## 4. Actual and Expected Policy Rates

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### Market pricing and expected policy path
- Market pricing points to an additional 45 basis points of policy easing in the United States by the end of 2020.
- Market pricing suggests that policy rates could remain negative in the euro area, Japan, and Switzerland for many years.
- Market pricing indicates that about 20 percent of sovereign bonds will have a negative yield until at least 2022.

### Interest rates, bond yields, and negative-yielding debt
- Average 10-year government bond yields in large advanced economies (weighted by sovereign debt outstanding) have fallen by about 75 basis points since the previous GFSR.
- The amount of bonds with negative yields has increased to about $15 trillion.
- More than $7 trillion of the negative-yielding bonds are government bonds from large advanced economies.
- Negative-yielding government bonds from large advanced economies represent 30 percent of the outstanding stock.
- Ten-year yields are now negative in: Austria, Belgium, Denmark, Finland, France, Germany, Japan, the Netherlands, Sweden, and Switzerland.
- Yield curves have flattened substantially, and in some cases have inverted, with the difference between 10-year, five-year, and one-year yields narrowing dramatically.

### Asset valuations and search for yield
- Declines in interest rates have motivated investors to increase duration and credit exposures, boosting asset valuations.
- Ten-year term premiums in major markets are now highly compressed and in some cases below levels justified by fundamentals.
- IMF staff valuation models suggest:
  - US equity volatility may be compressed by corporate earnings and payouts, and option-implied volatility may not fully reflect external factors such as trade tensions.
  - Equity markets appear overvalued in Japan and the United States (misalignments scaled by monthly price volatility).
  - Spreads of high-yield bonds are too compressed relative to fundamentals, along with investment-grade bonds in the euro area and United States.
  - Emerging market bonds appear overvalued for more than one-third of issuers included in the JPMorgan Emerging Markets Bond Index Global as of the third quarter of 2019.

### Global financial conditions and flows
- Sharp declines in market interest rates have resulted in a further easing of financial conditions in advanced economies since the April 2019 GFSR.
- In the United States, financial conditions continue to be accommodative relative to historical norms, although the easing slowed in the third quarter.
- In China, financial conditions are marginally tighter due to a decline in corporate valuations.
- In major emerging markets (excluding China), conditions have eased slightly in aggregate over the past six months.
- Portfolio flows rebounded in 2019, with debt flows rising as higher-yielding dollar-denominated bonds became increasingly attractive relative to advanced-economy bonds.
- Chinese local currency bond flows have benefited from inclusion in benchmark indices.
- Increased appetite for emerging market dollar debt supported a pickup in issuance by emerging and frontier market sovereigns over the past few months.

### Financial vulnerabilities and sectoral exposures
- Prolonged accommodative financial conditions have contributed to a buildup of vulnerabilities:
  - Balance sheet vulnerabilities in nonfinancial companies and in nonbank financial entities are elevated by historical standards in several large economies with systemically important financial sectors.
  - Vulnerabilities in other nonbank financial entities are high in 80 percent of economies with systemically important financial sectors (by GDP).
  - Vulnerabilities in the nonbank financial sector have increased in the United States and euro area since the April 2019 GFSR, largely reflecting increases in leverage and credit exposures.
  - In China, vulnerabilities remain high, largely due to leveraged positions in investment vehicles.
  - Vulnerabilities in the insurance sector remain elevated in advanced economies.
- Banking-sector exposures and capitalization:
  - Chinese banks have the largest weighted exposures to vulnerable sectors by the reported measure, given sizable lending to domestic firms, households, and other financial companies; banking systems in Brazil, India, Korea, and Turkey also show relatively high vulnerability-weighted exposures.
  - Lower interest rates and flatter yield curves have driven bank equity market valuations down and reduced market-adjusted capitalization.
  - Using market-adjusted capitalization and common equity Tier 1 thresholds:
    - Euro area institutions accounting for more than 30 percent of sample bank assets have relatively weak capitalization.
    - In China the proportion is about 25 percent.
- These vulnerabilities have coincided with strains in funding markets and recent authorities’ interventions in three regional Chinese banks.

### Nonbank financials, corporate, sovereign, and household vulnerabilities
- Leverage and credit exposures are a key source of vulnerability among other nonbank financial entities.
- Banks are overall stronger, but some banking systems have large exposures to sectors with high vulnerabilities.
- Corporate sector vulnerabilities:
  - Debt issued by companies whose earnings are insufficient to cover interest payments is elevated relative to GDP in several economies and could approach or exceed crisis levels in an adverse scenario that is half as severe as the global financial crisis.
  - Corporate weaknesses are concentrated in small and medium-sized firms and in large Chinese firms, including state-owned enterprises.
- Sovereign vulnerabilities:
  - Low interest rates have reduced debt service costs and may have contributed to an increase in sovereign debt, making some governments more susceptible to a sudden tightening in financial conditions.
  - Sovereign vulnerabilities are broadly unchanged globally but have fallen slightly in the euro area as debt levels declined in some economies.
  - Several governments have elevated debt relative to GDP.
    - Note: Ireland’s public debt is 106 percent if scaled by modified gross national income.
    - In Singapore, government debt is not issued to finance a deficit but for market deepening and other domestic policy purposes.
- Household sector:
  - Vulnerabilities continue to be elevated in China and a number of other advanced economies.
  - Economies that avoided the worst of the global financial crisis have tended to experience house price booms and now have the highest household-debt-to-GDP ratios.
  - In Ireland and Spain household debt has moderated and real house prices have fallen; in the United Kingdom and the United States house prices are at least back to crisis levels in real terms.
  - Household debt and house price growth data reference: household debt, 2018:Q4 and change in real house prices, 2008:Q3–2018:Q4.

### Growth-at-Risk (GaR) and medium-term risks
- Near-term growth-at-risk (defined as the fifth percentile of the one-year-ahead forecast distribution) is little changed compared to six months ago.
- Medium-term risks remain skewed to the downside and are elevated by historical standards.
- Events that could trigger a sharp tightening in financial conditions include:
  - Intensification or broadening of trade tensions.
  - Faster-than-expected slowdown in global growth.
  - Sudden market reassessment of monetary policy expectations, especially if communication gaps exist.
  - Crystallization of political and policy risks (geopolitical events causing contagion and capital flow reversals, renewed fiscal challenges in highly indebted countries, or a no-deal Brexit).
- Brexit: trading conditions in UK markets have been orderly recently, but market volatility may rise as key Brexit deadlines approach; a no-deal Brexit could cause substantial tightening in financial conditions.
- Box 1.2 (United States example) finds that higher private nonfinancial sector vulnerabilities increase downside risks to growth and financial stability, particularly in the medium term; when vulnerabilities are already high, downside risks are much more pronounced in both near and medium terms.

### Policy implications and recommendations
- Monetary policy:
  - Monetary policy should remain data dependent and any changes in stance should be clearly communicated to avoid mispricing of risk.
- Macroprudential policy:
  - To reduce the risk that additional monetary easing leads to a further buildup of financial vulnerabilities, macroprudential policies should be tightened where warranted.
  - Because necessary macroprudential tools are lacking in several major economies, such tools should be urgently developed.
  - Countries with robust economic activity, easy financial conditions, and high or rising vulnerabilities should urgently tighten macroprudential policies, including activating or tightening broad-based tools.
    - Countercyclical capital buffers have been deployed only infrequently; more economies with high vulnerabilities and easy financial conditions might benefit from activating this tool.
  - Countries easing macroeconomic policy but with sectoral vulnerabilities should consider targeted approaches: stress tests on banks’ exposures, higher risk weights on those exposures, sectoral capital buffers, or borrower-based tools.
  - Economies facing a significant slowdown should focus on accommodative policies considering available policy space; fiscal easing could complement monetary policy where fiscal space exists; countercyclical capital buffers could be released where built up.
- Regulatory and structural priorities:
  - Global policy coordination remains critical.
  - Policymakers need to complete and implement the regulatory reform agenda and further develop international resolution frameworks for internationally active firms.
  - Any rollback of regulatory standards should be avoided.
  - Prepare for LIBOR transition to alternative risk-free rates and accelerate netting down legacy derivatives; orderly transition by end-2021 is stressed.
  - Close ESG data gaps, develop standards, and promote consistent ESG reporting; regulators and central banks should take intellectual leadership.

### Macroprudential toolkit, regulatory reform, and sectoral initiatives
- Banks — capital and leverage:
  - BCBS (2019) reported generally good progress implementing the capital framework; only eight jurisdictions had final large exposure rules in force as of end-March 2019.
  - Leverage ratio revised with implementation date of January 2022.
  - Output floors will be phased in over 2022–27.
- Banks — liquidity, maturity, and foreign currency mismatches:
  - All BCBS member countries have implemented the liquidity coverage ratio (LCR); 11 of its 27 members had final net stable funding ratio (NSFR) rules in force as of end-March 2019; a further 15 countries are in the process of adopting the NSFR.
  - Basel III requires monitoring of the LCR and NSFR by material currency.
  - Market risk framework revised with an implementation deadline of January 2022.
- Insurance companies:
  - Risk-based capital standards expected to be adopted for internationally active insurance groups by end-2019, with a five-year monitoring period prior to final review and subsequent international agreement and adoption.
  - No common global standard for economic-based solvency regimes; potential for regulatory arbitrage.
- Investment funds:
  - Work on leverage measures is ongoing; IOSCO expected to finalize its leverage report by end-2019.
  - February 2018 IOSCO report on liquidity risk management includes recommendations; assessment of implementation expected in 2020.

### Case study: Recent bank interventions in China (Box 1.1)
- Events and market impact:
  - Late May: Chinese authorities took over Baoshang Bank, imposing marginal haircuts on corporate and interbank depositors.
  - Late July: several large state-owned financial institutions purchased minor stakes in the Bank of Jinzhou, which had liquidity problems.
  - Early August: Hengfeng received a capital injection from a unit of China’s sovereign wealth fund; no haircuts occurred in the Jinzhou and Hengfeng cases.
  - Spread between funding costs of highly rated and weaker borrowers widened from an average of 16 basis points before the Baoshang takeover to nearly 90 basis points in early July.
  - Negotiable certificates of deposit (NCD) issuance for weaker borrowers declined sharply.
- Underlying vulnerabilities:
  - Liquidity, funding, and solvency risks: the three banks were among a dozen or so that had delayed annual reports; relied on wholesale funding and held large shares of risky nonloan assets.
  - Interlinkages between banks, nonbank financial institutions, and investment vehicles create circularity and interconnectedness, amplifying shock transmission.
  - Maturity mismatches and other risks within investment vehicles that rely on short-term wholesale funding while funding long-term credit.
- Policy implications:
  - Liquidity and funding squeeze and solvency concerns are likely to increase pressure on banks to raise deposit funding and pay more for other sources of funds, forcing trade-offs between improving resilience and maintaining credit growth.
  - IMF staff analysis suggests loan books of smaller banks would have to contract significantly if banks were required to increase core Tier 1 equity ratios to the system average (10.5 percent) and hold adequate capital against roughly half of their on- and off-balance-sheet shadow credit.
  - Policymakers urgently need to introduce a bank resolution regime and reform the asset management industry and its linkages to banks.

### Growth-at-Risk (GaR) analysis for the United States and Box 1.2
- Methodology:
  - GaR specification differs from the global GFSR specification by: (1) using a financial conditions index that includes only price-of-risk variables (credit variables excluded), and (2) including information on vulnerabilities separately via a financial vulnerability index for the private nonfinancial sector (households and nonfinancial companies).
  - The private nonfinancial (PNF) vulnerability index is constructed as a credit-weighted aggregate of corporate and household FVIs and is orthogonalized with respect to the FCI.
- Counterfactual scenarios:
  - Scenario 1 — Level of vulnerabilities:
    - Baseline GaR indicates medium-term risks are elevated compared to near-term risks.
    - Assuming financial conditions remain unchanged, a one-standard-deviation increase in the level of vulnerabilities meaningfully increases medium-term downside risks to growth.
  - Scenario 2 — Tightening in financial conditions:
    - A one-standard-deviation tightening in financial conditions when vulnerabilities are high increases risks at both time horizons relative to the baseline, with a relatively larger impact over the near term.
    - When vulnerabilities are low, a tightening in financial conditions raises near-term risks to growth relative to the baseline but significantly reduces medium-term risks.
- Baseline and plotted values (Box 1.2, GaR fifth percentiles, as of 2019:Q3):
  - Baseline annotations: –1.24 and 1.56.
  - Figure panel annotations for vulnerability changes: –3.0, 2.0, 0.0, –1.0, –2.0, 1.0.
  - Figure panel annotations for tightening financial conditions and vulnerability interactions: 0.5, 0.0, –0.5, –1.0, –1.5, –2.0, –2.5, 1.0, 1.5, 2.5, 2.0.
- Policy implication:
  - Policymakers should adopt policies aimed at reducing vulnerabilities while vulnerabilities are still low and financial conditions are relatively easy.

*Source: IMF staff, Global Financial Stability Report: LOWER FOR LONGER, October 2019.*

### 4. Actual and Expected Policy Rates

### ch1 - 4. Actual and Expected Policy Rates

### Market pricing and expected policy path
- Market pricing points to an additional 45 basis points of policy easing in the United States by the end of 2020.
- Market pricing suggests that policy rates could remain negative in the euro area, Japan, and Switzerland for many years.
- Market pricing indicates that about 20 percent of sovereign bonds will have a negative yield until at least 2022.

### Interest rates, bond yields, and negative-yielding debt
- Average 10-year government bond yields in large advanced economies (weighted by sovereign debt outstanding) have fallen by about 75 basis points since the previous GFSR.
- The amount of bonds with negative yields has increased to about $15 trillion.
- More than $7 trillion of the negative-yielding bonds are government bonds from large advanced economies.
- Negative-yielding government bonds from large advanced economies represent 30 percent of the outstanding stock.
- Ten-year yields are now negative in a range of countries, including Austria, Belgium, Denmark, Finland, France, Germany, Japan, the Netherlands, Sweden, and Switzerland.
- Yield curves have flattened substantially, and in some cases have inverted, with the difference between 10-year, five-year, and one-year yields narrowing dramatically.

### Asset valuations and search for yield
- Declines in interest rates have motivated investors to increase duration and credit exposures, boosting asset valuations.
- Ten-year term premiums in major markets are now highly compressed and in some cases below levels justified by fundamentals.
- IMF staff valuation models suggest:
  - US equity volatility may be compressed by corporate earnings and payouts, and option-implied volatility may not fully reflect external factors such as trade tensions.
  - Equity markets appear overvalued in Japan and the United States (misalignments scaled by monthly price volatility).
  - Spreads of high-yield bonds are too compressed relative to fundamentals, along with investment-grade bonds in the euro area and United States.
  - Emerging market bonds appear overvalued for more than one-third of issuers included in the JPMorgan Emerging Markets Bond Index Global as of the third quarter of 2019.

### Global financial conditions and flows
- Sharp declines in market interest rates have resulted in a further easing of financial conditions in advanced economies since the April 2019 GFSR.
- In the United States, financial conditions continue to be accommodative relative to historical norms, although the easing slowed in the third quarter.
- In China, financial conditions are marginally tighter due to a decline in corporate valuations.
- In major emerging markets (excluding China), conditions have eased slightly in aggregate over the past six months.
- Portfolio flows rebounded in 2019, with debt flows rising as higher-yielding dollar-denominated bonds became increasingly attractive relative to advanced-economy bonds.
- Chinese local currency bond flows have benefited from inclusion in benchmark indices.
- Increased appetite for emerging market dollar debt supported a pickup in issuance by emerging and frontier market sovereigns over the past few months.

### Financial vulnerabilities and sectoral exposures
- The prolonged period of accommodative financial conditions has contributed to a buildup of vulnerabilities:
  - Balance sheet vulnerabilities in nonfinancial companies and in nonbank financial entities are elevated by historical standards in several large economies with systemically important financial sectors.
  - Vulnerabilities in other nonbank financial entities are high in 80 percent of economies with systemically important financial sectors (by GDP).
  - Vulnerabilities in the nonbank financial sector have increased in the United States and euro area since the April 2019 GFSR, largely reflecting increases in leverage and credit exposures.
  - In China, vulnerabilities remain high, largely due to leveraged positions in investment vehicles.
  - Vulnerabilities in the insurance sector remain elevated in advanced economies.
- Banking-sector exposures and capitalization:
  - Chinese banks have the largest weighted exposures to vulnerable sectors by the reported measure, given sizable lending to domestic firms, households, and other financial companies; banking systems in Brazil, India, Korea, and Turkey also show relatively high vulnerability-weighted exposures.
  - Lower interest rates and flatter yield curves have driven bank equity market valuations down and reduced market-adjusted capitalization.
  - Using market-adjusted capitalization and common equity Tier 1 thresholds:
    - Euro area institutions accounting for more than 30 percent of sample bank assets have relatively weak capitalization.
    - In China the proportion is about 25 percent.
- These vulnerabilities have coincided with strains in funding markets and recent authorities’ interventions in three regional Chinese banks.

*Sources: Bloomberg Finance L.P.; and IMF staff calculations.*

### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEw: LOwER FOR LONGER

### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEw: LOwER FOR LONGER

### Elevated and shifting vulnerabilities
- Vulnerabilities have increased among other nonbank financial entities and remain high in the corporate sector.
- Nonfinancial firm, insurer, bank, household, sovereign, and other nonbank financials are assessed across systemically important economies; vulnerability comparisons use pooled samples (advanced and emerging market economies pooled separately) for 2000–18 (or longest sample available) and identify top 20 percent and bottom 20 percent values.
- Global financial crisis reference reflects the maximum vulnerability value during 2007–08.

### Nonbank financials and corporate sector risks
- Leverage and credit exposures are a key source of vulnerability among other nonbank financial entities.
- Banks are overall stronger, but some banking systems have large exposures to sectors with high vulnerabilities.
- Corporate sector vulnerabilities:
  - Debt issued by companies whose earnings are insufficient to cover interest payments is elevated relative to GDP in several economies and could approach or exceed crisis levels in an adverse scenario that is half as severe as the global financial crisis.
  - Corporate weaknesses are concentrated in small and medium-sized firms and in large Chinese firms, including state-owned enterprises.
- Chapter 2 provides a comprehensive assessment of corporate sector credit quality in eight major economies: China, France, Germany, Italy, Japan, Spain, the United Kingdom, and the United States.
- Definitions and metrics:
  - Interest coverage ratio (ICR) is EBIT relative to interest expense.
  - Speculative grade debt is defined as debt owed by firms with an ICR of less than 4.1 and net debt/assets greater than 0.25.
  - Debt-at-risk includes firms with ICR < 1.

### Sovereign and household vulnerabilities
- Low interest rates have reduced debt service costs and may have contributed to an increase in sovereign debt, making some governments more susceptible to a sudden tightening in financial conditions.
- Sovereign vulnerabilities are broadly unchanged globally but have fallen slightly in the euro area as debt levels declined in some economies.
- Several governments have elevated debt relative to GDP.
  - Note: Ireland’s public debt is 106 percent if scaled by modified gross national income.
  - In Singapore, government debt is not issued to finance a deficit but for market deepening and other domestic policy purposes.
- Household sector:
  - Vulnerabilities continue to be elevated in China and a number of other advanced economies.
  - Economies that avoided the worst of the global financial crisis have tended to experience house price booms and now have the highest household-debt-to-GDP ratios.
  - In Ireland and Spain household debt has moderated and real house prices have fallen; in the United Kingdom and the United States house prices are at least back to crisis levels in real terms.
- Household debt and house price growth data reference: household debt, 2018:Q4 and change in real house prices, 2008:Q3–2018:Q4.

### Growth-at-risk and medium-term financial stability risks
- Near-term growth-at-risk (defined as the fifth percentile of the one-year-ahead forecast distribution) is little changed compared to six months ago.
- Medium-term risks remain skewed to the downside and are elevated by historical standards.
- The growth-at-risk framework assesses downside risks via shifts in the 5th percentile of the growth distribution in response to financial conditions and vulnerabilities.
- Events that could trigger a sharp tightening in financial conditions include:
  - Intensification or broadening of trade tensions.
  - Faster-than-expected slowdown in global growth.
  - Sudden market reassessment of monetary policy expectations, especially if communication gaps exist.
  - Crystallization of political and policy risks (geopolitical events causing contagion and capital flow reversals, renewed fiscal challenges in highly indebted countries, or a no-deal Brexit).
- Brexit: trading conditions in UK markets have been orderly recently, but market volatility may rise as key Brexit deadlines approach; a no-deal Brexit could cause substantial tightening in financial conditions.
- Box 1.2 (United States example) finds that higher private nonfinancial sector vulnerabilities increase downside risks to growth and financial stability, particularly in the medium term; when vulnerabilities are already high, downside risks are much more pronounced in both near and medium terms.

### Policy implications and recommendations
- Monetary policy should remain data dependent and any changes in stance should be clearly communicated to avoid mispricing of risk.
- To reduce the risk that additional monetary easing leads to a further buildup of financial vulnerabilities, macroprudential policies should be tightened where warranted.
  - Because necessary macroprudential tools are lacking in several major economies, such tools should be urgently developed.
- Tailoring the policy mix:
  - Countries with robust economic activity, easy financial conditions, and high or rising vulnerabilities should urgently tighten macroprudential policies, including activating or tightening broad-based tools.
    - Countercyclical capital buffers have been deployed only infrequently; more economies with high vulnerabilities and easy financial conditions might benefit from activating this tool.
  - Countries easing macroeconomic policy but with sectoral vulnerabilities should consider targeted approaches: stress tests on banks’ exposures, higher risk weights on those exposures, sectoral capital buffers, or borrower-based tools.
    - Figure and table references show countercyclical capital buffer levels as of summer 2019 and jurisdictions’ tool counts from the IMF Macroprudential Policy Survey.
  - Economies facing a significant slowdown should focus on accommodative policies considering available policy space; fiscal easing could complement monetary policy where fiscal space exists; countercyclical capital buffers could be released where built up.
- Regulation since the global financial crisis has improved banking sector resilience, but pockets of vulnerability remain.

*International Monetary Fund | October 2019*

### 2. Countercyclical Capital Buffers, 20193. Central Bank Monetary Policy Space, 2019

### 2. Countercyclical Capital Buffers, 2019 3. Central Bank Monetary Policy Space, 2019

### Financial conditions and monetary policy space
- Financial conditions are already easy and could ease even further.
- Monetary policy space may be limited in some countries.
- Financial conditions indices reflect pricing of risk and cost of funding; easy conditions support near-term growth but may encourage excessive risk-taking and put medium-term growth at risk.

### Vulnerabilities and policy urgency
- Despite elevated vulnerabilities, many countries have not deployed countercyclical capital buffers.
- Urgent policy action is needed where vulnerabilities are high and few tools are available. Key areas and recommended actions:
  - Rising corporate debt burdens:
    - Maintain stringent supervision of banks’ credit risk assessment and lending practices.
    - Increase disclosure and transparency in nonbank finance markets.
    - Consider developing prudential tools for highly leveraged firms where corporate sector debt is systemically high.
    - Consider widening the regulatory and supervisory perimeter to include nonbank financial entities that provide financial intermediation services to firms, as warranted.
    - Reduce tax biases favoring debt over equity to lower incentives for excessive borrowing by firms.
  - Increased holdings of riskier and more illiquid securities by institutional investors:
    - Use appropriate incentives to reduce offering of guaranteed return products.
    - Implement minimum solvency and liquidity standards and enhanced disclosures.
    - Require institutional investors to hold liquid assets commensurate with rising risks, informed by stress tests built on severe and plausible assumptions.
    - Step up implementation of policy initiatives to mitigate leverage and other balance sheet mismatches in insurance firms and mutual funds.
  - Increased reliance on external borrowing by emerging and frontier market economies:
    - Mitigate debt sustainability risks through prudent debt management practices and strong debt management frameworks, taking a holistic view on overall debt-related risks.

### Macroprudential toolkit and countercyclical capital buffers
- Table 1.1 summarizes macroprudential policy tools in use in 2018 and the level of the countercyclical capital buffer in 2019 (percent). (Table content not reproduced here; source data from IMF Macroprudential Policy Survey and IMF staff calculations.)
- Note: The table shows the level of the countercyclical capital buffer as of summer 2019. Some countries have announced that the countercyclical capital buffer will be tightened at a future date.

### Regulatory reform and coordination
- Global policy coordination remains critical.
- Policymakers need to complete and implement the regulatory reform agenda and further develop international resolution frameworks for internationally active firms.
- Any rollback of regulatory standards should be avoided.

### Transition risks and structural policy priorities
- LIBOR transition:
  - Market participants need to prepare for the transition from LIBOR to alternative risk-free interest rate benchmarks.
  - Continued reliance on LIBOR and the current pace of progress raise concerns about potential financial stability risks if the orderly transition is not completed by end-2021.
  - Supervisors should encourage market participants to net down legacy derivative positions and accelerate adoption of the new benchmark rates.
- Environmental, social, and governance (ESG) considerations:
  - Closing data gaps is crucial for efficient pricing of externalities, mitigating risks, and rewarding long-term benefits from sustainability.
  - Progress is needed in developing standards and promoting consistent ESG reporting.
  - Regulators and central banks should take intellectual leadership in assessing ESG risks.
  - The IMF will continue to incorporate ESG considerations critical to the economy into its surveillance.

### Policy initiatives to mitigate leverage and balance sheet mismatches (Table 1.2 summary)
- Banks — capital and leverage:
  - BCBS (2019) reported generally good progress implementing the capital framework; only eight jurisdictions had final large exposure rules in force as of end-March 2019.
  - Leverage ratio revised with implementation date of January 2022.
  - Output floors will be phased in over 2022–27.
  - BCBS discussion on regulatory treatment of sovereign exposures has not reached consensus.
- Banks — liquidity, maturity, and foreign currency mismatches:
  - All BCBS member countries have implemented the liquidity coverage ratio (LCR); 11 of its 27 members had final net stable funding ratio (NSFR) rules in force as of end-March 2019; a further 15 countries are in the process of adopting the NSFR.
  - Basel III requires monitoring of the LCR and NSFR by material currency.
  - Market risk framework revised with an implementation deadline of January 2022.
- Insurance companies:
  - Risk-based capital standards expected to be adopted for internationally active insurance groups by end-2019, with a five-year monitoring period prior to final review and subsequent international agreement and adoption.
  - Implementation delay noted relative to original plan.
  - No common global standard for economic-based solvency regimes; potential for regulatory arbitrage.
  - IAIS guidance on liquidity management and planning released; holistic framework for systemic risks in the insurance sector is being developed.
- Investment funds:
  - Work on leverage measures is ongoing; IOSCO expected to finalize its leverage report by end-2019.
  - February 2018 IOSCO report on liquidity risk management includes recommendations; assessment of implementation expected in 2020.

### Case study: Recent bank interventions in China (Box 1.1)
- Events and market impact:
  - In late May, Chinese authorities took over Baoshang Bank, imposing marginal haircuts on corporate and interbank depositors.
  - In late July, several large state-owned financial institutions purchased minor stakes in the Bank of Jinzhou, which had liquidity problems.
  - In early August, Hengfeng received a capital injection from a unit of China’s sovereign wealth fund; no haircuts occurred in the Jinzhou and Hengfeng cases.
  - Spread between funding costs of highly rated and weaker borrowers widened from an average of 16 basis points before the Baoshang takeover to nearly 90 basis points in early July.
  - Negotiable certificates of deposit (NCD) issuance for weaker borrowers declined sharply.
- Underlying vulnerabilities highlighted:
  - Liquidity, funding, and solvency risks: the three banks were among a dozen or so that had delayed annual reports; relied on wholesale funding and held large shares of risky nonloan assets.
  - Interlinkages between banks, nonbank financial institutions, and investment vehicles create circularity and interconnectedness, amplifying shock transmission.
  - Maturity mismatches and other risks within investment vehicles (wealth management products, asset management products, trust beneficiary rights) that rely on short-term wholesale funding while funding long-term credit.
- Policy implications:
  - The liquidity and funding squeeze and solvency concerns are likely to increase pressure on banks to raise deposit funding and pay more for other sources of funds, forcing trade-offs between improving resilience and maintaining credit growth.
  - IMF staff analysis suggests loan books of smaller banks would have to contract significantly if banks were required to increase core Tier 1 equity ratios to the system average (10.5 percent) and hold adequate capital against roughly half of their on- and off-balance-sheet shadow credit.
  - Authorities took different approaches across Baoshang, Jinzhou, and Hengfeng, reflecting institution-specific circumstances.
  - Policymakers urgently need to introduce a bank resolution regime and reform the asset management industry and its linkages to banks.

### Growth-at-Risk (GaR) analysis for the United States
- Methodology notes:
  - The GaR specification here differs from the global GFSR specification by: (1) using a financial conditions index that includes only price-of-risk variables (credit variables excluded), and (2) including information on vulnerabilities separately via a financial vulnerability index for the private nonfinancial sector (households and nonfinancial companies).
  - The private nonfinancial sector vulnerability index is constructed as a credit-weighted aggregate of corporate and household financial vulnerability indices; it is orthogonalized with respect to the financial conditions index.
- Counterfactual scenarios and findings:
  - Scenario 1 — Level of vulnerabilities:
    - Baseline GaR indicates medium-term risks are elevated compared to near-term risks.
    - Assuming financial conditions remain unchanged, a one-standard-deviation increase in the level of vulnerabilities meaningfully increases medium-term downside risks to growth.
  - Scenario 2 — Tightening in financial conditions:
    - A one-standard-deviation tightening in financial conditions when vulnerabilities are high increases risks at both time horizons relative to the baseline, with a relatively larger impact over the near term.
    - When vulnerabilities are low, a tightening in financial conditions raises near-term risks to growth relative to the baseline but significantly reduces medium-term risks.
- Policy implication:
  - Policymakers should adopt policies aimed at reducing vulnerabilities while vulnerabilities are still low and financial conditions are relatively easy.

*Source: IMF staff, Global Financial Stability Report: LOWER FOR LONGER, October 2019.*

### Box 1.2. Assessing the Impact of Changes in Financial Conditions and Vulnerabilities in the

### Box 1.2. Assessing the Impact of Changes in Financial Conditions and Vulnerabilities in the Growth-at-Risk Model for the United States

### Baseline near- and medium-term risks (GaR fifth percentiles, as of 2019:Q3)
- Baseline specification: medium-term risks are higher than near-term risks.
- Baseline as of 2019:Q3 (figure annotations): –1.24 and 1.56 appear as labeled values in the figure context.

### Impact of changing vulnerability levels (one-standard-deviation change in PNF FVI)
- Private nonfinancial (PNF) financial vulnerability indices (FVIs) are constructed as a credit-weighted aggregate of corporate and household FVIs in the GaR specification.
- Assuming financial conditions are unchanged, a higher level of vulnerabilities raises medium-term risks more than near-term risks.
- Figure panel annotations include numeric values: –3.0, 2.0, 0.0, –1.0, –2.0, 1.0 (presented as plotted near-term and medium-term coordinates).

### Impact of tightening financial conditions (one-standard-deviation increase in FCI; one-standard-deviation change in PNF FVI)
- A tightening in financial conditions when private nonfinancial vulnerabilities are low:
  - Results in increased risk in the near term, but helps mitigate medium-term risks.
- A tightening in financial conditions when private nonfinancial vulnerabilities are high:
  - Increases risks at both time horizons relative to the baseline.
- Figure panel annotations include numeric values: 0.5, 0.0, –0.5, –1.0, –1.5, –2.0, –2.5, 1.0, 1.5, 2.5, 2.0 (presented as plotted near-term and medium-term coordinates).

### Model and data notes
- Lines in panels 1–3 indicate pairs of near- and medium-term forecasts and do not denote a linear relationship between the two horizons.
- FCI = financial conditions index.
- Sources: Bank for International Settlements; Bloomberg Finance L.P.; Haver Analytics; and IMF staff calculations.

*Prepared by David Jones, Yingyuan Chen, Sanjay Hazarika, and John Caparusso.*

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