## GLOBAL FINANCIAL STABILITY REPORT: PREEMPTING A LEGACY OF VULNERABILITIES ## Source details **Canonical URL:** [GLOBAL FINANCIAL STABILITY REPORT: PREEMPTING A LEGACY OF VULNERABILITIES](https://www.imf.org/-/media/files/publications/gfsr/2021/april/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2021/april/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2021/april/english/text.pdf.json) --- ### Preface — purpose, scope, and central assessments - Purpose and scope - The GFSR assesses key vulnerabilities the global financial system is exposed to and highlights policies to mitigate systemic risks to contribute to global financial stability and sustained economic growth. - This GFSR reflects information available as of March 24, 2021. - Report benefited from Executive Directors’ discussions on March 25, 2021; analysis and policy considerations are those of contributing staff. - Central assessments and outlook - IMF forecast upgraded to "6 percent global growth for 2021." - Extraordinary policy measures noted: - "$1.9 trillion fiscal stimulus in the United States." - "Central bank asset purchases at nearly $10 trillion globally." - Longer-term interest rates have risen materially: the yield on the 10-year US Treasury note increased from "just over ½ percent in August 2020 to about 1¾ percent recently." - Two overarching themes: - Unprecedented policy support may have unintended consequences: stretched valuations and rising financial vulnerabilities that could become a legacy if not addressed. - Recovery expected to be asynchronous and divergent across economies, posing particular challenges for emerging markets. ### Key vulnerabilities and risks (Preface and Executive Summary) - Asset valuations and market risks - Equity markets have rallied and are trading materially above model-implied fundamentals. - Corporate bond spreads have remained very tight despite increased leverage in the corporate sector. - A rapid and persistent increase in real rates could trigger a repricing of risk and sudden tightening in financial conditions. - Emerging market vulnerabilities - "Given large external financing needs, emerging markets face daunting challenges, especially if a persistent rise in US rates brings about a repricing of risk and tighter financial conditions." - Portfolio flows outlook improved overall, but "countries with weaker fundamentals or limited access to COVID-19 vaccines are vulnerable." - Sovereign-bank nexus intensified: "60 percent of sovereign debt issued after January 2020 ending up on domestic banks’ balance sheets." - Note on sample correction: figures based on a sample of "11 major emerging markets" (revision from "12 emerging markets"). - China-specific risks - Faster recovery accompanied by further buildup in vulnerabilities, notably risky corporate debt. - Funding for capital instruments tightened for weaker, smaller banks; unwinding implicit guarantees is a delicate and urgent challenge. - Corporate and banking sectors - Corporate leverage increased; solvency risk elevated at small and mid-sized firms and at some large firms. - Banks’ profitability expected to be low in many jurisdictions, potentially disincentivizing use of capital buffers. - Bank lending may become strained, complicating monetary policy stance. ### Policy recommendations and strategic priorities (executive guidance) - Prevent a legacy of vulnerabilities - Tighten selected macroprudential policy tools (targeted rather than broad-based tightening). - Support balance sheet repair to foster a sustainable and inclusive recovery. - Monetary and market-based finance trade-offs - Central banks face trade-offs between undoing tightening in financial conditions and avoiding unintended consequences for market-based finance. - Country-specific and sectoral priorities - Manage unwinding of implicit guarantees in China carefully. - Triage corporate-sector policies using the report’s decision framework to assess market financing, government support, restructuring, or liquidation. - International and climate work - IMF engaged in climate-related financial work ahead of COP26: establishing climate disclosure standards, defining climate taxonomy, and improving climate data in cooperation with other institutions and networks. ### Executive Summary — targeted findings and policy timing - Macroeconomic and financial context - Global financial stability risks contained so far due to unprecedented policy accommodation and health progress. - Two themes reiterated: asynchronous and divergent recovery; highly accommodative conditions producing stretched valuations and vulnerabilities. - Corporate sector and commercial real estate - Liquidity stress high at small firms; solvency stress high at small firms and notable at mid-sized and large firms in affected sectors. - Commercial property: estimated permanent increase in vacancy rate by 5 percentage points results, on average, in a drop in fair values by about 15 percent after five years. - Chapter 1 decision tree framework to determine market financing, government support, restructuring, or liquidation for firms. - Banks, lending, and nonbank intermediation - Banks entered pandemic with high capital and liquidity buffers; resilience supported by policy measures. - Loan growth slowed; loan officers do not anticipate loosening in lending standards. - Persistent fragilities in nonbank financial intermediation; macroprudential tools lacking in some segments. - Sovereign and market-access issues in emerging and frontier markets - Emerging markets face large financing needs and rollover risk; many frontier markets have impaired access. - Policy advice: - Countries with market access: improve debt composition. - Countries with limited market access: seek additional international assistance; deeper debt restructuring where needed. - Rebuilding buffers prioritized to prepare for sudden price adjustments and capital-flow reversals. - Policy timing and sequencing - Continue accommodative monetary policy until mandated objectives achieved. - Maintain fiscal support and prioritize health spending and targeted support for worst-affected households and viable firms. - Take early action on macroprudential policy given lags: tighten selected tools, develop tools for NBFI sector, and build buffers elsewhere if operationalizing tools is challenging. - Repair corporate balance sheets, strengthen NPL management, expedite resolution frameworks, and develop distressed debt markets. - Financial sector guidance on provisioning and capital distributions: maintain restrictions or relax progressively where appropriate and validated by stress tests. - International cooperation priorities - Accelerate vaccine production and ensure affordable access worldwide. - Ensure financially constrained countries have adequate international liquidity. - Pursue collective solutions on climate, international tax policy, and international trade. ### Chapter 1 — financial conditions, asset valuations, and systemic risks - Financial conditions and valuation dynamics - Financial conditions are "easy and supportive of growth" underpinned by extremely low rates and high corporate valuations. - Equity markets "rallied aggressively" and are significantly higher than model-based fundamentals. - After accounting for very low real yields, "valuations in risk assets may look less stretched" because "the compensation for bearing risk does not appear overly compressed by historical norms." - Recent market events and nonbank risk-taking - Elevated volatility in US equity markets in early 2021 highlighted leveraged retail investors. - Losses at a highly levered fund spilled over to investment banks, raising concerns about opaque leverage and systemic implications. - SPAC issuance has surged. - Search for yield in NBFIs - Panel based on 700 largest pension funds representing $13 trillion in assets. - Pension funds increased allocations to alternative assets (private equity, infrastructure, real estate). - Insurers increased investments in less liquid and lower-rated corporate bonds and foreign bonds. - Equity return correlation of banks and insurance companies reached new historical highs. - Rising US long-term rates and spillovers - Long-term US interest rates rose about 125 basis points since summer 2020. - Drivers: higher inflation breakevens initially; more recently real rates have begun to increase. - "Investors now expect long-term interest rates in the United States to return to pre-pandemic levels in coming months." - "Average advanced economy 10-year rates have increased 50 basis points so far in 2021." - Risk: rapid and persistent increase in real rates could repricing risk and tighten global financial conditions. - Emerging markets: debt, financing needs, and vulnerabilities - Recovery in emerging markets expected to be slower than in advanced economies, with significant divergence across countries. - "Government debt in emerging markets (excluding China) is expected to reach 61 percent of GDP in 2021." - "Gross financing needs are anticipated to remain elevated at 13 percent of GDP in 2021, coming off record levels in 2020." - Policy measures used include shorter local currency debt duration, asset purchase programs, and reliance on domestic banks for new debt—each with attendant risks (rollover risk, sovereign-bank nexus, crowding out). - Portfolio flows and fragility - Quarterly portfolio inflows reached their highest level ever in Q4 2020 (figure referenced). - Aggregate nonresident holdings of domestic sovereign debt remain lower than January 2020 (USD terms) despite outstanding domestic debt increasing by nearly $500 billion (sample of 11 major emerging markets). - Tail risks higher for countries with weaker fundamentals or limited vaccine access. ### Chapter 1 — country- and region-specific highlights - Emerging market term premia and transmission - Local currency sovereign yields rose sharply in early 2021 driven by an increase in US long-term real yields. - Empirical estimates (Online Annex 1.1): - 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 inflation expectations reverting to pre-pandemic levels, this translates into roughly a 1 percentage point increase in emerging market term premia, on average, by end-2021. - Frontier markets and debt-treatment access - Some frontier spreads narrowed (Angola, Gabon, Mongolia); others widened (Belize, Sri Lanka, Suriname). - External factors offset almost 70 percent of drag from worsening domestic fundamentals for higher-rated sovereigns, but only 25 percent for frontier economies. - Currently 73 countries eligible for the Debt Service Suspension Initiative and Common Framework; fewer than one-third have outstanding international bonds; only about half of frontier issuers are eligible to participate in these initiatives. - China - Rapid recovery with rising vulnerabilities: sharp increase in government and corporate debt; new corporate credit flowing largely to riskier borrowers. - Debt issued by firms with two years of operating losses pre-pandemic or net-debt-to-EBIT > 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 implying default risk below 200 basis points. - Policy challenge: urgent, carefully sequenced, well-communicated transition away from implicit guarantees. ### Chapter 1 — corporate sector, issuance, and policy framework - Corporate issuance and private debt - Debt and equity issuance rose to record levels in 2020; SPAC IPO surge. - Large firms with market access used debt to bolster liquidity; many accessed equity markets. - Small and mid-sized firms (about half the corporate sector by debt) have limited market access and fared less well. - Firm-level assessment framework (Chapter 1 & Chapter 1 at a glance) - Viability assessed over a three-year horizon (2021–23 projections). - Indicators: liquidity (2021 projected cash balance, liquidity buffer ratio, interest coverage, current ratio); solvency (2021 projected equity position, net-debt-to-earnings, gross-debt-to-earnings, equity-to-assets); viability (2021–23 projected interest coverage, projected EBIT-to-revenue, debt-to-assets, price-to-book and relative price-to-book). - Sample: ~19,500 firms; small and mid-sized firms >50% of sample; ~2,500 private firms; countries covered include Brazil, China, France, Germany, India, Italy, Japan, Mexico, Poland, Russia, Spain, Turkey, the United Kingdom, and the United States. - Key firm-level findings (exact illustrative figures preserved) - 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. - For small firms, share of nonviable firms’ debt in advanced economies is 20 percent. - 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 slightly lower. - Policy implications for firm support - Target support on viable firms facing temporary liquidity or solvency risks; restructure or liquidate nonviable firms. - For small firms without market access and high liquidity risk: targeted liquidity support (loan guarantees). - For small firms without market access and solvency concerns: consider equity-like support or hybrid instruments. - For larger firms without market access: capital injections in form of preference shares with governance and clear exit strategy. - Emphasize administrative controls, transparency, accountability, and private-sector participation in solvency support. ### Chapter 2 — nonfinancial sector, financial conditions, and macroprudential policy - Relationship between financial conditions and leverage - An easing in financial conditions by one unit is followed by an increase in nonfinancial corporate debt by 4 percentage points of GDP over three years. - A one-unit loosening implies an increase in household leverage by 1½ percentage points of GDP over a three-year horizon. - About 25 percent of economies in sample are in the credit boom regime in 2020:Q3. - Macro-financial stability implications (growth-at-risk) - A one-unit loosening of financial conditions is associated with an increase in the 10th percentile of real GDP growth in near term by 1½ percentage points; after seven quarters the boost vanishes and downside risk increases by about 1 percentage point. - During credit booms: - Near-term downside risk reduced by 2.5 percentage points after a one-unit loosening; - But downside risk increases by 3.3 percentage points after two years. - A 10 percentage point acceleration in nonfinancial corporate leverage buildup is associated with an increase in downside risks of about 1 percentage point in the near term. - Nonfinancial corporate leverage effect on downside risk stems mainly from emerging markets (about 2 percentage points increase medium term after 10 percentage-point buildup); household leverage adverse impact stronger for advanced economies in longer term. - Macroprudential policy effects and recommendations - Tightening borrower-based measures (LTV, DSTI) reduces household debt accumulation; bank-side liquidity tightenings reduce corporate leverage. - A net tightening across macroprudential categories associated with significantly lower downside risk to future growth by about half a percentage point. - When loosening financial conditions coincides with macroprudential tightening, the intertemporal trade-off is almost entirely mitigated. - Recommendations: - Monitor domestic financial conditions and sectoral leverage. - Use macroprudential tools to lean against excessive risk-taking during easy conditions and rapid credit growth. - Rebuild macroprudential buffers as recovery proceeds. - Urgently develop macroprudential toolkit for nonbank financial intermediaries and consider building buffers elsewhere if tools are hard to operationalize. ### Banking sector resilience, lending support phaseout, and capital-buffer usability - Banks’ resilience - More than 90 percent of banks by assets across 29 systemically important jurisdictions would remain above statutory minimum capital levels through 2022 under the October 2020 GFSR severely adverse scenario. - Without policy relief, estimated proportion of capital-deficient bank assets would have roughly doubled. - Phaseout impacts (as of 2020:Q3) - Loans under moratorium across monitored European banks: €600 billion, or more than 3 percent of total loans. - Guaranteed loans accounted for almost 2 percent of total loans on average; up to 4 percent in some countries. - Termination of moratoriums: average reduction of about 20 basis points in capital ratios; in worst-affected countries nearly 100 basis points. - Runoff of guaranteed loans replacement with nonguaranteed loans: estimated average decline of about 25 basis points in capital ratios; up to 100 basis points in countries with large guarantee programs. - Capital-buffer usability framework and outcomes - Three hurdles for banks to use buffers: capacity, supervisory (rebuild within five years and 2019 NPLs ≤ three times regional averages), and management (equity fair value at least 20 percent above counterfactual by third year). - Sample of 72 banks representing about 60 percent of global banking system market capitalization: only banks accounting for 5 percent of market capitalization manage to clear all three hurdles. - Profitability is the key determinant enabling buffer use. - Policy implications - Maintain borrower-support measures until recovery indicators justify phaseout. - Recalibrate support carefully and communicate transparently. - Keep monetary policy accommodative until objectives met. - Tighten selected macroprudential tools early to address pockets of elevated vulnerability. - Restrict capital distributions while uncertainty remains; progressively relax in countries advanced in pandemic fight based on supervisory stress tests. ### Chapter 3 — commercial real estate (CRE): risks, scenarios, and policy - Market developments and vulnerabilities - COVID-19 hit CRE hard: transactions and prices slumped in 2020; structural demand shifts (e-commerce, teleworking) could produce permanent effects. - Median CRE price misalignment increased in 2020 to about 3.6 percent. - Pre-pandemic average deviation of CRE prices from fair values estimated at about minus 2 percent. - Scenario and quantitative findings - Scenario: permanent increase in vacancy rate of 5 percentage points ⇒ median drop in fair values of about 15 percent after five years. - Real CRE prices almost doubled in Sweden and the United States between 2009 and 2019. - Loan-to-value on new CRE loans averaged about 60 percent in 2019 (vs. 82 percent in 2007 in US and EU). - Banking and investment impacts - In the United States, mild adverse scenario (16 percent drop in CRE prices over eight quarters, one standard deviation) implies: - losses relative to banks’ RWA before shock average 14 basis points; - losses exceed 1 percentage point of RWA for banks with very high CRE exposures (top 3 percent by CRE-loans-to-total-assets; smaller/community banks). - A permanent 5 percentage point increase in vacancy rates would produce about twice the impact on bank capital compared with the mild adverse scenario. - A one standard deviation decrease in market value of real estate assets implies a decrease in investment-to-PPE ratio by 21 percent; each additional $1 of real estate collateral increases investment by $0.03. - Policy considerations for CRE - Near term: continue policy support to keep credit flowing to nonfinancial corporates and stimulate demand. - Medium term: - Swiftly deploy targeted macroprudential tools (caps on LTV, debt-service-coverage ratios) where vulnerabilities and misalignments persist. - Broaden macroprudential coverage to relevant NBFIs. - Use stress tests embedding large CRE price declines to assess capital adequacy. - Consider CRE-specific capital flow management measures only under specific circumstances per IMF guidance. - Cross-border and NBFI risks: - Cross-border CRE flows recovered post-GFC but dropped in 2020; segments and regions affected heterogeneously. - Institutional investors increased share in cross-border flows, raising price synchronization. - Policy responses: broaden macroprudential powers for nonbank supervisors, enhance data, consider stricter rules for property investment funds and insurer capital linkages to property types or LTV/DSTI metrics. ### Conclusion — cross-cutting policy priorities - Preserve near-term support while preventing legacy vulnerabilities - Maintain accommodative monetary and supportive fiscal measures until recovery is secure. - Keep borrower-support measures until sustainable recovery is evident. - Early and targeted macroprudential action - Tighten selected macroprudential tools early to address pockets of elevated vulnerability; account for implementation lags. - Develop macroprudential toolkits for nonbank financial intermediaries urgently. - Consider building buffers elsewhere where targeted tools are hard to operationalize. - Corporate balance sheet repair and resolution frameworks - Repair corporate balance sheets, strengthen NPL management, expedite reforms to enhance resolution frameworks, and develop distressed debt and NPL markets. - International cooperation and vaccine access - Accelerate vaccine production and ensure affordable access worldwide to reduce divergence in recovery and limit financing pressures on vulnerable countries. *Source: Preface, Executive Summary, Chapters 1–3, and selected chapter text from the IMF Global Financial Stability Report: Preempting a Legacy of Vulnerabilities (reflecting information as of March 24, 2021).* ### Preface vii ### Preface vii ### Purpose and scope - The Global Financial Stability Report (GFSR) assesses key vulnerabilities the global financial system is exposed to and highlights policies to mitigate systemic risks to contribute to global financial stability and sustained economic growth. - This GFSR reflects information available as of March 24, 2021. - The report benefited from Executive Directors’ discussions on March 25, 2021, but its analysis and policy considerations are those of the contributing staff. ### Central assessments and outlook - IMF forecast upgraded to "6 percent global growth for 2021." - Extraordinary policy measures have eased financial conditions and supported the economy, including: - "$1.9 trillion fiscal stimulus in the United States." - "Central bank asset purchases at nearly $10 trillion globally." - Longer-term interest rates have risen materially: - The yield on the 10-year US Treasury note increased from "just over ½ percent in August 2020 to about 1¾ percent recently." - Two overarching themes: - Unprecedented policy support may have unintended consequences: stretched valuations and rising financial vulnerabilities that could become a legacy if not addressed. - The recovery is expected to be asynchronous and divergent across economies, posing particular challenges for emerging markets. ### Key vulnerabilities and risks (enumerated findings) - Equity markets have rallied and are trading materially above model-implied fundamentals. - Corporate bond spreads have remained very tight despite increased leverage in the corporate sector. - A rapid and persistent increase in real rates could trigger a repricing of risk and sudden tightening in financial conditions, interacting with elevated vulnerabilities and threatening macro-financial stability. - Emerging market challenges: - "Given large external financing needs, emerging markets face daunting challenges, especially if a persistent rise in US rates brings about a repricing of risk and tighter financial conditions." - Portfolio flows outlook shows improvement overall, but "countries with weaker fundamentals or limited access to COVID-19 vaccines are vulnerable." - The sovereign-bank nexus intensified: "60 percent of sovereign debt issued after January 2020 ending up on domestic banks’ balance sheets." - For many frontier market economies, "market access remains impaired." - Note on sample and correction: figures and notes based on a sample of "11 major emerging markets" (revision from "12 emerging markets"). - China-specific risks: - Faster recovery accompanied by further buildup in vulnerabilities, notably risky corporate debt. - Funding conditions for capital instruments have tightened for weaker, smaller banks; unwinding implicit guarantees presents a delicate and urgent challenge. - Corporate sector: - Large firms with market access issued debt and eased liquidity pressures, but overall corporate leverage has increased, raising downside risks to growth. - Solvency risk remains elevated at small and mid-sized firms and at some large firms in both advanced and emerging markets. - Banking sector: - Bank profitability expected to be low in many jurisdictions, potentially disincentivizing the use of capital buffers to support recovery. - Bank lending may become strained, complicating the stance of monetary policy. ### Policy recommendations and strategic priorities - Policymakers should act early to prevent a legacy of vulnerabilities by: - Tightening selected macroprudential policy tools (targeted rather than broad-based tightening). - Supporting balance sheet repair to foster a sustainable and inclusive recovery. - Central banks face trade-offs between undoing tightening in financial conditions and avoiding unintended consequences for market-based finance. - National authorities should manage unwinding of implicit guarantees in China carefully to avoid disorderly repricing. - The report presents a decision framework for policymakers to triage corporate-sector policies amid varied firm conditions. - The IMF is engaged in climate-related financial work ahead of COP26: establishing climate disclosure standards, defining climate taxonomy, and improving climate data in cooperation with other institutions and networks. ### Production, authorship, and dissemination - Analysis coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director. - Project direction by Fabio Natalucci, Nassira Abbas, Antonio Garcia Pascual, Evan Papageorgiou, Mahvash Qureshi, and Jérôme Vandenbussche. - Individual contributors and editorial/production teams are listed in the Preface. - Corrections and revisions are incorporated into digital editions; this online version notes an update: in Figure 5 (page x) and Figure 1.6 (page 8) notes, "12 emerging markets" was updated to "11 emerging markets." - Print and digital access: - Print copies available from the IMF bookstore (ordering information provided in the Preface). - Digital editions and free PDF of the report and data sets available via IMF eLibrary and IMF publications pages as indicated in the Preface. *Source: Preface (vii) of the IMF Global Financial Stability Report: Preempting a Legacy of Vulnerabilities (reflecting information as of March 24, 2021).* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Key findings and threats - Global financial stability risks remain contained so far, owing to unprecedented policy accommodation and progress in health care solutions. - Two emerging themes: - An asynchronous and divergent global recovery could coincide with policy normalization in advanced economies and rapidly rising interest rates, potentially leading to tighter financial conditions and large portfolio outflows in emerging market economies. - Highly accommodative financial conditions may generate unintended consequences: stretched asset valuations and rising financial vulnerabilities that could become structural legacy problems if not addressed. - Downside risks to growth remain present despite an improved 2021 outlook; risks to future GDP growth are still skewed to the downside. ### Corporate sector and commercial real estate - Firm-level assessment: - Liquidity stress is high at small firms in most sectors and across countries. - Solvency stress is high at small firms, and is also notable at mid-sized and even large firms in the most affected sectors. - Commercial real estate: - Commercial property transactions and prices slumped in 2020. - A permanent increase in the vacancy rate by 5 percentage points is estimated to result, on average, in a drop in fair values by about 15 percent after five years. - Price misalignments in commercial real estate appear to have increased since the pandemic; if persistent, this could pose downside risks to growth. - Policy implications for firms: - Chapter 1 proposes a decision tree framework to assess whether firms should rely on market financing, seek government support, be restructured, or be liquidated. - Direct and firm-specific targeted policy support may be needed for viable firms facing temporary liquidity or solvency risks; nonviable firms would require resolution. ### Banks, lending, and nonbank financial intermediation - Banks entered the pandemic with high capital and liquidity buffers and have been resilient so far. - Uncertainties about credit losses and weak profitability prospects may discourage banks from significantly reducing capital buffers to support the recovery. - Loan growth, particularly to businesses, has slowed in some countries; loan demand is expected to firm up as the recovery strengthens. - Loan officers in most countries do not anticipate a loosening in lending standards. - Constraints on bank lending capacity are especially worrisome for firms dependent on bank credit. - Nonbank financial intermediation: persistent fragilities noted; in some market segments macroprudential tools are lacking and should be developed. ### Sovereign and market-access issues in emerging and frontier markets - Emerging market economies face large financing needs in the year and are exposed to rollover risk, especially if domestic inflation rises or global long-term interest rates continue to rise. - Countries with weaker positions or limited access to vaccines may face portfolio outflows; many frontier market economies have impaired market access. - Policy advice: - Countries with market access should take advantage of favorable financing conditions to improve debt composition. - Countries with limited market access may need additional international assistance; deeper debt restructuring could benefit those facing significant debt difficulties. - The G20 Common Framework for Debt Treatments can help address debt vulnerabilities. - Rebuilding buffers should be a key priority to prepare for sudden price adjustments and reversal of capital flows. ### Policy recommendations and timing - Continue accommodative monetary policy until mandated policy objectives are achieved. - Maintain flexibility and supportiveness of fiscal policy until the pandemic is under control globally; prioritize health spending and well-targeted fiscal support for worst-affected households and viable firms. - Take early action on macroprudential policy given potential lags between activation and impact: - Tighten selected macroprudential tools to tackle pockets of elevated vulnerability while avoiding broad tightening of financial conditions. - If macroprudential tools are unavailable in certain segments (for example, parts of the nonbank financial intermediation sector), develop them urgently. - Consider building buffers elsewhere where operationalizing macroprudential tools is challenging. - Repair corporate balance sheets to enable a sustainable and inclusive recovery; strengthen management of nonperforming assets and expedite reforms to enhance resolution frameworks, including development of distressed debt and nonperforming loan markets. - For commercial real estate, once structural changes are clearer, deploy targeted macroprudential tools (such as limits on loan-to-value or debt-service-coverage ratios) depending on economy-specific recovery pace and sector vulnerabilities; broaden macroprudential coverage to relevant nonbank financial institutions. - Financial sector guidance: - Provide regulatory guidance on provisioning for expected losses to avoid excessive procyclicality, subject to supervisory scrutiny. - Maintain restrictions on capital distributions or relax them only progressively in countries overcoming the pandemic, contingent on supervisory stress tests demonstrating banks remain well capitalized. - International cooperation: - Accelerate vaccine production and ensure affordable access worldwide. - Ensure financially constrained countries have adequate access to international liquidity. - Pursue collective solutions for climate change, international tax policy, and international trade. ### IMF Executive Board discussion highlights - Executive Directors broadly agreed with the assessment of the global outlook, risks, and policy priorities; welcomed better-than-anticipated performance in the second half of 2020. - Directors emphasized that medium-term output losses in emerging market and developing economies are likely larger than in advanced economies versus pre-pandemic projections, though emerging market economies will continue to grow faster than advanced economies. - Directors stressed the need to accelerate vaccinations and distribute vaccines at affordable cost to all countries as a key priority. - Directors highlighted the importance of balancing the risks from large and growing public and private debt with risks from premature withdrawal of fiscal support; credible medium-term fiscal frameworks can help rebuild fiscal buffers. - Directors noted that extended easy financial conditions could lead to stretched valuations and financial vulnerabilities; they recommended tightening selected macroprudential tools to tackle pockets of elevated vulnerability and developing tools for nonbank financial institutions. ### Chapter 1 at a Glance (selected points) - Extraordinary policy support eased financial conditions and contained financial stability risks, but asset valuations appear stretched in some segments and vulnerabilities are rising in some sectors. - Risk of asynchronous and divergent recovery, especially if advanced economy policy normalization and rapidly rising interest rates occur, could tighten financial conditions and spur outflows in emerging markets. - Emerging markets face large financing needs and rollover risk; frontier markets may have impaired access. - Corporate sector is overindebted in many countries with stress concentrated at small firms; solvency stress also present in mid-sized and large firms in affected sectors. - Banks have so far not been part of the problem; their ability and willingness to lend as support is unwound will be critical for recovery. - Policy priorities include supporting balance sheet repair and rebuilding buffers in emerging markets to prepare for possible repricing of risk and reversal of capital flows. *Source: https://www.imf.org/-/media/files/publications/gfsr/2021/april/english/text.pdf* ### 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 ### Financial conditions, asset valuations, and risk taking - Financial conditions are "easy and supportive of growth" underpinned by extremely low rates and high corporate valuations. - Equity markets have "rallied aggressively," reaching levels significantly higher than those derived by models based on fundamentals. - After accounting for the very low level of real yields, "valuations in risk assets may look less stretched" because "the compensation for bearing risk does not appear overly compressed by historical norms." - Recent market events highlighted new vulnerabilities: - A few days of elevated volatility in US equity markets in early 2021 brought attention to the role of leveraged retail investors. - Significant losses at a highly levered fund spilled over to a number of investment banks that had provided financing to that fund, raising questions about opaque financial leverage and systemic implications. - Special-purpose acquisition companies (SPACs) issuance has surged, reflecting the search for yield. ### Search for yield at nonbank financial institutions - Pension funds and insurers have increased allocations to less liquid and higher-risk assets in pursuit of nominal return targets: - Panel 1 is based on asset allocation data of 700 of the largest pension funds, representing $13 trillion in assets. - Pension funds have increased their share of investments in alternative assets such as private equity, infrastructure, and real estate—strategies with greater leverage and liquidity risks. - Insurers have increased investments in less liquid and riskier lower-rated corporate bonds, foreign bonds, and other illiquid exposures. - Consequences and indicators: - The equity return correlation of bank and insurance companies has reached new historical highs, likely reflecting larger exposures of life insurers to banks’ securities. ### Rising US long-term interest rates and global spillovers - Long-term interest rates in the United States have risen about 125 basis points since the summer of 2020. - Drivers of the rise: - Initially driven primarily by higher inflation breakevens (rebound from early-pandemic declines and rising commodity prices). - More recently, real rates have begun to increase (albeit from very low levels). - Market expectations: - "Investors now expect long-term interest rates in the United States to return to pre-pandemic levels in coming months." - Cross-border effects: - Higher long-end yields in the United States have put upward pressure on comparable-maturity yields in other advanced economies. - "Average advanced economy 10-year rates have increased 50 basis points so far in 2021." - Risk channel: - A rapid and persistent increase in rates, especially real rates, could lead to a repricing of risk and sudden tightening in financial conditions, interacting with elevated financial vulnerabilities and endangering macro-financial stability. ### Emerging markets: debt, financing needs, and vulnerabilities - Recovery prospects: - "The recovery in emerging markets is expected to be slower than in advanced economies, with significant divergence across countries." - Government debt and financing needs: - "Government debt in emerging markets (excluding China) is expected to reach 61 percent of GDP in 2021." - "Gross financing needs are anticipated to remain elevated at 13 percent of GDP in 2021, coming off record levels in 2020." - Policy responses and attendant risks: - Policymakers have used a mix of measures including shorter local currency debt duration; introduction of 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 measures include: - Sizable external issuance increases vulnerability to exchange rate shocks. - Shorter duration of local currency debt raises rollover risks and sensitivity of debt servicing to interest rate increases. - Greater exposure of domestic banks to government debt strengthens the sovereign-bank nexus and may crowd out private sector loan growth. - Participation in the Debt Service Suspension Initiative or the G20 Common Framework without transparent, timely market communication may increase uncertainty about private bondholder involvement and raise external credit spreads. ### Emerging market portfolio flows: recent patterns and fragilities - Portfolio flows have been volatile: - The sharp rebound in flows since the previous GFSR stalled in late February 2021, reflecting rising rates in advanced economies and volatile global market conditions. - The sharp rally in hard currency bond fund flows has stalled; local currency bond inflows have moderated in Q1 2021 after recovering toward the end of 2020. - Quarterly portfolio inflows reached their highest level ever in Q4 2020, amounting to more than (figure referenced in source). - Distributional dynamics: - External conditions remain favorable especially for higher-rated issuers, while frontier economies continue to face challenges. - Domestic banks have been the dominant buyers of local currency bonds, while nonresident funds have been sluggish. - Tail risks: - Although the outlook for portfolio flows has improved on average, "tail risks remain higher for countries with weaker fundamentals or limited access to vaccines." - Vaccine supply disparities (favoring high-income countries) may prolong higher financing needs for some emerging markets. ### Key policy considerations and implications for financial stability - Need for continued monetary accommodation in many economies to bridge to the recovery, but recognition that prolonged easy financial conditions can foster excessive risk taking and stretched valuations. - Manage trade-offs in emerging markets between meeting elevated post-pandemic budgetary funding needs and avoiding heightened future vulnerabilities from debt structure changes (shorter duration, greater domestic banking absorption, external issuance). - Importance of transparent and timely market communication when participating in debt relief frameworks to limit increases in external credit spreads and uncertainty about private creditor involvement. - Monitor nonbank financial institutions’ increased exposures to illiquid and leveraged assets to contain liquidity and leverage risks. - Prepare for potential adverse spillovers from rapid increases in long-term real rates in advanced economies, which could trigger repricing of risk and tighter financial conditions globally—particularly acute for emerging markets with high debt, high financing needs, and limited policy space. *International Monetary Fund | 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 fragility of financing for emerging markets - Rebound in portfolio flows has exceeded $200 billion (Figure 1.6, panel 2). - Recovery in flows has been broad-based: about two-thirds of countries experienced inflows. - IMF staff analysis: recovery in 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 boosted primarily by the improvement in risk sentiment after the March sell-off. - Aggregate nonresident holdings of domestic sovereign debt remain lower than January 2020 (in US dollar terms), even as outstanding domestic debt has increased by nearly $500 billion (sample of 11 major emerging markets). - Capital-flows-at-risk analysis: in the event of a pullback of portfolio flows from emerging markets, countries with poorer fundamentals and limited access to vaccines would fare worse than countries with better fundamentals or those with higher vaccine coverage (Figure 1.6, panels 4 and 5). - Frontier market economies are particularly exposed where rollover needs remain relatively large. ### Drivers and scenarios for emerging market local-currency term premia - Local currency sovereign yields rose sharply in early 2021, driven by an increase in US long-term real yields (Figure 1.7, panel 1). - 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 (Figure 1.7, panel 2). - Compressed term premia in 2020 reflected: 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 supporting local bond markets. - Issuance behavior: some countries increased issuance of short-term and floating-rate debt rather than extending maturities, helping contain market pressure but exposing governments to greater rollover risks and to a future rise in interest rates (Figure 1.7, panel 3). - Empirical estimates (Online Annex 1.1): - A 1 percentage point shock to inflation uncertainty tends to increase term premia by about 30 basis points. - A 1 percentage point shock to inflation expectations tends to increase term premia by about 10 basis points. - Transmission from US term premia: - 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, this would translate into roughly a 1 percentage point increase in emerging market term premia, on average, by the end of 2021 (Figure 1.7, panel 4). - Fiscal risk premium: proxy measured as the difference between interest rate swaps and government bond yields has remained wide in some countries (example: South Africa), underscoring risks for countries with large financing needs in local currency markets, limited market depth, and less credible medium-term fiscal frameworks. ### Frontier market economies — differentiation and debt-treatment access - Performance among frontier issuers has been variable during the market recovery: some spreads narrowed significantly (led by Angola, Gabon, Mongolia), while spreads continued to widen in others (Belize, Sri Lanka, Suriname) (Figure 1.8, panels 1 and 2). - IMF staff analysis: external factors offset almost 70 percent of the drag from worsening domestic fundamentals during the pandemic for higher-rated sovereigns; for frontier economies, external factors offset only 25 percent of the drag from domestic factors (Figure 1.8, panel 3). - Weaker domestic fundamentals affecting frontier issuers: growth and inflation deterioration, weaker reserve adequacy; idiosyncratic factors (political risks, IMF program relations, composition of debt) have driven significant country differentiation. - Debt treatment eligibility and exposure: - A large group of countries (currently 73) is eligible for the two key initiatives (the Debt Service Suspension Initiative 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, but only about half of them are eligible to participate in these initiatives (Figure 1.8, panel 4). - Exclusion from coordinated initiatives can prevent many countries with large debt vulnerability from benefiting from comprehensive debt treatment. ### China — rapid recovery accompanied by rising financial vulnerabilities - Recovery has been rapid but accompanied by a further buildup in financial vulnerabilities that were already significant in some sectors before the crisis. - Policy support boosted recovery but led to a sharp increase in government and corporate debt, with new corporate credit flowing largely to riskier borrowers. - Targeted credit policies: 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 (Figure 1.9, panel 1). - Funding conditions tightening for weaker, smaller banks after authorities bailed in subordinated debt eligible as Tier 2 capital for the first time; this could tighten conditions for smaller firms serviced by these banks (Figure 1.9, panel 2). - Several unexpected defaults of state-owned enterprises in Q4 2020 raised investor concerns about implicit guarantees, especially for borrowers relying on backstops from financially strained regional governments. - Credit extension to firms and households in the financially weakest provinces fell sharply toward end-2020, pushing these provinces’ share of total credit growth to the lowest levels on record (Figure 1.9, panel 3). - Scale of vulnerable corporate debt: - 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) (Figure 1.9, panel 4). - Policy challenge: urgent need for a carefully sequenced and well-communicated transition away from implicit guarantees to alleviate distortions in credit allocation and limit further growth in risky corporate debt. ### Global corporate sector — elevated debt burdens and heterogeneous stress - Corporate sector emerged from pandemic with higher debt loads; notable differences across sectors and firm sizes. - Small and mid-sized firms (about half of the corporate sector by debt) with limited market access have fared less well and continue to rely heavily on policy support. - Debt issuance rose to record levels as companies coped with liquidity pressures (Figure 1.10, panel 1). - Equity issuance also rose to record highs amid elevated equity valuations; surge in initial public offerings by special-purpose acquisition companies (SPACs). - Firms with market access used new debt to bolster liquidity buffers; many also accessed equity markets. - Rising debt burden and weaker earnings have started to impair firms’ capacity to service debt (Figure 1.11, panel 1). - High-yield defaults reached the highest level since the global financial crisis last year (Figure 1.11, panel 2), though the pace of defaults has recently dropped. - Sectoral differences: stress remained elevated in sectors most sensitive to the pandemic (Figure 1.11, panel 3). - Market mechanisms: countries with developed distressed asset markets are likely to benefit from readily available capital to deal with weaker firms through market mechanisms (Figure 1.10, panel 4). *Source: CHAPTER 1, GLOBAL FINANCIAL STABILITY REPORT: PREEMPTING A LEGACY OF VULNERABILITIES (text - CHAPTER 1 AN ASYNCHRONOUS AND DIVERGENT RECOVERY MAY PUT FINANCIAL STABILITY AT RISK).* ### 1. Global High-Yield Bond Issuance ### 1. Global High-Yield Bond Issuance ### Market developments and capital flows - Global equity issuance rose to a new high in 2020 as initial public offerings rebounded during the second half of 2020. - The pool of capital targeted for distressed debt has grown sharply and could be a key source of funding for troubled firms. - Corporate balance sheet liquidity has substantially improved. - Market-based finance has extended beyond traditional capital markets in some advanced economies as private debt markets have thrown a lifeline to small and mid-sized firms. - In contrast, many firms in emerging market economies, regardless of size, still rely heavily on bank financing. ### Firm-level assessment framework - The chapter proposes a framework to identify viable firms using three key elements: - Liquidity: the ability of a company to pay off short-term financial obligations without raising additional external financing. - Solvency: the ability of a company to meet its short- and long-term financial obligations, often calculated as assets minus liabilities. - Viability: the ability of a business to generate future positive profits (whether benefits of continuing a business exceed the costs). - Viability assessment horizon: profitability within a three-year horizon (the recovery from the COVID-19 crisis is expected to take hold within three years). - Indicators used: - Liquidity stress indicators include the 2021 projected cash balance, liquidity buffer ratio, interest coverage ratio, and current ratio. - Solvency stress indicators include the 2021 projected equity position, net-debt-to-earnings, gross-debt-to-earnings, and equity-to-assets ratios. - Viability indicators include the 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. - 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. The sample covers Brazil, China, France, Germany, India, Italy, Japan, Mexico, Poland, Russia, Spain, Turkey, the United Kingdom, and the United States. ### Key findings from the overall assessment - Liquidity and solvency concerns vary across firm size and sectors: - Liquidity stress is high at small firms in most sectors, but very low for large firms. - Small firms in more affected sectors (such as the automotive industry, telecommunication services, and energy) face notably higher liquidity risk. - In emerging markets, even mid-sized firms experience considerable liquidity risk. - Solvency stress: - Solvency stress is high for small firms and also significant for mid-sized and large firms in affected sectors (energy, services, transportation, and real estate). - Small firms face high solvency risk across sectors. - Debt shares by viability and firm size (selected exact figures from illustrative results): - For small firms with high liquidity risk, the share of debt accounted for by viable firms is 30 percent in advanced economies and nearly 20 percent in emerging markets. - For small firms, the share of nonviable firms’ debt in advanced economies is 20 percent. - For small firms with high solvency risk, in advanced economies the share of debt accounted for by still-viable small firms is more than 30 percent; in emerging markets the share is slightly lower. - Firms exposed to both solvency and liquidity risk would require a combination of liquidity and solvency measures. For firms with market access, equity raising would likely alleviate both liquidity and solvency risk. - Distressed-debt funds and growth in private debt markets signal availability of market-based solutions for firms in distress. ### Policy implications and recommended design of support - Policymakers face trade-offs: - Too little support may be inadequate in the short term and a premature withdrawal could lead to sudden repricing of credit, insolvencies, economic scarring, job losses, and feedback loops affecting lenders and sovereigns. - Too much or poorly targeted support may stretch credit valuations, allow nonviable "zombie" firms to survive, and lead to structurally slow growth, debt overhang, misallocation of credit, and a less resilient financial system. - Targeting and modalities: - Government support should be aimed at viable firms and sectors, while attending to other objectives (including strategic considerations). - Private sector financing could facilitate orderly restructuring in weaker sectors. - Firms with low liquidity or solvency risks and market access should be encouraged to use favorable market conditions to repair and adjust balance sheets. - For small firms with high liquidity risk that lack market access, targeted liquidity support is necessary, for example through loan guarantee programs. - For small firms lacking market access but with solvency concerns, policymakers should consider equity-like support. - Firms exposed to both liquidity and solvency risk may require combined liquidity and solvency interventions; for firms with market access, equity raising is likely effective. - Design and governance of solvency support: - Appropriate administrative controls, transparency, and accountability are necessary to ensure effective use of government resources. - Government expertise and administrative capacity are often limited for assessing firms’ financial prospects, implementing support efficiently, and monitoring interventions. - Adequate safeguards are crucial when providing public equity support given government equity stakes’ implications. *Source: IMF, Global Financial Stability Report: Preempting a Legacy of Vulnerabilities (April 2021), chapter content excerpt.* ### 3. Share of Debt at Small Firms with Elevated Solvency Stress Indicators in Advanced Economies ### 3. Share of Debt at Small Firms with Elevated Solvency Stress Indicators in Advanced Economies ### Solvency and liquidity stress at small firms - Solvency stress is high at small firms and wide spread across sectors. - Most mid-sized firms with high liquidity stress have good viability, but a notable share of small firms has weak prospects. - Overall liquidity, solvency, and viability stress indicators are computed as combinations of the respective components. - Example: the overall liquidity stress indicator is assessed as “elevated” if at least three of four individual liquidity indicators exceed their respective thresholds. - In panels presented, averages across sectors are calculated separately for advanced economies and emerging market economies. - Policy graphic logic (from the source): If a firm has a high liquidity or solvency risk, its viability should be assessed to take appropriate policy action; outcomes include “Low viability risk,” “High viability risk,” and “Restructure or liquidate.” ### Policy options and targeted solvency support for firms - Conditionality on public support can include restrictions on dividend payments and share buybacks. - Debt-to-equity swaps are a powerful instrument to boost firm solvency and can be negotiated with private shareholders and creditors. - To lessen distortions, prudential authorities could provide quasi-equity injections conditional on participation of private lenders. - Governments should consider partnering with the private sector to assess firm viability and improve resource allocation, particularly for smaller firms. - Targeted solvency support by firm size: - For larger firms without market access: capital injections in the form of preference shares, with attention to governance trade-offs and a clear exit strategy. - For smaller firms: hybrid instruments (for example, profit participation loans) that combine solvency support with safeguards of the public interest. - Provide liquidity support (e.g., loan guarantees, public loans) and equity-like injections to small firms without market access. - Encourage equity raisings by large firms with market access and required debt rebalancing by large firms with market access. - Medium-term, sector-wide assessments of liquidity and solvency risk, and encourage consolidation among small firms where appropriate. ### Banks’ resilience through the COVID-19 downturn - Banks entered the pandemic with high capital and liquidity buffers due to post-2007–08 regulatory reforms. - Stress test result: more than 90 percent of banks by assets across 29 systemically important jurisdictions would remain above statutory minimum capital levels through 2022 under the October 2020 GFSR severely adverse scenario. - 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) underpinned 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 rose more than risk-weighted assets in advanced economies, pushing total buffers (capital plus loan-loss reserves) higher. - The outlook for credit costs improved materially in the United States but less so in most other advanced economies. - Loan growth decelerated and in many countries corporate loan growth is negative. - Bank loan officer surveys (as of 2020:Q4) show weak demand for credit by small and mid-sized firms and tight supply conditions in many countries; expectations for 2021:Q1 imply demand may strengthen while lending standards remain roughly stable, potentially tightening access for SMEs. - 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: moratoriums and guarantees - Loans under moratoriums and guaranteed loans supported credit flows but are slated to expire/run off in most countries during 2021. - Loans under moratorium (as of 2020:Q3): €600 billion, or more than 3 percent of total loans, across European banks monitored by the European Banking Authority. - In some countries, loans under moratorium account for more than 10 percent of total loans. - These moratorium loans are generally of lower quality than banks’ overall portfolios, with a higher share of risky loans and lower loan-loss reserve coverage. - Guaranteed loans (as of 2020:Q3) accounted for almost 2 percent of total loans on average and in some countries were as high as 4 percent. - Estimated impacts of phaseout: - Termination of moratoriums: average reduction of about 20 basis points in capital ratios (average of red bars in the referenced figure); in the worst-affected countries, the end of moratoriums could reduce system-average capital ratios by nearly 100 basis points. - Runoff of guaranteed loans and their replacement with nonguaranteed loans: estimated average decline of about 25 basis points in capital ratios; up to 100 basis points in countries with large guarantee programs (sum of effects from moratoriums and guarantees). - Guaranteed loans have a more gradual “ramp” than a “cliff” because their maturity averaged about 2.5 years at origination, so runoff will proceed gradually. - Some banking systems that could face the largest downside risks from the phaseout also have comparatively low buffers, necessitating carefully managed exit strategies where the pandemic’s macroeconomic impact is larger. ### Capital buffers: policy stance and bank behavior - Supervisory actions: many supervisors released countercyclical capital buffers, recalibrated or revised implementation timelines of other macroprudential buffers, and encouraged banks to use regulatory capital buffers, allowing temporary operation below combined buffer requirements. - These measures were intended to stimulate lending while preserving banking system resilience. - Banks have largely not drawn down capital buffers and have reiterated medium-term capital ratio targets. - Possible reasons for reluctance to use capital buffers include concerns about future credit quality amid high uncertainty, despite regulatory support. *Source: Global Financial Stability Report: Preempting a Legacy of Vulnerabilities (chapter text).* ### 4. Adjusted CET1 Ratio vs. Capital Impact from the Phaseout of ### 4. Adjusted CET1 Ratio vs. Capital Impact from the Phaseout of Moratoriums and Guarantees, as of 2020:Q3 ### Key findings on lending support phaseout and capital impact - 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. - The asset quality and level of provisions of loans under moratoriums are weaker than the overall loan book. - Systems that combine the lowest total buffers and the greatest downside risks from the phaseout of policy relief are of most concern. - Sources cited: European Banking Authority; European Central Bank; Federal Reserve; Reserve Bank of Australia; and S&P Global Intelligence. - Note definitions preserved exactly: - Risky loans are defined as Stage 2 plus NPLs. - Expected loan losses = NPLs × loss given default. - Data labels use International Organization for Standardization (ISO) country codes. - CET1 = common equity Tier 1; NPL = nonperforming loan; RWA = risk-weighted assets. ### Banks’ assessment of capital buffer usability — framework and empirical results - Three conditions (hurdles) banks must satisfy before using buffers: - Capacity hurdle: a bank must have a sufficient amount of “management buffers.” - Supervisory hurdle: the bank must be able to rebuild buffers within a time frame that does not trigger supervisory pressure (two complementary factors considered: rebuild within five years or less; and 2019 pre-pandemic NPL ratios not greater than three times respective regional averages). - Management hurdle: using the buffers must provide higher returns than not using them (evaluated as bank’s equity fair value exceeding the counterfactual by 20 percent and doing so by the third year following the buffer drawdown). - Empirical sample and outcome: - 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. - Additional modeling assumptions and sensitivity notes: - Analysis based on 2022 consensus expectations compiled by Bloomberg for assets, risk-weighted-asset density, net earnings, and cash payouts. - For CET1 ratios, the analysis uses each bank’s medium-term targets rather than 2022 expectations. - Model assumes a bank’s AT1 yield equals half its cost of equity capital. - The third hurdle uses the 20 percent equity fair value threshold and a reasonable time frame defined as the third year after drawdown. - Sensitivity: reducing 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. ### Drivers determining whether banks use buffers - Profitability: - Profitability is the single most important factor enabling a bank to clear supervisory and management hurdles. - Only banks with returns well above their cost of equity tend to clear all hurdles. - Bank heterogeneity and outcomes: - Less profitable banks (bottom three quartiles) generally clear the capacity hurdle due to larger discretionary management buffers, but struggle on supervisory and management hurdles because of long rebuilding periods and negative equity valuation impacts. - The most profitable banks (top quartile) often fail the capacity hurdle because they operate with thinner discretionary buffers and may be too close to the MDA threshold if they draw down buffers. - Other important factors: - Credit quality of new loans: worse-than-expected credit quality lengthens rebuilding time; guarantees that reduce effective cost of risk can improve returns on new loans. - Bank leverage and dividend policy: deleveraging accelerates rebuilding but may run contrary to policy goals; dividend cuts can help high-return banks. - Legacy NPLs: institutions with 2019 pre-pandemic NPL ratios greater than three times regional averages are considered to have ratios too high to clear the supervisory hurdle. ### Policy implications and recommendations - Maintain borrower-support measures (debt repayment relief, credit guarantees, direct support) until economic indicators point to a sustainable recovery. - As recovery gains momentum, limit general borrower support programs to borrowers deemed temporarily distressed but fundamentally viable; adjust support to reflect program effectiveness, scope for targeted/time-bound programs, and estimated impact on banks’ capital, earnings, and liquidity. - Country authorities should recalibrate policy support carefully and communicate openly and transparently. - Monetary policy should remain accommodative until mandated policy objectives are achieved. - Preventing entrenched financial vulnerabilities: - Take early action and tighten selected macroprudential tools to tackle pockets of elevated vulnerability while avoiding broad tightening of financial conditions. - Develop macroprudential tools for segments lacking them, including parts of nonbank financial intermediation. - Consider building buffers elsewhere if designing/operationalizing targeted tools is challenging. - Strengthen resilience of nonbank financial intermediation by assessing risk factors, interconnections, and cross-border spillovers and by strengthening nonbank institutions’ resilience. - Country-specific recommendations: - Emerging and frontier markets: accelerate vaccine access and consider reserve accumulation strategies where appropriate; employ macroprudential policies and prudent macro-financial risk management. - Countries with market access: use favorable financing conditions to improve debt composition (for example, extend maturities, lock in low interest rates) and reverse departures from sound public debt management. - Countries with limited market access: consider additional assistance (Debt Service Suspension Initiative, concessional and emergency financing), rescheduling or reprofiling of debt service for sustainable debt, and deeper restructuring where needed; consider broadening coverage of the Common Framework for Debt Treatments. - Nonfinancial corporate sector measures: - Develop distressed debt and NPL markets to reduce corporate restructuring costs. - Encourage consolidation, particularly among smaller firms, to lower fiscal support costs while minimizing bankruptcy-related economic costs. - Improve debt resolution regimes, augment court capacity with out-of-court restructuring and hybrid restructuring alternatives, and employ judicial reorganization for complex cases. - Implement fast-track resolution for nonviable firms to facilitate timely, orderly exits. - Supervisory and provisioning guidance: - Maintain regulatory guidance on provisioning to cover expected losses, subject to adequate supervisory scrutiny to prevent underprovisioning. - Investigate variability in provisioning practices across banks to ensure appropriate classification and gradual provisioning. - Capital distributions and balance sheet repair: - While uncertainty remains high, continue policy restricting capital distributions on prudential grounds. - In countries advanced in the pandemic fight where losses can be quantified with greater comfort, progressively relax system-wide policies limiting capital distributions, using supervisory stress tests to ensure banks remain sufficiently well capitalized. - Support balance sheet repair by strengthening NPL management and using market-based solutions to dispose of problem assets as moratoriums expire. - Market conduct and investor protection: - Ensure investors have adequate and timely information amid increasing retail presence in equity markets and no-fee trading apps. - Consider investor education programs and monitor trading behavior to assess market impact and need for regulatory or supervisory adjustments. *Source: GLOBAL FINANCIAL STABILITY REPORT: PREEMPTING A LEGACY OF VULNERABILITIES, International Monetary Fund | 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 ### Global financial vulnerabilities (Indicator-Based Framework update) - The Indicator-Based Framework monitors key global financial vulnerabilities arising from leverage, liquidity, maturity, and currency mismatches. - Vulnerabilities are elevated across several sectors amid the ongoing COVID-19 pandemic. - Sovereign vulnerabilities are elevated in systemically important countries that account for about 80 percent of the GDP of sample countries. - Most current data points are through the second quarter of 2020. ### Sectoral vulnerabilities and recent developments - Sovereigns - Debt levels have hit historic highs due to large fiscal lifelines enacted in response to the pandemic. - Loose financial conditions have eased debt service burdens, but many economies could face large post-pandemic fiscal deficits and high debt overhangs absent a robust recovery. - Emerging market economies could face significant challenges in servicing debt, especially if sovereign risk premia rise. - Nonfinancial firms (nonfinancial private sector) - Firms have issued debt and equity to strengthen balance sheets, particularly in the United States and other advanced economies. - Leverage has increased across most regions, while liquidity positions improved as firms built cash buffers, extended maturities, and often reduced interest on new and existing debt. - The nonfinancial private sector entered the COVID-19 crisis with historically high leverage levels due to highly accommodative monetary policies since the global financial crisis. - Households - Vulnerabilities remain elevated in China and a number of advanced economies. - Unemployment benefits and other support measures have been critical, but household debt servicing capacity has deteriorated in several major economies as some households took on more debt to cover lost income. - Banks and 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 uncertainty about the economic outlook weighing on profitability. - Other regions have seen faster recoveries in profitability and liquidity positions. - Among nonbank financial institutions, vulnerabilities are generally moderate to elevated. - Insurers: vulnerabilities increased in some advanced economies as profitability measures were hit and foreign exchange mismatches rose. - 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, but interconnectedness remains a concern (mutual funds sustain large precautionary credit lines with banks). - Quantitative indicators (as presented) - Nonfinancial firms (20) - Insurers (12) - Banks (14) - Households (16) - Sovereigns (13) - Other financial institutions (16) ### The GameStop short squeeze: market structure and regulatory implications - Event summary - A short squeeze in early 2021 produced significant volatility in US equity markets for a brief period, concentrated in stocks representing a small share of the US stock market (less than ½ percent). - Retail investors coordinated via social media (Reddit) and purchased small-cap stocks through commission-free platforms (e.g., Robinhood), most prominently GameStop. - Institutional investors with short positions rushed to repurchase stocks, amplifying price increases; subsequent trading suspensions by retail platforms on January 27 and 28, 2021 were followed by rapid declines in affected share prices. - Amplifying factors with numeric detail - Leverage through margin debt and expiring options magnified the short squeeze. - The required deposit by clearinghouses increased more than 30 percent on January 28, 2021, creating significant liquidity pressure on some brokers. - Key market-structure and regulatory issues identified - Rise in retail social media investing - Off-exchange trading and options volumes rose substantially; the number of customers with small options positions rose to record highs in early 2021. - FINRA (2021) survey: new retail investors are on average younger with less investment experience and rely more on advice from friends and family than on personal research or professional advice. - Shorting practices - Short positions against GameStop as a percentage of tradable shares exceeded 100 percent since 2019; rehypothecation can lengthen the trading chain and increase available shares for short selling. - Inadequate disclosure of short selling practices can adversely affect public trust in capital markets. - Payment for order flow - Commission-free brokers outsource trade executions to high-frequency trading firms and receive significant revenues, raising questions about conflicts of interest and disclosure of trade execution quality. - Liquidity pressure on online brokers - Margin requirements by clearinghouses drove a required deposit increase of more than 30 percent on January 28, 2021; affected brokers recovered liquidity through bank credit lines and equity capital, but some temporarily suspended trading in volatile stocks. - Supporting indicators (as presented) - Figure references: Market share of off-exchange trading (Percent of total US equity trading volume) and Number of Call Options in US Stocks (Number of contracts, moving average). Commission-free trading becomes mainstream; sharp rise of retail participation in short-dated options. ### Macro-financial trade-offs, risks, and policy recommendations - Core trade-off - Loosening financial conditions boost short-term growth but accelerate leverage buildups that heighten downside risks to medium-term growth, complicating policymakers’ intertemporal trade-off. - Recommended policy stance - While policy support remains necessary in the near term to aid recovery, policymakers should be mindful of increasing macro-financial stability risks from high leverage. - Policymakers should take early action to tighten selected macroprudential tools to address rising nonfinancial sector vulnerabilities, recognizing possible lags between activation and full impact. - Targeted macroprudential policies that “lean against the wind” can help contain or reverse leverage buildups, improve the intertemporal trade-off, and reduce risks to future financial stability. - The appropriate timing for deploying macroprudential tools should be country-specific, depending on the pace of recovery, postcrisis vulnerabilities, and the available policy toolkit. - As the nonbank financial sector expands its role in financing the nonfinancial sector, urgent efforts are needed to develop macroprudential toolkits for this sector. - Policymakers should consider whether buffers need to be built elsewhere to protect the financial system given challenges in designing and operationalizing macroprudential tools within existing frameworks. ### Chapter at a glance (key takeaways) - Leverage in the nonfinancial private sector reached historical highs for many economies before the COVID-19 crisis, reflecting easy financial conditions since the global financial crisis. - Leverage increased further as policymakers stepped in to prevent disruption to credit flows to households and firms. - Loose financial conditions remain needed to support a nascent recovery but could exacerbate leverage buildup and increase downside risk to future activity. - Policymakers face a trade-off between boosting short-term growth through easier financial conditions and containing downside risk later; high and rapidly building leverage amplifies this trade-off. - Targeted macroprudential policies should be ready to be tightened as the recovery takes hold; early action is advised given implementation lags. *CHAPTER 1 AN ASYNCHRONOUS AND DIVERGENT RECOVERY MAY PUT FINANCIAL STABILITY AT RISK* ### Introduction ### Introduction ### Background: pre-COVID leverage trends - Nonfinancial sector debt worldwide increased from 138 percent to 152 percent of GDP over the decade leading up to the end of 2019. - Nonfinancial corporate sector debt increased in both advanced and emerging market economies, reaching a historical high of 91 percent of GDP at the end of 2019. - Household debt rose sharply among emerging market economies but fell in advanced economies as a group, reaching 60 percent worldwide at the end of 2019. - Drivers noted include highly accommodative monetary policies pursued by major central banks and loose global financial conditions since the global financial crisis. ### Impact of the COVID-19 shock on leverage - The COVID-19 shock further increased nonfinancial sector leverage across economies, through: - Squeezed cash flows for the corporate sector. - Increased financing needs of households due to employment impacts. - Unprecedented monetary and fiscal policy support that eased market dysfunction and maintained the flow of credit to households and firms. - Global nonfinancial corporate and household debt increased by 11½ percentage points and 5 percentage points of GDP, respectively, between the end of 2019 and the third quarter of 2020. - The increase in debt-to-GDP ratios reflects both sharp declines in output (particularly in emerging markets) and visible rises in debt levels during the COVID-19 crisis. ### Intertemporal trade-off and risks to macro-financial stability - Policymakers face an intertemporal trade-off: accommodative policy to support near-term activity can, if continued after recovery gains momentum, increase medium-term downside risks by adding to elevated leverage vulnerabilities and inducing excessive risk taking (moral hazard). - Evidence supports two central relationships: - Loose financial conditions are associated with substantial buildups in leverage over the subsequent 12 months in both advanced and emerging market economies. - Stronger buildups in leverage tend to be followed by more subdued economic activity over the subsequent 12 quarters in both advanced and emerging market economies. - Periods of strong growth in corporate and household leverage are often followed by lower growth in output over the subsequent 12 quarters. - The chapter emphasizes that both the level of leverage and the growth of leverage matter for amplification of adverse shocks. ### Empirical focus, sample, and approach - The chapter draws on data from the past three decades for a sample of 29 economies (19 advanced economies and 10 emerging markets) to investigate implications of elevated levels of leverage and rapid leverage buildup for a post–COVID-19 recovery. - The sample economies are listed in the analysis and the sample period is from 1996:Q1 to 2020:Q3. - The analysis adopts a growth-at-risk (GaR) approach focusing on the lower tail (10th percentile) of the distribution of future economic growth to reflect financial-stability-related downside risk to future activity. - The analysis distinguishes between corporate and household leverage and separates advanced and emerging market economies. ### Conceptual framework and mechanisms - Financial conditions (the price of risk in an economy) are a key driver of leverage buildups: - Loose financial conditions increase intermediaries’ and markets’ incentives and capacity to take on risk and lend. - Borrowers have greater incentives and capacity to borrow when asset values and net worth rise. - Macro-financial policies (monetary, macroprudential, fiscal) affect leverage buildups via financial conditions, credit availability, and effects on income, unemployment, inflation, and debt service costs. - Macroprudential policies can "lean against the wind" by tightening to: - Tame leverage buildups. - Strengthen borrower and lender resilience. - High levels of indebtedness increase the likelihood that adverse shocks and tightening financial conditions will cause abrupt deleveraging, asset-price repricing, and nonlinear amplification of financial stability risks. - The growth of leverage may magnify the effect of a shock if new lending is extended to riskier borrowers. ### Empirical strategy (measurement and regression approach) - Financial conditions are measured by the Financial Conditions Index (FCI) used in Chapter 1 of the GFSR; for some analysis the negative of the FCI is used so that higher values indicate looser financial conditions. - Empirical results on the link between FCIs and leverage are obtained from local projection regressions of changes in leverage (debt-to-GDP ratio) at various horizons on the FCI, control variables, and time fixed effects. - The GaR framework focuses on the 10th percentile of the distribution of future economic growth to capture downside risks associated with financial distress. *Source: IMF staff, Introduction, Chapter 2, GLOBAL FINANCIAL STABILITY REPORT: PREEMPTING A LEGACY OF VULNERABILITIES (April 2021).* ### CHAPTER 2 NONFINANCIAL SECTOR: LOOSE FINANCIAL CONDITIONS, RISING LEVERAGE, AND RISKS TO MACRO-FINANCIAL STABILITY ### CHAPTER 2 NONFINANCIAL SECTOR: LOOSE FINANCIAL CONDITIONS, RISING LEVERAGE, AND RISKS TO MACRO-FINANCIAL STABILITY ### Relationship between financial conditions and leverage buildup - An easing in financial conditions by one unit is followed by an increase in nonfinancial corporate debt by 4 percentage points of GDP over three years. - A one-unit loosening of financial conditions implies an increase in household leverage by 1½ percentage points of GDP over a three-year horizon. - The increase in leverage in response to financial conditions is nonlinear: - An easing of financial conditions during a credit boom—defined as sharp growth in the credit-to-GDP ratio in the context of already easy financial conditions—is followed by a larger increase in leverage than in periods without a boom. - There is evidence of a stronger association with easing financial conditions when the initial level of leverage is high (that is, in the top three deciles of the debt-to-GDP distribution), particularly for household leverage. - About 25 percent of the economies in the sample are in the credit boom regime in 2020:Q3. - Robustness and endogeneity checks undertaken include: - Purging macroeconomic factors from the FCI; - Using a global FCI or the Chicago Board Options Exchange Volatility Index (VIX); - Undertaking a panel vector autoregression (PVAR); - Removing cyclical components (6 to 32 quarters) from real GDP (in log), leverage, and the FCI. - Using growth in inflation-adjusted debt as an alternative variable yields qualitatively similar results. ### Macro-financial stability implications: effects on the distribution of future growth - The analysis focuses on the left tail—the 10th percentile—of future real GDP growth as a measure of downside risk. - A one-unit loosening of financial conditions is associated with an increase in the 10th percentile of real GDP growth in the near term—amounting to a reduction in downside risk—by 1½ percentage points. - After the seventh quarter, the boost-to-output effect vanishes and the downside risk increases by about 1 percentage point. - During credit boom episodes: - A one-unit loosening in financial conditions is associated with a reduction in near-term downside risk by 2.5 percentage points; - But an increase in downside risk by 3.3 percentage points after two years. - A 10 percentage point acceleration in nonfinancial corporate leverage buildup is associated with an increase in downside risks of about 1 percentage point in the near term. - Acceleration in household leverage has a similar association with downside risk, with statistical significance either in the near term or after 10 quarters out. - Cross-economy differences: - The effect of nonfinancial corporate leverage on downside risks stems mainly from emerging markets, with downside risks increasing significantly by about 2 percentage points in the medium term following a 10 percentage-point buildup in leverage. - The adverse impact of household leverage on longer-term growth is more robust for advanced economies. ### Interpretation and channels - The greater sensitivity of leverage buildups to financial conditions when debt is already increasing rapidly aligns with the financial accelerator mechanism and suggests a risk-taking channel that amplifies macro-financial outcomes during high credit growth. - Loose financial conditions imply an intertemporal trade-off: a short-term boost to output but larger medium-term downside risks, especially when accompanied by rapid credit expansion and high leverage or high debt-service-to-income ratios. ### Macroprudential policy: managing the intertemporal trade-off - Policymakers face two objectives in the post–COVID-19 recovery: - Continuing to limit scarring from the pandemic; - Guarding against a flare-up in financial stability risks down the road. - Macroprudential policy is the key tool to safeguard future financial stability by leaning against the wind and strengthening resilience. - Types of macroprudential measures and evidence: - Borrower-based measures (loan-to-value (LTV) and debt-service-to-income (DSTI) limits) can slow household debt accumulation. - Bank-side measures include capital adequacy measures, liquidity measures, limits to credit growth, and foreign currency exposure limits. - Empirical evidence cited: - Tightening macroprudential policies is associated with lower future growth in domestic credit, particularly household credit. - LTV and DSTI ceilings slow household debt accumulation. - Limits on high loan-to-income ratios in mortgage lending can reduce house price declines and mortgage defaults during price corrections. - The analysis considers a range of macroprudential measures grouped into six categories from the IMF’s Integrated Macroprudential Policy database (1990–2018): 1. Borrower-based measures (LTV and DSTI limits); 2. Bank capital measures (capital requirements, leverage limits, loan-loss provision requirements, countercyclical capital buffers, capital conservation buffer requirements, measures targeting systemically important banks); 3. Banks’ foreign currency exposure measures (limits on foreign currency lending, limits on gross open foreign currency positions, reserve requirements on foreign currency assets); 4. Bank liquidity measures (reserve requirements, liquidity requirements, limits to the loan-deposit ratio); 5. Credit measures (limits on credit growth, loan restrictions); 6. Other measures (stress testing, restrictions on profit distribution, limits on exposures between financial institutions). ### Policy implications and recommendations - Because loose financial conditions are associated with faster leverage buildup and amplified downside risks—particularly during credit booms—policymakers should: - Monitor domestic financial conditions closely and their effects on sectoral leverage; - Use macroprudential tools to lean against excessive borrower or lender risk-taking during periods of easy financial conditions and rapid credit growth; - Build resilience through lender-side measures (capital and liquidity) alongside borrower-based constraints (LTV, DSTI) as recovery proceeds; - Be aware of cross-country heterogeneity: emerging markets may require particular attention to corporate leverage dynamics, while advanced economies may face larger household-leverage-related long-term effects. - Complementarity between policies: - Monetary policy and fiscal support remain essential for providing liquidity and supporting activity; - Some degree of macroprudential loosening was appropriate during the crisis, but as recovery proceeds, rebuilding macroprudential buffers will be necessary to protect against future shocks. *Source: CHAPTER 2 NONFINANCIAL SECTOR: LOOSE FINANCIAL CONDITIONS, RISING LEVERAGE, AND RISKS TO MACRO-FINANCIAL STABILITY (text - CHAPTER 2 NONFINANCIAL SECTOR: LOOSE FINANCIAL CONDITIONS, RISING LEVERAGE, AND RISKS TO MACRO-FINANCIAL STABILITY).* ### CHAPTER 2 NONFINANCIAL SECTOR: LOOSE FINANCIAL CONDITIONS, RISING LEVERAGE, AND RISKS TO MACRO-FINANCIAL STABILITY ### CHAPTER 2 NONFINANCIAL SECTOR: LOOSE FINANCIAL CONDITIONS, RISING LEVERAGE, AND RISKS TO MACRO-FINANCIAL STABILITY ### Composition and evolution of macroprudential policy - Sample and coverage: - The sample includes 19 advanced economies (AE) and 10 emerging markets (EM). - Periods highlighted include 1990–95, 1996–2000, 2001–05, 2006–10, 2011–15, 2016–18 and the 2011–18 share of countries undertaking net tightening. - Observed patterns: - Macroprudential measures were tightened more frequently after the global financial crisis and leading up to the COVID-19 crisis. - Measures related to bank capital and liquidity were tightened most often owing to banking sector regulatory reforms after the global financial crisis. - Measures related to the foreign currency exposure of banks are more prevalent in emerging markets than in advanced economies. - Net tightening metric: - For a given category and quarter, net tightening is computed as the difference between total number of tightening and loosening actions, and assigned a value of 1 if the difference is positive, 0 if there is no difference, and –1 if the difference is negative. ### Empirical effects of macroprudential tightening on leverage - Household sector: - Tightening a borrower-based measure (for example, household LTV or DSTI) is followed by a reduction in the household debt-to-GDP ratio by up to 1 percentage point over a two-year horizon. - Corporate sector: - A net tightening of banks’ liquidity requirements is associated with a reduction in corporate leverage by up to 1 percentage point of GDP over a two-year horizon. - For emerging markets, a net tightening of foreign-exchange-related measures for banks is followed by a decline in nonfinancial corporate leverage of about 2½ percentage points over three years. - Methodological notes: - The analysis focuses on the number of tightening episodes rather than the intensity of measures. - Tests considered six categories of macroprudential policies; reported results highlight the categories yielding the most robust estimated responses. - Using an ordered probit–based measure of macroprudential shocks yields qualitatively similar results. ### Macroprudential tightening and downside risk to growth - Collective impact: - A net tightening across all categories of macroprudential policies is associated with a significantly lower downside risk to future growth by about half a percentage point (from a growth-at-risk perspective, a higher value is interpreted as lower downside risk). - Interaction with financial conditions: - When a loosening of financial conditions coincides with macroprudential tightening, the intertemporal trade-off is almost entirely mitigated. - Interpretation: - Macroprudential policies play two important roles: - Tightening targeted measures helps to lean against the wind, tempering or reversing leverage buildups during credit booms. - Overall tightening contributes to mitigating the intertemporal trade-off, either reducing downside risk directly or counteracting the risk inherent in loose financial conditions when leverage has been growing rapidly. ### Conclusions and policy recommendations - Current state and risks: - In the decade following the global financial crisis, leverage increased steadily in the nonfinancial corporate and household sectors across many economies. - Global nonfinancial sector leverage reached a historically high level by the end of 2019, just before the onset of the COVID-19 pandemic. - Central banks pursued highly expansionary monetary policy during the pandemic to ease financial conditions and maintain the flow of credit; additional debt has cushioned the effects of the pandemic for now. - Rising leverage could increase risks to financial stability and create a policy trade-off: accommodative policy boosts short-term activity but increases medium-term downside risk to growth via increased nonfinancial sector leverage. - Recommended policy actions: - Maintain adequate policy support to firms and households in the near term where recovery has not yet taken hold or remains fragile. - Remain vigilant to risks of high leverage and prepare to reduce those risks through: - Well-designed policies to deal with highly indebted firms. - Greater supervisory attention to risk taking. - Swift implementation of macroprudential tightening as soon as macroeconomic conditions permit. - Limit potential leakages that weaken the effectiveness of macroprudential tools as finance increasingly migrates away from banks to NBFIs. - Urgently develop the macroprudential toolkit for non-bank financial intermediaries. - Consider building buffers elsewhere to protect the financial system, given challenges in designing and operationalizing macroprudential tools within existing frameworks. - Calibrate timing of macroprudential deployment to economy-specific conditions, depending on pace of recovery, postcrisis vulnerabilities, and available policy toolkit. - Be mindful of implementation lags for macroprudential measures and take early action to tighten selected tools to address rising vulnerabilities in the nonfinancial sector. *Source: CHAPTER 2 NONFINANCIAL SECTOR: LOOSE FINANCIAL CONDITIONS, RISING LEVERAGE, AND RISKS TO MACRO-FINANCIAL STABILITY (text - CHAPTER 2 NONFINANCIAL SECTOR: LOOSE FINANCIAL CONDITIONS, RISING LEVERAGE, AND RISKS TO MACRO-FINANCIAL STABILITY).* ### Chapter 2 in OECD Economic Outlook, vol. 2017 (2). Paris. ### Chapter 2 in OECD Economic Outlook, vol. 2017 (2). Paris. ### Introduction and scope - The coronavirus disease (COVID-19) crisis has hit the commercial real estate (CRE) sector hard; global commercial property transactions and prices slumped in 2020 as containment measures severely affected economic activity. - Part of the adverse impact on the retail, office, and hotel segments could be permanent owing to virtual activities and relocation outside large cities. - The chapter analyzes financial stability risks from the commercial real estate market and policy tools to mitigate those risks. - The analysis uses quarterly data for a sample of 30 economies over a 20-year period, from the first quarter of 2000 to the second quarter of 2020. - Core sample of economies: Australia, Austria, Belgium, Canada, China, the Czech Republic, Denmark, France, Germany, Hong Kong SAR, Hungary, Indonesia, Ireland, Italy, Japan, Korea, Malaysia, The Netherlands, New Zealand, Norway, Poland, Portugal, Singapore, South Africa, Spain, Sweden, Switzerland, Thailand, the United Kingdom, and the United States. ### Chapter 3 at a Glance — Key findings (verbatim) - The COVID-19 crisis has hit the commercial real estate sector hard and increased uncertainty about the outlook for some of its segments due to possible structural shifts in demand, warranting enhanced supervisory attention. - While there is little evidence of large price misalignments at the onset of the pandemic, signs of overvaluation have now emerged in some economies as actual prices have not fallen as much as prices implied by fundamentals. - Misalignments in commercial real estate prices, especially if they interact with other vulnerabilities, increase downside risks to future growth due to the possibility of sharp price corrections. Such corrections could threaten financial stability and hurt corporate investment, hampering the economic recovery. - In the near term, policy support to maintain the flow of credit to the nonfinancial corporate sector and to stimulate aggregate demand will help facilitate the recovery in the commercial real estate sector. - To the extent that large price misalignments persist, policymakers should swiftly deploy targeted macroprudential measures to contain vulnerabilities in the sector as warranted. Capital flow management measures could be considered under specific circumstances to limit potential risks from excessive cross-border inflows. ### Financial-stability transmission channels - Bank solvency channel: - Banks are exposed via commercial real estate loans and commercial mortgage-backed security holdings. - A downturn worsens borrower credit quality, may lead to borrower default, and weakens banks’ capital positions, potentially reducing credit supply. - Collateral channel: - Commercial property used as collateral declines in value, limiting corporate borrowing and curtailing investment. - A drop in collateral values increases loan-to-value ratios on existing loans and raises banks’ risk-weighted assets, reducing regulatory capital ratios. - Nonbank financial institutions (NBFIs) channel: - Insurers, pension funds, investment funds hold CRE debt and equity; price declines reduce asset values and the ability to provide financing. - Redemption pressures on investment funds can trigger fire sales in an illiquid market, amplifying price declines and feeding back to banks when NBFIs are leveraged and rely on bank financing. ### Vulnerabilities identified before and during the pandemic - Elevated size and debt reliance of the CRE sector imply potentially large implications for financial stability, with significant roles for banks, nonbank financial institutions, and cross-border investors in some jurisdictions. - Preexisting structural trends were exacerbated by the pandemic, notably: - Retail: demand for brick-and-mortar retail had been eroding pre-pandemic due to e-commerce. - Offices and hotels: potential persistent adverse effects from more liberal work-from-home policies and substitution of online meetings. - Leverage of real estate firms: - Median debt-to-total-assets ratio for listed real estate firms is 35 percent, versus 20 percent for other firms as of end-2019 Q4. - Historical loss experience (United States example): - Cumulative loss rate for commercial mortgage-backed securities was about 14 percent and for commercial real estate loans about 8 percent in the 2007–09 crisis, translating into a much higher likelihood of bank failure for US commercial banks with high CRE exposures. - Credit-market stress during COVID-19: - Commercial property transaction volumes and prices plummeted in 2020:Q2; sector recovered somewhat since then, especially in Asia, but generally remained depressed. - Delinquencies on commercial mortgage-backed securities surged; delinquencies in the retail and hotel sectors reached an all-time high in 2020:Q2. - Net operating income dropped notably in retail and hotel segments during the pandemic. ### Risks to growth and financial stability - Price misalignments in CRE have increased during the pandemic; where actual prices have not fallen as much as fundamentals imply, signs of overvaluation have emerged in some economies. - Misalignments increase downside risk to future GDP growth through potential sharp price corrections. - Sharp CRE price corrections can: - Hurt the creditworthiness of borrowers in the sector. - Damage solvency of lenders (banks and NBFIs). - Reduce nonfinancial corporate investment, hampering economic recovery. ### Policy considerations and recommendations - Near-term: - Continued policy support is warranted to keep financial conditions easy, maintain the flow of credit to the nonfinancial corporate sector, and stimulate aggregate demand to aid sector recovery. - Medium-term / structural-risk mitigation: - Targeted macroprudential policy tools (for example, limits on loan-to-value and debt-service-coverage ratios) should be swiftly deployed where vulnerabilities and price misalignments persist. - Where large capital inflows to the CRE sector pose financial stability risks, capital flow management measures could be considered under specific circumstances. - Broaden the reach of macroprudential policy to cover nonbank financial institutions, given their important role in CRE funding markets. - Conduct stress testing exercises to inform decisions on the adequacy of capital buffers for exposures to commercial real estate. *Authors: Andrea Deghi (team lead), Salih Fendoglu, Zhi Ken Gan, Oksana Khadarina, Junghwan Mok, Tomohiro Tsuruga; guidance by Fabio Natalucci, Mahvash Qureshi, Jérôme Vandenbussche.* ### 2. United States: Commercial Bank Failure Rate by Quarter, ### 2. United States: Commercial Bank Failure Rate by Quarter ### Commercial real estate exposures and bank vulnerabilities - Time series covered: 2001:Q1–2020:Q2 (Percent). - Commercial real estate (CRE) sector size and bank exposures: - The commercial real estate sector had total assets of about 20 percent of GDP as of the end of 2019, on average, across major advanced and emerging market economies, up from 17 percent a decade ago. - In some economies (Singapore, Sweden, Switzerland) CRE assets were as high as 50 percent or more of GDP. - In the United States and some European economies (Estonia and Poland), direct lending related to commercial real estate constituted more than 50 percent of total bank lending to nonfinancial corporations in 2019. - In the United States, CRE lending is highly concentrated among smaller banks (defined as those with total assets of less than $100 billion), with over 165 percent of their regulatory capital committed to commercial real estate and construction lending in 2019, compared with only 50 percent for large banks. - Channels of vulnerability: - Banks are the largest providers of debt funding for CRE globally; nonbank financial institutions also play important roles in some jurisdictions (for example, insurance companies in The Netherlands and Norway). - The US commercial mortgage-backed securities (CMBS) market: annual issuance reached about $230 billion in the run-up to the global financial crisis, fell to just a few billion dollars in 2008–09, gradually recovered thereafter, and dropped again during the COVID-19 crisis. - Historical correlation: - High CRE exposures were positively correlated with bank failures during the global financial crisis (GFC). ### Valuations, price dynamics, and misalignment estimates - Pre-pandemic valuation summary: - A fair-value model indicates most economies did not enter the pandemic with large CRE price misalignments; the average deviation of CRE prices from fair values before the pandemic is estimated at about minus 2 percent (contrast: an 8 percent overvaluation before the global financial crisis). - Price and return dynamics (selected metrics, exact figures preserved where provided): - In Sweden and the United States, real CRE prices almost doubled between 2009 and 2019. - Nominal annual capital appreciation for some segments averaged about 3 percent globally. - Loan-to-value ratios on new CRE loans averaged about 60 percent in 2019 compared with 82 percent in 2007 in the United States and the European Union (according to market contacts). - Regulatory soft guidance (implemented in 2006): banks whose total CRE loans relative to total risk-based capital exceeded 300 percent were subject to enhanced oversight and potential increases in capital requirements. - Misalignment developments in 2020: - Commercial real estate price misalignments generally increased in 2020 despite a decline in CRE prices. - The median value across economies reached about 3.6 percent (Figure 3.6, panel 2). - The deterioration largely reflects worsening fundamentals, such as drops in aggregate demand and net operating income. - In the United States, the sharp decline in aggregate demand and net operating income during 2020 put downward pressure on fair values, implying an overvaluation. - Across segments, misalignment is generally smaller in the office sector than in retail, though in some economies large overvaluations emerged in both segments. ### Scenario analysis: structural demand shifts and vacancy-rate shock - Scenario setup: - The model assumes a persistent increase in vacancy rates as a proxy for a continuous decline in CRE demand over the next five years (shifts in structural demand such as increased e-commerce and teleworking are proxied by vacancy-rate shocks). - Shocks to vacancy rates are treated as exogenous and unexpected in the scenario. - Scenario outcome (numeric results preserved): - A permanent increase in the vacancy rate of 5 percentage points would result in a median drop in fair values of about 15 percent after five years (Figure 3.6, panel 4). - A 5 percentage point decline in the vacancy rate is equivalent to what was experienced by the United States during the global financial crisis (note: scenario abstracts from potential repurposing of properties). - Interpretation: - Fair values could drop sharply if demand declines permanently; the size of the impact varies across economies. - If actual market prices do not adjust downward due to valuation uncertainty, prices may become overvalued and increase the risk of a sharp price correction later. ### Macro-financial links and systemic considerations - Procyclicality: - CRE prices are highly procyclical: the short-term cross-correlation between changes in real CRE prices and real GDP growth is strongly positive across economies. - Potential channels to financial stability: - A continuous deterioration in CRE markets could affect financial stability through bank losses, reduced capital, and stresses on interconnected investors and funding channels (including CMBS and nonbank institutions). - The ultimate effect depends on balance-sheet vulnerabilities of market participants and the extent of price misalignments, which affects susceptibility to sharp price corrections. - Uncertainty and caveats: - The pandemic produced large shocks to CRE fundamentals; some factors are conjunctural (recession-related) while others may reflect structural changes. - Considerable uncertainty remains about business survival rates and net operating income estimates; larger-than-expected declines in net operating income would imply larger drops in fair values and greater misalignment in 2020. - Possible triggers for sharp downward price adjustments include negative shocks to income growth, vacancy rates, CRE capital inflows (especially in emerging markets), and premature withdrawal of policy or lender support (such as loan extensions and deferred payment options). *Italic: Source — IMF staff calculations; data and analysis from Bloomberg Finance L.P.; Haver Analytics; MSCI Real Estate; FFIEC Call Reports; FDIC; Moody’s; Oxford Economics; and related IMF analysis as presented in the chapter.* ### CHAPTER 3 COMMERCIAL REAL ESTATE: FINANCIAL STABILITY RISKS DURING THE COVID-19 CRISIS AND BEYOND ### CHAPTER 3 COMMERCIAL REAL ESTATE: FINANCIAL STABILITY RISKS DURING THE COVID-19 CRISIS AND BEYOND ### Downside risks to GDP growth - Objective: quantify how commercial real estate (CRE) price misalignment affects downside risk to GDP growth (5th percentile of cross-country distribution of future average real GDP growth). - Misalignment measure used: deviation of the capitalization rate from its historical trend (broader sample including advanced and emerging market economies). - Key empirical findings: - A one standard deviation increase in CRE price misalignment is associated with an increase in GDP downside risk in the near term in both advanced and emerging market economies, with a smaller and statistically weaker impact for emerging market economies. - In advanced economies, a one standard deviation increase in CRE price misalignment—corresponding to a negative deviation of the capitalization rate from its long-term trend by 10 basis points—is associated with an increase in downside risk of ½ percentage point in GDP in the short term and ¼ percentage point in the medium term. - For emerging market economies, the impact is about 0.2 percentage point in the short term. - Interpretation: CRE is highly procyclical; higher CRE price misalignment raises downside risks to GDP growth in the short and medium terms. ### Banking sector profits and solvency - Channel: CRE price declines deteriorate bank loan portfolio quality, increase credit losses, reduce revenues, and can drag on capital adequacy. - Data scope: detailed bank-level CRE exposure and subnational CRE price data are publicly available only for the United States; used as a case study. - Empirical responses (United States): - Banks with larger CRE loan exposures experience significantly higher CRE nonperforming loan ratios and higher CRE loan charge-offs over the subsequent eight quarters. - Consequent effects include lower net revenues before provisioning and lower total regulatory capital over the same horizon. - Simulation under a mild adverse scenario: - Mild adverse scenario defined as a drop in CRE prices by 16 percent over eight quarters (equivalent to one standard deviation). - Estimated losses relative to banks’ risk-weighted assets before the shock average 14 basis points. - Losses exceed 1 percentage point of risk-weighted assets for banks with very high CRE exposures (top 3 percent for the ratio of CRE loans to total assets; smaller and community banks). - Quantitative example for banks with high ex ante CRE-loans-to-total-assets exposure (75th percentile; corresponding to 43 percentage points higher exposure): - A cumulative one standard deviation (16 percent) decline in local CRE prices over a two-year horizon implies: - cumulative 8 percentage point increase in the CRE nonperforming loan ratio; - cumulative 2.5 percentage point increase in the net charge-off rate of CRE loans; - 12 percent drop in net revenues before provisioning; - 4.9 percent decline in total regulatory capital (compared with banks with no CRE loan exposure). - Structural-shift scenario: - A permanent increase in vacancy rates by 5 percentage points would produce about twice the impact on bank capital compared with the mild adverse scenario. - Distributional insights: - Capital losses are concentrated in smaller and geographically concentrated banks; community banks in densely populated areas are at greater risk for a given CRE loan exposure. ### Decline in corporate investment - Channel: firms’ CRE holdings act as collateral; declines in market value of real estate holdings reduce investment via tightened borrowing constraints. - Key quantitative findings: - A one standard deviation decrease in the market value of real estate assets implies a decrease in the ratio of investment to the value of property, plant, and equipment by 21 percent. - The standard deviation of the market-value-to-property-plant-and-equipment ratio is 1.4. - Each additional $1 of real estate collateral increases investment by $0.03. - The effect is generally greater for financially constrained firms (proxied by firms that are small, do not pay dividends, or do not have a credit rating). - Declines in CRE prices contribute to a tightening of firms’ borrowing constraints, with similar magnitude across advanced economies and emerging market economies; effect particularly salient for long-term debt. ### Impact of policies on commercial real estate prices - Policy question: can macroprudential policies prevent buildup of CRE vulnerabilities and reduce downside risks to CRE prices? - Two categories of measures analyzed: 1. Targeted measures specific to the CRE sector (caps on loan-to-value or debt-service-to-income ratios for CRE; higher risk weights or sectoral capital buffers; limits on bank concentration in CRE; supervisory guidance). 2. Broader borrower-based measures (including residential mortgage LTV and DSTI caps), which can spill over to multifamily CRE segments. - Considerations: - Targeted macroprudential measures apply mainly to domestic banks and can be circumvented by direct foreign borrowing or nonbank financial institutions. - Examples of additional policy tools include capital flow management measures restricting nonresident investment (ownership restrictions, higher stamp duties). - Empirical effects on downside risks to (real) CRE price growth (5th percentile of future distribution): - Tighter targeted macroprudential measures reduce downside risks to CRE prices by 0.26 percentage point a quarter in the near term. - Broader borrower-based measures reduce downside risks to CRE prices by about 2 percentage points (cumulative) in the medium and long term. - Capital flow management measures (overall index of capital inflow restrictiveness and CRE-specific inflow restrictiveness) are associated with lower downside risks in CRE prices (sample limited to advanced economies where such measures have been applied). - Policy caveat: use of capital flow management measures to address financial stability risks should be considered only under specific circumstances as outlined in IMF guidance. *Italic: Source — CHAPTER 3 COMMERCIAL REAL ESTATE: FINANCIAL STABILITY RISKS DURING THE COVID-19 CRISIS AND BEYOND (text - CHAPTER 3 COMMERCIAL REAL ESTATE: FINANCIAL STABILITY RISKS DURING THE COVID-19 CRISIS AND BEYOND).* ### Conclusion and Policy Recommendations ### Conclusion and Policy Recommendations ### Sector-wide impact and risks - The commercial real estate sector has been severely affected by the COVID-19 crisis, with transaction volumes and prices falling globally, especially in retail, hotels, and offices. - The sector’s relevance for macro‑financial stability reflects: - its large size, - heavy reliance on debt funding, - strong interconnectedness with the real economy. - Findings indicate commercial real estate price misalignments: - amplify downside risks to future growth, - affect macro‑financial outcomes via weakening of bank soundness and declines in corporate investment. - Preliminary estimates point to overvaluation in 2020, as actual prices did not fall as much as implied by model‑based estimates. ### Empirical context and numeric evidence - The macroprudential measures exercise uses a sample of 30 economies over 2000:Q1–2019:Q4. - Counterfactual estimate: a borrower‑based macroprudential tightening in the run‑up to the global financial crisis would have reduced the decline in commercial real estate prices from about 11 percent to 9 percent. - City‑level sample: 64 cities in 11 economies. - City examples and reported price changes (2020:Q2, quarter over quarter): - Winnipeg recorded the highest quarter‑over‑quarter decline, of about 5½ percent. - Among “first‑tier” cities, London recorded the largest fall (–1.2 percent), followed by New York (–1 percent). - Retail segment extremes: declines up to 9½ percent in Minneapolis, Minnesota, and Baltimore, Maryland; increases of 4 percent in Austin, Texas, and Fukuoka, Japan. - Cities with an above‑median score in containment stringency recorded about a 0.6 percentage point larger price decline than other cities in 2020:Q2. - Historical urban/suburban difference (2010–19): the increase in urban commercial real estate prices was, on average, 1.4 percent larger than for suburban areas. ### Policy recommendations — near term - Maintain policy support to ensure the flow of credit to nonfinancial corporations and stimulate aggregate demand to facilitate sector recovery and preserve financial stability. - Keep borrower support measures in place (examples include debt repayment relief, credit guarantees, and direct support for viable firms) until the economic recovery is firmly established. - Encourage nonviable firms with high solvency and liquidity risks to restructure or liquidate (see Chapter 1 framework referenced). ### Policy recommendations — prudential and supervisory actions - Consider stress testing exercises embedding large declines in commercial real estate prices to inform decisions on adequacy of capital buffers for commercial real estate exposures and ensure banking sector resilience. - Supervisors should review banks’ commercial real estate valuation assumptions and ensure provisions are adequate. - Deploy targeted macroprudential tools once the extent of structural changes from the pandemic is clearer to address excessive financial risk taking and prevent persistent large price misalignments that could put growth at risk in the medium term. - Potential tools include borrower‑based measures such as loan‑to‑value and debt‑service‑to‑income ratios. - Measures targeting risk taking in new lending are less likely to conflict with resolution efforts for nonperforming loans. - Optimal timing of macroprudential actions depends on economy‑specific pace of recovery and degree of financial vulnerabilities; possible lags between implementation and full impact argue for early action. ### Cross‑border investment, nonbank risks, and policy responses - Cross‑border commercial real estate investment trends: - Flows fell sharply after the global financial crisis, recovered to near precrisis levels by 2015, averaging about $270 billion a year during 2014–19. - In 2020 these flows dropped again. - Office and retail segments fell the most during the crisis: 48 percent and 65 percent, respectively. - Frontier markets in Africa and the Middle East experienced large declines in 2020, falling 5 percent to 100 percent relative to 2019. - The greater the share of cross‑border investment before the pandemic, the larger the decline in total commercial real estate acquisition in the first three quarters of 2020. - There was no commercial real estate investment in 2020 in economies that relied entirely on foreign investors. - Institutional investors (pension funds and insurance companies) have increased their share in cross‑border flows, raising synchronization of international prices; synchronization is calculated with a metric normalized with a maximum value equal to 100. - Policy responses for cross‑border risks: - Consider commercial‑real‑estate‑specific capital flow management measures if a surge in capital flows into the sector poses systemic financial risks that cannot be addressed with other tools; these measures should be phased out once risks subside. - Address systemic risks stemming from nonbank financial institutions by broadening the reach of macroprudential tools and granting macroprudential powers to relevant supervisors, and by enhancing data collection. - Nonbank supervisors can reduce structural vulnerabilities (examples provided in source): stricter rules for property investment funds to reduce maturity mismatches; linking life insurers’ capital requirements to property type or to loan‑to‑value and debt‑service‑to‑income ratios. ### Sector outlook drivers and heterogeneity - The sector’s outlook is closely tied to the broader economic recovery and to possible pandemic‑induced structural changes in demand for certain property types. - City‑level heterogeneity in price changes reflects: - stringency of containment measures and changes in workplace mobility, - city size, - pre‑pandemic commercial real estate capital growth, - declines in market liquidity during the pandemic, - breadth of national‑level policy support (mortgage holidays, tax relief, financial support to businesses, additional spending and forgone revenue compensation programs). - Across segments, the correlation between containment stringency and price decline is highest for the retail sector, followed by office property. *Source: Conclusion and Policy Recommendations (text), GLOBAL FINANCIAL STABILITY REPORT: PREEMPTING A LEGACY OF VULNERABILITIES, April 2021.* ### 3. Growth in CRE investments in 2020 and ### 3. Growth in CRE investments in 2020 and ### Global and cross-border CRE investment trends - Global and cross-border CRE investments had recovered since the global financial crisis, but the impact of the COVID-19 crisis varied across emerging market economies. - Total inflows declined most in markets with a higher precrisis share of foreign participation. - CRE price co-movements spiked during the pandemic. ### Pre-COVID cross-border shares and emerging market outcomes - Pre-COVID share of cross-border investments (Percent) and cross-border share of investments in 2018–19 are used to classify market exposure to foreign participation. - Cross-Border Investments in Emerging Market Economies: cumulative volume in 2018–20 (Billions of US dollars, left scale) and annual growth rate in 2020 (Percent, right scale) show heterogeneous outcomes across economies. - Panel descriptions indicate cumulative commercial real estate (CRE) investments in the 2018–20 period and recent change in volumes computed for the first three quarters of 2020 relative to the previous period. (Figures display country labels CHN, POL, IND, BRA, RUS, MEX, HUN, MYS, Other.) ### US Commercial Mortgage-Backed Securities (CMBS) market during COVID-19 - Funding costs increased sharply in March 2020, with spreads on BBB-rated commercial mortgage-backed securities and these securities’ indices jumping sharply. - Monthly commercial mortgage-backed securities issuance fell from $14.8 billion in February to $0.3 billion in April. - To prevent a collapse, the Federal Reserve stepped into the agency commercial mortgage-backed securities market, buying almost $9.3 billion in securities issued by Fannie Mae, Freddie Mac, and Ginnie Mae during the second quarter. - As a result of Federal Reserve interventions, spreads of agency securities tightened significantly and returned to their precrisis level after a few weeks. - Issuance of agency CMBS rebounded during the second quarter, allowing resumption of credit flows to the multifamily housing sector, although year-to-date cumulative issuance at the end of June 2020 was still lower than for the corresponding period in 2019. - Early in the program the total amount of bids submitted greatly exceeded the announced maximum purchase amount at the weekly auction; the difference declined rapidly thereafter, indicating market recovery. - Recovery was more uneven in nonagency segments of the CMBS market: - The CARES Act tied much mortgage relief to residential mortgages (including the multifamily segment), but no explicit protection was granted to nonresidential commercial real estate borrowers. - The Federal Reserve included nonagency AAA CMBS in its Term Asset-Backed Securities Loan Facility (TALF 2.0) program in early April 2020, but did not intervene more broadly in the nonagency CMBS market. - As a result, the spread between BBB-rated and AAA-rated securities continued to widen over the second half of 2020, raising the question of gaps in the policy response. ### Financial stability risks and policy considerations for CMBS and CRE - A sluggish recovery in commercial real estate markets may result in greater losses than current initiatives can address. - Stress in the CMBS market could spill over to other financial market segments, leading to liquidity or potential solvency problems for banks and nonbank financial institutions, especially those with large exposures to commercial mortgage-backed securities. - Indirect support measures included the Main Street Lending Program (loans with deferred repayments for smaller companies) and the Small Business Administration’s Paycheck Protection Program. - Regulatory reforms such as Dodd-Frank credit risk retention requirements (launched in 2014) require issuers to retain at least 5 percent of any security they issue on their books; these reforms may have reduced overall risk and improved lending standards but may not suffice if CRE losses are large. *Source: IMF, Global Financial Stability Report: Preempting a Legacy of Vulnerabilities (April 2021), Chapter 3 excerpts.* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2021/april/english/text.pdf_