## EXECUTIVE SUMMARY

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### Overall Assessment: Where Do We Stand?
- Financial stability risks have been contained so far, reflecting ongoing monetary and fiscal policy support and the rebound of the global economy this year.
- Financial conditions have eased further in advanced economies, but optimism faded over the summer as investors grew concerned about the economic outlook amid rising virus infections and greater uncertainty about the strength of the recovery, particularly in emerging markets.
- In late September, concerns that inflationary pressures may be more persistent than initially anticipated have pushed nominal yields higher, in some countries entirely reversing their earlier moves.
- Financial vulnerabilities continue to be elevated in a number of sectors, masked in part by massive policy stimulus.
- Policymakers face a trade-off: maintaining near-term support for the global economy while preventing unintended consequences and medium-term financial stability risks.
- A prolonged period of extremely easy financial conditions may result in overly stretched asset valuations and could fuel financial vulnerabilities.
- Warning signs include increased financial risk-taking and rising fragilities in the nonbank financial institutions sector; if unchecked, these vulnerabilities may evolve into structural legacy problems, putting medium-term growth at risk and testing the resilience of the global financial system.

### Progress since the April 2021 Global Financial Stability Report
- Financial conditions:
  - Eased further, on net, in advanced economies, buoyed by expectations of continued accommodative monetary policy and rising risk asset valuations.
  - Changed little, on balance, in emerging markets, as monetary policy tightening in response to inflation pressure in some countries offset gains in risk asset prices.
- Corporate sector:
  - Corporate balance sheets have strengthened overall; a feared substantial pickup in bankruptcies has not materialized thanks to targeted fiscal support and unprecedented monetary policy support.
  - Revenues have risen, with profitability surpassing pre-pandemic levels in several economies.
  - Credit quality in speculative-grade bond markets has continued to strengthen, with default rates expected to remain low.
- Households:
  - Household financial positions have improved and appear stronger than during the global financial crisis.
  - Households have benefited from lower interest rates and support for income and interest costs, including debt payment moratoria in some countries.
  - Debt service ratios have fallen in many countries, reducing the risk of defaults on mortgage and other consumer loans.
- Emerging and frontier markets:
  - Outlook for portfolio flows has improved, boosted by the ongoing economic recovery and robust global risk sentiment, though local currency debt flows have not recovered from the first-quarter weakness.
  - Hard currency issuance has rebounded strongly, with many lower-rated issuers returning to capital markets.
- Banking sector:
  - With a solid global capital position, the global banking sector has continued to play a crucial role in supporting the flow of credit to the economy; banks have remained resilient, reflecting years of capital buildup and continued policy support.
- Sustainable finance and climate transition:
  - The investment fund sector can catalyze private investment to accelerate the transition to a low-carbon economy.
  - Flows into sustainable funds, and into climate funds in particular, have surged since early 2020.
  - Sustainable fund sector remains small: "$3.6 trillion in assets under management at the end of 2020, of which only $130 billion is in climate funds."

### However, Risks Remain amid Still-Elevated Financial Vulnerabilities
- Yields and inflation:
  - After declining through the summer, global long-term yields have risen in late September, in some countries entirely reversing earlier moves, on concerns that price pressures may be more persistent than anticipated.
  - Investors expect recent price pressures to moderate then gradually subside, but concerns about inflation risks have intensified recently.
  - Causes include rise in energy and commodity prices and potential persistence of supply chain disruptions and shortages of labor and materials feeding into wage dynamics and inflation expectations.
- Asset valuations and markets:
  - Asset valuations appear stretched in some market segments.
  - Equity prices have risen further, on net, since the April 2021 GFSR, boosted by accommodative monetary policy and strong earnings.
  - Equity price misalignments (relative to fundamentals-based values) have remained elevated in most markets.
  - Credit spreads have narrowed to below pre-pandemic levels.
  - House prices have risen rapidly in many countries.
- Emerging and frontier market vulnerabilities:
  - Local currency government bond yields have increased in many countries due to higher inflation and fiscal concerns.
  - The late-September increase in the US Treasury yields may exert additional pressure, leading to higher funding costs for many countries.
  - Inflation pressure has led many central banks to adopt a tighter monetary policy stance.
  - Monetary conditions remain broadly accommodative, with deeply negative real rates, but there is a risk that real rates may rise significantly in coming years.
  - A sudden change in the monetary policy stance of advanced economies may sharply tighten financial conditions, adversely affecting capital flows and exacerbating pressures in countries with debt sustainability concerns.
- Nonfinancial firms and sectoral risks:
  - Recovery remains uneven across countries, sectors, and firm sizes.
  - Solvency risks continue to be elevated in sectors hit hardest by the pandemic (for example, transportation and services) and in small firms.
  - In China, credit conditions have tightened, particularly for firms with weak credit ratings and in provinces with weaker public finances.
- Nonbank financial institutions and investment funds:
  - Vulnerabilities in investment funds unmasked by the “dash for cash” in March 2020 remain, and risks are rising at some other nonbank financial institutions as they reach for yield to meet nominal return targets.
  - Life insurance companies in the US and Europe have increased their share of lower-quality bonds and still face elevated asset-liability duration mismatches in many jurisdictions.
  - Greater use of financial leverage to boost returns could prompt volatility in financial markets.
- Banking sector credit supply:
  - Loan underwriting standards remain restrictive in many countries; bank loan officer surveys indicate this posture is expected to persist, with risks to the credit outlook as the main constraint to loan growth.
  - A slowdown in international bank lending may pose additional downside risks to many emerging market economies.
- Crypto ecosystem:
  - Crypto ecosystem continues its rapid growth, presenting new opportunities and challenges.
  - Crypto asset exchanges pose operational and financial integrity risks through cross-border operations.
  - Investor protection risks are large for crypto assets and decentralized finance; stablecoins generally have poor disclosures and can be subject to runs if their reserves come into question.
  - In emerging markets, crypto assets may accelerate dollarization and erode effectiveness of exchange restrictions and capital control measures; increased crypto trading by emerging market users can potentially lead to destabilizing capital flows.
  - Emerging market and developing economies facing these risks should prioritize strengthening macro policies and consider the benefits of issuing central bank digital currencies.
  - Globally, policymakers should work together through the G20 Cross Border Payments Roadmap to make cross-border payments faster, cheaper, more transparent, and inclusive.

### Policy Recommendations
- General stance:
  - Policy support remains key to sustaining the ongoing recovery, but should be tailored to country circumstances given the mixed pace of recovery across countries.
  - Central banks should provide clear guidance about their future policy stance to prevent an abrupt tightening of financial conditions.
  - If price pressures are more persistent than expected, monetary authorities should act decisively to prevent an unmooring of inflation expectations.
  - Fiscal policy should continue to support vulnerable firms and individuals; given policy space, fiscal measures should be targeted and tailored to country characteristics and needs.
- Macroprudential and financial sector measures:
  - Policymakers should tighten selected macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding a broad tightening of financial conditions.
  - Due to possible lags between activation and impact, authorities should take early action.
  - If macroprudential tools are not available—for example, in the nonbank financial intermediary sector—policymakers should urgently develop them.
  - Given challenges in designing and operationalizing macroprudential tools within existing frameworks, policymakers should consider building buffers elsewhere to protect the financial system.
  - Policymakers should urgently address vulnerabilities in investment funds through enhanced prudential supervision and regulation to raise ex ante resilience against liquidity risks.
  - Further reform of the global investment fund business should be achieved on an internationally coordinated basis through the Financial Stability Board.
- Emerging and frontier markets:
  - Remain exposed to the risk of a sudden tightening in external financing conditions; should, while leveraging the historic general special drawing rights allocation, rebuild buffers as appropriate and implement structural reforms to insulate themselves from capital flow reversals and abrupt increases in funding costs.
  - Address challenges posed by digital dollarization: reverse or avert dollarization by strengthening the credibility of monetary policy, safeguarding central bank independence, and maintaining a sound fiscal position.
  - Implement effective legal and regulatory measures to disincentivize foreign currency use and establish adequate frameworks for crypto asset service providers with coordination among national regulators.
  - Reconsider capital flow restrictions in a more digital world and pursue cross-border collaboration to address technological, legal, regulatory, and supervisory challenges.
- Climate and sustainable finance:
  - To foster growth of the sustainable fund sector and mitigate potential financial stability risks from the transition to a green economy, policymakers should urgently strengthen the global climate information architecture (data, disclosures, sustainable finance classifications).
  - Once this architecture is in place, consider tools to channel savings toward transition-enhancing funds (such as financial incentives for investment in climate funds).
  - Conduct scenario analysis and stress testing of the investment fund sector to mitigate potential financial stability risks from the transition.

*International Monetary Fund | October 2021*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2021/october/english/execsum.pdf_