## Global Financial Stability Report: LOWER FOR LONGER — October 2019 ## Source details **Canonical URL:** [Global Financial Stability Report: LOWER FOR LONGER — October 2019](https://www.imf.org/-/media/files/publications/gfsr/2019/october/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2019/october/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2019/october/english/text.pdf.json) --- ### Market environment and financial conditions - Trade disputes and policy uncertainty have weakened business sentiment and increased concerns about downside risks to the global economy. - Market pricing suggests that rates will remain "lower for longer" compared with expectations at the beginning of the year. - About $15 trillion of outstanding debt features negative yields. - 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. - 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. - 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. ### Buildup of financial vulnerabilities (overview) - Easier financial conditions have encouraged more financial risk-taking and a further buildup of financial vulnerabilities, increasing medium-term growth risks. - Elevated vulnerabilities identified in source figures by sector counts: Nonfinancial firms (15), Insurers (11), Banks (8), Households (15), Sovereigns (10), Other nonbank financials (18). - Near-term Growth-at-Risk (fifth percentile of one-year-ahead forecast) is little changed compared to six months prior; medium-term risks are skewed to the downside and remain elevated by historical standards. - Potential triggers for tightening financial conditions include: - Intensification or broadening of trade tensions. - Faster-than-expected slowdown in global growth. - Sudden market reassessment of monetary policy expectations. - Crystallization of political and policy risks (for example, a no-deal Brexit). ### Corporate sector vulnerabilities (Chapter 2 highlights) - Debt-at-risk defined: debt at firms with interest coverage ratio (ICR) < 1. - Speculative-grade debt defined: debt at firms with ICR < 4.1 and net debt-to-assets > 0.25. - In an adverse scenario (half the severity of the global financial crisis): - Corporate debt-at-risk could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies—above crisis levels (aggregate for eight economies in analysis). - Aggregate outcome for the eight economies analyzed: debt-at-risk would amount to $19 trillion, or nearly 40 percent of total corporate debt, in the adverse scenario in 2021. - Country- and firm-level observations: - The estimated share of speculative-grade debt in total corporate sector debt is now nearly 50 percent in China and the United States and is even higher in Italy, Spain, and the United Kingdom. - The share of debt-at-risk in total corporate sector debt is above 25 percent in the United Kingdom and the United States. - China: SMEs remain highly profitable, large firms (including state-owned enterprises) have relatively weak profitability; debt-at-risk in China is very sensitive to deteriorations in growth and funding conditions. - United States: large firms remain highly profitable; US SMEs are relatively weak; rapid growth in leveraged loan and private credit segments is concerning. - Financial intermediation shifts: - The bulk of recent US corporate debt increase was funded by leveraged loans and private lending. - Private debt funds currently hold the largest exposure and dry powder across loans to SMEs; private debt market has reached nearly $1 trillion. - Mutual fund ownership of US corporate bonds has increased more than 150 percent from levels before the global financial crisis. ### Nonbank financial institutions and institutional investors (Chapter 3 highlights) - Vulnerabilities among nonbank financial institutions are elevated in 80 percent of economies with systemically important financial sectors (by GDP). - Institutional investor behavior and exposures: - Fixed-income funds increased duration and credit exposures, decreased liquidity buffers; sample represents some 60 percent of global bond fund industry assets of $10.5 trillion (as of March 2019) and is 70 percent US dollar–denominated, 10 percent euros, 20 percent other currencies. - Pension funds’ notional derivatives positions rose to 155 percent of net assets, on average, from 95 percent in 2011 (sample of largest pension funds). - Asian life insurers’ foreign assets rose to nearly $1.5 trillion, almost double five years earlier; Asian insurers’ combined share of the US dollar credit market rose to 11 percent from 8 percent over the past five years. - Taiwanese life insurers’ foreign investment rose to more than two-thirds of their assets; about one-quarter of their foreign currency investments are unhedged; their investment has risen to more than $400 billion, or 7 percent of all corporate and bank bonds outstanding denominated in US dollars. - Liquidity stress for fixed-income funds (Box 3.1): - Total liquidity shortfall of fixed-income funds with $10.5 trillion AUM estimated at $160 billion (as of March 2019). - Funds with estimated shortfalls account for almost one-sixth of all fixed-income fund assets and nearly half of all high-yield fund assets. - Average shortfall as share of all fixed-income fund assets about 1.5 percent; for funds with shortfalls average shortfall remains stable at 10 percent of those funds’ assets; for the weak tail of one-fifth of these funds, shortfalls exceed 20 percent of assets. ### Emerging and frontier markets: external borrowing and debt dynamics (Chapter 4 highlights) - Median external debt in emerging market economies rose to 160 percent of exports from 100 percent in 2008. - In some countries the external-debt-to-exports ratio has increased to more than 300 percent. - Frontier markets: - Outstanding hard-currency debt of frontier markets tripled over the past five years to more than $200 billion as of mid-2019. - For the median frontier borrower, outstanding hard-currency bonds grew to 7 percent of GDP and are close to half of gross reserves (2014: 3 percent of GDP and 20 percent of reserves). - SOEs and spillovers: - Debt issued by fully government-owned SOEs comprises one-third of the entire emerging market sovereign hard currency bond universe. - If all SOEs (including majority-owned) were combined, they would make up half of corporate debt securities in indices. - SOE leverage and decline in profitability have increased SOE–sovereign spillovers. - Frontier market vulnerabilities and debt distress: - The share of low-income developing countries assessed at high risk of debt distress or in debt distress doubled since 2013 to 43 percent. - Median public debt for low-income developing countries rose by 13 percentage points of GDP since 2013 to about 46 percent of GDP in 2018. - Median public debt for frontier issuers rose by close to 20 percentage points of GDP to about 55 percent. ### Banks’ US dollar funding fragility and cross-border spillovers (Chapters 5 and Annex 5.3 highlights) - Non-US banks’ US dollar–denominated assets exceeded $12 trillion by early 2018 (up from $9.7 trillion in 2012). - Cross-currency funding gap and ratio: - Mid-2008 peak of the cross-currency funding gap: $1 trillion (or 10 percent of US dollar assets). - Recent level: exceeding $1.4 trillion corresponding to a cross-currency funding ratio of 13 percent of US dollar assets. - Of 26 economies, 17 had positive funding gaps as of Q1 2018. - In economies with positive gaps, gaps totaled $1.8 trillion—18 percent of US dollar–denominated assets (Q1 2018). - Cross-currency basis and amplification: - A 50 basis point increase in the cross-currency basis (equivalent to average quarterly change at onset of the global financial crisis) is associated with: - 0.22 standard deviation increase in the probability of banking sector default in the home economy (equivalent to a 7½ percent increase). - 0.29 standard deviation tightening in domestic financial conditions. - 0.1 standard deviation increase in the probability of default of the recipient’s banking sector (a 3.3 percent increase). - A 50 basis point annual cumulative increase in US dollar funding costs is associated with a 5.3 percent reduction in US dollar cross-border lending (full sample). - Effects by lender type: - Emerging market lender → 7.1 percent decrease in cross-border lending to all recipients; 9.3 percent decrease to other emerging markets. - Increase in US dollar funding costs by 50 basis points affects US dollar lending to emerging market recipients by about –6.6 percent. - Substitution limits: - Average recipient compensates for about one-half of a cutback from other lenders; emerging market recipients compensate about one-quarter. - When lending costs tighten across a recipient’s foreign lending partners, local banks compensate only 20 percent of US dollar credit by domestic lending. - Borrowing in other currencies falls by one-third of the initial US dollar cutback. - Amplification by US dollar activities and funding fragility: - High share of US dollar assets (fourth quintile): 50 basis point increase raises probability of banking sector default by 0.32 standard deviations (an 11 percent increase). - High cross-currency funding gap ratio (fourth quintile): 50 basis point increase raises default probability by 0.41 standard deviations (a 14 percent increase). - Mitigants and policy notes: - Larger capital buffers, stronger liquidity, higher profitability reduce transmission. - Access to swap lines with the Federal Reserve limits deviation from covered interest parity and curbs funding risk; regression analysis finds no statistically significant association between change in funding conditions and change in domestic financial stress in economies with swap lines. - International reserves mitigate cutbacks: in economies with high reserves (fourth quintile), cutbacks in cross-border lending are about 40 percent less than in those with low reserves (bottom quintile). - Policy guidance: monitor US dollar funding fragility; develop currency-specific liquidity risk frameworks, stress tests, emergency funding strategies, and resolution planning; consider strengthening global financial safety net, including IMF resources and swap line access. ### Institutional investor policy guidance and recommendations - Investment funds: - Introduce minimum eligibility criteria for asset inclusion in fixed-income funds (credit quality and liquidity). - Require better matching of redemption terms to portfolio liquidity; enhance stress testing and disclosures; harmonize leverage measurement. - Pension funds: - Improve reporting and governance around illiquid assets and synthetic leverage; require standardized stress-liquidity reporting; consider cost-sharing arrangements for guaranteed benefits. - Life insurers: - Adopt globally harmonized minimum solvency standards and group-level capital requirements; consider disincentives to guaranteed-return products. - Macroprudential and supervisory priorities: - Strengthen oversight and disclosures of nonbank financial entities; set minimum solvency and liquidity standards; require institutional investors to hold liquid assets commensurate with risks. ### Macro policy stance and tailored recommendations - Policy guidance by cyclical conditions and vulnerabilities: - Economies with robust activity but high or rising vulnerabilities amid easy financial conditions: urgently tighten macroprudential policies, including activating broad-based tools such as the countercyclical capital buffer (CCyB). - Economies easing macroeconomic policy but with sectoral vulnerabilities: use targeted measures (stress tests, higher risk weights, sectoral capital buffers, borrower-based tools). - Economies facing significant slowdown: focus on accommodative policies, considering available policy space; use fiscal easing where fiscal space exists; release countercyclical capital buffers where built up. - Urgent policy actions to tackle key vulnerabilities: - Rising corporate debt burdens: maintain stringent supervision of bank credit risk; increase disclosure and transparency in nonbank finance; consider prudential tools for highly leveraged firms; reduce tax biases favoring debt over equity. - Institutional investor risk-taking: strengthen oversight; introduce incentives and minimum solvency/liquidity standards; enhance disclosure and stress testing. - Emerging and frontier market external borrowing: mitigate debt sustainability risks through prudent debt management practices and strong frameworks. - Global coordination priorities: - Resolve trade tensions and de-escalate tariffs. - Complete and fully implement the global regulatory reform agenda; avoid regulatory rollback. - Coordinate to ensure smooth transition from LIBOR to new reference rates for a wide range of financial contracts around the world by the end of 2021. - Supervisors should encourage market participants to net down legacy derivative positions and accelerate adoption of new benchmark rates. ### Sustainable finance and ESG considerations (Chapter excerpts) - Sustainable finance defined: incorporation of environmental, social, and governance (ESG) principles into business decisions, economic development, and investment strategies. - Climate-related financial risks channels: - Physical risks: damage from catastrophic weather-related events and broader climate trends. - Transition risks: changes in prices of stranded assets and economic disruption from policy, technology, and market sentiment during adjustment to a lower-carbon economy. - Key metrics and observations: - Insurance claims from natural losses have quadrupled since the 1980s. - CDP 2019 estimate cited: $1 trillion expected climate change costs for a group of large listed companies. - Labeled green-bond stock grew to an estimated $590 billion in August 2019 from $78 billion in 2015. - Global green bond issuance reached $168.4 billion in 2018. - ESG-dedicated funds control some $850 billion in assets (less than 2 percent of total investment fund universe); ESG equity funds reached $560 billion in 2019. - No conclusive evidence that sustainable funds consistently out- or underperform conventional funds. - Disclosure and market infrastructure gaps: - Corporate ESG reporting is largely voluntary and inconsistent; third-party ESG score providers have opaque and inconsistent methodologies. - Policy recommendations: - Develop standards and foster consistent ESG disclosure (including mandatory minimum disclosure of financially material information, taking into account costs and complexities). - Close data gaps to improve pricing of externalities and risk assessment. - Regulators and central banks should take intellectual leadership; incorporate ESG into financial stability monitoring and stress testing. - Consider incentives to promote green finance (examples cited in source: Singapore’s sustainable bond grant program; expansion of collateral by the People’s Bank of China for a lending facility to include green bonds). - Clarify fiduciary duties and reconcile long-term objectives with investment governance. *Source: IMF Global Financial Stability Report: LOWER FOR LONGER (October 2019) — Preface, Executive Summary, Chapters 1–5, Annexes, and selected boxes and figures, information current as of September 27, 2019; discussed by Executive Directors on October 3, 2019.* ### Preface ### Preface ### Purpose and scope - The Global Financial Stability Report (GFSR) assesses key vulnerabilities in the global financial system and seeks to prevent crises by highlighting policies that may 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; project direction by Fabio Natalucci, Deputy Director, Claudio Raddatz, Advisor, and Anna Ilyina, Division Chief. - This GFSR reflects information available as of September 27, 2019, and the IMF Executive Directors discussed the GFSR on October 3, 2019. ### Key findings: market environment and financial conditions - Trade disputes and policy uncertainty have weakened business sentiment and increased concerns about downside risks to the global economy. - Market pricing suggests that rates will remain "lower for longer" compared with expectations at the beginning of the year. - About $15 trillion of outstanding debt features negative yields. - Lower government bond yields have eased global financial conditions, particularly in the United States and the euro area, supporting near-term economic growth and containing near-term downside risks. ### Key findings: buildup of financial vulnerabilities - Easier financial conditions have encouraged more financial risk-taking and a further buildup of financial vulnerabilities, increasing medium-term growth risks. - Elevated vulnerabilities are identified in: - The corporate sector: corporate debt burdens have risen; the share of debt owed by firms with weak debt repayment capacity is sizable in several major economies and could reach post–global financial crisis levels in a material downturn. - The nonbank financial sector: insurance companies, pension funds, and other institutional investors with nominal return targets have shifted into riskier and less liquid securities to meet targets. - Emerging and frontier markets: low rates in advanced economies have spurred capital flows to emerging and frontier economies, facilitating further accumulation of external debt. - Global US dollar funding markets: US dollar funding fragilities among non-US banks amplify adverse shocks and create spillovers to countries that borrow in US dollars from foreign non-US banks, posing a source of vulnerability for the global financial system. ### Analysis emphasis and special topics (as summarized in the Preface and Foreword) - The report documents stretched valuations in risky asset markets owing to search-for-yield behavior in a prolonged low-interest-rate environment and warns of the possibility of sharp, sudden adjustments in financial conditions. - The report contains dedicated analyses on corporate vulnerabilities, institutional investors, emerging and frontier markets’ debt dynamics, banks’ US dollar funding, and sustainable finance (see chapter listings in the report contents). ### Policy recommendations and priorities - Policymakers should "lean against the buildup of vulnerabilities" by: - Deploying and developing macroprudential tools as warranted. - Maintaining stringent financial supervision. - Specific points on macroprudential policy: - Many countries have demand-side housing-market tools (limits on loan-to-value and debt-to-income ratios). - More jurisdictions would benefit from activating broad-based macroprudential tools such as the countercyclical capital buffer. - Macroprudential tools for the corporate sector and market-based finance are often lacking; there is an urgent need to develop such tools. - The overarching near-term policy priorities remain resolving trade disputes and providing clarity of economic policies. ### Report production and inputs - The analysis was coordinated and produced by IMF staff with contributions from numerous named staff and input from banks, securities firms, asset management companies, hedge funds, standard setters, financial consultants, pension funds, central banks, national treasuries, and academic researchers. - The Preface lists individual contributors and editorial and production staff involved in preparing the report. *Source: IMF Global Financial Stability Report (Preface), information current as of September 27, 2019; discussed by Executive Directors on October 3, 2019.* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Global market context and recent dynamics - Financial markets have been buffeted by the ebb and flow of trade tensions and growing concerns about the global economic outlook. - Weakening economic activity and increased downside risks prompted a shift toward a more dovish stance of monetary policy across the globe, accompanied by sharp declines in market yields. - The amount of bonds with negative yields has increased to about $15 trillion. - Investors now expect interest rates to remain very low for longer than anticipated at the beginning of the year. - Chapter 1: investors’ search for yield has left asset prices in some markets overstretched and fostered further easing in financial conditions since the April 2019 Global Financial Stability Report. ### Corporate sector vulnerabilities - Accommodative monetary policy is supporting the economy in the near term, but easy financial conditions are encouraging financial risk-taking and fueling a further buildup of vulnerabilities in some sectors and countries. - Chapter 2: corporate sector vulnerabilities are already elevated in several systemically important economies due to rising debt burdens and weakening debt service capacity. - In a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk (debt owed by firms that are unable to cover their interest expenses with their earnings) could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies—above crisis levels. - Policy guidance: stringent supervision of bank credit risk assessment and lending practices; increase disclosure and transparency in nonbank finance markets; consider prudential tools for highly leveraged firms; reduce tax biases that favor debt over equity. ### Nonbank financial institutions and institutional investors - Very low rates are prompting investors to search for yield and take on riskier and more illiquid assets. - Chapter 3: vulnerabilities among nonbank financial institutions are now elevated in 80 percent of economies with systemically important financial sectors (by GDP); this share is similar to that at the height of the global financial crisis. - Vulnerabilities remain high in the insurance sector. - Institutional investors’ search for yield could lead to exposures that amplify shocks during market stress: - Similarities in investment funds’ portfolios could magnify a market sell-off. - Pension funds’ illiquid investments could constrain their ability to stabilize markets. - Cross-border investments by life insurers could facilitate spillovers across markets. - Policy guidance: strengthen oversight and disclosures of nonbank financial entities; use incentives to reduce offering of guaranteed-return products; set minimum solvency and liquidity standards. ### Emerging and frontier market external borrowing risks - Capital flows to emerging markets have been spurred by low interest rates in advanced economies (Chapter 4). - Median external debt in emerging market economies has risen to 160 percent of exports from 100 percent in 2008. - In some countries, this ratio has increased to more than 300 percent. - Increased borrowing could raise rollover and debt sustainability risks in the event of a sharp tightening in global financial conditions; some overindebted state-owned enterprises may find market access and liability servicing harder without sovereign support. - Greater reliance on external borrowing in some frontier market economies could increase the risk of future debt distress. - Policy guidance: indebted emerging market and frontier economies should mitigate debt sustainability risks through prudent debt management practices and strong debt management frameworks. ### Banking sector resilience and dollar funding fragility - Post-crisis regulation has improved overall banking sector resilience, but pockets of weaker institutions remain. - Negative yields and flatter yield curves, along with a subdued growth outlook, have reduced expectations of bank profitability and lowered market capitalization for some banks. - Banks are exposed to high-vulnerability sectors through lending, leaving them susceptible to potential losses; in China, authorities intervened in three regional banks. - Among non-US banks, US dollar funding fragilities remain a source of vulnerability in many economies (Chapter 5); this fragility could amplify the impact of a tightening in funding conditions and create spillovers to countries that borrow in US dollars from non-US banks. - Policy guidance: monitor and address US dollar funding fragility; maintain regulatory vigilance to prevent rollback of standards. ### ESG considerations and climate-related financial risks - Environmental, social, and governance (ESG) principles are becoming increasingly important for borrowers and investors. - ESG factors could have a material impact on corporate performance and may give rise to financial stability risks, particularly through climate-related losses (Chapter 6). - Authorities have a key role in developing standards for ESG investing and closing data gaps to encourage more consistent reporting. - Policy guidance: develop ESG standards, close data gaps, and encourage consistent ESG reporting. ### Macro policy stance and recommendations - Medium-term risks to global growth and financial stability remain firmly skewed to the downside against easy financial conditions and stretched valuations. - Policy recommendations by economic circumstance: - Economies with robust activity but high or rising vulnerabilities amid easy financial conditions: urgently tighten macroprudential policies, including broad-based tools such as the countercyclical capital buffer. - Economies easing macroeconomic policy due to deteriorating outlook but with sectoral vulnerabilities: use targeted approaches to address specific pockets of vulnerability. - Economies facing significant slowdown: focus on more accommodative policies, considering available policy space. - Urgent policy actions to tackle financial vulnerabilities: - Rising corporate debt burdens: maintain stringent supervision of bank credit risk; increase disclosure and transparency in nonbank finance; consider prudential tools for highly leveraged firms; reduce tax bias favoring debt. - Increasing holdings of riskier and more illiquid securities by institutional investors: strengthen oversight; implement incentives and minimum solvency/liquidity standards; enhance disclosure. - Increased reliance on external borrowing by emerging and frontier markets: use prudent debt management and strong frameworks. - Global coordination priorities: - Resolve trade tensions and de-escalate tariffs. - Complete and fully implement the global regulatory reform agenda; avoid regulatory rollback. - Coordinate to ensure smooth transition from LIBOR to new reference rates for a wide range of financial contracts around the world by the end of 2021. ### Key vulnerabilities at a glance - Rising corporate debt burdens - Increasing holdings of riskier and more illiquid assets by institutional investors - Greater reliance on external borrowing by emerging and frontier market economies *Source: EXECUTIVE SUMMARY, Global Financial Stability Report: Lower for Longer — International Monetary Fund | October 2019* ### 4. Actual and Expected Policy Rates ### 4. Actual and Expected Policy Rates ### Market pricing and policy expectations - 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 and government bond yields - 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, or 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 volatility - Declines in interest rates have motivated investors to search for yield by increasing 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. - An IMF staff fair-value model points to corporate earnings and payouts as a key factor compressing US equity volatility; the model suggests current volatility may not fully account for external factors such as trade tensions and global economic uncertainty. - Equity markets appear overvalued in Japan and the United States (misalignments scaled by monthly price volatility). - Equity valuations in major emerging markets are closer to fair value. - IMF staff valuation models suggest that 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 capital 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 remain accommodative relative to historical norms, although the easing slowed in the third quarter of 2019. - In China, financial conditions are marginally tighter as a result of 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; debt flows have risen as higher-yielding dollar-denominated bonds became increasingly attractive relative to bonds issued by advanced economies. - Chinese local currency bond flows 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 recent months. ### Financial vulnerabilities and sectoral exposures - 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 increased in the United States and euro area since the April 2019 GFSR, reflecting higher leverage and credit exposures as institutional investors sought returns. - In China, vulnerabilities remain high largely due to leveraged positions in investment vehicles. - Vulnerabilities in the insurance sector remain elevated in advanced economies, reflecting the search for yield in a low-interest-rate environment. - Chinese banks have the largest weighted exposures (by vulnerability-weighted measure) reflecting sizable lending to domestic firms, households, and other financial companies. - Banking systems in Brazil, India, Korea, and Turkey also have relatively high vulnerability-weighted exposures. - Market-adjusted capitalization (using market value of equity in place of book value) has fallen; this metric signals pockets of weaker banks and is a relatively good predictor of banking sector stress. - Euro area institutions accounting for more than 30 percent of sample bank assets have relatively weak capitalization by these indicators. - In China the proportion is about 25 percent. - Many small and medium-sized Chinese banks have lower capital ratios and profits than the five largest institutions; recent strains surfaced in funding markets and prompted 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 financial vulnerabilities - Vulnerabilities have increased among other nonbank financial entities and remain high in the corporate sector. - Sectors highlighted with counts in the source figure: Nonfinancial firms (15), Insurers (11), Banks (8), Households (15), Sovereigns (10), Other nonbank financials (18). - Regional and sectoral observations: - Vulnerabilities are elevated in several economies and have increased among other nonbank financial entities in advanced economies. - Corporate sector vulnerabilities continue to be elevated, particularly in China, other emerging market economies in aggregate, and the United States. - Household vulnerabilities continue to be elevated in China and a number of other advanced economies; economies that avoided the worst of the global financial crisis subsequently tended to experience house price booms and now have the highest household-debt-to-GDP ratios. - Sovereign sector vulnerabilities are broadly unchanged at the global level but have fallen slightly in the euro area as a whole as debt levels have declined in some economies. Several governments, however, have elevated debt relative to GDP. - Corporate credit quality assessment (summary of Chapter 2): - Chapter 2 assesses corporate sector credit quality in eight major economies: China, France, Germany, Italy, Japan, Spain, the United Kingdom, and the United States. - It finds 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 the crisis levels in an adverse scenario, which is half as severe as the global financial crisis. - Corporate weaknesses are primarily concentrated in small and medium-sized firms and in large Chinese firms, including state-owned enterprises. ### Financial sector strength and concentration of risks - Banks: - Regulation since the global financial crisis has improved overall banking sector resilience, but pockets of vulnerability remain. - Although banks are stronger overall, some banking systems have large exposures to sectors with high vulnerabilities. - Individual bank vulnerability indicators vary significantly, including among small and medium-sized banks in China. - The label definitions used in the source: “stronger banks” = lowest proportion of banks with common equity Tier 1 ratio of 15 percent or more, or a market-adjusted capitalization ratio of 3 percent or more; “weaker banks” = highest proportion of banks with common equity Tier 1 ratio of 10 percent or less, or a market-adjusted capitalization ratio of 1.5 percent or less. Market-adjusted capitalization = min{price-to-book ratio, 1} × tangible common equity (percent of tangible assets). - Other nonbank financials: - Leverage and credit exposures are a source of vulnerability among other nonbank financial entities. - Exposures of banks to vulnerable sectors are material in a set of 29 economies with systemically important financial sectors (weighted by vulnerability scores). ### Growth-at-Risk and macrofinancial outlook - Growth-at-Risk framework and findings: - Near-term growth-at-risk (defined as the fifth percentile of the one-year-ahead forecast distribution) is little changed compared to six months prior. - Medium-term risks are skewed to the downside and remain elevated by historical standards. - The growth-at-risk framework assesses how the 5th percentile of growth outcomes shifts in response to changes in financial conditions and vulnerabilities. - Potential triggers for tightening financial conditions: - Intensification or broadening of trade tensions. - Faster-than-expected slowdown in global growth. - Sudden market reassessment of the outlook for monetary policy, especially if there is a gap between market expectations and central banks’ communications. - Crystallization of political and policy risks (for example, a geopolitical event causing contagion and capital flow reversals from emerging markets, renewed fiscal concerns in highly indebted countries, or a no-deal Brexit). - Markets have been orderly despite Brexit uncertainty, but volatility may rise near key deadlines and a no-deal outcome could cause substantial tightening. - Interaction of vulnerabilities and shocks: - Box 1.2 (United States example) shows higher private nonfinancial sector vulnerabilities increase downside risks to growth and financial stability, particularly in the medium term. - If vulnerabilities are already high, a tightening of financial conditions produces much more pronounced downside risks in both the near and medium term. - Policy implication: best time to reduce financial stability risks is when vulnerabilities are still relatively low and financial conditions are accommodative. ### Policy guidance and recommended actions - General stance: - Monetary policy should remain data dependent and any changes in stance should be clearly communicated to avoid mispricing of risk by market participants. - Given accommodative financial conditions and stretched asset valuations, macroprudential policies should be tightened as warranted to reduce the risk that further easing fuels a buildup of vulnerabilities. - Because necessary macroprudential tools are lacking in several major economies, such tools should be urgently developed. - Tailored policy mix by cyclical conditions and vulnerabilities: - Countries with robust economic activity, easy financial conditions, and high or rising vulnerabilities: - Urgently tighten macroprudential policies, including activating or tightening broad-based tools to increase resilience and reduce risk-taking. - Note: 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: - Consider targeted measures such as stress tests on banks’ exposures to certain borrower types, higher risk weights on these exposures, sectoral capital buffers, and borrower-based tools where appropriate. - Economies facing a significant slowdown: - Focus on accommodative policies, considering available policy space. - Monetary policy may be complemented by fiscal easing where there is fiscal space and financial conditions allow. - Countercyclical capital buffers could be released in economies that have built them up. - Implementation notes: - Authorities should recognize that tightening macroprudential measures may encourage a shift in lending activity from banks to the nonbank financial sector, requiring monitoring and possibly targeted measures for nonbanks. - Institutional arrangements can implement macroprudential policies through mechanisms other than tool counts reported in surveys (example cited: designation powers used in the United States). *Italicized source attribution: CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEw: LOwER FOR LONGER — October 2019 Global Financial Stability Report, International Monetary Fund* ### 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 the cost of funding; easy financial conditions can support near-term growth but encourage excessive risk-taking that puts growth at risk over the medium term. ### Urgent policy priorities where vulnerabilities are high and tools are lacking - Rising corporate debt burdens: - Maintain stringent supervision of banks’ credit risk assessment and lending practices. - Increase disclosure and transparency in nonbank finance markets to enable more comprehensive risk assessment. - In economies where overall corporate sector debt is deemed to be systemically high, consider developing prudential tools for highly leveraged firms (see Chapter 2). - Consider widening the regulatory and supervisory perimeter to include nonbank financial entities providing financial intermediation services to firms, as warranted. - Reduce tax-system biases that favor debt over equity financing to reduce incentives for excessive borrowing by firms. - Increased holdings of riskier and more illiquid securities by institutional investors: - Use appropriate incentives to reduce the offering of guaranteed return products. - Introduce 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 efforts to mitigate leverage and balance sheet mismatches in insurance firms and mutual funds (see Table 1.2 and Chapter 3). - 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 (as discussed in Chapter 4). ### Macroprudential toolkit and countercyclical capital buffers (CCyB) - Despite elevated vulnerabilities, many countries have not deployed countercyclical capital buffers. - Table 1.1 summarizes number of macroprudential policy tools in use in 2018 and level of the countercyclical capital buffer in 2019, with levels reported as of summer 2019. (Table omitted here; source data derived from IMF Macroprudential Policy Survey.) - Note on data and interpretation: - The table shows the level of the countercyclical capital buffer as of summer 2019. - Some countries announced that the countercyclical capital buffer will be tightened at a future date. - Macroprudential tool inclusion reflects information provided by IMF member countries and is not an IMF judgment on tool classification. - Examples of tools in the database: - Corporate sector: sector-specific capital requirements, caps on loan-to-value ratio for commercial real estate credit. - Nonbank financial sector: countercyclical capital requirements for insurers, resecuritization prohibitions, default fund requirements for central counterparties. ### Regulatory implementation and cross-sector initiatives (Table 1.2 summary) - Banks - BCBS (2019) reported generally good progress implementing the capital framework; only eight jurisdictions had final large exposure framework rules in force as of end-March 2019. - The leverage ratio was revised with an implementation date of January 2022; changes include refining the exposure measure, introducing a GSIB buffer, and addressing potential “window dressing” of balance sheets. - Output floors for banks using the advanced approach for Tier 1 capital ratios will be phased in over the period 2022–27. - No consensus reached on regulatory treatment of sovereign exposures as of the discussion paper published December 2017. - BCBS noted all members implemented the liquidity coverage ratio (LCR); only 11 of 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 LCR and NSFR by material currency but does not include minimum liquidity requirements per currency. - The market risk framework was revised with an implementation deadline of January 2022. - Insurance companies - Risk-based capital standards are expected to be adopted for internationally active insurance groups by end-2019, with a five-year monitoring period prior to final review and international agreement and adoption. - Implementation of economic and risk-based capital frameworks would encourage insurers to minimize duration mismatches; current low and negative yield environments may mask these mismatches under standard formulas (for example, Solvency II). - IAIS released guidance on liquidity management and planning and is developing a holistic framework for systemic risks in the insurance sector. - Investment funds - Work is ongoing on leverage measures for investment funds; IOSCO expected to finalize its leverage report by end-2019. - The February 2018 IOSCO report on liquidity risk management includes new recommendations, with an assessment on implementation expected in 2020. - Abbreviations used: BCBS = Basel Committee on Banking Supervision; GSIB = globally systemically important bank; IAIS = International Association of Insurance Supervisors; IOSCO = International Organization of Securities Commissions. ### LIBOR transition and ESG considerations - Market participants need to prepare for the transition from LIBOR to alternative risk-free interest rate benchmarks. - Authorities are actively consulting the market, but issuance of new products based on LIBOR continues. - Continued reliance on LIBOR and 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 new benchmark rates. - Environmental, social, and governance (ESG) principles: - ESG considerations are increasingly important for borrowers and investors (see Chapter 6). - Closing data gaps is crucial for efficient pricing of externalities, risk mitigation, 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; financial sector policies for mitigating climate change are discussed in the Fiscal Monitor. ### Case study: recent bank interventions in China — implications and vulnerabilities - Events and market reactions: - In late May, Chinese authorities took over Baoshang Bank, imposing marginal haircuts on corporate and interbank depositors; this raised the possibility of creditor losses for the first time in two decades. - 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; there were no haircuts for depositors in the Jinzhou and Hengfeng cases. - Interbank funding markets became strained; the 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 fell sharply for weaker borrowers. - Underlying vulnerabilities highlighted: - Liquidity, funding, and solvency risks: these banks relied on wholesale funding and held a large share of risky nonloan assets; they faced low capital and weak profitability similar to other small and medium-sized banks. - Interlinkages: banks relying on NCD funding are often large investors or guarantors of investment vehicles that themselves invest in such certificates and bank debt, creating circularity and interconnectedness that amplify shock transmission. - Maturity mismatches in investment vehicles (wealth management products, asset management products, trust beneficiary rights) relying on short-term wholesale funding to finance long-term credit, including loans to local governments. - Policy implications: - The liquidity and funding squeeze is likely to increase pressure on banks to raise deposit funding while paying more for other sources, sharpening the trade-off between resilience and 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’ differing approaches to Baoshang, Jinzhou, and Hengfeng reflect institution-specific assessments; 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 — scenarios and policy implications - Methodological notes: - The GaR specification for the United States here uses a financial conditions index containing only price of risk variables; information on vulnerabilities is included separately via a financial vulnerability index for the private nonfinancial sector (households and nonfinancial companies). - The private nonfinancial sector vulnerability index is a credit-weighted aggregate of corporate and household financial vulnerability indices; it is orthogonalized with respect to the financial conditions index to disentangle effects. - Counterfactual scenarios considered: 1. Implications of the level of private nonfinancial sector vulnerabilities: - A baseline GaR specification incorporating financial conditions and the vulnerability index suggests 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. 2. Impact of a 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 and financial conditions are tightened, near-term risks to growth rise relative to the baseline, but medium-term risks are significantly reduced. - Policy implication: - Policymakers should adopt policies aimed at reducing vulnerabilities while these vulnerabilities are still low and financial conditions are relatively easy. *Italicized 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 ### Model setup and data - Growth-at-Risk (GaR) model for the United States uses private nonfinancial (PNF) financial vulnerability indices (FVIs) constructed as a credit-weighted aggregate of corporate and household FVIs. - FCI = financial conditions index. - Sources: Bank for International Settlements; Bloomberg Finance L.P.; Haver Analytics; and IMF staff calculations. - Note: In panels 1–3, the lines indicate pairs of near- and medium-term forecasts and do not denote a linear relationship between the two horizons. ### 1. Baseline: Near- and Medium-Term Risks (as of 2019:Q3) - In the baseline specification, medium-term risks are higher than near-term risks. - Baseline as of 2019:Q3 ### 2. Impact of Changing Vulnerability Levels - Assuming financial conditions are unchanged, a higher level of vulnerabilities would raise medium-term risks more than near-term risks. - Vulnerability level: High - Vulnerability level: Low ### 3. Impact of Tightening Financial Conditions - Scenario: 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. - In contrast, when vulnerabilities are high, a tightening in financial conditions increases risks at both time horizons relative to the baseline. - Financial conditions: Tight - Vulnerability level: Low - Vulnerability level: High ### Key numerical values shown in the figure panels and annotations - –1.24 - 1.56 - –3.0 - 2.0 - 0.0 - –1.0 - –2.0 - 1.0 - 0.5 - –0.5 - –1.5 - –2.5 - 1.5 - 2.5 *Source: IMF staff calculations, Box 1.2, Global Financial Stability Report: LOWER FOR LONGER (October 2019).* ### Section 2 of Online Annex 1.1 for details. ### Section 2 of Online Annex 1.1 for details. ### Corporate performance and outlook - Debt-at-risk is defined as debt at firms with an interest coverage ratio (ICR)—defined as the ratio of earnings before interest and taxes to interest—below 1. - Speculative-grade debt is defined as debt at firms with implied speculative-grade ratings based on ICR and net debt to assets. - Recent observations: - Corporate earnings forecasts have been revised down since April. - Dispersion in analysts’ forecasts (uncertainty about future earnings) has recently increased. - Corporate bond spreads are very low by historical standards and appear compressed relative to fundamentals, reflecting strong investor risk appetite. - Misalignments are relatively large in the United States and moderate in Europe. - Declining interest rates have led to outflows from loan mutual funds and inflows into bond funds, further suppressing bond yields. - Bank lending standards have broadly eased since 2016 in both the United States and the euro area, with a modest tightening for small firms in Europe. ### Funding conditions, issuance, and leverage - Global issuance of corporate bonds and syndicated loans has remained robust and still dwarfs equity issuance. - Relative to GDP, corporate debt has continued to rise in several major economies, particularly the United States, Germany (though from low levels), and Japan. - The bulk of the recent increase in US corporate debt was funded by leveraged loans and private lending. - Financial risk-taking trends: - Payouts (dividends and share buybacks) at US large firms have grown to record high levels; debt-funded payouts have increased since 2017. - Smaller firms have increasingly used leveraged loans and high-yield bonds to fund payouts. - M&A volume has surged to record levels in the United States; markups on intangibles associated with debt-funded M&A by US large firms have risen significantly. - Highly leveraged deals accounted for close to 60 percent of LBO activity over H1 2019. - Earnings add-backs in M&A and LBO deals have reached record highs and could understate the extent of leverage. ### Riskiness of lending and nonbank intermediation - The riskiness of credit allocation rose significantly in major advanced economies from 2016 to 2018, particularly because of nonbank lenders. - Europe: rapid expansion of the nonbank segment of the leveraged loan market (institutional loans) and weakening covenant protections. - United States: provision of credit, especially to risky firms, has shifted further to nonbanks; credit quality of new loans continues to deteriorate. - The share of highly leveraged deals has grown and now surpasses precrisis highs. - Significant growth in the nonbank private lending market, which has reached nearly $1 trillion. - Private debt funds currently hold the largest exposure and dry powder across loans to SMEs; search for yield and competition have led to weaker underwriting standards and rising leverage. ### Corporate debt vulnerabilities and metrics - The IMF staff analysis focuses on: 1. Debt-at-risk: debt at firms with ICR below 1. 2. Speculative-grade debt: debt at firms with ICR less than 4.1 and net debt-to-assets ratio greater than 0.25. Net debt is gross debt minus cash. - Country-level observations since 2009: - China: SMEs remain highly profitable, large firms (including state-owned enterprises) have relatively weak profitability. - Europe and Japan: profitability close to median global levels. - United States: large firms remain highly profitable; SMEs have weak profitability. - Interest costs have broadly declined; wedges in interest costs between large firms and SMEs remain significant in China and the United States. - Debt-to-assets ratios have declined in Europe and Japan and more recently in China; debt ratios remain elevated at large firms in several countries and have risen to record levels at US large firms. - Debt-at-risk (share of total debt) in the SME segment has risen to high levels in the United States and remains elevated in the United Kingdom and some euro area countries. - Debt-at-risk at large firms has declined to relatively low levels in Japan and the United States but remains elevated in the United Kingdom and, to a lesser extent, in China. - Aggregate credit-quality shares: - The estimated share of speculative-grade debt in total corporate sector debt is now nearly 50 percent in China and the United States and is even higher in Italy, Spain, and the United Kingdom. - The share of debt-at-risk in total corporate sector debt is above 25 percent in the United Kingdom and the United States. ### Adverse scenario and projections - Adverse scenario calibration: - The same GDP shock is applied to all the countries—at half the average severity of the global financial crisis in terms of declines in GDP growth. - Interest rates paid by firms rise to half the level in the global financial crisis. - Under the adverse scenario (based on the IMF staff corporate bonds valuation model): - Spreads are projected to widen significantly as corporate fundamentals deteriorate and economic uncertainty rises. - Firms would face lower profits and, given heavy debt loads, valuation pressures, and likely limited market liquidity, would not be able to deleverage quickly. - Debt-at-risk rises quickly as weaker profits and higher interest costs lower ICRs. - In France and Spain, debt-at-risk approaches levels seen during previous crises; in China, the United Kingdom, and the United States it exceeds these levels—despite the shock being only about half the global financial crisis severity. - The increase in debt-at-risk is partly explained by post-crisis growth in indebtedness and by migration of speculative-grade debt into the debt-at-risk category. - Deterioration drivers: - China and the United Kingdom: driven mainly by large firms. - France and Spain: attributable to both large firms and SMEs. - Aggregate outcome for the eight economies analyzed: debt-at-risk would amount to $19 trillion, or nearly 40 percent of total corporate debt, in the adverse scenario in 2021. *Section 2 of Online Annex 1.1 for details.* ### 1. Nonfinancial Firms: Profitability ### 1. Nonfinancial Firms: Profitability ### Profitability trends - Since 2009, profitability (EBIT to assets, aggregate) has improved at European SMEs, Japanese firms, and US large firms. - Data for 2019 are estimates. E = estimated; EBIT = earnings before interest and taxes; SME = small and medium-sized enterprise. ### Effective interest rates and cost of debt - Most firms have benefited from easy financial conditions, with little differentiation in costs by firm size in Europe and Japan. - The analysis covers aggregate interest-to-debt outcomes across the Euro area, Japan, United Kingdom, United States, and China. ### Debt levels and leverage - Debt-to-asset ratios have declined in Europe and Japan, but increased at US firms. - Debt-at-risk (debt at firms with EBIT-to-interest ratios below 1) has fallen in the euro area, Japan, and at US large firms but has remained elevated at UK firms and has risen in China and at US SMEs. ### Sample coverage and data scope - The sample includes about 1.3 million firms from Orbis, 10,000 firms from Capital IQ, and 10,000 Chinese firms from WIND. - The sample’s coverage based on aggregate corporate debt from the Bank for International Settlements and national sources is at least: - 44 percent in China - 38 percent in France - 55 percent in Germany - 53 percent in Italy - 51 percent in Japan - 62 percent in Spain - close to 100 percent in the United Kingdom - 39 percent in the United States ### Speculative-grade debt and debt-at-risk - The shares of speculative-grade debt and debt-at-risk remain significant in China, the United Kingdom, and the United States, but have declined in Japan. - In the euro area, credit quality has improved, but the shares of speculative-grade debt are still sizable. - ICR = interest coverage ratio. Debt-at-risk is defined as debt with ICR < 1. - Aggregate corporate debt in France includes intercompany debt. ### Stress scenarios and projections - Corporate credit quality is projected to weaken in a stress scenario emulating half the severity of the global financial crisis. - In an adverse scenario, the debt-at-risk is estimated to approach crisis levels in France, Spain, and the United Kingdom. - The debt-at-risk in China is found to be very sensitive to deteriorations in growth and funding conditions and surpasses postcrisis crests in the adverse scenario presented. - The analysis uses the corporate bond spread valuations model; corporate bond spreads could widen significantly in a stress scenario with weaker growth, higher economic uncertainty, and reduced investor risk appetite. ### Financial institutions’ exposures and investor-base shifts - High corporate debt-at-risk may translate into higher credit losses for financial institutions with significant exposures to corporate loans and bonds. - Smaller and regional banks are more exposed to the SME segment, which is relatively weak in several European countries and in the United States. - In the euro area and China, a large fraction of corporate loans comes from banks. - In the United States, bond and institutional leveraged loan holders face weakening credit quality; US regional banks are more exposed to SMEs and risky commercial real estate loans and increasingly buy tranches of syndicated leveraged loans. - Liquidity risks could be higher in a downturn, given that the shares of bonds held by mutual funds and exchange-traded funds, as well as by foreign investors, have risen. - Capital market instruments have gained in prominence in the United States, whereas bank lending remains prevalent in the euro area and China. - Mutual fund ownership of US corporate bonds has increased more than 150 percent from levels before the global financial crisis. ### Key regional assessments (conclusions) - China: - Overall corporate debt is very high, and the size of speculative-grade debt is economically significant, mainly because of large firms, including state-owned enterprises. - Debt-at-risk in China is very sensitive to deteriorations in growth and funding conditions and surpasses postcrisis crests in the adverse scenario. - Assessment is complicated by implicit government guarantees and the lack of granular data on corporate sector exposures. - Europe: - Progress in deleveraging since the euro area debt crisis has been significant; both aggregate corporate debt and debt-at-risk have declined in major economies. - The window for an organic cyclical improvement in credit metrics has likely closed; sales and profits at large firms in the euro area appear to have weakened more than at their US peers this year. - Levels of speculative-grade debt and debt-at-risk are already high in several countries—mainly because of SMEs. Small and medium banks have large exposures to SMEs. - United States: - Solid fundamentals at large firms and easy financial conditions have boosted corporate valuations. - Financial risk-taking by nonfinancial companies has increased, often funded by debt. - Rapid growth in the risky leveraged loan and private credit segments is of particular concern. - The US SME segment is relatively weak, contributing to elevated speculative-grade debt and debt-at-risk. ### Policy recommendations - Address corporate vulnerabilities urgently and reduce policy uncertainty to minimize the likelihood of an adverse scenario. - Financial regulation and oversight should remain robust and rigorous; consider broadening the regulatory and supervisory perimeter to include nonbank financial intermediaries, especially those with large exposures to firms. - Regulators and supervisors of regional banks should closely monitor and address sizable exposures to potentially vulnerable nonfinancial firms and commercial real estate through adequate risk management, provisioning, and capital buffers. - Improve disclosures at nonbank financial institutions, including their exposures; enhance transparency in the growing private debt market, including through collection of data on cross-border exposures. - More countries should actively use macroprudential tools to increase financial systems’ resilience and to cool down credit growth where it may pose risks to financial stability: - Broad-based macroprudential tools (such as countercyclical buffers) should be activated preemptively in countries where economic conditions are still relatively benign or financial conditions are still loose. - Where credit developments are a concern in a particular sector, conduct targeted stress tests at banks and consider targeted sectoral capital buffers for banks or increase risk weights on such exposures. - Consider developing prudential tools for highly leveraged firms. - Countries should reduce potential debt bias in tax systems—which allows firms to deduct at least some interest expenses and thus may encourage excessive corporate borrowing. *Source: IMF Global Financial Stability Report: Lower for Longer (October 2019), Chapter 2 — Global Corporate Vulnerabilities: riskier business.* ### References ### text - References ### Bibliographic References - Aikman, David, Andrew G. 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Celina Vansetti. 2019. “US Banks—Rising Leveraged Lending Risks Are Contained, Barring Adverse Turn in Operating Environment.” Moody’s Investor Services, New York. ### Chapter summary — Institutional Investors: Falling Rates, Rising Risks - Key context and framing: - Persistently low and declining yields on fixed-income instruments have continued to drive institutional investors to use leverage and invest in riskier and less liquid assets. - The monetary policy cycle may have reached a turning point in major advanced economies (Chapter 1). - The amount of global bonds with negative yields has reached almost $15 trillion (Figure 3.1, panel 1). - Besides accommodative monetary policies, aging trends and low productivity in most advanced economies are adding further downward pressure on interest rates. - Observed investor behavior and exposures: - Fixed-income investment funds have: - Invested in assets of lower or even unrated credit quality (Figure 3.1, panel 2). - Increased their effective average portfolio maturities (Figure 3.1, panel 3). - Decreased their liquidity buffers. - Fund samples include fixed-income funds domiciled in all major economies, with shares denominated in all major currencies and with assets of at least $1 billion. They represent some 60 percent of the global bond fund industry’s assets of $10.5 trillion (as of March 2019). Funds are denominated in US dollars (70 percent), euros (10 percent), and other currencies (20 percent). - Pension funds: - Defined-benefit pension liabilities (sample of Dutch, UK, and US defined-benefit pensions with $5.5 trillion in assets as of 2019:Q1) have increased sharply when long-term interest rates have fallen (Figure 3.1, panel 4). - Largest pension funds’ notional derivatives positions have risen to 155 percent of net assets, on average, from 95 percent in 2011 (Figure 3.3, panel 1). - Asset allocation data of 700 of the largest pension funds represent $13 trillion in assets (panel 5 basis). - Pension funds have increased exposure to long-duration assets and alternative asset classes with long lockups, including private equity, real estate, and infrastructure. - Life insurers: - Exhibit gaps between guaranteed returns and domestic sovereign bond yields and duration mismatches, notably for some European countries (including Germany) and major Asian insurers (Figure 3.1, panel 6). - The nine countries in panel 6 are the largest life insurance jurisdictions, accounting for 73 percent of the world’s life insurance premiums. - Risks and transmission channels: - Increased demand for risky assets from institutional investors may boost asset prices and encourage more borrowing by nonfinancial firms. - Rising balance sheet vulnerabilities could force institutional investors to react to shocks in ways that amplify market and economic impacts. - Key amplification mechanisms identified: - Mismatch between illiquid asset holdings and promise of daily liquidity may pressure funds to sell into illiquid markets during redemptions, exacerbating price declines. - Increasing portfolio similarities (higher correlation between top and bottom deciles of fixed-income fund returns) raise potential for rapid transmission of shocks across funds and markets. - Contingent calls from illiquid pension fund investments could constrain pension funds’ liquidity and reduce their stabilizing role during stress. - Cross-border allocation by insurers could propagate shocks across markets even when sell-offs are triggered by seemingly unrelated factors. - Evidence of rising conformity: - Return correlations of fixed-income funds have increased as sovereign yields declined (Figure 3.2, panel 1). - Funds show rising home currency exposures and lower cash positions during low-yield periods (Figure 3.2, panel 2). - Average return sensitivity of fixed-income funds to proxies for market illiquidity tends to rise as sovereign yields fall (Figure 3.2, panel 3). - Fixed-income funds increased their share in riskier US corporate credit markets (Figure 3.2, panel 4). - Empirical and data notes: - Panel 4 (Figure 3.1) pension liabilities are drawn from a sample with $5.5 trillion in assets as of 2019:Q1; interest rate shown is simple average of Dutch, UK, and US 10-year government bond yields at the end of the quarter. - Panel 5 is based on asset allocation data of 700 of the largest pension funds, representing $13 trillion in assets. - For fixed-income fund sensitivity estimation (Figure 3.2, panel 3), models use bivariate vector autoregression with 48-month rolling windows for each estimation over March 2009–March 2019. - Return sensitivities are evaluated at the 5 percent significance level and aggregated on an asset-weighted basis. - Monitoring and policy implications (as stated in the chapter): - The underlying vulnerabilities associated with increased institutional risk-taking could amplify shocks and should be closely monitored and carefully managed. - Specific areas for attention include: - Liquidity mismatches in fixed-income funds and potential for forced sales into illiquid markets. - Growing portfolio similarities across funds and resulting systemic transmission channels. - Pension funds’ increasing exposure to illiquid investments and large notional derivatives positions. - Life insurers’ duration mismatches and cross-border investment exposures that may facilitate shock propagation. *International Monetary Fund | October 2019* ### CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS ### CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS ### Financial leverage, derivative use, and liquidity risks in pension funds - Financial leverage has grown, particularly when net assets are adjusted for illiquid assets that are typically not available to repay borrowing and have separate and undisclosed embedded leverage. - Use of derivative- and leverage-based strategies has grown, increasing market and liquidity risk related to margin calls. - Pension funds dynamically adjust interest rate hedges: in the Netherlands, the sensitivity of the interest rate derivatives portfolio to changes in interest rates increased when rates fell and declined when rates were expected to rise. This active management magnifies gains when rates fall and limits losses when rates rise but can contribute to procyclicality in interest rate markets. - Alternative investments typically entail leveraged exposures to assets with stretched valuations, such as corporate equity and debt in leveraged buyout deals. - Margin calls on derivative positions in stress periods can create sizable contingent liquidity demands that can be met only by selling or lending other assets or by closing out the position. - Capital commitments on alternative asset investments may be more likely to be drawn on a net basis following periods of severe market stress, creating liquidity outflows; during the global financial crisis investors experienced net liquidity outflows as managers called in capital commitments while distributions from previously drawn commitments fell. - Liquidity buffers have declined relative to alternative investments in many pension funds: - For approximately 20 percent of pension fund assets under management, estimated capital commitments related to alternative investments are more than half of their liquid assets. - Drawdowns of alternative asset capital commitments following market stress would be in addition to potential liquidity requirements related to derivative and leveraged positions, for which there are insufficient data. - Given higher liquidity risks, pension funds will likely have to set aside more of their liquid assets to cover potential outflows during and after periods of stress, especially if market funding becomes more expensive, reducing their ability to invest countercyclically and play a stabilizing role. - Pension funds’ dynamic adjustment of leverage-based strategies could also increase volatility during periods of rapid increases in interest rates. ### Quantitative indicators and specific figures (as presented) - Sample of 11 of world’s 50 largest defined-benefit pension funds with available data represents $2 trillion in assets; adding nine funds adds an additional $1 trillion in assets. - Panel-level figures referenced: 2018 = 653; 2011 = 409; 2018 = 398; 2011 = 62, 2018 = 84; 2011 = 142, 2018 = 177 (as labeled in figure panels). - For ~20 percent of pension fund assets under management, estimated capital commitments related to alternative investments are more than half of their liquid assets. ### Increased cross-border portfolio allocation by life insurers and new transmission channels - Low domestic yields and larger-than-average spreads between return guarantees and local yields have driven Asian life insurers (Japan, Korea, Taiwan Province of China) to search for yield, increasing their foreign assets to nearly $1.5 trillion, almost double the amount five years ago. - Given relatively small domestic corporate bond markets, foreign corporate bonds represent an attractive investment for these insurers; a significant share has been in US dollar credit, the largest credit market globally. - The Asian insurers’ combined share of the US dollar credit market has risen to 11 percent from 8 percent over the past five years. - Taiwan Province of China life insurers added $0.25 trillion in new investment in US dollar–denominated credit during 2013–18, equivalent to almost 15 percent of the increase in market capitalization over the period. ### Life insurers from Taiwan Province of China: concentration and vulnerabilities - Foreign exposures for Taiwanese life insurers have grown rapidly to more than two-thirds of their assets over the past five years, significantly above peer levels. - About one-quarter of their foreign currency investments are unhedged. - Capital adequacy of Taiwanese insurers is weaker relative to peers. - Taiwanese insurers’ investment has risen to more than $400 billion, or 7 percent of all corporate and bank bonds outstanding denominated in US dollars. - Their exposure is concentrated in dollar bonds of non-US issuers, where they hold an estimated 18 percent of bank debt and 9 percent of corporate bonds. - These concentrated holdings make them increasingly vulnerable to shocks such as further declines in US interest rates or a weaker US dollar vis-à-vis the Taiwan dollar. - Life insurers from Taiwan Province of China own a growing share of US dollar credit from non-US bank issuers and are also vulnerable to a sharp depreciation of the US dollar versus the new Taiwan dollar. - Their large holdings of US dollar callable bonds are associated with large dealer short option exposures; lower rates increase the risk of these bonds being called, triggering the unwinding of hedging positions and a volatility spike. - FX volatility reserves for Taiwanese life insurers dropped to 29 percent of the previous year level (panel note). ### Policy implications and systemic transmission risks - Larger contingent liquidity demands from margin calls and capital calls could force pension funds and insurers to liquidate assets into stressed markets, amplifying price moves and market volatility. - Increased cross-border allocations, concentrated holdings in US dollar credit, and currency mismatches can create new cross-border risk transmission channels, particularly for jurisdictions with weaker capital buffers. - Where liquidity buffers are insufficient, pension funds and life insurers may be less able to act countercyclically, potentially transmitting stress to sponsoring governments and firms via increased contingent liabilities. *CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS — Global Financial Stability Report (October 2019), International Monetary Fund* ### CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS ### CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS ### Risks from falling US rates, callable bonds, and currency movements - Currency losses could reduce demand for new investments or force sales to raise capital following a sharp depreciation of the US dollar. - A further decline in US rates could amplify interest rate volatility and losses for Taiwan Province of China life insurers through large holdings of US dollar callable bonds. - Exposures related to the embedded options in US dollar callable bond holdings amounts to $300 billion, roughly equivalent to half of the exposures from hedging privately held mortgage-backed securities. - Callable bonds are more likely to be redeemed early when interest rates decline; if bonds are called, unwinding of related hedges could further increase interest rate volatility and induce large losses on unhedged callable bond holdings, raising prospects of spillovers to US dollar credit markets. ### Policy actions to reduce buildup of vulnerabilities - Investment funds: - Introduce minimum eligibility criteria (based on credit quality and liquidity) for asset inclusion in fixed-income funds’ portfolios to help lessen credit risks and liquidity mismatches. - Require funds to better match redemption periods to the liquidity profiles of their portfolios to mitigate potential for fire sales. - Enhance guidance for frequent and rigorous stress testing and appropriate disclosures of risks to ensure minimum standards for liquidity risk management. - Provide appropriate labeling of funds to increase transparency on liquidity risks. - Harmonize standards for the measurement of leverage to help identify and mitigate vulnerabilities. - Pension funds: - Regulation, governance, and disclosure should more explicitly consider risk from illiquid assets and synthetic leverage. - Require reporting of detailed and standardized calculations of projected liquidity inflows and outflows during periods of stress, and exposure to market risks. - Consider limiting risks associated with guaranteed benefits by adopting cost-sharing arrangements that link a portion of pension payouts to market performance. - Life insurance companies: - Adopt a globally harmonized minimum solvency standard to reduce vulnerabilities and limit spillovers across jurisdictions. - Implement capital requirements for insurance groups globally to help prevent regulatory arbitrage. - Consider policies that serve as a disincentive to new life insurance products offering guaranteed returns. ### Fire-sale and redemption risk for open-ended investment funds - Open-ended investment funds typically offer daily share redemptions for cash; during stress, funds may be unable to cover redemption requests with available liquid assets, cash reserves, or credit lines, which can force fire sales and amplify asset price volatility and systemic risk. - Alternative means to mitigate redemption pressure include pricing to discourage or delay redemptions and stops or restrictions on redemption, such as gating of redemptions. ### Box 3.1 — Liquidity stress scenarios for fixed-income funds: key findings - Sample and methodology: - Liquid assets include cash and assets that can be sold quickly, following the principles of the Basel III standard for high-quality liquid assets (HQLA) and an adjusted variant, alternative high-quality liquid assets (AQLA). - Redemption shocks are assumed equivalent to the worst percentile of funds’ monthly asset outflows during 2000–19; if these shocks cannot be absorbed, funds suffer liquidity shortfalls. - Aggregate and cross-sectional results: - The total liquidity shortfall of fixed-income funds with $10.5 trillion in assets under management is estimated at $160 billion (as of March 2019). - Funds with estimated liquidity shortfalls account for almost one-sixth of all fixed income fund assets and nearly half of all high-yield fund assets. - The average shortfall (calculated as a share of assets of all fixed-income funds) has increased by about one-third over the past two years to about 1.5 percent. - In terms of the assets of funds with liquidity shortfalls, the average shortfall has remained stable at 10 percent. - For a weak tail of one-fifth of these funds, the shortfalls exceed 20 percent of assets. - Larger funds typically face lower redemption stress, allowing them to hold less cash, and diversified portfolios provide them with more ample liquidity. - Shortfalls of funds in the euro area are higher than those of US-based funds. ### Emerging and frontier markets — portfolio flows and external factors - External financing conditions for emerging markets were broadly favorable in 2019 despite a gloomier outlook for trade and global growth. - Equity flows suffered most from trade tensions; debt portfolio inflows rebounded in 2019, led by strong inflows into hard currency bond markets. - Lower rates and positive investor sentiment supported asset prices and portfolio flows to emerging and frontier markets in 2019. - Drivers and magnitudes: - Risk appetite rebounded after the global equity sell-off in late 2018, boosting demand for emerging market bonds by an estimated $25 billion. - Ten-year Treasury yields have declined by over 100 basis points so far this year, boosting inflows by some $20 billion. - Risks and vulnerabilities: - With private and public debt already high in some countries, easy financing conditions may encourage excessive buildup of debt, raising rollover and debt sustainability risks. - Overindebted state-owned enterprises (SOEs) may find it hard to maintain market access and service their debt without sovereign support. - For frontier market economies, a growing reliance on external debt may increase the risk of debt distress. - These risks may materialize in a significant growth slowdown or if an escalation of trade tensions sparks a sharp tightening of financial conditions. - Model estimates: - Model estimates of capital flows-at-risk suggest that medium-term downside risks have moderated relative to the end of 2018, but remain elevated by historical standards. - The reduction in US Treasury yields is the key driver behind reduced downside risks to the debt portfolio flows in the medium term; this benign effect is partially offset by slower growth in emerging market economies and the decline in portfolio flows observed over the past year. *Source: CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS, Global Financial Stability Report: Lower for Longer, October 2019.* ### CHAPTER 4 EMERGING ANd FRONTIER MARkETS: MINd ThE dEBT ### CHAPTER 4 EMERGING ANd FRONTIER MARkETS: MINd ThE dEBT ### Emerging market hard-currency bond valuations and spread dynamics - Median emerging market bonds are currently fairly valued relative to countries’ economic fundamentals and financial conditions. - Bonds in more than one-third of countries are estimated to be somewhat or significantly overvalued. - High-yield (lower-rated) issuers are more overvalued than investment-grade issuers: - Half of the lowest-rated (B and lower) issuers are estimated to be overvalued when weighted by GDP. - 8 percent of higher-rated (BBB and higher) issuers are estimated to be overvalued. - External factors have been the dominant driver of recent EMBIG spread tightening, notably a rebound in global risk appetite in 2019. - Sensitivity of EM credit spreads to global risk-aversion shocks has increased: - A 100 basis points increase in US BBB corporate spreads could widen spreads of B-rated emerging market bonds by more than 200 basis points. - The same shock would widen spreads of A-rated emerging market issuers by 50 basis points. - Changing investor base (greater exposure to benchmark-driven and potentially “flighty” investors) raises the risk of sudden repricing and swift investor exodus, threatening market access for lower-rated borrowers. - Historical context: Overvaluation was significantly more pronounced in 2006 and in April 2018 before the emerging market sell-off. ### Continued easy financing conditions and rising external and government debt - Median external debt has risen from 100 percent of exports in 2008 to 160 percent in 2019. - In some countries the external-debt-to-exports ratio has increased to more than 300 percent. - Government debt is nearing 100 percent of GDP in some countries. - Corporate sector creditworthiness has deteriorated alongside rising corporate leverage. - Corporate debt-to-GDP has risen in many emerging market economies. - Countries that have not addressed vulnerabilities during the favorable period face higher risk of capital flow reversals and higher borrowing costs if global financial conditions tighten. ### Overindebted state-owned enterprises (SOEs) - Debt issued by fully government-owned SOEs comprises one-third of the entire emerging market sovereign hard currency bond universe. - If all SOEs (including majority-owned) were combined in emerging market corporate indices, they would make up half of corporate debt securities. - SOE leverage has increased markedly since 2007, with leverage rising most notably in oil and gas SOEs; emerging market oil and gas SOE leverage has nearly doubled since the global financial crisis. - Despite higher leverage, SOE profitability has declined: the median return on invested capital has fallen significantly since the financial crisis. - SOE creditworthiness has deteriorated since the financial crisis; the average rating of SOE firms in the sample has worsened while sovereign ratings have been on average stable. - Most SOEs now generally trade wider than their sovereigns, although many still trade close to sovereign spreads; rating agencies often assume an implied credit uplift from the sovereign when assigning SOE ratings. - SOE–sovereign spillovers have increased: widening in major SOE spreads can spill over to sovereign spreads, and spillovers from SOEs to sovereigns have been rising in recent years (Jan. 2013 = 100 index used). - A shock to SOEs could have substantial fiscal implications, particularly where SOE debt is large relative to government debt. - Loss of an investment-grade rating may have a larger impact on emerging market SOEs than on comparable firms in developed markets because the pool of available high-yield corporate investors is narrower. ### Frontier market issuance, composition, and vulnerabilities - Yields on frontier market bonds declined in 2019 following a spike at end-2018; the rally was driven largely by favorable external conditions rather than domestic fundamentals. - Outstanding hard-currency debt of frontier markets has tripled over the past five years to reach more than $200 billion as of mid-2019. - For the median frontier borrower: - Outstanding hard-currency bonds have grown to 7 percent of GDP. - Outstanding hard-currency bonds are close to half of gross reserves. - In 2014 these figures were 3 percent of GDP and 20 percent of reserves, respectively. - The weaker upper quartile of frontier issuers have increased their stock of debt to almost 140 percent of reserves. - New financing sources have altered external-debt composition and increased vulnerabilities: - A rising share of commercial debt (primarily hard-currency bonds) as issuers rely more on banks, capital markets, and private lenders. - Private external debt servicing costs, including interest payments, are set to continue rising, mainly because of rising debt servicing costs for hard-currency bonds. - Several issuers (Angola, Gabon, Tunisia, Zambia, Belize, Ecuador, Jamaica) face substantially rising or elevated future private-sector debt service obligations. - Non–Paris Club bilateral loans (including from China) are a growing share of official bilateral credit for many low-income developing countries; a large proportion of these loans is to SOEs. - A significant share of exposure to non–Paris Club creditors may not appear in government debt statistics because many loans are to SOEs and reporting often covers only central government debt. - The share of countries at high risk of debt distress has continued to increase, underscoring the need for enhanced creditor coordination between Paris Club and non–Paris Club creditors to support timely and sustainable outcomes. *Source: CHAPTER 4 EMERGING ANd FRONTIER MARkETS: MINd ThE dEBT (text), Global Financial Stability Report: Lower for Longer, October 2019.* ### 4. Hard Currency Debt Redemptions of Frontier Markets ### 4. Hard Currency Debt Redemptions of Frontier Markets ### Key findings - Favorable external conditions have allowed frontier issuers to fund themselves at attractive yields lately. - Reliance on hard currency debt issuance is set to reach a new high in 2019. - Rollover needs are low for many issuers in the coming years but are set to rise. - The composition of external debt has shifted toward a higher share for private sector debt, particularly for frontier markets. - Bonds are driving the increase in private debt servicing costs. - The share of countries at high risk or already in debt distress has increased since 2013. ### Debt vulnerabilities and composition - A high stock of debt backed by collateral has been revealed in recent debt distress cases and new IMF programs (particularly in sub-Saharan Africa), including commodity-linked loans from the private sector or through bilateral official lending. - Some issuers (such as Ecuador and Egypt) and domestic banks have relied on repurchase agreements from international banks using sovereign debt as collateral at significant haircuts. - Such arrangements can constrain issuer options in debt restructuring, lower recovery for unsecured creditors, and increase liquidity risks. - Vulnerabilities linked to collateralized debt are compounded by poor debt recording, monitoring, and reporting practices of many issuers (Group of Twenty 2018). - Frontier low-income developing countries (LIDCs) are a subset of frontier market economies that have a risk rating using the Debt Sustainability Framework for Low-Income Countries. About 45 percent of frontier issuers had such a risk rating in the panel 6 example. ### Trends in debt sustainability and public indebtedness - The share of low-income developing countries assessed at high risk of debt distress or in debt distress under the IMF’s debt sustainability framework (IMF 2018b) has doubled since 2013 to 43 percent. - Even for countries assessed at low or moderate risk of debt distress, debt servicing capacity has deteriorated. - Median public debt: - For low-income developing countries has risen by 13 percentage points of GDP since 2013 to about 46 percent of GDP in 2018. - For frontier issuers, median debt has risen by close to 20 percentage points of GDP to about 55 percent. ### US dollar funding and non-US banks (relevant context) - US dollar–denominated assets of non-US banks amount to more than $12 trillion, compared with $10 trillion just before the onset of the crisis. - US dollar assets of global non-US banks increased from $9.7 trillion in 2012 to $12.4 trillion by early 2018. - Non-US banks’ participation in US dollar intermediation provides benefits but is also a potential source of risk because stable US dollar deposits outside the United States are insufficient to fund all global US dollar credit. - Other sources of US dollar funding (US branches and subsidiaries, foreign exchange swaps) tend to be wholesale, short term, and volatile, and are subject to sizable refinancing risk. ### Policies to contain excessive buildup of debt (recommendations) - Emerging market authorities should maintain strong policy and institutional frameworks and rebuild policy space, where possible, to guard against rising global policy uncertainty and escalating trade tensions. - Financing decisions by borrowers in emerging and frontier markets should be grounded in medium-term debt management strategies, based on an assessment of costs and risks, and borrowed funds must be used efficiently to increase productive capacity. - Issuers should avoid instruments with features that may aggravate financing constraints under downside scenarios. - To increase resilience to external shocks, policymakers should continue developing local bond markets and promoting a stable local investor base. - Given growing debt of state-owned enterprises (SOEs): - Improve profitability, efficiency, and governance of SOEs. - SOEs should rely on well-designed business plans with credible operational and financial targets. - Government guarantees on new and existing debt for systemically important firms should be linked to credible business plans. - New investment plans should be subject to full cost-benefit and feasibility analysis. - Consider enhanced cooperation with private firms for overindebted or inefficient SOEs. - Strengthen transparency and debt monitoring with more detailed disclosure of fiscal spending and guarantees related to SOEs. - For frontier markets specifically: - Containing debt-related vulnerabilities should be the top policy priority. - Countries with elevated debt sustainability risks should limit increases in nonconcessional external indebtedness to investment projects with credibly high rates of return. - Put safeguards in place to match the debt service profile with investment returns, and include contingency features to deal with shocks. - Strengthen efforts to mobilize domestic resources, improve the efficiency of public expenditures, and strengthen management of public investment. - Strengthen public debt recording, monitoring, and reporting, and build capacity to manage public debt. - Take advantage of favorable external conditions to reduce reliance on collateralized debt. - Creditors should emphasize timely resolution of debt distress cases underpinned by efficient creditor coordination processes to minimize the costs for both the issuer and creditors. - Non–Paris Club creditors should consider adopting sustainable lending rules, such as those endorsed by the Group of Twenty. *Source: IMF staff, “4. Hard Currency Debt Redemptions of Frontier Markets,” Global Financial Stability Report: Lower for Longer, October 2019.* ### Annex 5.3. Non-US banks’ US dollar balance sheet aggregates ### Annex 5.3. Non-US banks’ US dollar balance sheet aggregates ### Definitions and balance sheet scope - “International position” (Bank for International Settlements definition) = cross-border positions plus those in branches outside the United States. - “International position plus branches” = international position + US-based branches (primary dataset for econometric analysis in the chapter). - “Foreign position” = international position plus branches + subsidiaries in the United States (used as a robustness check). - Positions at US branches: - Their share surpasses 10 percent in 15 of the 26 economies examined. - Their share is as high as 40 to 50 percent for some economies. - Positions at US subsidiaries tend to be much smaller, except in a handful of cases (see Figure 5.1, panel 4). - Note: The econometric analysis is conducted primarily using international position plus branches; foreign position is used for robustness checks. ### Cross-currency funding gap and cross-currency funding ratio - Cross-currency funding gap = US dollar–denominated assets − US dollar–denominated liabilities. - Cross-currency funding ratio = cross-currency funding gap expressed as a ratio to US dollar assets (approximates reliance on foreign exchange swap market for marginal USD funding). - Key facts: - Mid-2008 peak of the cross-currency funding gap: $1 trillion (or 10 percent of US dollar assets). - Recent level: exceeding $1.4 trillion corresponding to a cross-currency funding ratio of 13 percent of US dollar assets (Figure 5.2, panel 1). - Of the 26 economies, 17 had positive funding gaps as of the first quarter of 2018. - Almost all of the 26 economies had experienced an increase in their gap since 2012. - In economies with positive cross-currency funding gaps, in the first quarter of 2018 the gaps totaled $1.8 trillion—18 percent of US dollar–denominated assets. The bulk of the drop in the gap since early 2016 is attributable to Japan. ### Liquidity and stable funding indicators (US dollar focus) - US dollar liquidity ratio: - Constructed analogously to the regulatory liquidity coverage ratio: holdings of US dollar high-quality liquid assets (HQLA) relative to US dollar net cash outflows over a one-month stress scenario. - Intended to reflect ability to withstand rapid withdrawals of US dollar funding by liquidating US dollar assets. - Caveat: “The liquidity ratio should not be interpreted in strictly the same way as the liquidity coverage ratio: for example, a level below 100 percent does not necessarily represent insufficient liquidity, nor should the liquidity ratio be compared with existing data on regulatory ratios.” - US dollar liquidity developments: - US dollar liquidity of non-US banks has been increasing steadily since the global financial crisis (Figure 5.2, panel 2). - Increase primarily reflects an increase in US dollar high-quality liquid assets (Figure 5.2, panel 3). - Virtually all 14 economies for which this measure is constructed registered notable increases between 2008 and 2018, with a small drop since 2016 attributable to a few European economies and Japan. - US dollar liquidity remains below overall liquidity as measured by an all-currencies liquidity ratio (Figure 5.2, panel 4). - Panels 2 through 6 are based on a subset of 14 economies because of data limitations; panels 3 and 6 were computed using the sample-wide aggregate values. - US dollar stable funding ratio (SFR): - Constructed in the spirit of the net stable funding ratio for the entire balance sheet; reflects ability to fund US dollar assets over a longer horizon using stable funding. - The US dollar stable funding ratio has improved only moderately since the global financial crisis, with little change among components (Figure 5.2, panels 5 and 6). ### Measurement of US dollar funding costs: the cross-currency basis - Cross-currency basis definition: - Calculated as the difference between the cost of funding US dollars directly from the cash market and the synthetic US dollar interest rate obtained when funding in a different currency and swapping that currency into US dollars. - Funding costs in each currency are measured using the relevant London interbank offered rate at one- and three-month tenors. - A positive (negative) currency basis implies that the direct dollar cost is higher (lower) than the synthetic one. - Throughout the chapter, “increase in US dollar funding cost” means widening of the cross-currency basis; that is, it becomes more negative (exception: Australia, which has a persistently positive cross-currency basis). - Cross-currency basis dynamics: - Before the global financial crisis, the cross-currency basis was close to zero across many currencies (covered interest parity held approximately). - During the global financial crisis and the European sovereign debt crisis, the bases became large and negative for many currencies due to impaired interbank markets and limited arbitrage. - Swap lines between the Federal Reserve and several central banks lessened dollar shortfalls and narrowed the basis, but deviations from covered interest parity have persisted and bases have not fully reverted to zero (Figure 5.3, panel 1). - The three-month LIBOR cross-currency basis is shown as monthly averages for selected currencies (Figure 5.3, panel 1). ### Drivers of the cross-currency basis and amplification by funding fragility - Supply-side factors that widen the cross-currency basis: - Heightened risks in interbank funding markets (LIBOR-OIS spread). - High transaction costs (bid-ask spread). - Demand-side factors that widen the cross-currency basis: - Higher default probability of the banking sector in the home economy (average expected default frequency of home economies’ listed banks). - Narrower home economy interest margin relative to the United States (increases incentive to hold USD-denominated investments funded in USD). - US market sentiment: - Rising US risk aversion (proxied by the Chicago Board Options Exchange Volatility Index, VIX) dampens demand for risky USD investments and alleviates pressure on the basis. - Amplification by cross-currency funding ratio (CCFR): - When CCFR is large, non-US banks are more vulnerable to foreign exchange market strains and conditions of swap suppliers; shocks have a stronger impact on the cross-currency basis. - Example: for a given increase in FX implied volatility, an economy with a high CCFR (fourth quintile) will experience a larger widening (on the order of 50 percent) of its cross-currency basis relative to one with a low CCFR (first quintile) (Figure 5.3, panel 2). - Heterogeneity and endogeneity: - There is considerable heterogeneity in determinants of the basis across economies and time. - While CCFR is treated mainly as an independent driver, some interdependence exists; unrestricted panel vector autoregression impulse responses corroborate that the basis responds to shocks to the cross-country funding ratio. ### Regulatory changes and other institutional factors affecting the basis - Quarter-end reporting and leverage ratio reporting: - Since January 2015 (when European banks first required to report quarter-end leverage ratios), seasonal spikes in cost of balance sheet expansion spilled over to global USD funding markets, causing jumps in the cross-currency basis around quarter ends (Figure 5.4, panel 1). - Pressure to adjust balance sheets before reporting dates is stronger for the one-month basis than the three-month basis. - 2016 US money market mutual fund reform: - Associated with the sharpest widening observed in the basis (Figure 5.4, panel 2). - Draining of funds out of prime institutional money market funds (important lenders in wholesale dollar funding) led non-US banks to increase use of synthetic dollar funding, strengthening the relationship between CCFR and the basis. - Other regulatory constraints: - Introduction of the liquidity coverage ratio constrained US banks’ supply of foreign exchange swaps, with a similar effect on the relationship between CCFR and the basis. - Globally important systemic bank capital surcharge and resolution funding requirements phased in since 2016 may also be captured in these effects. ### Macroeconomic scenarios and potential risks - Macroeconomic changes that could widen the basis in home economies of non-US banks: - Increased fiscal pressure and/or widening interest rate gap between the United States and other major economies (tilts term spread differential toward greater demand for USD assets). - US dollar appreciation could have further effects on demand for USD funding and the basis. *Source: Annex 5.3, “Non-US banks’ US dollar balance sheet aggregates,” Global Financial Stability Report: Lower for Longer, International Monetary Fund | October 2019.* ### CHAPTER 5 BANkS’ DOLLAR FuNDING: A SOuRCE OF FINANCIAL VuLNERABILITY ### CHAPTER 5 BANkS’ DOLLAR FuNDING: A SOuRCE OF FINANCIAL VuLNERABILITY ### Summary - The chapter analyzes how rising US dollar funding costs (proxied by widening of the cross-currency basis) affect profitability and financial stress of global non-US banks, cross-border US dollar lending, recipient economies’ ability to substitute funding, and ultimate financial stress in recipient banking systems. - The relationship between US dollar funding costs and financial stress is nonlinear and strongest during large basis increases and episodes of systemic stress (global financial crisis; 2011 US money market fund run on European banks). ### Financial stress in home economies and spillovers to recipients - A 50 basis point increase in the cross-currency basis (equivalent to the average quarterly change at the onset of the global financial crisis) is associated with: - 0.22 standard deviation increase in the probability of banking sector default in the home economy (equivalent to a 7½ percent increase). - An additional tightening by 0.29 standard deviation in domestic financial conditions. - A 50 basis point increase in the funding costs of a recipient economy’s main lenders results in: - 0.1 standard deviation increase in the probability of default of the recipient’s banking sector (a 3.3 percent increase). - Spillovers are quantitatively stronger and statistically significant for the top 10 US dollar cross-border recipients. ### Cross-border lending: magnitude of cutbacks and substitution possibilities - A 50 basis point annual cumulative increase in US dollar funding costs is associated with: - A 5.3 percent reduction in US dollar cross-border lending (full sample). - A 7.1 percent decrease when the lender is an emerging market (all recipients). - A 9.3 percent decrease in lending from emerging market lenders to other emerging market recipients. - Differential vulnerability of recipients: - Emerging market recipients: US dollar lending falls by about –6.6 percent—about twice the effect on advanced economy recipients. - Limited substitution for recipients facing cutbacks: - An average recipient can compensate for only about half of a cutback by increasing US dollar borrowing from other lenders. - Emerging market recipients compensate only about one-quarter of the loss from other lenders. - When lending costs tighten across a recipient’s foreign lending partners, local banks compensate only 20 percent of US dollar credit by domestic lending. - Cross-border borrowing in other currencies falls as well—by one-third of the initial US dollar cutback—rather than compensating for the decline. ### Amplification effects of US dollar activities and US dollar funding fragility - Greater home-economy exposure to US dollar activities amplifies adverse impacts: - When the share of US dollar assets to total assets is high (fourth quintile), a 50 basis point increase in US dollar funding costs raises the probability of banking sector default by 0.32 standard deviations (an 11 percent increase). - When the share is low (first quintile), the impact is negligible and statistically insignificant. - Cross-currency funding fragility amplifies shocks: - If the cross-currency funding gap ratio is high (fourth quintile, with positive CCFG), a 50 basis point increase in US dollar funding costs raises the probability of banking sector default by 0.41 standard deviations (a 14 percent increase). - If the cross-currency funding gap ratio is low (first quintile), the effect is statistically insignificant. - Other liquidity and funding stability measures (US dollar liquidity ratio; US dollar stable funding ratio) similarly amplify the relationship between US dollar funding costs and home-economy financial stress. - Greater US dollar funding fragility in the home economy results in sharper cutbacks in cross-border lending when US dollar funding conditions tighten. ### Key quantitative observations (preserved exactly as in source) - 50 basis point increase → 0.22 standard deviation increase in probability of banking sector default (equivalent to a 7½ percent increase). - 50 basis point increase → 0.29 standard deviation tightening in domestic financial conditions. - 50 basis point increase → 0.1 standard deviation increase in recipient banking sector default probability (a 3.3 percent increase). - 50 basis point annual cumulative increase → 5.3 percent reduction in US dollar cross-border lending. - Emerging market lender → 7.1 percent decrease in cross-border lending to all recipients; 9.3 percent decrease to other emerging markets. - Increase in US dollar funding costs by 50 basis points affects US dollar lending to emerging market recipients by about –6.6 percent. - Average recipient compensates for about one-half of a cutback from other lenders; emerging market recipients compensate about one-quarter. - Weighted average of cross-border lenders’ US dollar funding costs increase → compensation of only 20 percent of US dollar credit by local banks. - Borrowing in other currencies falls by one-third of the initial US dollar cutback. - High share of US dollar assets (fourth quintile) → 0.32 standard deviations impact (an 11 percent increase). - High cross-currency funding gap ratio (fourth quintile) → 0.41 standard deviations impact (a 14 percent increase). - For the quarterly change in the probability of default, an increase by one standard deviation is equivalent to an increase by 33 percent. - The average quarterly increase in the probability of default of the banking sector for the sample was 34 percent at the peak of the global financial crisis. *Source: CHAPTER 5 BANkS’ DOLLAR FuNDING: A SOuRCE OF FINANCIAL VuLNERABILITY — International Monetary Fund | October 2019* ### 2. Amplification Effect of the Cross-Currency Funding Gap ### 2. Amplification Effect of the Cross-Currency Funding Gap ### US dollar funding costs and domestic financial stress - A 50 basis point increase in US dollar funding conditions raises the probability of default of the banking sector in the home economy by 0.33 standard deviations (a 10 percent increase) if the US dollar liquidity ratio is low (at the first quintile); the impact becomes statistically insignificant if the US dollar liquidity ratio is high (at the fourth quintile). - Similar amplification arises when the US dollar stable funding ratio is low by historical standards. - Additional analysis finds that the impact on domestic financial conditions is qualitatively similar and the magnitude is slightly larger. ### Transmission to cross-border lending and role of subsidiaries/branches - A 50 basis point increase in the one-quarter-ahead US dollar funding cost leads economies with more fragile US dollar funding (relative to their own historical levels) to cut back cross-border lending by a greater amount. - The adverse impact of funding costs on cross-border lending is greater when the cross-currency funding ratio is larger, and is amplified when the liquidity ratio and stable funding ratio are smaller. - US dollar liquidity held at US subsidiaries of non-US banks does not significantly mitigate home economy financial stress induced by tightening US dollar funding conditions. - Foreign bank presence: - A high share of foreign subsidiaries residing in the home economy does not have a significant amplification effect. - Home economies with substantial foreign branch presence are estimated to experience a large 0.64 standard deviations, or 21 percent, and statistically significant increase in financial system stress in response to tightening US dollar funding. ### Mitigating factors: bank health, swap lines, international reserves - Bank health - Larger capital buffers, stronger overall liquidity, and higher profitability (return on assets) are associated with weaker transmission of shocks in US dollar funding costs to financial stability. - Example: a 50 basis point increase in US dollar funding conditions raises the probability of default by 0.40 standard deviations (14 percentage points) if the capital ratio is low (first quintile), but decreases to 0.25 standard deviations (an 8 percent increase) if the capital ratio is high (fourth quintile). - Following a 50 basis point increase in funding costs, economies whose banking system average capital ratio is at the lowest quintile cut their US dollar cross-border lending by 4.7 percent more than those whose capital is at the fourth quintile. - Swap lines - Central bank swap arrangements with the Federal Reserve limit deviation from covered interest parity and tend to curb funding risk. - The number of central banks engaging in temporary US dollar liquidity swap arrangements peaked at 14 in October 2008, before stabilizing to five major advanced economy central banks in May 2010 with full allotment. - The Federal Reserve’s unexpected announcement on November 30, 2011, that it would lower the swap line rate by 0.5 percent narrowed daily cross-currency bases noticeably, primarily for currencies with swap arrangements. - Regression analysis finds that in economies with swap line arrangements there was no statistically significant association between the change in US dollar funding conditions and a change in domestic financial stress; without swap lines the association was statistically significant. - Economies without a swap line arrangement with the Federal Reserve provide about 3.2 percent less cross-border US dollar lending in response to similar funding cost increases. - International reserve holdings - Non-US central banks’ international reserve holdings can mitigate US dollar funding tightness by providing contingent US dollar liquidity and by increasing the willingness of external providers to supply liquidity. - With US dollar liquidity at its historical median, a 50 basis point increase in US dollar funding costs results in a 0.38 standard deviation increase in an economy with high reserve holdings (fourth quintile), compared with a 1.22 standard deviation increase when reserve holdings are low (first quintile). - In economies with high international reserves (top quintile), cutbacks in cross-border lending are about 40 percent less than in those with low (bottom quintile) reserve holdings. ### Policy implications - The US dollar is likely to maintain a predominant role in global trade and finance; non-US banks will continue to be key providers of US dollar intermediation, which entails liquidity risk for both home economies and recipient economies. - Key policy messages: - Some postcrisis regulatory reforms may have had unintended consequences in global US dollar funding markets; trade-offs should be considered between risk abatement and reductions in financial intermediation activity, and between public provision of liquidity buffers and ex ante incentives (moral hazard). - Regulators should monitor the US dollar funding fragility of local banks and develop or enhance currency-specific liquidity risk frameworks, including stress tests, emergency funding strategies, and resolution planning. The cross-currency funding ratio, liquidity ratio, and stable funding ratio measures used in this chapter could be useful monitoring tools. - Access to US dollar liquidity during periods of stress benefits both home economies of global banks and recipient economies. International reserves should be considered in assessing reserve adequacy. Access to US dollar liquidity through swap lines at times of strain can contribute to stability, including through a signaling effect. - There is a case for a stronger global financial safety net, including through adequate IMF resources such as those provided through flexible credit lines. *International Monetary Fund | October 2019 — CHAPTER 5 BANKS’ DOLLAR FUNDING: A SOURCE OF FINANCIAL VULNERABILITY* ### CHAPTER 5 BANkS’ DOLLAR FuNDING: A SOuRCE OF FINANCIAL VuLNERABILITY ### CHAPTER 5 BANkS’ DOLLAR FuNDING: A SOuRCE OF FINANCIAL VuLNERABILITY ### References - Extensive bibliography listing research on dollar funding, covered interest parity deviations, global dollar funding of non-US banks, central bank dollar swap lines, and related topics. (Authors and works include Aldasoro; Avdjiev; Baba and Packer; Borio et al.; Bruno and Shin; Cerutti, Obstfeld, and Zhou; Cetorelli and Goldberg; Du, Tepper, and Verdelhan; Fiechter et al.; Fillat, Garetto, and Smith; Goldberg, Kennedy, and Miu; Gopinath and Stein; Hofstetter, López, and Urrutia; Hoggarth, Hooley, and Korniyenko; Iida, Kimura, and Sudo; IMF; Ivashina, Scharfstein, and Stein; McGuire and von Peter; Nakaso; Saito, Hiyama, and Shiotani; Sushko et al.) ### Sustainable Finance — overview and definition - Sustainable finance = incorporation of environmental, social, and governance (ESG) principles into business decisions, economic development, and investment strategies. - ESG considerations generate public good externalities and can produce positive societal impacts. - Efforts to promote ESG considerations in finance started some 30 years ago and have accelerated more recently. - The scope of ESG factors is very wide, covering environmental, social, and governance pillars with multiple issues (examples given include climate change, carbon footprint, energy efficiency, workplace health and safety, board structure and accountability, accounting and disclosure practices). ### Economic case and firm incentives - Firms may invest in ESG projects because: - evolving investor or consumer preferences that could lower costs of capital or improve profit margins; - benefits such as a more motivated workforce, greater trust with stakeholders, or less firm-level tail risk from carbon emissions; - policy-driven actions where delayed compliance with forthcoming regulatory requirements could be costly. - Information provision on firms’ incorporation of ESG principles is necessary to incentivize firms, but currently often insufficient for adequate differentiation; policy action is still needed to incentivize investment or business-practice changes that reduce negative externalities, especially climate-change-related risks. ### Climate-related financial risks: channels and characteristics - Two channels of climate-related financial risks: - Physical risks: damage to property, land, and infrastructure from catastrophic weather-related events and broader climate trends. - Transition risks: changes in price of stranded assets and broader economic disruption from evolving climate policy, technology, and market sentiment during adjustment to a lower-carbon economy. - Climate risks are large, non-linear, and hard to estimate; they affect the financial system: - directly via price impairment, reduced collateral values, and underwriting losses; - indirectly via lower economic growth and tighter financial conditions. - Insurance claims from natural losses have already quadrupled since the 1980s. - Studies point to very large economic and financial costs from climate risks (examples cited: Burke, Hsiang, and Miguel (2015); Cambridge Centre for Risk Studies (2015); Economist Intelligence Unit (2015); CDP 2019 estimate of $1 trillion expected climate change costs for a group of large listed companies). ### Systemic features and nonlinearity - Risks are not linear; catastrophic tail risks are non-negligible. - Sudden reassessment of valuations in exposed sectors could occur if asset prices do not fully internalize climate risks. - The broad scope of climate change across sectors and countries contributes to the systemic nature of risks. - Climate change mitigation costs per unit of emission are likely to fall on industrialized economies under “common but different responsibilities,” because most future low-cost mitigation opportunities are in large emerging market economies (reference to October 2019 Fiscal Monitor; De Cian and others 2016). - Lower- and middle-income countries are very vulnerable due to geography, dependence on agriculture, and lack of resources for adaptation (IMF 2019). ### Legal, disclosure, and investor-driven channels - Growing awareness of ESG risks is likely to raise costs of noncompliance with ESG standards: - Legal risks include lawsuits seeking compensation for climate-related losses (example: growing number of lawsuits in the United States brought by local authorities against fossil fuel companies). - Failure to disclose climate and other ESG risks is a liability for investors. - As ESG investment strategies are more widely adopted, issuers face exposure to investor ESG guidelines (example: asset owners pledging to divest from fossil fuels; some banks and insurers curtail financing or insuring of the sector). - Large-scale divestments, combined with regulatory actions, can have significant effects, potentially causing disorderly price corrections similar to benchmark-driven investing shifts. ### Evidence on losses, insurance, and investor behavior (selected indicators) - Insurance claims from natural losses: have quadrupled since the 1980s (figure reference). - Institutional investor fossil fuel divestment pledges: cumulative pledges tracked (panel 3) with assets under management in trillions of US dollars and number of organizations (right scale); 2019 data are until July 2019. - Transition risks have materially affected the coal sector (figure reference showing coal-sector indicators relative to broader indices). ### Policy implications and roles for policymakers - Policymakers should develop standards, foster disclosure and transparency, and promote integration of sustainability considerations into investments and business decisions. - Policy action is needed to ensure that externalities—especially from climate change—are adequately reflected in firm and investor decisions. - Standardization and improved disclosure would help investors differentiate firms on ESG grounds and incentivize firm behavior changes. *International Monetary Fund | October 2019* ### 4. US Coal Sector Valuations and Regulatory Announcements ### 4. US Coal Sector Valuations and Regulatory Announcements ### Context and observable regulatory events - Indexes normalized end-2010 = 100 (left scale); right scale: US dollars per short ton. - Annotated regulatory and policy events identified in the figure include: - China’s emission reduction plan - US EPA implemented MATS - US Clean Power Plan announced - US CCR - US NSPS ### Relationship to ESG and market pricing (summary of chapter context) - ESG considerations are influencing valuation and capital/insurance costs for exposed sectors such as coal by making capital and insurance more difficult and costlier to obtain. - Sovereigns are also at risk from ESG noncompliance, with rating agencies and large investors increasingly incorporating ESG considerations into their sovereign credit assessments. ### Key findings on sustainable finance relevant to coal-sector valuations - Labeled bonds (primarily green bonds) carry certification processes for use of proceeds with periodic validation, but investors generally rely on voluntary disclosures. - Labeled green-bond stock grew to an estimated $590 billion in August 2019 from $78 billion in 2015. - Global green bond issuance reached $168.4 billion in 2018. - ESG-dedicated funds control some $850 billion in assets (less than 2 percent of the total investment fund universe). - ESG equity funds reached $560 billion in 2019. - There is no conclusive evidence that sustainable funds consistently out- or underperform conventional funds. - Fees: in the absence of clear evidence of underperformance, investors have justified allocation to ESG funds on the basis of similar fees between ESG and regular funds for some retail funds; anecdotal evidence suggests fees of sustainable active management funds are often higher than those of other active funds. ### Challenges that can affect coal valuations and capital access - Lack of consistent methodologies and reporting standards; corporate reporting on ESG factors is largely voluntary and inconsistent, particularly sparse on environmental and social dimensions. - Third-party ESG score providers face concerns about opaqueness of methodologies and informational materiality; ESG scores across providers are often inconsistent. - Greenwashing and inconsistent investment fund classifications pose reputational risk (example: only 37 percent of Lipper ethical funds also carry a “sustainable” designation by Bloomberg). - Measuring ESG impact is difficult; activist engagement or positive screening may have greater impact than negative screening, but measuring effects remains challenging. - Issuers face high cost of ESG reporting, expensive and complicated external review procedures, and a lack of eligible assets; complexity and unclear definitions of E, S, and G increase reputational risk. ### Implications for investors and issuers in coal and related sectors - ESG integration in fixed income has grown because ESG issues present material credit risk; bond development aided by multilaterals and development of standards by China, the European Commission, the United Nations, and the United Kingdom. - There is little evidence that issuers achieve lower costs through green bonds than conventional bonds, likely reflecting identical credit risk profiles. - Secondary market liquidity for green bonds appears to be slightly worse than for comparable conventional bonds, reflecting a large role of buy-and-hold investors. ### Policy recommendations to foster sustainable finance (relevant to coal-sector transition) - Standardization of ESG investment terminology, product definitions, and clarifications of what constitutes E, S, and G could support market development, address greenwashing concerns, and reduce reputational risk. - Closing data gaps is crucial for investors and issuers to efficiently price externalities, mitigate risks, and reward long-term benefits from sustainability; more and better data can also help inform public policy when market-based mechanisms are insufficient to address significant negative externalities. *Source: Chapter excerpt from the IMF Global Financial Stability Report: LOWER FOR LONGER, October 2019.* ### 1. ESG Reporting by Firms ### 1. ESG Reporting by Firms ### ESG disclosure measures and presentation - "100 is the best possible disclosure score" - Panel heading: "Percent of firms with ESG disclosure score >50" - Chart labels and reference markers appearing in source: "45 degree line"; "0"; "100"; "60"; "40"; "20"; "80"; "0"; "20"; "10"; "5"; "15"; "0"; "20"; "40"; "60"; "80"; "100"; "201011121314151617"; "91" - Data sources noted: Bloomberg Finance L.P.; Refinitiv Datastream; RobecoSAM; Sustainalytics; and IMF staff calculations. - Note: "In panel 4, the data are for all companies with Refinitiv Datastream ESG ratings. ESG = environmental, social, and governance." ### Relationship between ESG rankings and market valuation - The source presents an analysis linking ESG score ranks to price-to-book ratios (label: "Relationship between ESG Score Ranks and Price-to-Book Ratios"). - Market indices referenced in visual comparisons: "US: S&P 500"; "Europe: Stoxx 600"; "Japan: TOPIX". - ESG dimensions shown separately in the figures: "Environmental"; "Social"; "Governance"; combined "ESG score" and "ESGESGESG" labels appear in the figure text. ### Policy findings and recommendations - Consistent corporate ESG reporting would incentivize acquisition of ESG data and assessment of financial materiality by investors. - "Consideration could be given to mandatory minimum ESG disclosure requirements, especially of financially material information, taking into account costs and complexities of new regulations and reporting requirements." - "ESG disclosure and reporting requirements for asset managers could help investors better assess ESG risk exposures." - Better ESG data would aid regulators in financial stability analysis. - "Clarification of the role of ESG factors in prudent investment governance by regulators would help reduce uncertainty regarding fiduciary duties among some investors." - "Reconciling fiduciary responsibility with long-term goals through clear metrics can provide clearer objectives to asset managers, institutional investors, and service providers, such as credit rating agencies and pension funds’ investment consultants ('gatekeepers')." ### Regulatory, supervisory, and market development actions - Regulators and central banks can support ESG-related market development by fostering awareness and offering intellectual leadership in assessing ESG risks. - Policymakers should incorporate ESG principles, and climate-related financial risks in particular, into financial stability monitoring and assessment and into microsupervision (such as stress testing). - Consider incentives to jump-start green finance markets, examples cited: - "Singapore’s sustainable bond grant program" - "expansion of collateral by the People’s Bank of China for a lending facility to include green bonds" - "Credit rating agencies and ESG data providers can further integrate material ESG information into credit ratings and other scores, aggregate relevant information, and design reliable metrics for ESG benchmarks." - EU regulatory developments noted: "EU regulation on integrating sustainability risks in credit rating agencies is underway"; "the European Union via its green bond standards is seeking to clarify the responsibility of third-party verifiers of emissions." ### Standards, verification, and accountability - Initiatives cited that aim to improve comparability and materiality of ESG reporting: Sustainability Accounting Standards Board; Task Force on Climate-Related Financial Disclosures; Global Reporting Initiative. - "In 2019 the Principles for Responsible Investment incorporated mandatory climate risk reporting. A new European Union disclosure regulation aims to mandate disclosure requirements." - "Third-party verifiers play an important role in certifying the compliance of sustainable investment products with ESG criteria." Regulators "should consider developing standards and accountability for third-party verifiers and auditors." ### IMF role, planned work, and multilateral coordination - "The IMF will continue to incorporate ESG-related considerations, in particular related to climate change, when critical to the macroeconomy." - IMF incorporation activities described: "incorporating climate change into multilateral (October 2019 Fiscal Monitor) and bilateral surveillance (through analysis in Article IV consultations and in Financial Sector Assessment Programs, including in stress tests)." - Planned additional research: "To better understand the long-term consequences of ESG-related risk factors, including but not limited to climate change, additional research is planned in the April 2020 GFSR." - "Multilateral cooperation can help bridge gaps in supervisory capacity on ESG issues" and is important "to avoid fragmentation of sustainable asset markets." ### Broader policy context - Finance can help mobilize funding to achieve sustainability goals and ensure risks are appropriately priced, but complementary policies are needed to set price signals for markets. - Fiscal measures emphasized: "pricing of externalities such as carbon emissions and phasing out fuel subsidies (see Chapter 2 of the October 2019 Fiscal Monitor), as well as structural policies supporting investment in climate infrastructure (Jobst and Pazarbasioglu 2019)." *Source: IMF Global Financial Stability Report: October 2019 — Chapter excerpt "Sustainable Finance: Looking Farther" (section "1. ESG Reporting by Firms").* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2019/october/english/text.pdf_