## Preface and Executive Summary (Global Financial Stability Report, April 2019) ## Source details **Canonical URL:** [Preface and Executive Summary (Global Financial Stability Report, April 2019)](https://www.imf.org/-/media/files/publications/gfsr/2019/april/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2019/april/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2019/april/english/text.pdf.json) --- ### Purpose and scope - The GFSR assesses key risks facing the global financial system and highlights policies to mitigate systemic risks and support sustained economic growth. - Analysis coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian; project directed by Fabio Natalucci, Claudio Raddatz, and Anna Ilyina. - This GFSR reflects information available as of March 21, 2019. ### New vulnerability‑monitoring framework - Introduces a structured, systematic approach to monitor financial vulnerabilities using data back to 2000 for 29 systemically important economies. - Framework assesses vulnerability levels across regions and sectors: banks, nonbank financial institutions, sovereigns, firms, and households. - Framework detects elevated financial vulnerability in several sectors, including sovereigns, firms, and nonbank financial institutions. ### Key findings on vulnerabilities (high level) - Corporate sector: - Corporate debt rising globally; a weak tail of companies has high leverage and weak earnings prospects. - Credit cycle appears to be maturing; signs that risks of an economic slowdown are rising. - Corporate sector vulnerabilities appear elevated in about 70 percent of systemically important countries (by GDP). - Sovereign–financial sector nexus (Europe): - Fiscal challenges in some euro area countries, notably Italy, have reignited sovereign–financial nexus concerns. - Potential losses on nonperforming loans and mark‑to‑market declines in government bonds could hit bank capital; insurers’ holdings could entangle them in the nexus. - China and emerging/frontier markets: - Financial vulnerabilities in China remain high; small and medium‑size banks remain weak. - Further monetary and credit easing could increase vulnerabilities by slowing bank balance sheet repair and exacerbating credit allocation biases. - China’s inclusion in benchmark indices expected to raise portfolio flows to China by as much as $150 billion by 2020. - Portfolio flows to emerging markets: - Funds benchmarked against widely followed emerging market bond indices 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. ### Market and policy context - Markets sold off sharply late in 2018; policymakers responded forcefully, triggering a sharp rebound in risk assets in early 2019. - Financial conditions tightened in Q4 2018 but rebounded in early 2019 as major central banks adopted a more patient and flexible approach to monetary policy normalization. - Potential triggers of abrupt deterioration: sharp repricing of risk; intensification of trade tensions; further slowdown in global economic activity; political shocks. ### Policy priorities and recommendations (executive summary) - Act now to reduce rising financial vulnerabilities while there is room to do so. - Activate countercyclical capital buffers in countries with rising vulnerabilities. - Develop macroprudential tools to contain corporate vulnerabilities and address maturity and liquidity mismatches in the nonbank sector. - Monetary policies should remain data dependent and well communicated to avoid market overreaction and prevent further growth deceleration. - Step up measures to repair public and private balance sheets; pursue gradual fiscal adjustment where debt is elevated; support growth where fiscal space exists. - Emerging markets: reduce excessive external liabilities, cut reliance on short‑term debt, and maintain adequate fiscal and foreign exchange reserve buffers. - China: continue financial sector de‑risking and deleveraging; emphasize addressing bank vulnerabilities and structural reforms. *International Monetary Fund | April 2019. This GFSR reflects information available as of March 21, 2019.* --- ### US MOVE, Term Premium, and Market Dynamics ### US monetary policy communications and market response - The Federal Reserve indicated it would be "more flexible and patient" in determining the appropriate path of monetary policy. - At the March FOMC meeting, it announced the current runoff of the balance sheet will end in September 2019. - Market reassessment results: - "The policy rate path shifted lower, with investors no longer anticipating any policy rate hikes in 2019–20" (Figure 1.1, panel 3). - The Treasury yield curve "moved down sharply" (Figure 1.1, panel 4). - Note: "The Federal Funds futures rate would need to be adjusted for term premiums to provide a more accurate reading of the market expectations of the future policy rate path." (footnote text) ### Market volatility, term premium, and equity sentiment - Dovish shift contributed to easing of financial conditions and supported positive risk sentiment; market implied volatility (VIX) and earnings uncertainty declined (Figure 1.1, panel 5). - MOVE dropped to historically low levels (Figure 1.1, panel 6); term premium also dropped to historically low levels and is described as "historically low but mostly fairly priced" (Figure 1.6, panel 5). - Term premiums historically very low or negative ahead of downturns; unconventional monetary policies may mute term‑premium signals. ### Growth‑at‑Risk (GaR) and medium‑term risks - GaR framework assessment: - "The range of outcomes associated with the severely adverse scenario (5th percentile of the distribution) shifted toward lower growth rates" (Figure 1.3, panel 2). - "The net increase in downside risks to growth over the near term remains statistically significant" (Figure 1.3, panel 3), though "these risks are moderate by historical standards" (Figure 1.3, panel 4). - Medium‑term risks "remain elevated" (Figure 1.3, panel 5), suggesting prolonged easy conditions could set the stage for a more severe downturn later. ### Regional linkages and vulnerabilities - Dovish US shift and rebound in corporate valuations eased global financial conditions. - Euro area: ECB ended net purchases at end of 2018 and signaled unchanged policy rates at least through 2019; investors not expecting hikes before end of 2020. - China: regulatory tightening and deleveraging reduced corporate valuations in 2018; authorities cut reserve requirements and eased credit conditions to lower interbank spreads. --- ### Chapter 1 — Vulnerabilities in a Maturing Credit Cycle ### Asset price misalignments and real estate - Term premiums broadly in line with fundamentals; capitalization rates in most commercial real estate markets reached all‑time lows in some countries, though spread to risk‑free rates remains above precrisis levels (Figure 1.6, panel 6). - Equity valuations in most major markets seem close to fair values; residential real estate downside risks remain in a number of countries. ### Triggers for renewed sell‑off of risk assets - Sharper‑than‑expected global growth slowdown; unexpected less‑dovish monetary policy; protracted trade tensions; Brexit‑related disruption. ### Late‑cycle corporate sector risks - Debt‑service capacity improved during upswing but overall debt and financial risk taking increased; creditworthiness deteriorated in investment‑grade bond and leveraged loan markets. - If monetary and financial conditions remain easy longer, debt likely to continue rising absent policy action, raising future adjustment risk. ### Credit market developments and structure - Investment funds’ holdings of US corporate bonds: about 20 percent in 2018. - Foreign investors’ share in US corporate bonds increased from 25 percent to 30 percent. - Share of speculative‑grade credit declined from 31 percent in 2007 to 25 percent in 2018. - Outstanding leveraged loans: 554 (2007) versus 1,147 (2018) [$ billions]. - Covenant‑lite share (percent of new issuance): 29.2 (2007) versus 84.7 (2018). - B‑Rated (percent of new issuance): 22.6 (2007) versus 58.0 (2018). - Total Debt/EBITDA (times): 4.9 (2007) versus 5.3 (2018). - First Lien Debt/EBITDA (times): 3.5 (2007) versus 4.3 (2018). - Deals with EBITDA Add‑Backs (percent of new issuance): 8.4 (2007) versus 27.1 (2018). ### US corporate credit cycle — late‑stage indicators - Leverage close to cycle highs across most rating buckets; corporate debt skewed toward lower‑rated issuers. - US leveraged loan market now approaches size of high‑yield market; characterized by elevated leverage, limited liquidity, and reduced investor protections. ### BBB space and downgrade risk (Chapter 5) - Universe of BBB‑rated US corporate bonds roughly twice the size of entire US high‑yield bond market. - About 6 percent of BBB‑rated companies, or approximately $200 billion in par value, trade closer to high yield than to the BBB spread curve. - A large downgrade wave could temporarily increase high‑yield credit risk premiums by as much as an estimated 90 basis points if all bonds rated BBB– with negative outlook were downgraded. ### Leveraged loan market structure and risks - Loans originated and retained on banks’ balance sheets 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 total CLO stock, mainly highest‑rated tranches. - Concentration: top 5 and top 20 US loan products own nearly 15 percent and 30 percent of US loan market, respectively. ### Euro area sovereign–financial sector nexus - Fiscal challenges in Italy widened sovereign spreads in H2 2018; sovereign shocks spilled to banks (CDS spreads rose in lockstep). - Two sovereign yield scenarios simulated for EBA banks: mild and severe; loan‑loss scenarios labeled moderate and adverse applied. - Severe scenario: sharp rises in government yields would generate significant losses for EBA banks in Italy, Portugal, and Spain. - In the adverse downside scenario, post‑shock Tier 1 ratios for Italian and Portuguese EBA banks are slightly lower than in 2010. - Caveats: analysis excludes some exposures (loans to SOEs, off‑balance sheet), and some banks may shift holdings to held‑to‑maturity. ### Insurers and solvency implications - "Euro area insurers overall own more than 15 percent of outstanding euro area sovereign bonds" and "almost 25 percent of euro area bank bonds." - 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. - Severe scenarios would imply significant losses for euro area insurers in more indebted sovereign jurisdictions; volatility adjustment under Solvency II alleviates somewhat. ### Banks: funding costs, NPLs, profitability - Bank of Italy finding: "a 100‑basis‑point rise in Italian government bond yields would reduce capital ratios of 'significant banks' by 40 basis points, but that capital ratios of 'less significant banks' would fall by 90 basis points." - 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 (ECB 2018). - If NPLs rise substantially to crisis levels, extra provisioning would "put a substantial drag on profits for some banks." ### Policy measures, resolution frameworks, residual risks - Bank Recovery and Resolution Directive preference for bail‑in should reduce likelihood of sovereign‑funded bailouts. - Recent interventions suggest some national authorities prefer less stringent burden sharing while loss‑absorbing buffers remain underdeveloped. - If higher government bond yields materialize, contagion through the sovereign–financial nexus could occur; banks/insurers not suffering losses could act as stabilizers if they buy into falling markets. --- ### Emerging and Frontier Markets; Benchmark‑Driven Flows and China Inclusion ### Emerging market portfolio flows and benchmarks - Funds benchmarked to widely followed emerging market bond indices quadrupled in the past 10 years to $800 billion. - 70 percent of country allocations of investment funds are influenced by benchmark indices. - Benchmark‑driven flows more sensitive to common/global factors and more correlated across countries: - Average pair‑wise correlation between benchmark‑driven flows to individual emerging markets and inflows to all other emerging markets: 0.74 during 2010–18, compared with 0.27 for overall portfolio flows (BoP‑based). - A one standard deviation increase in the VIX (3.5 percentage points) reduces invested assets of benchmark‑driven emerging market investors by 2 percent, versus ½ percent for total portfolio investment. - A one standard deviation increase in US 10‑year Treasury yields (20 basis points) reduces invested assets by 1½ percent for benchmark‑driven investors, versus about ¼ percent for total portfolio investment. - Estimated outflows in response to a one standard deviation interest rate shock: - Using 2013 data: about $2 billion. - Using latest sensitivity and AUM: close to $11.5 billion. ### China index inclusion and estimated flows - Bloomberg Barclays Global Aggregate Bond Index inclusion of RMB government and policy bank bonds phased in over 20 months starting April 2019; about $2 trillion to $2.5 trillion AUM track the Bloomberg index. - Expected country weight of China in Bloomberg index after full inclusion: about 6 percent. - Estimated additional inflows to China by 2020 from Bloomberg inclusion: $150 billion. - Market analysts’ potential eventual inflows from other bond indices: 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. - Mechanical rebalancing in J.P. Morgan GBI‑EM may lead to a potential reduction in fund allocations of $1 billion to $3 billion each for most issuers. ### Frontier markets and vulnerabilities - Frontier issuers account for about 13 percent of outstanding debt eligible for inclusion in J.P. Morgan EMBIG; weight in EMBIG‑Diversified closer to 23 percent. - More than two‑thirds of frontier issuers were facing secondary market yields of 7.5 percent or more during end‑2018 risk‑off episode (compared with almost 10 percent of issuers a year earlier). - Debt‑management capacity assessments: 32 out of 70 low‑income countries assessed to have weak capacity. --- ### China: vulnerabilities, small/medium banks, and scenario analysis ### Overall assessment and regulatory actions - Vulnerabilities remain elevated in China (Figure 1.4); regulatory tightening contained risk buildup. - Required reserve ratio cut three times since October 2018 GFSR; other easing measures and liquidity injections undertaken in early 2019. - WMPs: conversion to NAV‑based WMPs minimal at 2.7 percent of all issuance in 2018, from 0.5 percent in 2017; WMPs still embed maturity and liquidity mismatches and leverage. ### Small and medium‑sized banks — scenarios - Small and medium‑sized banks account for just over half of commercial bank assets and more than 70 percent of growth in loans to SMEs since Q1 2015. - System average core Tier 1 equity ratio used in scenarios: 10.5 percent. - Scenario A (one year resilience): - Banks required to increase core Tier 1 equity ratios to system average (10.5 percent) and hold capital against roughly half of on‑ and off‑balance‑sheet shadow credit. - Result: small and medium‑sized banks would have to shrink current loan books about 30 percent to meet requirement within one year (Figure 1.26, panel 3). - Dividend payout ratio reduction assumption: 50 percent relative to 2017. - Scenario B (gradual resilience): - If loan growth 10 percent, most banks could not achieve balance sheet strengthening within five years; at 5 percent loan growth, most could do so within five years. ### Sectoral credit allocation risks - Nonfinancial corporate credit growth declined overall, but exposures to real estate (mortgages and developers) and infrastructure expanded faster. - Real estate and land valuations stretched; credit growth in these sectors likely to worsen asset‑price misalignments and increase household debt. - Further easing risks: may tilt credit allocation toward infrastructure and property, impede bank balance sheet repair, and worsen vulnerabilities. --- ### Chapter 2 — Downside Risks to House Prices (House Prices at Risk, HaR) ### Concept and methodology - Introduces house prices at risk (HaR) using panel quantile regression (growth‑at‑risk framework) to quantify downside risks to future house price growth (typically the 5th percentile). - Predictors of HaR up to three years ahead include: lower house price momentum, overvaluation, excessive credit growth, and tighter financial conditions. ### Key empirical findings - Drivers: - Tighter financial conditions, declines in real GDP growth, higher credit growth, and greater house price overvaluation predict higher HaR; effects stronger at the lower tail (5th percentile) and more pronounced at the city level. - A one‑standard‑deviation tightening of financial conditions associated with 0.3 to 0.7 percentage point higher downside risk to house prices in the short term (stronger in emerging markets). - Overvaluation: a one‑standard‑deviation increase in house‑prices‑to‑GDP‑per‑capita associated with higher HaR; likely signals a correction of between 0.5 and 1.0 percentage point in advanced economies and 0.7 to 1.0 percentage point in emerging markets. - Credit booms worsen HaR by up to 0.5 percentage point at short horizons in advanced economies and up to 1 percentage point at medium horizons in emerging markets. - Predictive value: - HaR improves forecasts of downside risk to GDP growth: a 1 percent improvement in HaR precedes on average a 0.3 percentage point improvement in growth at risk four to eight quarters ahead. - An annualized HaR of −12 percent (5 percent probability of 12 percent decline two years ahead) implies a 31 percent probability of a financial crisis two years ahead in advanced economies and 10 percent in emerging markets. ### Macroprudential, monetary policy, and capital flows - Macroprudential policy: - Borrower‑based measures (loan‑to‑value and debt‑service‑to‑income limits) lower downside risks to house prices. - A one‑unit tightening of macroprudential measures during a credit boom could lower one‑year‑ahead average HaR by up to 2 percentage points (annualized), from −9.4 percent to −7.4 percent. - Macroprudential policy more effective than monetary policy at reducing growth at risk in theoretical model. - Monetary policy: - Easier monetary policy associated with lower HaR in the short term in advanced economies; monetary policy’s effect largely indirect via financial conditions and generally short‑lived. - Capital flows and capital flow management: - In advanced economies, capital inflows raise upside house price risk in short term and increase HaR in the medium term (quantified: 1 percent of GDP inflow raises upside risks by 1.5 percent one quarter ahead and downside risks by 0.5 percent eight quarters ahead). - Tightening capital flow management measures in advanced economies may briefly increase downside risks one to three quarters ahead and reduce downside risks between one and two years ahead by about 3 percent (annualized). ### City‑ and province‑level insights - City level: - Financial conditions have larger effects on HaR at city level than country level; city HaR useful for targeted policies. - Box evidence: US and Canadian cities — US city downside risks show larger swings than Canadian cities; Canadian cities (Hamilton, Toronto, Vancouver) showed stretched valuations in 2018. - FDI inflows often associated with lower HaR in tech‑friendly US cities; other capital inflows amplify HaR in specific cities. - China province level: - Provincial HaR linked to credit booms, tighter financial conditions, higher provincial price‑to‑income ratios, and residential investment increases. - FDI associated with less HaR from second year onward in East and Northeast; portfolio flows associated with higher short‑term HaR. ### Synchronization and international implications - Short‑term comovement of three‑year‑ahead HaR increases sharply before major global recessions among advanced economies. - Greater financial openness correlates with higher synchronization of HaR; pairs with capital‑flow restrictions related to real estate show lower short‑term comovement. - Policy implication: targeted capital flow measures related to real estate can mitigate synchronization of downside risks in extreme events, but must be assessed case by case. ### Policy recommendations (HaR context) - Use HaR estimates as an early‑warning indicator to complement other housing vulnerability measures and guide macroprudential activation. - Strengthen borrower‑based macroprudential tools (LTV, DSTI) in toolkits and monitor their application to nonbank lenders to limit regulatory arbitrage. - Monetary policy should remain focused on inflation and output stabilization but use HaR information when macroprudential toolkit is incomplete. - Consider capital flow management measures when inflow surges materially raise HaR and other policy options are constrained; measures should be transparent, temporary, and part of a comprehensive package. - International coordination recommended when downside risks synchronize across countries. --- ### Special Feature — Liquidity Risks in Capital Markets ### Structural changes and implications - Postcrisis regulation, technological innovation, and growth of passive investors have reshaped liquidity supply and demand. - GSIB trading portfolios: $10.1 trillion (2012) versus $8.9 trillion (2017). - Rise of nonbank principal trading firms (PTFs) providing market‑making concentrated in liquid instruments; on US dealer‑to‑dealer electronic platforms, banks and broker‑dealers account for less than 40 percent of volumes, PTFs more than half. - ETFs/passive investors increase correlation and potential herding; central bank asset purchases reduced free float of safe liquid assets. ### Evidence and metrics - Quantity measures (turnover) declined since crisis; price measures (bid‑ask spreads) broadly tight but show deterioration in some FX and equity markets. - Electronic/high‑frequency trading penetration (selected): - Equity Futures: Electronic Trading 90%; High‑Frequency Trading 40% - Treasury Futures: Electronic Trading 90%; Automated Trading 70%; High‑Frequency Trading 60% - Cash Equities: Electronic Trading 50–80%; Automated Trading 45%; High‑Frequency Trading 35–70% - Cash Treasuries: Electronic Trading 70% - Investment Grade/High‑Yield Corporate Cash Bonds: Electronic Trading 15–50% - Flash events examples: yen spike (Jan. 3, 2019), S&P 500 futures drop (early Dec. 2018), flash rally in US Treasuries (June 2018). ### High‑frequency jump analysis and policy pointers - Framework distinguishes large news‑driven jumps and episodic small jumps indicating liquidity strain. - Empirical observations (Sept. 2018–Mar. 2019): - Frequency of liquidity strain events higher in emerging markets; sovereign bond markets more prone than equity markets. - Japan yen flash: price surged nearly "4 percent" in minutes on Jan. 3; on that day "over 85 percent" of price variation due to jumps. - UK gilt market: proportion of variation explained by jumps rose from "below 10 percent to close to 40 percent" around key Brexit events; UK gilt averaged "2.3 days a month" with liquidity strain between Nov. 2018 and Jan. 2019 versus "1.5 days a month" for other major advanced economy sovereign bond markets. - Policy implications: - Monitor market liquidity metrics beyond standard daily indicators; assess concentrations of nonbank liquidity providers and algorithmic interdependencies. - Improve data availability on nonbank market makers; strengthen trade infrastructure resilience and transparency; counterparties to PTFs should monitor intraday leverage. --- *Italic: Source: Selected excerpts from Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle (April 2019), International Monetary Fund. This GFSR reflects information available as of March 21, 2019.* ### Preface ### Preface ### Purpose and scope - The Global Financial Stability Report (GFSR) assesses key risks facing the global financial system and highlights policies to mitigate systemic risks and support sustained economic growth. - The analysis in this issue was coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director. The project was directed by Fabio Natalucci, Deputy Director, and by Claudio Raddatz and Anna Ilyina, both Division Chiefs. - This GFSR reflects information available as of March 21, 2019. ### New vulnerability-monitoring framework - A more structured, systematic approach is introduced to monitor financial vulnerabilities using data back to 2000 for 29 systemically important economies. - The framework assesses vulnerability levels across regions and sectors: banks, nonbank financial institutions, sovereigns, firms, and households. - The framework detects elevated financial vulnerability in several sectors, including sovereigns, firms, and nonbank financial institutions. ### Key findings on vulnerabilities - Corporate sector - Corporate debt has been rising globally; a weak tail of companies has high leverage and weak earnings prospects. - The credit cycle appears to be maturing with growing signs that risks of an economic slowdown are rising. - Corporate sector vulnerabilities appear elevated in about 70 percent of systemically important countries (by GDP). - Sovereign–financial sector nexus (Europe) - Fiscal challenges in some euro area countries, notably Italy, have reignited concerns about the sovereign–financial sector nexus as a potential amplification mechanism. - Although euro area bank capital ratios are higher, potential losses on nonperforming loans and mark-to-market declines in government bonds could hit bank capital; insurance companies’ holdings of sovereign, bank, and corporate bonds could entangle them in the nexus. - China and emerging/frontier markets - Financial vulnerabilities in China remain high; small and medium-size banks remain weak, weighing on financing conditions for smaller firms. - Further monetary and credit easing could increase vulnerabilities by slowing bank balance sheet repair and exacerbating credit allocation biases. - China’s inclusion in benchmark indices is expected to raise portfolio flows to China by as much as $150 billion by 2020. - Portfolio flows to emerging markets - Portfolio flows to emerging markets are increasingly influenced by benchmark-driven investors. - 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. ### Market and policy context - Markets sold off sharply late in 2018 across asset classes amid signs of slowing global growth and rising concerns about US-China trade tensions; policymakers responded forcefully, supporting market sentiment and triggering a sharp rebound in risk assets. - Financial conditions tightened in Q4 2018 but rebounded in early 2019 as major central banks adopted a more patient and flexible approach to monetary policy normalization; despite the rebound, financial markets remain susceptible to a sudden tightening in financial conditions. - Potential triggers of abrupt deterioration include a sharp repricing of risk, intensification of trade tensions, further slowdown in global economic activity, or political shocks. ### Policy priorities and recommendations - Policymakers should act now to reduce rising financial vulnerabilities while they can. - Countercyclical capital buffers should be activated in countries with rising vulnerabilities. - Macroprudential tools should be developed to contain corporate vulnerabilities. - Monetary policies should remain data dependent and well communicated to avoid market overreaction and prevent further growth deceleration. *Source: Preface, Global Financial Stability Report (April 2019), International Monetary Fund.* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Global outlook and near-term risks - Global economic activity has recently lost momentum; global trade has slowed sharply and concerns over trade tensions weakened business confidence. - Growth is expected to level off in the first half of this year and firm up thereafter, but the short-term outlook is subject to considerable uncertainty. - Over the medium term: - Growth is expected to moderate further in advanced economies as population aging constrains labor force expansion and labor productivity growth remains tepid. - Growth in emerging market and developing economies is expected to increase modestly; convergence toward advanced economy income levels remains slow for many of these economies owing to structural bottlenecks and, in some cases, high debt, subdued commodity prices, and civil strife. - Risks to the global outlook remain skewed to the downside amid high policy uncertainty, including: - Reescalation of trade tensions and disruptions from a no-deal Brexit. - A sudden shift in market sentiment and associated tightening in financial conditions given still-accommodative financial conditions. - Downside risks in systemic economies that, if realized, would weigh on the global outlook. - On the upside, rollback of recent tariff increases and resolution of trade tensions could lift business confidence and growth. ### Financial vulnerabilities and market developments - Financial conditions tightened since the October 2018 GFSR but remain relatively accommodative, notably in the United States. - After sharp declines in the fourth quarter of 2018, financial markets rebounded in early 2019, supported by the Federal Reserve’s more patient approach to monetary policy normalization. - Buoyant market sentiment may allow financial vulnerabilities—such as high leverage and liquidity, maturity, and currency mismatches—to continue building, raising medium-term risks to global financial stability. - Vulnerabilities in sovereign, corporate, and nonbank financial sectors are elevated by historical standards in several systemically important countries that account for a significant share of the global economy. - A sudden sharp tightening in financial conditions—triggered by investors’ reassessment of the outlook for monetary policy in major advanced economies, a sharper-than-expected growth slowdown, protracted trade tensions, or a no-deal Brexit—could expose these vulnerabilities and raise near-term financial stability risks. - Since the October 2018 GFSR, near-term risks to global financial stability have risen on balance, though they remain moderate by historical standards. ### House prices at risk (HaR) - A new house prices-at-risk framework (presented in Chapter 2) quantifies downside risks to house price growth. - Predictors of downside risks to house prices up to three years ahead include: - Lower house price momentum, - Overvaluation, - Excessive credit growth, - Tighter financial conditions. - The HaR measure helps forecast downside risks to GDP growth and predict financial crises. - The most recent data point to increased downside risks to house prices over the next one to three years in some countries. ### Potential triggers for abrupt tightening in financial conditions - A sharper-than-expected growth slowdown could lead to tighter financial conditions as risk asset prices fall, reflecting a weaker outlook for corporate earnings, even as policies turn more accommodative. - An unexpected shift to a less dovish outlook for monetary policy in advanced economies could trigger a repricing in markets, especially if investors realize they have been too benign about the monetary policy stance. - Political and policy risks, such as an escalation of trade tensions or a no-deal Brexit, could affect market sentiment and lead to a spike in risk aversion. ### Policy priorities and recommendations - General objective: avoid a sharper economic slowdown while keeping financial vulnerabilities in check. - Monetary policy communication: - Policymakers should clearly communicate any reassessment of the monetary policy stance that reflects changes in the economic outlook or risks surrounding it, to avoid unnecessary swings in financial markets or unduly compressed market volatility. - Macroprudential and regulatory measures: - In countries with high or rising financial vulnerabilities, proactively deploy prudential tools or expand macroprudential toolkits where needed. - Activate or tighten broad-based macroprudential measures, such as countercyclical capital buffers, to increase financial system resilience. - Develop prudential tools to address rising corporate debt from nonbank financial intermediaries and maturity and liquidity mismatches in the nonbank sector. - Ensure more comprehensive stress tests (including macro-financial feedback effects) for banks and nonbank lenders. - Balance sheet repair and fiscal policy: - Step up measures to repair public and private balance sheets. - A gradual fiscal adjustment is needed to reduce elevated risks, based on policies that will support medium-term growth. - Continue efforts to tackle nonperforming loans on euro area bank balance sheets. - Consider mitigating concentration risk in banks’ sovereign exposures given concerns about the sovereign–financial sector nexus. - Emerging market economy recommendations: - Ensure resilience against foreign portfolio outflows by reducing excessive external liabilities, cutting reliance on short-term debt, and maintaining adequate fiscal and foreign exchange reserve buffers. - Given the rising importance of benchmark-driven portfolio flows, maintain a close dialogue among index providers, the investment community, and regulators. - China-specific recommendations: - Continue financial sector de-risking and deleveraging policies and place greater emphasis on addressing bank vulnerabilities. - Structural reforms—such as reducing the emphasis on growth targets and tightening budget constraints for state-owned enterprises—are critical to reduce credit misallocation. - Structural reforms across economies: - Growth-enhancing structural reforms remain key to improving potential output, inclusiveness, and resilience. - Policies should aim to lift productivity, encourage labor force participation, and upgrade skills. - Further deregulation in product markets and services, supported by stronger competition law and policy, could help deter rising corporate market power in advanced economies. - Improve fiscal institutions, transparency, and governance to combat corruption; strengthen cooperation on foreign bribery, money laundering, and tax evasion. ### Executive Directors’ perspectives and policy guidance - Executive Directors broadly shared the assessment of global prospects and risks and noted that growth had lost momentum due to multiple factors in large economies. - Directors emphasized the urgent need for strong global cooperation and coordination to tackle shared challenges, prioritizing cooperative resolution of trade disagreements and strengthening the open, rules-based multilateral trading system. - Macroeconomic policy guidance: - Carefully calibrate macroeconomic policies to support growth where output may fall below potential and policy space exists, and ensure a soft landing where policy support needs withdrawal. - In the event of a deeper or protracted downturn, policies should become more accommodative where feasible. - Fiscal policy should strike the right balance between growth and debt sustainability appropriate to country circumstances: - In countries with high debt, pursue gradual fiscal adjustment, particularly if financing risks are large. - In countries with fiscal space, use fiscal policy to boost aggregate demand where there is slack and raise potential growth where the economy is operating above potential. - Recognize the role of automatic stabilizers during cyclical downswings and avoid procyclical fiscal stances in the event of protracted slowdowns. - Fiscal policy should adapt to shifting demographics, advancing technology, and deepening global integration; when budgetary room is limited, respond through budget recomposition and reprioritization. - Monetary policy: - Directors welcomed a more gradual approach to monetary policy normalization by major central banks since the beginning of the year and urged clear communication of any reassessment of the pace of normalization to avoid excessive market swings. - Emerging market and low-income economy guidance: - Emerging market and developing economies should focus monetary policy on anchoring inflation expectations where inflation remains high and support domestic activity where expectations are well anchored. - Continue efforts to raise revenue, reduce debt-related vulnerabilities, and make steady progress on economic and financial rebalancing. - Low-income developing economies should focus on drivers of growth, raise resilience to volatile external conditions, durably reduce debt vulnerabilities, and advance toward the 2030 Sustainable Development Goals with international support. - Commodity exporters should continue diversifying through improved education quality, narrowed infrastructure gaps, enhanced financial inclusion, and boosted private investment. ### Global Financial Stability Assessment — market dynamics - Markets rallied in early 2019 as perceptions shifted on monetary policy normalization and optimism on U.S.–China trade negotiations, allowing global equities to recoup most 2018 losses and credit spreads to tighten significantly. - Despite the rebound, concerns persist that the long-lasting credit cycle may be reaching its late stage in the United States and possibly other advanced economies. - Specific regional concerns noted: - Euro area: fiscal challenges in Italy rekindled concerns about the sovereign–financial nexus. - United Kingdom: fears of a no-deal Brexit continue to weigh on UK financial assets. - Emerging markets: relatively resilient during the late 2018 sell-off; aggregate portfolio flows supported by the early 2019 turnaround in global risk sentiment. *International Monetary Fund | April 2019. This GFSR reflects information available as of March 21, 2019, unless otherwise noted.* ### 6. US MOVE and Term Premium ### 6. US MOVE and Term Premium ### US monetary policy communications and market response - The Federal Reserve indicated early this year that it would be "more flexible and patient" as it determines the appropriate path of monetary policy. - At the March Federal Open Market Committee (FOMC) meeting, it announced that the current runoff of the balance sheet will end in September 2019. - These communications led to a reassessment of the outlook for monetary policy normalization by market participants: - "The policy rate path shifted lower, with investors no longer anticipating any policy rate hikes in 2019–20" (Figure 1.1, panel 3). - The Treasury yield curve "moved down sharply" (Figure 1.1, panel 4). - Note: "The Federal Funds futures rate would need to be adjusted for term premiums to provide a more accurate reading of the market expectations of the future policy rate path." (footnote text) ### Market volatility, term premium, and equity sentiment - Dovish shift in US monetary policy effects: - Contributed to an easing of financial conditions (Figure 1.2, panel 1). - Supported positive risk sentiment in equity markets, as reflected in declining market implied volatility (VIX) and earnings uncertainty (Figure 1.1, panel 5). - In Treasury markets: - Market implied volatility (MOVE) dropped to historically low levels (Figure 1.1, panel 6). - The term premium—the premium demanded by investors for holding long-term government bonds relative to the risk-free short-term interest rate—also dropped to historically low levels. - Term premiums are described as "historically low but mostly fairly priced" (Figure 1.6, panel 5). - As countercyclical variables, term premiums have historically been very low or negative ahead of economic downturns (Adrian and others 2014); unconventional monetary policies may mute the signal provided by term premiums. ### Broader financial conditions and vulnerabilities - Regional and sectoral context tied to US developments: - The dovish US shift, together with a rebound in corporate valuations, contributed to easing global financial conditions. - In the euro area, rebound in early 2019 helped attenuate tightening in late 2018; ECB ended net purchases at end of 2018 and signaled unchanged policy rates at least through 2019, with investors not expecting policy rate hikes before the end of 2020. - In China, regulatory tightening, deleveraging, and trade concerns reduced corporate valuations in 2018; authorities cut reserve requirements and eased credit conditions, helping lower interbank spreads. - Medium-term risks: - The tightening in global financial conditions has led to higher near-term risks to global growth and financial stability. - The impact is assessed using the growth-at-risk (GaR) framework: - "The range of outcomes associated with the severely adverse scenario (5th percentile of the distribution) shifted toward lower growth rates" (Figure 1.3, panel 2). - Despite recent market recovery, "the net increase in downside risks to growth over the near term remains statistically significant" (Figure 1.3, panel 3), though "these risks are moderate by historical standards" (Figure 1.3, panel 4). - Medium-term risks "remain elevated" (Figure 1.3, panel 5), suggesting a prolonged period of easy conditions could set the stage for a more severe downturn later. - Asset valuations and spreads: - Price misalignments have narrowed since the October 2018 GFSR; US price declines in late 2018 reduced overvaluation. - Equity recoveries accompanied by reduced earnings uncertainty (Figure 1.6, panel 2); equity valuations in most major markets seem close to fair values (Figure 1.6, panel 3). - On net, credit spreads have widened since the October 2018 GFSR, mostly due to higher credit risk premiums; valuations remain moderately elevated in US investment-grade, US high-yield, and emerging market corporate bonds. - Real estate valuations appear elevated relative to fundamentals in some countries; commercial real estate prices have risen sharply in a number of jurisdictions. ### Key figures, dates, and references appearing in text - September 2019 (end of current balance sheet runoff announced at March FOMC). - 2019–20 (period during which investors no longer anticipated policy rate hikes). - Jan. 4, 2019 (Powell AEA speech date referenced in figure annotations). - 5th percentile (severely adverse scenario in GaR framework). - 2019:Q1 (final observation referenced for financial conditions and GaR panels). - Figures referenced: Figure 1.1 (panels 3, 4, 5, 6), Figure 1.2 (panel 1), Figure 1.3 (panels 1–5), Figure 1.6 (panels 1–5), Figure 1.5 (panels 1–4), October 2018 GFSR comparisons. *Source: International Monetary Fund | April 2019* ### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE ### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE ### Asset Price Misalignments and Real Estate - Term premiums are broadly in line with values implied by fundamentals. - Capitalization rates in most commercial real estate markets reached all-time lows in some countries, indicative of overvaluation, though their spread to risk-free rates is still above precrisis levels (Figure 1.6, panel 6). - Equity valuations in most major markets seem close to fair values. - Equity prices recovered in early 2019 accompanied by a reduction in earnings uncertainty. - Concerns about downside risks to residential real estate prices remain in a number of countries (see Chapter 2). ### Triggers That Could Prompt a Renewed Sell-Off of Risk Assets - A sharper-than-expected global growth slowdown: - Could lead to earnings downgrades, poor credit performance, and repricing of risk assets. - A lack of policy space (monetary or fiscal) would amplify this risk. - Unexpected shifts to a less dovish outlook for monetary policy in advanced economies: - Changes in expectations—stemming from stronger-than-expected economic data releases or overly benign investor views—could trigger a sharp repricing. - Pressures on emerging markets could resume through disruptions in cross-border capital flows. - Protracted trade tensions: - An escalation, including in US-China trade negotiations, would likely trigger a renewed sell-off. - Brexit-related risks: - A stalemate threatens to unsettle financial 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, and temporary permission measures by the UK. - Remaining risks include lifecycle-event performance on uncleared derivative contracts, operational risks for banks/insurers/asset managers, reduced market liquidity, and supervisory constraints. - Trading conditions have been orderly on the whole despite intermittent strains and heightened gilt-market volatility around significant Brexit announcements; some real estate fund redemptions and increased volatility in sterling markets occurred. ### Late-Cycle Corporate Sector Risks in Advanced Economies - Overall: Debt-service capacity improved during the cyclical upswing but overall debt levels and financial risk taking have increased; creditworthiness deteriorated in investment-grade bond and leveraged loan markets. - If monetary and financial conditions remain easy for longer, debt will likely continue to rise over the medium term absent policy action, increasing risk of a sharper future adjustment. - A significant downturn or a sharp tightening of financial conditions could lead to notable repricing of credit risks and strain indebted firms’ debt-service capacity. ### Recent Credit Market Developments - Major credit markets rebounded in early 2019 after a late-2018 sell-off. - December 2018 dynamics: - 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. - Bond and loan investment funds experienced large outflows. - Early 2019: Corporate spreads tightened and primary high-yield bond markets reopened, amid slowing global growth and changing expectations about corporate earnings and monetary policy normalization in the United States. ### Unique Features of the Current Credit Cycle - Market-based finance expansion has outpaced bank lending to corporates, implying different stress-period dynamics. - Increased role of investment funds and foreign investors in corporate bond markets: - Holdings of corporate bonds by investment funds in the United States have 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 US leveraged loan market, the share of banks declined to 8 percent, while collateralized loan obligations increased from 47 percent to close to 60 percent. - Investor types and potential behavior: - Insurers and pension funds remain large holders and generally viewed as stable, but typically face credit rating restrictions. - ETFs offer daily liquidity to end-investors but may hold less liquid assets. - Credit quality and leverage changes: - The share of speculative-grade credit (high-yield bonds and leveraged loans) declined from 31 percent in 2007 to 25 percent in 2018. - The outstanding stock of BBB-rated bonds in the investment-grade market has quadrupled since the global financial crisis. - In the high-yield bond market, the share of CCC-rated bonds declined from 19 percent in 2007 to 15 percent in 2018. - US leveraged loan market has grown rapidly and approached the size of the high-yield bond market; characterized by elevated leverage, limited liquidity, and reduced investor protections. ### The US Corporate Credit Cycle: Advanced Stage Indicators - The US corporate credit cycle appears to be at its highest point in recent history and further along than in Europe. - Selected late-cycle indicators: - Leverage is close to cycle highs across most credit rating buckets. - Corporate debt is skewed toward lower-rated issuers. - European context: - The European credit cycle has been shorter and shallower to date, partly due to the euro area debt crisis. - European credit providers and firms have been more conservative than US peers, but structural weaknesses remain in the small and medium enterprise sector. ### Corporate Earnings and Financial Risk Taking - Corporate profitability improved over the past two years; returns on assets and profit growth higher in the United States than in other advanced economies. - Large US corporate profitability boosted by tax reform, strong revenue growth, and wider profit margins. - Profits declined notably in the fourth quarter of 2018. - Financial risk taking remains strong among US firms: - Increased payouts to shareholders and elevated merger-and-acquisition activity follow corporate-friendly tax reforms. - Late-stage credit cycle indicators include deteriorating underwriting conditions, increased risk taking, easy credit conditions, strong profits, and high leverage; downturns are associated with increasing defaults, falling profits, tighter credit conditions, and a shift from shareholder- to creditor-friendly activities. ### Key Statistics and Market Metrics (as reported) - Investment funds’ holdings of US corporate bonds: about 20 percent in 2018. - Foreign investors’ share in US corporate bond holdings: increased from 25 percent to 30 percent. - Share of speculative-grade credit: declined from 31 percent in 2007 to 25 percent in 2018. - BBB-rated bonds: outstanding stock has quadrupled since the global financial crisis. - High-yield market CCC share: declined from 19 percent in 2007 to 15 percent in 2018. - US leveraged loan market shares: - Banks: 8 percent. - Collateralized loan obligations: increased from 47 percent to close to 60 percent. - US IG holdings: $5.1 trillion (illustrative in panel 2). - HY holdings: $1.3 trillion (illustrative in panel 2). - Selected leveraged loan characteristics (2007 versus 2018, panel 6 highlights): - Outstanding Leveraged Loans: 554 (2007) versus 1,147 (2018) [$ billions]. - Covenant-Lite Share (percent of new issuance): 29.2 (2007) versus 84.7 (2018). - B-Rated (percent of new issuance): 22.6 (2007) versus 58.0 (2018). - Total Debt/EBITDA (times): 4.9 (2007) versus 5.3 (2018). - First Lien Debt/EBITDA (times): 3.5 (2007) versus 4.3 (2018). - Deals with EBITDA Add-Backs (percent of new issuance): 8.4 (2007) versus 27.1 (2018). _International Monetary Fund | April 2019 — CHAPTER 1: VULNERABILITIES IN A MATURING CREDIT CYCLE (text - CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE)_ ### 5. US Credit Fundamentals of BBBs: 2018 versus 2007 ### 5. US Credit Fundamentals of BBBs: 2018 versus 2007 ### Corporate profitability, payouts, and leverage - US profitability has been higher than in other advanced economies, supported by falling tax rates and strong revenue growth; expected earnings growth for 2019 has been revised down. - Strong profits were used for payouts and financial risk-taking, with dividends and share buybacks outstripping gains in investment and reaching postcrisis highs. - In some sectors, payouts have been financed with borrowing, adding to already-elevated debt ratios. - Aggregate corporate debt−to-GDP ratios have risen to historically high levels in advanced economies. - The share of debt at firms with: - high (above 0.6) debt-to-asset ratios has declined in some jurisdictions, while - moderate (between 0.3 and 0.6) indebtedness has increased in both the United States and the euro area. ### Debt-service capacity, liquidity, and net leverage - Debt-service capacity has improved in most major advanced economies, measured by the share of debt in firms with low (below 1) and subpar (between 1 and 3) interest coverage ratios; the United Kingdom is a notable exception where the share with low interest coverage ratios has increased. - Liquidity and rollover risks have declined: the share of debt owed by firms with low (below 10 percent) cash buffers relative to their short-term debt has fallen notably in most major advanced economies. - Net leverage ratios (share of debt in firms with high (above 6) net debt to EBITDA) have: - improved in the United States and the United Kingdom relative to the precrisis period, and - weakened in the euro area and Japan. - Despite improvements in some flow metrics, structural leverage indicators have deteriorated due to high aggregate corporate debt levels, leaving the corporate sector vulnerable to large economic and financial shocks. ### Risks from BBB-rated bonds and potential downgrades - The universe of BBB-rated US corporate bonds is roughly twice the size of the entire US high-yield bond market. - About 6 percent of BBB-rated companies, or approximately $200 billion in par value, currently trade at levels closer to high yield than to the BBB spread curve. - Market-based estimates of potential downgrades to high-yield bonds are within a range implied by rating agencies. - A large downgrade wave could temporarily increase high-yield credit risk premiums by as much as an estimated 90 basis points if all bonds that are rated at BBB– with negative outlook were downgraded. - The greatest impact on credit risk premiums may be felt in the CCC-rating space, where rollover risk would increase significantly. - Historical experience: waves of downgrades to high-yield bonds happened in the past and were not always associated with downturns and recessions. ### Leveraged loan market: size, composition, and vulnerabilities - 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 being used increasingly to fund financial risk taking: mergers and acquisitions, leveraged buyouts, dividends, and share buybacks. - Borrowers in the leveraged loan market remain dependent on capital markets for refinancing, leaving them vulnerable to liquidity stress and potential defaults. - Weaker underwriting standards, decreased investor protection, a higher share of weak credit, and reduced subordination increase likelihood of distress and reduce recovery rates. - Indicators on market structure and exposures: - 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 managers are estimated at about $20 billion currently versus more than $200 billion in 2008. - Global banks hold about 33 percent (or $250 billion) of the total stock of collateralized loan obligations and are estimated to hold mostly the highest-rated tranches. - Concentration of fund ownership is meaningful: estimates that the top 5 and top 20 US loan products own nearly 15 percent and 30 percent of the US loan market, respectively. - Potential mitigating factors for spillovers: - Banks play a smaller role in the leveraged loan market than in the past. - CLO holdings are mainly with non-bank investors and banks tend to hold higher-rated tranches. - Recent issuance of high-yield bonds has been relatively low, which may leave investors more 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 investment-grade ratings. ### Market signals and investor concerns - The widening in corporate bond spreads in late 2018 was driven by higher credit risk premiums rather than higher modeled default compensation. - Increased participation of investment funds and rating-sensitive investors could raise the odds of fire sales and more adverse market dynamics in the event of stress. - The high-yield bond market is less liquid and has a narrower investor base than the investment-grade market, amplifying potential market impact from a surge in high-yield supply. *Source: text - 5. US Credit Fundamentals of BBBs: 2018 versus 2007 — text.pdf (International Monetary Fund | April 2019).* ### 1. High-Yield Bond versus Leveraged Loan Debt Outstanding ### 1. High-Yield Bond versus Leveraged Loan Debt Outstanding ### Developments in the leveraged loan market - The amount of leveraged loans is almost as large as that of high-yield bonds. - Nonbanks have taken a larger role in financing highly indebted firms; some of the largest crossover credit funds have only marginal exposures to leveraged loans. - The share of proceeds used to fund acquisitions and shareholder enhancements is large. - A sizable 31 percent of issuance is used for refinancing. - US bank holdings of collateralized loan obligations (CLOs) remain relatively small. - Collateralized loan obligations have enjoyed a stable bid from asset managers and banks, and attractive currency-hedged returns have maintained a strong bid from foreign banks. ### Risks, market structure, and stress dynamics - The evolving market structure raises the possibility of different dynamics during times of stress compared with 2007–08. - Risk channel: large-scale redemptions from end-investors could force investment funds to liquidate holdings of leveraged loans; given these funds are important buyers, large redemptions could induce fire sales and further depress prices. - Broader impact: such dynamics could affect other institutional investors, block the flow of funds to the leveraged credit market, and jeopardize economic activity of borrowers across sectors. - Market friction: borrowers’ ability to shift swiftly to the high-yield bond market could be hampered by the relatively large size of the leveraged loan market. - Uncertainty: further financial stability implications will depend on whether nonbanks have retained material links to banks that could amplify market disruptions. ### Leveraged loan market structure items (as presented) - Panel definitions: institutional investors include finance companies, insurance companies, hedge funds, distressed debt funds, loan mutual funds, and collateralized loan obligations (CLOs). - Panel 5 (US CLO year-end 2018 investor base) is based on estimates from Citi. - JGB = Japanese government bond; JPY = Japanese yen; LBOs = leveraged buy-outs; M&A = mergers and acquisitions. --- ### The Euro Area Sovereign–Financial Sector Nexus ### Recent developments and transmission to banks - Fiscal challenges in Italy rekindled worries about the sovereign–financial sector nexus 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. ### Historical context and policy responses - During the euro area crisis in 2011−12, sharp rises in sovereign yields created mark-to-market losses on banks’ government bond holdings, raised bank funding costs, and were passed to companies and households via higher loan rates—contributing to recession and higher government-debt-to-GDP ratios and a rise in nonperforming loans. - Key measures adopted since then include increased bank capital and loan loss reserve buffers, reductions in nonperforming loans through sales and write-offs, central bank liquidity support, official sector asset purchases, and creation of the Single Supervisory Mechanism and Single Resolution Mechanism, and the Bank Recovery and Resolution Directive. - Remaining policy gap: measures are still needed to fully complete the Banking Union, such as establishing a European Deposit Insurance Scheme. ### Channels through which sovereign stress can affect the financial system (Figure 1.16) - Financial channels (mark-to-market losses on sovereign, bank, and insurer bond holdings): 1. Mark-to-market loss on sovereign bond holdings 2. Mark-to-market loss on sovereign bond holdings (bank/insurer holdings) 8. Mark-to-market loss on bank bond holdings 7. Mark-to-market loss on corporate bond holdings - Macro-financial channels (spillovers to companies and households): 4. Economic slowdown 5. Higher interest rates on loans 6. Higher nonperforming loans 9. Higher contingent liabilities (bailout) 10. Lower tax revenues - Bond demand channels (changes in bond demand that exacerbate yield increases): 11. Lower demand for sovereign bonds 12. Lower demand for sovereign bonds 13. Lower demand for bank bonds 14. Lower demand for corporate bonds - Note: channels can operate over different horizons and interact via feedback loops. --- ### Banking vulnerabilities, scenarios, and reserve adequacy ### Bank exposures to domestic sovereigns and rating shifts - Domestic government bond portfolios of banking systems are large relative to assets in several countries, particularly Belgium, Italy, Portugal, and Spain. - Factors contributing to larger government bond holdings: higher yields on government bonds in these countries, use of bonds as collateral for central bank liquidity facilities, zero risk weights on sovereign bonds, and liquidity regulations treating government bonds as liquid assets. - The proportion of lower-rated government bonds held by some banks (notably Italian and Portuguese banks in the EBA sample) has increased following downgrades to sovereign credit ratings. ### Scenario analysis and impacts - Two sovereign yield scenarios were simulated for EBA banks: a mild and a severe scenario calibrated to past stress events in sovereign bond markets; loan-loss scenarios labeled moderate and adverse were applied for nonperforming loans. - Severe scenario result: sharp rises in government bond yields would generate significant losses for EBA banks in Italy, Portugal, and Spain in particular. - Loan-loss assessment: the stock of nonperforming loans remains a significant burden that could induce further losses, which in some cases may be larger than loan loss reserves. - Buffer effects: - In the moderate downside scenario (mild mark-to-market and moderate loan-loss adjustment), EBA bank Tier 1 capital ratios—after adjustments—would be higher than in 2010. - In the adverse downside scenario, post-shock Tier 1 ratios are generally higher than in 2010 for most banks, but the post-shock Tier 1 ratios for Italian and Portuguese EBA banks are slightly lower than in 2010. ### Caveats and mitigating factors not fully captured - The analysis does not capture all bank exposures to sovereigns (for example, loans to state-owned entities or off-balance-sheet exposures are excluded). - Lack of available data prevented assessment of hedges banks may hold to mitigate losses from higher government bond yields. - Some banks may be moving government bond holdings from mark-to-market accounts to held-to-maturity portfolios—this reduces potential mark-to-market losses but also reduces balance sheet flexibility. - The adjustment to nonperforming loans uses transaction prices; some categories of nonperforming assets (for example, Italian nonperforming loans classified as unlikely to pay (UTP)) could have lower loss rates than assumed in the exercise. An example given: if UTP loss rates are 25 percent lower than 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. --- *Italic: Sources: Bloomberg Finance L.P.; Citi; Federal Reserve Y-9C Reports; S&P Leveraged Commentary & Data; SNL Financial; Deloitte; European Banking Authority; Haver Analytics; PricewaterhouseCoopers; IMF, Financial Soundness Indicators database; IMF, World Economic Outlook database; national central banks; Banca IFIS; and IMF staff calculations.* ### 1. Scenarios of Changes in Sovereign Bond Yields ### 1. Scenarios of Changes in Sovereign Bond Yields ### Scenario calibrations and loan-loss adjustments - Sovereign bond yield scenarios (Basis points): - Mild downside: –50 - Moderate downside: 48 - Severe downside: –100 - Adverse: 70 - Loan Loss Adjustment Scenarios (Percent of face value) by Sovereign Credit Rating and Type of Nonperforming Loan: - Sovereign credit rating columns: AAA AA A BBB BB B Speculative grade Not rated (as presented) - Type of nonperforming loan columns: Secured, Unsecured - Mild downside scenario: 0, 25, 50, 75 (values presented adjacently as "–500255075") - Moderate downside scenario: 48, 65 (values presented as "4865") - Severe downside scenario: –100, 50, 150, 250, 425 (values presented as "–10050150250425") - Adverse scenario: 70, 90 (values presented as "Adverse7090") - Notes on calibration (verbatim): - "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." - "The moderate loan loss scenario assumptions are based on secondary market prices of nonperforming loans from a survey of market participants." - "The adverse scenario is based on data for sales of nonperforming loans in Italy." *Sources: Banca IFIS; Bloomberg Finance L.P.; PricewaterhouseCoopers; and IMF staff analysis.* --- ### 2. Insurers: exposures, stress scenarios, and solvency implications ### Key exposures and trends - "Euro area insurers overall own more than 15 percent of outstanding euro area sovereign bonds—slightly less than the amount owned by banks—and almost 25 percent of euro area bank bonds." - "The 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." - Across countries, insurers in more indebted sovereign jurisdictions tend to have a greater share of lower-rated securities in corporate bond portfolios. - Some insurers have a high share of subordinated and hybrid debt in their bank bond holdings; such debt is more likely to be written down at times of market stress. ### Stress scenario application and outcomes - Scenarios applied to insurers’ balance sheets include shocks: - Same government bond shocks used for banks. - Shocks to corporate bond yields (calibrated similarly to sovereign shocks). - Shocks to equity and real estate investments. - Outcome highlights: - "These scenarios would imply significant losses for euro area insurers under the severe scenario, particularly for companies in more highly indebted sovereign jurisdictions." - Most euro area insurers remain well capitalized, but "a severe scenario would put pressure on insurers that already have lower solvency ratios." - The ultimate impact is "alleviated somewhat by the volatility adjustment under Solvency II," though mitigation is less effective where insurers have higher-risk portfolios than the reference portfolio used in the volatility adjustment. ### Specific calibrated shock magnitudes (as presented) - A fragment reporting shock magnitudes: "90 basis points, compared to around 280 basis points in the adverse downside scenario." (presented verbatim in the source) --- ### 3. Banks: funding costs, nonperforming loans, and profitability effects ### Funding and contagion channels - Macro-financial contagion channels emphasized: - Economic slowdown that sovereigns with limited fiscal space cannot offset, reducing company and household incomes and debt-servicing capacity. - Bank funding-cost channel: "Sovereign and bank credit spreads are tightly correlated," increasing cost of new wholesale funding for banks with lower-rated sovereigns. - Bank of Italy finding (verbatim): - "The Bank of Italy found in its November 2018 Financial Stability Report (Bank of Italy 2018) that a 100-basis-point rise in Italian government bond yields would reduce capital ratios of 'significant banks' by 40 basis points, but that capital ratios of 'less significant banks' would fall by 90 basis points." - Additional estimate (verbatim): - "Estimates by the Bank of Italy suggest that 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." ### Central bank liquidity and funding outlook - Central bank liquidity support (for example, targeted longer term refinancing operations renewed by the ECB) "has lowered overall funding costs" and may limit the pass-through of higher sovereign yields to lending rates so far. - Risk: If a sovereign is downgraded below investment grade by all four major rating agencies, that country's government bonds could become ineligible as collateral at central banks under current rules, exacerbating funding problems. ### Nonperforming loans (NPLs) and provisioning guidance - New guidance and proposals: - Guidance for banks 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 implications from illustrative exercises: - If banks increase reserves coverage according to ECB guidance, required provisioning is likely to be manageable if bad-debt formation is similar to the past five years. - If nonperforming loans rise substantially (for example, to levels seen during the euro area crisis), extra provisioning would "put a substantial drag on profits for some banks." - 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 nonperforming loans, particularly if there was a sharp rise in new nonperforming loans." ### Quantitative impacts on bank profitability and balance sheets (figure references) - Panels in Figure 1.19 show: - Banking sector interest rates on new loans and funding (Percent). - Central bank liquidity support to banking systems (Percent of banking sector assets; billions of euros shown in panels). - Estimated impact of provisioning to fully cover new nonperforming loans on profitability, 2019–23 (Percent of 2013–17 pre-provision profits, annualized). - Estimated losses from reducing gross NPL ratios to 5 percent by 2023 (Percent of 2013–17 pre-provision profits, annualized). --- ### 4. Policy measures, resolution frameworks, and residual risks ### Recent policy measures - Bank Recovery and Resolution Directive preference for bail-in of creditors should reduce likelihood of sovereign-funded bailouts. - Observations: - "Recent cases of intervention in euro area banks suggest that some national authorities have shown a preference for less stringent burden sharing, at a time when loss-absorbing buffers have not been fully developed." - "So while the new measures provide a good foundation, they are largely untested, and it may be too early to completely rule out the possibility of spillbacks from banks to sovereigns." ### Potential amplification and systemic consequences - If downside scenarios of higher government bond yields materialize, a further round of contagion through the sovereign–financial sector nexus could occur, with negative implications for economic growth. - Banks and insurers could propagate stress through bond demand channels: marked-to-market losses or downgrades to below investment grade could reduce willingness or ability to buy, adding pressure to yields and funding costs. - Note on potential stabilizing behavior: - "Banks and insurers not facing such losses could be a stabilizing force in markets if they were to buy into a falling market." --- *International Monetary Fund. Chapter: Vulnerabilities in a Maturing Credit Cycle — selected excerpts from text (figures and notes included), April 2019.* ### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE ### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE ### Emerging credit markets and market dynamics - Emerging credit markets recovered in early 2019 after late-2018 turbulence but were more affected in late 2018 because benchmark indices have a large weight of sovereign issuers with weaker fundamentals. - Mexico was a major contributor to the sell-off among higher-rated issuers amid concerns about PEMEX. - Bond issuance was subdued in Q4 2018; issuance resumed in early 2019, including by lower-rated entities: - Ecuador sold a bond at double-digit yield. - Uzbekistan issued for the first time. - Debt vulnerabilities remain high for many frontier markets, and new issuance has often been at very high cost. - China-specific developments: - China’s equity market sold off more sharply than other emerging markets in 2018 and rebounded in early 2019. - Pressures from the financial regulatory tightening campaign and dependence of some firms on borrowing collateralized by their own shares affected equity declines. - Chinese authorities eased monetary and credit policies to offset tightening: - 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. - These measures and improved global risk sentiment coincided with: - The equity market rising by more than 25 percent. - Nonfinancial credit growth accelerating in early 2019. - Funding costs for higher-rated bond issuers and bank borrowers declining. - Yields at issuance for lower-rated firms remaining elevated. - Bond market defaults rose sharply among private issuers. ### Portfolio flows to emerging markets: recent patterns - Portfolio flows rebounded in recent months after sustained outflow pressures in 2018. - Increased investor risk aversion is estimated to have reduced portfolio flows to emerging markets by some $20 billion in Q4 2018 (or about 10 percent of average annual inflows in 2015-18). - The Federal Reserve’s ongoing balance sheet normalization also dragged on flows. - Partial data for Q1 2019 point to a sizable recovery, led by debt portfolio flows. - Steady inflows into emerging-market-dedicated ETFs cushioned outflow pressures: - For equity ETFs, a large share of inflows has been to China since early 2017, reflecting MSCI’s decision to include certain Chinese shares in benchmark indices. - Inflows into hard currency ETFs were fairly resilient. ### Growth of benchmark-driven investments and assets under management - 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. - While ETFs and index funds explicitly replicate benchmarks, many mutual funds and assets in separate accounts tend to follow benchmarks closely because performance is assessed against them. - The share of purely passive investors (such as ETFs) remains small for both hard currency and local debt compared with mature markets. - Active managers and non-benchmark-driven opportunistic funds have, so far, acted as countervailing forces in fixed-income markets. ### Risks from larger share of benchmark-driven investors - Benchmark-driven flows are more sensitive to common/global factors and therefore more correlated across countries. - Historical episodic behavior: - May 2013 “taper tantrum” triggered large portfolio outflows by emerging-market-dedicated investment funds even as other investors added to exposures. - April–August 2018 sell-off saw sharp outflows by emerging market benchmark-driven funds after a buildup of positions in local currency bonds. - Empirical measures of sensitivity and correlation: - Average pair-wise correlation between benchmark-driven flows to individual emerging markets and inflows to all other emerging markets was 0.74 during 2010–18, compared with 0.27 for overall portfolio flows (BoP-based). - A one standard deviation increase in the VIX (which corresponds 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 (which amounts 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: - A larger share of benchmark-driven investments increases the risk of excessive inflows or outflows unrelated to country fundamentals and can have destabilizing effects. - 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. - Outflows from benchmark-driven funds in response to a given shock can be much greater now than a few years ago because of growing sensitivity and larger AUM. ### Distributional effects among countries and frontier issuers - Exposure to benchmark-driven investors depends on index inclusion rules and index provider choices; sovereign borrowers are generally more exposed than firms. - Countries with sizable shares of benchmark-driven investors in local currency debt include South Africa and Malaysia. - Frontier issuers: - The amount of international debt outstanding from frontier issuers has increased dramatically over the past decade, with more than 20 countries issuing foreign currency bonds for the first time. - 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 EMBIG-Diversified index is closer to 23 percent, making them large beneficiaries of benchmark-driven flows. - Given the sizable contribution of frontier markets to overall emerging market sovereign debt performance, increased distress among these issuers could prompt redemptions from passive and benchmark-driven funds and lead to outflows even from countries with strong fundamentals. ### Index inclusion and broader asset-class effects - Index inclusion decisions can lead to substantial portfolio rebalancing and alter asset-class risk characteristics. - Example: J.P. Morgan recently included several GCC countries in the EMBI Global index; given substantial issuance, their weight is expected to eventually rise to 12 percent. - Increase in China’s weight in global benchmark indices is expected to boost RMB portfolio flows, which could lead benchmark-driven investors to reduce exposures to other emerging markets. *Italic line: Source: CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE, International Monetary Fund | April 2019* ### 4. Estimated Benchmark-Driven Flows Due to China’s Inclusion in ### 4. Estimated Benchmark-Driven Flows Due to China’s Inclusion in JPM GBI-EM Global Diversified Index ### Index inclusion and estimated portfolio flows - The renminbi-denominated government and policy bank bonds will be added to the Bloomberg Barclays Global Aggregate Bond Index starting in April 2019 and will be 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 of China in the Bloomberg index after full inclusion: about 6 percent. - Estimated additional inflows to China by 2020 from Bloomberg inclusion: $150 billion. - Market analysts’ potential eventual inflows to China from inclusion in other bond indices: 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. - Mechanical rebalancing in J.P. Morgan GBI-EM: may lead to a potential reduction in fund allocations of $1 billion to $3 billion each for most issuers. - Actual rebalancing process is gradual and may be more complex because: - Passive investors follow benchmark weights mechanically. - Other benchmark-driven investors can substantially deviate to try to outperform the index. ### Impact on other emerging markets - Inclusion of China’s local currency debt in emerging market benchmarks will be more notable for other emerging markets because of their small weight in global bond benchmark indices. - Benchmark-driven outflows for most issuers from GBI-EM rebalancing estimated: $1 billion to $3 billion each. ### Figure- and panel-based data references (as reported in source) - Figure references include: Figure 1.24, panel 4; Figure 1.25 (panels 1–4); Figure 1.26 (panels 1–4); Figure 1.27 (panels 1–6); Figure 1.28 (panels 1–3). --- ### China’s vulnerabilities and effects of regulatory tightening - Overall assessment: vulnerabilities remain elevated in China (Figure 1.4), but regulatory tightening has succeeded in containing risk buildup. - Bank asset growth slowed considerably since the start of the regulatory campaign nearly two years ago, 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. - Contraction in credit led by small and medium-sized banks—previously the biggest contributors to shadow credit expansion. - Regulatory reforms for the asset management sector (introduced in late 2017) have been scaled back in recent months; implementation schedule eased through 2020. - Bank wealth management products (WMPs) developments: - WMPs will be allowed to increase leverage via debt issuance and invest in a wider range of equity and loan assets. - WMPs may receive coinvestment from sponsor banks. - WMPs still embed significant maturity and liquidity mismatches and leverage to provide yields well above corporate bond yields. - Conversion to net-asset-value-based WMPs minimal: just 2.7 percent of all issuance in 2018, from 0.5 percent in 2017. - Investment vehicle short-term borrowing remains elevated (Figure 1.25, panel 4). --- ### Bank weaknesses, lending capacity, and scenario analysis for small and medium-sized banks - Small and medium-sized banks account for just over half of commercial bank assets and more than 70 percent of growth in loans to small and medium-sized enterprises since Q1 2015. - Profitability and capital ratios at small and medium-sized banks continue to edge lower; many 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 small and medium-sized banks because they must compete to raise deposits. - Trade-off: improving resilience versus maintaining credit growth. Scenario A — Banks seek to improve their resilience within a year: - Assumption: banks 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. - Result: small and medium-sized banks would have to shrink current loan books about 30 percent to meet this requirement within one year (Figure 1.26, panel 3). - Scenario assumptions (from source footnote): - 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 the 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 allowed to achieve the same level of balance sheet strengthening over time and assuming loan growth of 10 percent, most small and medium-sized banks would not be able to do so within five years (Figure 1.26, panel 4). - If credit were to grow at 5 percent, then most banks would be able to grow out of their problems within five years. - Profitability (return on assets) and risk-weighted asset density assumed constant in these scenarios. Key quantitative references: - System average core Tier 1 equity ratio used in scenario: 10.5 percent. - Required loan book shrinkage for small and medium-sized banks in one-year resilience scenario: about 30 percent. - Dividend payout ratio reduction assumption: 50 percent relative to 2017. --- ### Sectoral credit allocation risks and potential consequences of further easing - Nonfinancial corporate credit growth has declined overall, but exposures to real estate (mortgages and developers) and infrastructure have expanded faster than lending to other firms (Figure 1.27, panel 1). - Tightening of shadow credit has led nonbank investors to reduce exposures mainly to sectors other than infrastructure and property (Figure 1.27, panel 2). - Among similarly rated issuers, infrastructure and property firms enjoy more favorable borrowing conditions and are affected less severely when market conditions tighten (Figure 1.27, panel 3). - Infrastructure and property firms: - Net issuance increases more during periods of easing and declines less during periods of tightening, particularly for lower-rated firms (Figure 1.27, panel 4). - Tend to have the lowest reported nonperforming loan ratios but higher leverage and weaker debt-service capacity than other nonfinancial firms (Figure 1.27, panels 5 and 6). - Real estate and land valuations are stretched; credit growth in these sectors 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. - Further monetary and credit easing risks: - May tilt credit allocation toward infrastructure and property, increasing debt at these firms and among households. - May impede bank balance sheet repair and worsen existing vulnerabilities, undermining the impact on financial conditions and raising financial stability risks. --- ### Frontier market vulnerabilities - After a lull in H2 2018, bond issuance by frontier borrowers restarted early 2019 and is expected to remain high in 2019 (Figure 1.28, panel 2). - Frontier and low-income issuers have higher debt vulnerabilities and lower liquidity compared with other emerging market borrowers; market access conditions remain highly sensitive to global risk sentiment. - During the risk-off episode at end-2018: - More than two-thirds of frontier issuers were facing secondary market yields of 7.5 percent or more. - This compares with almost 10 percent of issuers a year ago. - Issuers relying more on capital market financing in recent years may face significant deterioration in debt sustainability over the medium term. - Frontier markets with weak debt-management capacity tend to face more market pressures. - According to the latest debt recording and monitoring capacity assessment (Group of Twenty 2018), 32 out of 70 low-income countries were assessed to have weak capacity. - Examples of recent recognition of substantial previously undisclosed liabilities: Republic of Congo, Ecuador, Mozambique. - Recent market stress examples: market speculation about Zambia’s public debt; uncertainty about short-term sources of financing in Costa Rica led to substantial repricing of credit risk and rating downgrades. --- ### Policy priorities (from source) - As global expansion loses momentum, policymakers should aim to prevent a sharper slowdown while safeguarding financial system resilience. - Monetary policy: - Should be data dependent. - Any change in outlook should be well communicated to avoid unnecessary swings in financial markets or undue compression of market volatility. - Clear communication is critical to avoid market overreaction to changes in monetary policy stance. - Macroprudential policies: - Should be used more proactively where vulnerabilities are elevated and rising. - Efforts should focus on developing 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. - Measures needed to mitigate the sovereign–financial sector nexus. - Emerging market economies should bolster resilience to cope with capital flow volatility. - China-specific recommendations: - Continue financial sector de-risking and deleveraging policies. - Put greater emphasis on addressing bank vulnerabilities. *International Monetary Fund | April 2019 — Chapter excerpt: "4. Estimated Benchmark-Driven Flows Due to China’s Inclusion in JPM GBI-EM Global Diversified Index"* ### 1. CPIA Debt-Management Capacity Score2. Frontier Debt International Bond Issuance ### 1. CPIA Debt-Management Capacity Score2. Frontier Debt International Bond Issuance ### Frontier debt vulnerabilities and market access - Debt-management capacity has not kept up with increasing reliance on international debt. - Issuance needs are expected to remain high in 2019. - Borrowing costs for frontier issuers have risen: share of frontier issuers by secondary market yield shows higher yields through 2019 YTD. - Chart time series spans 2007–19 YTD and includes markers for "19 Expected" and "19 YTD". ### Key statistics and indicators (preserved exactly as reported) - Sample size for the prudential tools assessment: 29 jurisdictions. - Elevated vulnerabilities defined as a percentile rank in the respective vulnerability exceeding 60 percent. - Cells highlighted in blue have entries below 50 percent, which should be interpreted to mean that 50 percent or more of systemically important countries do not have any prudential tools to address specific vulnerabilities. - Countercyclical capital buffer examples: at the end of this year, three economies (Hong Kong SAR, Norway, Sweden) will have buffers at 2.5 percent. - China equity-market and SCL metrics: - Equity prices of SCL-reliant firms fell by more than 40 percent at the trough. - Overall stock market declined as much as 26 percent. - 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. ### Prudential and macroprudential policy recommendations - Central bank communications should avoid unduly compressing financial market volatility; central bank independence remains crucial. - Use prudential policies to tackle vulnerabilities including rising corporate debt, increasing house prices, stretched asset valuations, and elevated maturity and liquidity mismatches in parts of the nonbank financial sector. - Where prudential policies are insufficient, consider using monetary policy to lean against the wind in countries with strong cyclical positions and inflation at or above target. - Be proactive in deploying and expanding macroprudential toolkits where financial vulnerabilities are elevated or rising. - Broad-based macroprudential tools (for example, countercyclical capital buffers) have been activated or increased in several countries and more countries would benefit from active use. - Where credit developments are sector-specific, consider targeted sectoral capital buffers for banks or increase risk weights and provisions on such exposures. - Develop prudential tools for highly leveraged firms analogous to borrower-based household tools when corporate debt is systemically high. - Supervisors should ensure comprehensive stress tests that incorporate macro-financial feedback effects from high corporate sector indebtedness and correlated risks (for banks and nonbank financial intermediaries with significant corporate exposures). - For leveraged loans: - Take a comprehensive view of risks, intensify oversight, and enforce sound underwriting standards and risk management at banks and nonbank intermediaries. - Maintain risk retention rules for originating lenders to improve asset quality being securitized and sold to nonbanks. - To mitigate risks linked to rising house prices: - Apply loan-to-value ratios, debt-service ratios, and debt-to-income ratios more consistently and broadly to nonbank lenders and calibrate them to increase resilience to shocks. - Enforce the same limits for lending by nonbank financial institutions to limit regulatory arbitrage. - Use multiple indicators for a holistic view and to limit regulatory arbitrage opportunities. ### Prudential toolkit for nonbank financial institutions - Insurance companies: - Continue work on global risk-based insurance capital standards; implement guidance to insurers on managing default risk, correlation risk, and treatment of subordinated and “bail-inable” bond investments. - Develop a holistic framework for assessment and mitigation of systemic risk in the insurance sector. - Asset managers: - Encourage robust risk management and stress testing. - Consider harmonized methodologies for leverage calculation, limits on leverage or credit extension, minimum levels for liquidity buffers, and guidance on liquidity management in investment funds. - Note significant cross-country variation in availability of liquidity management tools. - Avoid rollback of regulatory reforms and maintain or strengthen the institutional framework for macroprudential oversight. ### Sovereign–bank nexus and emerging market resilience - Highly indebted sovereigns should aim to put debt-to-GDP ratios on a downward trajectory via gradual fiscal adjustment supportive of medium-term growth. - Euro area banks should continue repairing balance sheets, reduce nonperforming loans, and address backlogs in bad debt recovery; improvements to insolvency and creditor rights and collateral valuation would help. - Design policies addressing bank–sovereign links from a holistic perspective; consider mitigating concentration risk in banks’ sovereign exposures through coordinated policies. - Consider harmonizing national bank insolvency regimes and introducing a financial stability exemption to minimum bail-in requirements, subject to strict conditionality and governance, to allow departure only when financial stability is clearly at risk. - Emerging markets should prepare for foreign portfolio outflows: - Reduce excessive external liabilities and reliance on short-term debt; maintain fiscal buffers, bank liquidity buffers, and foreign exchange reserves. - Consider phasing in currency-differentiated liquidity coverage ratios where foreign currency risks challenge banks. - Monitor foreign ownership of local currency bonds, especially large shares held by benchmark-driven investors. - Use the exchange rate as a shock absorber in flexible regimes and intervene only if markets become disorderly after considering fundamentals and buffers. - Use capital flow management measures on outflows only in crisis or near-crisis situations; measures should be transparent, temporary, nondiscriminatory, and part of a comprehensive policy package. - Sovereign debt managers should 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 membership considerations: - As passive and benchmark-driven investment rises, index membership can be a financial stability consideration. - Encourage dialogue between index providers, the investment community, and regulators; enhance transparency by index providers on eligibility criteria and advance communication of changes. - Issuers should strive for prudent index inclusion and avoid premature or partial inclusion that could introduce fragmentation and concentration risks. *International Monetary Fund | April 2019* ### 1. Market Share of SCL-Reliant ### 1. Market Share of SCL-Reliant ### Market share and firm characteristics - SCL-reliant firms are defined as firms with at least 30 percent of shares pledged to lenders. - SCLs (share-collateralized lending) concentrate among privately owned enterprises (POEs) across market capitalization groupings (Figure 1.1.1, panel 1). - SCL-reliant firms tend to have weaker balance sheets than the broader sector: - Lower debt-service capacity (interest coverage). - Higher leverage (debt-to-asset ratio). - Loans are usually 50–60% of pledged share value at origination but must be closed out when loan-to-collateral value ratios rise above 75% due to share price declines. ### Lender exposures and systemic importance - Largest SCL lenders by share of total 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: - Banks: 0.4 percent of corporate loans (relatively small) - Seven largest securities firms: on-balance-sheet SCL exposures are significant at about 10 to 20 percent of assets (data for the seven largest securities firms imply this level) - Estimated loan amount ranges assuming loans are 50% to 75% of the market value of pledged shares as of October 2018 (Table 1.1.1): - Banks: 434–651 (RMB billion) - Trust companies: 318–478 (RMB billion) - Securities firms: 1,118–1,676 (RMB billion) - Estimated SCLs as percentages (Table 1.1.1): - As percentage of bank lending to firms (banks): 0.4–0.7 - As percentage of trust company balance sheets: 38.4–57.6 - As percentage of trust company balance sheets and client assets: 1.3–1.9 - As percentage of securities firm balance sheets: 17.5–26.3 - As percentage of securities company balance sheets and client assets: 5.2–7.7 ### Policy implications and recommendations - Although immediate financial stability risks appear limited at this point, authorities should further tighten SCL practices to prevent future risks to market functioning or financial stability. - Recommended actions: - Continue to reduce distortions favoring state-owned enterprises. - Reduce credit overhang at unviable borrowers. - Advance market reforms to discourage small privately owned enterprises from riskier borrowing from nonbank financial intermediaries. *Source: Box 1.1 and Table 1.1.1, Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle (April 2019), IMF staff calculations; Wind Information Co. database.* --- ### Special Feature: Liquidity Risks in Capital Markets ### Key structural changes affecting liquidity - Postcrisis financial regulatory reforms, technological innovations, and the growth of passive investors have reshaped market liquidity supply and demand. - Tighter leverage and capital requirements for banks have: - Increased resilience of systemically important institutions. - Increased the cost of providing capital market services and changed dealers’ incentives to make markets (some dealers cut services to less profitable clients). - Decline in bank trading books across jurisdictions (Figure 1.SF.1 panels 1 and 2): - GSIB trading portfolios: 2012: $10.1 trillion; 2017: $8.9 trillion. - Rise of nonbank principal trading firms (PTFs): - PTFs provide alternative market-making services with higher speed and lower execution costs via automated high-frequency trading strategies. - PTFs tend to be concentrated in liquid instruments (standardized, exchange-traded products such as equities and Treasury futures). - On US dealer-to-dealer electronic platforms, banks and broker-dealers currently 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 share of assets under management of ETFs and passive investors: - ETFs provide a liquid instrument exposing investors to portfolios of securities with varying liquidity; increased ETF participation in less liquid markets may increase liquidity mismatches. - Growth of passive investing could induce greater correlation of component securities, increasing herding risk and adverse implications for market liquidity. - Central bank asset purchases have altered supply/demand of safe liquid assets: - Expansion of central bank holdings reduced free float of securities available to investors. - Expansionary monetary policies encouraged investors to reach for yield in less liquid asset classes, potentially compressing liquidity risk premiums. ### Evidence on market liquidity metrics - Standard liquidity indicators may not fully capture current risks; they should be interpreted with caution. - Quantity-based measures show signs of deterioration while price-based measures appear more robust: - Turnover ratios (trading volumes relative to securities outstanding) have declined across markets since the global financial crisis. - Bid-ask spreads for major markets have been relatively tight overall, with some deterioration in a few foreign exchange markets and in equity markets in recent months. - One possible adjustment by traditional dealers: reduce quantities (market-making capacity) rather than widen prices for core clients. - Divergence between highly liquid and relatively illiquid markets has increased: - Traditional market makers (banks) provide liquidity across markets; nontraditional market makers (PTFs) tend to concentrate in the most liquid instruments, contributing to divergence. - Recent flash episodes (past year examples): - Yen spike in January 2019 - Sharp drop in S&P 500 futures in early December 2018 - Flash rally in US Treasuries in June 2018 ### Market structure and trading-electronification metrics (Table 1.SF.1 highlights) - Penetration of electronic, automated, and high-frequency trading (by share of volume traded): - Electronic Trading: - Equity Futures: 90% - Treasury Futures: 90% - Cash Equities: 50–80% - Foreign Exchange Spot: 80% - Cash Treasuries: 70% - European Cash and Futures Government Bonds: 60% - Japanese Government Bonds: 60% - Interest Rate Swaps: 20–50% - Investment Grade/High-Yield Corporate Cash Bonds: 15–50% - Automated Trading: - Equity Futures: — (not shown) - Treasury Futures: 70% - Cash Equities: 45% - Foreign Exchange Spot: 55% - Other cells: — (not shown) - High-Frequency Trading: - Equity Futures: 40% - Treasury Futures: 60% - Cash Equities: 35–70% - Foreign Exchange Spot: 25–30% - Other cells: — (not shown) - Major electronic brokering platforms listed for relevant markets (examples: CME, ICE, Tradeweb, Eurex, SGX, ASX; EBS/NEX Markets; Bloomberg; MarketAxess). ### Implications for monitoring and policy - Standard daily liquidity indicators may understate episodic fragility (e.g., flash crashes) and divergence across markets. - Monitoring should account for: - Concentration of nonbank liquidity providers in the most liquid instruments. - Increased algorithmic and high-frequency trading shares in major markets. - Reduced free float due to central bank holdings. - Growing ETF/passive investor participation and potential liquidity mismatches. - Policy attention recommended to: - Understand interaction between postcrisis regulation, market structure changes, and liquidity provision. - Assess resilience to sudden liquidity evaporation (flash events). - Consider regulatory and market-structure measures to preserve market functioning across stress episodes. *Source: Special Feature “Liquidity Risks in Capital Markets,” Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle (April 2019), IMF staff calculations and cited sources.* ### 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 ### Summary of findings - Bloomberg’s liquidity index (a proxy for aggregate on- and off-the-run spreads) for the Italian sovereign bond market has been consistently elevated in recent years, while a similar index for German bunds has been stable. - Divergence between on- and off-the-run bonds is becoming larger in Italy compared with Germany. - Bid-ask spreads in the Italian bond market have become more volatile even during periods when sovereign spreads were relatively tight and stable. - Trading volume may not be an accurate indicator of market liquidity conditions because a large part 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 significant proliferation of trading platforms. - “Algorithmic market making” can generate visible quotes without underlying transactions; if many market participants use similar algorithms, apparent market depth can evaporate quickly when faced with a large flow or shock. ### High-frequency intraday jump analysis framework and interpretation - The framework examines characteristics of jumps (discontinuities) in intraday price evolution to detect liquidity strain. - Price jumps interpreted as: - “Large” jumps (finite activity) linked to significant news shocks. - Episodic series of “small” jumps (infinite activity) interpreted as evidence of liquidity strains. - Uncovering statistically significant evidence of infinite activity jumps in intraday data is interpreted as evidence of liquidity strains. - In a market with ample liquidity, price adjustments to news are rapid; in poor liquidity, adjustments are sluggish and reflected by periods of small jumps. ### Empirical observations (September 2018–February/March 2019) - Sample of countries includes: Brazil, China, France, Germany, India, Italy, Korea, Mexico, Portugal, Spain, the United Kingdom, and the United States. - 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, particularly in emerging markets. - The incidence of liquidity strain has been rising over the past few months, particularly in sovereign bond markets. - The frequency of liquidity strained days detected each month is higher in emerging markets than in advanced economies. - Frequency correlations: - Frequency of strain in equities is loosely correlated with conventional liquidity metrics such as the turnover ratio. - 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). ### Key statistics and exact figures reported - On January 3, an exceptionally high proportion of price variation in the Japanese yen market was due to jumps: "over 85 percent". - VIX surged to "around 35 points" on two occasions in the past year; one spike (February 2, 2018) was accompanied by liquidity strain, the other (December 24, 2018) was not. - In the UK gilt market, the proportion of variation explained by jumps tended to rise from "below 10 percent to close to 40 percent" around key Brexit-related events. - Between November 2018 and January 2019, the UK gilt market averaged "2.3 days a month" with liquidity strain, compared with an average frequency for other major advanced economy sovereign bond markets of "1.5 days a month". - Event windows and sample period references: September 2018–March 2019; September 2018–February 2019 referenced for some analyses. ### Event study highlights - VIX tantrum (February 2, 2018) versus VIX spike (December 24, 2018): - The VIX tantrum spike was accompanied by liquidity strain; the later spike was not characterized by meaningful deterioration in intraday market liquidity. - Differences attributed to different underlying shocks: technical factors for the tantrum versus reassessment of growth and US monetary policy normalization for the December 2018 spike. - Japanese yen flash event (January 3, 2019 Japan Standard Time): - Currency surged nearly "4 percent" against the dollar in minutes between New York and Tokyo/Singapore trading hours. - Jump analysis shows liquidity strains were present days ahead of the flash event; on January 3, the proportion of price variation due to jumps exceeded "85 percent". - Brexit-related developments in the 10-year UK gilt market since September 2018: - Proportion of variation explained by jumps rose significantly around key events (from "below 10 percent to close to 40 percent"). - Frequency of liquidity strained days per month in the UK gilt market rose and averaged "2.3 days a month" between November 2018 and January 2019 versus "1.5 days a month" for other major advanced economy sovereign bond markets. ### Policy implications and recommendations - Market liquidity conditions merit close scrutiny by regulators due to the risk that illiquidity events can precipitate fire sales and sharp tightening in financial conditions. - Actions for authorities and market participants: - Assess robustness of trade infrastructure. - Support transparency in the marketplace. - Counterparties to PTFs should carefully monitor intraday activity and leverage exposures and strengthen liquidity risk management practices. - Improve availability of data on activities of nonbank market makers to help private and public sectors with timely assessment of liquidity risks in global capital markets. *Source: Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle (April 2019), International Monetary Fund* ### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE ### CHAPTER 1 VuLNERABILITIES IN A MATuRING CREdIT CYCLE ### Summary - Large house price declines can adversely affect macroeconomic performance and financial stability, as seen during the global financial crisis of 2008 and other historical episodes. - Housing roles highlighted: consumption good, long-term investment, store of wealth, and collateral for lending. - Rapid increases in house prices in many countries in recent years raise concerns about the possibility of a decline and its potential consequences. - This chapter studies and quantifies house prices at risk—a measure of downside risks to future house price growth—in a sample of 32 advanced and emerging market economies and major cities. - Key empirical findings: - Lower house price momentum, overvaluation, excessive credit growth, and tighter financial conditions predict heightened downside risks to house prices up to three years ahead. - The house-prices-at-risk measure helps forecast downside risks to GDP growth over and above other simpler measures of house price imbalances and adds to early-warning models for financial crises. - Downside risks to house prices have rotated since the global financial crisis: most countries at higher risk at end-2007 face lower risks today, but in many advanced and emerging market economies house prices remain at risk. - Policy linkages: - Tightening of macroprudential policies is associated with a reduction of downside risks to house prices, especially policies aimed at borrower resilience (limits on maximum loan-to-value or debt-service-to-income ratios). - An unexpected easing of the monetary policy rate is associated with lower downside risks to house prices, but only in the short term in advanced economies. - Tightening of capital flow management measures has a more nuanced relationship, with some results suggesting a temporary association with lower downside risks in advanced economies. - Policy guidance: - Estimates of house prices at risk can complement other surveillance indicators of housing market vulnerabilities and guide macroprudential policy actions aimed at building buffers and reducing vulnerabilities. - Downside risks to house prices could provide relevant information for monetary policymakers when assessing downside risks to the economic and inflation outlook. *Authors: Nico Valckx (team lead), Andrea Deghi, Mitsuru Katagiri, Oksana Khadarina, and Sohaib Shahid, with contributions from Adrian Alter, Elizabeth Mahoney, Peichu Xie, and Janice Yi Xue, under the guidance of Dong He, Fabio Natalucci, and Claudio Raddatz.* ### Introduction: macro-financial links and recent trends - Housing’s macroeconomic importance: - Housing is both a consumption good and a long-term investment. - Housing makes up a large share of households’ wealth in most countries; higher house prices can boost consumption by increasing net worth. - Housing provides collateral for borrowing to smooth income shocks and finance small businesses. - Housing consumption and investment accounted for about one-sixth of the US and the euro area economies in 2017. - Mortgages and housing-related lending often make up a large fraction of banks’ assets; house price changes affect bank portfolio quality and profitability. - Historical evidence and systemic risk: - Recessions are deeper and last longer when house prices fall more and more quickly (Claessens, Kose, and Terrones 2012). - More than two-thirds of the nearly 50 systemic banking crises in recent decades were preceded by boom-bust patterns in house prices. - Housing market characteristics associated with increased crisis risk include higher loan-to-value ratios and greater reliance on wholesale funding (Cerutti, Dagher, and Dell’Ariccia 2015). - Feedback loops: rising house prices expand credit via collateral effects; reversals can trigger credit and GDP collapses (Alter, Feng, and Valckx 2018). - Recent synchronization and concerns: - Many countries and cities experienced substantial house price increases over the past five years, reflecting increased synchronization of house prices. - Heightened synchronicity can signal downside risks to economic activity, especially when leverage is high. - Central banks have expressed concern over high house price growth and consequent risks to their economies. ### Measurement: house prices at risk methodology - Framework: - The chapter develops a methodology to model (large) house price declines with a given (low) probability and horizon—house prices at risk—building on the growth-at-risk (GaR) framework of the October 2017 GFSR. - House prices at risk identify very large declines in future house prices within the lowest quantiles (typically the 5th percentile) of conditional distributions. - Quantile regression is used to study how house prices at risk move when conditioning variables change. - Research questions the framework addresses: - How do known factors affecting expected house prices and housing vulnerabilities forecast downside risks to future house price growth? Does this vary with forecast length? - What is the relationship among macroprudential policy, monetary policy, capital account openness, capital flow measures, and house prices at risk? Do these policies reduce downside risks—intentionally or not? - What does elevated house prices at risk indicate about possible downside risks to economic growth and financial stability? ### Empirical findings - Drivers of house prices at risk: - House prices at risk worsen (deteriorate) with tightening financial conditions, declines in real GDP growth, higher credit growth, and greater house price overvaluation (deviation from fundamentals). - These effects vary with the forecast horizon and are generally more pronounced in the short term. - Effects on the 5 percent quantile (house-prices-at-risk) are stronger than on the median (50 percent quantile). - Effects appear stronger at the city level than at the country level. - Additional results suggest downside risks to house prices move together across advanced economies ahead of major crises. - Predictive value and early warning: - The house-prices-at-risk measure improves predictive power when added to standard growth-at-risk and financial-crisis-prediction models. - While house price levels are not advocated as targets for monetary, macroprudential, or capital flow management policies, the house-prices-at-risk measure can gauge financial stability risks and inform prospective policy action. - Policy effects: - Macroprudential tightening (e.g., constraints on loan-to-value and debt-service-to-income ratios) lowers downside risks to house prices. - Easier monetary policy improves house prices at risk in the short term (up to one year) in advanced economies and may have longer-lasting effects via financial conditions. - Capital inflows: - Capital inflows seem to increase downside risks to house prices in advanced economies. - Surges in capital inflows simultaneously raise the likelihood of high house price growth in the short term and downside risks to house prices in the medium term. - Capital flow management measures can support macroeconomic policy adjustment and financial stability during capital inflow surges when other policy options are limited or timing is crucial (IMF 2017). - City-level evidence indicates the relationship between various capital flows and house prices at risk varies with flow type and across countries. ### Policy implications and recommendations - Use of house-prices-at-risk for surveillance: - Policymakers in charge of financial stability can use house-prices-at-risk estimates to complement other housing vulnerability indicators and guide macroprudential policy actions aimed at building buffers and reducing vulnerabilities. - Downside risks to house prices provide relevant information for monetary policymakers when assessing downside risks to the economic and inflation outlook. - Preferential policy tools: - Targeted and timely macroprudential policies (strengthening borrower resilience) are found to be more effective than monetary policy in reducing downside risks to house prices. - Capital flow management measures may be warranted in specific cases where capital inflows increase downside risks and other policy tools are constrained or poorly timed. ### Organization of the chapter - The chapter places downside risks to house prices within the broader macro-financial stability framework, describes data and preliminary statistics, measures house prices at risk, examines implications for macro-financial stability and growth, evaluates the role of policies that may mitigate downside risks, and concludes with policy recommendations. *International Monetary Fund | April 2019 — CHAPTER 1 text excerpt.* ### CHAPTER 2 dOwNSIdE RISkS TO HOuSE PRICES ### CHAPTER 2 dOwNSIdE RISkS TO HOuSE PRICES ### Conceptual framework - Downside risks to house prices stem from the interaction of macro-financial vulnerabilities and negative shocks; vulnerabilities rise during good times through excessive risk taking by lenders and borrowers. - In the housing sector, easy financial conditions (easy credit, low price of risk) lead to vulnerabilities in the form of household overborrowing (excessive household leverage) and overvalued house prices (deviations from fundamentals). - Adverse shocks amplified by binding borrowing constraints can trigger a feedback loop: large house price declines → weakened household balance sheets → declines in real activity → increases in credit risk → declines in collateral values → banking-sector stress → tighter financial conditions. - Vulnerabilities interact nonlinearly with shocks: variables such as financial conditions, leverage, GDP growth, and house price overvaluation relate to the probability of large house price declines more strongly in the left tail of the distribution of future house price growth. - Quantile regressions are used to model this nonlinearity by relating conditioning variables to different parts (quantiles) of the distribution of future house price growth (the “house-prices-at-risk” measure). ### Overview of developments in house prices (data and stylized facts) - Sample: data for 22 major advanced economies and 10 emerging market economies; city-level analysis includes 31 cities. - Average (annualized) real house price growth (Q1 1990 to Q4 2017): - Advanced economies: about 2 percent a year. - Emerging market economies: about 2.6 percent a year. - Frequency of negative real house price growth: - Advanced economies: negative real growth occurs in about half of the observations over a one-year horizon. - Emerging market economies: negative real growth occurs in about a third of the observations over a one-year horizon. - Tail event magnitudes and probabilities: - In advanced economies, a 10.5 percent decline in average (annualized) real house prices occurs once every 20 years — associated with a 5 percent probability of downside risk. - In emerging market economies, the 5 percent greatest decline in average growth in real house prices corresponds to a 12 percent decline in real house prices. ### Variables linked to downside risk (bivariate evidence) - Financial conditions: Tighter financial conditions are associated with lower future house prices, with a stronger relationship in the lower tail (5th percentile). - Real GDP growth: Lower real GDP growth is generally associated with lower house price growth. - Credit-to-GDP ratio (detrended): When above its long-term mean, the negative relationship with future house price growth is more pronounced. - Price-to-GDP per capita ratio (misalignment proxy): Shows a more negative relationship with future house prices in the lower tail than elsewhere. ### Empirical analysis: quantile regression findings (house-prices-at-risk) - Models run separately for advanced and emerging market economies; control variables include lagged house price growth (momentum) plus financial conditions, house price misalignment, real GDP growth, and a credit boom dummy. - Financial conditions: - A one-standard-deviation tightening of financial conditions is associated with 0.3 to 0.7 percentage point higher downside risk to house prices in the short term (stronger in emerging market economies). - The effect diminishes to 0.1 percentage point in advanced economies and becomes insignificant for emerging market economies over longer horizons. - In a smaller model excluding house price overvaluation, the medium-term association between financial conditions and house-prices-at-risk turns positive, implying easy financial conditions today can increase future downside risk via increased overvaluation. - Real GDP growth: - A one-standard-deviation higher real GDP growth is associated with an insignificant reduction in downside risks to house prices one to three quarters ahead in advanced economies, but shows an opposite and significant relationship over longer horizons in advanced economies. - In emerging market economies, the association between GDP growth and downside risks is positive but not statistically significant. - Overvaluation (house price misalignment): - A one-standard-deviation increase in the ratio of house prices-to-GDP-per capita is consistently and significantly related to higher downside risks over time. - Magnitude: likely signals a correction in house prices of between 0.5 and 1.0 percentage point in advanced economies and 0.7 to 1.0 percentage point in emerging market economies. - Credit booms: - Defined as periods when the credit-to-GDP ratio is above the long-term trend. - Tend to worsen the house-prices-at-risk measure by up to 0.5 percentage point at short horizons in advanced economies (three quarters ahead) and up to 1 percentage point at medium-term horizons (up to seven quarters) in emerging market economies. - The immediate effect reflects the variable’s design, which signals over-stretched household balance sheets instantaneously. - Comparison with median house price effects: - Fundamental factors and overvaluation effects are generally more pronounced at the lower tail (5th percentile) than at the median. - Tightening financial conditions have larger negative associations with house prices at risk than with median house prices in both groups. - Overvaluation shocks and credit booms are more strongly related to downside house price corrections than to median outcomes. ### Dynamics, heterogeneity, and synchronization - House-prices-at-risk display cyclical short-term comovement and substantial cross-country heterogeneity: - Advanced economies: high downside risks in the early 1990s (Nordic crises) and immediately before the global financial crisis in 2008; cross-country distribution widened during these periods and more recently. - Emerging market economies: large heterogeneity in the early 1990s, around the Asian and Russian crises of 1997–98, and before the global financial crisis of 2008; median house-prices-at-risk show no pronounced recent cyclical trend. - Tail risks have rotated over time; downside risks appear to synchronize across advanced economies before major financial crises and global recessions, suggesting a role for global factors in downside risks to house prices. *International Monetary Fund | April 2019* ### CHAPTER 2 dOwNSIdE RISkS TO HOuSE PRICES ### CHAPTER 2 dOwNSIdE RISkS TO HOuSE PRICES ### Evolution of House Prices at Risk (HaR) - House prices at risk fluctuate substantially over time and across countries and display cyclical short-term comovement. - The predicted distribution of house price growth shifted progressively to the left ahead of the global financial crisis in both advanced economies and emerging market economies; both the mean and the tail of the distribution shifted left (Figure 2.7, panels 1 and 2). - On a GDP-weighted basis, between 2007:Q4 and 2017:Q4: - Short- and medium-term HaR decreased in advanced economies. - Short- and medium-term HaR increased in emerging market economies, especially in the short term. - In advanced economies, the level of downside house price risk in 2017:Q4 is above the overall median. - Comparison of HaR in 2007:Q4 and 2017:Q4 shows: - Some countries that were high risk in 2007 were less vulnerable in 2017, but several countries remained in the high-risk quadrant in both periods (Figures 2.6 panels 5 and 6). ### Short- versus Medium-Term Risk - One-year-ahead (short term) HaR generally indicates higher downside risk than three-year-ahead (medium term) HaR in both advanced and emerging market economies (Figure 2.7, panels 3 and 4). - Panels showing 5th percentiles of HaR forecast distributions emphasize larger short-term downside risks relative to medium-term. ### Drivers of HaR — Country Examples - United States (one-year HaR decomposition): - HaR gradually deteriorated beginning in the early 2000s, leading up to the global financial crisis. - Early deterioration was related to house price overvaluation. - Over time, past house price movements and credit also started to have a negative effect, partially offset by relatively loose financial conditions. - Once the global financial crisis set in, tightening of financial conditions weighed negatively on HaR. - Since late 2016, US HaR appears to have deteriorated gradually due to overvaluation concerns and high credit growth, partly offset by still-easy financial conditions and past house price momentum. - China (one-year HaR decomposition): - HaR was more volatile, partly following volatility in house price growth. - Easy financial conditions kept HaR contained until 2010. - After 2010, high credit-to-GDP gaps and tightening of financial conditions contributed to increased downside risks. - Since 2016, house price overvaluation also contributed to HaR deterioration. - Decomposition factors shown: past house prices, financial conditions (FCI), real GDP growth, house price misalignment, credit boom. ### City-Level versus Country-Level Findings - The relationship between financial conditions and HaR is larger at the city level than at the country level. - This effect is especially pronounced among emerging market economies. - Possible reasons: major cities in the sample are often financial centers and face more supply constraints (regulations, land shortages). - Panel quantile regression comparisons show statistically significant larger coefficients for FCI at the city level (Figure 2.9). ### Forecasting, Out-of-Sample Performance, and Surveillance - Out-of-sample forecasts using the HaR model closely track in-sample predictions for one-year-ahead real house price growth for the United States and China (Figure 2.10), suggesting the model signals downside vulnerabilities in real time. - Robustness checks (pseudo-R2 measures, empirical cumulative distribution of the probability integral transformation) indicate predictive distributions were generally within critical values for most countries. - The HaR model can be used for forecasting and surveillance, though model fit and degrees of freedom can affect robustness when applied at country-specific low quantiles. ### HaR and Financial Stability — Growth at Risk and Crisis Prediction - An increase in downside risks to house prices (a lower, more negative HaR measure) is associated with an increase in future downside risk to GDP growth: - The highest impact of HaR on growth at risk is four to eight quarters into the future. - A 1 percent improvement in the HaR measure precedes on average a 0.3 percentage point improvement in growth at risk. - The association between HaR and downside risks to GDP growth is stronger than the association with median growth. - HaR adds predictive power to statistical models of financial crises: - Adding HaR to models that include output growth, financial conditions, and the credit-to-GDP gap improves crisis-prediction accuracy across horizons (one, two, and three years) and for both advanced and emerging market economies. - Estimated example: an annualized HaR measure of −12 percent (an estimated 5 percent probability of a 12 percent decline in real house prices two years ahead) implies: - a 31 percent probability of a financial crisis two years ahead in advanced economies, and - a 10 percent probability in emerging market economies (Figure 2.11, panels 3 and 4). ### Policy Implications - Macroprudential policy can reduce downside risks to house prices by: - Taming accumulation of vulnerabilities arising from housing market valuation risks and household financial vulnerabilities. - Building buffers in financial intermediaries to absorb shocks and break negative feedback loops. - Monetary policy is primarily focused on inflation risk but may implicitly consider housing market developments because they underpin financial stability risks. - Empirical tests of fiscal policy measures (changes in property tax rates, tax base, interest deductibility) were conducted but results were not significant, possibly due to smaller sample size. *Source: IMF staff calculations.* ### CHAPTER 2 dOwNSIdE RISkS TO HOuSE PRICES ### CHAPTER 2 dOwNSIdE RISkS TO HOuSE PRICES ### Overview and methodology - Introduces a new methodology to estimate downside risk to house prices using panel quantile regression techniques based on the growth-at-risk model of Adrian and others (2018). - House prices at risk (likelihood of large house price declines) reflect fundamental factors, overvaluation, and past price dynamics. - House prices at risk are a useful early-warning indicator for financial stability surveillance and have a significant impact on growth at risk. ### Macroprudential policy versus monetary policy (theory and model results) - In a theoretical model, macroprudential policy is more effective than monetary policy at reducing growth at risk because: - Household debt generally exceeds the socially optimal level due to a pecuniary externality (households do not internalize the effect of fire-sale house prices on collateral values and macroeconomic performance). - Tightening macroprudential policy in response to higher household debt can prevent a housing crisis or mitigate its adverse effects by curbing run-ups in household debt before the crisis. - Monetary policy that departs from output-inflation stabilization and responds to high credit-to-GDP ratios can mitigate adverse effects on GDP but to a lesser extent than macroprudential policy because it fails to fully curb household debt buildup and affects other components of output. - Practical caveats: - If the macroprudential toolkit is incomplete or decision-making imperfect, monetary policy may still need to consider downside risks to house prices. - House prices at risk contain information value for growth at risk and thus impact monetary policy objectives directly. ### Empirical findings on macroprudential policy - Macroprudential policy measures affect house prices at risk via three channels: 1. Direct level effect: tightening reduces house prices at risk consistent with accumulation of buffers. 2. Interaction effect: macroprudential policy may change how financial conditions or credit relate to house prices at risk (for example, credit flows to less-leveraged households). 3. Indirect effect via related variables: macroprudential measures can reduce credit growth, which is related to house prices at risk. - Borrower-based measures (loan-to-value and debt-service-to-income restrictions) show a significant direct effect on house prices at risk. - Quantitative effects and horizons: - Macroprudential policy measures shift the entire term structure of house prices at risk upward (reducing downside risk). - In advanced economies, the effect appears to have a maximum impact between four and eight quarters ahead. - In emerging market economies, the impact is highest in the short term and remains mostly steady until about 12 quarters ahead. - A one-unit tightening of macroprudential measures during a credit boom could lower the one-year-ahead average house prices at risk by up to 2 percentage points (annualized), from –9.4 percent to –7.4 percent. - Policy design note: - Macroprudential policies should target the buildup of financial vulnerabilities signaled by downside risks to house prices, not house price levels, and should consider broader systemic-risk implications to avoid precipitating downward spirals in credit and prices when the economy is fragile. ### Empirical findings on monetary policy - Monetary policy tightening contributes to a deterioration of house prices at risk over a short horizon in advanced economies. - Identification: - Monetary policy shocks are measured as unexpected deviations of the short-term policy rate from an expanded Taylor rule. - Findings: - These shocks have a short-lived, negative relationship with house prices at risk only in advanced economies. - Monetary policy shocks influence house prices at risk mainly through financial conditions; beyond this indirect effect, conventional monetary policy shocks have only a short-term influence. - The inclusion of monetary policy shocks weakens the short-term relationship between financial conditions and house prices at risk, indicating part of that relationship was driven by changes in the short-term policy rate. ### Capital flows, capital flow management measures, and house prices at risk - Capital inflows and risks: - In advanced economies, capital inflows raise the likelihood of high house price growth (upside risk) in the short term and increase downside risks in the medium term (two to three years ahead). - Quantified effect: An increase in capital inflows of 1 percent of GDP would raise upside risks by 1.5 percent one quarter ahead and downside risks by 0.5 percent eight quarters ahead. - Among emerging market economies, no robustly significant relationship between overall capital inflows and downside or upside risks was found; heterogeneity exists by flow type (portfolio flows and FDI) and by country integration. - Capital flow management measures: - Tightening capital flow management measures in advanced economies appears to briefly increase downside risks to house prices in the very short term (one to three quarters ahead) and reduce downside risks between one and two years ahead by about 3 percent (annualized) in each quarter, with no significant effect at longer horizons. - Tightening of real estate inflow restrictions is not significantly related to downside risks to house prices in the available data (note: there are only 12 episodes of tightening of real estate restrictions in the data). ### Policy recommendations and implications - Use house-prices-at-risk as an additional early-warning indicator for financial stability surveillance and as part of a macroprudential toolkit. - Macroprudential policy: - Heightened downside risks to house prices should complement other indicators for the activation of macroprudential policies. - Countries should add borrower-based measures (loan-to-value and debt-service-to-income restrictions) to their macroprudential toolkits and monitor these measures over time. - Macroprudential policy should target downside risk (vulnerability buildup) rather than asset-price levels. - Policymakers should be mindful of broader systemic-risk implications to avoid precipitating declines in house price levels when markets are fragile. - Monetary policy: - Monetary policy’s ability to mitigate downside risks to house prices is mostly indirect through financial conditions and appears limited beyond short-term effects in advanced economies. - Monetary authorities should consider the short-term association between policy shocks and house prices at risk in cases where the macroprudential toolkit is incomplete or decision-making is imperfect. - Capital flow measures: - Capital flow management measures may support financial stability and macroeconomic adjustment during inflow surges when other policy options are limited or timing is crucial; their tightening can improve house prices at risk at some intermediate horizons in advanced economies. - International coordination: - Episodes of increased synchronization of downside risks strengthen the case for international policy coordination to mitigate adverse spillovers from house price downside risks. *International Monetary Fund | April 2019* ### CHAPTER 2 dOwNSIdE RISkS TO HOuSE PRICES ### CHAPTER 2 dOwNSIdE RISkS TO HOuSE PRICES ### Cross-country synchronization of house prices at risk - Short-term comovement (instantaneous quasi-correlation) of three-year-ahead house prices at risk increases sharply immediately before major global recessions or financial crises, especially among advanced economies. - The increase in short-term comovement before recessions is present only within advanced economies. - Greater financial openness (proxied by the stock of foreign assets plus foreign liabilities in percent of GDP) is associated with higher synchronization of downside risk: - Open pairs (both countries above the median in foreign assets plus foreign liabilities/GDP) show sharp increases in short-term comovement around global recessions. - Closed pairs (otherwise) do not display significant short-term comovement. - Country pairs with restrictions on capital flows related to real estate display much lower short-term comovement of downside risks around major recessions/crises than pairs without such restrictions. - Interpretation: - Common shocks can propagate tail risk of housing markets across countries, particularly when financial openness is high. - Well-targeted capital flow management measures related to real estate may mitigate synchronization of downside risk during extreme events. ### Capital inflows, macroprudential context, and policy framing - Capital inflows: - Seem associated with higher house prices in the short term and with more downside risks to house prices in the medium term in advanced economies. - Aggregate analysis finds that a surge in capital inflows tends to increase downside risks to house prices in advanced economies, with effects depending on types of flows and being region- or city-specific. - Policy framing: - Capital flow management measures may be justified under some conditions when nonresident buyers are a key risk contributing to systemic overvaluation that raises downside risk, and when other policy options are limited or timing is crucial. - Such measures would not target house prices directly but would be consistent with a risk management approach to policy, similar to macroprudential policies. - Any use of capital flow measures requires case-by-case assessment and weighing reductions in downside risks against direct and indirect benefits of free and unrestricted capital flows (including better smoothing of consumption, diversification of financial risks, and development of the financial sector). - IMF (2012) notes (as summarized): 1. Capital flows should be handled primarily through macroeconomic policies, supported by sound financial supervision and regulation and strong institutions. 2. In certain circumstances, capital flow measures can be useful to support macroeconomic adjustment and safeguard financial stability. 3. Capital flow measures should not substitute for warranted macroeconomic adjustment. ### City-level analysis: United States and Canada (Box 2.2) - Data and scope: - Quarterly data from 1980 to 2018 applied to multiple US and Canadian cities. - Downside risks defined as the 5 percent value at risk for a one-year-ahead horizon. - Key dynamics: - Downside risks across US cities show larger swings on average than in Canada, indicating US housing markets are more susceptible to abrupt booms and busts. - In Canada, there is considerable dispersion in downside risks across cities (volatility of the 5th percentile), and overall Canadian downside risks increased over the past two years, approaching global financial crisis levels. - City-level overvaluation (house-price-to-income ratio) is associated with deterioration in one-year-ahead house prices at risk: - US cities such as Miami, Tampa, and Phoenix were particularly overvalued before the global financial crisis. - In 2018, US valuations came down relative to 2008, reducing tail risks; in contrast, Canadian cities such as Hamilton, Toronto, and Vancouver showed stretched valuations in 2018. - Capital flow effects (city-level): - Foreign direct investment (FDI) inflows: - Typically associated with lower future downside risk in several US and Canadian housing markets. - Example: A 1 percentage point increase in FDI inflows to the United States is significantly associated with a reduction of about 1–2 percentage points in house prices at risk in tech-friendly US cities such as San Francisco, Seattle, and Portland, Oregon. - Other capital inflows (largely corresponding to foreign bank transactions): - Tend to amplify downside risks to house prices in cities including Las Vegas, Miami, Los Angeles, Toronto, Vancouver, and Calgary. - In Canada, effects are most pronounced for major cities in Alberta. - Policy implication: - Capital flow management measures targeted at regional inflows other than FDI or portfolio flows (for example, additional property taxes on foreign home buyers) could alleviate overvaluation pressure and reduce downside risks in affected cities, though heterogeneous city-level effects imply broader impacts may be limited. ### Province-level analysis: China (Box 2.3) - Context and scope: - Quarterly provincial data from 2005 to 2017 for 31 provinces and municipalities. - Residential investment grew from about 4 percent of GDP in 1997 to 13 percent in 2018 (peak of 15 percent of GDP in 2014). - Bank lending to the real estate sector accounts for 25 percent of total bank loans and about half of all new loans in 2016. - Determinants of downside risks: - Panel quantile regressions show provincial downside housing risks are related to common macro-financial factors: - Credit booms, tighter financial conditions, increases in provincial price-to-income ratios, and increases in residential-investment-to-GDP ratios are associated with deterioration in house prices at risk. - Foreign direct investment has an overall positive effect (mitigating downside risk), while portfolio flows are associated with increased downside risks. - Regional heterogeneity: - When estimated by region, FDI (long-term commitments) is associated with less downside risk from the second year onward, especially for the East and Northeast. - Portfolio investment (more speculative) is associated with significantly higher downside risks in the short term for all regions except the Northeast. - Recent developments and early-warning dimension: - Three-year-ahead house prices at risk reached all-time lows in 2011 after rapid property price increases and high price-to-income ratios, especially in eastern provinces. - Since late 2015, house prices at risk started to deteriorate again after an easing cycle ended, indicating renewed downside risks. - Loosening financial conditions and lower price-to-income ratios cushioned some deterioration until 2015. - Policy implication: - Large regional differences and market fragmentation justify targeted regional risk-management policies, including long-term structural reforms (for example, household registration reforms and social security). *Source: International Monetary Fund | April 2019* ### Box 2.3 (continued) ### Box 2.3 (continued) ### Contents - This unit continues Box 2.3 and contains: - A references section listing cited academic and policy sources (bibliographic listings omitted). - A "Highlights from IMF Publications" segment (bookstore listings omitted). *Source: text - Box 2.3 (continued), https://www.imf.org/-/media/files/publications/gfsr/2019/april/english/text.pdf* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2019/april/english/text.pdf_