## ch1

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---

### Returns by Asset Class — Global market developments
- Asset prices rebounded in 2019 year to date after negative returns in 2018 across: Oil (Brent); China equities; Commodities; S&P 500; Eurostoxx 50; EM equities; Topix; US corp HY; EM sov $; Euro corp HY; EM corp $; US corp IG; EM govts local; Euro corp IG; Gold; JGBs; US T-bills.
- Dovish US monetary policy shift supported risk sentiment, evidenced by:
  - Declining market implied volatility (VIX).
  - Declining earnings uncertainty (dispersion of global EPS forecasts).
- Treasury markets: MOVE and the term premium dropped to historically low levels.
- Panel numeric values preserved from figures:
  - Federal funds / yield ticks: 1.75, 2.00, 2.25, 2.50, 2.75, 3.00, 3.25, 3.50.
  - Time labels: Oct. 2018, Nov. 18, Dec. 18, Jan. 19, Feb. 19, Mar. 19.
  - Short-run federal funds plotted values: 1.9, 2.0, 2.1, 2.2, 2.3, 2.4.
  - VIX/MOVE scales include: 10, 15, 20, 25, 30, 35, 40, 45, 50, 55, 60, 65, 70, 75 and negative MOVE increments: –0.75, –0.65, –0.55, –0.45, –0.35, –0.25, –0.15.
  - Maturities and indices scales: 5, 6, 7, 8, 9, 10, 11 and 380, 400, 420, 440, 460, 480, 500, 520, 540, 560.

### Monetary policy outlook and yield-curve moves
- US Fed communications in early 2019:
  - Indicated greater flexibility and patience.
  - March FOMC announced current runoff of balance sheet will end in September 2019.
- Market expectations:
  - Investors no longer anticipated any policy rate hikes in 2019–20.
  - Federal funds futures curve and FOMC dot projections show a lower policy rate path.
- US Treasury yield curve moved down sharply.

### Financial conditions — Regional summaries
- United States:
  - Dovish shift, lower expected policy rates, and decline in term premium eased financial conditions; conditions tightened on net but remain accommodative.
- Euro area:
  - Early-2019 rebound attenuated late-2018 tightening.
  - ECB ended net purchases at end-2018 and intends to leave policy rates unchanged at least through 2019; investors did not expect rate hikes before end-2020.
  - Announced targeted longer-term refinancing operations to preserve bank lending conditions.
- China:
  - Regulatory tightening and deleveraging reduced corporate valuations in 2018; authorities cut reserve requirements and eased interbank spreads.
  - Equities rallied early 2019; overall financial conditions broadly stable.
- Systemically important EMs (ex-China):
  - Aggregate financial conditions remained stable and close to neutral in Q1 2019 after significant tightening in 2018.

### Growth-at-Risk (GaR) and risk outlook
- Net tightening in global financial conditions raised near-term downside risks:
  - Severely adverse scenario (5th percentile) shifted toward lower growth rates.
  - Net increase in near-term downside risks remains statistically significant despite recoveries.
  - Medium-term GaR remains elevated and close to historically high risk levels.
- Final observation corresponds to 2019:Q1; analysis refers to the 5th percentile (GaR).

### Global financial vulnerabilities — sectors and magnitude
- Vulnerabilities arise from leverage, liquidity, maturity, and currency mismatches across sovereigns, firms, households, banks, insurance companies, and other financial institutions.
- Key points:
  - Corporate-sector vulnerabilities are elevated in systemically important countries accounting for about 70 percent of total GDP.
  - Sovereign, corporate, and nonbank financial sector vulnerabilities are elevated by historical standards in several systemically important countries and regions.
  - Red shading in panels indicates top 20 percent of pooled samples for 2000–2018; dark green indicates bottom 20 percent.

### Aggregate assessment
- Medium-term financial stability risks remain elevated.
- Recent tightening was too short-lived to materially reduce buildup of vulnerabilities.
- A prolonged period of easy financial conditions could set the stage for a more severe downturn later.

---

### Nonfinancial firms — Debt-to-GDP and regional vulnerabilities
- Euro area: rising liquidity and maturity mismatches in investment funds; insurance sector moderate vulnerabilities in aggregate.
- Other advanced economies:
  - Household leverage elevated and rising in a number of countries.
  - Government debt remains elevated across most countries.
  - Banks generally low vulnerability, but some show high structural maturity and liquidity mismatches.
  - Japan: low bank profitability and elevated risk taking by nonbank financial intermediaries remain concerns.
- China:
  - Nonfinancial and financial-sector vulnerabilities remain elevated despite authorities’ efforts.
  - Regulatory tightening contracted investment vehicle assets; broker-dealer leverage rose.
  - Small and medium-sized banks need balance-sheet strengthening.
- Other major EMs:
  - Weaker fiscal balances partially mitigated by reduced rollover risk through maturity extension.
  - Bank-sector strains more pronounced in some EMs.

### Asset valuations, spreads, and real estate
- Equity valuations in most major markets seem close to fair values after narrowing since October 2018.
- Credit spreads widened on net since October 2018, mostly due to higher credit risk premiums.
- Valuations moderately elevated in US investment-grade, US high-yield, and EM corporate bonds.
- Term premiums historically low but mostly fairly priced.
- Commercial real estate capitalization rates reached all-time lows in some countries; spread to risk-free rates still above precrisis levels.
- Concerns about downside risks to residential real estate prices in a number of countries.

### Risks that could trigger renewed sell-off of risk assets
- Sharper-than-expected global growth slowdown, unexpected less-dovish monetary policy, protracted trade tensions (e.g., US-China), and Brexit stalemates.
- Brexit risks include lifecycle events on uncleared derivatives, operational risks, reduced liquidity, and supervisory challenges; mitigation measures enacted (currency swaps, time-limited equivalence, UK temporary permission measures).

---

### Late-cycle corporate sector risks in advanced economies
- Debt-service capacity improved during upswing; balance sheets can sustain moderate slowdown or gradual tightening.
- Overall debt levels and financial risk taking increased; creditworthiness deteriorated in IG bond and leveraged loan markets.
- Late-2018 sell-off, early-2019 recovery:
  - December 2018: spreads on corporate bonds and leveraged loans widened sharply in US and Europe, especially for lower-rated firms.
  - Leveraged finance issuance nearly dried up late 2018; bond and loan investment funds had large outflows.
  - Early 2019: corporate spreads tightened and primary high-yield bond markets reopened.

### Market structure and investor-base shifts
- Holdings of corporate bonds in US investment funds more than doubled since 2009, reaching about 20 percent in 2018.
- Foreign investors’ share in US corporate bond holdings increased from 25 percent to 30 percent in the United States.
- US leveraged loan market:
  - Banks’ share declined to 8 percent.
  - CLOs increased from 47 percent to close to 60 percent.
- Speculative-grade credit share declined from 31 percent in 2007 to 25 percent in 2018.
  - Speculative-grade credit = 3 percent of GDP in the euro area and 12 percent of GDP in the United States in 2018.
- Outstanding stock of BBB-rated bonds has quadrupled since the crisis.

---

### Nonfinancial business financing and holdings — exact holdings (IG and HY)
- IG holdings: $5.1 trillion
  - Life insurance: 29%
  - Pension funds and separate accounts: 22%
  - Insurance portfolios: 13%
  - Income funds: 15%
  - High-yield mutual funds and ETFs: 21%
  - Offshore funds: 3%
- HY holdings: $1.3 trillion
  - Banks: 3%
  - Mutual funds: 18%
  - P&C: 6%
  - Pension funds: 17%
  - Corporations: 6%
  - HFs: 14% (in one panel), 2% (in another panel)
  - Other: 19% (panel), Other: 8% (panel)

### BBB-rated bonds and downgrade risks
- Universe of BBB-rated US corporate bonds is roughly twice the size of the entire US high-yield bond market.
- Market-implied estimate of BBB bonds trading closer to high yield: approximately $200 billion in par value, or about 6 percent of BBB-rated companies.
- Widening in late-2018 spreads driven entirely by higher credit risk premiums rather than modeled default compensation.

---

### US leveraged loan market — selected 2007 versus 2018 statistics
- Size (as a percentage of IG outstanding): 2007: 34.6; 2018: 49.3.
- Gross Leverage (times): 2007: 2.4; 2018: 3.0.
- Net Leverage (times): 2007: 2.1; 2018: 2.6.
- Share of Companies with > 4× Leverage (percent): 2007: 16; 2018: 23.
- Interest Coverage (times)*: 2007: 7.3; 2018: 7.9.
- EBITDA Margin (percent)*: 2007: 19; 2018: 21.
- Gross Margin (percent)*: 2007: 35; 2018: 40.
- Spread (basis points): 2007: 198; 2018: 121.
- Outstanding Leveraged Loans ($ billions): 2007: 554; 2018: 1,147.
- US Issuance (percent of global issuance): 2007: 66.9; 2018: 75.8.
- Covenant Quality Index: 2007: 2.6; 2018: 4.1.
- Covenant-Lite Share (percent of new issuance): 2007: 29.2; 2018: 84.7.
- B-Rated (percent of new issuance): 2007: 22.6; 2018: 58.0.
- Total Debt/EBITDA (times): 2007: 4.9; 2018: 5.3.
- First Lien Debt/EBITDA (times): 2007: 3.5; 2018: 4.3.
- Other Debt/EBITDA (times): 2007: 1.4; 2018: 1.0.
- Deals with EBITDA Add-Backs (percent of new issuance): 2007: 8.4; 2018: 27.1.
- Covenant-lite share rose from 29.2 percent in 2007 to 84.7 percent in 2018.

---

### Corporate fundamentals and profitability
- Corporate profitability improved over past two years; returns on assets higher in the United States than other advanced economies.
- Large US corporations benefited from tax reform, strong revenue growth, and wider profit margins; profits declined notably in Q4 2018.
- Uses of cash: dividends and share buybacks outstripped investment, reaching postcrisis highs for US S&P 500 firms.
- Expected EPS growth for 2019 revised down, particularly for firms with significant international exposures (e.g., information technology).

---

### Downgrade rates of US BBB to high-yield and market impact
- A large downgrade wave from IG to HY could temporarily increase HY credit risk premiums by as much as an estimated 90 basis points if all bonds rated at BBB– with negative outlook were downgraded.
- HY market is less liquid and has a narrower investor base; recent HY issuance relatively low.
- Market-based estimates of potential downgrades to high yield are within a range implied by rating agencies.
- High-yield credit risk premium modeled as function of net supply, implied volatility from one-year at-the-money S&P 500 options, and HY CDS-cash basis.

### Leveraged loan market vulnerabilities and mitigating factors
- Leveraged loans approaching size of HY bonds; investor base shifted to nonbank investors.
- 31 percent of leveraged loan issuance used for refinancing.
- Mitigants:
  - Banks’ retained loans account for only 2.5 percent of total tangible bank equity.
  - Warehouse lines to CLO managers estimated at about $20 billion currently versus more than $200 billion in 2008.
  - Global banks hold about 33 percent (or $250 billion) of CLO stock, mostly highest-rated tranches.
  - Top 5 and top 20 US loan products own nearly 15 percent and 30 percent of US loan market, respectively.

---

### Sovereign–financial nexus (Euro area) and banking-sector resilience
- Fiscal challenges in Italy widened sovereign spreads in H2 2018 and spilled over to banks (CDS spreads rose with sovereign spreads).
- Domestic government bond portfolios large relative to assets in Belgium, Italy, Portugal, and Spain.
- Banks increased capital and loan loss reserve buffers since the crisis (2010 to 2018:Q2), reducing vulnerability but NPL stock remains a significant burden.
- Simulations show mark-to-market losses and loan-loss adjustments could pressure Tier 1 ratios under adverse scenarios; outcomes vary across banks and countries.
- Some estimated loan losses on NPLs could exceed existing loan loss reserves.

### Policy and structural measures highlighted
- Regulators required banks to increase capital and loan-loss reserve buffers.
- Central bank liquidity support and official asset purchases helped stabilize markets in past episodes.
- Banking Union reforms implemented include the Single Supervisory Mechanism, Single Resolution Mechanism, and Bank Recovery and Resolution Directive; establishing a European Deposit Insurance Scheme remains needed.

---

### Tier 1 capital ratios — moderate downside scenario (scenario inputs and outcomes)
- Scenario table entries preserved verbatim:
  - 1. Scenarios of Changes in Sovereign Bond Yields (Basis points)
    - Mild–500255075Moderate4865
    - Severe–10050150250425Adverse7090
  - 2. Loan Loss Adjustment Scenarios (Percent of face value)
    - Sovereign Credit RatingType of Nonperforming Loan
    - AAAAAABBBBBSecuredUnsecured
    - Downside  
      ScenarioScenario
- Note: mild (severe) bond yield scenario approximates the 90th (99th) percentile of 3-month changes in 5-year sovereign yields over 2000–18; scenarios assume a flight to quality to AAA-rated bonds approximating the 10th (1st) percentile.
- Loss-rate reference for NPL sales (Italy): secured bad loans averaged 26 percent (loss of 74 percent of face value); unsecured bad loans averaged 10 percent (loss of 90 percent of face value).
- Under moderate downside scenario (mark-to-market changes + NPL adjustments), EBA bank Tier 1 ratios would be higher than in 2010 (light blue bars in Figure 1.17, panel 5).
- In adverse scenario, most banks’ post-shock Tier 1 ratios remain higher than 2010, but Italian and Portuguese EBA banks’ post-shock Tier 1 ratios are slightly lower than in 2010.
- Caveats: analysis may omit loans to state-owned entities, off-balance-sheet exposures, and hedges; shifts to held-to-maturity reduce marks-to-market but also balance-sheet flexibility.

### NPLs and provisioning implications
- Stock of NPLs could induce further losses that may exceed loan loss reserves in some cases.
- If UTP loss rates are assumed 25 percent lower than other NPLs, estimated Italian EBA bank loan losses would be 12 percent lower than in adverse scenario; impact on Tier 1 ratio about 90 basis points versus around 280 basis points in adverse scenario.
- ECB guidance: raise loan loss reserve coverage to 100 percent on new nonperforming unsecured loans within two years and on new nonperforming secured loans over seven years.
- EBA proposal: banks with gross NPL ratios of 5 percent or above to establish a strategy to manage and mitigate NPLs.

### Insurance-sector exposures under scenarios
- Euro area insurers own >15 percent of outstanding euro area sovereign bonds and almost 25 percent of euro area bank bonds.
- Exposure of European insurers to BBB-rated corporate and sovereign bonds rose from about 5 percent to more than 20 percent from 2008 to 2017.
- Severe scenarios imply significant losses for insurers in highly indebted sovereign jurisdictions; most insurers remain well capitalized but severe shocks would pressure insurers with lower solvency ratios.
- Solvency II volatility adjustment alleviates some shocks; mitigation less effective where insurers’ portfolios are riskier than the Solvency II reference portfolio.

### Macro-financial contagion channels (selected mechanisms)
- Macro slowdown channel: economic slowdown reduces incomes and debt servicing, increasing NPLs and reducing government revenues.
- Funding-cost channel: a 100-basis-point rise in 10-year government bond spreads could cause similar increases in yields on new bank bonds (Bank of Italy estimate).
- Transmission to lending, bond-demand channel, and sovereign contingent-liability channel described; interplay noted across channels 1–14 in source material.
- Central bank liquidity support has limited funding-cost rises; eligibility of downgraded sovereign bonds as collateral could be constrained if downgraded below investment grade by all four major rating agencies.

### Policy priorities from scenarios
- Monitor and address sovereign–financial sector linkages; consider bank buffers and distribution of exposures.
- Implement and sustain NPL cleanup strategies consistent with ECB guidance and EBA proposals.
- Monitor insurers’ rising exposures to lower-rated debt and subordinated/hybrid bank debt; consider Solvency II interactions.
- Advance macroprudential, resolution, and loss-absorbing buffers to reduce likelihood of sovereign bailouts and limit spillbacks.

---

### Equity benchmarks, emerging and frontier markets, and portfolio flows
- Chinese equities rebounded early 2019; reserve ratio cut three times since October 2018 GFSR; equity market rose by more than 25 percent in early 2019.
- Nonfinancial credit growth accelerated early 2019; bond market defaults rose sharply among private issuers.
- Frontier issuance restarted early 2019; examples cited include Ecuador (double-digit yield) and Uzbekistan first issuance.
- Portfolio flows to EMs rebounded after outflows in 2018; increased investor risk aversion estimated to have reduced portfolio flows by some $20 billion in Q4 2018 (about 10 percent of average annual inflows in 2015-18).
- Role of ETFs: steady inflows into EM-dedicated ETFs cushioned outflow pressures; equity ETF inflows concentrated in China since early 2017.
- Benchmark-driven investors:
  - Funds benchmarked to widely followed EM bond indices quadrupled to $800 billion in past 10 years.
  - Estimated 70 percent of country allocations of investment funds influenced by benchmark indices.
  - Sensitivities:
    - One standard deviation increase in VIX (3.5 percentage points) reduces invested assets of benchmark-driven EM investors by 2 percent vs ½ percent for total portfolio investment.
    - One standard deviation increase in US 10-year yields (20 basis points) reduces invested assets by 1½ percent for benchmark-driven investors vs ~¼ percent for total portfolio investment.
  - Estimated outflows to a one standard deviation interest-rate shock:
    - Using 2013 data: about $2 billion.
    - Using latest sensitivity and AUM: close to $11.5 billion.
- Distributional impacts: frontier issuers account for ~13 percent of debt eligible for EMBIG; weight in EMBIG-Diversified ~23 percent.

---

### Benchmark-driven foreign holdings of local-currency sovereign debt
- Benchmark-driven flows highly correlated across countries and highly sensitive to external factors; sensitivity increased in recent years.
- Data notes: correlations based on EPFR Global country-level fund flows; panels and coefficients described for 36-month rolling regressions and data as of 2018:Q2.
- China index inclusion:
  - Bloomberg Barclays Global Aggregate will add renminbi-denominated government and policy bank bonds starting April 2019 phased over 20 months.
  - About $2 trillion to $2.5 trillion track the Bloomberg index.
  - Expected country weight after full inclusion: about 6 percent.
  - Could bring $150 billion in additional inflows to China by 2020; market analysts expect eventual inflows closer to $300 billion across indices.
  - Gradual inclusion of China’s A-shares in MSCI and FTSE could boost flows by more than $150 billion.

---

### China — shadow credit, small/medium banks, and policy scenarios
- Regulatory tightening slowed bank asset growth, with sharp reduction in claims on other financial institutions; shadow credit contraction led by small and medium-sized banks.
- WMP conversion to net-asset-value-based products minimal: 2.7 percent of all issuance in 2018 (from 0.5 percent in 2017).
- Small and medium-sized banks:
  - Account for just over half of commercial bank assets but >70 percent of commercial bank loan growth to SMEs since 2015:Q1.
  - Profitability and capital ratios edging lower; many near regulatory minima; core Tier 1 ratios near minimums.
- Hypothetical scenarios for small and medium-sized banks (Figure 1.26):
  - Scenario A — improve resilience within a year:
    - Increase core Tier 1 equity ratios to system average (10.5 percent) and hold capital against 50 percent of on-balance-sheet shadow credit and 30 percent of off-balance-sheet WMP assets → banks would have to shrink loan books about 30 percent within one year (assumes dividend payout ratio reduced by 50 percent from 2017).
  - Scenario B — build resilience over time:
    - If balance-sheet strengthening achieved over time, most banks could not do so within five years assuming 10 percent loan growth; at 5 percent loan growth most banks could grow out of problems within five years.
- Policy implications:
  - Higher credit growth will prolong balance-sheet weakness.
  - Further monetary/credit easing without reforms may increase vulnerabilities by tilting credit to infrastructure and property.
  - Bank capital buffers should be strengthened via injections or profit retention.
  - Timely implementation of asset management reforms is important to delink banks from sponsored investment products.

### China sectoral credit allocation risks
- Lending resilient to property and infrastructure while nonbank credit to other sectors contracted in 2018.
- Infrastructure and property firms enjoy more favorable borrowing conditions and net issuance increases more during easing; these firms tend to be more leveraged and weaker in debt-service capacity.
- Real estate and land valuations are stretched; further credit growth in these sectors likely to worsen asset price misalignments and increase household debt.
- Additional infrastructure projects may lack sufficient cash flow and increase contingent public debt.

---

### China’s Share-Collateralized Lending (SCL)
- Equity declines in 2018 exacerbated pressures on SCL-reliant firms:
  - Some firms’ equity prices fell >40 percent at trough; overall stock market declined as much as 26 percent.
- SCL concentration:
  - About 20 percent of market value of privately owned enterprises’ listed shares pledged vs 3 percent for central SOEs and 6 percent for local SOEs.
  - As of end-October 2018, SCL-reliant firms (≥30 percent shares pledged) accounted for 44 percent of listed private firm assets and 15 percent of all listed firm assets.
  - Nearly half of all mid-cap private nonfinancial companies were SCL-reliant.
- Lender composition and exposures:
  - Securities firms: ~52% of market value of pledged shares.
  - Banks: ~21%.
  - Trust companies: ~15%.
  - Direct bank exposures small: banks = 0.4% of corporate loans.
  - Seven largest securities firms’ on-balance-sheet SCL exposures estimated at about 10–20% of assets.
- Estimated SCL exposures (RMB billion; loans assumed 50%–75% of market value of pledged shares):
  - Banks: 434–651.
  - Trust Companies: 318–478.
  - Securities Firms: 1,118–1,676.
- Percentages of balance sheets/client assets:
  - Bank lending to firms: 0.4–0.7.
  - Trust company balance sheets: 38.4–57.6.
  - Trust company balance sheets and client assets: 1.3–1.9.
  - Securities firm balance sheets: 17.5–26.3.
  - Securities company balance sheets and client assets: 5.2–7.7.
- Policy recommendations:
  - Further tighten SCL practices, reduce distortions favoring SOEs, reduce credit overhang at unviable borrowers, and advance market reforms to discourage risky borrowing from nonbank intermediaries.

---

### Special feature — Liquidity risks in capital markets: structural changes and strains
- Postcrisis regulation and technology reshaped liquidity provision and demand; incidence of flash crashes and liquidity strain increased since September 2018.
- Structural supply/demand changes:
  - Tighter regulation raised market-making costs; dealer trading books reduced.
  - Rise of nonbank principal trading firms (PTFs) and high-frequency trading; on US dealer-to-dealer electronic platforms, banks and broker-dealers <40% of volumes, PTFs >50%.
  - ETFs and passive investors increase liquidity mismatches; growth of passive investing may increase component security correlation and herding.
  - Central bank asset purchases reduced free float of safe liquid securities; investors reached for yield in less liquid assets.
- Electronic trading penetration (selected):
  - Equity: 90%.
  - Futures: 90%.
  - Cash Equities: 80%.
  - Foreign Exchange Spot: 70%.
  - Cash Treasuries: 60%.
  - Japanese Government Bonds: 20–50%.
  - Interest Rate Swaps: 15–50%.
- Standard liquidity metrics show quantity declines (turnover ratios) while price-based measures remain relatively robust; divergence between highly liquid and illiquid markets increased.
- High-frequency intraday jump analysis:
  - Jumps account for large share of intraday variation in episodes (e.g., JPY/USD Jan. 3, 2019 flash: nearly 4% surge; over 85% of price variation due to jumps).
  - Sovereign bond markets more prone to liquidity strain than equity markets; emerging markets show higher frequency of liquidity-strained days.
  - UK gilt market: frequency of liquidity strained days (Nov 2018–Jan 2019) averaged 2.3 days/month vs other major advanced economy sovereigns 1.5 days/month.
- Policy recommendations:
  - Regulators should scrutinize market liquidity, assess trade infrastructure, support transparency, monitor PTF counterparties’ intraday activity and leverage, and improve data availability on nonbank market makers.

---

### Bloomberg liquidity index and bid-ask spreads (Italy)
- Bloomberg liquidity index consistently elevated for Italian sovereign bonds in recent years relative to German bunds.
- Off-the-run Italian bonds reflect higher credit and redenomination risks; bid-ask spreads in Italian market more volatile even when sovereign spreads relatively tight.
- Limitations: trading volume and algorithmic market making can mask fragile actual liquidity.

---

### Policy priorities and prudential toolkit recommendations (summary)
- Monetary policy: be data dependent and communicate outlook clearly to avoid market swings.
- Macroprudential: use countercyclical capital buffers and sectoral capital buffers where appropriate; calibrate borrower-based limits (LTV, DSR, DTI) broadly, including nonbank lenders.
- Nonbank sector tools:
  - Insurance: continue Solvency II implementation, strengthen risk management for default/correlation risk, assess subordinated/bail-inable bond treatment, move to holistic systemic-insurance framework.
  - Asset managers: harmonize leverage measurement, consider limits on leverage/credit extension, minimum liquidity buffers, and guidance on liquidity management.
- Sovereign–bank nexus:
  - Highly indebted sovereigns should place debt-to-GDP ratios on downward trajectory and pursue gradual fiscal adjustment.
  - Continue bank balance-sheet repair and NPL reduction using insolvency and creditor-rights reforms.
  - Complete Banking Union elements (e.g., European Deposit Insurance Scheme).
- Emerging markets:
  - Strengthen buffers: reduce external liabilities, maintain fiscal buffers, bank liquidity buffers, and FX reserves.
  - Use exchange rates as shock absorbers where flexible; intervene when disorderly.
  - Use capital flow management measures on outflows only in crisis/near-crisis, as part of comprehensive policy package.
  - Sovereign debt managers should mitigate rollover risk and plan ahead.
  - Encourage dialogue between index providers, investors, and regulators; enhance index-provider transparency.
- China-specific:
  - Continue de-risking and deleveraging while emphasizing bank vulnerability reduction.
  - Strengthen bank capital buffers via injections or profit retention.
  - Implement asset management reforms to delink banks from sponsored investment products and reduce implicit guarantees.
  - Structural reforms: reduce emphasis on growth targets and tighten SOE budget constraints to reduce credit misallocation.

*Italic: Source: ch1 — CHAPTER 1 Vulnerabilities in a Maturing Credit Cycle, International Monetary Fund | April 2019*

### 1. Returns by Asset Class

### 1. Returns by Asset Class

### Global Market Developments and Asset Returns
- After posting negative returns in 2018, asset prices rebounded in 2019 year to date across a range of asset classes, including:
  - Oil (Brent)
  - China equities
  - Commodities
  - S&P 500
  - Eurostoxx 50
  - EM equities
  - Topix
  - US corp HY
  - EM sov $
  - Euro corp HY
  - EM corp $
  - US corp IG
  - EM govts local
  - Euro corp IG
  - Gold
  - JGBs
  - US T-bills
- The dovish shift in US monetary policy reduced perceptions of downside risk and supported positive risk sentiment in equity markets, reflected in:
  - Declining market implied volatility (VIX)
  - Declining earnings uncertainty (dispersion of global EPS forecasts)
- In Treasury markets:
  - Market implied volatility (MOVE) and the term premium dropped to historically low levels.

### Monetary Policy Outlook and Yield Curves
- US Federal Reserve communications in early 2019:
  - Indicated greater flexibility and patience in setting monetary policy.
  - At the March FOMC meeting, announced that the current runoff of the balance sheet will end in September 2019.
- Market expectations shifted:
  - Investors no longer anticipated any policy rate hikes in 2019–20.
  - The federal funds futures curve and FOMC dot projections show a lower policy rate path (panel 3).
- US Treasury yield curve moved down sharply (panel 4).
- Panel numeric values captured in figures (as presented in source):
  - Federal funds / yield ticks: 1.75, 2.00, 2.25, 2.50, 2.75, 3.00, 3.25, 3.50
  - Time labels: Oct. 2018, Nov. 18, Dec. 18, Jan. 19, Feb. 19, Mar. 19
  - Maturities and indices shown with scales: 5, 6, 7, 8, 9, 10, 11 and 380, 400, 420, 440, 460, 480, 500, 520, 540, 560
  - Short-run federal funds plotted values: 1.9, 2.0, 2.1, 2.2, 2.3, 2.4
  - VIX/MOVE scales include values: 10, 15, 20, 25, 30, 35, 40, 45, 50, 55, 60, 65, 70, 75 and negative MOVE increments: –0.75, –0.65, –0.55, –0.45, –0.35, –0.25, –0.15

### Financial Conditions: Regional Summaries
- United States:
  - The dovish policy shift, lower expected policy rates, and a decline in term premium contributed to an easing of financial conditions.
  - Financial conditions have tightened, on net, but remain accommodative.
- Euro area:
  - Early-2019 rebound in financial markets attenuated late-2018 tightening in financial conditions.
  - ECB ended net purchases under its bond purchase program at the end of 2018 and intends to leave policy rates unchanged at least through 2019; investors did not expect rate hikes before end-2020.
  - Announced targeted longer-term refinancing operations to preserve favorable bank lending conditions.
- China:
  - Financial regulatory tightening and deleveraging reduced corporate valuations in 2018.
  - Authorities cut reserve requirements for banks and took other easing steps to lower interbank spreads.
  - Equities rallied early 2019; overall financial conditions remained broadly stable.
- Systemically important emerging markets other than China:
  - Aggregate financial conditions remained stable and close to neutral in Q1 2019 after significant tightening in 2018.

### Growth-at-Risk (GaR) and Near- to Medium-Term Risks
- The net tightening in global financial conditions raised near-term downside risks to global growth:
  - The range of outcomes associated with the severely adverse scenario (5th percentile of the distribution) shifted toward lower growth rates.
  - Despite market recoveries, the net increase in downside risks to growth over the near term remains statistically significant.
  - Medium-term risks remain elevated and are moderate by historical standards but could build further if easy financial conditions persist.
- GaR-related figure panels and notations:
  - Final observation corresponds to 2019:Q1.
  - The analysis refers to the 5th percentile (GaR) of forecast distributions.
  - Percentile ranks and quintile shading illustrate deterioration from a recently benign peak in near-term GaR, while medium-term GaR remains close to historically high risk levels.

### Global Financial Vulnerabilities: Sectors and Magnitude
- Vulnerabilities arise from leverage, liquidity, maturity, and currency mismatches across sovereigns, firms, households, banks, insurance companies, and other financial institutions.
- Key summary points:
  - Vulnerabilities in the corporate sector are elevated in systemically important countries accounting for about 70 percent of total GDP.
  - Sovereign, corporate, and nonbank financial sector vulnerabilities are elevated by historical standards in several systemically important countries and regions.
  - These vulnerabilities can amplify and propagate adverse shocks, increasing financial stability risks.
- Figure 1.4 panel notes and measures:
  - Proportion of GDP of systemically important countries with elevated vulnerabilities is shown as percentage of countries in the sample with high and medium-high vulnerabilities by GDP (assets for banks) with number of vulnerable countries in parentheses.
  - Red shading in panel 2 indicates values in the top 20 percent of pooled samples for each sector from 2000 through 2018; dark green indicates bottom 20 percent.

### Regional and Sectoral Balance Sheet Vulnerabilities (Selected Highlights)
- United States:
  - Procyclical fiscal policy has led to further deterioration of public debt dynamics.
  - Corporate debt-to-GDP ratio is at a historically high level.
  - Debt-service capacity of US firms has improved since the global financial crisis but could deteriorate quickly if growth slows or financial conditions tighten.
  - Nonbank financial sector: funds invested in less liquid assets experienced larger redemptions during recent market turbulence.
- Euro area:
  - Sovereign vulnerabilities are pronounced, with government debt elevated or growing in some countries (for example, Italy).
  - Corporate debt has increased significantly in several countries (for example, France); some corporate vulnerabilities linked to weaknesses among small and medium-sized enterprises.
  - Banking sector risks from sharp declines in equity valuations and continued structural challenges.

### Balance Sheet Indicators and Illustrative Panel Values
- Figure 1.5 panels and related indicators:
  - Sovereigns: z-score vulnerability indicators for advanced and emerging market economies (rescaled average z-scores over 2000–2018).
  - Banks: capitalization and market valuation shown as percent of risk-weighted assets and price-to-book ratios.
  - Redemptions versus High-Quality Liquid Assets (HQLA) for funds as of December 2018 reported in percent.
  - HQLA measurement assumptions used: 50 percent of equities, 67.5 percent of corporate IG bonds, and 93 percent of sovereign bonds treated as liquid assets; securitized assets split into IG and non-IG.
  - Sample includes the 50 largest global funds within each fund category reported in Bloomberg.

### Aggregate Assessment
- Medium-term financial stability risks remain elevated.
- Recent tightening in global financial conditions was too short-lived to materially reduce the buildup of financial vulnerabilities.
- A prolonged period of easy financial conditions could set the stage for a more severe downturn later.

*Source: April 2019 Global Financial Stability Report, Chapter 1 — “Vulnerabilities in a Maturing Credit Cycle.”*

### 2. Nonfinancial Firms: Debt to GDP, by Region

### 2. Nonfinancial Firms: Debt to GDP, by Region

### Key vulnerabilities by region and sector
- In the euro area, liquidity and maturity mismatches in investment funds have been rising since the global financial crisis; the insurance sector shows moderate vulnerabilities in aggregate, with concerns in some jurisdictions.
- In other advanced economies:
  - Household leverage remains a key concern, with the ratio of household debt to GDP elevated and rising in a number of countries.
  - Government debt remains elevated across most countries.
  - Bank vulnerabilities are generally low in this group, though some banking systems exhibit high structural maturity and liquidity mismatches.
  - In Japan, low profitability of banks and elevated risk taking by nonbank financial intermediaries remain concerns.
- In China:
  - Nonfinancial and financial sector vulnerabilities remain elevated notwithstanding authorities’ efforts to reduce them.
  - Financial regulatory tightening has led to a contraction of investment vehicles’ assets, but leverage in the broker-dealer sector has risen.
  - Liquidity and maturity mismatches in the investment vehicle sector have widened, and borrowing by these vehicles has increased.
  - Small and medium-sized banks are particularly in need of balance sheet strengthening.
- In other major emerging market economies:
  - Weaker fiscal balances have been partially mitigated by reduced rollover risk as fiscal authorities have used the low-interest-rate environment to extend the maturity profile of debt.
  - Bank-sector strains are more pronounced in some emerging market economies.

### Asset valuations, spreads, and real estate
- Asset valuations have declined since the October 2018 GFSR but remain somewhat stretched in some key markets.
- Equity markets:
  - Price misalignments narrowed in most major equity markets since the October 2018 GFSR; equity valuations in most major markets seem close to fair values.
  - In the United States, price declines in late 2018 reduced the extent of overvaluation; the recovery has been accompanied by a reduction in earnings uncertainty.
- Credit markets:
  - On net, credit spreads have widened since the October 2018 GFSR, mostly due to higher credit risk premiums—compensation for liquidity and market risk over and above compensation for default risk.
  - Valuations remain moderately elevated in US investment-grade, US high-yield, and emerging market corporate bonds.
  - The compensation for default risk remains low reflecting low defaults and a still strong economic environment.
- Term premiums:
  - Term premiums are historically low but mostly fairly priced; historically very low or negative term premiums have preceded downturns, though unconventional monetary policies may mute this signal.
- Real estate:
  - Capitalization rates in most commercial real estate markets reached all-time lows in some countries, indicative of overvaluation.
  - Capitalization rates’ spread to risk-free rates is still above precrisis levels.
  - Concerns about downside risks to residential real estate prices remain in a number of countries.

### Risks that could trigger a renewed sell-off of risk assets
- A sharper-than-expected global growth slowdown leading to earnings downgrades, poor credit performance, and repricing of risk assets; lack of policy space would amplify this risk.
- Unexpected shifts to a less dovish monetary policy outlook in advanced economies—stronger-than-expected data or mispricing of US monetary policy outlook could cause sharp repricing and pressures on emerging markets via cross-border capital flow disruptions.
- Protracted trade tensions—an escalation (for example, US-China) would likely trigger a renewed sell-off.
- Brexit-related risks:
  - A stalemate in the Brexit process could unsettle markets, damage investor confidence, adversely affect business investment, and create operational and contractual uncertainties in Europe and the United Kingdom.
  - Authorities have implemented risk-mitigation measures including activation of currency swap arrangements between the Bank of England and the ECB, time-limited equivalence decisions for UK central counterparties and central securities depositaries in the event of a no-deal Brexit, and UK temporary permission measures.
  - Remaining risks include lifecycle events on some uncleared derivative contracts, operational risks for banks, insurers, and asset managers, reduced market liquidity, and supervisory challenges.

### Late-cycle corporate sector risks in advanced economies
- Debt-service capacity in the corporate sector improved during the recent cyclical upswing; balance sheets appear strong enough to sustain a moderate slowdown or gradual tightening.
- Overall debt levels and financial risk taking have increased; creditworthiness has deteriorated in investment-grade bond and leveraged loan markets.
- A significant downturn or sharp tightening of financial conditions could cause notable repricing of credit risks and strain indebted firms’ debt-service capacity.
- Continued easy monetary and financial conditions without policy action would likely lead to rising debt over the medium term and higher risk of a sharper future adjustment.
- Recent market dynamics (late 2018 sell-off, early 2019 recovery):
  - In December 2018, spreads on corporate bonds and leveraged loans widened sharply in the United States and in Europe, especially for lower-rated firms.
  - Leveraged finance issuance nearly dried up in late 2018; bond and loan investment funds experienced large outflows.
  - In early 2019, corporate spreads tightened and primary high-yield bond markets reopened.

### The unique features of the current credit cycle and implications
- Market structure changes and investor base shifts create different dynamics in periods of stress:
  - The role of investment funds, including exchange-traded funds (ETFs), has increased; holdings of corporate bonds in the United States by these funds have more than doubled since 2009, reaching about 20 percent in 2018.
  - Insurers and pension funds remain large investors and typically have credit rating restrictions.
  - Foreign investors’ share in US corporate bond holdings has increased from 25 percent to 30 percent in the United States.
  - In the US leveraged loan market:
    - Banks’ share declined to only 8 percent.
    - Collateralized loan obligations increased from 47 percent to close to 60 percent.
- Credit quality and leverage trends:
  - The share of speculative-grade credit (high-yield bonds and leveraged loans) declined from 31 percent in 2007 to 25 percent in 2018.
  - Speculative-grade credit amounted to 3 percent of GDP in the euro area and 12 percent of GDP in the United States in 2018.
  - In the investment-grade market, the outstanding stock of BBB-rated bonds has quadrupled since the global financial crisis, driven by new BBB issuance, rating downgrades, and new entrants.
  - Debt-service capacity in the investment-grade market has improved, but leverage has risen.
  - In the high-yield bond market, the share of CCC-rated bonds declined from 19 percent in 2007 to 15 percent in 2018.
  - The US leveraged loan market has grown rapidly and approached the size of the high-yield bond market; it is characterized by elevated leverage, limited liquidity, and reduced investor protections.

### Corporate earnings, profitability, and risk taking
- Corporate profitability improved over the past two years, with returns on assets notably higher in the United States than in other advanced economies.
- Large US corporations saw profitability boosted by tax reform, supported by strong revenue growth and wider profit margins.
- Profits declined notably in the fourth quarter last year.
- Financial risk taking remains strong among US firms:
  - Increased financial risk taking—mergers and acquisitions and payouts—often follows corporate-friendly tax reforms.
  - Large US corporations have continued to increase payouts to shareholders.

*International Monetary Fund | April 2019 — Chapter 1, “Vulnerabilities in a Maturing Credit Cycle”*

### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE

### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE

### Nonfinancial business financing and holdings
- The loan market has doubled in size since the crisis, while investor protections and credit quality have deteriorated.
- Nonfinancial business sector reliance on capital-market financing has increased.
- Investment funds and foreign investors account for a large share of corporate bond holdings:
  - IG holdings: $5.1 trillion
    - Life insurance: 29%
    - Pension funds and separate accounts: 22%
    - Insurance portfolios: 13%
    - Income funds: 15%
    - High-yield mutual funds and ETFs: 21%
    - Offshore funds: 3%
  - HY holdings: $1.3 trillion
    - Life insurance shown separately above in IG holdings context
  - Banks: 3%
  - Mutual funds: 18%
  - P&C: 6%
  - Pension funds: 17%
  - Corporations: 6%
  - HFs (hedge funds): 14% (in one panel), 2% (in another panel), Other: 19% (panel), Other: 8% (panel)
- The outstanding stock of BBB-rated corporate bonds has more than quadrupled since the crisis, driven by new issuance, rating changes, and new entrants.

### BBB-rated bonds and potential downgrade risks
- The universe of BBB-rated US corporate bonds is roughly twice the size of the entire US high-yield bond market.
- Market-implied estimate of BBB bonds trading closer to high yield: approximately $200 billion in par value, or about 6 percent of BBB-rated companies.
- High-yield spread decomposition in late 2018:
  - Widening in spreads was driven entirely by higher credit risk premiums rather than modeled default compensation.
- Market-based estimates of potential downgrades to high-yield are within a range implied by rating agencies.
- Note: Waves of downgrades are not uncommon, tend to be led by certain sectors, and are not necessarily associated with recessions.

### US leveraged loan market characteristics (selected statistics, 2007 versus 2018)
- Selected level and percentile comparisons:
  - Size (as a percentage of IG outstanding)
    - 2007: 34.6
    - 2018: 49.3
  - Gross Leverage (times)
    - 2007: 2.4
    - 2018: 3.0
  - Net Leverage (times)
    - 2007: 2.1
    - 2018: 2.6
  - Share of Companies with > 4× Leverage (percent)
    - 2007: 16
    - 2018: 23
  - Interest Coverage (times)*
    - 2007: 7.3
    - 2018: 7.9
  - EBITDA Margin (percent)*
    - 2007: 19
    - 2018: 21
  - Gross Margin (percent)*
    - 2007: 35
    - 2018: 40
  - Spread (basis points)
    - 2007: 198
    - 2018: 121
- Market structure and covenant environment (selected metrics):
  - Outstanding Leveraged Loans ($ billions)
    - 2007: 554
    - 2018: 1,147
  - US Issuance (percent of global issuance)
    - 2007: 66.9
    - 2018: 75.8
  - Covenant Quality Index (higher score = weaker covenants)
    - 2007: 2.6
    - 2018: 4.1
  - Covenant-Lite Share (percent of new issuance)
    - 2007: 29.2
    - 2018: 84.7
  - B-Rated (percent of new issuance)
    - 2007: 22.6
    - 2018: 58.0
  - Total Debt/EBITDA (times)
    - 2007: 4.9
    - 2018: 5.3
  - First Lien Debt/EBITDA (times)
    - 2007: 3.5
    - 2018: 4.3
  - Other Debt/EBITDA (times)
    - 2007: 1.4
    - 2018: 1.0
  - Deals with EBITDA Add-Backs (percent of new issuance)
    - 2007: 8.4
    - 2018: 27.1
- Covenant-lite share of new issuance increased from 29.2 percent in 2007 to 84.7 percent in 2018.

### Corporate credit cycle: US versus Europe
- Indicators show the US credit cycle has advanced faster than the US business cycle; many risk-taking indicators point to a late stage of the credit cycle in the United States.
- Europe: economic indicators have started to decelerate, and the corporate credit cycle has been more muted given ongoing bank balance sheet repair.
- US credit-cycle and corporate fundamentals (selected latest levels and percentile signals):
  - Industrial Production (YoY percent): Latest Level 1.2; Percentile 42%; Signal 88%
  - Unemployment Rate (percent): Latest Level 8.1; Percentile 75%; Signal 80%
  - Consumer Confidence (percent balance/diffusion index): Latest Level –6.2; Percentile 68%; Signal 61%
  - Capacity Utilization (percent of total capacity): Latest Level 83.6; Percentile 62%; Signal 21%
  - Output Gap (percent of potential GDP): Latest Level –0.2; Percentile 3%; Signal 21%
  - MFI Loans to Nonfinancial Firms (YoY percent): Latest Level 2.9; Percentile 30%; Signal 63%
  - IG Net Leverage (times): Latest Level 2.0; Percentile 8%; Signal 11%
  - HY Net Leverage (times): Latest Level 2.9; Percentile 94%; Signal 2%
  - IG Int Coverage (times): Latest Level 7.0; Percentile 64%; Signal 53%
  - HY Int Coverage (times): Latest Level 2.3; Percentile 28%; Signal 47%
  - IG Capex to Sales: Latest Level 5.9; Percentile 99%; Signal 69%
  - HY Capex to Sales: Latest Level 5.0; Percentile 82%; Signal 71%
  - IG Cash to Debt: Latest Level 26.6; Percentile 99%; Signal 88%
  - HY Cash to Debt: Latest Level 19.9; Percentile 41%; Signal 41%
- Europe credit-cycle indicators (selected latest levels):
  - Debt/GDP - Nonfinancial Firms: 4.0
  - C&I Loan Growth (YoY percent, 6MMA): 3.9
  - IG Gross Leverage (times): 4.0
  - HY Gross Leverage (times): 6.4
  - IG Interest Coverage Ratio (times): 4.4
  - HY Interest Coverage Ratio (times): 9.8
  - BBB (percent of total IG): 13.6
  - HY/Loan Issuance (percent of outstanding): 49.3
  - Global CLO Volume ($ billions): 427.6
  - New Issue Leverage on all First-Lien Loans (times): 4.2

### Profitability, uses of cash, and balance-sheet vulnerabilities
- Global profitability trends: EBITDA in percent of assets shows higher profitability in the United States than in other advanced economies.
- US S&P 500 firms:
  - Profitability drivers include a falling effective tax rate and strong revenue growth (with a notable decline in Q4 2018).
  - Strong profits were used for payouts and other financial risk-taking.
  - In many sectors, payouts were financed with borrowing despite already elevated debt ratios.
- Uses of cash flow (US S&P 500, percent of assets, four-quarter moving average) show dividends and share buybacks outstripping gains in investment and reaching postcrisis highs.
- Expected EPS growth for 2019 has been revised down, particularly for firms with significant international exposures (e.g., information technology). Domestically oriented sectors (e.g., financials) were less affected.

### Corporate credit quality indicators and vulnerabilities
- Debt-service capacity:
  - Share of corporate debt owed by firms with low (below 1) and subpar (between 1 and 3) EBITDA-to-interest expense ratios has improved in most major advanced economies compared with precrisis levels, with the United Kingdom as a notable exception (share increased).
- Liquidity and rollover risk:
  - Share of debt owed by firms with low (below 10 percent) and subpar (between 10 percent and 50 percent) cash-to-short-term-debt ratios has fallen notably in most major advanced economies.
- Net leverage:
  - Share of corporate debt owed by firms with high (above 6) and elevated (between 4 and 6) net debt-to-EBITDA ratios improved in the United States and the United Kingdom relative to the precrisis period but weakened in the euro area and Japan.
- Structural leverage:
  - Aggregate corporate debt-to-GDP ratios have risen to historically high levels in advanced economies.
  - Share of debt owed by firms with high (above 0.6) debt-to-asset ratios has declined, but the share of debt at firms with moderate (between 0.3 and 0.6) indebtedness has increased in both the United States and the euro area.
- Overall risk assessment:
  - With debt at historically high levels, the corporate sector is vulnerable to large economic and financial shocks.
  - Corporate balance sheets can sustain a moderate slowdown or gradual tightening of financial conditions, but a significant deceleration in earnings growth or a sharp tightening of financial conditions could lead to notable deterioration in corporate credit quality.
  - A policy easing may work with a lag and may not quickly counter a sudden, significant widening of credit risk premiums.
  - Weakening in corporate credit quality would affect investors through direct credit losses and increased market stress from potential downgrades, particularly from the oversized cohort of BBB-rated issuers.

*Italic: Source: CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE, International Monetary Fund | April 2019*

### 4. Downgrade Rates of US BBB-Rated Bonds to High-Yield Bonds

### 4. Downgrade Rates of US BBB-Rated Bonds to High-Yield Bonds

### Downgrade risk and potential market impact
- A large downgrade wave from investment-grade to high-yield could temporarily increase credit risk premiums for high-yield bonds by as much as an estimated 90 basis points if all bonds that are rated at BBB– with negative outlook were to be downgraded.
- Historical waves of downgrades to high-yield bonds have occurred and were not always associated with downturns and recessions.
- The investor base for corporate bonds has shifted toward a larger share of investment funds and rating-sensitive investors, which could increase the odds of fire sales and more adverse market dynamics.
- The high-yield bond market is less liquid than the investment-grade market and has a narrower investor base; however, recent issuance of high-yield bonds has been relatively low, which may make investors more willing and able to absorb some increase in high-yield bond supply.
- Some BBB-rated companies may have sufficient profits and liquid assets to de-lever and preserve their investment-grade ratings.

### Decomposition and spread dynamics (as discussed)
- The high-yield credit risk premium is modeled as a function of net supply, implied volatility from one-year at-the-money S&P 500 options, and the high-yield credit-default-swap-cash basis.
- The given estimate of spread widening from downgraded bond supply assumes an increase in net supply and holds the risk factors constant.

### Leveraged loan market risks and size
- The value of leveraged loans outstanding is approaching that of high-yield bonds.
- The investor base for leveraged loans has shifted toward nonbank investors.
- Leveraged loans are increasingly and predominantly being used to fund:
  - mergers and acquisitions (M&A)
  - leveraged buyouts (LBOs)
  - dividends and share buybacks
  - refinancing and other uses
- A sizable 31 percent of issuance is used for refinancing, leaving borrowers vulnerable to capital market disruptions and refinancing risk.
- Borrowers in the leveraged loan market are dependent on capital markets for refinancing, increasing vulnerability to liquidity stress and potential defaults.

### Market structure and vulnerabilities
- Looser underwriting standards, decreased investor protection, a higher share of weak credit, and reduced subordination increase the likelihood of distress and reduce recovery rates in the event of a sudden tightening in financial conditions or a sharp downturn.
- Greater participation of investment funds in leveraged loans means large-scale redemptions could force investment funds to liquidate leveraged loan holdings, potentially causing fire sales and price declines that affect other institutional investors and the broader economy.

### Factors mitigating spillovers from leveraged loans
- Banks play a smaller role in the leveraged loan market: loans originated and retained on banks’ balance sheets account for only 2.5 percent of total tangible bank equity.
- Warehouse lines to collateralized loan obligation (CLO) managers are modest, estimated at about $20 billion currently versus more than $200 billion in 2008.
- Pipeline risk management has improved; overall pipeline levels are generally less than one-third of peak levels before the crisis.
- Mark-to-market losses on CLOs should remain contained given the small value of these investments held by banks.
- Collateralized loan obligations are held mainly by nonbank investors. Global banks hold about 33 percent (or $250 billion) of the total stock of CLOs but are estimated to hold mostly the highest-rated tranches.
- Foreign bank demand for CLOs remains strong; current US and EU AAA CLO yields, hedged into yen, have continued to provide attractive returns compared with domestic bonds, supporting demand. If hedging costs increase, foreign demand could weaken, potentially widening spreads.
- Demand from investment funds is sizable, but there are few crossover investors. Estimates indicate the top 5 and top 20 US loan products own nearly 15 percent and 30 percent of the US loan market, respectively, suggesting concentration but limited direct spillovers to other fixed-income markets.

### Sovereign–financial sector nexus in the euro area
- Fiscal challenges in Italy rekindled worries about the sovereign–financial sector nexus in the euro area and led to a widening in sovereign spreads in the second half of 2018.
- Sovereign shocks spilled over to the banking sector: bank credit default swap spreads rose in lockstep with sovereign spreads and equity valuations fell.
- Italian sovereign spreads have partially retraced in 2019 and so far there has been little spillover to sovereign yields in other euro area countries.
- The sovereign–financial sector nexus can transmit stress through three main channel types:
  - Financial channels of mark-to-market losses on bank and insurers’ bond holdings.
  - Macro-financial channels where sovereign and bank shocks spill over to companies and households via an economic slowdown or higher interest rates.
  - Bond demand channels that can exacerbate increases in bond yields.
- These channels can operate over different horizons and interact through multiple feedback loops (numbered channels summarized in source material: 1–14).

### Banking sector exposures and resilience
- Domestic government bond portfolios of banking systems are large relative to assets in several countries, particularly Belgium, Italy, Portugal, and Spain.
- The proportion of lower-rated government bonds held by some banks (notably Italian and Portuguese banks) has increased following downgrades to sovereign credit ratings.
- Banks increased capital and loan loss reserve buffers since the crisis (buffer improvements shown for 2010 to 2018:Q2), leaving most banks better prepared for shocks.
- Banks reduced the stock of nonperforming loans through sales and write-offs, though efforts to reduce nonperforming loans should continue.
- Simulations show mark-to-market losses on government bond portfolios and potential loan-loss adjustments could place pressure on Tier 1 capital ratios in adverse downside scenarios; outcomes vary across banks and countries.
- In some countries, estimated loan losses on nonperforming loans could exceed existing loan loss reserves, implying potential capital pressures under adverse scenarios.

### Policy and structural measures noted
- Regulators and supervisors required banks to increase their capital and loan loss reserves buffers.
- Central bank liquidity support and official sector asset purchases helped stabilize financial markets during past episodes.
- Financial sector framework reforms implemented include the Single Supervisory Mechanism, the Single Resolution Mechanism, and the Bank Recovery and Resolution Directive.
- Additional measures are needed to fully complete the Banking Union, such as establishing a European Deposit Insurance Scheme.
- Continued reduction of the stock of nonperforming loans is recommended to strengthen banking system resilience.

*International Monetary Fund | April 2019*

### 5. Tier 1 Capital Ratios: Moderate Downside Scenario

### 5. Tier 1 Capital Ratios: Moderate Downside Scenario

### Scenario design and key assumptions
- Table 1.2 scenario entries (preserved verbatim as in source):
  - 1. Scenarios of Changes in Sovereign Bond Yields (Basis points)
    - Mild–500255075Moderate4865
    - Severe–10050150250425Adverse7090
  - 2. Loan Loss Adjustment Scenarios (Percent of face value)
    - Sovereign Credit RatingType of Nonperforming Loan
    - AAAAAABBBBBSecuredUnsecured
    - Downside  
      ScenarioScenario
- Note from source: "The mild (severe) bond yield scenaro approximates to the 90th (99th) percentile of 3-month changes in 5-year sovereign yields over the period 2000–18. These scenarios assume a flight to quality to AAA-rated bonds, which approximates to the 10th (1st) percentile of 3-month changes over the same period."
- Loss-rate reference for nonperforming loan sales (Italy): secured bad loans averaged 26 percent (or a loss of 74 percent of face value); unsecured bad loans averaged 10 percent (loss of 90 percent of face value).

### Bank balance-sheet outcomes under the moderate downside scenario
- When accounting for:
  - mark-to-market changes in government bond values in the mild downside scenario, and
  - adjusting for potential losses on nonperforming loans in the moderate scenario,
  - EBA bank Tier 1 capital ratios would be higher than they were in 2010 (referenced as "the light blue bars in Figure 1.17, panel 5").
- In the adverse downside scenario:
  - Post-shock Tier 1 ratios for most banks would still be higher than in 2010, but post-shock Tier 1 ratios for Italian and Portuguese EBA banks are slightly lower than in 2010 (Figure 1.17, panel 6).
- Caveats and data limitations affecting these results:
  - The analysis may not reflect the full range of bank exposures to sovereigns because it does not include loans to state-owned entities or off-balance-sheet exposures.
  - Lack of available data prevented assessment of hedges banks may have in place to mitigate losses on higher government bond yields.
  - Some banks may be moving government bond holdings from mark-to-market accounts to held-to-maturity portfolios, reducing potential for marks-to-market losses but also reducing balance-sheet flexibility.
  - The adjustment to nonperforming loans is based on transaction prices; some categories of nonperforming assets (for example, UTP in Italy) could have lower loss rates than assumed.

### Nonperforming loans (NPLs) and provisioning implications
- The stock of nonperforming loans remains a significant burden and could induce further losses that in some cases may be larger than loan loss reserves.
- Using secondary market prices to estimate bad-debt values and offsetting these with loan loss reserves (and capital if reserves insufficient) provides an illustrative assessment of balance-sheet preparedness.
- Illustrative results:
  - If UTP loss rates are assumed to be 25 percent lower than those on other nonperforming loans, estimated loan losses for Italian EBA banks would be 12 percent lower than in the adverse loan loss scenario in 2018:Q2. Under this assumption, the impact on Italian EBA banks’ Tier 1 capital ratio would be about 90 basis points, compared to around 280 basis points in the adverse downside scenario. (Source text presents these comparisons in context.)
- Regulatory guidance and proposals affecting provisioning and NPL management:
  - Guidance to raise loan loss reserve coverage to 100 percent on new nonperforming unsecured loans within two years and on new nonperforming secured loans over seven years (ECB 2018).
  - Proposals for banks with gross nonperforming loan ratios of 5 percent or above to establish a strategy to manage and mitigate nonperforming exposures (EBA 2018).
- Profitability impacts:
  - If banks increase reserves coverage according to ECB guidance, required provisioning is likely to be manageable if new bad-debt formation is similar to the past five years.
  - If nonperforming loan formation rises substantially—such as during the euro area crisis—the extra provisioning would put a substantial drag on profits for some banks (Figure 1.19, panel 3).
  - If banks implement a strategy to reduce gross NPL ratios to 5 percent over five years, there would be a substantial drag on profits in countries with a high stock of NPLs, particularly if there was a sharp rise in new NPLs (Figure 1.19, panel 4).

### Insurance-sector exposures and impacts
- Insurers’ holdings and exposures:
  - Euro area insurers overall own more than 15 percent of outstanding euro area sovereign bonds and almost 25 percent of euro area bank bonds (Figure 1.18, panel 1).
  - Average exposure of European insurers to BBB-rated corporate and sovereign bonds increased from about 5 percent to more than 20 percent from 2008 to 2017 (Figure 1.18, panel 2).
  - Across countries, insurers’ exposure to lower-quality debt varies substantially; insurers in countries with more indebted sovereigns tend to have a greater share of lower-rated securities in corporate bond portfolios.
  - Some insurance companies hold significant shares of subordinated and hybrid bank debt, which is more likely to be written down during market stress.
- Scenario results for insurers:
  - Two downside scenarios (including the same sovereign-yield shocks used for banks, shocks to corporate bond yields, and shocks to equity and real estate investments) were applied to insurers’ balance sheets.
  - These scenarios would imply significant losses for euro area insurers under the severe scenario, particularly for companies in more highly indebted sovereign jurisdictions (Figure 1.18, panel 5).
  - Although most euro area insurers remain well capitalized, a severe scenario would put pressure on insurers that already have lower solvency ratios (Figure 1.18, panel 6).
  - The volatility adjustment under Solvency II will alleviate some of these shocks; however, mitigation is less effective where insurers have higher-risk portfolios than the Solvency II reference portfolio.

### Macro-financial contagion channels and systemic risks
- Identified channels through which sovereign stress could propagate:
  - Macro slowdown channel: an economic slowdown—either unoffsettable due to limited fiscal space or exacerbated by confidence effects—would reduce company and household incomes and hamper debt servicing capacity (channel 4 in Figure 1.16). This can increase NPLs (channel 6) and reduce government tax revenues (channel 10).
  - Funding-cost channel: sovereign and bank credit spreads are tightly correlated; rises in sovereign spreads have already put upward pressure on new wholesale funding costs for banks with lower-rated sovereigns (channel 3). Estimates cited: a 100-basis-point increase in the spread on 10-year government bonds could cause the yield on new bank bonds to rise by a similar amount (Bank of Italy estimate).
  - Transmission to lending: higher bank funding costs could be passed on through higher interest rates on loans (channel 5), though evidence to date is limited, possibly due to central bank liquidity support.
  - Bond-demand channel: mark-to-market losses or downgrades to below investment grade could reduce banks’ and insurers’ willingness or ability to buy bonds, lowering demand and adding pressure to yields (channels 11–14).
  - Sovereign contingent-liability channel: public-sector funds used to rescue failing banks would increase sovereign contingent liabilities (channel 9). The Bank Recovery and Resolution Directive’s bail-in preference should reduce bailout likelihood but remains largely untested; recent national interventions suggest some preference for less stringent burden sharing.
- Central bank liquidity and collateral risk:
  - Central bank liquidity support (e.g., targeted longer-term refinancing operations) has helped limit rises in overall funding costs.
  - Funding problems could be exacerbated if a sovereign were downgraded below investment grade by all four major rating agencies, making that sovereign’s bonds ineligible as collateral at central banks under current rules.

### Policy implications and priorities (as reflected in the source)
- Continue to monitor and address sovereign–financial sector linkages, taking into account:
  - Bank buffers (capital and loan-loss reserves) when assessing vulnerability to sovereign yield increases.
  - Possible hedges and shifts of bond holdings to held-to-maturity accounting that may mitigate or obscure mark-to-market vulnerabilities.
  - The distribution of exposures across bank sizes; smaller banks in high domestic-holding countries could exhibit different results than the larger EBA banks analyzed.
- For banks:
  - Implement and sustain cleanup strategies for nonperforming loans consistent with ECB guidance and EBA proposals, mindful of profitability impacts under adverse NPL formation scenarios.
- For insurers and prudential frameworks:
  - Monitor insurers’ rising exposures to lower-rated sovereign and corporate bonds and to subordinated/hybrid bank debt.
  - Consider the interaction of portfolio composition with Solvency II volatility adjustments, especially where insurers’ portfolios are riskier than the reference portfolio.
- For macroprudential and resolution frameworks:
  - Continue to develop and test loss-absorbing buffers and resolution regimes to reduce the likelihood of sovereign bailouts and limit spillbacks from banks to sovereigns.

*Italic line preserved: Source: ch1 - 5. Tier 1 Capital Ratios: Moderate Downside Scenario — CHAPTER 1 Vulnerabilities in a Maturing Credit Cycle, International Monetary Fund | April 2019*

### 1. Equity Benchmarks

### ch1 - 1. Equity Benchmarks

### Recent developments in emerging and frontier markets
- Chinese equities rebounded in early 2019 after declines due to trade tensions and global volatility.
- Policy easing in China:
  - The required reserve ratio for banks was cut three times since the October 2018 GFSR.
  - A variety of other credit-easing measures and liquidity injections were undertaken.
- Market outcomes and vulnerabilities:
  - The equity market rose by more than 25 percent in early 2019.
  - Nonfinancial credit growth accelerated in early 2019.
  - Funding costs for higher-rated bond issuers and bank borrowers have declined, but yields at issuance for lower-rated firms remained elevated.
  - Bond market defaults rose sharply among private issuers.
- Frontier market issuance and spreads:
  - After a lull in the second half of 2018, some frontier market issuers returned to the market.
  - Examples cited: Ecuador sold a bond at double-digit yield; Uzbekistan issued for the first time.
  - Debt vulnerabilities remain high for many frontier markets, and in many cases new issuance has been at a very high cost.
- FX and risk sentiment:
  - Stability in foreign exchange markets, along with hopes for a US-China trade deal, supported equities.
  - Currencies have been relatively stable after the sharp sell-off in 2018.

*Sources listed in the chapter: Bloomberg Finance L.P.; Bond Radar; Haver Analytics; JPMorgan Chase & Co; Wind Information Co.; and IMF staff estimates.*

### Portfolio flows to emerging markets: recent patterns and drivers
- Recent flow dynamics:
  - Portfolio flows to emerging markets rebounded in recent months after sustained outflow pressures in 2018.
  - Portfolio flows had stabilized in Q4 2018 despite a challenging external environment.
- Estimated impact of external factors:
  - Increased investor risk aversion is estimated to have reduced portfolio flows to emerging markets by some $20 billion in the fourth quarter of 2018 (or about 10 percent of average annual inflows in 2015-18).
  - The reassessment of the monetary policy normalization outlook provided some offset to these pressures, with partial data for the first quarter pointing to a sizable recovery, led by debt portfolio flows.
- Role of ETFs:
  - Steady inflows into emerging-market-dedicated exchange-traded funds (ETFs) cushioned outflow pressures in 2018.
  - For equity ETFs, a large share of inflows has been to China since early 2017, largely reflecting MSCI’s decision to include certain types of Chinese shares in its benchmark indices.
  - Bond fund flows were cushioned by resilient inflows into hard currency ETFs.

### Benchmark-driven investors: magnitude, behavior, and risks
- Growth and scale:
  - The amount of funds benchmarked against widely followed emerging market bond indices has quadrupled in the past 10 years to $800 billion.
  - Estimates suggest that 70 percent of country allocations of investment funds are influenced by benchmark indices.
- Characteristics and implications:
  - Benchmark-driven investors tend to treat emerging markets as an asset class, focusing on common factors rather than country-specific fundamentals.
  - This behavior increases correlation of flows across countries and sensitivity to global factors.
  - Benchmark-driven investors have a larger presence in hard currency debt than in local currency sovereign debt markets.
  - Passive investors (such as ETFs and index funds) remain a small share of the overall asset class, especially relative to mature markets.
- Measured sensitivities to external shocks:
  - A one standard deviation increase in the VIX (corresponding to a 3.5 percentage point increase) on average reduces invested assets of benchmark-driven emerging market investors by 2 percent, compared with ½ percent for total portfolio investment.
  - A one standard deviation increase in US 10-year Treasury yields (amounting to 20 basis points) reduces invested assets by 1½ percent for benchmark-driven investors, compared with about ¼ percent for total portfolio investment.
  - The sensitivity of benchmark-driven flows to external factors has increased in recent years.
- Consequences for potential reversals:
  - Estimated outflows in response to a one standard deviation interest rate shock:
    - Using 2013 data: about $2 billion.
    - Using the latest estimated sensitivity and assets under management: close to $11.5 billion.
  - A larger share of benchmark-driven investments raises the risk that portfolio flows become prone to reversals unrelated to country fundamentals and could, in some cases, have destabilizing effects.

### Distributional impacts: which countries are exposed
- Differential exposure:
  - Some countries are disproportionately exposed to benchmark-driven investors due to index inclusion rules and weighting schemes that cap large issuers and boost smaller ones.
  - Sovereign borrowers are generally more exposed to benchmark-driven investors than firms, especially where sovereign debt managers aim to meet index investability criteria.
- Frontier issuers and index inclusion:
  - Frontier issuers account for about 13 percent of the outstanding debt eligible for inclusion in the J.P. Morgan Emerging Market Bond Index Global (EMBIG).
  - Their weight in the more widely used version of the index that caps larger issuers (EMBIG-Diversified) is closer to 23 percent, making frontier issuers a large beneficiary of benchmark-driven flows.
- Country examples of sizable benchmark-driven shares in local currency debt markets: South Africa and Malaysia.

*Italic source attribution: International Monetary Fund, Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle, April 2019 — Chapter 1 (figures and text from "Recent Developments in Emerging and Frontier Markets" and "Portfolio Flows to Emerging Markets").*

### 1. Estimated Foreign Holdings of Local Currency Sovereign Debt

### 1. Estimated Foreign Holdings of Local Currency Sovereign Debt

### Benchmark-driven portfolio flows to emerging markets
- In recent outflow episodes, EM benchmark-driven investors have reduced their holdings rapidly.
- Benchmark-driven flows are highly correlated across countries.
- Benchmark-driven flows are highly sensitive to external factors, such as risk appetite and US rates.
- This sensitivity to external factors has increased in recent years.
- An adverse external shock would result in much larger outflows today than a few years ago.
- Benchmark-driven investors play a major role in some emerging market sovereign debt markets.
- Notes on data and methods:
  - Correlations (panel 2) are based on EPFR Global country-level fund flows; EPFR estimates country-level flows using assumptions about country portfolio weights (which tend to inflate estimated correlation coefficients). India and Thailand were excluded from that analysis.
  - Panels 3 and 4 report coefficient estimates for a one standard deviation shock.
  - Panels 4 and 5 use coefficients from a 36-month rolling regression.
  - Panel 6 estimates assume benchmark-driven investors and foreign investors follow index weights closely; actual deviations can be substantial. Panel 6 data are as of 2018:Q2.

### Sensitivity, magnitudes, and recent episodes (selected findings)
- Benchmark-driven flows react strongly to risk and interest-rate shocks (examples cited: BBB spread, VIX, US 10-year, Three-year Euro dollar rate).
- Specific episode comparisons noted: Taper tantrum (2013), RMB devaluation (2015), Latest (Dec. 2018).
- In Figure 1.23 and related analysis, estimated outflows from benchmark-driven investors in response to a one standard deviation shock are reported in billions of US dollars (panel 5).
- Local currency government bonds held by nonresident investors are expressed as percent of GDP (panel 6).

### Index inclusion effects and China’s inclusion in benchmark indices
- Index inclusion decisions can lead to substantial rebalancing of portfolios and can alter asset-class risk characteristics.
- J.P. Morgan included several GCC countries in the EMBI Global index; their weight is expected to eventually rise to 12 percent.
- Inclusion of GCC countries is expected to:
  - Boost flows to the GCC countries.
  - Alter index risk/return characteristics: increase average credit rating, increase share of oil exporters, potentially reduce price and flow sensitivity of EMBI Global to global financial conditions, and increase sensitivity to oil price developments.
- China’s local currency bond inclusion:
  - Renminbi-denominated government and policy bank bonds will be added to the Bloomberg Barclays Global Aggregate Bond Index starting in April 2019 and phased in over a 20-month period.
  - About $2 trillion to $2.5 trillion in assets under management track the Bloomberg index.
  - Expected country weight after full inclusion: about 6 percent.
  - This could bring $150 billion in additional inflows to China by 2020.
  - Market analysts expect inclusion in Bloomberg to pave the way to inclusion in other bond indices, which could eventually lead to inflows of closer to $300 billion.
  - Gradual inclusion of China’s A-shares in MSCI and FTSE equity indices could boost portfolio flows by more than $150 billion.
- Spillovers to other emerging markets:
  - Since EMs have small weights in global bond benchmarks, China’s inclusion is more notable for EMs when China’s local currency debt is included in EM benchmarks.
  - Inclusion in the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) may lead to a potential reduction in fund allocations of $1 billion to $3 billion each for most issuers because of mechanical rebalancing.
  - Rebalancing may be complex in practice; passive investors and other benchmark-driven investors can deviate substantially from index weights.

### China: vulnerabilities, regulatory tightening, and credit dynamics
- Regulatory tightening over nearly two years has slowed bank asset growth, driven by a sharp reduction in claims on other financial institutions.
- Banks have largely stopped increasing credit via on- and off-balance-sheet investment vehicles, leading to slower overall shadow credit growth.
- The slowdown was led by a sharp contraction in credit by small and medium-sized banks.
- Investment vehicle and wealth management product (WMP) vulnerabilities:
  - Regulatory reforms for the asset management sector (introduced in late 2017) have been scaled back recently; implementation schedule through 2020 has been eased.
  - Bank wealth management products will be allowed to increase leverage via debt issuance, invest in a wider range of equity and loan assets, and may receive coinvestment from sponsor banks.
  - Wealth management product conversion to net-asset-value-based products has been minimal: just 2.7 percent of all issuance in 2018, from 0.5 percent in 2017.
  - WMPs still embed significant maturity and liquidity mismatches and leverage to provide yields well above corporate bond yields.
  - Investment vehicle short-term borrowing remains elevated.
- Small and medium-sized bank balance-sheet weaknesses:
  - Small and medium-sized banks account for just over half of commercial bank assets, but more than 70 percent of commercial bank loan growth to small and medium-sized enterprises since 2015:Q1.
  - Profitability and capital ratios at small and medium-sized banks continue to edge lower; many banks face core Tier 1 capital ratios near regulatory minimums and significant future capital needs from unrecognized shadow credit positions.
  - Funding cost pressures are higher at these banks, limiting benefits from easing interbank funding conditions.
  - These constraints have limited these banks’ ability to offset the sharp reduction in shadow credit with an increase in regular loans.
- Hypothetical scenario analysis for small and medium-sized banks (Figure 1.26):
  - Scenario A — Banks seek to improve resilience within a year:
    - If banks were required to increase core Tier 1 equity ratios to the system average (10.5 percent) and hold adequate capital against roughly half of their on- and off-balance-sheet shadow credit, small and medium-sized banks would have to shrink their current loan books about 30 percent to meet this requirement within one year.
    - Assumptions: capital must be held against 50 percent of on-balance-sheet shadow credit and 30 percent of off-balance-sheet WMP assets (roughly half of estimated 65 percent that are nonfinancial credit assets). Each bank is assumed to reduce its dividend payout ratio by 50 percent relative to 2017.
  - Scenario B — Banks maintain credit growth and seek to build resilience over time:
    - If the same balance sheet strengthening is achieved over time, most small and medium-sized banks would not be able to do so within five years assuming loan growth of 10 percent.
    - If loan growth is 5 percent, most banks would be able to grow out of their problems within five years.
  - Profitability (return on assets) and risk-weighted asset density are assumed constant in these scenarios.
- Policy implications:
  - Higher credit growth will prolong balance sheet weakness, making it difficult to ease credit conditions for smaller borrowers and leaving banks vulnerable to shocks.
  - Further monetary and credit easing without deeper reforms may increase vulnerabilities by tilting credit allocation toward riskier sectors (infrastructure and property) and impeding bank balance-sheet repair.
  - Looser monetary and credit policies may primarily benefit infrastructure and property firms, increasing debt at these firms and among households, worsening asset price misalignments, and potentially increasing contingent public debt.

### Credit allocation and sectoral risks in China
- Financial sector exposures to real estate (to both mortgages and developers) and infrastructure have expanded faster than lending to other firms despite a slowdown in overall nonfinancial corporate credit growth.
- Tightening of shadow credit has accelerated reductions in nonbank investor exposures mainly to sectors other than infrastructure and property.
- Domestic bond market activity shows investors’ preference for infrastructure and property exposures:
  - Among similarly rated issuers, infrastructure and property firms enjoy more favorable borrowing conditions and are affected less when market conditions tighten.
  - These firms’ net issuance increases more during periods of easing and declines less during periods of tightening, particularly for lower-rated firms.
- Compared with other sectors, infrastructure and property firms tend to have higher leverage and weaker debt-service capacity, despite reporting lower nonperforming loan ratios.
- Residential mortgages and property developer loans offer more collateral for lenders, but real estate and land valuations are stretched; credit growth in these sectors is likely to worsen asset price misalignments and increase household debt.
- Additional infrastructure projects may lack sufficient cash flow and could potentially increase contingent public debt.

### Frontier market vulnerabilities
- After a lull in 2018:H2, bond issuance by frontier borrowers restarted early in 2019 and is expected to remain high in 2019.
- Frontier and low-income issuers have higher debt vulnerabilities and lower liquidity than other emerging market borrowers; market access conditions remain highly sensitive to changes in global risk sentiment.
- During the risk-off episode at end-2018, more than two-thirds of frontier issuers faced secondary market yields of 7.5 percent or more, compared with almost 10 percent of issuers a year earlier.
- Issuers that relied more on capital market financing over the past few years may face significant deterioration in their debt sustainability over the medium term.
- Frontier markets with weak debt-management capacity tend to face more market pressures; debt-management-capacity problems are related to gaps in reporting, recording, and monitoring of public debt (Figure 1.28, panel 1).

*Source: IMF — Chapter 1 excerpts from the April 2019 Global Financial Stability Report (figures and notes as provided in the source content).*

### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE

### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE

### China — Nonfinancial firms, funding patterns, and vulnerabilities
- Overall lending to property and infrastructure firms has been resilient, while nonbank credit to firms in other sectors contracted in 2018.
- Among similarly rated issuers, infrastructure and property firms enjoy more favorable borrowing conditions and greater access to the bond market through the cycle, particularly for lower-rated firms.
- Property and infrastructure firms tend to be more leveraged and have a larger weak tail of firms than in other sectors.
- Corporate sample and metrics:
  - Panels 5 and 6 are based on a sample of 3,700 Chinese firms from the Capital IQ database.
  - EBITDA = earnings before interest, tax, depreciation, and amortization; SOE = state-owned enterprises.
- Notes on data sources and definitions:
  - Sources: CEIC; SNL Financial; S&P Global Market Intelligence; Captial IQ database; Wind Information Co; and IMF staff calculations.
  - In panel 1, data are based on sector allocations for bank-disclosed loans, corporate bonds, and trust company assets under management.
  - In panel 2, data are based on corporate bonds and trust company assets under management.
  - In panel 4, high grade is defined as AAA-rated firms (at origination), and low grade are firms rated AA+ or lower.
  - In panel 6, firm-level interest expense is estimated using the median cost of funding (interest expense divided by interest-bearing debt) from each sector grouping and time period.

### Policy priorities (overall macro-financial stance)
- As the global economic expansion loses momentum, policymakers should:
  - Aim to prevent a sharper economic slowdown while safeguarding the resilience of the financial system.
  - Ensure monetary policy is data dependent and that any change in outlook is well communicated to avoid unnecessary swings in financial markets or undue compression of market volatility.
  - Use macroprudential policies more proactively where vulnerabilities are elevated and rising.
  - Develop prudential tools to address risks related to rising corporate debt funded by nonbank credit and to address maturity and liquidity mismatches in nonbank financial intermediaries.
  - Implement measures to mitigate the sovereign–financial sector nexus.
  - Emerging market economies should bolster resilience to cope with capital flow volatility.
  - In China, continue financial sector de-risking and deleveraging policies and increase emphasis on addressing bank vulnerabilities.

### Policies to contain financial vulnerabilities
- Financial sector policies should address vulnerabilities arising from low yields and low volatility, including:
  - Rising corporate debt, increasing house prices, stretched asset valuations, and elevated maturity and liquidity mismatches in parts of the nonbank financial sector.
- Prudential and macroprudential tool recommendations:
  - Broad-based macroprudential tools (such as countercyclical capital buffers) have been activated or increased in several countries, but more countries would benefit from active use to increase resilience and cool credit growth originating from banks.
  - Where sectoral credit developments are concerning, consider sectoral capital buffers for banks or increase risk weights and provisions on such exposures.
  - Develop prudential tools for highly leveraged firms (akin to those applied to households) where overall corporate debt is systemically high.
  - Conduct more comprehensive stress tests that incorporate macro-financial feedback effects from high corporate indebtedness and correlated risks (for banks and nonbank intermediaries with significant corporate exposures).
  - For leveraged loans:
    - Take a comprehensive view of risks, intensify oversight, and enforce sound underwriting standards and risk management practices at banks and nonbank financial intermediaries.
    - Maintain risk retention rules applied to originating lenders to improve asset quality securitized and sold to nonbanks.
  - To mitigate risks linked to rising house prices:
    - Apply loan-to-value ratios, debt-service ratios, and/or debt-to-income ratios more consistently and broadly to nonbank lenders.
    - Calibrate borrower-based limits to increase resilience to shocks to asset prices, interest rates, and incomes.
    - Enforce the same limits for lending by nonbank financial institutions to limit regulatory arbitrage.

### Prudential tools for the nonbank sector and specific institutions
- Need to develop an adequate prudential toolkit for nonbank financial institutions:
  - Insurance companies:
    - Implementation of Solvency II in Europe has strengthened insurers, but work on global risk-based insurance capital standards should continue.
    - Supervisors should provide guidance on enhancing risk management for default risk and correlation risk, and on appropriate treatment of subordinated and “bail-inable” bond investments.
    - Move forward with a holistic framework for assessment and mitigation of systemic risk in insurance.
  - Asset managers:
    - Encourage robust risk management and stress testing.
    - Prudential policies could include harmonized methodologies for leverage calculation, limits on leverage or credit extension, minimum liquidity buffers, and guidance on liquidity management in investment funds.
    - Proper liquidity risk management is crucial given rising liquidity risks in some segments; availability of liquidity management tools varies significantly across countries.
- Avoid rollback of regulatory reforms and maintain or strengthen institutional frameworks for macroprudential oversight.

### Availability and use of prudential tools (sample and interpretation)
- Assessment based on a sample of 29 jurisdictions with systemically important financial sectors.
- Elevated vulnerabilities refer to countries/sectors with a percentile rank in the respective vulnerability exceeding 60 percent.
- Cells with entries below 50 percent in the assessment should be interpreted to mean that 50 percent or more of systemically important countries do not have any prudential tools to address specific vulnerabilities.
- Remarks on tool classification:
  - Some reported tools can be classified as microprudential; available information does not always allow a clear distinction between availability and use.
  - FX = foreign exchange; NA = not available; NBNI = nonbank noninsurers.

### Policies to address the sovereign–bank nexus (Euro area and highly indebted sovereigns)
- Highly indebted sovereigns:
  - Take action to place debt-to-GDP ratios on a downward trajectory.
  - Implement gradual fiscal adjustment to reduce fiscal risks and support medium-term growth.
- Euro area banks:
  - Continue to repair balance sheets and reduce nonperforming loans through comprehensive approaches.
  - Use minimum standards for insolvency and creditor rights, and rules for valuation of collateral to help bad debt resolution.
- Design policies addressing bank–sovereign links from a holistic perspective:
  - Consider coordinated policies to mitigate concentration risk in banks’ sovereign exposures.
  - Design measures to improve banks’ resilience to sovereign shocks and discourage excessive holdings of sovereign bonds while minimizing procyclical effects.
- Resolution framework:
  - The European Commission’s Bank Recovery and Resolution Directive and associated bail-in requirements aim to reduce contingent sovereign liabilities.
  - There is scope to minimize bail-in through approaches differing from euro area resolution rules (for example, national bank insolvency regimes); harmonize national regimes.
  - Consider a financial stability exemption (subject to strict conditionality and governance) to allow departure from minimum bail-in requirements only when financial stability is clearly at risk.

### Emerging markets — resilience to capital flow volatility and frontier debt
- Countries should prepare for foreign portfolio outflows by:
  - Reducing external vulnerabilities and strengthening buffers:
    - Reduce excessive external liabilities and reliance on short-term debt.
    - Maintain adequate fiscal buffers, bank liquidity buffers, and foreign exchange reserves.
    - Countries where foreign currency risks pose challenges for banks could consider phasing in currency-differentiated liquidity coverage ratios.
    - Monitor risks related to foreign ownership of local currency bonds, especially when a large share is held by benchmark-driven investors.
  - Use the exchange rate as a shock absorber in countries with flexible exchange rate regimes and intervene in FX markets if conditions become disorderly, considering fundamentals, reserves, monetary stance, and private sector FX exposures before intervening.
  - Use capital flow management measures on outflows only in crisis or near-crisis situations; such measures should be transparent, temporary, nondiscriminatory, and part of a comprehensive policy package.
- Sovereign debt managers:
  - Act to mitigate short- and medium-term rollover risk as volatility and rates increase.
  - Plan ahead to avoid refinancing difficulties that could spill over to broader emerging debt markets.
- Index inclusion and passive flows:
  - As passive and benchmark-driven investment rises, index membership can be a financial stability consideration.
  - Encourage close dialogue between index providers, the investment community, and regulators.
  - Enhance transparency by index providers on eligibility criteria and advance communication of index changes.
  - Issuers should strive for index inclusion where prudent and avoid premature or partial inclusion that introduces fragmentation and concentration risks.

### China — further recommendations specific to China
- Continue financial sector de-risking and deleveraging policies and emphasize bank vulnerability reduction while mitigating external shocks.
- Continue to moderate credit growth gradually consistent with orderly deleveraging.
- Shadow banking activity has contracted, but credit reintermediation has absorbed bank capital and required additional funding from nonbank financial institutions.
- Bank capital buffers should be further strengthened via external injections or profit retention.
- Timely and effective implementation of announced asset management reforms is important to:
  - Credibly delink banks from their sponsored investment products and associated risks.
  - Reduce implicit guarantees in the financial system.
- Structural reforms needed:
  - Reduce emphasis on growth targets and tighten budget constraints for state-owned enterprises to reduce credit misallocation, especially to sectors perceived to have government support (property and infrastructure).

*International Monetary Fund | April 2019*

### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE

### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE

### China’s Share-Collateralized Lending (SCL): Market Developments and Risks
- China’s sharp equity market declines in 2018 were compounded by pressures on firms reliant on share-collateralized loans (SCLs).
  - These firms saw equity prices fall by more than 40 percent at the trough, weighing on the overall stock market, which declined as much as 26 percent.
  - Share price declines likely added to liquidity pressures on SCL borrowers, creating a negative feedback loop between stock market developments and the financial positions of these firms.
- SCL-reliant firms are concentrated among smaller and privately owned firms.
  - About 20 percent of the market value of privately owned enterprises’ listed shares are pledged for SCL, compared with 3 percent for central state-owned enterprises and 6 percent for local state-owned firms.
  - As of the end of October 2018, SCL-reliant firms—firms with at least 30 percent of shares pledged to lenders—accounted for 44 percent of listed private firm assets and 15 percent of all listed firm assets.
  - Nearly half of all mid-cap private nonfinancial companies were SCL-reliant.
- Balance-sheet characteristics and lender composition
  - SCL-reliant firms tend to have weaker balance sheets—lower debt-service capacity and higher leverage—than the broader sector.
  - Largest SCL lenders (market value of pledged shares as of October 2018):
    - Securities firms: about 52 percent
    - Banks: about 21 percent
    - Trust companies: about 15 percent
    - Remainder: mostly nonbank financial institutions such as asset management and investment firms
  - Direct exposures to SCLs are relatively small for banks but can be material for securities and trust firms:
    - Banks: 0.4 percent of corporate loans (direct exposure)
    - Data for the seven largest securities firms imply on-balance-sheet SCL exposures are significant at about 10 to 20 percent of assets.
- Table of estimated SCL exposures by lender type (as of October 2018)
  - In RMB billion (ranges shown are estimated loan amounts assuming loans are 50% to 75% of the market value of pledged shares as of October 2018):
    - Banks: 434–651
    - Trust Companies: 318–478
    - Securities Firms: 1,118–1,676
  - As percentage of:
    - Bank lending to firms: 0.4–0.7
    - Trust company balance sheets: 38.4–57.6
    - Trust company balance sheets and client assets: 1.3–1.9
    - Securities firm balance sheets: 17.5–26.3
    - Securities company balance sheets and client assets: 5.2–7.7

### Financial Stability Assessment and Policy Recommendations on SCLs
- Near-term financial stability risks from SCLs appear limited at the time of the assessment, but vulnerabilities warrant policy action to prevent future risks to market functioning or financial stability.
- Policy recommendations:
  - Further tighten SCL practices to limit market functioning and financial stability risks from share-pledging.
  - Continue to reduce distortions favoring state-owned enterprises.
  - Reduce credit overhang at unviable borrowers.
  - Advance market reforms to discourage small privately owned enterprises from more risky forms of borrowing from nonbank financial intermediaries.

### Special Feature: Liquidity Risks in Capital Markets — Structural Changes and Recent Strains
- Overview and recent episodes
  - Postcrisis regulatory reforms and technological innovations have reshaped market liquidity provision and demand.
  - Increased incidence of “flash crashes” has prompted concerns about liquidity fragility; recent “flash” episodes include:
    - the yen spike in January 2019
    - the sharp drop in S&P 500 futures in early December 2018
    - the flash rally in US Treasuries in June 2018
  - Since September 2018, incidence of liquidity strain has increased, with sovereign bond markets being more prone to episodes of liquidity strain than equity markets.
- Structural changes in supply of and demand for market liquidity
  - Tighter financial regulation and supervision have increased the cost of providing capital market services and changed dealers’ incentives to make markets.
    - Postcrisis regulatory reforms increased resilience but also raised costs of market-making through higher leverage and capital requirements.
    - The Volcker Rule in the United States curtailed banks’ proprietary trading activities.
    - Notable reduction in bank trading books across most jurisdictions during the postcrisis period.
  - Rise of nonbank principal trading firms (PTFs) and technological advances:
    - PTFs provide higher speed and lower execution costs via automated high-frequency trading strategies.
    - Key features of PTFs:
      - PTFs generally concentrated in liquid instruments, most prevalent in standardized, exchange-traded products such as equities and Treasury futures.
      - On US dealer-to-dealer electronic platforms, banks and broker-dealers account for less than 40 percent of total volumes, with PTFs making up more than half.
      - PTFs tend to use greater leverage, particularly intraday, than dealers, and face minimal regulation relative to banks.
  - Growing role of ETFs and passive investors affects demand for liquidity:
    - ETFs offer a liquid instrument with exposure to a portfolio of securities with varying liquidity and risk characteristics, increasing liquidity mismatches when mutual funds and ETFs participate in less liquid markets.
    - Growth of passive investors that track market index returns could induce greater correlation of component securities, increasing the likelihood of herding behavior and adverse implications for market liquidity.
  - Central bank asset purchases affected supply and demand for liquid assets:
    - Expanding central bank holdings of safe and liquid assets reduced the free float of securities available for investors.
    - Expansionary monetary policies nudged investors to reach for yield in less liquid asset classes, potentially compressing liquidity risk premiums.
- Changes in market structure of trading and electronification (selected metrics from Table 1.SF.1)
  - Electronic Trading (based on share of volume traded):
    - Equity: 90%
    - Futures: 90%
    - Treasury Futures: 50–80%
    - Cash Equities: 80%
    - Foreign Exchange Spot: 70%
    - Cash Treasuries: 60%
    - European Cash and Futures Government Bonds: 60%
    - Japanese Government Bonds: 20–50%
    - Interest Rate Swaps: 15–50%
  - Automated Trading and High-Frequency Trading penetration vary across markets (examples in table).
- Standard liquidity metrics and emerging limitations
  - Standard quantity-based measures show some signs of deterioration while price-based measures appear relatively more robust.
    - Turnover ratios (trading volumes relative to securities outstanding) have declined across markets since the global financial crisis, along with realized volatility.
    - Bid-ask spreads for major markets have been relatively tight, though some deterioration occurred in a few foreign exchange markets in recent years and in equity markets in recent months.
    - One interpretation: as traditional dealers reduce market-making capacity, adjustments are more through quantities (reducing services) rather than prices.
  - Divergence between highly liquid and relatively illiquid markets appears to have increased as participation by traditional market makers has declined while nontraditional market makers (such as PTFs) concentrate in more liquid instruments.
  - Standard daily liquidity indicators may not fully capture market liquidity risks and should be interpreted with caution.

*International Monetary Fund | April 2019*

### 2. Bloomberg Liquidity Index3. One-Month Standard Deviation of Bid-Ask Spreads in Italy Sovereign

### 2. Bloomberg Liquidity Index3. One-Month Standard Deviation of Bid-Ask Spreads in Italy Sovereign

### Bloomberg liquidity index and bid-ask spreads in Italian sovereign bonds
- Bloomberg’s liquidity index (a proxy for aggregate on- and off-the-run spreads) has been consistently elevated in recent years for the Italian sovereign bond market, while a similar index for German bunds has been stable.
- Divergence between on- and off-the-run bonds may be larger in Italy compared with Germany; off-the-run Italian bonds have recently reflected higher credit and redenomination risks compared to on-the-run bonds.
- Bid-ask spreads in the Italian bond market have become more volatile even during periods when sovereign spreads were relatively tight and stable.
- The index levels are measured by the root mean squared error between bonds’ market yields and theoretical yields based on cubic and exponential spline methodologies (Bloomberg).

### Limitations of standard liquidity indicators
- Trading volume may not necessarily be an accurate indicator of market liquidity conditions, given that a large part of it may be driven by electronic trading aimed at taking advantage of small pricing differences across trading platforms.
- More than three-quarters of spot trading in foreign exchange markets is electronic, with a significant proliferation of trading platforms.
- “Algorithmic market making” can generate quotes without underlying transactions, potentially making market depth appear decent while actual liquidity is fragile. If many traders follow similar algorithms, liquidity can evaporate quickly when faced with large flows or shocks.

### High-frequency intraday jump analysis: methodology and interpretation
- The framework examines characteristics of intraday price jumps: “large” jumps (finite activity) linked to significant news shocks, and episodic series of “small” jumps (infinite activity).
- Uncovering statistically significant evidence of infinite activity jumps in intraday data is interpreted as evidence of liquidity strains: in poorly liquid markets price adjustment to shocks is sluggish and reflected by periods of small jumps.
- The jump analysis applied to sovereign bond and equity markets during September 2018–February 2019 yielded the following observations:
  - The frequency of liquidity strain events has been higher in emerging markets relative to advanced economies. Jumps constitute a markedly larger proportion of intraday price variability in emerging markets than in advanced economies, for equities and especially sovereign bonds.
  - Sovereign bond markets have been more prone to episodes of liquidity strain than equity markets. Jumps and liquidity strain are especially pronounced in sovereign bonds in emerging markets.
  - The frequency of liquidity strained days detected each month is higher in emerging markets than in advanced economies.
  - The incidence of liquidity strain appears to have risen over the past few months, particularly in sovereign bond markets.
  - The frequency of liquidity strain in equities is loosely correlated with conventional liquidity metrics, such as the turnover ratio, while the frequency of strain in sovereign bonds is closely correlated with a risk-off proxy (the second principal component of US Treasury 10-year yields and US dollar index, both in levels).

### Quantitative findings and specific measures
- On January 3, 2019 (Japan Standard Time), an intraday flash event in JPY/USD produced a currency surge of nearly 4 percent against the dollar in minutes; on that day over 85 percent of price variation was due to jumps.
- In the UK gilt market, the proportion of variation explained by jumps tended to rise around key Brexit-related events from below 10 percent to close to 40 percent.
- Between November 2018 and January 2019, the frequency of liquidity strained days in the UK gilt market averaged 2.3 days a month, compared with an average frequency for other major advanced economy sovereign bond markets of 1.5 days a month.
- The analysis sample included: Brazil, China, France, Germany, India, Italy, Korea, Mexico, Portugal, Spain, the United Kingdom, and the United States.

### Event-study insights
- VIX spikes: Two large VIX spikes (around 35 points) occurred on February 2, 2018 (the “VIX tantrum”) and December 24, 2018. The February 2, 2018 spike was accompanied by liquidity strain; the December 24, 2018 spike showed no meaningful deterioration in intraday market liquidity, reflecting different underlying drivers.
- Japanese yen flash event (January 3, 2019): Jump analysis shows liquidity strains were present days ahead of the flash event, possibly exacerbated by a public holiday in Japan; the flash crash magnified already-strained liquidity conditions.
- Brexit-related events: Market liquidity strain in the 10-year UK gilt market rose significantly around key events, with an increase in the frequency of liquidity strained days since September 2018.

### Policy implications and recommendations
- Market liquidity conditions merit close scrutiny by regulators due to the potential for illiquidity events to precipitate fire sales, large asset price moves, and sudden tightening in financial conditions.
- Regulators and market participants should assess the robustness of trade infrastructure and support transparency in the marketplace.
- Counterparties to principal trading firms (PTFs) should monitor intraday activity and leverage exposures and strengthen liquidity risk management practices as trading frequencies increase.
- Improving availability of data on the activities of nonbank market makers would help timely assessment of liquidity risks in global capital markets.

*International Monetary Fund | April 2019*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2019/april/english/ch1.pdf_