## CHAPTER 1 A DECADE AFTER ThE GLOBAL FINANCIAL CRISIS: ARE WE SAFER?

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### Global financial conditions and regional snapshots
- Overall: global financial conditions have tightened a notch relative to six to twelve months earlier, despite a notable easing in financial conditions in the United States.
- United States:
  - U.S. financial conditions have eased further despite continued monetary policy tightening.
  - Market expectations of U.S. rates have drifted higher but remain below the Federal Reserve’s dot plot.
  - The slope of the U.S. Treasury yield curve has flattened to its lowest level since before the global financial crisis.
- Euro area and other systemically important advanced economies:
  - Financial conditions have remained relatively easy, supported by still-accommodative monetary policies and strong global risk appetite.
  - The European Central Bank announced its intention to end its bond purchase program by the end of 2018, and said it would keep interest rates on hold at least through summer 2019, subject to incoming data.
  - Investors have pushed out the expected timing of the first ECB policy rate hike, and German long-term yields have fallen since April.
  - The Bank of Japan signaled it would maintain current extremely low interest rates for an extended period, while allowing for a wider band around its long-term target for 10-year government bond yields.
  - Italy: policy uncertainty has led to renewed focus on the bank-sovereign nexus.
  - United Kingdom: market concerns about a no-deal Brexit have increased sterling volatility to a five-month high and suppressed corporate valuations.
- China:
  - Financial conditions broadly stable; easing in monetary policy largely offset external pressures.
  - Equity markets weakened on rising trade tensions.
  - Tighter liquidity from earlier regulatory de-risking and deleveraging led to pockets of stress in corporate bond markets, prompting authorities to ease monetary policy.
  - Central bank actions included cuts to the required reserve ratio and lending facilities.
  - Exchange rate weakened further, down 7 percent against the U.S. dollar (and down 5 percent compared with a basket of 24 currencies) since mid-June, prompting reintroduction of a 20 percent reserve requirement for foreign exchange forwards.
- Other systemically important emerging market economies:
  - Country-specific political or policy uncertainties and worsening external financing conditions have tightened financial conditions in more vulnerable economies, though on aggregate conditions remain broadly accommodative relative to historical levels.
  - Responses have included policy rate hikes, ending monetary easing, FX intervention, or exchange-rate adjustment.

### Near-term risks and scenarios
- Growth-at-Risk (GaR) indicators:
  - Near-term risks to global financial stability have increased modestly compared with the April 2018 GFSR.
  - Medium-term risks remain elevated.
  - Relative to historical norms, near-term risks are still fairly subdued, while medium-term risks continue to be elevated.
- Key triggers that could sharply tighten global financial conditions:
  - Further escalation of trade tensions, particularly China–U.S. relations, disproportionately affecting Chinese corporations and U.S. firms with large exposures to China.
  - Growing concerns about resilience and policy credibility of emerging markets with high external debt, substantial financing or rollover needs, limited policy space, and weak reserve buffers.
  - A rise in political and policy uncertainty (for example, fiscal uncertainty in highly indebted euro area countries or a breakdown in Brexit negotiations).
  - Faster-than-anticipated monetary policy normalization in advanced economies (for example, firmer-than-expected U.S. inflation), which would leave emerging markets vulnerable to spillovers.

### Financial vulnerabilities and leverage
- Aggregate nonfinancial sector debt:
  - Total nonfinancial sector debt in countries with systemically important financial sectors stands at $167 trillion, or over 250 percent of aggregate GDP, compared with $113 trillion (210 percent of GDP) in 2008.
  - Higher debt has made the nonfinancial sector more sensitive to changes in interest rates.
- Sectoral and regional vulnerabilities:
  - United States:
    - Public sector debt has continued to climb, with the anticipated expansion in the federal deficit exacerbating already-unsustainable debt dynamics.
    - Household debt ratios have declined; corporate sector leverage moderated since 2015–16 due to improved profitability, but the share of highly levered and speculative-grade firms in new debt issuance has grown.
    - Highly leveraged deals account for a growing share of new leveraged loan issuance and have surpassed precrisis highs.
    - Bank balance sheets have strengthened, but non-bank financial entities have increased leverage, including through derivatives.
  - Euro area:
    - Leverage in corporate and sovereign sectors remains elevated.
    - Share of lower-rated companies has increased as compressed spreads encouraged leverage buildup.
    - Public sector debt remains elevated in several economies; capital positions among banks have improved but some weaknesses (tight sovereign-bank links, elevated nonperforming loans) persist.
    - Market concerns about cross-border exposures of euro area banks to vulnerable emerging market borrowers.
  - Other advanced economies:
    - Leverage is moderate to high across several sectors.
    - Household leverage is a key concern—household debt to GDP rising in several countries, notably Australia, Canada, and the Nordic countries. In Australia, house prices have started to reverse course in major cities and nationwide since late 2017.
  - Emerging markets:
    - Some face rising external costs and deteriorating financial conditions; weak underwriting standards in some jurisdictions have led to rising nonperforming loans.
- Financial sector resilience:
  - Capital positions of banks in advanced economies have improved, but are less robust in some emerging market economies.
  - Nonbank financial intermediation has grown, with increased leverage and risk-taking outside the traditional banking sector.

### Observations on market responses and policy actions
- Market responses:
  - U.S. stocks have experienced a prolonged rally; U.S. shares of companies with large exposures to China have underperformed amid trade concerns.
  - Trade announcements have affected corporate earnings expectations in selected sectors in China and performance of selected U.S. firms.
- Policy actions:
  - Emerging market economies used policy rate hikes, FX intervention, or exchange-rate flexibility in response to external pressures.
  - Chinese authorities eased monetary policy and reintroduced a 20 percent reserve requirement for foreign exchange forwards after a 7 percent depreciation vs the U.S. dollar since mid-June.
  - ECB intended to end bond purchases by end-2018 while keeping interest rates on hold at least through summer 2019, conditional on data.

### Asset valuations and market liquidity
- Valuation signals:
  - Asset valuations appear relatively high in some markets, notably the United States.
  - U.S. equity market valuations appear stretched; cyclically adjusted price-to-earnings ratios remain elevated well beyond precrisis levels.
  - U.S. equity prices appear modestly higher than model-based values; market-priced equity volatility appears too low relative to model-based forecasts.
  - Term premiums remain at historically low levels but appear relatively close to fundamentals.
  - High-yield corporate bond spreads remain close to historically low levels; spreads on leveraged loans have narrowed appreciably; covenant quality at weakest level on record (Moody’s 2018).
  - Housing market valuations relatively high in several advanced economies; price-to-income and price-to-rent ratios and mortgage costs up over the past six years.
- Liquidity structure and risks:
  - Market liquidity may have become more segmented and more dependent on high-frequency trading firms, benchmark-driven institutional investors, and less price-sensitive participants.
  - No clear evidence of meaningful deterioration of market liquidity in major capital markets to date, though flash crashes have briefly evaporated liquidity.
  - A less favorable macroeconomic environment, continued monetary policy normalization, and further stress in emerging markets may test new market structures.

### Fragilities in emerging and frontier markets
- Recent tightening drivers: stronger dollar, rising idiosyncratic political and policy risks, escalation in trade tensions since mid-April.
- Vulnerability concentration: more pronounced in countries with larger external imbalances and weaker policy frameworks.
- External leverage: external debt buildup most prominent in Turkey; external debt accumulation worrisome for a broader set of emerging and frontier markets.
- Credit quality: share of debt at risk higher in emerging markets than elsewhere; rising nonperforming loans may weigh on bank capitalization.
- Public debt: gross public debt increased substantially in Brazil and remains elevated in India.

### Emerging market portfolio flows and policy responses
- Portfolio flows and market performance:
  - Portfolio outflows from EMs began in mid-April with a stronger U.S. dollar; pressures shifted to equity markets as trade tensions flared in June.
  - Since then, emerging market stock and bond funds have seen about $35 billion of outflows; outflow pressures eased in late July and August.
  - Historical comparison: fund outflows during the taper tantrum in 2013 and the China devaluation in 2015 were closer to $60 billion peak-to-trough.
- Central bank and policy actions:
  - Argentina and Turkey raised policy rates sharply; Indonesia, Mexico, and the Philippines hiked rates by more than markets had expected.
  - FX interventions occurred in spot (Argentina, Indonesia) and via derivatives (Argentina, Brazil, India, Turkey).
  - Chinese authorities injected liquidity via cuts in reserve requirements and guided short-term rates lower; adjusted policies to support the currency as trade tensions increased.
- Growth outlook implications:
  - Recent tightening has already impacted the growth outlook.
  - The combination of a stronger dollar, higher credit spreads, weaker equity prices, and higher domestic interest rates has led to a tightening of financial conditions similar, on aggregate, to the taper tantrum.

### Key metrics and indicators highlighted
- Total nonfinancial sector debt: $167 trillion (over 250 percent of aggregate GDP) versus $113 trillion (210 percent of GDP) in 2008.
- China exchange rate moves since mid-June: down 7 percent versus the U.S. dollar and down 5 percent versus a basket of 24 currencies.
- Reserve requirement reintroduced for foreign exchange forwards in China: 20 percent.
- Growth-at-Risk (GaR) metric: uses 5th percentile (tail) of forecast growth distributions to assess downside risk.
- Financial Conditions Indices: constructed from price-of-risk components, corporate valuation measures, and emerging market external costs, covering 29 jurisdictions with systemically important financial sectors.

### Banks, liquidity buffers, and cross-border banking risks
- Banks—aggregate position:
  - Banks now have higher levels of capital and more liquidity in aggregate since the global financial crisis.
  - Bank aggregate price-to-book ratios are less than one in the euro area, China, Japan, and the United Kingdom.
  - Market-adjusted capitalization for a number of banks would be less than 3 percent, the minimum level in the Basel III framework, if market valuations were used.
- Simulated stress results:
  - Institutions representing 7 percent of sample bank assets have a simulated stress capital need in 2018; most are in the euro area.
  - Capital needs assessed against a common equity Tier 1 ratio of 4.5 percent (plus G-SIB surcharges) and a leverage ratio of 3 percent.
- Liquidity buffers and funding composition:
  - Average liquidity buffers have grown and reliance on wholesale funding is trending downward, though some banking systems still rely significantly on wholesale funding.
  - Banks with large foreign currency and wholesale borrowing and significant foreign currency mismatches could find rollovers difficult after sharp local currency depreciations.
- Foreign banking offices (FBOs) and branches:
  - Branches rely more on intragroup funding; subsidiaries have broader deposit bases.
  - Fragmentation (increased branch liquidity, reduced intragroup claims or lending) can heighten systemic risks and weaken banks’ ability to direct liquidity to stressed country offices.
  - Regulatory changes (for example, Regulation YY in the United States) and ring-fencing trends affect branch-versus-subsidiary structures and intragroup liquidity.

### Policy recommendations to safeguard financial stability
- General:
  - Boost resilience and ensure adequate policy tools for systemic risks and market pressures.
  - Global policy coordination is critical.
- Macro and fiscal policy:
  - Advanced economy central banks should continue to gradually withdraw monetary accommodation, where appropriate, and communicate intentions clearly.
  - Countries with high public sector debt burdens should aim to improve debt sustainability and enhance fiscal buffers.
  - Jurisdictions with high and rising nonfinancial sector leverage should mitigate vulnerabilities through macroeconomic and prudential policies.
- Microprudential (bank-focused) measures:
  - Monitor bank lending to highly indebted private nonfinancial and sovereign borrowers and exposures to opaque or illiquid assets; take measures to reduce excessive risk taking.
  - Develop currency-specific liquidity risk frameworks; monitor liquidity coverage ratio (LCR) in all significant currencies (currency “significant” if aggregate liabilities in that currency ≥ 5 percent of total liabilities).
  - Consider implementing net stable funding ratios in more countries.
  - Ensure central bank swap lines are available to provide liquidity in periods of stress.
  - Address asset quality problems comprehensively, including tackling legacy nonperforming loans in the euro area and undertaking asset quality reviews in emerging markets with rising nonperforming loans.
- Macroprudential policy:
  - Deploy macroprudential tools proactively alongside macroeconomic policies.
  - Use broad-based tools, including countercyclical capital buffers, to reduce exuberance and slow credit growth.
  - Mitigate foreign currency mismatches via limits on borrowers’ access to foreign currency debt, additional risk weights for lenders, and adoption of currency-differentiated LCRs.
  - Improve data availability and develop tools for vulnerabilities outside banking (corporate sector, household sector, nonbank financial sector).
  - For asset managers, implement comprehensive and globally consistent standards to identify and mitigate risks related to liquidity mismatches and leverage, including limits on concentration risks.
- Emerging market-specific guidance:
  - Maintain sound macroeconomic, structural, financial, and macroprudential policies.
  - Build and maintain adequate foreign exchange reserves; consider trade-offs between using reserves today versus preserving policy space.
  - Complement reserve building with steps toward more flexible exchange rate regimes, where appropriate.
  - Use capital flow management measures only in crisis or near-crisis situations; ensure measures are transparent, temporary, nondiscriminatory, and lifted once crisis conditions abate.
  - Deepen local bond markets and promote a stable local investor base to increase resilience and reduce currency mismatches.
- Multilateral coordination:
  - Continue cooperative solutions for cross-border financial challenges, including for external debt issues.
  - Maintain international regulatory cooperation to prevent regulatory fragmentation and arbitrage; IMF will continue to promote cooperative financial policymaking.

### Growth-at-Risk and scenario box (Box 1.1) — key quantitative calibrations and findings
- Full WEO scenario: global GDP could be nearly 0.8 percent less than the baseline by end-2019.
- GaR-focused shock calibration:
  - U.S. corporate earnings decline assumed in extreme escalation: 15 percent.
  - Corresponding U.S. credit spread widening: roughly 100 basis points.
  - Corresponding U.S. equity price drop: 12 percent.
  - Horizon for persistence of market-valuation effects: three-year horizon.
  - Near-term leftward shift in the lower 5th percentile of growth distribution: about 1.5 percentage points (annotated as 1.45 percentage points in figure).
- Main result: a persistent financial conditions shock raises probability mass in the lower tail of the global growth distribution across horizons, elevating risk of severely adverse outcomes relative to the baseline.

### Capital flows, reserve adequacy, and risk-aversion scenarios
- Emerging market (excluding China) GDP growth: set to remain at 4.7 percent in 2018–19 per October 2018 WEO.
- Portfolio flows:
  - Record monthly pace of about $70 billion for all emerging market borrowers between January and April 2018; summer issuance fell below $20 billion per month thereafter.
  - Emerging market stock and bond funds saw about $35 billion of outflows since mid-April.
- Capital flows-at-risk (severely adverse 5th percentile scenarios):
  - Medium-term debt outflows could reach 0.6 percent of combined GDP of emerging market economies (excluding China) under a severely adverse scenario.
  - Under a broad-based rise in risk aversion (U.S. corporate spreads +100 basis points, U.S. 10-year yields −30 basis points, U.S. dollar +5 percent), near-term capital flows at risk would drop from less than −0.1 percent of GDP to −0.7 percent of GDP.
- External vulnerabilities and reserves:
  - External debt has increased much faster than exports in many emerging markets; countries where external debt is too high relative to exports account for roughly 40 percent of aggregate GDP of emerging markets (excluding China).
  - As of August 2018, over 45 percent of low-income countries were at high risk of, or already in, debt distress, compared with one-third in 2016 and one-quarter in 2013.
  - IMF ARA metric used to assess reserve coverage; countries with large stocks of external liabilities relative to foreign exchange reserves include Argentina, South Africa, and Turkey.
- Investor base and amplification risks:
  - Multisector bond funds assets have more than doubled since the global financial crisis to well over $1 trillion; aggregate emerging market investment is more than $150 billion.
  - Sample: over two-thirds of emerging market investment in 40 large multisector bond funds is managed by funds with derivatives leverage in the 90 percent to 850 percent range.
  - Concentrated positions and larger share of foreign nonbank investors increase susceptibility to reversals and liquidity strains.
- Estimated potential impact of U.S. Federal Reserve balance sheet contraction:
  - Pace of balance sheet contraction expected to hit its maximum in Q4 2018.
  - Estimates indicate deterioration in external factors could lead to a $50 billion reduction of inflows in 2018, easing modestly to an additional $40 billion in 2019.

*International Monetary Fund | October 2018*

### CHAPTER 1 A DECADE AFTER ThE GLOBAL FINANCIAL CRISIS: ARE WE SAFER?

### CHAPTER 1 A DECADE AFTER ThE GLOBAL FINANCIAL CRISIS: ARE WE SAFER?

### Global financial conditions and regional snapshots
- Overall global financial conditions have tightened a notch relative to six to twelve months earlier, despite a notable easing in financial conditions in the United States.
- United States:
  - Despite continued monetary policy tightening, U.S. financial conditions have eased further.
  - Market expectations of U.S. rates have drifted higher but remain below the Federal Reserve’s dot plot.
  - The slope of the U.S. Treasury yield curve has flattened to its lowest level since before the global financial crisis.
- Euro area and other systemically important advanced economies:
  - Financial conditions have remained relatively easy, supported by still-accommodative monetary policies and strong global risk appetite.
  - The European Central Bank announced its intention to end its bond purchase program by the end of 2018, and said it would keep interest rates on hold at least through summer 2019, subject to incoming data.
  - Investors have pushed out the expected timing of the first ECB policy rate hike, and German long-term yields have fallen since April.
  - The Bank of Japan signaled it would maintain current extremely low interest rates for an extended period, while allowing for a wider band around its long-term target for 10-year government bond yields.
  - In Italy, policy uncertainty has led to renewed focus on the bank-sovereign nexus. In the United Kingdom, market concerns about a no-deal Brexit have increased sterling volatility to a five-month high and suppressed corporate valuations.
- China:
  - Financial conditions have remained broadly stable, with an easing in monetary policy largely offsetting external pressures.
  - China’s equity markets have weakened on rising trade tensions.
  - Tighter liquidity from earlier regulatory de-risking and deleveraging led to pockets of stress in corporate bond markets, prompting authorities to ease monetary policy.
  - The central bank injected liquidity via cuts to the required reserve ratio and through lending facilities.
  - The exchange rate weakened further, down 7 percent against the U.S. dollar (and down 5 percent compared with a basket of 24 currencies) since mid-June, prompting authorities to reintroduce a 20 percent reserve requirement for foreign exchange forwards.
- Other systemically important emerging market economies:
  - A combination of country-specific political or policy uncertainties and worsening external financing conditions has led to significant tightening of financial conditions in more vulnerable economies, though on aggregate conditions remain broadly accommodative relative to historical levels.
  - Most emerging market economies have responded to market turbulence during the U.S. dollar rally and escalating trade tensions by hiking policy rates or by effectively ending their monetary easing; some have intervened in foreign exchange markets, while others have allowed exchange rates to absorb shocks.

### Near-term risks and scenarios
- The Growth-at-Risk (GaR) approach indicates:
  - Near-term risks to global financial stability have increased modestly compared with the April 2018 GFSR.
  - Medium-term risks remain elevated.
  - Relative to historical norms, near-term risks are still fairly subdued, while medium-term risks continue to be elevated.
- Key triggers that could sharply tighten global financial conditions:
  - Further escalation of trade tensions, particularly involving China-U.S. relations, which so far have disproportionately affected Chinese corporations with significant exposure to proposed U.S. tariffs and U.S. firms with large exposures to China.
  - Growing concerns about resilience and policy credibility of emerging markets facing external headwinds; countries with high external debt, substantial financing or rollover needs, limited policy space, and weak reserve buffers would be particularly vulnerable.
  - A rise in political and policy uncertainty (for example, fiscal uncertainty in highly indebted euro area countries or a breakdown in Brexit negotiations) damaging market confidence.
  - Faster-than-anticipated monetary policy normalization in advanced economies (for example, firmer-than-expected U.S. inflation stemming from capacity constraints created by procyclical fiscal policy or increases in import tariffs), which would leave emerging markets vulnerable to spillovers.

### Financial vulnerabilities and leverage
- Aggregate nonfinancial sector debt:
  - Total nonfinancial sector debt in countries with systemically important financial sectors stands at $167 trillion, or over 250 percent of aggregate GDP, compared with $113 trillion (210 percent of GDP) in 2008.
  - Higher debt has made the nonfinancial sector more sensitive to changes in interest rates.
- Sectoral and regional vulnerabilities:
  - United States:
    - Public sector debt has continued to climb, with the anticipated expansion in the federal deficit exacerbating already-unsustainable debt dynamics.
    - Household debt ratios have declined, and corporate sector leverage moderated since 2015–16 due to improved profitability; however, the share of highly levered and speculative-grade firms in new debt issuance has grown.
    - Highly leveraged deals account for a growing share of new leveraged loan issuance and have surpassed precrisis highs.
    - Bank balance sheets have strengthened, but non-bank financial entities have increased leverage, including through derivatives.
  - Euro area:
    - Leverage in the corporate and sovereign sectors remains elevated.
    - The share of lower-rated companies has increased as compressed spreads encouraged leverage buildup.
    - Public sector debt remains elevated in several economies; capital positions among banks have improved but some weaknesses (tight sovereign-bank links, elevated nonperforming loans) persist.
    - Market participants have become concerned about cross-border exposures of euro area banks to vulnerable emerging market borrowers.
  - Other advanced economies:
    - Leverage is moderate to high across several sectors.
    - Household leverage is a key concern, with the ratio of household debt to GDP on an upward trajectory in a number of countries—especially those with house price increases (notably, Australia, Canada, and the Nordic countries). In Australia, house prices have started to reverse course in major cities and nationwide since late 2017.
  - Emerging markets:
    - Some emerging market economies face rising external costs and deteriorating financial conditions; weak underwriting standards in some jurisdictions have led to rising nonperforming loans.
- Financial sector resilience:
  - Capital positions of banks in advanced economies have improved, but are less robust in some emerging market economies.
  - Nonbank financial intermediation has grown, with increased leverage and risk-taking outside the traditional banking sector.

### Observations on market responses and policy actions
- Market responses:
  - U.S. stocks have experienced a prolonged rally; U.S. shares of companies with large exposures to China have underperformed amid trade concerns.
  - Trade announcements have affected corporate earnings expectations in selected sectors in China and performance of selected U.S. firms.
- Policy actions:
  - Emerging market economies have used policy rate hikes, FX intervention, or exchange-rate flexibility in response to external pressures.
  - Chinese authorities eased monetary policy and reintroduced a 20 percent reserve requirement for foreign exchange forwards after a 7 percent depreciation vs the U.S. dollar since mid-June.
  - The ECB intended to end bond purchases by end-2018 while keeping interest rates on hold at least through summer 2019, conditional on data.

### Key metrics and indicators highlighted
- Total nonfinancial sector debt: $167 trillion (over 250 percent of aggregate GDP) versus $113 trillion (210 percent of GDP) in 2008.
- China exchange rate moves since mid-June: down 7 percent versus the U.S. dollar and down 5 percent versus a basket of 24 currencies.
- Reserve requirement reintroduced for foreign exchange forwards in China: 20 percent.
- Growth-at-Risk (GaR) metric: uses 5th percentile (tail) of forecast growth distributions to assess downside risk to growth and financial stability.
- Financial Conditions Indices are constructed from price-of-risk components (real short-term rate, term spreads or sovereign spreads, interbank spread), corporate valuation measures (price-to-book, corporate bond spreads, implied volatility), and emerging market external costs (sovereign and corporate external spreads, external debt-weighted exchange rate), covering 29 jurisdictions with systemically important financial sectors.

*International Monetary Fund | October 2018*

### 3. U.S. and European Leveraged Loan Issuance by Leverage Multiple

### 3. U.S. and European Leveraged Loan Issuance by Leverage Multiple

### Balance-sheet Leverage Metrics by Sector and Region
- Indicators covered: ratio of net debt to EBITDA, EBITDA to assets, interest coverage ratios, corporate debt to GDP (corporate sector); household debt-to-GDP and debt-service ratios (households); gross public debt to GDP (sovereign); equity to assets and Tier 1 capital ratio (banking); external debt to GDP (external); assets to equity, credit to assets, portfolio fraction of bonds rated BBB or lower, and default probabilities within the next three years (insurance); assets to equity, credit to assets, incurred debt to assets, and loans to assets (asset management and other nonbank financial sectors).
- Aggregation method: indicators aggregated within regions using GDP-weighted averages and within sectors using equal-weighted averages; within sectors, indicators for existing subsectors are aggregated using assets to GDP as weights.
- Shading convention: red indicates value in the top 20 percent of pooled samples of advanced or emerging market economies (2000–2018 or longest available); dark green indicates bottom 20 percent.
- Regional groupings called out: Other systemically important advanced economies include Australia, Canada, Denmark, Hong Kong SAR, Japan, Korea, Norway, Singapore, Sweden, Switzerland, and the United Kingdom. Other systemically important emerging economies include Brazil, India, Mexico, Poland, Russia, and Turkey.

### Key Findings on Leverage and Vulnerabilities
- "Total nonfinancial sector debt has continued to swell since the global financial crisis."
- "Household debt to GDP remains on an upward trajectory in a number of countries."
- In emerging market banks: "Emerging market banks are, on average, above critical thresholds for their Tier 1 ratio and ratio of capital to assets, even though their Tier 1 ratio is lower compared with advanced economy banks."
- In advanced economy banks: "Banks in advanced economies have Tier 1 ratios well above critical thresholds, but capital-to-assets ratios are roughly in line with thresholds."

### China: Deleveraging and De-risking Progress
- Regulatory tightening outcomes:
  - "Regulatory tightening has slowed the buildup of risks in the financial sector ... and led to tighter credit conditions for weaker borrowers ... but the deleveraging process is far from complete."
- Specific sectoral developments:
  - "In China, nonfinancial corporate sector leverage has been rising and is currently well above global historical benchmarks (Figure 1.7)."
  - "Despite low loan-to-value ratios, the rapid pace of growth of household debt, which is now at the high end for emerging markets, also raises concerns."
  - "The largest banks appear better capitalized, but vulnerabilities at small and medium-sized banks are high."
  - "Strong demand for high-yielding investment products has led to rapid growth in complex investment vehicles, which the authorities tried to curb through new asset management rules."
- Policy response trade-offs:
  - "Tighter financial regulation aimed at deleveraging and de-risking China’s financial system has led to less favorable credit conditions for weaker borrowers."
  - "To cushion the impact of regulatory tightening on the economy, authorities have responded by easing monetary policy and softening the implementation of proposed new rules."
  - "Although these recent steps may help support economic growth in the near term in the face of rising external pressures, they may entail greater risks to financial stability over the medium term should they set back progress toward reducing financial vulnerabilities."
- Additional observations:
  - "Rapid growth in complex investment vehicles" and efforts to curb them via new asset management rules.
  - Figures referenced include changes in investment products and small-to-medium bank claims (three-month change, trillions of renminbi), corporate defaults and corporate bond spreads (billions of renminbi, basis points), and leverage at nonfinancial traded companies (Top 100 Chinese firms by assets).

### Asset Valuations and Market Liquidity
- Overvaluation and volatility signals:
  - "Asset valuations appear to be relatively high in some markets, notably in the United States."
  - "U.S. equity market valuations appear to be stretched. Standard valuation metrics, such as cyclically adjusted price-to-earnings ratios, show that equity valuations in the United States have continued to be elevated well beyond precrisis levels despite trade tensions."
  - "U.S. equity prices now appear modestly higher than their model-based values, based on alternative measures of S&P 500 earnings expectations as well as proxies for both the risk-free rate and the equity risk premium components of the discount factor."
  - "Market-priced equity volatility appears to be too low relative to model-based forecasts."
  - "Term premiums remain at historically low levels, but they appear relatively close to fundamentals."
  - "High-yield corporate bond spreads remain close to historically low levels in absolute terms as well as when scaled by leverage."
  - "Spreads on leveraged loans have narrowed appreciably, and markets may be underpricing the deterioration in covenant quality, which is at the weakest level on record (Moody’s 2018)."
  - "Housing market valuations are relatively high in several advanced economies," with price-to-income and price-to-rent ratios and mortgage costs up over the past six years; valuations relatively high in Australia, Canada, and the Nordic countries.
- Liquidity structure and risks:
  - "The postcrisis decade has witnessed notable structural changes in market liquidity. There are indications that liquidity may have become more segmented across different trading platforms, and more dependent on high-frequency trading firms, benchmark-driven institutional investors, as well as less price-sensitive market participants (such as central banks)."
  - "So far, there does not appear to be clear evidence of a meaningful deterioration of market liquidity in major capital markets, albeit extraordinarily accommodative monetary conditions of the past decade could be masking underlying frictions."
  - "Liquidity has evaporated briefly during a few specific events, but at least so far, such flash crashes have had minimal lasting impacts on asset prices, much less on real activity."
- Forward-looking note: "A less favorable macroeconomic environment, continued monetary policy normalization, and further financial stress in emerging markets may test new market structures."

### Fragilities in Emerging and Frontier Markets
- Recent tightening drivers: "Financial conditions in emerging markets have tightened since mid-April, driven by a stronger dollar, rising idiosyncratic political and policy risks, and an escalation in trade tensions."
- Vulnerability concentration: "Market pressures have been more pronounced in countries with larger external imbalances and weaker policy frameworks, or in those more exposed to escalating trade tensions."
- External leverage and debt: "External debt buildup has been most prominent in Turkey, though external debt accumulation has also been worrisome for a broader universe of emerging and frontier markets."
- Credit quality and nonperforming loans: "In other major emerging market economies, credit quality remains a key concern. In the corporate sector, the share of debt at risk—debt owed by firms whose interest expenses exceed earnings—is higher in emerging markets than in other regions. Rising levels of nonperforming loans may weigh on bank capitalization going forward."
- Public debt: "Gross public debt has increased substantially in Brazil in recent years and remains elevated in India."

### Emerging Market Portfolio Flows and Policy Responses
- Portfolio flows and market performance:
  - "Portfolio outflows from EMs began in mid-April ... with the strengthening of the U.S. dollar ... but pressures shifted to equity markets as trade tensions flared up in June."
  - "Nonresident capital flows to emerging markets have slowed in recent quarters. Portfolio flows reversed starting in mid-April, led by retail investors, after strong inflows in 2017 and early 2018."
  - "Since then, emerging market stock and bond funds have seen about $35 billion of outflows, though outflow pressures eased in late July and August."
  - Note on historic comparison: "Fund outflows during the taper tantrum episode in 2013 and the China devaluation episode in 2015 were closer to $60 billion from peak to trough."
- Central bank and policy actions:
  - "Facing external pressures, central banks in several emerging market economies responded with interest rate hikes and interventions in currency markets."
  - Examples: "Argentina and Turkey reacted by raising policy rates sharply, while countries already in a tightening cycle (including Indonesia, Mexico, and the Philippines) hiked rates by more than markets had expected."
  - "Foreign exchange interventions were carried out in the spot market (Argentina, Indonesia) and via derivatives (Argentina, Brazil, India, Turkey)."
  - "In contrast, Chinese authorities maintained a more accommodative monetary policy by injecting liquidity via cuts in reserve requirements and by guiding short-term rates lower. However, as trade tensions increased, they also adjusted their policies to support the currency."
- Growth outlook implications:
  - "While financial conditions in emerging markets remain broadly accommodative, on aggregate, the recent tightening has already had an impact on the growth outlook."
  - "The combination of a stronger dollar, higher credit spreads, weaker equity prices, and higher domestic interest rates has led to a tightening of financial conditions that is similar, on aggregate, to the taper tantrum."

*International Monetary Fund | October 2018*

### 1. Emerging Market (Excluding China) Financial Conditions Index

### 1. Emerging Market (Excluding China) Financial Conditions Index

### Financial conditions and GDP growth
- Financial conditions Z-scores over 1996–2018:Q3 are the basis for the index (figure referenced).
- According to the October 2018 WEO, GDP growth in emerging market and developing economies is set to remain at 4.7 percent in 2018–19.
- The growth outlook was revised down by about 0.3 percentage points in 2018 and roughly 0.4 percentage points in 2019 compared with the April 2018 WEO, reflecting more subdued prospects in large Latin American economies (Argentina, Brazil, Mexico) and a sharp slowdown in Turkey.

### Investor differentiation across emerging markets
- Credit markets: widening of spreads on hard currency sovereign bonds has been more pronounced in lower-rated issuers (Figure 1.12, panel 1).
- Exchange rates: large depreciations in some emerging markets (such as Argentina and Turkey) can be largely explained by idiosyncratic factors; conversely, currencies in some countries benefited from positive country-specific political developments (Mexico, Colombia).
- Correlation and volatility:
  - EM exchange rates have become, on average, more correlated since early July, but correlation between idiosyncratic components remains very low/negative (Figure 1.12, panel 3).
  - A few EM currencies have been significantly more volatile than others (Figure 1.12, panel 4).
- Spillovers:
  - Spillover indices in emerging currency and equity markets have picked up recently but remain below highs seen in recent years (Figure 1.12, panels 5 and 6).
  - Directional spillover indices show a modest increase in level of spillovers but large variation across markets.

### Frontier markets, issuance, and redemptions
- First-time and lower-rated international bond issuers were hit hard during the recent sell-off.
- Issuance dynamics:
  - Record monthly pace of about $70 billion for all emerging market borrowers between January and April 2018.
  - Summer issuance fell below $20 billion per month thereafter.
- Slowdown was pronounced for low-income and frontier market issuers; some delayed external issuance plans or turned to international financial institutions for support.
- Rollover profile:
  - The amount of hard currency sovereign bonds maturing is set to rise only marginally in 2019 and remain small for many issuers until the end of 2021.
  - For some frontier market sovereigns, a sudden tightening of global financial conditions could coincide with large external rollover needs (Figure 1.13, panel 2).
  - Frontier market borrowers with sizable hard-currency bond redemptions over the next five years relative to reserve buffers include Ecuador, Pakistan, Sri Lanka, and Zambia.

### External environment and near-term pressures
- Key external risks identified (Figure 1.14):
  - Faster monetary policy normalization in advanced economies
  - Strong U.S. dollar
  - Rising interest rates
  - Political risks: trade tensions, policy uncertainty
  - Contagion risks amplified by high leverage, large external financing needs, short-term foreign currency debt, flighty investors, and trade exposures
- Buffers and mitigants listed (Figure 1.14):
  - Sound policy frameworks
  - Foreign exchange reserves
  - Fiscal buffers
  - Deep and liquid local markets
  - Strong local investor base
- Portfolio flows:
  - Retail outflows have been sizable and institutional inflows have slowed considerably.
  - Market participants revised upward expected path of interest rates by about 90 basis points over the past year, pricing in about 90 basis points of additional interest rate hikes over the next two years.
  - Based on current market pricing relative to WEO projections, there could be a further drag on portfolio flows of about $10 billion by the end of 2019, in addition to an estimated realized impact so far of $20 billion (Figure 1.15, panel 2).
- Federal Reserve balance sheet contraction:
  - Pace of balance sheet contraction is accelerating and is expected to hit its maximum in the fourth quarter of 2018.
  - Estimates indicate deterioration in external factors could lead to a $50 billion reduction of inflows in 2018, easing modestly to an additional $40 billion in 2019.

### Capital flows-at-risk: methodology, findings, and scenarios
- Methodology:
  - A quantile regression framework is used to assess capital flows at risk over the near term (current and next two quarters) and the medium term (five to eight quarters ahead).
  - Three main predictors of portfolio debt flows: risk appetite, U.S. market interest rates, and the U.S. dollar.
- Current outlook:
  - Near-term risks to capital flows are relatively limited; medium-term downside risks are elevated due to elevated U.S. interest rates, a strong dollar, and favorable global risk appetite (which boosts near-term flows but foreshadows weaker medium-term inflows).
- Severely adverse scenario (5th percentile of probability distribution):
  - Medium-term debt outflows could reach 0.6 percent of the combined GDP of emerging market economies (excluding China), comparable with outflows seen during the global financial crisis (measured over a four-quarter period) (Figure 1.15, panel 3).
  - Under a scenario of a broad-based rise in risk aversion (spreads on U.S. corporate bonds rise by 100 basis points, U.S. 10-year yields fall 30 basis points, and the U.S. dollar appreciates by 5 percent on safe-haven flows), near-term capital flows at risk would drop from less than –0.1 percent of GDP to −0.7 percent of GDP (Figure 1.15, panel 5).
- Historical comparison:
  - Estimated outflows under the 5th percentile scenario are much higher than in Q4 2011 (height of the European sovereign debt crisis), when U.S. interest rates were low and the dollar was weaker but risk aversion was high (Figure 1.15, panel 4).

### Policy implications and vulnerabilities
- Vulnerable groups:
  - Low-income and frontier market borrowers, first-time and lower-rated international bond issuers, and sovereign and corporate borrowers dependent on external financing are most at risk from capital flow reversals.
- Suggested resilience factors and policy emphases implied by the analysis:
  - Maintain and strengthen foreign exchange reserves and fiscal buffers.
  - Develop deep and liquid local markets and cultivate a strong local investor base to reduce reliance on volatile external financing.
  - Monitor external rollover needs, especially for frontier sovereigns with sizable upcoming hard-currency redemptions.
  - Prepare for tighter external financing conditions given ongoing U.S. monetary policy normalization and possible increases in global risk aversion.

*Source: IMF staff estimates and figures from Chapter 1, “A Decade After the Global Financial Crisis: Are We Safer?,” Global Financial Stability Report, October 2018.*

### 6. Risk-Aversion Scenario: Medium-Term Debt Portfolio Flows

### 6. Risk-Aversion Scenario: Medium-Term Debt Portfolio Flows

### Forecast Densities and Portfolio Flows
- Portfolio flows to emerging market economies have been under pressure in recent months and are expected to remain subdued given the external backdrop.
- Timeline / reference points shown: "Before taper tantrum (2013:Q1)"; "Year ago (2017:Q2)"; "Latest (2018:Q2)"; estimates through 2018:Q3.
- Charts and probability densities illustrate portfolio flows in percent of EM GDP with percentiles plotted (including "5th percentile").
- Time series referenced: 2013–2018 (panels include 2017:Q4, 18:Q2, 18:Q4, 19:Q2, 19:Q4 in estimate windows).

### High Levels of External and Foreign Currency Debt — Vulnerabilities
- External debt has increased much faster than exports in many emerging markets; countries where external debt is too high relative to exports now account for roughly 40 percent of aggregate GDP of emerging markets (excluding China).
- Current account imbalances of emerging market economies have decreased since 2013 on aggregate (China and oil exporters saw surpluses narrow; Brazil, India, Indonesia, Mexico, and South Africa shrank deficits).
- Public-sector vulnerabilities:
  - The share of countries with high public debt in aggregate GDP of emerging markets (excluding China) has more than doubled since 2008.
  - Roughly one-third of countries exhibit a high share of foreign currency debt.
  - Countries that have both high public sector debt and a high share of foreign currency debt are relatively few, including Lebanon, Tunisia, and Ukraine.
  - Among low-income countries, the number with debt-to-GDP ratios above critical levels has continued to rise.
- Debt distress metrics:
  - As of August 2018, over 45 percent of low-income countries were at high risk of, or already in, debt distress, compared with one-third in 2016 and one-quarter in 2013.
- Corporate sector leverage:
  - Firm-level data across a sample of 14,000 nonfinancial firms suggest high leverage has stretched debt-repayment capacity in some economies.
  - Indicators include average interest coverage ratios and the proportion of debt owed by firms with interest coverage ratios of less than 1 (debt at risk).
  - Median debt at risk has declined recently across regions, but challenges persist in some countries in Latin America and in emerging Asia.

### Reserve Buffers and Potential Foreign Exchange Liquidity Needs
- The IMF’s assessment of reserve adequacy (ARA) metric is used to assess reserve coverage against potential FX liquidity drains.
- Countries with large stocks of external liabilities relative to foreign exchange reserves include Argentina, South Africa, and Turkey.
- Composition of debt liabilities:
  - Turkey and Argentina have increased their shares of external foreign currency debt since 2013.
  - South Africa has maintained a large share of local currency liabilities.
- Potential drains on reserves:
  - Contingent liabilities of central banks and operations in derivatives markets can reduce usable reserves (for example, reserves borrowed through short-term foreign exchange swaps or provisions allowing banks to meet reserve requirements in foreign currency).
  - Foreign exchange reserves linked to derivatives transactions may not be available for balance of payments purposes during stress periods.
- Charted metrics and indicators:
  - Panels include "Potential Balance of Payment Drains (Percent of gross foreign exchange reserves)", "Composition of External Liabilities (Percent of GDP)", and "Reserves and Potential Foreign Exchange Drains Due to the Use of Derivatives (Percent of gross foreign exchange reserves, latest 2018 figures)".
- Vulnerable country characteristics include large export-to-GDP ratios or tight integration into global supply chains.

### Investor Base Composition and Amplification Risks
- The share of foreign nonbank investors in sovereign debt markets has been rising since 2013, increasing susceptibility to reversals.
- Multisector bond funds:
  - Assets have more than doubled since the global financial crisis to well over $1 trillion (more than 10 percent of the entire bond mutual fund sector globally).
  - Aggregate emerging market investment stands at more than $150 billion.
  - A sample of 40 large multisector bond funds: over two-thirds of their emerging market investment is managed by funds with derivatives leverage in the 90 percent to 850 percent range.
  - Multisector bond funds can hold highly concentrated positions that are at historical highs in a few countries; sudden shifts in asset allocations may amplify asset price comovements across bond markets and impair liquidity.
- Investor types and behaviors:
  - Increasing proportion of investors operate through mutual funds and exchange-traded funds (ETFs); these could increase volatility of portfolio flows due to greater sensitivity to global financial conditions.
  - Large institutional investors tend to be more sticky, but can react strongly to large shocks; retail investors behave differently.
- Corporate bond markets:
  - Hard-currency corporate bond issuance in emerging markets has reached new highs, led by China and the rest of EM Asia.
  - Investor base in emerging Asia largely consists of local or regional Asian accounts; global and out-of-region investors play a larger role in Latin America, emerging Europe, and to a lesser extent in MENA.
  - Local currency corporate bond markets are larger than hard currency markets and are growing fast, especially in Asia; investors remain predominantly domestic.
- Liquidity considerations:
  - Concentrated positions in local sovereign bond market segments can render parts of the domestic yield curve illiquid, potentially impairing monetary policy transmission and exacerbating market pressures.
  - Low liquidity can amplify the price impact of capital outflows and shifts in financial conditions.

### Deeper Domestic Markets as Buffers and Policy Implications
- Empirical evidence indicates that large banking sectors, deeper capital markets, and broader domestic institutional investor bases can mitigate the impact of global risk factors on emerging markets.
- Caveats:
  - There are speed limits to rapid market deepening; deepening too quickly can lead to economic and financial instability.
  - Developing sound institutional and regulatory frameworks can help mitigate challenges associated with market deepening.
  - Overreliance on holdings of sovereign debt by domestic banks may increase risks in times of stress as bank solvency may come under pressure.
- Examples of relative resilience:
  - Countries like South Africa and Malaysia have relatively large domestic investor bases and liquid currency markets (compared with the size of their local bond markets), which contribute to greater resilience.

*International Monetary Fund | October 2018 — Chapter 1, "Risk-Aversion Scenario: Medium-Term Debt Portfolio Flows"*

### CHAPTER 1 A DECADE AFTER ThE GLOBAL FINANCIAL CRISIS: ARE WE SAFER?

### CHAPTER 1 A DECADE AFTER ThE GLOBAL FINANCIAL CRISIS: ARE WE SAFER?

### Market Size and Domestic Investor Base
- Bond markets in many emerging market economies have grown significantly, but overall financial deepening varies across countries.
- In Asia (including China, India, and Indonesia):
  - Foreign exchange liquidity remains low compared to the size of the economy or of the local debt market.
  - The size of domestic mutual, insurance, and pension funds is in some cases among the lowest.
  - A significant foreign investor presence may result in higher volatility of capital flows and asset prices, including the exchange rate.
  - Central banks typically aim to maintain a high level of reserves and tend to be more active in foreign exchange interventions as a counterbalancing factor.
- In vulnerable countries with narrow domestic investor bases and low FX liquidity (for example, Argentina and Turkey):
  - Low reserve buffers make it more challenging to absorb external shocks.

### Banks—Stronger, but Not Yet Out of the Woods
- Aggregate improvements since the global financial crisis:
  - Banks now have higher levels of capital and more liquidity in aggregate.
  - Regulatory, supervisory, and market changes over the past decade have boosted capital buffers.
- Remaining concerns from market measures:
  - In the euro area, China, Japan, and the United Kingdom, bank aggregate price-to-book ratios are less than one.
  - If market valuations are used instead of balance sheet capital, a number of banks would have a market-adjusted capitalization of less than 3 percent, the minimum level in the Basel III framework.

### Bank Balance Sheets Are Stronger, but Some Weak Links Remain
- Simulated stress results:
  - The exercise estimates bank capital needs in stress scenarios through simulations of bank profits and losses.
  - Institutions representing 7 percent of sample bank assets have a simulated stress capital need in 2018; most of these institutions are in the euro area.
  - Capital needs are assessed against a common equity Tier 1 ratio of 4.5 percent (plus the capital surcharge for the global systemically important banks in the sample) and a leverage ratio of 3 percent.
- Market valuation caveats:
  - Bank market valuations can be affected by differences in business models and expectations of bank profitability.
  - A low price-to-book ratio is likely to make it more difficult for banks to raise capital in markets if they needed to do so.

### Banks Face a Series of Different Vulnerabilities
- High private-sector indebtedness:
  - Debt-service ratios (nonfinancial private sector interest and debt repayments relative to income) are already higher than their long-term average in a number of economies—particularly in Belgium, Canada, China, France, Hong Kong SAR, Russia, and Turkey—where the current debt-service ratio is more than 1 percentage point above each country’s long-term average.
  - The credit provided by banks in these countries amounts to more than $30 trillion, or about half of total borrowing from banks by the nonfinancial private sector of major economies.
  - Borrowers with stretched debt-service ratios are likely to have greater difficulty paying their debts if interest rates rise or if incomes fall, which could foster further rises in nonperforming loans.
- Foreign-currency borrowing risks:
  - Borrowing from banks in foreign currencies may become difficult to repay after sharp currency depreciations (as seen recently in Turkey), affecting local banks and potentially spilling over to foreign banks with exposures.
- Sovereign-bank nexus:
  - Bank holdings of bonds issued by highly indebted domestic sovereigns are a potential vulnerability.
  - Regulatory changes have increased incentives for banks to hold government bonds (they count as liquid assets under the Basel III liquidity coverage ratio) while the leverage ratio has reduced incentives to hold additional government bonds.
  - Recent events in Italy: government bond spreads rose sharply in May, inducing a rise in Italian bank credit default swap spreads. If market concerns about fiscal policy reemerge, there is a risk of reigniting the sovereign-bank nexus given banks’ holdings of Italian government bonds and exposure to the domestic economy.
- Opaque and illiquid assets (Level 2 and Level 3):
  - G-SIB holdings of Level 2 and Level 3 assets have fallen over the past few years, but Level 2 and Level 3 assets still represent significant multiples of capital in many G-SIBs.
  - The estimated loss on Level 2 and Level 3 assets that would reduce some banks’ leverage ratio by 100 basis points could, for several G-SIBs, result from a decline of less than 5 percent in the value of these portfolios; for other G-SIBs a much larger decline would be required.
- Interconnectedness:
  - Equity market prices imply a core set of G-SIBs that are interconnected or exposed to similar risks.
  - The range of outward spillovers (the percentage of variance in equity returns in one G-SIB explained by variation in other G-SIBs) suggests markets still view most G-SIBs as interconnected, though a few global banks outside the core group seem less interconnected than in the past.
- Funding models and liquidity:
  - Bank liquidity buffers have improved in aggregate since the global financial crisis, but challenges remain, and funding models remain uneven across countries and banks.

*International Monetary Fund | October 2018*

### Chapter 2 finds that average liquidity buffers have

### ch1 - Chapter 2 finds that average liquidity buffers have

### Liquidity buffers and funding composition
- Average liquidity buffers have grown and reliance on wholesale funding is trending downward, though some banking systems in major jurisdictions still rely significantly on wholesale funding.
- Figure 1.22, panel 4 shows variation in funding positions using:
  - the loan-to-deposit ratio, and
  - the proportion of liabilities in foreign currencies.
- Banks with large foreign currency and wholesale borrowing, and significant foreign currency mismatches, could find it difficult to roll over financing if their local currency has depreciated significantly, as has been seen in some emerging market economies.
- Liquidity problems often affect individual entities within banking groups; liquidity positions should be assessed at the individual entity level.
- The dollar balance sheets of internationally active banks headquartered outside the United States often have worse liquidity positions than suggested by their consolidated balance sheets.
- Institutions that rely on correspondent banking relationships have been under pressure because these relationships have been cut back.

### Historical FSAP findings and euro area resilience
- Reliance on wholesale funding was highlighted in Financial Sector Assessment Program (FSAP) reports for:
  - France in 2012,
  - Korea in 2014,
  - Japan and the Netherlands in 2017.
- IMF (2018a) finds that euro area banks are, for now, resilient to stressed liquidity conditions.
- Going forward, tighter financial conditions would unevenly affect banks’ funding costs and access to liquidity.

### Policy recommendations to safeguard financial stability
- General urgency:
  - The buildup of financial vulnerabilities raises urgency for policymakers to boost resilience and ensure adequate policy tools for systemic risks and market pressures.
  - Global policy coordination is critical to safeguarding global financial stability.
- Policymakers should proactively address potential systemic risks:
  - Advanced economy central banks should continue to gradually withdraw monetary accommodation, where appropriate, and communicate intentions clearly.
  - Countries with high public sector debt burdens should aim to improve debt sustainability and enhance fiscal buffers.
  - Jurisdictions with high and rising nonfinancial sector leverage should mitigate vulnerabilities through macroeconomic and prudential policies.

### Microprudential measures to increase bank resilience
- Regulators should:
  - continue to monitor bank lending to highly indebted private nonfinancial and sovereign borrowers, as well as exposures to opaque or illiquid assets, and take measures to reduce banks’ excessive risk taking.
  - develop currency-specific liquidity risk frameworks to lessen the risk of funding strains.
    - In the Basel framework, the liquidity coverage ratio (LCR) is required to be met in the single currency of use, but it is also suggested that banks and supervisors should monitor the LCR in all significant currencies.
    - A currency is considered “significant” if the aggregate liabilities denominated in that currency amount to 5 percent or more of the bank’s total liabilities.
    - In countries where monitoring has revealed high and persistent mismatches in significant currencies, recent FSAPs have recommended implementing currency-specific LCR requirements. Examples include proposals for Romania (IMF 2018e) and Mexico (IMF 2016b).
    - Liquidy stress tests for significant foreign currencies and holding sufficient counterbalancing capacity were recommended for Japan (IMF 2017a).
  - ensure central bank swap lines are available to provide liquidity in periods of stress.
  - consider implementing net stable funding ratios in more countries.
  - address asset quality problems comprehensively, including:
    - continued efforts to tackle legacy nonperforming loans in the euro area, and
    - in emerging markets with rising nonperforming loans, undertake comprehensive and credible asset quality reviews.

### Macroprudential policy recommendations
- Macroprudential tools should be deployed proactively, in conjunction with macroeconomic policies.
- Given rising debt levels, loosening underwriting standards, and stretched housing market valuations:
  - More active use of broad-based tools, including countercyclical capital buffers, has merit to reduce exuberance and slow credit growth while increasing bank resilience.
  - Rising foreign currency debt in emerging market economies calls for more active use of tools that mitigate foreign exchange mismatches, such as:
    - limiting borrowers’ access to foreign currency debt through eligibility criteria or required regulatory approval,
    - limiting lenders’ exposure through additional risk weights,
    - adoption of currency-differentiated liquidity coverage ratios to provide additional foreign currency buffers.
- Regulators should improve data availability and develop tools to address emerging vulnerabilities outside banking:
  - Macroprudential frameworks are more developed in advanced economies than in emerging markets, with more tools available for banks than for other entities.
  - Efforts to close toolkit gaps should focus on:
    - Corporate sector vulnerabilities:
      - Excessive corporate leverage is typically addressed indirectly through loan-to-value limits and restrictions on bank lenders.
      - Macroprudential tools affecting credit intermediated through capital markets are rare.
      - In rapidly increasing corporate debt environments, authorities may need tools to limit credit intermediated through nonbank lenders.
      - Emerging markets need instruments to limit foreign currency risk exposures in the corporate sector, which could include foreign exchange reserve requirements, currency-specific risk weights, and hedging requirements.
    - Household sector vulnerabilities:
      - With household leverage high and rising, authorities—especially in jurisdictions with lasting house price booms—should consider recalibrating and expanding relevant policy tools.
      - Periodic recalibration of tools limiting household credit or lenders’ exposures may be needed.
    - Nonbank financial sector:
      - Regulators should improve and harmonize prudential regimes.
      - For insurers, establish a global capital standard and strengthen resolution regimes given potential systemic risk.
      - There are relatively few macroprudential tools for asset managers; implementing comprehensive and globally consistent standards for asset managers would provide data and tools to identify and mitigate risks related to liquidity mismatches and leverage, including more rigorous limits on concentration risks.
  - Chapter 2 provides more details on tools for central counterparties, securitization markets, and global securities financing markets.

### Emerging market economies: preparing for portfolio outflows
- Given monetary policy normalization in advanced economies and escalating trade tensions, emerging market policymakers should prepare for portfolio flow reversals.
- To reduce likelihood and severity of outflows, countries should maintain sound macroeconomic, structural, financial, and macroprudential policies, taking into account cyclical position, balance sheet vulnerabilities, and policy space.
- During market stress:
  - Exchange rate flexibility often serves as a key shock absorber; central bank interventions can be used to prevent disorderly market conditions.
  - When deciding to intervene, policymakers should consider:
    - banks’ and corporations’ balance sheet exposures in foreign currencies,
    - how the exchange rate is valued relative to fundamentals,
    - the level of foreign exchange reserves,
    - whether alternative policy measures, such as policy rate hikes, are desirable.
  - Foreign exchange interventions through derivatives can have effects comparable to spot interventions, but potential fiscal implications (including fiscal costs arising from losses) and monetary implications (such as need to sterilize liquidity injection when settling losses) should be carefully considered.
  - Convertibility risks (for instruments settled in local currency) may impair effectiveness of interventions.
- Policy priorities:
  - Build and maintain adequate foreign exchange reserves and use reserves judiciously.
  - Consider trade-offs between using reserves today to smooth volatility versus preserving policy space to stem more significant outflows in the future.
  - Complement reserve building with steps toward more flexible exchange rate regimes, where appropriate.
- Capital flow management measures:
  - Should be implemented only in crisis or near-crisis situations and should not substitute for needed macroeconomic adjustment.
  - Should be part of a broader response addressing underlying causes of crises; when used, they should be transparent, temporary, nondiscriminatory, and lifted once crisis conditions abate.
- Deepen local bond markets and promote a stable local investor base to increase resilience to capital flow volatility and reduce currency mismatches.
  - Analyze risks related to foreign ownership of local currency bonds, including exposures through derivatives.

### Multilateral policy coordination
- Multilateral policy coordination was key after the global financial crisis to restore market confidence, address financial stability challenges, and support recovery.
- Risks from waning multilateralism and regulatory fatigue:
  - Insufficient coordination increases policy uncertainty, raises risk of policy missteps, and incentivizes regulatory fragmentation and arbitrage.
  - Coordinated policy action—including monetary policy communication—sends a strong signal to markets in times of stress; losing this ability could weaken international crisis responses.
  - Individual country policy actions may not account for externalities and spillovers.
    - Examples include spillovers from unwinding unconventional monetary policy to capital flows to emerging markets; host country subsidiarization and ring-fencing measures fragmenting international banking group liquidity; disruption to financial services and market fragmentation during Brexit.
  - Increased private and non–Paris Club lending to emerging market and low-income economies could complicate debt restructuring or resolution.
  - Competitive deregulation could undo past gains and lead to a race to the bottom in regulation and supervision.
- The international regulatory community must continue cooperative solutions, including for external debt issues; the IMF will continue to promote cooperative financial policymaking.

### U.S. Treasury yield curve and implications for growth uncertainty (Box)
- The slope of the U.S. Treasury curve—defined as the spread between longer- and shorter-dated yields—has narrowed meaningfully over the past several quarters, and now stands at less than 30 basis points between 2 and 10 years, near its lowest level since before the global financial crisis.
- Outright curve inversions, when shorter-dated yields exceed long rates, have typically tended to precede recessions; narrowing of the slope has prompted concerns about the longevity of the recovery.
- Quantile time-series regressions that forecast full distributions of future real GDP growth show:
  - Including the slope between 10- and one-year nominal constant-maturity U.S. Treasury yields lowers expected one-year-ahead GDP growth and increases the odds of a recession.
  - Inclusion of the slope also boosts uncertainty around the conditional forecast and tilts the distribution toward worse outcomes.
  - This result holds after controlling for other financial variables besides the term structure.
- Another potential explanation for the narrow slope is very low term premiums; distant-horizon term premiums across major bond markets have been more closely correlated in recent years.
  - Global factors, perhaps related to unconventional monetary policies, have put downward pressure on longer-dated U.S. Treasuries, making the signal from the flatter term structure more ambiguous today.

*Italic: Chapter 1, GLOBAL FINANCIAL STABILITY REPORT—A DECADE AFTER THE GLOBAL FINANCIAL CRISIS: ARE WE SAFER?, International Monetary Fund | October 2018*

### Box 1.1. Implications of the U.S. Yield Curve Slope for the GDP Growth Distribution

### Box 1.1. Implications of the U.S. Yield Curve Slope for the GDP Growth Distribution

### Context and scenario design
- The analysis complements the October 2018 World Economic Outlook (WEO) “Scenario Box 1—Global Trade Tensions” by focusing on the financial conditions shock component and its implications for downside risks to future global growth using the growth-at-risk (GaR) approach.
- The full WEO scenario, including real, confidence, and financial shocks, can have a marked impact on global growth, with global GDP potentially coming in nearly 0.8 percent less than its current baseline forecast by the end of 2019.
- The GaR-focused shock is modeled as a widening of corporate credit spreads reflecting market participants’ expectations of a significant escalation of trade tensions between the United States and China. The effects are assumed to be persistent, lasting throughout a three-year horizon.
- Specific calibration used in the scenario:
  - A decline in U.S. corporate earnings of 15 percent in the event of an extreme escalation of trade tensions.
  - Historical relationships imply this decline corresponds to a roughly 100 basis point widening of aggregate U.S. credit spreads and a 12 percent drop of U.S. equity prices.
  - For other Group of Twenty countries, the widening of credit spreads and decline of equity prices are based on their credit ratings and stock market correlations (betas), respectively.
- Contrast with WEO timing assumption: the WEO analysis assumes the full impact of the financial shock occurs in 2019, dissipates by half by 2020, and has no impact over the medium term. In this GaR-based box, the financial condition shock is assumed to be more persistent.

### Main findings from the GaR analysis
- Near-term impact:
  - Over the near term, the financial conditions shock leads to a meaningful increase in the likelihood of severely adverse growth.
  - Compared with the baseline, growth rates in the lower 5th percentile of the distribution shift leftward by about 1.5 percentage points.
  - (Figure annotation: 1.45 percentage points is shown as a measure of the shift.)
- Medium-term impact:
  - Over the medium term, the tightening of financial conditions leads to both a leftward shift in the mode of the growth distribution and greater downside risks (a fatter left tail).
  - Normally, near-term tightening of financial conditions can mitigate medium-term downside risks by curtailing the buildup of vulnerabilities; however, because the financial condition shock is modeled as more persistent here, increased downside risk across horizons more than offsets any reduction in vulnerabilities.
  - Overall, the range of severely adverse growth outcomes shifts into negative territory, representing a relatively adverse level compared with the past three decades.
- Distributional implications:
  - The persistent financial conditions shock increases the probability mass in the lower tail of the global growth distribution across horizons, elevating the risk of severely adverse outcomes relative to the baseline.

### Key quantitative values preserved from the analysis
- Global GDP could be nearly 0.8 percent less than the baseline by end-2019 under the full WEO scenario.
- U.S. corporate earnings decline assumed in extreme escalation: 15 percent.
- Corresponding U.S. credit spread widening: roughly 100 basis points.
- Corresponding U.S. equity price drop: 12 percent.
- Horizon for persistence of market-valuation effects: three-year horizon.
- Near-term leftward shift in the lower 5th percentile of growth distribution: about 1.5 percentage points (annotated as 1.45 percentage points in figure).

*Prepared by Jeffrey Williams and Sheheryar Malik; analysis uses the growth-at-risk (GaR) framework and IMF staff estimates as presented in the source.*

### Box 1.4. Jumps and Liquidity in the U.S. Stock Market

### Box 1.4. Jumps and Liquidity in the U.S. Stock Market

### Definitions and methodology
- Jumps reflect discontinuities in prices and can be characterized as infinite activity (small jumps) or finite activity (large jumps).
- Large jumps reflect news-related shocks; small jumps correspond to price moves significant over a period of few seconds but not necessarily at lower frequency and likely reflect insufficient liquidity.
- Both small and large jumps can occur within a day; a news event can generate a large jump followed by small jumps as prices drift after an announcement.
- Methodologies used:
  - Detection of significant jumps: Huang and Tauchen (2005) and Andersen, Bollerslev, and Diebold (2006).
  - Categorization of finite vs infinite activity: spectral analysis methodology proposed by Ait-Sahalia and Jacod (2012).
  - Note: The methodology based on Ait-Sahalia and Jacod (2012) defines a range of possible distributional properties, from Poisson process (finite activity) to different Levy processes (infinite activity) and Brownian motion (continuous evolution).

### Aggregate findings on jumps in the U.S. equity market
- The proportion of daily price variation explained by jumps (either small or large) is currently at a historical low, notwithstanding a number of flash crash events in recent years (Figure 1.4.1, panel 1).
- The frequency of significant jump days per month has declined, "to about one 1" and is a standard deviation below historical norms (Figure 1.4.1, panel 2).
- Overall, the results point to a decline in the proportion of price variations explained by jumps.

### Small jumps, large jumps, and liquidity implications
- Small jumps are more likely related to poor liquidity; small jumps are less common than news-related large jumps on most days (Figure 1.4.1, panel 3).
- During episodes of dramatically spiked volatility—including the VIX Tantrum, Black Monday, and the Flash Crash—small jumps were most prevalent.
- Overall interpretation: these findings suggest that liquidity has not materially deteriorated in the U.S. equity market.
- Caution: although aggregate evidence points to resilience, flash crashes do not necessarily signal sustained market liquidity strains; similar analyses in fixed income, foreign exchange, or global corporate bond markets may imply more worrying inferences for market liquidity.

### Sectoral analysis
- Analysis of sectoral S&P indices indicates that relatively "illiquid" sectors, as measured by trading volume, tend to display a higher share of small jumps (Figure 1.4.1, panel 4).
- This sectoral finding supports an intuitive link between lower market liquidity and higher prevalence of small jumps.

### Key in-text references and notes
- Figures referenced: Figure 1.4.1 panels 1–4 illustrate the proportion of price variation due to jumps, frequency of significant jump days, relative prevalence of small vs large jumps across volatility episodes, and sectoral shares of small jumps.
- Related empirical evidence: results are consistent with recent research on high-frequency commodity futures activity (CFTC 2018) and a recent study on the UK equity market (Acquilina, Eyles, Shao, and Ysusi (2018)).

*Source: Box 1.4. Jumps and Liquidity in the U.S. Stock Market (ch1) — Global Financial Stability Report — October 2018, International Monetary Fund.*

### 1. Foreign Claims by Domestic Banks and FBOs

### 1. Foreign Claims by Domestic Banks and FBOs

### Balance sheet structures of foreign bank branches and subsidiaries (End-2017)
- Both branches and subsidiaries lend to customers, but branches also provide intragroup liquidity.
- Liquid assets include cash, reserves at the central bank, and holdings of government securities.
- Visualization notes: Data labels use International Organization for Standardization (ISO) country codes. FBO = foreign banking office; LT = long term; ST = short term.
- Sources listed in the figure: KPMG; national regulators and supervisors; S&P Global Market Intelligence; and IMF staff analysis.

### Asset mix and funding mix (Branches versus Subsidiaries)
- Branches rely on intragroup funding, while subsidiaries have broader deposit bases.
- Asset mix categories shown: Liquid assets; Marketable securities; Loans; Intragroup claims; Other assets.
- Funding mix categories shown: ST wholesale; Deposits; LT funding; Intragroup liabilities; Other; Net worth.

### Trends in branch liquidity, lending, and intragroup positions (2010–17)
- Liquid assets have risen while either customer credit has fallen or intragroup net claims have declined.
- Change observations:
  - Change in Branch Liquid Assets and Customer Credit (Percent of assets, 2010–17).
  - Net intragroup claims (percentage of assets).
- Simulations:
  - Simulations assume an increase in holdings of liquid assets—which increases the branch’s liquidity ratio—and then calculate how much loans (intragroup credit) would need to drop if intragroup credit (loans) is held constant, increases (by 10 percentage points of assets), or falls (by 10 percentage points of assets).
  - Simulated scenarios reported as:
    - If loans-to-asset ratio: Falls by 10 percentage points; Is unchanged; Increases by 10 percentage points.
    - If intragroup claims-to-assets ratio: Falls by 10 percentage points; Is unchanged; Increases by 10 percentage points.
- Simulation outputs presented as:
  - Simulated Branch Loans under Different Liquidity Ratios (Percent of assets).
  - Simulated Branch Intragroup Claims under Different Liquidity Ratios (Percent of assets).
- Note: Liquidity ratio defined as liquid assets divided by total assets. Liquid assets include cash, deposits with central banks, and government securities.
- Sources: Bank for International Settlements; KPMG; national regulators and supervisors; S&P Global Market Intelligence; and IMF staff analysis.

### Drivers and implications of higher branch liquidity
- Possible drivers of higher branch liquidity:
  - Commercial incentives to hold more liquid assets (examples in text: foreign banks seeking higher-yielding government bonds in the United States; foreign banks in Japan depositing swap proceeds).
  - Unconventional monetary policies leading to elevated levels of reserves at central banks.
  - Host regulators’ guidance and pressures prompting banks to hold more liquid assets.
- Consequences and systemic considerations:
  - Where liquid assets have increased significantly, branches have tended to reduce either lending (examples: Japan and Germany), gross intragroup claims, or net lending to group affiliates (example: the United States), fragmenting intragroup activity.
  - Further increases in branch liquidity ratios are likely to result in a significant reduction of loans to customers or intragroup claims per the simulations.
  - Fragmentation of the international banking system could heighten systemic risks:
    - Ring-fencing can prevent contagion within banking groups and protect local depositors.
    - Heightened local control weakens foreign banks’ ability to direct liquidity into stressed country offices.
    - Eligibility of FBOs for central bank liquidity varies across jurisdictions; in several countries, subsidiaries are eligible but branches are not (BIS 2017a).
  - Regulatory tightening combined with tightening foreign currency liquidity conditions could make a sudden spike in funding costs more likely.
  - Banking groups might respond to restrictions on branch networks by increasing cross-border lending, which has historically been a more procyclical supply of credit than lending through branches.
  - Local banks might need to finance a sharp expansion in credit with less stable short-term funding if they fill gaps left by FBOs.
  - Reduced provision of some services to multinational corporate clients could push these clients toward nonbank substitutes whose risks are not fully understood.

### Changes in regulation of foreign branches (examples and timelines)
- Before 2015:
  - Structural measures introduced include:
    - United Kingdom: Ring-fencing provisions recommended in ICB (2011) aka The Vickers Report and Liikanen and others (2012).
    - United States: Dodd-Frank Act and Volcker Rule (2010).
  - Of 31 countries in an OECD survey:
    - 22 impose local financial requirements on FBO branches.
    - 14 have changed regulation of FBO branch operations.
    - 4 effectively require local entities.
    - Nearly half may require systemic operations to convert to subsidiaries, depending on size, complexity, and other considerations.
  - In emerging market economies, specific requirements on branch operations exist in Indonesia, India, and Singapore.
- 2015–Present (examples from the United States):
  - Regulation YY (implemented in 2016) requires FBOs with assets greater than $50 billion to establish intermediate holding companies subject to capital and liquidity rules as well as stress tests.
  - The Intermediate Holding Company framework includes branches within the “responsible officer” governance perimeter.
  - The framework in the United States includes:
    - A 14-day liquidity buffer for U.S. branch operations.
    - A 30-day liquidity buffer for the U.S. Intermediate Holding Company.
- Emerging and future measures (examples):
  - The European Union is currently defining an Intermediate Parent Undertaking framework.
  - The United Kingdom is updating its approach to authorization and supervision of FBO branches, emphasizing a pragmatic balance between safety and openness.
  - In the United States in 2018:
    - Many FBOs permitted to submit limited or reduced resolution plans in 2018.
    - For the first time, systemic FBO branches of six non-U.S. global systemically important banks must be explicitly recognized in resolution plans.
    - 2018 guidance requires FBOs to conform to resolution liquidity requirements, including intragroup liquidity tracking. Intragroup liquidity transfers are permitted, but should be supported by financial and legal impact analyses.
    - Material branches must identify and map financial and operational interconnections that affect other group entities or the U.S. resolution strategy.
- Sources for table: Cleary Gottlieb 2017; Financial Stability Board 2014; Gambacorta and van Rixtel 2013; Ichiue and Lambert 2016; IMF 2014; OECD 2017; Vinals and others 2013; interviews with market participants; and IMF staff.

### Main advantages and disadvantages of centralized and decentralized international banking models (summary)
- Provision of Services:
  - Centralized models have greater flexibility to transfer funds across borders, helping banking groups provide services to multinational companies.
  - Research suggests lending provided by subsidiaries can be less procyclical than credit supplied by branches.
- Resilience of Banking Groups:
  - Centralized banking groups are more susceptible to contagion because distress in one entity can be transmitted more readily to other entities in the banking group.
  - In decentralized models, banking groups can be shielded from distress in local entities, but parent support to limit reputational risk can reduce this benefit.
  - Subsidiaries operating in decentralized models might receive limited liquidity support from the rest of the group, but being separate legal entities may mean they have more resilient funding profiles than branches.
- Resolution:
  - Subsidiaries, as separate legal entities, can be more easily resolved than branches.
- Sources: Beck and others 2015; Berrospide and others 2016; Ervin 2018; Faykiss, Grosz, and Szigel 2013; Fiechter and others 2011; Goldberg and Gupta 2013; Hoggarth, Hooley, and Korniyenko 2013; Vinals and others 2013; discussions with market contacts; and IMF staff analysis.

### Policy recommendations to manage risks in banking groups
- Home-Host Collaboration:
  - Where home-host collaboration does not currently take place, regulators should more actively coordinate. Where agreements exist, regulators should assess whether changes are needed to make them more effective.
  - BIS (2017b) reports progress on information sharing but notes challenges remain.
- Regulatory Coordination:
  - Greater coordination is needed to ensure that measures adopted in individual countries do not impose significant costs on the global financial system.
  - International standards for regulatory and supervisory regimes applied to large, internationally active banks should be consistently implemented.
  - Subsidiarization and ring-fencing measures should be assessed for incentives they create for risk migration into the less regulated nonbank sector.
- Enhanced Resolution:
  - Harmonization of creditor hierarchies would facilitate cross-border resolution.
  - Significant differences in creditor hierarchies between jurisdictions, particularly in the treatment of deposits, pose obstacles to cross-border resolution of branches.
  - Better dissemination of information about international bank branches and their exposures—including more regular, consistent, and comprehensive use of legal entity identifiers by all supervisors—can improve host authorities’ visibility into branch risks.
- Central Bank Liquidity Support:
  - Host central banks may consider providing liquidity assistance to foreign branches if they do not already do so.
  - Home supervisors should facilitate host liquidity support by providing enhanced information about banking group conditions and risks.
- Source: IMF staff.

*International Monetary Fund | October 2018*

### CHAPTER 1 A DECADE AFTER ThE GLOBAL FINANCIAL CRISIS: ARE WE SAFER?

### CHAPTER 1 A DECADE AFTER ThE GLOBAL FINANCIAL CRISIS: ARE WE SAFER?

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- Ichiue, Hibiki, and Frederic Lambert. 2016. “Post-Crisis International Banking: An Analysis with New Regulatory Survey Data.” IMF Working Paper 16/88, International Monetary Fund, Washington, DC.
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- ———. 2017a. “Japan: Financial System Stability Assessment.” IMF Country Report 17/244, Washington, DC.
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- ———. 2017d. “Recent Trends in Correspondent Banking Relationships—Further Considerations.” IMF Policy Paper, Washington, DC.
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*International Monetary Fund | October 2018*

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