquidity ratios vary widely between banking systems.

### Bank balance-sheet health and remaining resilience needs
- Markets give mixed signals about banking sector health; equity market price-to-book ratios vary across banks, reflecting investor concerns about sustainability of some banks’ business models.
- Balance sheet improvements over the past decade:
  - In 2007 almost 40 percent of the sample, by assets, had weak buffers and high loan-to-deposit ratios; this proportion is now less than 10 percent.
  - Improvements have been achieved by increasing capital and liquidity, raising provisions, and improving funding profiles in response to enhanced prudential standards, stricter supervision, better risk management, and investor pressure.
- Remaining vulnerabilities:
  - There is a tail of weaker banks, representing about 20 percent of sample assets, with lower levels of capital and provisions against non-performing loans (NPLs); these banks are mainly concentrated in Europe (inside and outside the euro area).
  - NPL levels remain high at some banks despite recent declines.
  - About one-third of sample banks, by assets, still have loan-to-deposit ratios in excess of 100 percent.
- Recommended actions:
  - Continue fortifying balance sheets, especially at weaker institutions.
  - Implement a comprehensive strategy to address NPLs: strict supervision, ambitious NPL reduction targets, modernizing insolvency and foreclosure frameworks, and developing distressed debt markets.
  - Pay continued attention to liquidity risks, particularly dollar-funding profiles of internationally operating banks.

_This content is from "3. China Bond Market: Corporate and Non-Policy-Bank Financial Bonds" (c1 - 3. China Bond Market: Corporate and Non-Policy-Bank Financial Bonds)._

### 4. US Subsidiaries of Non-US Banks: Intragroup Borrowing and Lending

### 4. US Subsidiaries of Non-US Banks: Intragroup Borrowing and Lending

### Role of branches versus subsidiaries in dollar intermediation
- Loans remain the largest form of dollar credit even as dollar bonds outstanding have increased.
- Dollar intermediation is dominated by non-US banks operating through international branch networks; subsidiaries play a very limited role.
- Non-US banks’ international branches are key dollar intermediation channels while subsidiaries play a very limited role.

### Patterns in US dollar liquidity and stable funding ratios (2006–17)
- Aggregate US dollar liquidity ratios improved since the global financial crisis, driven largely by large increases in High Quality Liquid Assets (HQLA, reserves at central banks and holdings of official sector bonds).
- Japan’s banking system liquidity ratio declined over the same period but currently stands at about 100 percent.
- Aggregate US dollar stable funding ratios are largely unchanged over 2006–17.
- Individual banking systems show mixed performance: some systems’ stable funding ratios have fallen, reflecting rapid growth in dollar loans that exceeded banks’ ability or willingness to source deposits.
- Systems whose stable funding ratios improved (UK and German banking systems) did so primarily by shrinking dollar loans.

### Drivers of changes in dollar liquidity and stable funding ratios
- Major drivers identified (2006–17) include:
  - Growth in HQLA (reserves and official bonds)
  - Changes in deposits and long-term securities
  - Changes in swaps and interbank asset/liability positions
  - Rapid growth in dollar claims, particularly loans in Canadian, French, and Japanese banking systems
- Rapid loan growth has in several cases outpaced deposit growth, contributing to weaker stable funding ratios.

### Use of foreign exchange swaps and short-term funding markets
- Non-US banks use foreign exchange swap markets to meet short-term currency needs; overall use of cross-currency swaps has increased over the past decade.
- Japanese banks rely relatively heavily on cross-currency swaps.
- Cross-currency basis swap spreads have moved sharply in the past; swap markets have been more volatile than other short-term funding sources such as repo and interbank markets, suggesting swap markets may not be a reliable backstop in periods of stress.
- The yen-dollar market may have become more procyclical: as sovereign yields fell below policy-guaranteed return targets, Asian life insurers sought yield in dollar-denominated securities, driving a surge in demand for swaps.
- US banks’ dollar swap supply has not kept up with growing demand in the yen-dollar market.
- Non-traditional lenders (hedge funds and sovereign wealth funds) now account for about 70 percent of the supply of foreign currency derivatives to Japanese financial institutions.
- About 85 percent of short-term Japanese government bills are now held by non-Japanese investors and the Bank of Japan, potentially constraining the ability of nontraditional suppliers to provide dollar funding in the yen-dollar market.
- The US dollar LIBOR-OIS spread has widened recently, illustrating tightening in dollar funding markets.

### Risks from tightening dollar funding conditions
- Several forces tightening dollar funding conditions include an expected rise in Treasury bill issuance, US companies changing investment patterns ahead of repatriating offshore assets, and continued central bank normalization.
- Country-specific liquidity regulations and increased surveillance of cross-border intragroup liquidity flows can introduce frictions in international funding markets and extend liquidity requirements to foreign banks operating in a jurisdiction.
- The combination of balance sheet vulnerabilities and market tightening could:
  - Make it more difficult for banks to manage currency gaps in volatile swap markets, possibly rendering some banks unable to roll over short-term dollar funding.
  - Lead banks to sell assets in turbulent markets to meet liabilities, amplifying market strains.
  - Induce banks to shrink dollar lending to non-US borrowers, reducing credit availability.
  - Ultimately raise the risk that banks could default on their dollar obligations.

### Policy recommendations and regulatory implications
- Banks should ensure that currency-specific mismatches within individual entities in their banking groups continue to be managed effectively to reduce the risk of funding strains.
- Consideration should be given to enhancing disclosure of foreign currency funding risks to help investors and analysts better assess international liquidity and maturity mismatches.
- Regulators should develop or maintain currency-specific liquidity risk frameworks, including stress tests, emergency funding strategies, and resolution planning; coordination and sharing of information among regulators are crucial to reduce unintended cross-border spillovers from jurisdiction-specific liquidity requirements.
- Central bank swap lines should be retained to provide foreign exchange liquidity in periods of systemic stress to help prevent foreign currency funding difficulties from spilling over to other parts of the financial system.
- Completing the postcrisis reform agenda, including full implementation of the Basel III package of reforms and ensuring independence of supervision, remains vital; attention should also be paid to new challenges posed by technology.

*Source: c1 - 4. US Subsidiaries of Non-US Banks: Intragroup Borrowing and Lending (PDF chapter).*

### 1. United States

### 1. United States

### Estimated Term Premiums and Drivers
- Outside the United States, estimated term premiums on 10-year German bunds are close to historical lows.
- The latest fitted value for Germany is about −15 basis points, which is less than the observed estimate of about 15 basis points.
- Estimated term premiums are similarly close to their fitted values across Canada, France, Japan, and the United Kingdom.
- Low fitted values of term premiums are attributed to:
  - low survey-based uncertainty about near-term GDP growth and inflation,
  - subdued volatility of US Treasury returns,
  - a persistently lower correlation between Treasury and risky asset returns.
- Models do not predict future directions of underlying factors; increases in uncertainty about inflation, growth, or monetary policy could imply significant increases in term premiums.
- Limitations of the time-series approach include difficulty capturing regulatory restrictions affecting demand for government paper and debt-management considerations.
- Interpretation: statistical results are consistent with the view that overall levels of longer-dated yields are appropriate given the stance of monetary policy, which should remain largely accommodative to support growth and to bring inflation closer to central banks’ targets.
- Methodological notes:
  - Ten-year term premium estimates follow the Adrian, Crump, and Moench (2013) model.
  - US term premium estimates follow a five-factor specification using underlying fitted yield data from June 1961 (for example, ACMTP10 Index).
  - Germany estimates follow a four-factor specification using fitted yields from Bloomberg from October 1991.
  - The weighted-average fair value estimate is the average of all estimated conditional term premium models; the shaded area denotes the range of fitted values from these models.

### US Leveraged Loan Market: Changing Investor Base
- Structural shift: buyer base moved further toward institutional investors, notably collateralized loan obligations (CLOs) and loan mutual funds.
- Since 2014, CLOs have purchased more than half of total issuance of leveraged loans.
- Key figures:
  - US CLOs accounted for 57 percent of leveraged loans outstanding in 2017, with $495 billion in assets under management.
  - CLO issuance reached $118 billion in 2017.
  - Loan mutual funds (including exchange-traded funds) grew from roughly $20 billion in 2007 to $170 billion in assets in 2017, and now account for more than 20 percent of the institutional loan market.
  - Asset managers, insurance companies, and pension funds account for 45 percent of AAA CLO market share.
- Risks and market dynamics:
  - Migration of loan assets to open-end loan mutual funds offering daily liquidity may exacerbate price moves during large investor redemptions under distress.
  - In the precrisis period, AAA CLO tranches were often funded in the repo market using financial leverage; unwinding such leveraged positions amplified loan price moves when safety and liquidity were questioned.
  - Currently, use of financial leverage to fund CLO positions appears limited; total return swaps are not widely used to gain leveraged exposure to the loan market as in 2006–07.
- Conclusion: CLO formation and loan fund growth remain robust, but increased nonbank holdings could amplify stress dynamics.

### Central Bank Digital Currencies (CBDCs)
- Crypto assets currently do not fulfill the three basic functions of money; underlying technology needs further development.
- Cryptocoin properties attractive for payments:
  - instantaneous clearing and settlement without an intermediary,
  - anonymity for transacting parties,
  - no need for physical co-location,
  - flexibility in denomination structure.
- Several central banks (Bank of Canada, People’s Bank of China, Monetary Authority of Singapore, Swedish Riksbank) are exploring CBDCs.
- CBDC definition in text: a digital form of central bank money that can be exchanged, peer to peer, in a decentralized manner; a token representation of, or an addition to, cash and/or electronic deposits; issued to commercial banks and other payment service providers or to individuals; exchanged at par with the central bank’s other monetary liabilities.
- Potential benefits:
  - counter monopoly power of private payment networks,
  - improve payment system efficiency and stability,
  - reduce state costs of maintaining notes and coins,
  - reduce transaction costs for individuals and small enterprises with limited banking access,
  - facilitate financial inclusion,
  - tailor anonymity levels to ensure cash-like anonymity for small-value payments while allowing regulatory compliance for larger-value payments,
  - help maintain demand for central bank money in the digital age,
  - allow central banks to continue seigniorage and financing operations.
- Monetary policy considerations:
  - CBDCs, along with abolition of cash, might allow central banks to overcome the zero lower bound and facilitate truly negative interest rates when necessary.
  - Potential cost: CBDCs could compete with commercial bank deposits, leading to volatility in fund flows and possible bank runs toward CBDCs, hampering financial stability.
- Policy recommendation: a gradual and cautious approach to CBDC exploration that builds on experience and considers evolving financial technologies; design should respect the two-tier banking system to reduce financial stability risks.

### Regulatory Reform: Progress and Remaining Challenges
- Postcrisis regulatory reforms have enhanced the resilience of major banks, primarily through implementation of the Basel III package.
- Concern: excessive variation in outputs of internal models used by banks to compute regulatory capital; potential gaming to reduce regulatory requirements without reducing risk exposures.
- Basel Committee enhancements agreed in December 2017 include:
  - limiting risk-weighted assets based on the internal-ratings-based approach to a minimum of 72.5 percent of the amount calculated using the standardized approach.
  - revisions aim for a better balance between simplicity, risk sensitivity, and comparability.
  - postponement of full implementation of the Fundamental Review of the Trading Book to 2022.
  - revision of the standardized approach to credit risk to make it more risk sensitive (for example, varying risk weights for real estate exposures using loan-to-value ratios).
- Compromises in the agreement:
  - a less conservative risk-weighted assets floor than the initially proposed 80 percent;
  - further extension of the implementation timeline to 2022–27 (20 years since the start of the crisis);
  - an annual cap on any increase in risk-weighted assets resulting from the measures;
  - lowering some minimum risk weights in the standardized approach.
- Implementation challenges:
  - operational independence shortcomings of supervisors from political and market influence.
  - IMF Financial Sector Assessment Programs found only a handful of nearly 40 assessed countries are in full compliance with the Basel Core Principles on independence and accountability.
  - supervisors need resources and power to take timely, preemptive, and corrective actions.
- Remaining agenda items:
  - translating Financial Stability Board recommendations to transform shadow banking into resilient market-based finance into operational guidance for consistent national implementation,
  - resolution efforts for nonbanks, including central counterparties, remain a work in progress,
  - reform agenda for insurers has not kept pace with planned timelines,
  - focus shifting from regulating remuneration to reforming governance, addressing misconduct, reinforcing individual accountability, and creating supportive institutional culture,
  - decision on better incorporating sovereign risks into the regulatory framework has been shelved for now.
- Overall message: despite significant achievements, completion and consistent implementation of the postcrisis agenda is vital to address emerging challenges from financial technology and cyberattacks.

*Source: c1 - 1. United States (c1.pdf), IMF Global Financial Stability Report: A BuMPY ROAd AhEAd, April 2018.*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2018/april/ch1/doc/c1.pdf_