## CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk ## Source details **Canonical URL:** [CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk](https://www.imf.org/-/media/files/publications/gfsr/2021/april/english/ch1.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2021/april/english/ch1.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2021/april/english/ch1.pdf.json) --- ### Main findings: financial conditions and vulnerabilities - Extraordinary policy support measures have eased financial conditions and supported the economy, helping to contain financial stability risks; asset valuations, however, appear stretched in some segments, and financial vulnerabilities are rising further in some sectors. - A repricing of risk in markets and the associated tightening in financial conditions—for example, due to a rapid and persistent increase in interest rates—may interact with such vulnerabilities, with repercussions for confidence and endangering macro-financial stability. - Two emerging themes: - An asynchronous and divergent global economic recovery—especially if accompanied by a move toward policy normalization in advanced economies and rapid rising interest rates—may result in tighter financial conditions and large portfolio outflows in emerging market economies. - Highly accommodative financial conditions may have unintended consequences: if not addressed, financial vulnerabilities exposed by the pandemic may become new structural legacy problems. - The global financial system has shown remarkable resilience so far, despite unprecedented output loss and sectoral stress, though vulnerabilities were already elevated before the pandemic in some sectors and are now rising further amid very buoyant financial markets. - The GFSR growth-at-risk framework shows the improved 2021 outlook has reduced the range of severe economic outcomes but risks to future GDP growth remain skewed to the downside. ### Emerging and frontier market economies: financing needs and risks - Many emerging market economies face large financing needs in 2021 and are exposed to rollover risk, especially if domestic inflation rises or global long-term interest rates continue to rise. - Government debt in emerging markets (excluding China) is expected to reach 61 percent of GDP in 2021. - Gross financing needs for emerging markets are anticipated to remain elevated at 13 percent of GDP in 2021, coming off record levels in 2020. - Recent increases in US long-term yields (about 125 basis points since the summer of 2020) and an average advanced economy 10-year rate increase of 50 basis points so far in 2021 have put upward pressure on yields elsewhere and rattled some emerging market bond markets and currencies. - Policy responses in emerging markets have included a mix of shorter local currency debt duration; asset purchase programs (in some cases involving explicit monetary financing); and increased reliance on the domestic banking system for newly issued debt. - Risks from these actions include greater vulnerability to exchange rate shocks from sizable external issuance; higher rollover risk from shorter local currency debt duration; stronger sovereign-bank nexus and potential crowding out of private lending; and impaired market access for many frontier market economies. - Quarterly portfolio inflows reached their highest level ever in the fourth quarter of 2020, amounting to more than $200 billion. - The sharp rebound in portfolio flows stalled in late February 2021 amid rising rates in advanced economies and volatile global market conditions. - In a sample of 11 major emerging markets, aggregate nonresident holdings of domestic sovereign debt remain lower than they were in January 2020 (in US dollar terms), even as outstanding domestic debt has increased by nearly $500 billion. ### Market rates, term premia, and spillovers - US long-term interest rates rose about 125 basis points since the summer of 2020; until the beginning of 2021 the rise was driven primarily by higher inflation breakevens, with real rates beginning to increase more recently (albeit from very low levels). - Markets expect long-end yields in the United States to return to pre-pandemic levels in coming months. - After declining to historically low levels in late 2020, local currency sovereign yields rose sharply in early 2021 driven by increases in US long-term real yields. - Most of the increase in long-end rates came from a rise in local bond term premia, which had previously compressed to levels last seen before the 2013 taper tantrum. - Factors that compressed term premia in 2020 included the decline in long-term interest rates in advanced economies; subdued actual and expected inflation despite elevated macroeconomic uncertainty; and domestic asset purchase programs and other measures aimed at supporting local bond markets. - Quantified sensitivities and scenarios: - A 1 percentage point shock to inflation uncertainty increases term premia by about 30 basis points. - A 1 percentage point shock to inflation expectations increases term premia by about 10 basis points. - A 1 percentage point rise in US term premia leads to an increase in emerging market term premia of 60 basis points, on average. - Combined with an increase in inflation expectations to pre-pandemic levels, these effects would translate into roughly a 1 percentage point increase in emerging market term premia, on average, by the end of 2021. ### Frontier markets and external funding vulnerabilities - Spreads of higher-rated emerging market issuers have generally declined sharply, returning to their precrisis levels. - Frontier issuer spreads have been more variable; some have tightened significantly while others continue to widen (examples cited include widening: Belize, Sri Lanka, Suriname; narrowing: Angola, Gabon, Mongolia). - For higher-rated sovereigns, external factors offset almost 70 percent of the drag from worsened domestic fundamentals during the pandemic. - For frontier economies, external factors offset only 25 percent of the drag from domestic fundamentals. - A large group of countries (currently 73) is eligible for the Debt Service Suspension Initiative (DSSI) and the Common Framework for Debt Treatments, but fewer than one-third of them have outstanding international bonds. - International bonds and bilateral loans are a material part of the debt structure of most frontier issuers, yet only about half of them are eligible to participate in these initiatives. ### China: rapid recovery with rising vulnerabilities - The Chinese economy recovered more rapidly than other countries, supported by substantial policy measures that boosted activity but increased government and corporate debt. - Targeted credit policies led to rapid growth in credit for small firms and microenterprises, a segment with elevated credit risk. - Among larger firms, new credit has largely flowed to borrowers with weak debt servicing capacity before the pandemic, pointing to future default risks. - Debt issued by firms that had sustained two years of operating losses before the pandemic or net-debt-to-EBIT ratios above 15 account for nearly 40 percent of GDP, or half of the debt of all nonfinancial bond market issuers. - Over two-thirds of these bond issuers enjoyed credit spreads that imply relatively low risk of default (below 200 basis points). - Authorities signaled a shift toward containment of debt risks and introduced measures to impose financial discipline on banks, local governments, and property developers. - Funding conditions for capital instruments have tightened for weaker, smaller banks since authorities bailed in subordinated debt eligible as Tier 2 capital for the first time, which could tighten conditions for smaller firms served by these banks. - Several unexpected defaults of state-owned enterprises in 2020:Q4 raised investor concerns about implicit guarantees for weaker borrowers relying on regional government backstops. - Credit extension to firms and households in the financially weakest provinces fell sharply toward the end of 2020, pushing these provinces’ share of total credit growth to the lowest levels on record. - Policy challenge: authorities face a delicate and urgent challenge in unwinding implicit guarantees; a carefully sequenced and well-communicated transition is needed to avoid disorderly repricing of credit risk, alleviate distortions in credit allocation, and limit further growth in risky corporate debt. ### Corporate sector: debt, heterogeneity, and decision framework - Nonfinancial firms are emerging from the pandemic overindebted, with notable differences across firm sizes and sectors. - Debt issuance has risen to record levels as companies have tried to cope with liquidity pressures. - Equity issuance rose to record highs amid elevated equity valuations; initial public offerings by special-purpose acquisition companies (SPACs) surged to historic highs. - The pool of capital targeted for distressed debt has grown sharply and could be a key source of funding for troubled firms. - Sample and definitions: - Sample: approximately 19,500 firms, of which small and mid-sized firms make up over half of the sample; about 2,500 firms are private. - Country coverage: Brazil, China, France, Germany, India, Italy, Japan, Mexico, Poland, Russia, Spain, Turkey, the United Kingdom, and the United States. - Firm size classification: Large firms: assets exceeding $500 million; Mid-sized firms: assets between $50 million and $500 million; Small firms: assets below $50 million. - Liquidity stress findings: - High at small firms in most sectors; very low for large firms. - Small firms have relatively low liquidity buffers and limited market access. - In emerging markets, even mid-sized firms experience considerable liquidity risk. - Solvency stress findings: - High for small firms and significant for mid-sized and even large firms in affected sectors (energy, services, transportation, real estate). - Viability and decision framework: - Liquidity: ability to pay off short-term financial obligations without raising additional external financing. - Solvency: ability to meet short- and long-term financial obligations. - Viability: ability of a business to generate future positive profits within a three-year horizon. - Decision tree outcomes (policy action): - Low viability risk + high liquidity risk → None. - High viability risk + high liquidity risk → Restructure or liquidate. - Low viability risk + high solvency risk → None. - High viability risk + high solvency risk → Restructure or liquidate. - Quantitative assessment highlights: - For small firms with high liquidity risk: Share of debt accounted for by viable firms is 30 percent in advanced economies and nearly 20 percent in emerging markets. - Share of nonviable firms’ debt among small firms is 20 percent in advanced economies. - For small firms with high solvency risk: In advanced economies, share of debt accounted for by still-viable small firms is more than 30 percent; in emerging markets, the share is slightly lower. ### Corporate funding, restructuring, and policy trade-offs - Policy trade-offs: - Too little support: may be inadequate short term and risk sudden repricing of credit, widespread insolvencies, economic scarring, and negative feedback to banks, nonbank lenders, and sovereigns. - Too much support: may cause zombification, structurally slow growth, debt overhang, misallocation of credit, and a less resilient financial system. - Targeting and design: - Support should be aimed at viable firms and sectors while considering strategic objectives. - In advanced economies with well-developed markets, authorities may have fiscal space to address specific corporate vulnerabilities; market mechanisms (M&A, distressed debt funds) can facilitate restructuring. - In emerging market economies with limited market access and many small and mid-sized firms, more active firm-specific support may be needed if fiscal space exists. - Where solvency support is provided, ensure administrative controls, transparency, accountability, and adequate safeguards—public equity support requires special attention. - Targeted solvency support modalities: - Conditionality could be attached to government support (restrictions on dividend payments and share buybacks). - Debt-to-equity swaps; quasi-equity injections conditional on private lender participation. - Capital injections in the form of preference shares for larger firms without market access; hybrid instruments (for example, profit participation loans) for smaller firms. - Partner with private sector to assess firm viability and improve resource allocation, particularly for smaller firms. - Private sector financing and market-based solutions (distressed debt funds, developed distressed asset markets) can facilitate orderly restructuring. ### Nonbank financial intermediation and search for yield - Low-interest-rate environment has intensified search for yield at nonbank financial institutions: - Pension funds have increased allocations to alternative assets (private equity, infrastructure, real estate); panel data are based on asset allocation data of 700 of the largest pension funds, representing $13 trillion in assets. - Insurers have increased investments in less liquid and riskier lower-rated corporate bonds, foreign bonds, and other illiquid exposures. - The equity return correlation of bank and insurance companies has reached new historical highs, likely reflecting larger exposure of life insurance companies to banks’ securities. - A surge in initial public offerings of SPACs reflects continued search-for-yield behavior. - Strengthen resilience of the nonbank financial intermediation sector via assessment, understanding systemic risks and cross-border spillovers, and bolstering resilience of nonbank institutions. - Urgently develop macroprudential tools for segments where they are not available (for example, parts of the nonbank financial intermediation sector). ### Banks: current resilience, buffers, and credit supply risks - Banks have so far not been part of the problem, but their ability and willingness to lend once government support is unwound will determine whether the recovery is even and whether scarring effects occur. - Banks entered the pandemic with high capital and liquidity buffers due to post-2007–08 regulatory reforms. - Stress test results from the October 2020 GFSR indicate that, even under a severely adverse macroeconomic scenario, more than 90 percent of banks by assets across 29 systemically important jurisdictions would remain above statutory minimum capital levels through 2022. - Extraordinary monetary and fiscal policy support and bank-specific mitigation policies contributed to resilience; without such policies, the estimated proportion of capital-deficient bank assets would have roughly doubled. - Provision charges to build precautionary reserves rose more than risk-weighted assets in advanced economies, pushing total buffers (capital plus loan-loss reserves) higher. - Some (mainly US) banks cut back loan-loss reserves in the fourth quarter of 2020 and announced resumption of dividend distributions. - Loan growth decelerated, and in many countries corporate loan growth is negative. - As of 2020:Q4, many countries exhibited both weak demand for credit by small and mid-sized firms and tight supply conditions. - Loan repayment moratoriums and government loan guarantees supported credit flows but are slated to expire or run off in 2021 in most countries. - Loans under moratorium amounted to €600 billion, or more than 3 percent of total loans, as of the third quarter of 2020 (among European banks monitored by the European Banking Authority); in some countries such loans account for more than 10 percent of total loans. - Termination of moratoriums will require increases in loan-loss provisioning resulting in an average reduction of about 20 basis points in capital ratios; in the worst-affected countries, the end of moratoriums could reduce system-average capital ratios by nearly 100 basis points. - Guaranteed loans accounted for almost 2 percent of total loans on average as of the third quarter of 2020, though in some countries that figure was as high as 4 percent. - Replacement of guaranteed loans with nonguaranteed loans will require higher provisions and risk weights; this “cliff effect” is estimated to result in an average decline of about 25 basis points in capital ratios, and up to 100 basis points in countries with large guarantee programs. - Guaranteed loans’ maturity averaged about 2.5 years at origination, implying a more gradual “ramp” than a sharp “cliff” effect on runoff. - Some banking systems that could face the largest downside risks from the phaseout of moratoriums and guarantees also have comparatively low buffers, making a carefully managed exit strategy critical. - Banks have been reluctant to draw down capital buffers: for a sample of 72 banks representing about 60 percent of the global banking system’s aggregate market capitalization, only banks accounting for 5 percent of market capitalization manage to clear all three hurdles to draw down capital buffers. - Three hurdles banks must clear before using buffers: - Capacity hurdle: sufficient management buffers. - Supervisory hurdle: ability to rebuild buffers within five years or less and having pre-pandemic NPL ratios not greater than three times regional averages. - Management hurdle: using buffers must provide higher returns than not using them (equity fair value must exceed the counterfactual by 20 percent by Year 3). - Profitability is the single most important factor enabling banks to clear the supervisory and management hurdles. - Model assumptions and sensitivity notes: - Analysis based on 2022 consensus expectations compiled by Bloomberg for assets, risk-weighted-asset density, net earnings, and cash payouts; medium-term CET1 targets used instead of 2022 expectations for CET1 ratios. - Assumes new loans generated by drawing down buffers are equal in returns and risk-weight density to the bank’s back book. - Assumes banks can fill AT1 debt shortfall via issuance; an AT1 yield equal to half the cost of equity is assumed. - Reducing the initial capital drawdown (from 2.5 percent to 1 percent of RWA) increases likelihood of clearing first and second hurdles but barely changes likelihood of clearing the third hurdle. ### Indicator-Based Framework and cross-sector vulnerabilities - The Indicator-Based Framework monitors vulnerabilities from leverage, liquidity, maturity, and currency mismatches; most data points are through the second quarter of 2020. - In the sovereign sector, vulnerabilities are elevated in systemically important countries that account for about 80 percent of the GDP of sample countries. - For households, vulnerabilities continue to be elevated in China and a number of advanced economies. - Close to half of banks in systemically important economies are now in the medium-high and high vulnerability category. - Vulnerabilities are generally moderate to elevated across nonbank financial institutions; insurance sector vulnerabilities increased in some advanced economies. ### Market events, leverage, and microstructure: the GameStop episode - Short squeeze in early 2021 led to significant volatility in US equity markets for a brief period; volatility was confined mostly to stocks representing less than ½ percent of the US stock market. - Retail investors purchased small-cap stocks (notably GameStop) via online commission-free platforms such as Robinhood. - Amplifying factors: - Leverage through margin debt in brokerage accounts and expiring options magnified the squeeze. - Hedging by options market makers contributed to sharp price moves. - Margin requirements by clearinghouses increased required deposits by more than 30 percent on January 28, 2021, triggering liquidity pressure on some brokers. - Policy lessons and regulatory issues highlighted: - Rise in retail social media investing; FINRA (2021) survey indicates new retail investors are on average younger, with less investment experience, relying more on advice from friends and family and less on personal research or professional advice. - Shorting practices: Short positions against GameStop exceeded 100 percent of tradable shares since 2019; rehypothecation can lengthen the trading chain. - Payment for order flow raises questions about potential conflicts of interest and disclosure of execution quality. - Liquidity pressure on online brokers led to temporary trading suspensions while brokers recovered liquidity through credit lines from banks and equity capital. ### Policy recommendations and priorities - Ongoing policy support remains necessary to bridge to recovery, but a range of policy measures are needed to address vulnerabilities and protect the recovery. - Policymakers should: - Support balance sheet repair, for example by strengthening management of nonperforming assets. - Rebuild buffers in emerging markets to prepare for a possible repricing of risk and a reversal of capital flows. - Take early action to avoid a legacy of vulnerabilities, including tightening selected macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding a broad tightening of financial conditions. - Urgently develop macroprudential tools for segments where they are not available (for example, parts of the nonbank financial intermediation sector). - Consider building buffers elsewhere to protect the financial system given challenges in designing and operationalizing macroprudential tools within existing frameworks. - Given possible lags between activation and impact of macroprudential tools, early action is emphasized. - Additional recommendations: - Monetary policy should continue to be accommodative until mandated policy objectives are achieved. - Maintain borrower-support measures such as debt repayment relief, credit guarantees, and direct support until economic indicators point to a sustainable recovery; as recovery gains momentum, limit support to temporarily distressed but fundamentally viable borrowers. - Recalibrate policy support carefully and communicate openly and transparently to provide appropriate signals and incentives. - Strengthen management of nonperforming loans and employ market-based disposal solutions; prepare for bankruptcies and loan defaults by strengthening insolvency regimes and fast-track restructuring procedures. - Continue restrictions on capital distributions while uncertainty remains high; relax system-wide limits progressively where losses can be quantified and use supervisory stress tests to ensure adequate capitalization. - With increased retail participation in equity markets and no-fee trading apps, ensure timely investor information, consider investor education programs, and monitor trading behavior for possible regulatory or supervisory responses. - Emerging and frontier markets: accelerate access to vaccines and consider rebuilding buffers, transparent reserve accumulation strategies, and prudent macro-financial risk management. - Countries with market access: use favorable financing conditions to improve debt composition (extend maturities, lock in low interest rates) and reverse departures from sound public debt management. - Countries with limited market access: consider increased allocation of special drawing rights, Debt Service Suspension Initiative, concessional and emergency financing, rescheduling or reprofiling, and deeper restructuring as needed; consider broadening coverage of the Common Framework for Debt Treatments. - Nonfinancial corporate sector: provide firm-specific support for viable firms; develop distressed debt and NPL markets; facilitate consolidation, especially among smaller firms; improve debt resolution regimes with out-of-court and hybrid restructuring options; implement fast-track resolution for nonviable firms. *International Monetary Fund, Chapter 1 at a Glance, April 2021.* ### Chapter 1 at a Glance ### Chapter 1 at a Glance ### Main findings: financial conditions and vulnerabilities - Extraordinary policy support measures have eased financial conditions and supported the economy, helping to contain financial stability risks; asset valuations, however, appear stretched in some segments, and financial vulnerabilities are rising further in some sectors. - A repricing of risk in markets and the associated tightening in financial conditions—for example, due to a rapid and persistent increase in interest rates—may interact with such vulnerabilities, with repercussions for confidence and endangering macro-financial stability. - Two emerging themes: - An asynchronous and divergent global economic recovery—especially if accompanied by a move toward policy normalization in advanced economies and rapid rising interest rates—may result in tighter financial conditions and large portfolio outflows in emerging market economies. - Highly accommodative financial conditions may have unintended consequences: if not addressed, financial vulnerabilities exposed by the pandemic may become new structural legacy problems. - The global financial system has shown remarkable resilience so far, despite unprecedented output loss and sectoral stress, though vulnerabilities were already elevated before the pandemic in some sectors and are now rising further amid very buoyant financial markets. - The GFSR growth-at-risk framework shows the improved 2021 outlook has reduced the range of severe economic outcomes but risks to future GDP growth remain skewed to the downside. ### Emerging and frontier market economies: financing needs and risks - Many emerging market economies face large financing needs in 2021 and are exposed to rollover risk, especially if domestic inflation rises or global long-term interest rates continue to rise. - Government debt in emerging markets (excluding China) is expected to reach 61 percent of GDP in 2021. - Gross financing needs for emerging markets are anticipated to remain elevated at 13 percent of GDP in 2021, coming off record levels in 2020. - Recent increases in US long-term yields (about 125 basis points since the summer of 2020) and an average advanced economy 10-year rate increase of 50 basis points so far in 2021 have put upward pressure on yields elsewhere and rattled some emerging market bond markets and currencies. - Policy responses in emerging markets have included a mix of shorter local currency debt duration; asset purchase programs (in some cases involving explicit monetary financing); and increased reliance on the domestic banking system for newly issued debt. - Risks from these actions include greater vulnerability to exchange rate shocks from sizable external issuance; higher rollover risk from shorter local currency debt duration; stronger sovereign-bank nexus and potential crowding out of private lending; and impaired market access for many frontier market economies. ### Corporate sector: debt, heterogeneity, and decision framework - Nonfinancial firms are emerging from the pandemic overindebted, with notable differences across firm sizes and sectors. - Stress is high at small firms in most sectors across countries. - Solvency stress is high at small firms, but also notable at mid-sized and even large firms in affected sectors. - The report uses a decision tree to assess whether firms should rely on market financing, seek government support, be restructured, or be liquidated. ### Nonbank financial intermediation and search for yield - Low-interest-rate environment has intensified search for yield at nonbank financial institutions: - Pension funds have increased allocations to alternative assets (private equity, infrastructure, real estate) to meet return targets; panel data are based on asset allocation data of 700 of the largest pension funds, representing $13 trillion in assets. - Insurers have increased investments in less liquid and riskier lower-rated corporate bonds, foreign bonds, and other illiquid exposures. - The equity return correlation of bank and insurance companies has reached new historical highs, likely reflecting larger exposure of life insurance companies to banks’ securities. - A surge in initial public offerings of special-purpose acquisition companies (SPACs) reflects continued search-for-yield behavior. ### Banks: current resilience and future role - Banks have so far not been part of the problem, but their ability and willingness to lend once government support is unwound will determine whether the recovery is even and whether scarring effects occur. - Concerns about credit quality of hard-hit borrowers and the profitability outlook are likely to weigh on banks’ risk appetite. - Banking systems may become less supportive of economic growth when policy support is eventually withdrawn, especially in countries where the recovery may be slower and profitability challenges predate the crisis. ### Key dynamics in market rates and volatility - US long-term interest rates rose about 125 basis points since the summer of 2020; until the beginning of 2021 the rise was driven primarily by higher inflation breakevens, with real rates beginning to increase more recently (albeit from very low levels). - Markets expect long-end yields in the United States to return to pre-pandemic levels in coming months. - The recent volatility in US equity markets highlighted the role of leveraged retail investors and raised questions about opaque financial leverage following significant losses at a highly levered fund that spilled over to several investment banks. ### Policy recommendations and priorities - Ongoing policy support remains necessary to bridge to recovery, but a range of policy measures are needed to address vulnerabilities and protect the recovery. - Policymakers should: - Support balance sheet repair, for example by strengthening management of nonperforming assets. - Rebuild buffers in emerging markets to prepare for a possible repricing of risk and a reversal of capital flows. - Take early action to avoid a legacy of vulnerabilities, including tightening selected macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding a broad tightening of financial conditions. - Urgently develop macroprudential tools for segments where they are not available (for example, parts of the nonbank financial intermediation sector). - Consider building buffers elsewhere to protect the financial system given challenges in designing and operationalizing macroprudential tools within existing frameworks. - Given possible lags between activation and impact of macroprudential tools, early action is emphasized. *International Monetary Fund, Chapter 1 at a Glance, April 2021.* ### CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk ### CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk ### Portfolio flows and emerging market financing - Quarterly portfolio inflows reached their highest level ever in the fourth quarter of 2020, amounting to more than $200 billion. - The sharp rebound in portfolio flows stalled in late February 2021 amid rising rates in advanced economies and volatile global market conditions. - Flow dynamics by asset type: - Hard currency bond fund flows: sharp rally in 2020:Q4, then stalled in early 2021. - Local currency bond inflows: moderated in Q1 2021 after recovering sharply toward the end of 2020. - Drivers of the recovery: - Equity and local currency debt flows: estimated to have benefited primarily from optimism about vaccines and the anticipated improvement in the growth outlook. - Hard currency debt flows: appear to have been boosted primarily by the improvement in risk sentiment after the March sell-off. - Risks and asymmetries: - The rebound in portfolio flows is beneficial for emerging markets with large financing needs but fragility remains; outlook can worsen quickly with shifts in investor sentiment and tighter global financial conditions. - Countries with weaker fundamentals and limited access to vaccines face greater risks; capital-flows-at-risk analysis indicates larger downside tail risks for these countries. - In a sample of 11 major emerging markets, aggregate nonresident holdings of domestic sovereign debt remain lower than they were in January 2020 (in US dollar terms), even as outstanding domestic debt has increased by nearly $500 billion. ### Local currency term premia and drivers of higher borrowing costs - After declining to historically low levels in late 2020, local currency sovereign yields rose sharply in early 2021 driven by increases in US long-term real yields. - Most of the increase in long-end rates came from a rise in local bond term premia, which had previously compressed to levels last seen before the 2013 taper tantrum. - Factors that compressed term premia in 2020: - Decline in long-term interest rates in advanced economies. - Subdued actual and expected inflation despite elevated macroeconomic uncertainty. - Domestic asset purchase programs and other measures aimed at supporting local bond markets. - Issuance and rollover risks: - Several countries shortened debt duration and increased issuance of short-term and floating-rate debt, containing market pressure in times of risk aversion but exposing governments to greater rollover risks and to a future rise in interest rates. - Quantified sensitivities and scenarios: - Empirical analysis finds that a 1 percentage point shock to inflation uncertainty increases term premia by about 30 basis points. - A 1 percentage point shock to inflation expectations increases term premia by about 10 basis points. - A 1 percentage point rise in US term premia leads to an increase in emerging market term premia of 60 basis points, on average. - Combined with an increase in inflation expectations to pre-pandemic levels, these effects would translate into roughly a 1 percentage point increase in emerging market term premia, on average, by the end of 2021. ### Frontier markets and external funding vulnerabilities - Spread behavior: - Spreads of higher-rated emerging market issuers have generally declined sharply, returning to their precrisis levels. - Frontier issuer spreads have been more variable; some have tightened significantly while others continue to widen (examples cited in the text include Belize, Sri Lanka, Suriname widening; Angola, Gabon, Mongolia showing significant narrowing). - Role of external versus domestic factors: - For higher-rated sovereigns, external factors offset almost 70 percent of the drag from worsened domestic fundamentals during the pandemic. - For frontier economies, external factors offset only 25 percent of the drag from domestic fundamentals. - Weaker domestic fundamentals (growth, inflation) and weaker reserve adequacy have weighed on frontier funding costs; idiosyncratic factors (political risks, IMF program relations, debt composition) also drive differentiation. - Coverage by debt-relief initiatives: - A large group of countries (currently 73) is eligible for the Debt Service Suspension Initiative (DSSI) and the Common Framework for Debt Treatments, but fewer than one-third of them have outstanding international bonds. - International bonds and bilateral loans are a material part of the debt structure of most frontier issuers, yet only about half of them are eligible to participate in these initiatives. - Exclusion from these initiatives can prevent many countries with large debt vulnerability from benefiting from coordinated and comprehensive debt treatment. ### China: rapid recovery with rising vulnerabilities - Recovery and policy support: - The Chinese economy recovered more rapidly than other countries, supported by substantial policy measures that boosted activity but increased government and corporate debt. - Corporate credit risks: - Targeted credit policies led to rapid growth in credit for small firms and microenterprises, a segment with elevated credit risk. - Among larger firms, new credit has largely flowed to borrowers with weak debt servicing capacity before the pandemic, pointing to future default risks. - Debt issued by firms that had sustained two years of operating losses before the pandemic or net-debt-to-EBIT ratios above 15 account for nearly 40 percent of GDP, or half of the debt of all nonfinancial bond market issuers. - Over two-thirds of these bond issuers enjoyed credit spreads that imply relatively low risk of default (below 200 basis points). - Financial sector and implicit guarantees: - Authorities signaled a shift toward containment of debt risks and introduced measures to impose financial discipline on banks, local governments, and property developers. - Funding conditions for capital instruments have tightened for weaker, smaller banks since authorities bailed in subordinated debt eligible as Tier 2 capital for the first time, which could tighten conditions for smaller firms served by these banks. - Several unexpected defaults of state-owned enterprises in 2020:Q4 raised investor concerns about implicit guarantees for weaker borrowers relying on regional government backstops. - Credit extension to firms and households in the financially weakest provinces fell sharply toward the end of 2020, pushing these provinces’ share of total credit growth to the lowest levels on record. - Policy challenge: - Authorities face a delicate and urgent challenge in unwinding implicit guarantees; a carefully sequenced and well-communicated transition is needed to avoid disorderly repricing of credit risk, alleviate distortions in credit allocation, and limit further growth in risky corporate debt. ### Corporate sector outlook - The corporate sector has been hit hard by the pandemic and is likely to emerge with higher debt loads, with notable differences across sectors and firm sizes. - Unprecedented policy support compressed credit spreads and averted a surge in insolvencies, but a weak tail of firms continues to struggle. - Firms with market access have benefited from supportive conditions, while weaker firms and those reliant on implicitly guaranteed funding face elevated default and repricing risks. *Source: CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk, Global Financial Stability Report, April 2021.* ### CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk ### CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk ### Corporate funding trends and market conditions - Debt issuance has risen to record levels as companies have tried to cope with liquidity pressures. - Equity issuance rose to record highs amid elevated equity valuations; initial public offerings by special-purpose acquisition companies surged to historic highs. - Merger and acquisition activity in advanced economies has accelerated, supporting market-driven consolidation. - The pool of capital targeted for distressed debt has grown sharply and could be a key source of funding for troubled firms. - Private debt markets have expanded and provided a lifeline to small and mid-sized firms in some advanced economies. - In contrast, many firms in emerging market economies still rely heavily on bank financing. ### Definitions and sample - Firm size classification: - Large firms: assets exceeding $500 million and can access all capital markets, as well as bank financing. - Mid-sized firms: assets between $50 million and $500 million and cannot generally access the bond market. - Small firms: assets below $50 million and rely predominately on bilateral bank loans. - Sample: approximately 19,500 firms, of which small and mid-sized firms make up over half of the sample; about 2,500 firms are private. - Country coverage: Brazil, China, France, Germany, India, Italy, Japan, Mexico, Poland, Russia, Spain, Turkey, the United Kingdom, and the United States. ### Emerging vulnerabilities and sectoral differences - Vulnerabilities have risen as corporate debt has accumulated primarily among firms with the weakest debt-servicing capacity. - A growing debt burden, together with weaker earnings, has started to impair many firms’ capacity to service debt. - The number of high-yield defaults reached the highest level since the global financial crisis in 2020; while the pace of defaults has recently dropped, stress remains elevated in sectors most sensitive to the pandemic. - Liquidity stress: - High at small firms in most sectors; very low for large firms. - Small firms have relatively low liquidity buffers (including liquid asset holdings and bank credit lines) and limited market access. - In emerging markets, even mid-sized firms experience considerable liquidity risk. - Solvency stress: - High for small firms and significant for mid-sized and even large firms in affected sectors (energy, services, transportation, real estate). - Small firms face high solvency risk across sectors. ### Firm-level assessment framework (three elements) - Liquidity: ability to pay off short-term financial obligations without raising additional external financing. - Solvency: ability to meet short- and long-term financial obligations; often calculated as assets minus liabilities. - Viability: ability of a business to generate future positive profits within a three-year horizon (whether benefits of continuing exceed costs). - Viability assessment combines market-based measures for firms with market access and medium-term balance sheet projections for smaller firms without market access. - Liquidity stress indicators include: 2021 projected cash balance, liquidity buffer ratio, interest coverage ratio, and current ratio. - Solvency stress indicators include: 2021 projected equity position, net-debt-to-earnings, gross-debt-to-earnings, and equity-to-assets ratios. - Viability indicators include: 2021–23 projected interest coverage ratio, projected EBIT-to-revenue ratio, debt-to-assets ratio, price-to-book ratio, and price-to-book ratio relative to a firm’s sectoral average. ### Quantitative assessment highlights - For small firms with high liquidity risk: - Share of debt accounted for by viable firms is 30 percent in advanced economies and nearly 20 percent in emerging markets. - Share of nonviable firms’ debt among small firms is notable, especially in advanced economies: 20 percent. - Policy implication: targeted liquidity support (for example, loan guarantee programs) is necessary; nonviable firms should be restructured or liquidated. - For small firms with high solvency risk: - In advanced economies, share of debt accounted for by still-viable small firms is more than 30 percent. - In emerging markets, the share is slightly lower. - Policy implication: where firms have market access, they should raise equity; where they do not, policymakers should consider equity-like support. - Firms exposed to both solvency and liquidity risk require a combination of liquidity and solvency measures; for market-accessible firms, equity raising would likely alleviate both risks. ### Policy trade-offs and recommendations - Policymakers face difficult trade-offs due to reduced fiscal space: - Too little support: may be inadequate short term and risk sudden repricing of credit, widespread insolvencies, economic scarring, and negative feedback to banks, nonbank lenders, and sovereigns. - Too much support: may cause zombification (nonviable firms surviving), structurally slow growth, debt overhang, misallocation of credit, and a less resilient financial system. - Targeting and design of support: - Support should be aimed at viable firms and sectors while considering strategic objectives. - In advanced economies with well-developed markets, authorities may have fiscal space to address specific corporate vulnerabilities; market mechanisms (M&A, distressed debt funds) can facilitate restructuring. - In emerging market economies with limited market access and many small and mid-sized firms, more active firm-specific support may be needed if fiscal space exists. - Where solvency support is provided, ensure administrative controls, transparency, accountability, and adequate safeguards—public equity support requires special attention due to government stakes and associated implications. - Private sector financing and market-based solutions (distressed debt funds, developed distressed asset markets) can facilitate orderly restructuring and benefit economies with such market infrastructure. *Source: CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk (IMF Global Financial Stability Report, April 2021).* ### 2. Share of Debt at Firms with Elevated Solvency Stress Indicators by Firm Size and by Sector ### 2. Share of Debt at Firms with Elevated Solvency Stress Indicators by Firm Size and by Sector ### Overall findings - Solvency stress is high at small firms and widespread across sectors. - Solvency stress is substantial even at large firms in the most affected sectors. - Liquidity stress is substantial at small firms and mid-sized emerging market firms, with a large differentiation across sectors. - Most mid-sized firms with high liquidity stress have good viability, but a notable share of small firms has weak prospects. ### Sector and firm-size assessments (figure-based observations) - Panels show shares of debt at firms with elevated liquidity and solvency stress indicators, by firm size (large, mid-sized, small) and by sector. - For each firm size and each type of stress—liquidity and solvency—sectors corresponding to the bottom 25th, 50th, and 75th percentile by the share of debt with high stress are shown. - Large, mid-sized, and small refer to firms’ total assets. Overall liquidity, solvency, and viability stress indicators are computed as combinations of the respective components (for example, overall liquidity stress is “elevated” if at least three of four individual liquidity indicators exceed their thresholds). - In panels 2 and 3, averages across sectors are calculated separately for advanced economies and emerging market economies. ### Viability assessment and decision framework - Proposed decision tree for policymakers: - If a firm has a high liquidity or solvency risk, assess viability risk to determine policy action. - Immediate, firm-specific steps include: assess viability risk → decide on direct government support or other policy action. - Policy action outcomes illustrated: - Low viability risk + high liquidity risk → None. - High viability risk + high liquidity risk → Restructure or liquidate. - Low viability risk + high solvency risk → None. - High viability risk + high solvency risk → Restructure or liquidate. - Medium-term, sector-wide policy options suggested in the figure include: - Provide liquidity support, e.g., loan guarantees, to small firms. - Encourage required debt raisings by large firms with market access. - Equity-like injections to small firms with no market access. - Encourage equity raisings by large firms with market access. - Deepen capital markets to facilitate market-based options for small firms; encourage consolidation among small firms; develop distressed debt market; strengthen resolution regime. ### Targeted solvency support modalities - Conditionality could be attached to government support (restrictions on dividend payments and share buybacks, depending on instrument). - Debt-to-equity swaps can boost solvency and could be negotiated with private shareholders and creditors. - Prudential authorities could provide quasi-equity injections conditional on private lender participation to lessen distortions. - For larger firms without market access, capital injections in the form of preference shares are an option, with attention to governance trade-offs and a clear exit strategy. - For smaller firms, hybrid instruments (for example, profit participation loans) can combine solvency support with safeguards of the public interest. - Governments should consider partnering with the private sector to assess firm viability and improve resource allocation, particularly for smaller firms. ### Banks, buffers, and implications for credit supply - Banks entered the pandemic with high capital and liquidity buffers due to post-2007–08 regulatory reforms. - Stress test results from the October 2020 GFSR indicate that, even under a severely adverse macroeconomic scenario, more than 90 percent of banks by assets across 29 systemically important jurisdictions would remain above statutory minimum capital levels through 2022. - Extraordinary monetary and fiscal policy support and bank-specific mitigation policies (changes in accounting recognition of loan losses and calculation of risk-weighted assets and suspension of capital distributions, among others) contributed to resilience; without such policies, the estimated proportion of capital-deficient bank assets would have roughly doubled. - Despite the downturn, banks generally reported loan-loss provisions low enough to support capital positions; capital ratios of US and European global systemically important banks rose over the first three quarters of 2020. - Provision charges to build precautionary reserves rose more than risk-weighted assets in advanced economies, pushing total buffers (capital plus loan-loss reserves) higher. - Some (mainly US) banks cut back loan-loss reserves in the fourth quarter of 2020 and announced resumption of dividend distributions. ### Loan demand, lending standards, and risks to recovery - Loan growth decelerated, and in many countries corporate loan growth is negative. - As of 2020:Q4, many countries exhibited both weak demand for credit by small and mid-sized firms and tight supply conditions (as proxied by bank lending standards). - As the economic outlook improves, loan demand may strengthen, particularly from small and mid-sized firms; however, loan officers in many countries see little prospect for a proportional loosening in lending standards to small and mid-sized firms, likely resulting in tighter conditions. - Survey respondents across advanced and emerging economies cite “external” factors (economic outlook and borrower risk) as important reasons for tightening standards; “internal” factors (capital and liquidity) are less frequently cited. ### Emerging market bank vulnerabilities and credit concentration - Emerging market banks are more vulnerable than developed market peers to capital shortfalls per the October 2020 GFSR stress test. - Banks’ ownership of domestic sovereign debt has increased sharply in some cases. - In most emerging markets, banks account for 70 percent or more of credit to nonfinancial borrowers, compared with only 36 percent in advanced economies. ### Phaseout of lending support policies and capital impact estimates - Loan repayment moratoriums and government loan guarantees supported credit flows but are slated to expire or run off in 2021 in most countries. - Loans under moratorium amounted to €600 billion, or more than 3 percent of total loans, as of the third quarter of 2020 (among European banks monitored by the European Banking Authority); in some countries such loans account for more than 10 percent of total loans. - These loans are generally of lower quality than banks’ overall portfolios, with a higher share of risky loans and lower loan-loss reserve coverage. - Termination of moratoriums will require increases in loan-loss provisioning to raise reserve coverage to the standard used for the overall loan book, resulting in an average reduction of about 20 basis points in capital ratios; in the worst-affected countries, the end of moratoriums could reduce system-average capital ratios by nearly 100 basis points. - Guaranteed loans accounted for almost 2 percent of total loans on average as of the third quarter of 2020, though in some countries that figure was as high as 4 percent. - Replacement of guaranteed loans with nonguaranteed loans will require higher provisions and risk weights; this “cliff effect” is estimated to result in an average decline of about 25 basis points in capital ratios, and up to 100 basis points in countries with large guarantee programs. - Guaranteed loans’ maturity averaged about 2.5 years at origination, implying a more gradual “ramp” than a sharp “cliff” effect on runoff. - Some banking systems that could face the largest downside risks from the phaseout of moratoriums and guarantees also have comparatively low buffers, making a carefully managed exit strategy critical. ### Bank buffers and reluctance to draw them down - Supervisors released or recalibrated macroprudential buffers and encouraged banks to use regulatory capital buffers, allowing temporary operation below combined buffer requirements. - These measures were intended to stimulate lending without materially compromising resilience, and using buffers is vital to ensure continued supply of credit. - However, banks have not materially drawn down capital buffers and most have reiterated medium-term capital ratio targets. - Bank management reluctance to draw buffers may reflect concerns about credit quality amid uncertainty. *Sources: S&P Capital IQ; and IMF staff calculations.* ### 1. Loans under Moratoriums and Guaranteed Loans, ### 1. Loans under Moratoriums and Guaranteed Loans ### Lending support measures: volumes, quality, and impact of withdrawal - Phaseout of moratoriums and guarantees could lower CET1 ratios by about 40 basis points on average. - Some countries have a large share of loans under lending support programs. - Systems that combine the lowest total buffers and the greatest downside risks from the phaseout of policy relief are of most concern. - In panel definitions: risky loans are defined as Stage 2 plus NPLs. Expected loan losses = NPLs × loss given default. - CET1 = common equity Tier 1; NPL = nonperforming loan; RWA = risk-weighted assets. ### Asset quality and reserve coverage of loans under moratorium versus loans not under moratorium (as of 2020:Q3) - The asset quality and level of provisions of loans under moratoriums are weaker than the overall loan book. - Data labels use International Organization for Standardization (ISO) country codes (examples shown in source figure include CYP, PRT, GRC, HUN, ITA, SVK, HRV, MLT, SVN, ESP, ROU, ISL, POL, BGR, IRL, FRA, AUT, SWE, FIN, LVA, BEL, USA, EST, NLD, AUS, LTU, LUX, DEU). - Panel metrics are reported as percentage points and percent (figures in source present distributions across countries; exact country-level values are shown in the source figure). ### Total capital impact from the phaseout of moratoriums and guarantees (as of 2020:Q3) - Capital impact is measured in basis points of RWA; country-level impacts are reported in the source figure (examples of countries with notable capital impacts in the figure include CYP, ESP, FRA, GRC, HUN, ITA, PRT, ROU). - Average impact bars in the figure separately show average impact from guarantees and average impact from moratoriums. ### Adjusted CET1 ratio vs. capital impact from the phaseout - Current total buffer defined as (CET1 capital + reserves – expected loan losses) / RWA, reported in percent of RWA. - The figure highlights countries with low current total buffers and high capital-impact exposure to policy withdrawal as the most vulnerable. ### Assessment of banks’ incentives and buffer usability - For a sample of 72 banks representing about 60 percent of the global banking system’s aggregate market capitalization, only banks accounting for 5 percent of market capitalization manage to clear all three hurdles to draw down capital buffers. - Three hurdles banks must clear before using buffers: - Capacity hurdle: sufficient management buffers (difference between CET1 and the MDA is larger than the regulatory buffers the bank could be expected to draw down). - Supervisory hurdle: ability to rebuild buffers within five years or less and having pre-pandemic NPL ratios not greater than three times regional averages. - Management hurdle: using buffers must provide higher returns than not using them (equity fair value must exceed the counterfactual by 20 percent by Year 3). - Only about 5 percent of banks—mainly those with returns well above their cost of equity—have incentives to draw down buffers. - Profitability is the single most important factor enabling banks to clear the supervisory and management hurdles. - The more profitable a bank is, the less time it takes to rebuild buffers. - Worse-than-expected credit quality on new loans lengthens the rebuilding period. - Higher return on new loans (for example, due to guarantees) improves the return on investment from buffer drawdown. - Deleveraging accelerates capital rebuilding regardless of return profile but would run contrary to policymakers’ aim of supporting the economy. - For high-return banks, dividend cuts can help because the market value of incremental earnings may exceed forgone dividend income. - Model assumptions and sensitivity notes: - Analysis based on 2022 consensus expectations compiled by Bloomberg for assets, risk-weighted-asset density, net earnings, and cash payouts; medium-term CET1 targets used instead of 2022 expectations for CET1 ratios. - Assumes new loans generated by drawing down buffers are equal in returns and risk-weight density to the bank’s back book. - Assumes banks can fill AT1 debt shortfall via issuance; an AT1 yield equal to half the cost of equity is assumed. - Reducing the initial capital drawdown (from 2.5 percent to 1 percent of RWA) increases likelihood of clearing first and second hurdles but barely changes likelihood of clearing the third hurdle. ### Table 1.1 summary: Drivers of buffer usability (sample coverage and quartile outcomes) - Only banks representing 5 percent of the sample used here (covering 60 percent of the global banking system’s aggregate market capitalization) clear the three key hurdles to draw down their capital buffers. - Banks ranked by price-to-book ratio (market capitalization over CET1 levels) and performance on hurdles (table entries shown in source): - 1st Quartile [bottom] 1.5×17.90 - 2nd Quartile 1.1×5.90 - 3rd Quartile 1.3×5.20 - 4th Quartile [top] 0.7×2.910 - World 1.0×4.85 - Table headings: Capacity Hurdle 1; Supervisory Hurdle 2; Management Hurdle 3. - Table notes: Asset quality hurdle at 3 times the region’s pre-COVID NPL ratio; bank’s equity fair value hurdle at a 20 percent RoI by Year 3; years to rebuild buffers hurdle at ≤5 years; capital buffer availability hurdle at 1 times buffers drawn. ### Policy implications and recommendations - Extraordinary policy measures have eased financial conditions and must remain until a sustainable and inclusive recovery takes hold to maintain credit flow and prevent systemic threats. - Monetary policy should continue to be accommodative until mandated policy objectives are achieved. - Policymakers should maintain borrower-support measures such as debt repayment relief, credit guarantees, and direct support until economic indicators point to a sustainable recovery; as recovery gains momentum, support should be limited to temporarily distressed but fundamentally viable borrowers. - Recalibrate policy support carefully and communicate openly and transparently to provide appropriate signals and incentives. - Early action on macroprudential tools is recommended to prevent vulnerabilities from becoming entrenched; tighten selected macroprudential tools where vulnerabilities are building and develop tools for segments lacking them (for example, nonbank financial intermediation). - Strengthen resilience of the nonbank financial intermediation sector via assessment, understanding systemic risks and cross-border spillovers, and bolstering resilience of nonbank institutions. - Emerging and frontier markets: accelerate access to vaccines and consider rebuilding buffers, transparent reserve accumulation strategies, and prudent macro-financial risk management. - Countries with market access: use favorable financing conditions to improve debt composition (extend maturities, lock in low interest rates) and reverse departures from sound public debt management. - Countries with limited market access: consider increased allocation of special drawing rights, Debt Service Suspension Initiative, concessional and emergency financing, rescheduling or reprofiling, and deeper restructuring as needed; consider broadening coverage of the Common Framework for Debt Treatments. - Nonfinancial corporate sector: provide firm-specific support for viable firms; develop distressed debt and NPL markets; facilitate consolidation, especially among smaller firms; improve debt resolution regimes with out-of-court and hybrid restructuring options; implement fast-track resolution for nonviable firms. - Regulatory guidance on provisioning should remain but be subject to supervisory scrutiny to prevent underprovisioning; investigate variability in provisioning practices. - Continue restrictions on capital distributions while uncertainty remains high; relax system-wide limits progressively where losses can be quantified and use supervisory stress tests to ensure adequate capitalization. - Strengthen management of nonperforming loans and employ market-based disposal solutions; as insolvency moratoriums expire, prepare for bankruptcies and loan defaults by strengthening insolvency regimes and fast-track restructuring procedures. - With increased retail participation in equity markets and no-fee trading apps, regulators should ensure timely investor information, consider investor education programs, and monitor trading behavior for possible regulatory or supervisory responses. *Sources: European Banking Authority; European Central Bank; Federal Reserve; Reserve Bank of Australia; and S&P Global Intelligence. Notes and figures as presented in the source chapter.* ### CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk ### CHAPTER 1 AN ASYNChRONOuS ANd dIVERGENT RECOVERY MAY PuT FINANCIAL STABILITY AT RISk ### Indicator-Based Framework and overall vulnerabilities - The Indicator-Based Framework is a quantitative methodology to monitor key financial vulnerabilities arising from leverage, liquidity, maturity, and currency mismatches. - Most current data points are through the second quarter of 2020. - In the sovereign sector, vulnerabilities are elevated in systemically important countries that account for about 80 percent of the GDP of sample countries. - The framework focus is restricted to on-balance-sheet vulnerabilities due to data limitations for off-balance-sheet items. - Panel coverage referenced: 29 jurisdictions with systemically important financial sectors. ### Sovereign sector - Debt levels have hit historic highs in response to the large fiscal lifelines put in place during the pandemic. - Loose financial conditions have eased debt service burdens, but many economies could be left with large post-pandemic fiscal deficits and high debt overhangs in the absence of a robust recovery. - Emerging market economies could face significant challenges in servicing debt, especially if sovereign risk premia rise. ### Nonfinancial firms (corporates) - Firms have taken advantage of easy financing conditions and the reopening of capital markets after the March 2020 turmoil to issue debt and equity, particularly in the United States and other advanced economies. - Data through the second quarter of 2020 indicate leverage has increased across most regions. - Liquidity positions improved as firms built cash buffers, extended maturities, and often reduced interest on new and existing debt. - Improved liquidity conditions have tempered near-term risks for large firms. ### Household sector - Vulnerabilities continue to be elevated in China and a number of advanced economies. - Unemployment benefits and other support measures have been critical in bridging lockdowns to reopenings. - Household debt servicing capacity has deteriorated in a number of major economies as some households have taken on more debt to cover lost income. ### Banking sector and other financial institutions - Close to half of banks in systemically important economies are now in the medium-high and high vulnerability category. - Banking sectors in some emerging market economies, and to a lesser extent in the euro area, remain the most vulnerable due to lower interest rates and uncertainties about the economic outlook weighing on profitability. - Banks in other regions have seen profitability and liquidity positions recover much faster from the COVID-19 shock. ### Nonbank financial institutions (asset managers, insurers, other financial institutions) - Vulnerabilities are generally moderate to elevated across nonbank financial institutions. - Insurance sector vulnerabilities increased in some advanced economies as profitability measures were hit and foreign exchange mismatches rose. - For asset managers, vulnerabilities have not changed materially since the October 2020 GFSR. - In some regions, liquidity mismatches improved as funds increased holdings of short-term liquid assets. - Interconnectedness remains a concern: the mutual funds sector sustains large precautionary credit lines with banks. ### Figure and cross-sector observations (Figure 1.1.1 highlights) - Vulnerabilities are presented by GDP for sovereigns, households, and nonfinancial firms; and by assets for banks, asset managers, other financial institutions, and insurers. - “Global financial crisis” reflects the maximum vulnerability value during 2007–08. - For households, the debt service ratio for emerging market economies is based on all private nonfinancial firms and households. - Regional grouping labels used: “Other advanced” economies are Australia, Canada, Denmark, Hong Kong Special Administrative Region, Japan, Korea, Norway, Singapore, Sweden, Switzerland, and the United Kingdom. “Other emerging” market economies are Brazil, India, Mexico, Poland, Russia, and Turkey. ### Box 1.2 — The GameStop short squeeze: market structure and regulatory implications - Event description: - Short squeeze in early 2021 led to significant volatility in US equity markets for a brief period. - Retail investors purchased small-cap stocks (notably GameStop) via online commission-free platforms such as Robinhood. - Price increases led institutional investors with short positions (notably hedge funds) to repurchase stocks, amplifying price moves. - The volatility was confined mostly to stocks representing a small share of the US stock market (less than ½ percent). - Several retail trading platforms suspended trading on January 27 and 28, 2021. - Share prices of these stocks declined rapidly over the following days. - Amplifying factors: - Leverage through margin debt in brokerage accounts and expiring options magnified the squeeze. - Hedging by options market makers (purchasing rising stocks) contributed to sharp price moves. - Margin requirements by clearinghouses increased required deposits by more than 30 percent on January 28, 2021, triggering liquidity pressure on some brokers. - Policy lessons and regulatory issues highlighted: - Rise in retail social media investing: - Off-exchange trading and options volumes rose substantially; retail has played a key role. - A FINRA (2021) survey indicates new retail investors are on average younger, with less investment experience, relying more on advice from friends and family and less on personal research or professional advice. - Shorting practices: - Short positions against GameStop exceeded 100 percent of tradable shares since 2019; other stocks have also surpassed 100 percent. - Rehypothecation can lengthen the trading chain and effectively increase shares available for short selling. - The incident highlights adverse impacts of inadequate disclosure of short selling practices on public trust. - Payment for order flow: - Commission-free brokers outsource executions to high-frequency trading firms and receive significant revenues, raising questions about potential conflicts of interest and disclosure of execution quality. - Liquidity pressure on online brokers: - Temporary trading suspensions occurred while brokers recovered liquidity through credit lines from banks and equity capital. *Italic: International Monetary Fund | April 2021* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2021/april/english/ch1.pdf_