## Preface and selected chapters — Global Financial Stability Report: Bridge to Recovery (October 2020) ## Source details **Canonical URL:** [Preface and selected chapters — Global Financial Stability Report: Bridge to Recovery (October 2020)](https://www.imf.org/-/media/files/publications/gfsr/2020/october/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2020/october/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2020/october/english/text.pdf.json) --- ### Preface — purpose, contributors, and high-level findings - Purpose and scope: - The GFSR assesses key vulnerabilities the global financial system is exposed to and seeks to highlight policies that may mitigate systemic risks to contribute to global financial stability and the sustained economic growth of the IMF’s member countries. - This GFSR reflects information available as of September 29, 2020. Executive Directors discussed the GFSR on September 30, 2020. - Coordination and contributors: - Analysis coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director. - Project directed by Fabio Natalucci, Claudio Raddatz (former Advisor), Anna Ilyina, Evan Papageorgiou, Mahvash Qureshi, and Jérôme Vandenbussche (roles as listed). - Individual contributors and editorial team listed in source. - Key high-level findings: - Near-term global financial stability risks have been contained for now due to unprecedented and timely policy response maintaining the flow of credit and avoiding adverse macro-financial feedback loops. - Vulnerabilities are rising, intensifying financial stability concerns in some countries, notably: - Nonfinancial corporate sector: firms have taken on more debt to cope with cash shortages. - Sovereign sector: fiscal deficits have widened to support the economy. - Corporate liquidity pressures may morph into insolvencies if the recovery is delayed; SMEs more vulnerable than large firms with capital market access. - Global banking system remains fairly well capitalized, but there is a weak tail of fragile banks; some banking systems may experience capital shortfalls in the October 2020 World Economic Outlook adverse scenario even with currently deployed policy measures. - Some emerging and frontier market economies face financing challenges that may tip some into debt distress or financial instability and may require official support. - Financial conditions have eased significantly since late March 2020, but stretched valuations in risk asset markets persist and corporate debt is at record levels relative to GDP in most countries. - Quantified policy impacts and macro environment (selected figures from the text): - Central banks in G10 countries: nearly $7.5 trillion balance sheet expansion to date in G10 countries. - Fiscal policy global response: $12 trillion globally. - Global economy expected growth: 5.2 percent in 2021 (October 2020 World Economic Outlook). - Information cutoff for the report: September 29, 2020; Executive Directors discussed the GFSR on September 30, 2020. - Editorial updates and corrections noted in the Editor's Note dated December 11, 2020, and updates to earlier online versions published on October 13 and 23. ### Monetary and financial policy road map (phase-based priorities) - Gradual Reopening under Uncertainty: - Monetary policy: Maintain accommodation to support the recovery. - Liquidity support: Maintain support but adjust pricing to incentivize a gradual exit. - Credit provision: Encourage banks to use capital and liquidity buffers to continue lending. - Nonfinancial private sector: Extend moratoria on debt service only if necessary; support viable firms through restructuring and efficient out-of-court workouts; provide solvency support (as appropriate). - Multilateral support: Provide support to emerging and frontier market economies facing financing difficulties. - Pandemic under Control: - Monetary policy: Maintain accommodation until monetary policy objectives are achieved. - Liquidity support: Gradually withdraw. - Credit provision: Require banks to gradually rebuild capital and liquidity buffers; develop credible plans to reduce problem assets; create markets for problem assets. - Nonfinancial private sector: Recapitalize, restructure, or resolve nonviable firms. - Green recovery and digitalization: Encourage green investments and greater digital investment. - Post-pandemic Financial Reform Agenda: - Strengthen regulatory framework for nonbank financial sector. - Implement prudential measures to contain risk-taking in a lower-for-longer interest-rate environment. --- ### Chapter 1 — Global financial stability overview: key vulnerabilities and channels - Risk asset rebound amid high economic uncertainty: - Global equity markets rebounded from March lows; differentiation across countries and sectors driven by virus spread, policy support, and sectoral composition. - The top five S&P stocks (Alphabet, Amazon, Apple, Facebook, Microsoft) account for about 25 percent of total market capitalization. - Equity valuation and volatility: - Decline in corporate earnings outlook in the United States was more than offset by a lower risk-free rate and a compression of the equity risk premium. - Option-implied volatility (VIX) and realized volatility declined sharply in late March–April despite continued earnings uncertainty. - Rising global financial vulnerabilities since COVID-19 outbreak: - Vulnerabilities were elevated across asset management companies, nonfinancial firms, and sovereigns in 29 jurisdictions with systemically important financial sectors (S29) before the outbreak; they have continued to rise since. - Key channels of impediment to recovery: - Solvency risks shifted into the future as firms borrowed more to cope with cash shortages; SMEs in contact-intensive industries are particularly vulnerable. - Credit losses could deplete banks’ capital buffers, constraining credit provision. - Fragilities in the nonbank financial sector aggravated market dislocations in March; central bank support limited but did not eliminate these fragilities. - Shrinking policy space could constrain public-sector backstops. - External financing challenges for emerging/frontier markets may push some into debt distress or financial instability. - Solvency risks and policy mitigation: - The share of S29 economies with high or medium-high corporate sector vulnerabilities was close to 80 percent (by GDP) before the pandemic. - Policy measures to date mitigated widespread bankruptcies but accumulation of debt may lead to future solvency pressures, especially for SMEs and contact-intensive sectors. --- ### Chapter 2 — Emerging and frontier markets: asset purchase programs and local market stress - Asset Purchase Programs (APPs) — selected magnitudes (Total Purchases, percent of GDP): - Colombia: 1.1 - Chile: 2.9* - Croatia: 4.9 - Ghana: 1.4 - Guatemala: 1.9 - Hungary: 1.4 - India: 1.0 - Indonesia: 3.8** - Malaysia: 0.6 - Philippines: 4.3 (7.3)*** - Poland: 4.6 - Romania: 0.5 - South Africa: 0.7 - Thailand: 1.0 - Turkey: 1.6 - Notes: Chile’s APP purchases included only Special Asset (June) and Bank Bond (March) Purchase Programs; Chile’s central bank did not gain legal ability to purchase government bonds until August 12. Indonesia and Philippines entries include staff-estimate nuances as noted. - Local market stress dynamics (Local Stress Index — LSI): - Aggregate LSI during the COVID-19 sell-off was comparable to the global financial crisis in level but the period of stress was considerably shorter. - Probability of outflows over the next three quarters fell from about 60 percent at the peak of market turmoil to about 25 percent in September. - Capital flows at risk (5th percentile) stands at –1.9 percent of GDP, compared with –3.3 percent of GDP on March 23 and realized portfolio outflows of almost 2 percent of GDP in 2020:Q1. - Effectiveness and limits of APPs: - APP announcements reduced long-end bond yields by 20 to 60 basis points in event studies; effects on currencies were relatively limited and short-lived. - APPs contributed to improved market liquidity measures (bid-offer spreads, intraday volatility) and acted as circuit breakers. - APPs were generally small and short-lived in emerging markets, limiting impact; stronger effects where program size was larger (Chile, Indonesia, Philippines, Poland). - Risks of large-scale or open-ended APPs include weakening central bank credibility, fiscal-dominance perceptions, impaired price discovery, and distortion of market dynamics. - Policy design considerations: - Coordinate APPs with fiscal financing needs; monitor bond supply risks and foreign investor presence; complement APPs with FX liquidity tools (swap lines, repo facilities) and market-making support. --- ### Chapter 3 — Corporate funding: liquidity strains cushioned by policies - Corporate liquidity and funding patterns: - Listed firms’ credit line drawdowns increased more than 40 percent, on average, compared with the first half of 2019; in the United States net drawdowns at the end of March doubled, representing an increase of $250 billion. - Loans are the major source of corporate debt funding in the G7: ranging from 58 percent in the United States to 90 percent in Germany. - Total debt growth of listed firms generally exceeded 10 percent year‑over‑year in early 2020; firms used additional borrowing mostly to build cash reserves. - Cash accumulation in 2020:Q1: about 0.5 percent of assets in Japan; about 1.5 percent of assets in Canada and the United States. - Market and issuance dynamics: - Investment-grade issuance surged in the second quarter to levels twice as large as those in 2019 for several jurisdictions; US high-yield issuance in Q2 more than doubled compared with 2019. - In G7 economies, nearly 60 percent of high-yield new issues during the first half of the year were BB rated; more than 30 percent of bonds were secured. - Commercial paper: in the United States volumes have not recovered since March; in the euro area CP issuance rebounded and hit a record high in June. - Heterogeneity of firm stress: - Firms with weaker solvency/liquidity positions and smaller firms suffered relatively more financial stress; cumulative abnormal returns underperformance for small firms in February–March in several economies was close to or greater than 10 percentage points. - SMEs are especially vulnerable and dominate contact-intensive sectors; widespread SME insolvencies could have significant macro and banking-sector implications. - Empirical evidence on policy effectiveness: - Short-window event analysis (85 announcement days): - Small firms: about 0.3 percentage point of overperformance a day over two days. - High‑leverage firms: about 0.1 percentage point a day over two days. - Policies with direct impact on corporate funding (government guarantees, central bank purchases) benefited firms with liquidity vulnerabilities more than indirect policies. - By end‑June: stress at smaller firms generally disappeared in most markets except the United Kingdom; stress persisted at liquidity‑vulnerable firms in France, the United Kingdom, and the United States. - Policy implications: - Carefully calibrate withdrawal of fiscal support; maintain measures that preserve credit flows while targeting solvency support to viable firms. - Monitor bank lending standards as guarantee programs end and revisit regulation of nonbank financial institutions. --- ### Chapter 4 — Bank capital: COVID-19 challenges and policy responses (stress test findings) - Stress test design and scope: - Stand-alone solvency stress test on about 350 banks across 29 jurisdictions accounting for 73 percent of global banking sector assets; static balance sheets assumed; does not model liquidity, contagion, or macro-feedbacks. - Government guarantees assumed fully used (full uptake) and evenly benefit banks in a country proportional to guarantees-to-corporate-loans ratio; capital adequacy policies quantified from announced measures and maintained over a three-year horizon unless explicit expiry. - Aggregate CET1 trajectory (no mitigation): - Minimum CET1 of the global banking system: 9.6 percent in the baseline scenario and 9.3 percent in the adverse scenario. - These are drops of 3.6 percentage points and 3.9 percentage points, respectively, below the CET1 level in 2019. - Baseline: CET1 recovers but remains 0.7 percentage points below initial level by end-2022. - Adverse: CET1 remains 2.4 percentage points below initial levels by 2022. - Drivers and heterogeneity: - Main driver of CET1 decline: increase in loan loss provisions (baseline contribution: 5 percentage points; adverse: 6 percentage points). - Distributional outcomes (adverse scenario, pre-mitigation): - Banks accounting for 13 percent of assets fall below 4.5 percent CET1; additional 3 percent of assets below 6 percent. - Weak tail (CET1 below 4.5 percent plus GSIB buffer) amounts to 14 percent by assets. - GSIBs: 8 percent of GSIB assets end with CET1 below 4.5 percent. - Non‑GSIBs: 16 percent of assets fail to maintain a 4.5 percent CET1 ratio. - Emerging markets: almost 40 percent of total banking assets end with CET1 below 4.5 percent. - Capital shortfalls (pre-mitigation, adverse scenario): - Barebones capital shortfall (minimum CET1 4.5 percent + GSIB buffer): about $200 billion. - Broad capital shortfall (including capital conservation and countercyclical buffers): about $420 billion (0.6 percent of sample banking assets). - Broad shortfall represents about 0.8 percent of GDP of countries where at least one bank has a capital shortfall; average broad shortfall across those countries is 1.1 percent of GDP. - Effect of bank‑specific policies (quantified mitigation): - Policy mitigations (government guarantees + capital adequacy policies) materially reduce capital depletion: - CET1 for advanced economies about 110 basis points higher at end of simulation with both policies. - Share of bank assets with CET1 below 4.5 percent declines from 13 percent to 8 percent with mitigation. - Weak tail (CET1 below 4.5 percent plus GSIB buffers) declines from 14 percent to 8.3 percent of bank assets. - Capital shortfall with mitigation (adverse scenario): broad shortfall about $220 billion. - Sensitivity: half uptake of guarantees reduces mitigating effect roughly by half. - Risks, trade-offs, and supervisory implications: - Using regulatory flexibility reduces short‑term solvency risks but may undermine transparency and future loss absorption, possibly increasing future fiscal costs. - Recommendations: strengthen financial safety nets, limit distributions temporarily, use stress tests to guide timing/pace of unwinding exceptional measures, ensure prompt recognition of losses as impairment evidence emerges. --- ### Chapter 5 — Corporate sustainability: COVID-19, financial constraints, and environmental performance - Key findings: - Tighter financial constraints and weaker economic conditions can act as a drag on firms’ environmental performance. - The COVID-19 crisis could substantially reduce firms’ green investments, reversing past gains. - Policy packages supporting green recovery, better disclosure standards, and product standardization can help mobilize green investments and alleviate firms’ financial constraints. - Evidence and quantified impacts: - Green corporate bond issuance declined in March 2020 but picked up beginning in April 2020; share of green bonds in total corporate bond issuance returned to 2019 levels. - Financially constrained firms exhibit significantly weaker environmental performance: - Environmental performance falls by 10 points when firm size drops from the median to the 25th percentile. - When a firm does not pay dividends its environmental score is 4 points lower than dividend-paying firms. - When a firm is not rated its environmental score is 3 points lower than rated firms. - Environmental score is 1 point lower when the Kaplan-Zingales index is above the median. - Quantified shocks: - A VIX jump of 16.3 points (difference in 2020 average to 2019 average up to July 31, 2020) would lead to a persistent drop in firms’ environmental performance by up to 5 points, with pre-shock performance not attained for at least three years. - For firms with ICR < 1 or unrated firms, the same VIX shock lowers environmental performance by 2 additional points relative to better-rated firms. - A 10 percentage point decline in the output gap would lead to a 3 point decline in firms’ environmental performance and could increase firms’ carbon intensity by up to 8.5 percent in the medium term. - Oil price shock nuance: - Oil price declines due to demand-side shocks are associated with weaker corporate environmental performance; declines due to supply-side shocks can improve environmental performance. - Global energy demand declined by 3.8 percent in the first quarter of 2020; the March–April 2020 oil price shock was largely demand-driven. - Climate discussion and firm behavior: - A firm-level climate index based on 4,109 firms’ earnings-call transcripts shows a sharp increase in climate-related discussions in 2020. - Policy recommendations: - Implement green recovery packages and public policies to offset deterioration in environmental performance. - Support sustainable finance through improved disclosure standards, green taxonomies, and product standardization. *Source: Preface and Chapters 1–5, Global Financial Stability Report: Bridge to Recovery (October 2020).* ### Preface ### Preface ### Purpose and scope - The Global Financial Stability Report (GFSR) assesses key vulnerabilities the global financial system is exposed to and seeks to highlight policies that may mitigate systemic risks to contribute to global financial stability and the sustained economic growth of the IMF’s member countries. - This GFSR reflects information available as of September 29, 2020. The report benefited from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussions of the GFSR on September 30, 2020. The analysis and policy considerations are those of the contributing staff and should not be attributed to the IMF, its Executive Directors, or their national authorities. ### Coordination, contributors, and editorial production - Analysis coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director. - Project directed by Fabio Natalucci, Deputy Director; Claudio Raddatz, former Advisor; Anna Ilyina, Division Chief; Evan Papageorgiou, Deputy Division Chief; Mahvash Qureshi, Division Chief; and Jérôme Vandenbussche, Deputy Division Chief. - Individual contributors include: Sergei Antoshin, Romain Bouis, John Caparusso, Yingyuan Chen, Dan Cheng, Fabio Cortes, Reinout De Bock, Andrea Deghi, Xioadan Ding, Dimitris Drakopoulos, Kelly Eckhold, Ibrahim Ergen, Salih Fendoglu, Ken (Zhi) Gan, Deepali Gautam, Rohit Goel, Pierpaolo Grippa, Marco Gross, Pierre Guérin, Sanjay Hazarika, Frank Hespeler, Henry Hoyle, Mohamed Jaber, Phakawa Jeasakul, Oksana Khadarina, Piyusha Khot, Annamaria Kokenyne, Ivo Krznar, Dimitrios Laliotis, Fabian Lipinsky, Pavel Lukyantsau, Elizabeth Mahoney, Sheheryar Malik, Samuel Mann, Manuel Perez, Dmitri Petrov, Nicola Pierri, Thomas Piontek, Umang Rawat, Jochen Markus Schmittmann, Patrick Schneider, Dulani Seneviratne, Can Sever, Juan Solé, Felix Suntheim, Thierry Tressel, Tomohiro Tsuruga, Germán Villegas Bauer, Jeffrey Williams, Yizhi Xu, Dmitry Yakovlev, Akihiko Yokoyama, and Xingmi Zheng. - Input provided by Hee Kyong Chon, Alan Feng, Caio Ferreira, Alejandro Lopez, Luc Riedweg, and Julia Xueliang Wang. - Editorial team led by Gemma Diaz with editorial assistance from Christine Ebrahimzadeh, David Einhorn, Lucy Scott Morales, Katy Whipple/The Grauel Group, AGS, and Vector Talent Resources. - Magally Bernal, Monica Devi, Leroy Perumal, and Andre Vasquez responsible for word processing. - The issue draws on discussions with banks, securities firms, asset management companies, hedge funds, standard setters, financial consultants, pension funds, central banks, national treasuries, and academic researchers. ### Key high-level findings and market developments - Near-term global financial stability risks have been contained for now due to unprecedented and timely policy response maintaining the flow of credit and avoiding adverse macro-financial feedback loops. - Vulnerabilities are rising, intensifying financial stability concerns in some countries, notably: - Nonfinancial corporate sector: firms have taken on more debt to cope with cash shortages. - Sovereign sector: fiscal deficits have widened to support the economy. - Corporate liquidity pressures may morph into insolvencies as the crisis unfolds, especially if the recovery is delayed; small and medium-sized enterprises are more vulnerable than large firms with capital market access. - Global banking system remains fairly well capitalized, but there is a weak tail of fragile banks; some banking systems may experience capital shortfalls in the October 2020 World Economic Outlook adverse scenario even with currently deployed policy measures. - Some emerging and frontier market economies face financing challenges that may tip some into debt distress or financial instability and may require official support. - Financial conditions have eased significantly and rapidly since late March 2020, aided by policy measures, but stretched valuations in risk asset markets persist and corporate debt is at record levels relative to gross domestic product in most countries. ### Quantified policy impacts and macro environment (selected figures from the text) - Central banks in G10 countries: nearly $7.5 trillion balance sheet expansion to date in G10 countries. - Fiscal policy global response: $12 trillion globally. - Global economy expected growth: 5.2 percent in 2021 (October 2020 World Economic Outlook). - Information cutoff for the report: September 29, 2020; Executive Directors discussed the GFSR on September 30, 2020. - Editorial updates and corrections noted in the Editor's Note dated December 11, 2020, and updates to earlier online versions published on October 13 and 23. ### Monetary and financial policy road map (as presented) - Gradual Reopening under Uncertainty - Monetary policy: Maintain accommodation to support the recovery - Liquidity support: Maintain support but adjust pricing to incentivize a gradual exit - Credit provision: Encourage banks to use capital and liquidity buffers to continue lending - Nonfinancial private sector: Extend moratoria on debt service only if necessary to prevent widespread insolvencies; support viable firms through restructuring and efficient out-of-court workouts; provide solvency support (as appropriate) - Multilateral support: Provide support to emerging and frontier market economies facing financing difficulties - Pandemic under Control - Monetary policy: Maintain accommodation until monetary policy objectives are achieved - Liquidity support: Gradually withdraw - Credit provision: Require banks to gradually rebuild capital and liquidity buffers, develop credible plans to reduce problem assets, and create markets for problem assets - Nonfinancial private sector: Recapitalize, restructure, or resolve nonviable firms - Green recovery: Encourage more proactive management of climate-related risks and green investments - Digitalization: Encourage greater digital investment to enhance financial sector efficiency and inclusion - Post-pandemic Financial Reform Agenda - Nonbank financial sector: Strengthen the regulatory framework to address vulnerabilities exposed during the COVID-19 crisis - Lower for longer: Implement prudential measures to contain risk-taking in the lower-for-longer interest-rate environment ### Conventions and editorial notes - Conventions used throughout the GFSR include symbols: . . . for unavailable data; — for zero or less than half the final digit shown; – between years/months for ranges (e.g., 2019–20); / for fiscal/financial years (e.g., 2019/20). - Definitions: “Billion” means a thousand million. “Trillion” means a thousand billion. “Basis points” = hundredths of 1 percentage point. - If no source is listed on tables and figures, data are based on IMF staff estimates or calculations. - Minor discrepancies from rounding may exist. - Geographic and mapping details do not imply IMF judgment on legal status of territories or endorsement of boundaries. - Corrections and revisions are incorporated into digital editions; substantive changes are listed in the online table of contents. - Print and digital edition access information and copyright/reuse instructions are provided in the report. *Source: Preface, Global Financial Stability Report: Bridge to Recovery (October 2020).* ### Chapter 3). ### Chapter 3) ### Global financial conditions and capital flows - Aggregate portfolio flows to emerging markets have recovered from their March lows, though about half of emerging market economies have continued to experience outflows over the past three months. - The probability of outflows over the next three quarters fell from about 60 percent at the peak of market turmoil to 25 percent in September (Figure 4). - Hard currency bond issuance in emerging markets has been strong as well. - Frontier market economies face financing challenges as the COVID-19 shock pushed borrowing costs for many to prohibitive levels—calling for official support. ### Asset prices, equity markets, and bond spreads - Global equity markets have rebounded strongly from pandemic lows, with notable differentiation across countries depending on the spread of the virus, the scope of policy support, and sectoral composition. - Equity markets in China and the United States have outperformed other markets, driven by technology stocks; more contact-intensive sectors (hotels, restaurants, leisure) have been hurt by lockdowns and social distancing. - Energy and financial sectors underperformed, reflecting investors’ assessments of weaker growth prospects. - Disconnect between rising market valuations and the evolution of the economy persists: - A sharp decline in the corporate earnings outlook in the United States has been more than offset by lower risk-free rates and a compression of the equity risk premium. - Declines in corporate bond yields have been driven by the fall in risk-free rates and compression in credit spreads—in many cases below values estimated to be consistent with economic fundamentals (Figure 6). - Spread compression can be partly attributed to policy support and, for emerging markets, policy easing by central banks in advanced economies. - If markets believe policy support will be maintained or scaled up, current risk asset valuations could be sustained; if investors reassess the scope for policy support or the recovery is delayed, the odds of a sharp adjustment may rise. ### Corporate sector: liquidity strains and debt at risk - Nonfinancial firms have come under significant liquidity strains following the COVID-19 outbreak. - More vulnerable firms—with weaker solvency and liquidity positions, and smaller firms—have experienced greater financial stress than peers in the early stages of the crisis. - Many firms whose earnings fell short of their interest expenses have increased borrowing (Figure 7), adding to already high corporate debt levels in several economies (Figure 8). - Default rates have been on the rise; as the crisis continues, and especially if a sustainable recovery is delayed, liquidity pressures may morph into insolvencies. - Small and medium-sized enterprises are generally more vulnerable and dominate some of the most contact-intensive sectors (hotels, restaurants, entertainment), representing a significant transmission channel of the shock. - Indicators of debt at risk: - ICR < 1 in 2019:Q4 - ICR < 1 in 2020:Q2 - ICR < 1 in 2020:Q2 and an increase in net debt between Q4 and Q2 ### Banking sector resilience and risks - Banks entered the COVID-19 crisis with significantly stronger capital and liquidity buffers than in 2008–09, allowing continued credit provision. - Policies supporting borrowers and encouraging banks to use regulatory flexibility have likely supported banks’ willingness and ability to lend. - Some banks are already starting to tighten lending standards, which could adversely affect the recovery. - Forward-looking analysis of bank solvency in 29 countries (not including China): - Under the October 2020 WEO baseline scenario most banks will be able to absorb losses and maintain capital buffers above minimum capital requirements. - In the WEO adverse scenario (deeper recession, weaker recovery), a sizable weak tail of banks could see capital buffers depleted to levels that could constrain lending capacity (Figure 9). - The weak banks’ capital shortfall relative to broad regulatory requirements could reach $220 billion, even after accounting for borrower- and bank-oriented mitigation policies. ### Nonbank financial institutions (NBFIs) - NBFIs entered the crisis with elevated vulnerabilities (Figure 10). - They have coped with pandemic-induced market turmoil thanks to policy support, but fragilities remain high. - Asset managers could be forced into fire sales if portfolio losses are larger and redemptions last longer than during the March sell-off. - NBFIs play a growing role in credit markets, including riskier segments; increased links between NBFIs and banks imply fragilities could spread through the financial system. ### Sovereign vulnerabilities and emerging market financing - Sovereign vulnerabilities have increased because countries expanded fiscal support; sovereigns may face a sharp rise in contingent liabilities. - Vulnerabilities have increased across multiple sectors, with 6 out of 29 jurisdictions with systemically important financial sectors now showing elevated vulnerabilities in the corporate, banking, and sovereign sectors (Figure 11). - Financing needs of emerging markets have risen sharply due to the pandemic. - Concerns about new debt supply and weak domestic fundamentals may have curtailed demand for local currency bonds from foreign investors, especially where foreigners hold large shares of debt and the domestic investor base is not sufficiently deep. - Some emerging market central banks purchased a substantial share of bonds in the secondary market to stabilize conditions. ### Policy directions and priorities - As policymakers build a bridge to recovery, policies must adjust depending on the evolution of the pandemic and the pace of the economic rebound; intertemporal trade-offs and unintended consequences should be carefully balanced. - Key policy priorities: - Continued monetary policy accommodation and targeted liquidity support will be essential for sustaining the recovery as economies reopen. - A robust framework for debt restructuring will be critical for reducing debt overhangs and resolving nonviable firms. - Low-income countries with financing difficulties may require multilateral support. - The COVID-19 crisis presents an opportunity to engineer a transition to a greener economy, despite its adverse effect on firms’ environmental performance. *GLOBAL FINANCIAL STABILITY REPORT: BRIDGE TO RECOVERY — International Monetary Fund | October 2020* ### Chapter 5). ### Chapter 5) ### Policy priorities during and after the pandemic - After the pandemic is fully under control, policy support can be gradually withdrawn. - Postpandemic policy priorities should focus on: - rebuilding bank buffers, - strengthening regulation of nonbank financial institutions, - stepping up prudential supervision to contain excessive risk taking in a lower-for-longer interest-rate environment. ### Executive Board discussion: outlook, risks, and policy guidance - Directors broadly concurred with the assessment of the global economic outlook, risks, and policy priorities. - Key judgments and concerns: - The path to prepandemic activity will be long and precarious with persistent scarring effects on output and employment. - Projections assume social distancing will continue into 2021 and then fade as therapies improve and vaccines become more broadly available. - The pandemic is having dramatic effects on vulnerable people, leading to higher inequality and a sharp increase in the number of people living in extreme poverty. - The uncertainty surrounding baseline projections remains exceptionally large; recovery will be shaped primarily by the path of the pandemic, the efficacy of containment measures, and pharmaceutical innovations. - Other important sources of uncertainty include global spillovers, damage to supply potential, efficacy and duration of policy support, and potential shifts in financial market sentiment. - Prepandemic risks persist: trade and technology tensions, geopolitical challenges, and climate change. - Near-term policy priorities highlighted by Directors: - Support the economic recovery, protect vulnerable people, and strengthen health care systems. - Reduce scarring effects on potential output and employment and reverse trends toward greater inequality and setbacks to human capital accumulation. - Use the crisis as an opportunity to stimulate innovation, develop digital infrastructure, and transition to lower carbon emissions with tools such as green investment and a gradual increase of the carbon price, with attention to offsetting negative social impacts. - Fiscal policy guidance from Directors: - Lifelines should not be withdrawn prematurely as economies tentatively reopen. - Support should gradually shift from protecting jobs to helping displaced workers find new jobs through retraining and reskilling. - When the pandemic is under control, governments will need to address legacies of the crisis: record deficits and public debt levels, elevated unemployment, and increased poverty. - Public investment should play a crucial role in supporting the postpandemic recovery, with good governance, budget execution, and communication emphasized. - Governments will need credible and equitable measures to reduce fiscal deficits and debts over the medium term; countries with limited fiscal space should protect public investment and support lower-income households. - Considerations for revenue and tax policy: increasing progressive taxation and reforms to modernize business taxation, including multilateral cooperation on international corporate taxation to address digital economy challenges. - LICs face significant financing constraints and many will require external support, including debt relief, grants, and concessional financing. - Monetary and financial policy guidance: - Bold policy actions by central banks to ease policy, provide ample liquidity, and maintain credit flows have helped contain near-term global financial stability risks. - As economies reopen, accommodative policies and continued flow of credit will be essential; once the pandemic is under control, policy support can be gradually withdrawn. - The postpandemic financial reform agenda should focus on addressing vulnerabilities in the nonbank financial sector and stepping up prudential supervision to contain excessive risk taking in the lower-for-longer interest rate environment. - International cooperation: - Scale up production capacity and distribution channels to ensure all countries have access to an effective, affordable, and safe vaccine. - Several emerging market and developing countries require international assistance through debt relief, grants, and concessional financing. - The IMF has rapidly scaled up its lending facilities since the onset of the pandemic, providing swift financial assistance to more than 80 countries. - Opportunities exist for multilateral cooperation to alleviate trade and technology tensions and collectively implement climate change mitigation policies. ### Economic contraction and projections - The COVID-19 pandemic has led to an unprecedented contraction in economic activity globally. - Global growth projections (October 2020 World Economic Outlook): - global growth projected at –4.4 percent this year, - global growth forecast of +5.2 percent for 2021. - More than 85 percent of countries around the world are expected to see subzero growth this year. - The distributional outlook and risks: - The probability of global growth falling below zero in 2021 is close to 5 percent. - The recovery is expected to be uneven across sectors and countries; delayed recovery could lead to renewed liquidity pressures and sharply rising insolvencies. - Some vulnerable firms (such as SMEs) and contact-intensive sectors will experience greater distress. ### Financial stability assessment and channels - Unprecedented policy support has been successful in boosting investor sentiment and maintaining the flow of credit. - Policy measures have included central bank asset purchases (including for some emerging market central banks), liquidity provision, and fiscal lifelines, which have helped contain downside risks and bought time for authorities. - Risks and vulnerabilities: - Vulnerabilities are rising, notably in the nonfinancial corporate sector as firms have taken on more debt to cope with cash shortages. - Sovereign vulnerabilities have increased as fiscal deficits have widened to support economies. - Corporate liquidity pressures may morph into insolvencies—SMEs are more vulnerable than large firms with access to capital markets. - While the global banking system is overall well capitalized, there is a weak tail of banks and some banking systems may experience capital shortfalls in the October 2020 World Economic Outlook adverse scenario. - Rising defaults could lead to significant losses at banks and nonbank financial institutions. - Some emerging and frontier market economies face financing challenges that may tip some into debt distress or lead to financial instability, requiring official support. - Financial conditions and market indicators: - Since June 2020, global financial conditions have remained accommodative on the back of continued policy support. - In advanced economies, low interest rates and recovery in risk asset markets have supported further easing in financial conditions; real yields have been driven down to historic lows. - Market-implied inflation expectations have recovered since the March sell-off but remain slightly below pre–COVID-19 levels. - In other emerging markets (excluding China), financial conditions have generally eased since June, more so in emerging market economies in Asia and Latin America than in Europe, the Middle East, and Africa; external spreads for many emerging markets remain above pre–COVID-19 levels. - In China, financial conditions remained broadly stable over the summer; policy shifts in May led to a rebound in bond and money market yields amid improving economic activity and concerns about rising financial sector risks. - Policy trade-offs and potential unintended consequences: - Sustained policy measures may contribute to stretched asset valuations or fuel financial vulnerabilities if kept in place for an extended period and if investors become used to them. - Central banks need to take such considerations into account when planning the eventual withdrawal of support. ### Sectoral differentiation and outlook - The pandemic has hit some economic sectors harder than others: - More affected sectors: airlines, hotels, energy, and financials. - Less affected sectors: information technology, communications. - Equity market rebounds have been stronger in indices with a larger share of sectors less affected by COVID-19. - Market analysts’ earnings forecasts show: - Large swings in 2020–21 earnings per share forecasts, large dispersion across analysts, and significant downgrades in sectors such as consumer services (hotels, restaurants, leisure), industrials (capital goods), and financials (banks). *Source: text - Chapter 5). PDF (October 2020) — International Monetary Fund* ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY ### Risk asset rebound amid high economic uncertainty - Global equity markets have rebounded from the March lows despite subdued activity and a highly uncertain outlook. - Rebound shows notable differentiation across countries and sectors, depending on the spread of the virus, the scope of policy support, and sectoral composition. - Stock market recovery drivers: - A decomposition of S&P 500 year-to-date performance shows a sharp deterioration in the corporate earnings outlook contributed negatively, but this was more than offset by: - A lower risk-free rate (noted as the primary positive contributor). - A compression of the equity risk premium (shown as a positive contribution). - Sectoral composition and investor base effects (for example, the large share of tech firms in the S&P 500) boosted US market performance. - Retail investor participation increased in several markets and likely provided further support to equity prices. - Concentration and sectoral dominance: - The top five S&P stocks (Alphabet, Amazon, Apple, Facebook, Microsoft) account for about 25 percent of total market capitalization. - These top five firms tend to dominate information technology, telecommunications, and consumer discretionary sectors and have large international exposures. - Market corrections and risks: - The September correction in equity markets illustrated vulnerability to sector-specific re-pricing (for example, tech). - Market valuations may be sustained while market participants expect policy support to be maintained or scaled up, but the risk of a sharp adjustment or periodic volatility remains if perceptions about the extent or duration of policy support change or the recovery is delayed. ### Equity valuation misalignments and volatility patterns - IMF staff equity valuation models indicate overvaluations are at historically high levels in some countries. - Divergence between elevated economic uncertainty and compressed equity market volatility: - Both option-implied volatility (VIX) and realized market volatility declined sharply in late March–April even though uncertainty about earnings outlook remained elevated. - The VIX and realized volatility decline reflected improved funding and liquidity conditions following policy interventions. - Model caveats: - The equity valuation model relies on 12-month- and 18-month-ahead earnings forecasts and does not capture the impact of the longer-term earning growth expectations on equity valuations. - Misalignment is interpreted as the portion of the equity risk premium unexplained by expected corporate earnings, uncertainty about future earnings, term spreads, and interest rates. ### Credit market valuations and policy support effects - Yields in credit markets declined since the start of the pandemic, reflecting both a decline in risk-free rates and compression in credit spreads due to policy support. - US investment-grade corporate bond yield decomposition (model-based) indicates policy support (including Federal Reserve rate cuts, asset purchases, and facilities) substantially offset the impact of deteriorating economic fundamentals that would have otherwise pushed yields higher. - Bond spread misalignments: - Credit spreads appear too compressed relative to economic fundamentals across both advanced and emerging markets. - In emerging markets, declines in hard currency bond spreads and in local currency bond yields since March are partly traced to policy support, including spillovers from advanced economy easing. - Rough estimates suggest US policy actions since the COVID-19 sell-off account for about one-quarter to one-half of the decline in emerging markets’ long-term interest rates (see Online Annex 1.1 referenced in source). - Local currency bond markets in some emerging market central banks experienced lower short rates and long-term yields due to both conventional and unconventional policies, including asset purchases. ### Rising global financial vulnerabilities since the COVID-19 outbreak - Vulnerabilities were already elevated before the outbreak across asset management companies, nonfinancial firms, and sovereigns in 29 jurisdictions with systemically important financial sectors (S29). - Since the outbreak, vulnerabilities have continued to rise, increasing the risk of adverse macro-financial feedback loops if triggers occur (new outbreaks, policy missteps, or other shocks). - Key channels through which rising vulnerabilities may impede recovery: - Widespread bankruptcies were largely avoided so far because of large and frontloaded policy support, but solvency risks have been shifted into the future as firms borrowed more to cope with cash shortages. - SMEs, especially in contact-intensive industries, are much more vulnerable than large firms with access to capital markets. - Credit losses could deplete banks’ capital buffers, affecting banks’ ability and willingness to provide credit to households and firms. - Although the global banking system is well capitalized, a weak tail of banks exists, and some banking systems may experience capital shortfalls in the adverse WEO scenario even with current policy measures. - Fragilities in the nonbank financial sector aggravated market dislocations during the March sell-off; central bank support limited but did not eliminate these fragilities. - Market expectation that central banks will extend policy support in response to adverse shocks may encourage excess risk taking. - Shrinking policy space could constrain public-sector capacity to continue backstopping the private sector, especially where vulnerabilities are high and rising across several sectors. - External financing challenges facing emerging and frontier markets may push some into debt distress or lead to financial instability. ### Solvency risks in the nonfinancial sector and policy mitigation - Nonfinancial firms in many systemically important economies entered the COVID-19 recession with elevated vulnerabilities. - The share of S29 economies with high or medium-high corporate sector vulnerabilities was already close to 80 percent (by GDP) before the pandemic. - After the outbreak, cash flows fell sharply as activity declined. More vulnerable firms experienced larger hits to cash flow. - Policy measures have so far mitigated widespread bankruptcies, but accumulation of debt may lead to future solvency pressures, particularly for SMEs and contact-intensive sectors. - Potential adverse dynamics: - More widespread bankruptcies could lead to repricing of credit risk, tightening of bank lending standards, and renewed sharp tightening of financial conditions, potentially requiring further liquidity and solvency policy measures. *International Monetary Fund | October 2020* ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY ### Vulnerabilities Across Sectors and Regions - Vulnerabilities have increased across more regions in the corporate and sovereign sectors as corporate borrowing surged amid the COVID-19 pandemic, whereas vulnerabilities in the nonbank financial sectors remain elevated. - Even though latest readings for some insurance sectors and asset managers put them slightly below the threshold for “medium-high vulnerability” as of 2020:Q1, given the exceptionally high uncertainty these sectors are categorized as “medium-high” in this assessment. - In the assessment visuals: dark red shading indicates a value in the top 20 percent of pooled samples (advanced and emerging market economies pooled separately) for each sector during 2000–20 (or longest sample available); dark green shading indicates values in the bottom 20 percent. ### Corporate Sector: Borrowing, Liquidity, and Solvency Risks - Firms in advanced and emerging market economies stepped up bond issuance and increased bank borrowing to cope with cash shortages, refinance debt, or build precautionary cash buffers. - Rapid expansion of bank credit in the first half of 2020 partly reflects sizable credit line drawdowns (especially in the United States), government guaranteed loans, and lending under government-supported programs. - The share of firms that had to raise new debt because they could not generate enough cash to cover their debt service costs rose sharply. - Increased net borrowing has helped reduce liquidity pressures and mitigated a larger increase in defaults for now; however, rising debt may deteriorate repayment capacity over the medium term, putting solvency at risk. - Corporate credit quality deterioration: - Credit rating downgrades initially spiked. - Year-to-date speculative-grade defaults have risen quickly, particularly in the United States. - Missed debt payments were reported as the leading cause of defaults in 2020 to date. - Firms in sectors most affected by the pandemic—air travel, retail, hospitality, and energy—have seen higher default rates. - Largest increase in defaults has been among high-yield bond issuers, followed by leveraged loans and middle-market loans, even though defaults are still significantly lower than in 2008–09. - Rating agencies’ forecasts for speculative-grade defaults in 2021 show a fairly wide range, reflecting significant uncertainty about the evolution of the pandemic and corporate credit quality. - Policy implication: The future path of defaults and bankruptcies will critically depend on the evolution of the pandemic and on policymakers’ capacity to maintain accommodative funding conditions and continue to provide fiscal support to viable firms. ### Small and Medium-Sized Enterprises (SMEs) - SMEs are much more vulnerable than large firms because they tend to have thin equity cushions, low liquidity buffers (lack of precautionary credit lines and liquid and noncore assets), limited financing options, and nondiversified revenues. - The COVID-19 shock was particularly damaging for SMEs because they tend to dominate contact-intensive sectors (hotels, restaurants, entertainment). - Widespread insolvencies among SMEs could have a significant direct macroeconomic impact and adverse implications for the health of the banking sector. - Notably in Europe, SMEs account for more than half of total output and about two-thirds of employment and thus can affect financial stability through macro-financial linkages. - Because SMEs rely almost entirely on bank financing, they could be a source of vulnerability, especially for regional and small banks. ### Household Sector and Housing - The COVID-19 pandemic resulted in unprecedented job losses, especially in the United States and in some emerging market economies where unemployment support has been more limited. - With sharply reduced personal income of affected households, indebtedness has risen to cover lost income, further weakening debt servicing capacity in the future. - The new buildup of debt is occurring on top of already elevated household leverage in a number of major economies. - Historically, higher unemployment portends more delinquencies and larger bank losses on unsecured consumer credit. - Example: Delinquencies on US credit cards started to accelerate in the first quarter of 2020, whereas delinquencies on mortgages remained low. - Housing markets: - Real house price growth was positive in most advanced economies in the first quarter of 2020, boosted by policy support (lower mortgage rates and moratoriums on interest payments, foreclosures, and evictions). - In emerging market economies, year-over-year real house prices declined in China and India but continued to rise in other major economies. ### Bank Resilience and Stress Scenarios - Banks entered the COVID-19 crisis with significantly stronger capital and liquidity buffers than at the time of the global financial crisis. - Policies supporting borrowers and encouraging banks to use regulatory flexibility have likely supported banks’ willingness to provide credit. - Some banks have started tightening lending standards in response to deteriorating economic conditions and borrowers’ financial positions. - Forward-looking bank solvency analysis covers about 350 banks accounting for about 75 percent of global banking assets across 29 jurisdictions (largest banks covering up to 80 percent of banking assets in each jurisdiction). The simulation does not include consequences for small banks. - Scenario outcomes: - Baseline (October 2020 WEO baseline): Most banks are able to absorb losses and maintain capital buffers above minimum regulatory capital requirements. - Adverse scenario (deeper recession and weaker recovery): There is a sizable weak tail of banks whose capital falls below regulatory minimum. - Capital shortfalls in October 2020 WEO adverse scenario: - Capital shortfall relative to minimum capital requirements is about $110 billion. - Capital shortfall relative to broad capital requirements (including the countercyclical capital buffer, the capital conservation buffer, and systemic risk buffers) could reach $220 billion, after accounting for policy support. - This implies the average capital shortfall in the adverse scenario is close to 1 percent of GDP. - For comparison, the median government bank recapitalization during the global financial crisis was about 3.6 percent of GDP. - Regulatory reference: The regulatory minimum is the “Pillar 1” requirement—4.5 percent of risk-weighted assets—plus the mandatory buffers required of each global systemically important bank. - Caveat: The full fiscal cost of ensuring banks are adequately capitalized must include direct fiscal support to firms and households, which effectively reduced bank recapitalization needs ex ante and may affect fiscal capacity to provide additional support in the future if needed. - A more severe adverse scenario with larger banking sector losses cannot be ruled out. ### Fragilities in Nonbank Financial Institutions - Asset managers in advanced economies entered the pandemic with already elevated vulnerabilities, including sizable liquidity mismatches. - After the outbreak, asset managers faced increased credit risk and became more interconnected with banks; exposures through investment positions (including bank deposits and money market fund shares) have risen. - Borrowing from banks by funds has increased as funds tapped into credit lines. - Combined higher credit risk and increased leverage in other financial institutions could lead to larger potential losses if market stress returns. - During the March 2020 sell-off, fixed-income funds saw a surge in redemptions, leading to selling pressures and revealing weaknesses in market infrastructures and dealers’ intermediation capacity. - Jurisdictions with swing pricing reportedly saw less price pressure from redemptions. - Fund flows have generally recovered with the rebound in asset markets supported by strong policy measures. - Insurance companies and pension funds saw portfolio losses during the March sell-off but have also seen portfolio values recover. *International Monetary Fund | October 2020 — CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY* ### 1. Distribution of Bank Assets by Capital Ratio under Adverse Scenario, ### 1. Distribution of Bank Assets by Capital Ratio under Adverse Scenario, ### Banking sector: capital depletion and shortfalls - In the adverse scenario, "the weak tail of banks is large, especially in emerging markets." - Policy mitigation "helps cushion some of the capital depletion and has been stronger in advanced economies." - Panel note: the shortfall in panel 2 is measured against bank-specific and fully loaded capital requirements effective August 2020, which include a minimum CET1 of 4.5 percent, a GSIB buffer, a systemic risk buffer, a stress capital buffer, a conservation capital buffer, and a countercyclical capital buffer, where applicable. - Acronyms preserved: AE = advanced economy; CET1 = common equity Tier 1; EM = emerging market; GSIB = global systemically important bank; T = trough year. ### Nonbank financial sector vulnerabilities and amplification channels - Existing fragilities could lead to portfolio rebalancing in response to investor redemptions and market losses or to a pullback from certain markets, with potential sizable credit losses in riskier segments (leveraged loans and private debt). - Key channels and findings: - Liquidity mismatches in the asset management sector "remain elevated, especially in some fragile segments." - Fixed-income funds during the March sell-off "reacted primarily by reducing liquid assets, but also by selling less-liquid assets," contributing to price dislocations and potential for larger-scale fire sales absent central bank interventions. - Extremely low yields, compressed market volatility, and perceived central bank backstops create incentives for financial releveraging; volatility-targeting investors may re-leverage as volatility normalizes. - Variable annuity funds are noted as the largest among volatility-sensitive strategies, "at an estimated $0.5 trillion in assets under management," and are more likely to deleverage quickly when volatility spikes. - Theoretical volatility-targeting portfolio assumptions: 60 percent global equities / 40 percent bonds and an annual return volatility target of 10 percent; leverage defined as total investment exposure divided by net asset value. - Correlations across risk assets "remain well above the 2008–09 levels," reducing diversification and increasing contagion risk. - Conclusion: "fragilities in the sector remain elevated and may lead to larger-scale distress and fire sales in a more prolonged episode of market stress." ### Sovereign debt, contingent liabilities, and sovereign-bank linkages - The COVID-19 crisis is expected to push global public debt above 100 percent of GDP in 2020, "the highest ever." - Public debt reached historic highs in most systemically important economies at the end of the first quarter of 2020. - Headline fiscal deficits in advanced economies in 2020 "are expected to be five times higher than in 2019." - In the baseline scenario, public debt ratios are generally expected to stabilize in 2021, "except in the United States and China." - Six out of S29 jurisdictions show elevated vulnerabilities in corporate, banking, and sovereign sectors ("6 out of S29 jurisdictions now showing elevated vulnerabilities in the corporate, banking, and sovereign sectors"). - Bank holdings of government debt "have increased in most countries, again tightening sovereign-bank linkages." - The simultaneous increase in private and public sector vulnerabilities can raise financial stability risks through sovereign-corporate linkages at the local government level. ### Emerging and frontier market external financing risks - Local currency government bond issuance picked up pace in some emerging markets, with several economies (Chile, Colombia, Thailand) managing to fund large portions of projected deficits for 2020–21, while many others still face significant financing requirements. - Portfolio flows into local currency bond funds "remain weak since the COVID-19 sell-off." - Many emerging markets (India and Mexico, among others) have delayed new local debt issuance to the second half of the year; some have increased reliance on foreign currency debt. - IMF staff capital-flows-at-risk analysis: - Probability of outflows over the next three quarters fell from about 60 percent at the peak of market turmoil to about 25 percent in September. - The capital flows at risk (measured as the 5th percentile of the distribution) stands at –1.9 percent of GDP according to the latest assessment, compared with –3.3 percent of GDP on March 23 and realized portfolio outflows of almost 2 percent of GDP in 2020:Q1. - Frontier market economies face considerable financing challenges; many low-income countries with marketable debt have large rollover needs. - Restructuring milestone: in late July and early August, Argentina and Ecuador reached restructuring deals with bondholders. ### Policy priorities and phased focus - As the recovery takes hold, policy focus shifts from liquidity provision to managing gradual reopening and supporting a sustainable recovery. - For the "gradual reopening" phase (lockdown measures eased but uncertainty remains), the priority is to ensure policy support is maintained so the recovery can become sustainable. - Monetary accommodation: "should be maintained." Advanced economies face effective lower bounds for conventional monetary policy; many emerging markets still have room for further policy cuts. *Sources: Bloomberg Finance L.P.; Fitch; IMF, October 2020 World Economic Outlook; and IMF staff estimates.* ### 1. Hard Currency Bond Spreads ### 1. Hard Currency Bond Spreads ### Emerging and Frontier Market Spreads and Market Access — Key Findings - The COVID-19 pandemic pushed spreads of lower-rated economies to prohibitive levels, highlighting large refinancing needs of several frontier market economies. - Figure context: 1. Hard Currency Bond Spreads (Basis points); 2. External Debt Service through the End of 2021 (Share of foreign reserves, percent, as of July 2020). - Country-level spread markers listed in the source (preserved as presented): 136, 112, 102, 57, 52, 41, 36, 34, 24, 15, 8. - Sources cited in the figure: Bloomberg Finance L.P.; World Bank Debtor Reporting System; and IMF staff calculations. - Note from the figure: EMBI = JP Morgan Emerging Markets Bond Index; IG = investment grade. ### Liquidity, Market Functioning, and Central Bank Actions — Observations - Some emerging market central banks launched asset purchase programs to stabilize local markets and ease financial conditions; in some cases these purchases facilitated financing of government deficits. - Transparency and clear communication of policy objectives are crucial to minimize risks to central bank credibility and the perception of monetary financing—especially in countries with weaker institutional and governance frameworks. - A number of backstops remain in place to provide necessary liquidity support to financial markets and institutions; many central bank programs were designed to provide support at prices attractive in stressed markets but at a premium in normal conditions, creating incentives for institutions to return to market funding as conditions normalize. - Example noted: the Federal Reserve extended its support programs until the end of 2020. ### Monetary and Financial Policy Road Map — Phase-by-Phase Priorities (as presented) - Great Lockdown - Monetary Policy: Ease monetary policy, including use of unconventional monetary policy tools. - Liquidity Support to Core Funding Markets: Provide support to maintain market functioning and liquidity. - Liquidity Support to Financial Institutions: Provide support to alleviate liquidity stress and support monetary policy accommodation. - Measures to Maintain the Flow of Credit: Release macroprudential buffers, allow the use of capital and liquidity buffers, and apply regulatory flexibility as appropriate; suspend distribution of banks’ profits (dividend payouts and share buybacks); provide financing support to households and businesses. - Measures to Address Problem Assets: Provide guidance on asset classification and provisioning. - Financing Support to Business: Provide credit guarantees (or other risk mitigation) and term funding to support new lending. - Debt Restructuring for Businesses and Households: Introduce repayment moratoria. - Gradual Reopening under Uncertainty - Monetary Policy: Maintain monetary policy accommodation. - Liquidity Support to Core Funding Markets: Maintain support, but adjust pricing as appropriate to incentivize and prepare the ground for exit from use of central bank facilities. - Liquidity Support to Financial Institutions: Maintain support, but adjust pricing as appropriate to incentivize the return to normal market funding. - Measures to Maintain the Flow of Credit: Continue allowing the use of capital and liquidity buffers; suspend distribution of banks’ profits; provide financing support to households and businesses. - Measures to Address Problem Assets: Maintain prudential standards to incentivize the recognition and handling of problem assets. - Financing Support to Business: Maintain financing support if containment measures are reintroduced, but tighten eligibility criteria to better target illiquid but solvent firms. - Debt Restructuring for Businesses and Households: Extend repayment moratoria only if necessary to prevent widespread insolvencies; facilitate debt restructuring that reduces debt overhang and/or adjust repayment schedule; provide solvency support to viable systemic firms, grants for smaller firms; ensure efficient out-of-court agreements, with fast-track procedures to support debt restructuring. - Pandemic under Control - Monetary Policy: Maintain monetary policy accommodation until the policy objectives (for example, inflation target) are achieved. - Liquidity Support to Core Funding Markets: Gradually withdraw support, as warranted. - Liquidity Support to Financial Institutions: Maintain liquidity support only as required to support monetary policy accommodation. - Measures to Maintain the Flow of Credit: Rebuild capital and liquidity buffers gradually over time while ensuring continued financial institutions’ capacity to extend credit; suspend distribution of banks’ profits. - Measures to Address Problem Assets: Require banks to develop credible plans to reduce problem assets over an appropriate period of time; handle weak banks that experience significant credit losses; foster the development of markets for distressed assets. - Financing Support to Business: Withdraw unwarranted support. - Debt Restructuring for Businesses and Households: Facilitate debt restructuring that reduces debt overhang; ensure efficient out-of-court agreements; provide solvency support where appropriate. ### Bank Lending, Provisions, and Supervisory Guidance — Analysis and Recommendations - Banks should be encouraged to continue lending while maintaining prudential and accounting standards for loan classification and provisioning. - Timely and reliable recognition of loan losses based on the expected credit loss framework (under International Financial Reporting Standard 9) is essential; country authorities may delay the impact of additional provisions on regulatory capital with adequate disclosure of fully loaded capital positions. - Supervisors should provide guidance on restructured loans, including those from moratoria on repayments. - Guidance on the usability of bank buffers and the optimal pace of rebuilding buffers once recovery becomes sustainable should be balanced against the need for continued credit provision. - Banks with high levels of nonperforming loans should be required to develop and implement credible action plans to reduce nonperforming loans within an appropriate time frame; supervisors may consider suspending automatic triggers for corrective actions and instead require banks to present credible plans to restore capital. ### Solvency, Restructuring, and Insolvency Frameworks — Policy Actions - Policymakers should shift focus from liquidity support to solvency support as temporary measures expire; financing support increases indebtedness and may leave firms and households with solvency pressures after moratoria are lifted. - Options for firms: - Recapitalization for firms deemed viable, with equity-like support preferable to additional debt in some cases. - Restructuring for firms facing structural challenges, with simplified, standardized procedures to facilitate out-of-court agreements. - Resolution or orderly exit for unviable firms; foster development of markets for distressed assets. - Policymakers should prepare for corporate and household insolvencies’ implications for banks, nonbank financial institutions, and sovereigns; ensure credible recovery strategies, contingency plans, and use of resolution tools where necessary. - At the sovereign level, develop credible medium-term fiscal strategies to ensure debt sustainability given possible significant fiscal costs from prolonged policy support. ### Policy Responses if Recovery Is Delayed — Contingent Measures - Be prepared to scale up liquidity support in a more targeted manner if the economic outlook deteriorates (for example, due to new outbreaks). - Targeted fiscal measures should efficiently help the most vulnerable firms and individuals; eligibility criteria must be gradually tightened to focus support on viable firms and avoid a debt overhang. - Moratoria on repayments should be extended only if necessary to prevent widespread insolvencies stemming from renewed lockdowns. - Monetary policy may be eased further as needed, including reactivating or expanding emergency lending and unconventional monetary policy measures. - Provide solvency support (targeted transfers, tax relief, scaled-up support to viable strategic or systemic firms) to mitigate systemic risk. ### Post-Pandemic Financial Reform Agenda — Priorities for Stability and Resilience - Strengthen the regulatory framework for the nonbank financial sector and broaden the regulatory perimeter as lessons from the COVID-19 crisis suggest central banks may need to backstop essential market segments. - Adjust operational frameworks for central counterparty clearing houses (CCPs) to limit procyclicality in margin calls and ensure counterparties can anticipate and prepare for margin demands. - Adopt a more robust liquidity risk management framework for investment funds (International Organization of Securities Commissions 2018), including tools to better manage redemptions and identify risks early; consider the usability of liquidity buffers in crisis times. - Step up prudential supervision to curb excessive risk taking in a lower-for-longer interest rate environment. *Source: IMF staff, Chapter 1, GLOBAL FINANCIAL STABILITY REPORT: BRIDGE TO RECOVERY — October 2020.* ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OvERvIEW: BRIdGE TO RECOvERY ### CHAPTER 1 GLOBAL FINANCIAL STABILITY OVERVIEW: BRIDGE TO RECOVERY ### Policy tools, recommendations, and macroprudential stance - Swing pricing - Wider adoption of swing pricing in investment funds is advisable to help contain redemptions, particularly in jurisdictions with sizable asset management sectors. - Implementation will likely need to be phased in over time because of jurisdiction-specific institutional and legal arrangements and will require modifications to existing operational infrastructure. - An internationally harmonized measurement of leverage in investment funds (International Organization of Securities Commissions 2019) should help with timely recognition and mitigation of financial stability risks. - Macro- and microprudential measures to curb excessive risk taking in a lower-for-longer interest rate environment - Strengthen the macroprudential policy framework to ensure adequate capital and liquidity buffers in banking systems. - Contain excessive risk taking in the nonbank financial sector and create macroprudential space that could be used to cushion the impact of adverse shocks. - Prudential authorities could implement measures such as loan-to-value ratio and debt-to-income ratio limits to prevent excessive risk taking that could inflate property prices, including in commercial real estate. - Example: the ECB emphasized creating releasable countercyclical capital buffers (CCyBs) in the euro area to help sustain credit in a downturn. ### Commercial real estate (CRE): size, recent trends, and vulnerabilities - Systemic importance and exposure - In several economies, commercial real estate loans constitute a significant part of banks’ lending portfolios (example figures given for the United States and the euro area in the source). - Commercial mortgage-backed securities (CMBS) issuance exceeded $100 billion in 2019. - Valuations and capitalization - Over 2009–19, commercial property asset valuations rose, on average, 4.5 percent a year to reach historical highs in several economies. - Capitalization rates fell to their lowest levels in recent years. - COVID-19 impact on transactions, sector segments, prices, and funding - Global commercial property transactions slumped by about 50 percent in 2020:Q2 relative to 2019:Q2. - Within the sector, retail and hospitality businesses were most affected, with sales down by 60 percent and 80 percent, respectively (panel 3). - Available price data show the retail sector price index fell by about 18 percent and 23 percent in July year over year in the European Union and the United States, respectively (panel 4). - Funding costs increased sharply in mid-March 2020: spreads on BBB-rated CMBS and CMBS indices remained much higher in June relative to pre-pandemic levels. - Syndicated CRE lending dropped by about 50 percent in North America, 70 percent in Europe, and 40 percent in Asia in 2020:Q2, year over year. - In the United States, 5.8 percent of CMBS loans were delinquent in 2020:Q2, an increase of more than 200 basis points relative to the previous year. - Outlook and risks - Rating-agency projections suggest CMBS default rates are expected to more than double in 2020:Q3. - Structural shifts (increased e-commerce; cost savings from work-from-home) could reduce demand for retail and office space, potentially inducing significant volatility and broader macro-financial risks. ### Behavior of investment funds during the March 2020 market turmoil (fixed-income funds) - Observed dynamics and market liquidity - Fixed-income and nongovernment money market funds experienced a short period of intense withdrawals in March 2020. - Market liquidity of securities held by fixed-income funds deteriorated substantially: average bid-ask spreads near doubled for a sample of 323 fixed-income funds. - For the most affected portfolios, average bid-ask spreads more than tripled temporarily. - Funds’ responses to redemptions - Most fixed-income funds used liquidity buffers and shed liquid assets (cash, cash equivalents, US Treasuries) to cover redemptions; funds receiving inflows hoarded cash and delayed investments. - Some funds purchased assets at high bid-ask spreads, possibly using cash reserves to exploit illiquidity discounts. - Funds facing outflows reduced exposures to corporate bonds given investor sensitivity to performance. - Only a handful of funds suspended redemptions; Fitch reported mutual funds suspended a total of $62 billion year to date, equivalent to 0.11 percent of the sector’s total assets (Fitch Ratings 2020). - Data limitations prevented a full analysis of swing pricing effectiveness during March 2020, though swing pricing may have helped manage redemptions and Jin and others (2019) provide evidence for UK corporate bond funds in stress periods. - Market impact of fund asset sales - Fixed-income funds forced to sell assets contributed to price pressures and liquidity strains: bid-ask spreads of assets sold most heavily by such funds increased more than those not facing selling pressure. - Cumulative returns of assets under selling pressure declined more than assets experiencing no pressure (panel 4). - Some funds, even those with large outflows, absorbed relatively illiquid assets and mitigated price pressures. - Policy implication - A comprehensive review of prudential tools in the investment fund sector, including broader adoption of swing pricing, would help mitigate vulnerabilities revealed during the COVID-19 turmoil. ### China: local government debt vulnerabilities and financial stability implications - Rapid rise in local government borrowing and LGFV exposure - Direct borrowing by local governments was first permitted in 2015 and has risen quickly to 24 percent of GDP, significantly outpacing growth in local government tax revenues. - Entities identifying as local government financing vehicles (LGFVs) in bond prospectuses have outstanding debt equivalent to 39 percent of GDP. - Sensitivity of LGFV and lower-rated firm borrowing conditions to local government debt - LGFVs in provinces with financially weaker local governments have seen bond market credit spreads widen notably relative to other provinces; overall debt growth has slowed or contracted in those provinces. - Province-level bond market credit spreads for lower-rated non-LGFV firms showed sharply increased differentiation based on government direct debt loads in 2019. - Effectiveness of COVID-19 credit measures and credit impulses - Net new credit to the household and corporate sectors in the first half of 2020 was equivalent to 18 percent of 2019 GDP, but 40 percent of that increase occurred in just three provinces. - Provinces with worse debt-to-revenue ratios saw significantly weaker credit impulses than the national average. - Unserviceable debt and potential fiscal spillovers - Roughly 75 percent (RMB 26 trillion) of outstanding LGFV debt is likely unserviceable, defined as owed by LGFVs with a net-debt-to-earnings ratio of more than 15 or negative earnings. - Local SOEs owe another RMB 10 trillion in similarly defined unserviceable debt. - If local governments assume this unserviceable debt, it will more than double existing debt loads and increase by tenfold the debt owed by provinces with debt-to-revenue ratios above 400 percent (panel 4). - Bank exposure and systemic risk - Banks are the primary creditors to LGFVs and local SOEs; potential nonperforming loans could cause large negative spillovers to banks’ asset quality. - Linkages between local governments, firms, and banks could pose significant financial stability risks. - Policy priorities for China - Strengthen intergovernmental fiscal coordination framework. - Introduce bank and corporate restructuring frameworks in line with international best practices. - Address remaining gaps in financial supervision and regulation. *International Monetary Fund | October 2020* ### Box 1.3. Interlinkages among Local Government, Corporate, and Bank Vulnerabilities in China ### Box 1.3. Interlinkages among Local Government, Corporate, and Bank Vulnerabilities in China ### Key mechanisms and qualitative findings - Direct local government debt has been rising faster than indirect debt incurred via local government financing vehicles, outpacing growth in local tax revenues. - Bigger government debt loads may weaken backstops for local firms, resulting in increased credit risk premiums and deleveraging for firms with weaker stand-alone debt servicing capacity. - Much of the LGFV and local SOE debt local governments are exposed to is unserviceable, implying significant further deterioration in backstops. - Policy-driven credit growth acceleration in response to the COVID-19 pandemic has disproportionately benefited provinces with more manageable government debt loads. ### Quantitative indicators and thresholds (as presented) - Financial strength quintile (labeling used in figures): - 5th (strongest) - 4th - 3rd - 2nd - 1st (weakest) - Debt to revenue (right scale) bands shown: - 0–200 percent - 200–400 percent - 400–600 percent - 600–800 percent - 800–1000 percent - Total 2020:H1 new credit/2019 GDP: 18.26% - Regression and fit statistics displayed in figures: - R2 = 0.3473 - R2 = 0.3808 - R2 = 0.1885 - Fitted line reported: y = –0.0219x + 19.893 ### Data sources, definitions, and methodological notes - Sources: Bloomberg Finance L.P.; CEIC; and IMF staff calculations. - LGFV debt measure: - Based on financial statements of 1,852 firms with bonds designated as urban investment vehicle bonds. - 2020:H1 LGFV total borrowing is estimated as the 2020:Q1 level multiplied by the 2020:Q1 quarterly growth rate. - In panel 2 (top chart), province quintiles are based on equally weighted ranking of fiscal deficit and debt-to-GDP ratio. - Borrowing cost measures are based on weighted average bond coupons. - In the bottom-right chart of panel 2, change is the 2019 average minus the 2018 average. - In panel 4, "unserviceable debt" is defined as debt held by firms with a net debt to EBIT ratio above 15 (or negative earnings). - Consolidated firm earnings are added to local government revenues. - Acronyms preserved as presented: EBIT; LG; LGFV; SOE. ### Implications for vulnerability transmission - Rising direct local government borrowing, together with substantial unserviceable LGFV and local SOE debt, increases the risk that local government fiscal stress will transmit to corporate credit conditions via weaker backstops. - Provinces with higher government debt-to-revenue ratios experienced less of the policy-driven credit growth acceleration in 2020:H1, indicating heterogeneity in how pandemic-era credit support reached local firms. - Increased credit risk premiums and deleveraging pressures on weaker firms can amplify corporate vulnerability and, through banks' corporate exposures, raise banking sector risks. *Source: IMF staff analysis as presented in Box 1.3 of the publication.* ### CHAPTER 2 EMERGING ANd FRONTIER MARkETS: A GREATER SET OF POLICY OPTIONS TO RESTORE STABILITY ### CHAPTER 2 EMERGING ANd FRONTIER MARkETS: A GREATER SET OF POLICY OPTIONS TO RESTORE STABILITY ### Asset purchase programs implemented in response to COVID-19 - Table 2.1 summarizes country-level asset purchase programs (APPs) across emerging market economies with program objectives, asset types, market (primary/secondary/both), total purchases (percent of GDP), program duration (observed or explicit), significant announcement dates, general government 2020 deficit (percent of GDP), and government debt (percent of GDP). - Selected country program magnitudes (Total Purchases, percent of GDP): - Colombia: 1.1 - Chile: 2.9* - Croatia: 4.9 - Ghana: 1.4 - Guatemala: 1.9 - Hungary: 1.4 - India: 1.0 - Indonesia: 3.8** - Malaysia: 0.6 - Philippines: 4.3 (7.3)*** - Poland: 4.6 - Romania: 0.5 - South Africa: 0.7 - Thailand: 1.0 - Turkey: 1.6 - Selected fiscal context (General Government 2020 Deficit, percent of GDP / Government Debt, percent of GDP): - Colombia: –9.5 / 68.2 - Chile: –8.7 / 32.8 - Ghana: –16.4 / 76.7 - India: –13.1 / 89.3 - Indonesia: –6.3 / 38.5 - Philippines: –8.1 / 48.9 - Poland: –10.5 / 60.0 - South Africa: –14.0 / 78.8 - Turkey: –7.9 / 41.7 - Notes and program nuances included in the source: - Chile’s APP purchases included only Special Asset (June) and Bank Bond (March) Purchase Programs; Chile’s central bank did not gain the legal ability to purchase government bonds until August 12. - Indonesia includes staff estimates of secondary market purchases, primary market purchases prior to July, and the full 397.6 tn July burden sharing agreement, though only about 60 percent of the agreed purchases had been completed through mid-September. - Philippines includes staff estimates of secondary market purchases and a three-month repurchase agreement of 540 bn (3.0% of GDP) with the central government added in parentheses; the BSP closed out a previous 300 bn repurchase agreement in September. - bn = billion; OMO = open market operations; tn = trillion. ### Local market stress dynamics during COVID-19 (Local Stress Index — LSI) - Aggregate LSI outcomes: - The level of stress in local markets during the COVID-19 sell-off, as measured by the LSI, was comparable to that of the global financial crisis, but the period of stress was considerably shorter. - In aggregate, the LSI was well above previous episodes such as the 2013 taper tantrum and 2014–15 stress episodes, but markets normalized much faster than during previous episodes. - Drivers of stress and spillovers: - Large part of increase (and subsequent partial reduction) in local bond market stress originated from developments in global financial markets. - FX market spillovers from the United States and the European Union rose sharply; currencies acted as shock absorbers. - Spillovers to local bond markets were more pronounced than in past tightening episodes, potentially exacerbated by increased non-resident participation in local bond markets since the global financial crisis. - Differences FX versus local bonds: - Stress in FX markets was lower than during 2008–09, with less noticeable demand for dollar liquidity. - Wider cross-currency basis—a measure of dollar funding liquidity stress—was more short-lived in the COVID-19 episode. - Structural factors contributing to calmer FX stress included rapid establishment of central bank swap lines and bond repo facilities by the Federal Reserve and the European Central Bank, increased turnover in emerging market currencies, more electronic trading, and a larger set of market-making institutions. - Unlike FX markets, local bond markets became more stressed, showing larger increases in risk premiums of long-end government bonds relative to short-end bonds and onshore swap rates. - Factors keeping local bond stress elevated: - High local bond supply risks that weigh on yields through risk premiums. - Weak foreign flows to local bond markets negatively impacting liquidity. - Relatively limited depth of local currency government bond markets; domestic banks often the sole liquidity providers in times of stress. ### Effectiveness of domestic asset purchase programs (APPs) - Timing and initial impact: - APP announcements in the second half of March did not have an immediate impact on local stress indices due to very tight global financial conditions, illiquidity, strong risk aversion, and fiscal concerns. - As external conditions improved in April and APP implementation stepped up, country-level local stress indices showed improvement and differentiation. - Market liquidity and term premia: - APPs contributed largely to improvement in market liquidity measures, such as bid-offer spreads and intraday volatility reductions. - Term premiums in some local bond markets remained elevated because investors faced longer-horizon bond supply risks from pandemic-related government financing needs. - Role as circuit breaker: - Introduction of APPs at the height of the crisis likely served as a useful circuit breaker, preventing further escalation of stress by signaling that emerging market central banks were ready to stand as buyer of last resort. - Size and persistence of APPs: - The size of APPs in emerging markets was overall small (except in Chile, Indonesia, the Philippines, and Poland) and short-lived, with a slowdown of asset purchases since May for most countries. - Announcements and implementations can affect markets differently; lack of local currency bond inflows undermined market liquidity in markets with large foreign presence. - Event-study and empirical findings: - Event studies show APP announcements had a significant immediate impact on asset prices and helped turn sentiment around, with a sharp reduction in government bond yields and term premiums but relatively limited impact on currencies. - Empirical analysis (local projections method, daily data from 13 emerging market economies, January to mid-May 2020) controlling for domestic policy rate cuts, the VIX and its rate of change, and Federal Reserve APP announcements finds: - APP announcements by emerging market central banks reduce long-end bond yields in a significant and persistent way, even after controlling for Federal Reserve APP announcements and changes in global risk appetite. - The analysis uses country fixed effects and examines the cumulative change in bond yields with the APP announcement indicator as the main variable of interest. - Caution on large-scale or open-ended APPs: - Large-scale APPs, especially when open-ended, carry risks and may negate their initial effectiveness. ### Key empirical and policy-relevant takeaways - APPs helped reduce local bond market stress and lower long-end government bond yields, while having relatively limited and muted effects on exchange rates. - APPs were often small and short-lived in emerging markets, limiting their overall impact; stronger effects were observed where program size was larger (Chile, Indonesia, Philippines, Poland). - APPs can act as effective circuit breakers during acute stress, signaling central bank readiness to provide liquidity and stabilize domestic bond markets. - Risks and constraints: - Persistent term premia and bond supply concerns may limit the longevity of APP benefits. - Large or open-ended APPs can introduce countervailing risks that may weaken initial gains. - Policy design considerations: - Coordination with fiscal financing needs and monitoring of bond supply risks is important. - The presence and behavior of foreign investors and depth of domestic investor base should inform APP sizing and implementation. - Complementary measures that address FX liquidity (swap lines, repo facilities) and that shore up market-making capacity can enhance APP effectiveness. *Italicized source attribution: International Monetary Fund, GLOBAL FINANCIAL STABILITY REPORT: BRIdGE TO RECOvERY — CHAPTER 2 (October 2020).* ### 1. EM 10-Year Government Bond Yields ### 1. EM 10-Year Government Bond Yields ### Market reaction to domestic asset purchase program (APP) announcements - Event studies show a significant change following APP announcements: a decline in sovereign bond yields and a decline in term premiums, but a relatively small and short-lived impact on EM currencies. - Intraday price reaction: government yields reacted very sharply, while emerging market currencies experienced relatively limited impact. - Sample for event studies comprises Chile, Colombia, Hungary, India, Indonesia, Malaysia, the Philippines, Poland, South Africa, and Turkey (across a total of 16 dates). - In panels 1–3 of the underlying figures, the black line denotes the median across the sample, while the blue range highlights the interquartile range across the events. - Term premium calculations in panel 2 are based on the methodology detailed in Adrian, Crump, and Moench (2013) (ACM). ### Magnitude and persistence of yield effects - The impact of domestic APP announcements on yields ranges from 20 to 60 basis points and is statistically significant within one standard error confidence interval. - The magnitudes of the effect of APP announcements by emerging market central banks and the Federal Reserve are broadly similar. - The Federal Reserve asset purchase program announcement on March 23 had a significant and persistent impact on lowering long-end yields. - Improved global risk appetite (proxied by the VIX) also had a positive effect on decreasing yields. ### Local projections analysis (daily panel) - Results are based on the local projections method (Jordà 2005; Teulings and Zubanov 2014) using panel data from 13 emerging markets at daily frequency from the beginning of January to mid-May 2020. - Dependent variable: cumulative change (in percentage points) in local currency sovereign bond yields. - Two specifications: - Specification 1: controls for the APP announcement by the Federal Reserve and domestic rate cuts (panels 1, 3, and 5). - Specification 2: controls for the VIX and domestic rate cuts (panels 2, 4, and 6). - Country fixed effects included; coefficient estimates reported with one standard error confidence interval. - Domestic rate cuts do not appear to have a significant effect on yields, controlling for other factors such as APPs (Figure 2.7, panels 5 and 6). ### Impact on currencies - Announcements of APPs did not lead to a significant depreciation of emerging market currencies (Figure 2.8). - Intraday event studies (Figure 2.6, panel 4) are consistent with limited FX impact. - Panel analysis for currencies uses the same local projections method and controls for the Federal Reserve APP and domestic rate cuts; the dependent variable is the cumulative change (in percent) in the value of domestic currencies vis-à-vis the US dollar. - Possible reasons: relatively small size of programs, sterilization of purchases in many cases, restoration of stability from decisive central bank actions, and reversal of earlier FX sell-off. ### Policy implications and near-term guidance on APPs - APPs had a catalyzing effect on lowering local currency government bond yields without indications of immediate risks to financial stability in the pandemic episode. - APPs can temporarily ease pressure on domestic investors when there is increased issuance or foreign investor outflows and can exert control over the medium- to long-end of the yield curve even when policy rates remain substantially above zero. - APPs may be suitable where: - countries are constrained by their own effective lower bound, - inflation expectations are steady, - concern over capital outflows and FX depreciation is low, - domestic absorption capacity of new bond supply is limited. - Central bank communication and benign market perception about scope, timing, and temporary nature were essential to contain perceived fiscal dominance risks. ### Risks, caveats, and conditions for APP use - Potential risks if large-scale or open-ended APPs are used beyond the pandemic-related extraordinary situation: - Institutional and central bank credibility may be weakened; increased balance sheet exposure to long-term debt may raise concerns about ability to raise interest rates or achieve price stability. - APPs may invite concerns about fiscal dominance, especially in economies with weak monetary and fiscal policy frameworks, leading to higher risk premiums and steeper yield curves. - APPs may intensify capital outflow pressure in countries with weaker fundamentals, possibly prompting investor portfolio rebalancing if APPs create excessive gaps between domestic and peer-group risk premiums. - Lasting central bank presence as buyers in local currency bond markets may distort market dynamics, impair price discovery (especially in primary markets), affect collateral availability, and impact policy rate transmission; possible overvaluation of assets. - Effectiveness and risks vary considerably across countries and depend on capital market structure and liquidity, availability of high-quality domestic assets, extent of foreign investor participation, and financial sector development. - Recommendation: Focused use of APPs as part of the crisis toolkit for central banks with credible monetary policy frameworks and good governance, with ongoing evaluation as more data become available—especially for open-ended programs. ### Supporting references within source - ACM = Adrian, Crump, and Moench (2013). - APP = asset purchase program; VIX = Chicago Board Options Exchange Volatility Index. - See Online Annex 2.1 for more methodological details. *Source: IMF staff calculations; text and figures from Chapter 2, Global Financial Stability Report: BRIDGE TO RECOVERY, October 2020.* ### 5. Debt Outstanding: Private versus Official Creditors ### 5. Debt Outstanding: Private versus Official Creditors ### Public external debt composition and country examples - For several countries, private creditor debt is significant. - Country examples shown: AGO, BEN, CMR, COG, ETH, GHA, HND, CIV, KEN, MNG, NGA, PAK, PNG, RWA, SEN, TJK, TZA, UZB, ZMB. ### Investor expectations in sovereign restructurings - Markets appear to perceive that, in a default situation, private creditors would be forced to take a larger haircut than bilateral creditors. - Model results are consistent with investors expecting that bilateral creditors would take a 30 percent haircut in the case of a country that requires an overall 40 percent haircut. - Considering that bilateral loans are often extended at concessional levels, or at times when countries are not able to consistently borrow from private markets, bilateral creditors would be expected to receive more favorable treatment in a restructuring scenario. ### Stylized example and spread implications - Stylized exercise assumptions: - Assumes a 10-year bond with an 8 percent coupon. - Assumes an overall debt reduction of 40 percent is required. - Stylized scenarios of seniority shares illustrated: - 50 percent senior share - 33 percent senior share - 20 percent senior share - 0 percent senior share - Key mechanism: - If one class of creditors is treated as senior (receives smaller haircuts), other creditors need to take a greater burden. - Investors pricing a larger required haircut in case of default could meaningfully impact bond spreads. - Figure 2.11 (panel 2) findings (conceptual): - A country whose debt is entirely “junior,” or private sector, would have a much lower spread than one for which half of the debt is considered senior. - The spread impact increases as credit quality decreases (higher expected default probability). - Example comparisons depicted: aggregate 40 percent haircut vs. 20 percent haircut vs. 60 percent haircut across varying expected default probabilities (percent). ### Policy implications and context - Markets reacting to perceived creditor seniority can drive higher sovereign bond spreads, raising borrowing costs. - Debt restructuring outcomes that favor bilateral or multilateral creditors can shift burdens onto private creditors and affect market pricing. - In designing debt-management and restructuring strategies, authorities should consider: - The composition of creditors (private versus official) and expected treatment in default. - The potential for higher spreads if large shares of debt are perceived as senior. - The concessional nature of many bilateral loans and implications for creditors’ relative treatment. *Source: IMF staff calculations. Note: Panel 2 assumes a bond with an 8 percent coupon and 10-year maturity. It assumes that an overall debt reduction of 40 percent is required, with senior debt holders accepting only a 20 percent haircut.* ### 2020. As a result, firms managed to build cash buffers ### text - 2020. As a result, firms managed to build cash buffers ### Liquidity buffers, bank credit, and credit line drawdowns - Firms managed to build cash buffers to cope with a period of reduced cash flow and high uncertainty. - Loans represent the major source of corporate debt funding in the G7 economies, ranging from 58 percent in the United States to 90 percent in Germany. - The ratio of syndicated loans to bonds (for issuance by large firms) ranges from two to three. - Outstanding amounts of bank credit to firms grew significantly in March and in the second quarter in all seven economies analyzed. - On a year-over-year basis, the rate of bank credit growth during the first half of the year was clearly above trend. - Listed firms’ credit line drawdowns increased more than 40 percent, on average, compared with the first half of 2019. - In the United States, net drawdowns at the end of March doubled, representing an increase of $250 billion. - Gross drawdowns were concentrated in March, with a peak on the last day of the month. - Utilization rates declined after March in the United States and Canada; utilization in Japan continued during the second quarter, resulting in a utilization rate of 60 percent. - Utilization rates across the seven economies remained well below 50 percent, on average, at the end of June. ### Government liquidity support and fiscal programs - Bank credit developments during the second quarter reflected implementation of government programs (notably, off-budget credit guarantees) that transferred part—sometimes all—of the credit risk to the sovereign, as well as government-sponsored loans with a significant grant component. - Direct support programs to corporate funding represented between 2.6 and 34 percent of GDP as of June 12. - These direct measures complemented on-budget fiscal measures supporting corporate cash flows and solvency (for example, grants, employment support programs, and reductions in tax liabilities). - As of early July, committed amounts appeared to have been significantly smaller than announced amounts in European economies. ### Syndicated loans, CLOs, and leveraged loan markets - Syndicated loan issuance in the first half of the year was generally stronger than in 2019 in Europe and Japan, but weaker in the United States and Canada, especially during the second quarter. - The pattern was driven by a surge in investment-grade loan issuance in Europe and Japan and a drop in leveraged loan issuance outside of Germany and Italy. - Collateralized loan obligation (CLO) new issuance was slow to restart; new CLO supply ran at half of last year’s pace while still accounting for more than 70 percent of new leveraged loan demand. - CLO investors were concerned about a wave of downgrades and defaults, which may affect lower-rated tranches. ### Corporate bond markets and issuance characteristics - Corporate bond markets were generally more resilient in the first quarter despite intense pressure in mid-March. - Policy responses by central banks in the second half of March, especially facilities aimed at directly supporting corporate bond markets, appear to have boosted activity and contributed to a reversal in corporate bond fund flows. - During the second quarter, investment-grade issuance surged to levels twice as large as those in 2019 for several jurisdictions. - High-yield issuance in the United States during the second quarter more than doubled compared with 2019. - In G7 economies, nearly 60 percent of high-yield new issues during the first half of the year were BB rated, and more than 30 percent of the bonds were secured—the highest levels for the past 15 years at least. - By use of proceeds, more than 80 percent of year-to-date high-yield supply was for refinancing existing debt or for short-term expenses such as working capital. - Issuances motivated by acquisition and dividends or share repurchases were at their lowest in a decade. ### Shift toward bond financing (jurisdictional differences) - Developments suggest that for firms with access to both markets, the bond market was the preferred source of debt financing in the United States, but not uniformly in other G7 economies. - Controlling for firm characteristics and macro-financial variables, analysis documents a shift toward bond financing in the United States but not in other jurisdictions. - The Federal Reserve’s March 23 announcement of new corporate credit facilities appears to have had a stimulative impact on US domestic bond markets. - The choice between bond versus loan financing was not affected in other jurisdictions, likely reflecting the presence of central bank corporate bond purchase programs predating the pandemic (except in Canada). - The US shift toward bonds occurred in both the investment-grade and high-yield segments, with the shift in investment grade already visible in the first quarter. ### Commercial paper and money market developments - Commercial paper volumes in the United States have not recovered since their sharp drop in March, when investors shifted funds from prime to government money market funds. - The Federal Reserve reintroduced the Commercial Paper Funding Facility on March 17; inflows into prime funds resumed, especially from institutional investors, but CP issuance remained depressed. ### Heterogeneity of firm stress and policy implications - Among listed firms, entities with weaker solvency or liquidity positions before COVID-19, as well as smaller firms, suffered relatively more financial stress in some economies during the early stages of the crisis; residual signs of strain remained as of the end of June. - Policy interventions, especially those directly targeting the corporate sector, had a beneficial effect, on average. - These findings inform discussions about the appropriate level of policy support as the global economy moves toward the recovery phase. - Premature withdrawal of policy support could jeopardize the success achieved so far in broadly meeting the nonfinancial corporate sector’s funding needs. - Trade-offs with other policy objectives must be considered, especially in a context of limited fiscal space. *Source: CHAPTER 3, "CORPORATE FuNDING: LIquIDITY STRAINS CuShIONED BY A POwERFuL SET OF POLICIES", Global Financial Stability Report: Bridge to Recovery, International Monetary Fund, October 2020.* ### 7. Total Value of Nonfinancial Commercial Paper Issuance8. Total Debt Growth of Listed Firms ### 7. Total Value of Nonfinancial Commercial Paper Issuance8. Total Debt Growth of Listed Firms ### Commercial paper issuance dynamics - Volumes in the commercial paper market had opposite dynamics in the United States and the euro area. - In the United States: - Fall in bond market yields appears to have tempted firms to reduce refinancing risk and substitute commercial paper with longer-term debt. - In the euro area: - Commercial paper issuance rebounded quickly from the March trough and hit a record high in June, supported by the European Central Bank’s expansion of its commercial paper purchases through the Asset Purchase Programme and the Pandemic Emergency Purchase Programme. - Incentives to substitute commercial paper with longer-term bonds were weaker because the yield differential remained more stable than in the United States. - Central banks in other jurisdictions also intervened: - The Bank of Canada and the Bank of England introduced commercial paper purchase programs, and the Bank of Japan stepped up its existing program (these countries are not shown on the chart for lack of data). ### Total debt growth of listed firms and cash accumulation - All in all, the year-over-year growth rate of total debt of listed firms was strong, generally exceeding 10 percent. - Notable contributions to borrowing during the first quarter came from credit line drawdowns in Canada and the United States. - Evidence on use of additional borrowing: - Additional borrowing was used mostly to build cash reserves to cope with uncertainty and expected reduction in cash flow triggered by the pandemic shock. - Quarterly reporting requirements: listed firms in Canada, Japan, and the United States are required to report quarterly, unlike firms in Europe. - Cash accumulation in the first quarter of 2020: - About 0.5 percent of assets in Japan. - About 1.5 percent of assets in Canada and the United States. - This accumulation contrasts sharply with the lack of cash accumulation during the peak of the global financial crisis in the fourth quarter of 2008. - Drivers of the change in cash levels relative to 2019: - Canada: mostly an increase in financing. - Japan: a reduction in investment. - United States: a combination of increased financing and reduced investment. - During the second quarter of 2020: - Listed Japanese and US firms built their cash buffers further. - Listed Canadian firms reduced their cash buffers somewhat. - Nonfinancial corporate deposit data show a further large expansion during the second quarter, especially in France and the United Kingdom. ### Shifts in aggregate credit supply conditions - The large increase in borrowing (net of withdrawals from existing credit lines) in March and the second quarter of 2020 was associated with credit spreads that widened sharply in March and subsequently slowly declined. - Reasons for wider spreads: - Sharp deterioration in corporate fundamentals and concerns about default risk in all seven economies. - A tightening in credit supply may also have contributed. - Methodology and data sources referenced: - Central banks’ quarterly surveys of bank lending officers are used to assess the commercial bank loan market (measure perceptions of credit demand and evolution of lending standards). - For the European and US primary syndicated loan markets, an empirical supply-demand system using transaction-level issuance data was estimated; the credit supply shock is the time-varying residual from the credit supply equation. - For the secondary corporate bond market, the excess bond premium (Gilchrist and Zakrajšek 2012) is constructed as a measure of investor risk appetite. - Identification addresses endogeneity via an identification-through-heteroscedasticity methodology (Rigobon 2003). - Caveats: - Bank lending officers’ surveys do not always clearly distinguish between changes in default risk and changes in credit supply in their definition of lending standards. ### Credit supply conditions across markets and countries - Commercial bank loan market (survey evidence): - The United States was an outlier in the second quarter: credit demand fell and lending standards tightened sharply. - Japan and the United Kingdom saw a large loosening of credit conditions. - Other G7 economies experienced muted changes or easing. - This pattern contrasts with the global financial crisis, when banks tightened lending standards consistently across the board. - Rapid policy support and government lending programs helped normalize bank funding stress after a brief spike in late March. - Syndicated loan vs. bond markets (United States): - Syndicated loan market: - Credit conditions were neutral in the first quarter and tightened during the second quarter (market moved into a tight position, though not as tight as after the global financial crisis). - Investment-grade syndicated loans and leveraged loans moved from easy to tight during the second quarter. - Bond market: - A large part of the March tightening was undone during the second quarter; bond market conditions were generally favorable in the second quarter. - Two supply-side considerations supported the US bond market: - Short-term rates near zero and Federal Reserve Treasury purchases reduced term premia, pushing investors toward yield-providing assets within central bank support perimeters. - Expectations of no rise in the policy rate for several years reduced incentives to hold floating-rate instruments; syndicated loans are floating-rate while bonds are fixed-rate. - United Kingdom: - Bond market dynamics mirrored the United States (easing after March), while the syndicated loan market remained, on average, neutral. - Euro area: - Syndicated loan market experienced a clear loosening of conditions during the second quarter. - Bond market conditions continued to be broadly neutral on average during the first half of the year. - Japan: - March bond market tightening persisted through the end of June; overall risk aversion remained within the normal range observed over the past decade. - Overall interpretation: - Conditions in bond markets were generally favorable during the second quarter, especially in the United Kingdom and the United States. - Bank lending standards in the United States were tight, making the bank loan market an outlier among G7 economies. - Differences across economies and markets likely reflect the relative strengths and scope of policy responses, including government loan guarantee programs and investors’ search for yield in an ultra-low interest rate environment. ### Differential impact on vulnerable firms and evidence of greater financial stress - Vulnerability dimensions measured at end-2019: 1. Small size (low total assets). 2. Low cash and short-term financial investments relative to industry peers (share of total assets). 3. High short-term debt net of cash and short-term financial investments (share of total assets). - These vulnerabilities are examined over and above leverage-related vulnerabilities, which amplified the negative cash flow shock related to COVID-19 in five of the seven economies. - Stock market evidence: - Cumulative abnormal returns indicate pervasive greater financial stress for relatively smaller firms. - Underperformance for small firms during February–March in Germany, Japan, the United Kingdom, and the United States was close to, or greater than, 10 percentage points. - Firms with higher liquidity vulnerabilities experienced relatively greater financial stress in some economies during late February and March. - In the United States, a wedge in cumulative abnormal returns opened between firms with low and high relative cash beginning in late February and widened during the second half of March. - Econometric analysis controlling for firm characteristics and expected size of pandemic-related revenue shock confirms: - Firms with relatively less cash suffered more financial stress in the United Kingdom and the United States. - Firms with relatively higher short-term debt (net of cash) suffered more in France, the United Kingdom, and the United States. - In these five cases (France, the United Kingdom, the United States, plus the two others where leverage amplified effects), the underperformance of firms with liquidity vulnerabilities between early February and end-March was about 5 percentage points. ### Policies that helped relieve funding stress - Precise measurement of policy effects in the COVID-19 crisis is challenging. - Policy actions and factors referenced as contributing to relief of funding stress: - Speed of policy support to financial markets and the economy. - Government programs to support lending to businesses (including loan guarantee programs). - Central bank market interventions (for example, Federal Reserve corporate credit facilities and Treasury purchases that reduced term premia). - These measures helped normalize funding conditions after the initial March stress, particularly in bond markets. *Italic: Source — GLOBAL FINANCIAL STABILITY REPORT: BRIDGE TO RECOVERY, Chapter 3 (excerpts from specified content unit).* ### CHAPTER 3 CORPORATE FuNDING: LIquIDITY STRAINS CuShIONED BY A POwERFuL SET OF POLICIES ### CHAPTER 3 CORPORATE FuNDING: LIquID STRAINS CuShIONED BY A POwERFuL SET OF POLICIES ### Policy environment and identification challenges - A variety of monetary, fiscal, and financial policy measures were announced over a short period, sometimes on the same day, complicating isolation of individual policy effects. - Important details of announced policy packages were sometimes released with a lag; policies announced on different days could have strong complementarities. - Many policy announcements coincided with negative pandemic news and containment measures, further complicating assessment. - Global financial market volatility is treated as extreme when the Chicago Board Options Exchange Volatility Index (VIX) is above the 80th percentile of its distribution during February–June 2020. ### Empirical approaches used - Two complementary approaches are used to gauge policy impact on corporate funding liquidity stress: - Short window event analysis: effect of policy announcements on relative stock market performance of vulnerable firms over a horizon of two trading days, netting out days of extreme global market volatility. - Extended window analysis: relative stock market performance of vulnerable groups through the end of June 2020 (cumulative abnormal returns during February 3–June 30, 2020). - Several firm characteristics are controlled for; vulnerable firms’ relative performance is interpreted as a symptom of changing credit supply conditions. ### Key empirical findings — short window (event) effects - Pooling all 85 announcement days in the sample: - Small firms: about 0.3 percentage point of overperformance a day over two days for smaller firms. - High‑leverage firms: about 0.1 percentage point a day over two days for high‑leverage firms. - No significant short‑window effect found for firms with liquidity vulnerabilities in the pooled sample. - Country‑level signals (limited by small number of announcement days): - Positive short‑window effect suggested for small firms in Canada. - Positive short‑window effects suggested for small firms and high‑leverage firms in Japan. ### Heterogeneity by policy type - Policies classified as having a direct impact on corporate funding (for example, government guarantees or purchases of corporate securities by central banks) versus policies with only an indirect impact (for example, macroprudential measures or changes in financial sector regulation). - Comparing announcement days: - Policies with a direct impact benefited firms with liquidity vulnerabilities relatively more than policies with only an indirect impact. - Effect magnitudes (average over two days, net of extreme volatility): - Liquidity‑poor firms: 0.2 percentage point of overperformance a day over two days. - Cash‑poor firms: 0.13 percentage point of overperformance a day over two days. - No differential effect by policy type observed for high‑leverage firms and small firms. - Among measures with a direct impact, announcements of on‑budget fiscal measures supporting firm solvency appear most powerful; excluding days with such measures weakens the significance of the direct vs indirect difference. Among the other direct measures, corporate asset purchase programs appear relatively more powerful. ### Key empirical findings — extended window through end‑June 2020 - By end‑June: - Stress at smaller firms generally disappeared in most markets, except in the United Kingdom where small‑firm stress remained significant. - Strains in high‑leverage firms remained in Germany and Japan. - Stress at firms with liquidity vulnerabilities persisted in France, the United Kingdom, and the United States. - US bond markets were buoyant, but bank‑dependent firms and those with pre–COVID‑19 liquidity vulnerabilities continued to face a more difficult environment. ### Aggregate conclusion on policy effectiveness - The tightening of credit conditions across G7 economies in March was quelled to a very large extent by an unprecedented set of powerful policy interventions. - Policies supporting firms directly had the most beneficial effect on firms with liquidity vulnerabilities and helped cushion financial strains in smaller firms. - Nonetheless, segments of the credit market and some firm types with viable business models but vulnerable to liquidity shocks continued to face tighter conditions. ### Banking sector resilience and risks - Banks entered the crisis with higher capital levels than before the global financial crisis, and policymakers rapidly deployed policies to support lending. - Forward‑looking simulation (sample details and results): - Sample: about 350 banks from 29 jurisdictions, accounting for 73 percent of global banking assets. - Simulated outcome: capital ratios would decline as a result of the COVID‑19 crisis but remain, on average, comfortably above regulatory minimums. - Heterogeneity: a weak tail of banks, accounting for 8.3 percent of banking assets in the sample, might fail to meet minimum regulatory capital requirements in an adverse scenario. - Government loan guarantees and other bank‑specific policies that adjust the calculation of capital ratios help relieve the decline of reported capital ratios and reduce incidence of capital shortfalls. - Policymakers should consider the intertemporal trade‑off: measures that reduce financial stability risks of a transitory shock may increase vulnerabilities related to banks’ loss‑absorbing capacity and overall indebtedness if the crisis is persistent. ### Policy recommendations and considerations - Carefully calibrate any withdrawal of fiscal policy support to funding markets, given that policies targeting firms directly were most effective for liquidity‑vulnerable firms and small firms benefited from policy support. - Monitor potential tightening of bank lending standards as guarantee programs end (evidence from the euro area bank lending survey). - Maintain policies aimed at limiting capital distributions and ensure adequate funding for deposit guarantee programs; develop contingency plans to respond to possible pressures. - Revisit regulation of nonbank financial institutions and devise mechanisms to enhance their resilience to large liquidity shocks. - Supervisory authorities should continue to monitor corporate vulnerabilities closely and consider the benefits of macroprudential policy tools for the nonfinancial corporate sector. *Source: CHAPTER 3 CORPORATE FuNDING: LIquIDITY STRAINS CuShIONED BY A POwERFuL SET OF POLICIES, Global Financial Stability Report: Bridge to Recovery, October 2020.* ### Introduction ### Introduction ### Chapter 4 at a Glance - The coronavirus disease (COVID-19) crisis may pose challenges to the capital of banks, even though they entered the crisis with higher capital ratios than before the global financial crisis and despite the large policy interventions aimed at containing the economic fallout from the current crisis. - Forward-looking simulations based on a new global stress test tool show that in a baseline scenario consistent with the October 2020 World Economic Outlook (WEO) bank capital falls sharply but recovers quickly, while an adverse scenario suggests sustained damage to average capital ratios. - In the adverse scenario, a weak tail of banks, corresponding to 8.3 percent of banking system assets, would fail to meet minimum regulatory requirements, and the capital shortfall relative to broad statutory regulatory thresholds reaches $220 billion. - In absence of the bank-specific mitigation policies already implemented, the weak tail of banks would reach 14 percent of banking system assets, and the global capital shortfall would be $420 billion. - Bank-specific mitigation policies would help reduce financial stability risks if the crisis recedes promptly but may pose risks to banks’ capital adequacy if the crisis proves to be longer lasting. ### Initial Impact of COVID-19 on the Global Banking Industry - Banks entered the COVID-19 crisis in much better shape than before previous crises after spending the past decade building capital and liquidity buffers (Figure 4.1, panel 1). - Bank profitability was already challenged in many jurisdictions amid the prolonged period of low interest rates and low term spreads (Figure 4.1, panel 2). - The low-interest-rate environment is likely to persist for several years, as policymakers have engaged in further expansive monetary policies (see the April 2020 GFSR). - The initial contractionary shock triggered a scramble for liquidity: - In the United States, corporate borrowers aggressively drew on committed credit lines, causing a sudden increase in loans that drove down bank capital ratios. - Risk weights for undrawn credit lines are in the range of 20–50 percent, whereas those for drawn credit lines are 100 percent. - Increased loan loss provisioning—particularly among US banks, for which the onset of the crisis coincided with a transition to “expected credit loss” accounting standards—weighed on bank financial results in the first quarter of 2020. - The transition to expected credit losses in the United States became effective on January 1, 2020. - The Federal Reserve announced a rule allowing banks to phase in the impact of current expected credit losses transition provisions over three years, later lengthening the phase-in path to zero capital charges over two years, followed by a three-year phase-in path. - In the second quarter of 2020, US financial market stress subsided, but most banks took sharply higher loan loss provisions and tightened lending standards; US loan officers reported the tightest credit standards since 2005. - After an initial plunge, bank equity prices partially recovered; bank credit expanded in March as corporate borrowers drew on committed credit lines and has since remained stable, though credit conditions remained tight. - Despite significantly increased loan loss provisions in virtually all systems, most banks continue to report positive earnings, and capital positions have declined only modestly over the initial quarters of the crisis. ### Reactions of Financial Sector Authorities to the COVID-19 Crisis - Governments responded with policies of unprecedented scope and magnitude to support the real economy, prevent permanent damage to balance sheets, and maintain the flow of credit. - The chapter focuses on government loan guarantee programs and capital adequacy policies that can be directly quantified ("bank-specific" policies). Other policies have indirect effects on banks’ capital adequacy (fiscal stimulus, monetary policy, policies supporting bank funding, borrower repayment support such as repayment moratoria). - Within the risk-based capital framework, the policies analyzed alter capital space through three channels: - Increasing capital levels: - Promoted mainly through restrictions (often “voluntary” guidance) on distribution of profits through dividends and share buybacks. - Most of these come with specific end dates (typically not later than the end of 2020). - Government loan guarantees can also boost capital levels by reducing loss given default and the need to set aside loan loss provisions. - Lowering risk-weighted assets or “leverage exposure” (the capital ratio denominators): - National regulators have typically waived risk-asset weights for loans covered by government guarantees. - Some policymakers have reduced risk weights on exposures to targeted borrowers, often small businesses. - A few countries—Japan, the United Kingdom, and the United States—have exempted central bank reserves, and the latter two have exempted holdings of government bond holdings, from banks’ leverage exposure measures. - Releasing some capital buffers: - Policymakers have increased banks’ overall space between reported and regulatory capital levels by releasing the countercyclical capital buffer. - In some instances, policymakers have formally released required capital buffers; in other cases, they have publicly reminded banks that buffers—typically the capital conservation buffer of 2.5 percent of total capital—could be used to support lending and be gradually rebuilt through retained earnings as conditions improve. - The chapter characterizes the latter as reductions in the “guidance buffer” that determines de facto minimum capital levels. - These policies combined are estimated to have already improved banks’ reported common equity Tier 1 (CET1) ratios and, either by statute or by guidance releasing some capital buffer requirements, regulators have further expanded the capital space between banks’ current positions and broad regulatory capital levels. - In a few jurisdictions (Japan, Switzerland, United States) authorities have eased constraints on banks’ leverage ratios, typically by excluding government bonds, central bank reserves, or other low-risk assets from the leverage exposure denominator. ### Bank Capital Ratios in the Wake of COVID-19 and the Role of Policies - The chapter assesses consequences for future capital ratios using the baseline projection of the economic outlook and the adverse scenario outlined in the October 2020 WEO (Figure 4.4). - These macro scenarios implicitly incorporate broad macroeconomic and monetary policy interventions (interest rate cuts, unconventional monetary policies, fiscal measures, social safety net packages). - The chapter assumes the accounting impact of bank-specific policies on bank balance sheets is not fully captured in macro trajectories. - The assessment relies on a recently developed global stress test that uses publicly available data on the financial statements of about 350 banks in 29 major banking systems—accounting for 73 percent of global banking sector assets—to estimate how key components of banks’ financial statements react to macroeconomic variables. - The forward-looking simulation projects profitability and capital positions of each bank in the sample and aggregates them across regions and global systemically important banks. - The stress test relies on publicly available data, allowing a global assessment at the cost of lower data granularity and higher reliance on statistical methods than supervisory stress tests; this constrains the types of policies that can be analyzed and requires assumptions to map policy impacts. *Source: Introduction, Chapter 4, GLOBAL FINANCIAL STABILITY REPORT: BRIDGE TO RECOVERY (October 2020).* ### CHAPTER 4 BANk CAPITAL: COvId-19 ChALLENGES ANd POLICY RESPONSES ### CHAPTER 4 BANk CAPITAL: COvId-19 ChALLENGES ANd POLICY RESPONSES ### Stress test design and key assumptions - Stand-alone solvency stress test relying on banks’ financial statements augmented by a satellite model for corporate and consumer risk; does not model liquidity, contagion, macro-feedback effects, or behavioral responses by banks. - Assumes static bank balance sheets during the simulation period (no deleveraging allowed). - Government guarantee impact: all banks in a country assumed to benefit equally in proportion to the ratio of government guarantees to total corporate loans; guarantees assumed used to the full extent of announced amounts (full uptake). - Capital adequacy policy impacts quantified from announced measures (for example, canceling dividends, release of capital buffers, changes to RWA calculations); assumed maintained over the three-year horizon unless an explicit expiration date was announced. ### Consequences of COVID-19 for bank capital before bank-specific mitigation - Aggregate CET1 ratios: - Minimum CET1 of the global banking system: 9.6 percent in the baseline scenario and 9.3 percent in the adverse scenario. - These represent drops of 3.6 percentage points and 3.9 percentage points, respectively, below the CET1 level in 2019. - Recovery trajectories: - Baseline: CET1 steadily recovers after a trough in 2020 but is still 0.7 percentage points below its initial level at the end of the simulation in 2022. - Adverse: CET1 remains 2.4 percentage points below initial levels by 2022. ### Drivers of CET1 decline - Main driver: increase in loan loss provisions. - Baseline scenario: higher loan loss provision expenses contribute to a 5 percentage point decline in CET1. - Adverse scenario: provision contribution is 6 percentage points. - Increase in risk-weighted assets plays only a minor role in CET1 changes. ### Heterogeneity across regions, bank types, and individual banks - Regional and scenario differences: - Baseline: maximum decline in CET1 is much larger in advanced economies. - Adverse: advanced economies see a maximum decline of about 4.0 percentage points; emerging markets see about 4.9 percentage points. - Difference driven mainly by higher provision costs in emerging markets under adverse scenario. - Distribution and weak tail: - Even at trough in the adverse scenario, more than half of banks (by assets) have CET1 ratios above 10 percent. - Banks accounting for 13 percent of assets fall below 4.5 percent CET1 in the adverse scenario, with an additional 3 percent of assets below 6 percent. - Weak tail (CET1 below 4.5 percent plus GSIB buffer) amounts to 14 percent by assets in adverse scenario; in baseline scenario the weak tail is 5 percent. - Systemic importance and regional outcomes: - Global systemically important banks (GSIBs) fare better overall but still: 8 percent of GSIB assets end the simulation with CET1 ratios below 4.5 percent. - Non–GSIBs: 16 percent of bank assets fail to maintain a 4.5 percent CET1 ratio. - Emerging markets: almost 40 percent of total banking assets end the simulation with CET1 ratios below 4.5 percent. - Advanced economies: 12 percent of banks’ assets are below 4.5 percent by 2022. - Distinguishing factors for banks that fail regulatory minimums: - Initial CET1 levels are about 0.8 percentage point lower for banks that fall below 4.5 percent plus GSIB buffer compared with banks that maintain adequate capital. - Banks with high propensity to fall below minimum capital generate meaningfully lower returns than peers that maintain adequate capital. ### Capital shortfalls (pre-mitigation) - Measurement benchmarks: - Barebones shortfall: regulatory minimum CET1 of 4.5 percent plus GSIB buffer. - Broad shortfall: includes statutory capital conservation buffer and countercyclical buffer in place as of June 2020. - Global shortfalls in the adverse scenario: - Barebones capital shortfall: about $200 billion. - Broad capital shortfall: about $420 billion (0.6 percent of sample banking assets). - When measured against GDP: - Global broad shortfall represents 0.8 percent of GDP of countries where at least one bank has a capital shortfall. - Across those countries, the average broad shortfall is 1.1 percent of GDP. - Notes on calculation: - For large US banks, stressed capital ratio levels recently defined by the Federal Reserve are used instead of the countercyclical and capital conservation buffers. - Calculation assumes countercyclical capital buffers remain at current levels (0 percent in almost all countries) and does not assume reversion to pre-pandemic levels. ### Effect of bank-specific policies on capital ratios - Policy types quantified: - Government loan guarantees (modeled as reducing loss given default and thus expected losses/provisions). - Capital adequacy policies (dividend cancellations, release of capital buffers, changes to RWA calculation). - Aggregate impacts (adverse scenario, with quantified policies maintained over three years): - CET1 ratio for advanced economies is about 110 basis points higher at the end of the simulation when both government loan guarantees and capital adequacy policies are considered. - Improvement primarily driven by decline in provision expenses because of government loan guarantees; capital adequacy policies explain about one-third of CET1 improvement in advanced economies. - In emerging markets sample, capital adequacy policies do not play a meaningful role (largely absent). - Sensitivity to uptake: an ultimate uptake of half the announced guarantee amounts would reduce the mitigating effect of guarantees roughly by half. - Distributional effects on weak tail and asset shares (adverse scenario): - Share of bank assets with CET1 below 4.5 percent declines from 13 percent without mitigation to 8 percent with mitigation. - GSIBs: assets with CET1 below 4.5 percent fall from 8 percent to 3 percent. - Non–GSIBs: fall from 16 percent to 12 percent. - Advanced economies: segment below 4.5 percent shrinks from 12 percent to 6 percent. - Emerging markets: only a small effect on the troubled tail. - Overall weak tail (CET1 below 4.5 percent plus GSIB buffers) declines from 14 percent to 8.3 percent of bank assets. - Capital shortfalls with mitigation (adverse scenario): - Broad capital shortfall about $220 billion, with roughly half corresponding to the barebones shortfall. - In economies where banks with shortfalls are headquartered, the broad shortfall represents about 0.4 percent of their combined GDP. - Across countries, the average shortfall is about 0.7 percent of GDP. - Initial CET1 ratios of banks that experience shortfalls in the adverse scenario: the global shortfall reaches 6.5 percent and the average is 7.7 percent. - Overall assessment: - Quantified bank-specific policies materially mitigate the adverse scenario’s impact on bank capital ratios, but the remaining impact remains sizable and a share of GSIB assets would still be in the weak tail even when maximizing these policy effects. *Source: CHAPTER 4 BANk CAPITAL: COvId-19 ChALLENGES ANd POLICY RESPONSES (text - CHAPTER 4 BANk CAPITAL: COvId-19 ChALLENGES ANd POLICY RESPONSES)* ### 4. Maximum Broad Capital Shortfall under Adverse Scenario ### Maximum Broad Capital Shortfall under Adverse Scenario ### Key findings - Policy mitigations reduce the weak tail of banks by 5 percent. - Policy mitigations reduce the capital shortfall by over $200 billion. - Under an alternative treatment that treats all guidance statements as reducing capital buffers, the shortfall is about $110 billion, or about 0.2 percent of global GDP. - Aggregate banking systems analyzed would remain solvent in coming years, but a weak tail of banks could see solvency challenged in an adverse, persistent downturn. - Banks analyzed had a median CET1 ratio of 11.9 in 2007, compared with 16.2 percent in 2019. - The increase in loan loss provision expenses in response to the macroeconomic scenario is the main driver of simulated declines in capital ratios. ### Policy mitigations and quantified effects - Provision mitigation policies (including guarantees only) materially cushion capital depletion, especially through provision policies. - Broad policy packages implemented by authorities mainly support bank capital indirectly via macroeconomic support that reduces loan loss provisions. - Some measures are hard to quantify in the stress test model: - Guidance on loan classification, provisioning, and disclosure and revisions to automatic reclassification for restructured loans can spare loans from increased risk-asset weighting, but the quantity of loans affected is generally not reported and thus not captured. - Changes in reclassification criteria or frozen classifications affect reported provisions and risk-weighted assets but are not fully quantified. ### Risks, trade-offs, and caveats - Using regulatory flexibility can help prevent temporary liquidity shocks from becoming insolvency (reducing procyclicality), but relaxing loan classification and provisioning rules undermines transparency and data reliability. - Delaying provisions or maintaining generous guarantee programs over extended periods may: - Require larger future provisions if borrower solvency deteriorates. - Reduce banks’ buffers against future shocks, including a meaningful second wave of the virus. - Jeopardize fiscal solvency if defaults materialize and lead to bank losses via sovereign exposures. - A more adverse macroeconomic trajectory in the absence of broad support would likely produce significantly lower capital ratios; a severely adverse scenario cannot be ruled out. ### Supervisory implications and recommended actions - Forward-looking stress tests are useful to assess banking system health and guide policy responses; regulator-conducted assessments should use more granular data. - Authorities should: - Strengthen the financial safety net, including deposit guarantee programs, resolution regimes, and central bank liquidity facilities. - Adopt capital preservation measures, including temporarily limiting distributions of dividends. - Use stress test results to guide timing and pace of unwinding exceptional measures and to reassess forward-looking capital plans. - Prepare contingency plans detailing responses to possible future pressures. - Supervisors should ensure banks promptly recognize losses for borrowers that become insolvent as evidence of impairment becomes available. - Phase-out of support measures requires balance: phasing out too quickly would harm the economy; phasing out too late could damage public finances or keep insolvent borrowers afloat. ### Supplementary analysis — Loan loss provisions by borrower type (Box 4.1) - A satellite model decomposes loan loss provisions into corporate (firms) and consumer (households) components using local projection methods. - Baseline scenario simulation (World Economic Outlook) shows a strong but gradual increase in loan loss provisions that peaks during the first half of 2021: - Peak increase in the loan loss provision ratio is about 1 percentage point in advanced economies. - Peak increase in the loan loss provision ratio is about 0.4 percentage point in emerging market economies. - Most of the increase is due to heightened corporate risk; households contribute significantly in advanced economies because of their larger share of bank portfolios. - Implication: the level and composition of provisions depends on loan portfolio mix and relative shock sizes to firms and households; sector-targeted policies (for example, government loan guarantees focused on corporate loans) should account for this heterogeneity. *Source: IMF — Chapter 4, "Maximum Broad Capital Shortfall under Adverse Scenario," Global Financial Stability Report: Bridge to Recovery (October 2020).* ### Chapter 5 at a Glance ### Chapter 5 at a Glance ### Key findings - Tighter financial constraints and weaker economic conditions can act as a drag on firms’ environmental performance. - The coronavirus disease (COVID-19) crisis could substantially reduce firms’ green investments, reversing gains in their environmental performance made in past years. - Climate policies and green investment packages are therefore warranted to support a green recovery and the transition to a low-carbon economy. - Policies aimed at fostering sustainable finance such as better disclosure standards and product standardization could further help mobilize green investments and alleviate firms’ financial constraints. ### Evidence on green financing during the COVID-19 crisis - Green corporate bond issuance declined in March 2020 during market turmoil but picked up beginning in April 2020; the share of green bonds in total corporate bond issuance returned to 2019 levels (Figure 5.2, panel 1). - Loans in the syndicated loan market to firms with an above-median environmental score have increased over the past decade relative to loans to firms with a below-median score; lending to both types of firms dropped slightly in the first quarter of 2020 (Figure 5.2, panel 2). - Investment funds focused on sustainable or environmental investments continued to attract investors throughout the crisis, especially fixed-income funds, with only a small drop in aggregate inflows in some asset classes (Figure 5.2, panel 3). - Equity indices with an environmental focus performed at least as well as the overall market during the crisis (Figure 5.2, panel 4). - Overall: the impact of the COVID-19 crisis on financing of green investments so far appears modest and short-lived, but the severity and persistence of the shock could produce significant strains on corporate balance sheets and future green investment. ### Financial constraints and firms’ environmental performance (global sample) - Financially constrained firms exhibit significantly weaker environmental performance across multiple proxies for financial constraint: - Environmental performance falls by 10 points when firm size drops from the median to the 25th percentile of the firm size distribution. - When a firm does not pay dividends its environmental score is 4 points lower than dividend-paying firms. - When a firm is not rated its environmental score is 3 points lower than rated firms. - The environmental score is 1 point lower when the Kaplan-Zingales index is above the median. - Similar patterns are observed when analyzing firms’ carbon intensity instead of environmental scores. - Financially constrained firms are less likely to make environmental investments: - The probability that a firm will make an environmental investment falls by 6 percentage points when firm size drops from the median to the 25th percentile of the firm size distribution. ### Quantified shocks and projected impacts - Global financial stress shock (proxied by the Chicago Board Options Exchange Volatility Index [VIX]): - A sudden jump in the VIX equal to 16.3 points (the difference in the average value of the VIX in 2020, using data up to July 31, 2020, relative to the average value in 2019) would lead to a persistent drop in firms’ environmental performance by up to 5 points, with pre-shock performance not attained for at least three years after the shock (Figure 5.3, panel 3). - The adverse effect of global financial shocks is magnified for financially constrained firms: for firms with an interest coverage ratio below 1 or for unrated firms in 2019, the VIX shock observed thus far in 2020 is estimated to lower environmental performance by 2 additional points relative to firms with an interest coverage ratio above 1 or rated firms (interaction calculation uses the 16.3 point VIX increase). - Real economic activity shock: - A large decline in the output gap (10 percentage points, about 50 percent larger than that observed in the Group of Seven [G7] economies during the global financial crisis) would lead to a 3 point decline in firms’ environmental performance in the medium term (Figure 5.4, panel 1). - Firms’ carbon intensity (total carbon emissions relative to revenue) could increase by up to 8.5 percent in the medium term after such a decline in the output gap (Figure 5.4, panel 2). - Notes on interpretation: - The VIX shock response is based on a 16.3 point increase in the VIX and local projection firm-level panel regressions including firm-level controls, country-specific output gaps, the price of oil, and country and industry fixed effects. - The real economic activity shock is scaled as a 10 percentage point drop in the output gap; regressions include firm-level controls, the price of oil (log West Texas Intermediate), the VIX, and country and sector fixed effects. ### Policy implications and recommendations - Given the risk that the COVID-19 crisis could reduce green investments and weaken firms’ environmental performance, policy measures are warranted to support a green recovery and the transition to a low-carbon economy. - Climate policies and green investment packages can help sustain green investment and avoid reversing past environmental gains. - Policies to foster sustainable finance—such as better disclosure standards and product standardization—could help mobilize green investments and alleviate firms’ financial constraints. *International Monetary Fund | October 2020 — Chapter 5 at a Glance* ### CHAPTER 5 CORPORATE SuSTAINABILITY: FIRMS’ ENvIRONMENTAL PERFORMANCE ANd ThE COvId-19 CRISIS ### CHAPTER 5 CORPORATE SuSTAINABILITY: FIRMS’ ENvIRONMENTAL PERFORMANCE ANd ThE COvId-19 CRISIS ### Oil price shocks and firms’ environmental performance - The onset of the COVID-19 crisis was accompanied by a steep decline in the international price of oil. - The effect of a decline in oil prices on firms’ environmental performance is ambiguous: - Lower oil prices may relax firms’ financial constraints and reduce incentives to improve energy efficiency and shift away from fossil fuels, hindering development of clean energy projects. - Conversely, low oil prices could hurt the profitability of the oil sector, reduce investments in fossil fuels, and make it easier for clean energy firms to compete. - The impact depends on the source of the oil price shock: - A negative global demand shock that reduces demand for oil is likely associated with lower corporate environmental performance because cleaner energy investments are delayed amid tight financial conditions. - A drop in oil prices due to an oil supply shock could increase global economic activity (Baumeister and Hamilton 2019), easing financial constraints and allowing firms to improve environmental performance. - Empirical results: - Econometric analysis finds that when oil prices fall due to demand-side factors, environmental corporate performance has been weaker; when oil prices decline due to an oil supply shock, environmental performance has improved. - Responses are represented at a two-year horizon; regressions control for the log of total assets, earnings, a dividend dummy variable, country-specific output gaps, the Chicago Board Options Exchange Volatility Index, and the price of oil (log West Texas Intermediate), and include country and sector fixed effects. - Solid bars in the reported figure indicate significance at the 10 percent level. - Contextual datapoints and notes: - Global energy demand declined by 3.8 percent in the first quarter of 2020. - A decomposition of the oil price shock in March and April 2020 suggests it was largely driven by demand-side factors. ### Financial constraints, COVID-19, and environmental outcomes - Core finding: - Tighter financial constraints are associated with weaker corporate environmental performance. - Implications of the COVID-19 crisis: - Adverse global financial and output shocks that increase uncertainty and amplify firms’ financial constraints weigh significantly on environmental performance. - A reduction in oil prices against the backdrop of declining global economic activity is unlikely by itself to improve corporate environmental performance. - Absent strong supportive policy actions, tighter financial constraints and weaker economic activity related to the COVID-19 crisis are likely to act as a drag on firms’ environmental performance in the future. ### Climate awareness and the climate index based on earnings calls - Construction and coverage: - A firm-level climate index was constructed based on quarterly earnings call transcripts using a climate change dictionary built from four climate change glossaries. - Earnings call transcripts from 4,109 firms located in 46 countries are used. - The climate change discussion index assigns a value of 1 to each earnings call transcript that contains a phrase included in the dictionary (terms include, for example, “climate change,” “CO2,” and “emissions”). - Empirical observations: - A sharp increase in discussions involving climate change topics is observed in 2020, coinciding with the COVID-19 pandemic. - In energy sector firms, mentions of climate-change-related terms spiked after the Paris Agreement in 2016, highlighting the importance of policy risk for this sector. - The increase in discussions involving climate change over the past few years is consistent across countries. ### Conclusions and policy recommendations - Long-term emission trajectory: - The COVID-19 crisis has resulted in a temporary decline in global carbon emissions, but its long-term impact is uncertain. - There is a real possibility that, barring public interventions, firms’ investment to improve environmental performance may decline during this period of macro-financial stress. - To achieve needed emissions reductions to keep global warming below 2°C: - An increase in green investments, in combination with steadily rising carbon prices, is critical. - Recommended public policies and actions: - Implement green recovery packages and public policies to offset potential deterioration in firms’ environmental performance resulting from the crisis. - Support the sustainable finance sector to alleviate firms’ financial constraints and aid green investment by: - Improving disclosure standards. - Developing green taxonomies. - Promoting product standardization. *Source: CHAPTER 5 CORPORATE SuSTAINABILITY: FIRMS’ ENvIRONMENTAL PERFORMANCE ANd ThE COvId-19 CRISIS, Global Financial Stability Report, October 2020.* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2020/october/english/text.pdf_