## Preface — Global Financial Stability Report (April 2022) ## Source details **Canonical URL:** [Preface — Global Financial Stability Report (April 2022)](https://www.imf.org/-/media/files/publications/gfsr/2022/april/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2022/april/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2022/april/english/text.pdf.json) --- ### Purpose, scope, and coordination - Purpose: assesses key vulnerabilities the global financial system is exposed to and highlights policies to mitigate systemic risks to support global financial stability and sustained economic growth. - Inputs: draws on discussions with banks, securities firms, asset management companies, hedge funds, standard setters, financial consultants, pension funds, trade associations, central banks, national treasuries, and academic researchers. - Coordination: Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director; project directed by Fabio Natalucci, Deputy Director; Ranjit Singh, Assistant Director; Nassira Abbas, Deputy Division Chief; Antonio Garcia Pascual, Deputy Division Chief; Evan Papageorgiou, Deputy Division Chief; Mahvash Qureshi, Division Chief; and Jérôme Vandenbussche, Deputy Division Chief. - Editorial and production led by Gemma Rose Diaz; word processing by Javier Chang, Monica Devi, Olga Tamara Maria Lefebvre, and Srujana Sammeta. ### Key dated information and review - Information reflects data available as of April 7, 2022. - Executive Directors discussed the GFSR on April 11, 2022. - Editor’s Note (May 18, 2022): corrections to Chapter 3, Figure 3.11 panel 1 subtitle on page 79 and to Chapter 2, Box 2.1 on page 62 (country labels and sentence corrections). - Online version updated to reflect changes published online on April 13, 2022. ### Major findings and risk summary - Financial conditions and outlook: - Global financial conditions have tightened notably and downside risks to the economic outlook have increased as a result of the war in Ukraine. - Global economic growth for 2022 has been marked down to 3.6 percent, 0.8 percentage point lower than projected in the January 2022 WEO Update. - The probability of growth falling below zero in 2022 is estimated at about 8 percent. - Amplification channels of the war in Ukraine: - Inflation pressure from commodity price shocks. - Direct and indirect exposures of banks and nonbank financial intermediaries and firms to Russia and Ukraine. - Disruptions in commodity markets and increased counterparty risk. - Poor market liquidity and funding strains. - Acceleration of cryptoization in emerging markets. - Possible cyber-related events affecting market utilities and market functioning. - Market and institution observations: - Advanced economy nominal bond yields increased further since the invasion with heightened volatility of rates; inflation break-evens have risen significantly. - Banks’ direct exposures to Russia are relatively small except for some non-systemic European banks. - Foreign nonbank financial intermediaries held about one-fifth of Russia’s sovereign debt, about one-half of Russia’s corporate debt, and more than 40 percent of Russian equities as of Q4 2021. - Global funds benchmarked to global indices had an average 0.2 percent of their assets invested in Russian debt in 2022. - Emerging-market-dedicated funds reduced their share of Russian debt from more than 10 percent before 2014 to just over 4 percent (since the Crimea occupation in 2014). ### Select quantified exposures and market metrics - Foreign banks’ claims on Russian residents (Q3 2021): about $120 billion, with 60 percent in foreign currencies. - Foreign banks’ exposures to Ukraine (Q3 2021): $11 billion. - Russian banks’ US dollar deposits (end-September 2021): around $220 billion. - Total gross notional amount of OTC foreign exchange swaps and forwards between Russian banks and foreign dealer banks (end-2021): about $69 billion. - Open-end investment funds (OEFs) exposures to Russia: - Russian equities: about $100 billion (vast majority held by US funds). - Fixed-income assets linked to Russia: $34 billion (about two-thirds held by European funds). - Federal Reserve balance-sheet unwinding: expected to be fast, with more than $1 trillion of assets (approximately 20 percent of the Treasury securities held in the Federal Reserve System Open Market Account portfolio) maturing in 2022. ### Policy implications (high level) - Central banks face a challenging trade-off: bring inflation back down to target and prevent an unmooring of inflation expectations while avoiding a disorderly tightening of financial conditions that could interact with financial vulnerabilities and weigh on growth. - Policymakers will need to take decisive actions to address financial vulnerabilities and rein in rising inflation. - Multilateral cooperation is key to overcoming medium-term challenges, including potential capital markets fragmentation, implications for the role of the US dollar, payment system fragmentation, and risks from more widespread crypto asset use in emerging markets. --- ### Financial Conditions — Emerging Markets and Commodities ### Tightening, inflation, and central bank responses - Emerging market and developing economies inflation forecast for 2022 revised up 2.7 percentage points to 8.6 percent (relative to January 2022 WEO Update). - Emerging market and developing economies GDP forecast for 2022 revised down 0.9 percentage point to 3.9 percent (relative to January 2022 WEO Update). - Inflation breakevens and market-implied probability of inflation outcomes greater than 3 percent have risen notably since the prior GFSR. - Many emerging market central banks front-loaded policy tightening; two notable exceptions where inflation expectations remain well above targets are Argentina and Turkey. ### Market developments and capital flows - Emerging market hard-currency spreads widened sharply after the invasion; credit spreads moved as much as 113 basis points higher—or 84 basis points excluding Russia and Ukraine—after the war started. - The number of issuers trading at distressed levels surged to nearly 25 percent of issuers, surpassing pandemic-peak levels. - Fund flows: - Flows in local currency bonds and equities experienced the largest weekly redemptions since March 2020. - Capital flows at risk (5th percentile) increased to 2.3 percent of GDP from 1.7 percent of GDP in the October 2021 GFSR. - The probability of outflows rose to about 30 percent from 20 percent in the October 2021 GFSR. - A risk aversion shock similar to March 2020 would take capital flows at risk to 2.5 percent and increase the probability of outflows to almost 50 percent. ### Commodity markets, dealers, and volatility - Severe disruptions in commodity markets and supply chains caused extreme volatility in commodity prices and pressures in commodity trade finance and derivatives markets. - Dealer banks provide collateralized funding for commodity shipments and act as intermediaries in commodity derivatives markets; a small group of large energy trading firms are heavily reliant on dealer bank financing. - Commodity-derivative margin calls and dealer balance-sheet constraints can amplify liquidity and counterparty risks across markets. ### Policy recommendations for emerging markets - Front-load policy tightening where necessary to preserve central bank credibility and anchor inflation expectations. - Use the exchange rate as a shock absorber when appropriate and alongside other tools. - Communicate clearly and proactively about balance sheet normalization (timing, speed, composition). - Tighten selected macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding disorderly tightening of financial conditions. - Monitor and address counterparty risk, funding strains, and dollar-funding market stress. --- ### Sovereign–Bank Nexus in Emerging Markets (Chapter 2) ### Stylized facts and magnitude - Banks’ domestic sovereign debt exposure increased during the pandemic; bank holdings of government debt rose to historic highs in 2021. - Banks’ domestic sovereign debt exposure reached 17 percent of total banking sector assets in emerging markets in 2021. - Average public-debt-to-GDP ratio in emerging markets surged to a record 67 percent in 2021 from about 52 percent before the pandemic. - Banks’ share in sovereign debt holdings increased from an average of about 20 percent two decades ago to more than 30 percent in 2020. - Heterogeneity: in some economies (example: Uruguay) banks hold less than 10 percent of total sovereign debt; in others (example: China) the share exceeds 80 percent. ### Empirical findings and stress sensitivities - Sovereign and bank default risk move together; at low levels of bank distress, a 1 percentage point increase in sovereign default risk is associated with a 0.4 basis point increase in banks’ expected default frequency. - Structural analysis conclusions: - The nexus is strong on average with significant feedback effects between sectors. - Spillovers from sovereign default risk to banks are on average larger than those from banks to sovereign default risk. - Transmission strength differs across countries; in some cases transmission is three to five times higher than the average. - Scenario sensitivities: - Haircuts as small as 30 percent on sovereign holdings would breach minimum CET1 capital ratios in domestic banks in sub-Saharan Africa. - Historical average direct loss-given-default rates for sovereign debt holders: 37 percent (1978–2010) and 50 percent (1998–2010) (Cruces and Trebesch (2013)). ### Channels: exposure, safety net, macroeconomic - Exposure channel: direct holdings of government debt reduce bank capital when sovereign spreads widen. - Safety net channel: government support (proxied by Fitch support rating floors) affects bank risk-taking; higher support is associated with lower capital ratios and higher risk-taking by less-capitalized banks. - Macroeconomic channel: sovereign downgrades and ceilings transmit to corporate ratings and investment; bound firms reduce investment by nearly 17 percentage points more than unbound firms two years after a sovereign downgrade in the sample. ### Policy recommendations - Fiscal measures: - Extend maturities of public debt where feasible and avoid further buildup of currency mismatches. - Improve targeting and embed fiscal policy in credible medium-term plans. - Banking and supervisory measures: - Preserve bank resources by restricting capital distributions where needed. - Conduct asset quality reviews and comprehensive stress tests incorporating sovereign–bank nexus channels. - Consider measures to reduce incentives to hold excessive sovereign debt once normalization permits (examples include nonzero, risk-sensitive capital requirements; concentration limits; calibrated capital surcharges). - Mandate disclosure of material sovereign exposures by banks. - Market development: - Foster a deep and diversified investor base in local currency bond markets to reduce reliance on banks and improve resilience. - Crisis preparation: - Strengthen deposit guarantee schemes, resolution regimes, and central bank liquidity facilities; prepare contingency plans for possible pressures. --- ### Fintech, Neobanks, and DeFi (Chapter 3) ### Neobanks and fintech vulnerabilities - Business model and risk profile: - Neobanks use digital technologies (cloud computing, APIs, big data, AI) and target underserved clients. - Client base is younger and lower-income with lower credit scores; loan books are often unsecured. - Credit and provisioning: - Neobanks exhibit higher credit risk but loan loss reserves as a proportion of overall (risk-weighted) assets are well below those of traditional banks—implying looser provisioning. - Some parts of the sample show meaningfully negative risk-adjusted net interest margins after accounting for loan-related fee income. - Liquidity and funding: - Deposits are likely less sticky; Basel III calibration notes “internet deposits” as at least 10 percent runoff for less stable deposits (3 percent for “stable deposits”). - Neobanks’ ratio of liquid assets to total deposits is lower than traditional banks; they hold a larger share of interbank loans in liquid asset portfolios, increasing interconnectedness. - Costs and profitability: - Neobanks are less cost-efficient largely due to higher nonstaff expenses (marketing, compliance). - Only a few neobanks generate profits; young neobanks operate with higher equity/assets ratios while loss-making. ### DeFi mechanics, usage, and risks - DeFi (definition): financial applications (“smart contracts”) processed by computer code on blockchains with limited or no centralized intermediaries. - DeFi lending structure: - More than 90 percent of DeFi lending denominated in stablecoins. - 75 percent of collateral in DeFi lending denominated in volatile crypto assets. - Collateral factors typically range from 0 to 0.8 across assets. - Risk and fragility metrics: - Modeled one-year probability of liquidation averaged 24 percent. - Expected loss from liquidation averaged about 0.9 percent. - During the January 2022 crypto sell-off, liquidations erased $50 billion in borrowed asset value. - Liquidity provision concentration: on average, half of deposits are provided by fewer than 10 accounts. - Cyber and operational incidents: - Cyberattacks increased substantially in mid-2021; event analysis indicates about 30 percent of total value locked is lost or withdrawn after attacks in most cases. - Deposits in DeFi are not eligible for deposit insurance or central bank liquidity support. - Margins and pricing: - DeFi shows high cost-efficiency and narrow margins but likely underprices risk; DeFi expected losses in samples suggest underpricing relative to banks and nonbanks. ### Regulatory and policy recommendations for fintech and DeFi - Neobanks and fintech: - Review prudential regulations at entity and group levels to ensure capital, liquidity, and operational risk-management requirements are commensurate with risks taken. - Strengthen supervision of incumbents that are technology laggards and smaller banks vulnerable to fintech competition. - Enhance monitoring of underwriting, provisioning, AML/CFT, and IT/cybersecurity. - DeFi and crypto: - Develop comprehensive global standards for crypto assets across the activity and risk spectrum. - Regulatory focus areas: stablecoin issuers; centralized crypto exchanges and hosted wallet providers; reserve managers, network administrators, and market makers. - Consider direct regulation of key DeFi functions via public-private collaboration on code regulation, ex ante guidelines, ex post code reviews/audits, disclosure and user education, and promotion of robust governance (industry codes, self-regulatory organizations). - Consider restricting exposures of regulated firms to unregulated DeFi markets to limit contagion while frameworks evolve. - Implement Financial Action Task Force standards and expand laws/regulations for foreign exchange and capital flow management to cover crypto assets where needed. --- ### Energy, Commodities, Market Infrastructure, and Cyber Risks ### Energy security and climate transition tensions - Europe relies on Russia for roughly 40 percent of its consumption of natural gas and for more than 50 percent of thermal coal. - Renewable energy accounts for 22 percent of energy consumption in Europe. - The war has pushed commodity prices higher across oil, gas, and widely used metals (including those used for renewables), complicating the net-zero transition and raising the cost and complexity of renewable deployment. - Policy imperative: intensify efforts to implement the COP26 roadmap, scale up private finance for the green transition, and strengthen climate finance information architecture. ### Commodity-market functioning and governance - Severe commodity market disruptions have raised margin calls, funding needs, and counterparty concerns; dealers’ balance-sheet capacity may be constrained. - Market functioning events (example highlighted): London Metal Exchange actions around nickel market (suspension, cancellation of trades, deferred delivery) illustrate governance challenges and potential migration to more opaque OTC markets. - Recommendations: - Strengthen exchange and CCP resilience and governance. - Improve transparency, margining, and stress-testing for concentrated positions. - Monitor dealer balance-sheet capacity and concentration of exposures to large commodity trading firms. ### Cyber risks and operational resilience - Cyberattacks against Ukraine and coordination of disruptive campaigns (including SMS disinformation) have raised first-order concerns for financial institutions and market infrastructure. - Historical precedent: 2017 NotPetya malware attack estimated worldwide losses of about $10 billion. - Priorities: - Enhance cyber regulation and supervision, incident reporting, and information sharing. - Improve operational resilience and recovery capabilities. - Help emerging market economies build cybersecurity capacity and coordinate international deterrence efforts. --- *Source: Global Financial Stability Report: Shockwaves from the War in Ukraine Test the Financial System’s Resilience — International Monetary Fund, April 2022 (information reflects data available as of April 7, 2022).* ### Preface ### Preface ### Purpose and scope - The Global Financial Stability Report (GFSR) assesses key vulnerabilities the global financial system is exposed to and aims to highlight policies that may mitigate systemic risks to support global financial stability and sustained economic growth. - This issue draws on discussions with banks, securities firms, asset management companies, hedge funds, standard setters, financial consultants, pension funds, trade associations, central banks, national treasuries, and academic researchers. ### Coordination, authorship, and review - Coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director. - Project directed by Fabio Natalucci, Deputy Director; Ranjit Singh, Assistant Director; Nassira Abbas, Deputy Division Chief; Antonio Garcia Pascual, Deputy Division Chief; Evan Papageorgiou, Deputy Division Chief; Mahvash Qureshi, Division Chief; and Jérôme Vandenbussche, Deputy Division Chief. - Individual contributors include Jose Abad; Sergei Antoshin; Parma Bains; Liumin Chen; Yingyuan Chen; Fabio Cortes; Reinout De Bock; Andrea Deghi; Mohamed Diaby; Dimitris Drakopoulos; Torsten Ehlers; Salih Fendoglu; Charlotte Gardes-Landolfini; Deepali Gautam; Rohit Goel; Sanjay Hazarika; Frank Hespeler; Henry Hoyle; Shoko Ikarashi; Tara Iyer; Phakawa Jeasakul; Esti Kemp; Oksana Khadarina; Sheheryar Malik; Fabiana Melo; Junghwan Mok; Kleopatra Nikolaou; Natalia Novikova; Thomas Piontek; Patrick Schneider; Nobuyasu Sugimoto; Hamid Reza Tabarraei; Tomohiro Tsuruga; Jeffrey David Williams; Hong Xiao; Yizhi Xu; Dmitry Yakovlev; Mustafa Yenice; Akihiko Yokoyama; Zhichao Yuan; and Xingmi Zheng. - Editorial and production led by Gemma Rose Diaz from the Communications Department with editorial assistance from David Einhorn, Harold Medina (and team), Lucy Scott Morales, Nancy Morrison, Grauel Group, and TalentMEDIA Services. - Word processing by Javier Chang, Monica Devi, Olga Tamara Maria Lefebvre, and Srujana Sammeta. ### Key dated information and review - This GFSR reflects information available as of April 7, 2022. - The report benefited from comments and suggestions from staff in other IMF departments and from Executive Directors following their discussions of the GFSR on April 11, 2022. - Editor's Note (May 18, 2022): corrections made to Chapter 3, Figure 3.11 panel 1 subtitle on page 79 ("(Billions of US dollars)" corrected to "(Millions of US dollars)"); and Chapter 2, Box 2.1 on page 62: country labels in Figure 2.1.1 were amended and the last three countries mentioned in the second sentence of the first paragraph were corrected to "China, Hungary, and Pakistan." - Online version updated to reflect changes to the version published online on April 13, 2022. ### Major findings and risks highlighted - Global financial conditions have tightened notably and downside risks to the economic outlook have increased as a result of the war in Ukraine. - Tightening has been particularly pronounced in eastern Europe and Middle East countries with close ties to Russia, reflecting lower equity valuations and higher funding costs. - Financial stability risks have risen on several fronts though no global systemic event affecting financial institutions or markets has materialized so far. - Key amplification channels of the war in Ukraine include: - Inflation pressure from commodity price shocks. - Direct and indirect exposures of banks and nonbank financial intermediaries and firms to Russia and Ukraine. - Disruptions in commodity markets and increased counterparty risk. - Poor market liquidity and funding strains. - Acceleration of cryptoization in emerging markets. - Possible cyber-related events affecting market utilities and market functioning. - Central banks face a challenging trade-off: bringing inflation back down to target and preventing an unmooring of inflation expectations while avoiding a disorderly tightening of financial conditions that could interact with financial vulnerabilities and weigh on growth. - Advanced economy nominal bond yields increased further since the invasion, with heightened volatility of rates; inflation break-evens have risen significantly on the back of sharply higher commodity prices. - Banks’ direct exposures to Russia are relatively small except for some non-systemic European banks; indirect exposures are harder to identify and could be meaningful and surprising once revealed. - Foreign nonbank financial intermediaries have sizable investments in Russian assets, with US and European investment funds accounting for most exposures, though as a share of total assets the exposure to Russia is small. - Dedicated emerging market funds have reduced their share of Russian debt from more than 10 percent before 2014 to just over 4 percent (since the Crimea occupation in 2014). ### Policy implications and recommendations - Policymakers will need to take decisive actions to address financial vulnerabilities and rein in rising inflation. - To manage the trade-off between containing inflation and supporting the recovery from the pandemic, interest rates might have to rise beyond what is currently priced in markets to get inflation back to target in a timely manner; for many countries, this may entail pushing interest rates well above their neutral level. - While addressing energy security concerns, policymakers should intensify efforts to implement the COP26 roadmap and scale up private finance for the transition to a greener economy. - Multilateral cooperation is emphasized as key to overcoming medium-term challenges such as potential capital markets fragmentation, implications for the role of the US dollar, fragmentation of payment systems, and risks from more widespread crypto asset use in emerging markets. ### Assumptions and conventions used in the GFSR - “Billion” means a thousand million. - “Trillion” means a thousand billion. - “Basis points” refers to hundredths of 1 percentage point (for example, 25 basis points are equivalent to 1/4 of 1 percentage point). - Notation conventions: - . . . to indicate that data are not available or not applicable; - — to indicate that the figure is zero or less than half the final digit shown or that the item does not exist; - – between years or months (for example, 2021–22 or January–June) to indicate the years or months covered, including the beginning and ending years or months; - / between years or months (for example, 2021/22) to indicate a fiscal or financial year. - If no source is listed on tables and figures, data are based on IMF staff estimates or calculations. - Minor discrepancies between sums of constituent figures and totals reflect rounding. - The terms “country” and “economy” may include territorial entities that are not states but for which statistical data are maintained on a separate and independent basis. - Map boundaries, colors, denominations, and any other information shown on maps do not imply IMF judgment on legal status or endorsement of boundaries. ### Further information, corrections, and digital access - Corrections and revisions are incorporated into digital editions available from the IMF website and on the IMF eLibrary; all substantive changes are listed in the online table of contents. - Multiple digital editions, including ePub, enhanced PDF, and HTML, are available on the IMF eLibrary at www.elibrary.imf.org/APR22GFSR. - A free PDF of the report and data sets for each chart are downloadable from www.imf.org/publications/gfsr. - Print copies can be ordered from the IMF bookstore at imfbk.st/516157. *Source: Global Financial Stability Report: Shockwaves from the War in Ukraine Test the Financial System’s Resilience — Preface, Foreword, Executive Summary; International Monetary Fund, April 2022. (Information reflects data available as of April 7, 2022.)* ### 2022. Funds benchmarked to global indices have had a much ### 2022. Funds benchmarked to global indices have had a much ### Commodity markets, dealer banks, and price volatility - Funds benchmarked to global indices had an average 0.2 percent of their assets invested in Russian debt in 2022. - Severe disruptions in commodity markets and supply chains caused extreme volatility in commodity prices, amplified by pressures in commodity trade finance and derivatives markets. - Dealer banks play a crucial role and have significant exposures in these markets, including by providing liquidity and credit to a small group of large energy trading firms that operate globally, are largely unregulated, and are mostly privately owned. - Pressures in commodity markets, often magnified by poor liquidity, led to lower risk appetite and rising counterparty risk concerns, with implications for funding conditions. - Russia’s share in global production and price change between February 23 and March 23, 2022 were highlighted across commodities including Aluminum, Copper, Nickel, Coal, Platinum, Oil, and Gas (see Figure 10 for detailed percent shares and price changes). ### Emerging and frontier markets: tighter conditions and capital flow stress - Since the war in Ukraine began, emerging market (EM) hard currency yields increased at a rapid pace before retracing some in mid-March (see Figure 6). - The number of issuers trading at distressed levels surged to nearly 25 percent of issuers, surpassing pandemic-peak levels (Figure 7). - The deterioration in spreads, combined with the increase in US yields, pushed financing costs well above pre-pandemic levels for many borrowers. - Markets remained open for issuance at higher funding costs. - Flows in local currency bonds and equities experienced the largest weekly redemptions since March 2020. - Tighter external financial conditions due to US monetary policy normalization and heightened geopolitical uncertainty are likely to increase downside risks for portfolio flows. Key numerical markers from figures and notes: - Distressed sovereigns defined as spread >1,000 basis points. - Emerging Market Bond yields panel spans Jan. 2016 through Jan. 2022 with axis ticks at 2.5, 3.5, 4.5, 5.5, 6.5, 7.5, 8.5, 9.5, 10.5, 11.5, 12.5 percent (Figure 6). - Fund flows to emerging markets charted as two-week moving sum with vertical scale including –10, –5, 0, 5, 10, 15, 20 (Billions of US dollars) (Figure 8). ### Bank-sovereign nexus, China, and domestic vulnerabilities - In many EMs, additional government financing needs to cushion the pandemic were mostly met by banks, intensifying interlinkages between sovereigns and domestic banks. - Bank holdings of domestic sovereign debt surged to historic highs in 2021 (Figure 9). - Distress in emerging markets could trigger an adverse feedback loop between sovereigns and banks—the sovereign-bank nexus—potentially reducing bank soundness and lending to the economy. - In China, the recent equity sell-off, particularly in the tech sector, and the increase in COVID-19 cases raised concerns about a growth slowdown with possible spillovers to emerging markets. - Ongoing stress in China’s real estate sector increased financial stability risks and added to growth pressures. - Extraordinary financial support measures to ease pandemic-driven balance sheet pressures could add further to medium-term debt vulnerabilities. Quantitative references related to bank-sovereign exposure: - Bank-sovereign debt exposure shown for 2005–09, 2010–14, 2015–19, 2020, 2021 with percent of banking sector assets axis including 0, 2, 4, 6, 8, 10, 12, 14, 16, 18 percent (Figure 9). ### Crypto, fintech, and financial innovation risks - Crypto asset trading volumes against some emerging market currencies spiked following sanctions on Russia and capital restrictions in Russia and Ukraine, against a longer-term increase in cross-border transactions. - Rapid growth of risky fintech business segments can be a concern for financial stability when fintech firms are subject to less stringent regulation. - Value of DeFi assets and stablecoins increased markedly from Jan. 2020 through Jan. 2022: - DeFi total and stablecoins tracked with left-scale and right-scale axes showing stablecoins (USDT, USDC, others) and DeFi total in Billions of US dollars (Figure 11). ### Policy recommendations and priorities - Central banks should act decisively to prevent inflation pressure from becoming entrenched and avoid an unmooring of inflation expectations; advanced-economy central banks should provide clear guidance about the normalization process while remaining data dependent. - Emerging market central banks: further rate increases or normalization of pandemic measures (such as asset purchases) should continue as warranted according to country-specific inflation and economic outlook to anchor inflation expectations and preserve policy credibility. - Policymakers should tighten selected macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding a disorderly tightening of financial conditions; balance is important given uncertainty about the economic outlook, monetary policy normalization, and limits on fiscal space post-pandemic. - While addressing energy security concerns, policymakers should intensify efforts to implement the 2021 United Nations Climate Change Conference (COP26) road map to achieve net-zero targets, increase availability and lower cost of fossil fuel alternatives and renewables, improve energy efficiency, scale up private finance for the green transition, and strengthen climate finance information architecture. - Policymakers should develop comprehensive global standards for crypto assets across the activity and risk spectrum; more robust oversight of fintech firms and DeFi platforms is needed. - To preserve the effectiveness of capital flow management measures amid growing crypto usage, pursue a multifaceted policy strategy. - Regulators should examine broader implications of measures taken in response to commodity price volatility, including exchange governance mechanisms, resiliency of trading systems, concentration of risk, margin setting, and trading transparency in exchange and over-the-counter markets. ### IMF Executive Board and multilateral priorities - Executive Directors broadly agreed with staff’s assessment: the war in Ukraine led to a downgrade to the global economic outlook and increased inflationary pressures while the global economy had not yet recovered from COVID-19. - Directors noted emerging risks including intensification of the war, further sanctions on Russia, fragmentation in financial and trade markets, a sharper-than-expected slowdown in China, and new COVID-19 variants, tilting risks to the downside. - Directors emphasized different policy priorities across countries due to local circumstances and exposures; fiscal support should focus on priority areas and the most vulnerable, with phase-out of pandemic-related exceptional support where growth is strong and inflation elevated. - In the face of potential sudden tightening of global financial conditions, emerging and developing economies should be ready to use all available tools, including foreign exchange interventions and capital flow management measures, in line with the Fund’s Institutional View and without substituting for exchange rate flexibility and warranted macroeconomic adjustments. - Directors called for strong multilateral cooperation to defuse geopolitical tensions, avoid fragmentation, end the pandemic, respond to humanitarian crises, safeguard global liquidity, manage debt distress, ensure food security, mitigate and adapt to climate change, and intensify implementation of the COP26 roadmap. *International Monetary Fund | April 2022 — Global Financial Stability Report: Shockwaves from the War in Ukraine Test the Financial System’s Resilience.* ### Chapter 1 at a Glance ### Chapter 1 at a Glance ### Global financial conditions and risks - Global financial conditions have tightened notably and downside risks to the economic outlook have increased as a result of the Russian invasion of Ukraine. - This tightening has occurred in the context of the pandemic, which was slowly being brought under control, and the consequent recovery of the global economy from COVID-19. - Financial stability risks have risen along many dimensions, although no global systemic event affecting financial institutions or markets has materialized so far. - The sharp rise in commodity prices, which has exacerbated preexisting inflation pressure, poses challenging trade-offs for central banks. ### Direct and indirect financial system channels of stress - Repercussions of the war will test resiliency through: - direct and indirect exposures of banks, nonbank financial intermediaries, and firms; - market disruptions (including in commodity markets) and increased counterparty risk; - acceleration of cryptoization in emerging markets; - possible cyber-related events. - Emerging and frontier markets are facing tighter financial conditions and a higher probability of portfolio outflows (forecast at 30 percent now, up from 20 percent in the October 2021 Global Financial Stability Report [GFSR]). - In China, financial vulnerabilities remain elevated amid ongoing stress in the property development sector and new COVID-19 outbreaks. ### Commodities, supply chains, and inflation - The sharp rise in commodity prices and spikes in commodity volatility have intensified inflationary pressure: - Energy and food prices have risen sharply, and volatility has jumped. - Metals prices have surged amid risks to supply chains and trading disruptions on exchanges. - Supply shortages are expected to persist, as seen in the very high relative price of short-term contracts over longer-term ones. - Energy and food security concerns are acute and may put climate transition efforts at risk. - Disruptions could intensify if sanctions escalate to include an explicit ban of energy imports from Russia by Europe. ### Market reactions and asset prices - Russian and Ukrainian assets experienced the largest price declines: - dollar-denominated sovereign bonds pricing a very high probability of default and a low rate of recovery; - the Russian ruble fell to all-time low levels against the US dollar before recovering a substantial portion of the earlier declines; - the Ukrainian hryvnia exchange rate has been effectively fixed as of February 24. - Stock trading on the Moscow Exchange was halted on February 25 and reopened only on March 24 with substantial restrictions on trading. - After initial deterioration, investors became more optimistic about risk assets since mid-March, with global equities recouping most earlier losses. - Sectoral impacts: - Large declines in airline and hospitality sectors. - Energy-intensive and energy-dependent sectors (automobiles, consumer durables, industrials) hit by surging energy and metal prices, exacerbating supply chain challenges. - Food industry under pressure from higher energy and agricultural commodity prices. - Semiconductors and information technology sector face input shortages (gases and precious metals), raising concerns about further chip shortages. ### Regional and market divergence - Across regions: - Equity prices less affected in the United States and advanced Asia. - Equities fell in Europe and emerging markets, with pronounced impact in central and eastern Europe. - Chinese equities underperformed due to geopolitical risks, COVID-related lockdowns, and regulatory uncertainty in tech. - Global corporate bond spreads widened, surpassing pre-pandemic levels across major sectors and most high-yield segments; the increase more evident for the lowest-rated firms. - In emerging markets, countries with closer economic ties to Russia and risk-sensitive frontier markets were hit hardest. - Currencies: Latin American countries and commodity exporters outperformed relative to eastern European countries and oil importers in Asia. ### Volatility and financial conditions - Volatility has risen sharply in both equity and interest rate markets after the invasion: - Market-implied equity volatility has declined sharply recently in some cases to below pre-war levels and is anticipated to remain around these levels through the end of 2022. - Market-implied interest rate volatility has remained elevated, reflecting uncertainties about the policy normalization process in advanced economies. - On balance, financial conditions in advanced economies have tightened notably this year due to: - decline in corporate valuations; - higher government bond yields; - continued expectations of monetary policy normalization. - Relative to historical levels, financial conditions remain easy or roughly neutral. - The sudden and significant increase in external borrowing costs and rising local currency rates have weighed heavily on financial conditions in eastern Europe and the Middle East with close ties to Russia. - Conditions have eased in China as policymakers provided additional policy support to offset an economic slowdown. ### Macroeconomic outlook and downside risks - The Russian invasion of Ukraine is anticipated to have a material impact on the post-pandemic global economic recovery. - Global economic growth for 2022 has been marked down to 3.6 percent, 0.8 percentage point lower than projected in the January 2022 WEO Update. - Amid heightened uncertainty, the balance of risks to growth in 2022 remains skewed to the downside: - the probability of growth falling below zero in 2022 is estimated at about 8 percent, with downside risks now at elevated levels compared with historical norms. ### Policy implications and recommendations - Policymakers need to: - take decisive actions to rein in rising inflation; - address financial vulnerabilities while avoiding a disorderly tightening of financial conditions that would jeopardize the post-pandemic economic recovery; - consider short-term fiscal support for some businesses and households to navigate the consequences of the war. - The surge in volatility and dislocations in commodity markets underscores the importance of ensuring the adequacy of disclosures and standards of transparency to counterparties, especially major financial institutions, to support comprehensive risk management and supervisory oversight. - In coming years, policymakers will need to confront structural issues brought to the fore by the war and sanctions, including: - the trade-off between energy security and climate transition; - market fragmentation risks; - the role of the US dollar in asset allocation. *Source: Chapter 1 at a Glance, text - Chapter 1 at a Glance (IMF Global Financial Stability Report, April 2022).* ### 2. Financial Conditions: Emerging Markets ### 2. Financial Conditions: Emerging Markets ### Tightening of Financial Conditions and Market Developments - Financial conditions have tightened notably on average in Q1 in advanced economies, especially in the euro area, and have reached extremely tight levels in eastern Europe. - After rising early in the year on inflation concerns, advanced economy nominal bond yields increased sharply in March amid heightened interest rate volatility, reflecting an increase of both breakevens and real rates. - Inflation breakevens (a market-implied proxy for future inflation) have risen significantly since the beginning of the year on the back of sharply higher commodity prices. - Pricing in inflation options markets points to a notable increase in the probability of high inflation—specifically, inflation outcomes greater than 3 percent—since the time of the previous GFSR. - The market-implied expected path of policy has risen significantly in advanced economies since the beginning of the year and moved further upward since the Russian invasion of Ukraine. - The unwinding of the Federal Reserve’s balance sheet is expected to be fast, with more than $1 trillion of assets (approximately 20 percent of the Treasury securities held in the Federal Reserve System Open Market Account portfolio) maturing in 2022. - While still low by historical standards, southern European countries’ spreads have widened since the ECB’s announcements of its intention to scale back asset purchases, underscoring the risk of market fragmentation in the euro area. ### Transmission Channels of the War in Ukraine to Emerging Markets - Potential transmission channels include: - Inflation pressure related to rising commodity prices. - Exposures of banks and nonbank financial intermediaries to Russian and Ukrainian assets. - Disruptions in commodity markets transmitted through commodity trade finance and derivatives. - Growing concerns about counterparty risks leading to a broad pullback in risk-taking amid poor market liquidity and funding strains. - A Russian default on its debt obligations and potential capital outflows from emerging markets. - Cyberattacks affecting the resilience of the financial system. - The war has crystallized amplification channels that operate through financial markets—for example through disruptions in commodity markets and widespread counterparty risk concerns that have propagated and weighed on risk-taking appetite across market segments. ### Inflation, Central Bank Responses, and Policy Stance in Emerging Markets - Even before the Russian invasion of Ukraine and the associated surge in commodity prices, emerging market central banks in Latin America and Europe were facing rising inflation pressure; inflation prints came in well above central bank targets last year, outpacing inflation forecasts. - Many central banks responded decisively and front-loaded policy tightening to maintain market confidence in their ability to meet their mandates—evidenced by the relative stability of longer-term inflation expectations. - Two notable exceptions where inflation expectations remain well above the inflation targets in the relevant policy horizon are Argentina and Turkey. - Market participants were pricing that central banks in Latin America and eastern Europe would be able to halt or even reverse earlier hikes within a one-year horizon on the back of an improvement in the inflation outlook. - Emerging market central banks face further inflation pressure as a result of the war in Ukraine and higher commodity prices. ### Revisions to Forecasts and Regional Heterogeneity - Relative to the January 2022 WEO Update, the inflation forecast for emerging market and developing economies for 2022 has been revised up 2.7 percentage points to 8.6 percent. - The GDP forecast for emerging market and developing economies for 2022 has been revised down 0.9 percentage point to 3.9 percent. - The war in Ukraine has had a larger impact on economies in central and eastern Europe, where a notable tightening of financial conditions has been accompanied by currency interventions and a shift to an even more hawkish monetary policy stance in some cases. - Commodity exporters across emerging markets, such as Brazil, Chile, and South Africa, have seen an improvement in their terms of trade and a relatively milder impact on financial conditions, providing central banks with more space to calibrate monetary policy to domestic developments. - Emerging market economies in Asia with limited direct links to Russia and Ukraine and a more benign inflation outlook have continued with more delayed and gradual policy normalization. - Some countries (example given: Egypt) have used the exchange rate as a shock absorber; other countries resorted to measures to stem outflows of foreign exchange (example given in source: Kazakhstan banned people leaving the country with more than $10,000 and imposed restrictions on gold and silver departures). ### Risks from Monetary Policy Normalization and Market Fragmentation - Central banks face a challenging trade-off between fighting multiyear-high inflation and safeguarding the recovery amid heightened uncertainty. - A disorderly tightening of financial conditions, especially interacting with financial vulnerabilities, could pose risks to financial stability and weigh on growth. - Clear communication on plans to unwind the unprecedented expansion of central bank balance sheets—in terms of timing, speed of reduction, and composition of both the asset and liability sides—will be crucial to avoid unnecessary market volatility. - The 2017–19 quantitative tightening (QT) experience highlights the risk of a sudden increase in term premia given the larger size of the Federal Reserve’s balance sheet and its footprint in some market segments. - With fiscal deficits and debt levels remaining relatively high in some euro area countries, additional fiscal stimulus is being considered to cushion the impact of the war in Ukraine (including future defense and climate spending), which could interact with the wind-down of asset purchases and contribute to tightening of financial conditions. ### Policy Implications and Recommendations - Front-load policy tightening where necessary to preserve central bank credibility and anchor longer-term inflation expectations. - Use the exchange rate as a shock absorber when appropriate and alongside other policy tools, recognizing trade-offs. - Communicate clearly and proactively about balance sheet normalization (timing, speed, composition) to avoid unnecessary market volatility and a disorderly tightening of financial conditions. - Monitor and address counterparty risk concerns, funding strains, and dollar-funding market stress to limit spillovers to emerging markets. - Account for heterogeneity across emerging markets: calibrate monetary and macroprudential responses to country-specific exposures to commodity shocks and direct trade links to Russia and Ukraine. *Italic: Source — text - 2. Financial Conditions: Emerging Markets (chapter excerpt) from the IMF Global Financial Stability Report, April 2022.* ### 1. Deviation from Target for Inflation ### 1. Deviation from Target for Inflation ### Financial-stability context and shock amplifiers - The war in Ukraine amplifies shocks across global markets and financial intermediaries through poor liquidity, lower risk appetite, rising counterparty risk concerns (for example, in relation to commodity financing and derivatives), and supply chain disruptions. - The prospect of a Russian default on government debt and the removal of Russian assets from global indices would have implications for emerging market capital flows. - Cyberattacks have become a first-order concern for financial institutions and policymakers. - These factors can operate as shock amplifiers and, in some cases, lead to severe market disruptions. ### Foreign banks’ direct exposures to Russia and Ukraine - As of the third quarter of 2021, claims of foreign banks on Russian residents totaled about $120 billion, with 60 percent in foreign currencies. - For Ukraine, exposures were $11 billion. - The vast majority of these exposures were held by euro area banks. - Market capitalization and equity impacts: - An index of European bank equity prices fell over 20 percent after February 24. - Equity prices of US banks dropped about 8 percent at the worst point. - The cost of equity (CoE) for European banks increased from 11 percent to 16.5 percent after the invasion, before recovering to modestly above the pre-invasion level. - Capital impact estimates: - Exit strategy (foreign bank exit from Russia) is estimated to reduce group-level common equity Tier 1 (CET1) ratio by an average of 20 basis points. - The impact is about four times larger for the most exposed bank. - If cross-border exposures are pulled back or experience some losses, the total impact could reach an average of 80 basis points (about 2½ times the impact for the most exposed bank). ### Indirect exposures and derivatives - Indirect exposures are harder to identify and assess and could be meaningful, surprising investors, and sharply raise counterparty risk and risk premia. - Sources of indirect exposures include investment banking and wealth management, derivatives (including commodity derivatives), off-balance-sheet exposures related to supply chain or commodity financing, and contingent liabilities and guarantees. - Commodity derivative exposure from euro area banks that are designated as significant institutions stood at 52 million euros, according to an ECB assessment as of March 15, 2022. - Foreign exchange swap and forward contracts involve exchange of notional amounts and are akin to collateralized lending; gross positions matter for counterparty and settlement risks, especially if foreign currency settlement is restricted. - Russian banks had around $220 billion US dollar deposits as of the end of September 2021, according to Bank for International Settlements locational banking statistics. - The total gross notional amount of over-the-counter foreign exchange swaps and forwards between Russian banks and foreign dealer banks amounted to about $69 billion at the end of 2021. - Over-the-counter interest rate derivatives outstanding amounts are generally lower than foreign exchange gross notional amounts and clearing requirements help contain counterparty risk exposures. ### Nonbank financial intermediaries (NBFIs) and investment funds - Foreign NBFIs had sizable investments in Russian assets as of Q4 2021: - Held about one-fifth of Russia’s total sovereign debt. - Held about one-half of Russia’s corporate debt. - Held more than 40 percent of Russian equities. - Open-end investment funds (OEFs): - OEFs have exposures to Russian equities of about $100 billion, the vast majority held by US funds. - OEFs have a combined $34 billion in fixed-income assets linked to Russia, about two-thirds of which is held by European funds. - As a share of total assets, exposures are small; for European funds aggregate exposures are less than 2 percent of funds’ assets. - Fund-type patterns: - Emerging-market-dedicated funds hold the vast majority of Russian debt and equity within OEFs, but have been cautious since 2014. - Emerging-market-dedicated funds reduced their share of Russian debt from over 10 percent prior to 2014 to just over 4 percent in 2022. - Global equity funds had an average 0.2 percent of assets invested in Russian debt in 2022. - Russian exposure in emerging-market-dedicated funds stood at 4 percent of total assets before the invasion; for global equity funds it was less than 0.2 percent. - Post-invasion dynamics: - The very sharp drop in valuations of Russian assets since the invasion dramatically reduced the market value of investment funds’ exposures to Russia. - Some regulators have started to consider options to isolate Russian assets from broader portfolios by allowing the separation of the Russian exposures into so-called side pockets, which are portfolio tranches exclusively owned by affected investors. *Source: https://www.imf.org/-/media/files/publications/gfsr/2022/april/english/text.pdf* ### CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE ### CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE ### Investor exposures, valuation challenges, and market access - Some NBFIs, such as specialized insurers and leasing companies, may face greater risks in cyber underwriting, trade credit, and aircraft leasing. - Cyber insurance is estimated at $8 billion globally and has experienced rapid growth amid concerns about the uncertainty of expected losses. - Aircraft leasing companies, many domiciled in Ireland, are exposed to potential large losses if Russia refuses to return leased aircraft. - Foreign providers of trade credit are exposed to Russia, with an estimated $16 billion of trade credit as of the last quarter of 2021. - Foreign sanctions, capital controls, and retaliatory measures have increased risks for foreign investors in Russian securities; actions by Russian and other international securities depositories (ICSDs) and the freezing of some of Russia’s international reserves have made payments more difficult. - At the time of writing, Russian authorities continued servicing Russia’s foreign law debt in hard currency but suspended transfer of payments to foreigners on local law ruble-denominated bonds. - Foreign law bonds and CDS do not contain cross-default terms with local law bonds, limiting immediate complications for foreign law debt (Figure 1.14, panel 1). - Further sanctions could prevent bonds from trading in the secondary market, which would hamper the CDS settlement process. - Some foreign investors hold non-deliverable forwards (NDFs) that settle in dollars but use the onshore foreign exchange rate as the reference rate; Russian and Ukrainian onshore rates have been tightly controlled (Russian central bank) or not updated (Ukrainian central bank), causing divergence between onshore and offshore exchange rates and rendering NDFs ineffective hedges (Figure 1.14, panel 2). - Sanctions and valuation differences between onshore and offshore markets can be problematic for foreign banks with foreign exchange derivatives exposures vis-à-vis Russian banks. ### Index exclusion, reallocation, and benchmark effects - The reduced investability of Russian assets led to their exclusion from multiple benchmark indices used by emerging-market-dedicated funds. - Global bond benchmarks rely on Russia maintaining an investment-grade rating, which is no longer the case; ESG-related indices have also excluded Russian assets. - Ukraine’s inclusion in the JPMorgan Government Bond Index-Emerging Markets (GBI-EM) index family, scheduled for March 31, 2022, is subject to further review given current circumstances. - Benchmark-driven investors are a key source of intermediating cross-border flows to emerging markets; index exclusion adds to price pressures and illiquidity. - Russia’s median weight across major indices dropped from 10 percent during the global financial crisis to just 3 percent before the Russian invasion of Ukraine, and less than 1 percent immediately thereafter, largely due to valuation declines (Figure 1.15, panel 1). - Index exclusion of Russia could lead to positive portfolio reallocation flows to other emerging markets as their benchmark weight mechanically increases. - Historical precedent: the 2014–15 Russian annexation of Crimea led to foreign investor exit from Russian local assets while foreign ownership in other high-yielding emerging markets rose (Figure 1.15, panel 2). - JP Morgan’s March 2022 client survey showed that nearly half of participants plan to divest as much of their Russian debt holdings as possible and hold the rest off-index, while nearly a quarter plan to continue investing. ### Commodity price volatility, trade finance, and derivatives exposures - The war in Ukraine, sanctions, market participants’ actions, and rising counterparty risk have caused severe disruptions in commodity markets and supply chains. - Prices have skyrocketed across the commodity complex amid sharply rising volatility, causing severe pressures in commodity financing and derivatives markets. - Shipping costs of commodities have increased, raising the financing needs of commodity traders and supply-chain participants. - Users of commodity derivatives (including commodity producers using futures or options for hedging, commodity trading firms, dealer banks, levered investors, and investment funds) have faced massive margin calls on short positions due to huge swings in commodity prices. - Dealer banks play a crucial role: they provide collateralized funding to finance shipment of commodities, provide leverage to some investors, and act as intermediaries in commodity derivatives markets. - Dealers often take the opposite side of producers’ hedges and then hedge their books (for example, on an exchange); in the event of sharp price increases, dealers can face margin calls and may be caught with unhedged exposures if producers cannot meet margin calls. - Differences in initial margin modeling and prevalence/frequency of posting variation margins may incentivize some derivative users to trade bilaterally with broker dealers instead of centrally cleared trades, potentially exposing dealer banks to higher margin calls than they receive from clients. - Liquidity risk may morph into counterparty credit risk, lowering dealers’ balance sheet capacity and raising the cost of intermediation across multiple markets. - Concentration and interconnectedness are concerns: the number of dealer banks active in commodity markets has declined, and a small group of large energy trading firms—largely unregulated, mostly privately owned, and highly reliant on dealer bank financing—represent concentrated exposures. - Available data suggest investors are growing concerned about credit availability and liquidity positions of commodity trading firms amid large commodity price moves (Figure 1.16, panels 1 and 2). - Strains in commodity markets can affect end users (commodity producers and consumers); banks may become less willing to finance shipments and hedging costs may become prohibitively expensive for some producers. - In the event of default on a derivatives contract by a counterparty, smaller clearing members of exchanges may face default risk themselves, adding system strains. ### Liquidity, funding risks, and market functioning - Short-term dollar funding market tensions have been limited so far but are beginning to emerge. - In US unsecured money markets, LIBOR-OIS and FRA-OIS spreads have widened since the announcement of sanctions, but remain well below levels seen in early 2020. - Issuance of financial and nonfinancial commercial paper has risen, leading to increased borrowing costs (Figure 1.17, panel 1). - Secured US money markets (repo) have not displayed signs of stress thus far. - International dollar funding conditions, as measured by the cross-currency swap basis, have tightened since late February, but spreads remain well below pandemic levels (Figure 1.17, panel 2). - Actions to freeze the Central Bank of Russia’s reserves and disconnect a number of Russian banks from SWIFT have been mentioned as contributors to spread widening, though the overall impact on dollar funding markets has been relatively modest to date. - Bid-ask spreads of high-quality government bonds are the widest since the peak of the COVID-19 crisis, reflecting divergence from fair value models and traders’ unwillingness to provide liquidity (Figure 1.17, panel 3). - Rising risk aversion, severe commodity market disruptions, and perception of rising counterparty risk may be starting to weigh on dealer banks’ balance sheet capacity and appetite for intermediation, with implications for liquidity, funding conditions, and broader market functioning. *Source: CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE (text - CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE).* ### 4. Liquidity Indices: Root Mean Square Error of the Fitted ### 4. Liquidity Indices: Root Mean Square Error of the Fitted ### Market liquidity and government bond markets - Market liquidity of high-quality government bond markets has deteriorated based on multiple metrics. - Price-based liquidity metrics that have worsened include bid-ask spreads and fitting errors of yield curve models (root mean square error between fair-value model yields and actual Treasury yields). - Market-makers’ unwillingness to hold inventories in a higher volatility environment is cited as a driver of worse liquidity metrics. - Further deterioration could amplify a repricing of duration risk and increase the risk of tighter funding conditions due to the link between market liquidity and funding liquidity. ### Financial system resilience and central bank backstops - Despite higher volatility and some strains in funding markets, there are no signs of the “dash-for-cash” dynamics seen in March 2020; the financial system appears more resilient. - Global liquidity remains at record high levels in advanced economies. - Banks are described as better capitalized and more liquid, with a large surplus of reserves. - Central bank tools available to alleviate funding stresses include: - Activation of standing swap lines between central banks. - Government paper repo lines such as the US Federal Reserve’s standing repo facility (SRP) and the Foreign and International Monetary Authorities (FIMA) repo facility. - The ECB’s Eurosystem repo facility for central banks. - Usage statistic: The usage of the US Federal Reserve reverse repo facility as of March 25 stood at a level similar to February 23 ($1.7 trillion). ### Cyber risks and operational threats - The war in Ukraine has raised acute concerns about cyber operations; cyberattacks targeting Ukraine date back several years. - Historical estimate: The 2017 NotPetya malware attack caused worldwide losses estimated at about $10 billion. - Recent coordination of attacks has included disruptions to banks’ online services combined with text message (SMS) disinformation campaigns. - Potential impacts of successful attacks on systemically important financial institutions include loss of confidence in the broader financial system and adverse impacts on global financial stability. - Cyber threats against SWIFT and other shared financial and non-financial market infrastructure could increase; intense hacktivism and false-flag operations complicate attribution and escalation risks. - Operational costs have increased across industries with potential for significant economic loss. ### Corporate sector risks and repricing of risk - The war clouds the corporate outlook, with firms in Russia most at risk due to trade barriers, lack of intermediate inputs, and depressed domestic demand. - More than 60 percent of Russia’s external debt of close to $500 billion is owed by nonfinancial firms. - European firms have the largest direct exposures to Russia and Ukraine as measured by revenues from the region; many large European firms have exposures above 2 percent of revenues. - Share of debt at firms with substantial exposures (above 5 percent of revenues) is less than 10 percent of the total debt of all firms in these sectors. - Since the invasion, most large international companies have announced exits of various types from Russia. - Analysts initially maintained a positive earnings outlook for 2022 (except airlines) with 2022 earnings projected to be well above pre-pandemic levels, but analysts have started to substantially downgrade earnings forecasts across sectors other than energy. - A prolonged war, escalation of sanctions, higher commodity prices, or increased investor risk aversion could further worsen the corporate outlook and funding conditions. - Risks in risky credit markets: - Spreads on high-yield bonds and leveraged loans have widened in advanced economies and are now slightly above pre-pandemic levels. - Outflows have accelerated from high-yield bond funds; new issuance has slowed. - Issuance in the collateralized loan obligation (CLO) market has decelerated; spreads have increased in both secondary market leveraged loans and CLO tranches. - Weaker underwriting standards and thinner loss-absorbing buffers noted in recent years (weaker covenants, reduced first-lien protections). - Tighter monetary policy raises interest costs for leveraged loan issuers and could pressure debt servicing capacity. ### Emerging markets: spreads, issuance, and differentiation - Emerging market hard currency spreads widened rapidly after the Russian invasion of Ukraine: - Credit spreads moved as much as 113 basis points higher—or 84 basis points excluding Russia and Ukraine—after the war started. - The number of issuers trading at distressed levels surged to nearly 25 percent of issuers, surpassing pandemic-peak levels. - The deterioration in spreads combined with higher US yields has pushed financing costs well above pre-pandemic levels for many borrowers. - Emerging market sovereign issuance has been sluggish and has practically disappeared since the start of the war. - High-yield issuance share dropped notably since Q3 2021, including a nearly four-week freeze following the escalation of hostilities. - Market reopenings: Nigeria and Turkey reopened the market on March 17, 2022, with substantial premiums and coupons over 8 percent. - Commodity exposures and trade linkages to Russia and Ukraine drive differentiation: - Commodity exporters have generally outperformed in 2022 in credit and equity markets. - Lower-rated commodity importers have experienced significant spread widenings. ### Portfolio flows, capital flows at risk, and downside scenarios - After a challenging end to 2021, flows into emerging market local currency debt and equities strengthened in early 2022 before reversing following the invasion. - The first signs of differentiation in flows emerged: commodity beneficiaries (e.g., Brazil and Indonesia) saw large equity inflows, while energy importers saw sharp equity outflows. - Technical factors amplified outflows in some markets (for example, reported large monthly outflow in Chinese sovereign bonds in February as fund managers raised cash). - IMF staff analysis of downside risks: - Capital flows at risk (the 5th percentile of capital flow forecasts) increased to 2.3 percent of GDP from 1.7 percent of GDP in the October 2021 GFSR. - The probability of outflows rose to about 30 percent from 20 percent in the October 2021 GFSR. - A risk aversion shock similar to March 2020 would take capital flows at risk to 2.5 percent and increase the probability of outflows to almost 50 percent. - A sharp rise in US term premia combined with a further rise in risk aversion would entail more significant financing risks, especially for countries with lingering inflation risks and/or elevated debt vulnerabilities. *Source: IMF staff analysis in "GLOBAL FINANCIAL STABILITY REPORT: ShOCkwAvES FROM ThE wAR IN UkRAINE TEST ThE FINANCIAL SYSTEM’S RESILIENCE" (April 2022).* ### CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE ### CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE ### Crypto Asset Markets, Sanctions, and Financial Integrity - Tether—the largest stablecoin used to settle spot and derivative trades—has seen a notable rise in trading volumes against emerging market currencies; the share of Tether volumes against EM currencies has been rising since the pandemic began. - The ruble and hryvnia have seen a spike in crypto trading volumes in centralized exchanges; however, liquidity in the ruble and hryvnia trading pairs in centralized exchanges remains limited and has even declined more recently in the case of ruble, making large-scale transfers of value through crypto asset exchanges impractical. - The crypto ecosystem could allow users to circumvent sanctions and capital flow management measures through several means: - use of exchanges and other crypto asset providers that are non-compliant with sanctions and/or capital flow management measures; - poor implementation of adequate due diligence procedures by crypto asset providers; - use of technologies and platforms that increase the anonymity of transactions (such as mixers, decentralized exchanges, and privacy coins). - Regulators in the United States and United Kingdom, among others, have urged firms in their jurisdictions, including the crypto asset sector, to increase vigilance with regard to potential Russian sanction evasion attempts. - Mining could be used by sanctioned countries to monetize energy resources directly on blockchains, outside the financial system where sanctions are implemented; miners can also generate revenues directly from users that pay transaction fees to miners (which in this case might be sanctioned governments). - Magnitude of current mining-related flows appears relatively contained: - monthly average of all Bitcoin mining revenues last year was about $1.4 billion, of which Russian miners could have captured close to 11 percent, and Iranian miners, 3 percent. - Evidence reviewed (Chainalysis (2022)) did not show a sustained spike in volumes at the time of writing. ### Financial Vulnerabilities in China: Property Development Sector and COVID-19 Risks - Concerns about a sharper-than-anticipated growth deceleration in China amid elevated financial vulnerabilities have weighed on the global economic outlook. - Chinese equity prices have slumped, particularly in the tech sector, amid new outbreaks of COVID-19 and worsening investor sentiment, reflecting continued regulatory uncertainty and rising geopolitical risks. - The property development sector is under severe financing strain, generating spillovers to housing sales, real estate investment, and land sales. - Property developers have nearly $215 billion in debt outstanding in offshore US dollar bond markets. - Credit availability has deteriorated for some corporate borrowers, notably home builders, whose offshore US dollar bonds have slumped by more than 50 percent since the second half of 2021. - Property developers have relied heavily on presales of unfinished properties as a key source of funding; disruptions to completing presold housing could reinforce market pressures: - the large stock of presold but unfinished housing has grown rapidly and is nearly equivalent to the size of all private housing completed since 2015. - nearly half of presale liabilities are owed by “developers-at-risk,” defined as those with liquidity shortfalls. - Definitions and measurement notes: - Liquidity shortfalls are defined as cash being less than combined net current liabilities, net interest payment, and contractual capital commitments. - In panel 1 of Figure 1.22, the estimated increase in cash escrow requirements is calculated as the lesser of 20 percent of unearned revenues or 40 percent of unearned revenues less restricted cash. - In panel 2 of Figure 1.22, developers considered at risk have insufficient cash to cover net current liabilities (including net interest payments and contracted capital commitments) or net current liabilities and an estimated increase in cash escrow requirements as calculated in panel 1. Data for 2021 are from end-June. - Macro-financial spillover channels from property sector stress: - A correction in property prices could be triggered by prolonged dislocations in new home sales; prices appear stretched across the country, with inventory overhangs significant in smaller Tier 2 and Tier 3 cities. - Property developers’ financial strains are likely to add to the fiscal pressures of local governments, constraining financing conditions for vulnerable firms dependent on local authorities’ support; land sales, a sizable share of local governments’ gross funding, are falling sharply. - Rising defaults by property developers could impair balance sheets across the broader private sector, weighing on credit intermediation and aggregate demand. - Aggregate exposures and at-risk liabilities: - Aggregated total liabilities of property developers with publicly available data are nearly 25 percent of GDP, with roughly half of that attributable to those with liquidity shortfalls (defined as “liabilities-at-risk”). - Roughly half of these liabilities-at-risk, or about 6 percent of GDP, are owed to business partners and homebuyers, with the other half owed to financial institutions. - Policy actions taken and recommended: - Chinese authorities have taken steps to ease property sector financing controls, lower policy interest rates, and increase fiscal spending. - Exceptional financial support measures may be necessary to ease balance sheet pressures but would add further to medium-term debt vulnerabilities. ### Energy Security, Commodity Markets, and the Climate Transition - The Russian invasion of Ukraine, ensuing sanctions, and market participant actions have pushed commodity prices higher across the entire complex; given Russia’s large footprint in global commodity production, not only oil and gas prices, but also widely used metals (including those used for renewables), have increased sharply. - The war has crystallized concerns about energy security and the trade-off between energy security and the energy transition; there is a risk that the transition toward renewables may become more costly, complex, and disorderly. - Policy imperative: it is crucial that policymakers intensify their efforts to achieve net-zero targets and lever up private finance to accelerate the transition toward a greener economy. - European energy dependency specifics: - Europe relies on Russia for roughly 40 percent of its consumption of natural gas and for more than 50 percent of thermal coal. - Renewable energy currently accounts for only 22 percent of energy consumption in Europe. - Responses and challenges: - Europe is rethinking its energy landscape (for example, through the REPower EU agenda). - Physical bottlenecks are significant in switching to coal-fired power generation; diversification strategies (increasing imports from Asia, Australia, and the United States) will take time amid rising global energy demand and supply constraints. - Some countries have indicated intentions to switch to domestic coal-fired power generation and fossil fuel production in the short term; the energy crisis is likely to weigh on the speed of phasing out fossil fuel subsidies in emerging market and developing economies and could delay decommissioning plans for coal-fired power plants in major coal-exporting countries (Australia, Indonesia, South Africa, United States). - Rising inflation pressure may lead authorities to resort to subsidies or other fiscal support to households or firms, with the risk of delaying climate transition plans. - Scenario and capacity notes referenced in Figure 1.24: - Commodity price changes and production shares are highlighted, and scenarios include “Net zero by 2050 (additional capacity)”, “Accelerated case (additional capacity)”, and “Main case” versus actuals. *Italic: IMF — Global Financial Stability Report: Shockwaves from the War in Ukraine — CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE* ### 1. Russia’s Share in Global Production and Price Change since the ### 1. Russia’s Share in Global Production and Price Change since the Start of the War ### Renewable energy deployment, commodity constraints, and market performance - Buildup of renewable energy infrastructure will require time and is likely to face headwinds amid rising prices and supply disruptions of critical commodities (such as cobalt, palladium, and nickel). - Increased focus on energy security appears to have adversely affected the performance of clean energy indices relative to fossil fuels despite: - strong investor demand for low-carbon assets, and - a substantial decline in renewable energy costs in recent years (Figure 1.24, panel 3). - Renewable energy supply remains limited amid a shortfall in renewable energy investment (Figure 1.24, panel 4). - IEA forecasts shown for 2026: - main case = base case scenario, - accelerated case = more optimistic scenario, - Net-zero by 2050 case = estimates capacity needed to transition to a net-zero energy system by 2050. - Figure labels and time points present in the source (verbatim as in figures): Apr. 16, Apr. 21, Aug. 16, Aug. 20, Nov. 19, July 19, Feb. 19, Oct. 18, June 18, Jan. 18, May 17, Dec. 20, Dec. 2015, Dec. 16, Jan. 22, Mar. 20, Sep. 21, Sep. 17, and years 2005 2010 2015 2021 shown on axes. - Commodities explicitly mentioned in figures and text: Aluminum, Copper, Nickel, Platinum, Coal, Oil, Gas. ### Geopolitics, reserves composition, and payment infrastructures - Swift imposition of sanctions and immobilization of the assets of the Central Bank of Russia raise questions about whether the composition of exchange rate reserves will change. - Possible diversification away from the US dollar and currencies of advanced economies has been discussed; potential beneficiaries noted include: - the Chinese renminbi, - commodities, - potentially crypto assets. - Historical evidence: composition of currencies held by central banks has remained largely steady over decades; reserve compositional changes described as glacial in pace (Iancu and others 2020). - Medium- to long-term drivers that could prompt reserve rethink: - geopolitical shifts, - technological changes, - increased issuance of debt in currencies of emerging creditors (such as China), - shifts toward localized production reducing demand for international currencies, - increased attractiveness of alternative reserve currencies through leveraging digital technology. - Sharing common payment infrastructures has strong welfare effects but risks single points of failure and potential loss of efficiency if parallel/fragmented systems develop. - Current landscape: only a few international payment message providers other than SWIFT; CIPS users still rely partly on SWIFT. - Risk of competing “CBDC blocs” with fragmentation across technology and design, reducing cross-bloc compatibility for cross-border payments. - IMF/G20 context: ongoing international collaboration to increase compatibility and improve cross-border payments (FSB 2020). ### Financial markets, commodity markets, and market infrastructure governance - Surge in commodity price volatility and supply disruptions heighten importance of: - accurate disclosures and transparency standards for counterparties (especially dealer banks), - robust risk management (margining, stress testing) for concentration, market, and credit risks. - Margin calls to date "appear to have been generally orderly and not disruptive to market functioning," but recent exchange measures highlight broader implications. - Commodity markets operate differently from securities markets; trading disruptions can exert significant adverse impacts on the real sector. - Exchanges and central counterparty clearing houses should ensure robustness and resilience of information technology systems under current trading conditions. - Governance mechanisms for the LME need strengthening to address conflicts of interest and concentration of trading. - Supervisors and regulators should consider enhancing transparency in exchange-traded and over-the-counter markets to preempt buildup of concentrated positions and limit financial stability implications. - Recent developments on the nickel market on the London Metal Exchange (LME) suggest lessons for policymakers: - The stated objective of cancellation of trades by the LME was to stabilize the nickel market, but counterparties with long positions were disadvantaged. - Reported concerns that cancellation and price change limits may harm market confidence and participation, risking migration to uncleared over-the-counter derivatives, which are more opaque and lack comparable counterparty risk mitigation. - Footnote in source: On April 4, 2022, UK regulators announced a review of the LME’s approach to managing the suspension and resumption of the market in nickel.47 ### Cyber risk, crypto assets, and nonbank financial intermediation (NBFI) - Geopolitical tensions increase cyber risks; imperative to incorporate cyber risk into financial stability analysis. - Priorities: - ensure cyber regulation and supervision are fit for purpose, - improve response and recovery capacity to resume operations quickly after attacks, - enhance information-sharing and incident reporting frameworks, - help emerging market economies build cybersecurity capacity, - step up international efforts to prevent and deter attackers. - Crypto and capital flow management: - Policymakers need a multifaceted strategy to preserve effectiveness of capital flow management measures in the context of increasing crypto asset use. - Essential steps include developing a comprehensive, consistent, and coordinated regulatory approach to crypto assets, establishing international collaborative arrangements for implementation, addressing data gaps, and leveraging technology ("regtech" and "suptech"). - Implementation of Financial Action Task Force standards is key to mitigating financial integrity risks and illicit capital flows. - Laws and regulations for foreign exchange and capital flow management measures should be reviewed and amended if necessary to cover crypto assets even if they are not classified as financial assets or foreign currency. - Broader discussion of policy recommendations referenced in October 2021 GFSR and He and others (forthcoming).48 - Nonbank financial intermediation: - Urgent need to develop appropriate macroprudential tools to address risks from NBFIs given their growing role in the financial system and cross-border capital intermediation. - IMF working with the Financial Stability Board and standard-setting bodies to develop these tools. ### Monetary, macroprudential, and fiscal policy recommendations - Monetary policy: - Central banks face a trade-off between fighting persistent inflation and safeguarding the recovery while avoiding disorderly tightening of global financial conditions. - Higher policy interest rates and unwinding of pandemic-related balance sheet policies will lead to tighter financial conditions—an intended objective to slow aggregate demand. - With inflation expected to remain stubbornly high and significantly above target in many advanced economies, central banks should act decisively to prevent inflation pressures becoming entrenched and to avoid an unmooring of inflation expectations. - Central banks in advanced economies will need to normalize the monetary policy stance at a faster pace than anticipated only a few months ago to bring inflation credibly back to target. - Policymakers should provide clear guidance about the policy normalization process while remaining data dependent. Guidance should include the expected path of policy rates and anticipated unwinding of pandemic-related asset purchases. - Consider a faster pace of balance sheet normalization given significant accommodation still in place (as evidenced by still meaningfully negative real rates in many advanced economies). - Emerging market economies: - Remain vulnerable to tightening of global financial conditions. - Many central banks have already significantly tightened policy, most notably in Latin America and eastern Europe. - Further rate increases or other policy normalization should continue as warranted by country-specific inflation and economic outlooks and persistence of commodity price increases to anchor inflation expectations and preserve policy credibility. - In countries where inflation has surprised on the upside and there are tangible risks of persistent price pressures that put central bank credibility at risk, a more frontloaded and decisive monetary policy response is needed. - Abrupt and rapid increases in US rates could lead to significant spillovers to some emerging and frontier markets, adversely affecting the recovery and widening the gap with advanced economies. - Macroprudential policy: - Policymakers should take targeted actions to contain buildup of financial vulnerabilities during normalization, including tightening selected macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding disorderly tightening of financial conditions. - If such tools are not available (for example, in NBFI), policymakers should urgently develop them. - Balance between containing vulnerabilities and avoiding procyclicality is important given uncertainties from the war in Ukraine, monetary policy normalization, and fiscal limits post-COVID-19. - Fiscal policy: - Tailored and agile fiscal policy responses are warranted amid heightened uncertainty and marked divergence across countries (see April 2022 Fiscal Monitor reference in source). - Economies hardest hit by the war will need fiscal measures addressing humanitarian crises and economic disruption. - Given rising inflation and interest rates, fiscal support should be targeted to those most affected and to priority areas. - In many emerging markets and low-income economies, prudence is required; fiscal support should be focused on those hardest hit by higher commodity prices and where recovery was already weaker. - To alleviate burdens of higher food and energy prices, governments should provide targeted, temporary, and direct support to vulnerable households while allowing domestic prices to adjust. - Energy and climate policy: - While addressing energy security concerns raised by the war, policymakers should intensify efforts to implement the COP26 roadmap to achieve net-zero targets. - Actions include increasing availability and lowering cost of fossil fuel alternatives and renewables, improving energy efficiency, and scaling up private finance in the transition to a greener economy. - Strengthen the climate finance information architecture to: - improve availability of high-quality, consistent, and comparable climate-related data, - develop science-based classifications for climate finance to align capital flows with net-zero goals, - implement global climate-related disclosure standards that involve transition plans. *Source: CHAPTER 1 — THE FINANCIAL STABILITY IMPLICATIONS OF THE WAR IN UKRAINE, International Monetary Fund | April 2022.* ### CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE ### CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE ### Emerging and frontier market vulnerabilities and policy imperatives - Authorities in emerging and frontier markets need to safeguard against risks related to tighter external financial conditions. - Countries with stronger fiscal positions and clearer policy frameworks will be better positioned to manage tighter conditions. - There is a need to rebuild fiscal policy space and retire extraordinary crisis measures where possible, especially in some commodity-exporting economies that have seen an improvement in terms of trade and experienced positive growth surprises. - Given the significant volatility in financial markets since the start of the war in Ukraine, appropriate use of foreign exchange intervention measures may be needed, as long as they do not prevent credible macroeconomic policies and necessary adjustments. - In cases of crises or imminent crises, capital flow management measures may be an option for some countries to limit outflow pressures. - For weaker sovereign borrowers, enhanced efforts to contain the risks from high debt and weak recovery should continue, including via multilateral cooperation and decisive support from the international community. ### Corporate sector risks and fiscal support guidance - The corporate sector outlook has deteriorated since the Russian invasion of Ukraine, including as a result of the surge of energy and raw material prices. - Corporate balance sheets have continued to strengthen, benefiting from unprecedented policy support and the ongoing economic recovery, but smaller firms may be less resilient and more exposed to a tightening in financial conditions and a more stringent lending posture by banks. - Solvency risk has remained elevated for small firms in some countries. - Direct government support to firms may be needed to prevent the risk of a wave of bankruptcies; such support should: - depend on firms’ viability and available fiscal space, - be limited to circumstances in which there was clear market failure. - Policymakers should continue to undertake structural measures, including strengthening insolvency frameworks via a fast-track process. - Supervisors should take a comprehensive view of risks in risky credit markets, intensify monitoring, and enforce sound underwriting standards and risk management practices at banks and non-bank financial intermediaries active in these segments. - Supervisors should ensure that more comprehensive stress tests—incorporating macro-financial feedback effects from high corporate sector indebtedness, as well as correlated risks in related sectors (such as commercial real estate)—are conducted for banks and non-bank financial intermediaries with significant corporate exposures. ### Extreme volatility in commodities: the nickel trading suspension (Box 1.1) - Events and market actions: - The London Metal Exchange (LME) suspended trading in the nickel market for six trading days after the three-month nickel forward price skyrocketed on March 8, 2022. - The LME suspended trading, canceled all contracts executed on the morning of March 8, and deferred physical delivery of maturing contracts, citing orderly market grounds. - Trading resumed on March 16 under daily price change limits, which were hit and widened various times. - To contain market volatility, the LME imposed daily price limits on other base metals and on March 24 prohibited the submission of orders outside the daily limit. - Market concentrations and positions: - One of the world’s largest nickel producers, Tsingshan Holding Group, reportedly had large short futures positions (approximately 150,000 tons, of which about 30,000 tons were on the LME and the rest were bilateral over-the-counter [OTC] exposures with various banks). - If margins are not posted or contracts are canceled on derivatives markets, large banks acting as dealers are left with open risk positions. - Dealer banks typically hold small net positions but very large gross positions (about 1 million metric tons in long and short positions) as they act as intermediaries in the nickel and many other derivatives markets. - Several large dealer banks were reportedly left with open short positions after March 8 due to unpaid margins. - Market functioning and spillovers: - Commodity producers typically hedge against price declines; as prices increased rapidly, counterparties (including Tsingshan) were apparently unable to post the necessary margins with brokers at the LME and for OTC positions with banks. - Suspension of trades wiped out profits of those on the long side and led to widespread criticism from market participants. - The current volatility can create serious market functioning problems: typical daily price moves are only a few percentage points, enabling substantial hedging across maturities; the March 7 price increase exceeded what traders had hedged against. - An impairment of derivatives markets may ultimately spill over into strained availability of commodities and create liquidity stress and concerns about counterparty risk that may spill over to other corners of the financial system. - Market data notes: - All call options outstanding on March 4, 2022, were “in-the-money” at prices prevailing on March 7/8, 2022. - Options have a maturity of maximum two years but mature mostly in 2022. ### The sovereign-bank nexus in emerging markets: key developments and risks - Public debt and bank sovereign exposures: - The average public-debt-to-GDP ratio in emerging markets surged to a record 67 percent in 2021 from about 52 percent before the pandemic. - Banks’ domestic sovereign debt exposure increased relatively more in emerging markets, reaching 17 percent of total banking sector assets in 2021. - Drivers and transmission: - Additional government financing needs have been met mostly by domestic banks amid declining foreign participation in local currency bond markets and a generally limited domestic investor base. - The linkages between the financial health of the sovereign and banking sectors—the sovereign-bank nexus—have intensified in these economies. - The relationship has become more complex as interdependencies with the real sector have deepened due to unprecedented policy measures to support firms (accommodative monetary policy, fiscal measures such as cash transfers, equity injections, loans, and guarantee programs). - Fiscal support to firms during the pandemic: - In emerging markets, the discretionary fiscal response to the pandemic averaged about 10 percent of GDP during 2020–21—of which 6 percent consisted of additional spending and forgone revenues and 4 percent consisted of equity, loans, and guarantees. - The corporate sector has become highly dependent on the continuation of policy support in cases where the economic recovery has yet to firmly take hold and corporate vulnerabilities are high. - Charted magnitudes and descriptive data: - Public debt is presented in real terms, in trillions of chained 2010 US dollars (panel references in source). - Banks’ sovereign exposure corresponds to claims on central government debt divided by total banking sector assets. - Change in local currency sovereign bond holdings measured in billions of US dollars, cumulative change since end-2019. - For 2021, fiscal support and the corporate-debt-to-GDP ratio shown correspond to September data. ### Policy options and regulatory considerations - Country-level policy response (tailored to circumstances) should include: - Better targeting of spending and strengthening of medium-term fiscal frameworks in countries with limited fiscal space and tight borrowing constraints to build resilience and mitigate the impact of an adverse shock. - Rebuilding fiscal policy space and retiring extraordinary crisis measures where possible. - Preserving bank resources to absorb losses by restricting capital distribution where needed. - Conducting bank stress tests by taking into account the multiple channels of the sovereign-bank nexus. - Examining options to weaken the nexus—such as capital surcharges on banks’ holdings of sovereign bonds above certain thresholds—once the economic recovery has taken hold and pandemic-related financial sector support measures have been withdrawn. - Continuing efforts to foster a deep and diversified investor base to strengthen market resilience in countries with underdeveloped local currency bond markets. - Supervisory and international actions: - Supervisors should intensify monitoring, enforce sound underwriting standards and risk management, and ensure comprehensive stress testing for banks and non-bank financial intermediaries with significant corporate and sovereign exposures. - Given that risks from the sovereign-bank nexus are not limited to emerging markets, the Basel Committee on Banking Supervision could consider resuming efforts to develop international standards that reflect a more risk-sensitive regulatory and supervisory treatment. - To foster market discipline, banks should be mandated to disclose data on all material sovereign exposures. *Source: CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE, text - CHAPTER 1 ThE FINANCIAL STABILITY IMPLICATIONS OF ThE wAR IN UkRAINE (PDF).* ### CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE ### CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE ### Emerging market fiscal and financing vulnerabilities - Growth prospects are generally weaker relative to the pre-pandemic trend in emerging markets compared with advanced economies (see the April 2022 World Economic Outlook). - Governments’ fiscal space is more limited in emerging markets, with a higher debt-servicing burden (Figure 2.2, panel 1). - The public-debt-to-GDP ratio is projected to continue to grow in several emerging markets over the medium term, while it is expected to decline in advanced economies (Figure 2.2, panel 2). - Refinancing risks are higher in emerging markets because of: - shorter average maturity profile of public debt (October 2021 Fiscal Monitor); - a higher share of public debt denominated in foreign currency (especially in US dollars) (Figure 2.2, panel 3); - rising sovereign spreads amid a worsening sovereign credit outlook (Figure 2.2, panels 4–5). - Local currency government bond yields have increased for most emerging markets recently as foreign participation declined and central banks tightened monetary policy amid rising inflationary pressures (Figure 2.2, panel 6). ### How shocks can trigger an adverse sovereign–bank feedback loop - A sharp tightening in global financial conditions (for example, monetary policy normalization in advanced economies and intensifying geopolitical tensions) could: - push emerging market borrowing costs higher; - trigger adverse feedback between sovereign and banking sectors through multiple channels. - Specific transmission examples noted: - with public debt already elevated, higher sovereign borrowing rates could fuel debt sustainability concerns and adversely affect banks’ funding conditions and balance sheets through their exposure to sovereign debt. - countries whose banks are more exposed to sovereign debt tend also to have a higher public-debt-to-GDP ratio and lower bank capital ratios (Figure 2.3, panels 1 and 2). - tighter borrowing constraints could reduce governments’ ability to support banks through implicit or explicit guarantees (the safety net), increasing stress in the banking sector and raising the need for fiscal support, further weakening the sovereign balance sheet. - widening sovereign spreads amid constrained fiscal space could lead to withdrawal of policy support to the real economy, hurting growth and intensifying bank losses that magnify sovereign stress. - Domestic shocks (for example, weaker-than-anticipated recovery, spread of new COVID-19 variants) could similarly worsen public finances, raise sovereign funding costs, and increase corporate bankruptcies, undermining banks’ capital adequacy and lending willingness. ### Conceptual framework: three key channels connecting sovereigns and banks - Sovereign exposure channel: - Direct exposure of banks to sovereign risk through holdings of government debt. - A rise in sovereign spreads reduces market value of government debt banks hold and use as collateral, increasing funding costs and liquidity strains and potentially restricting lending. - Safety net channel: - Government support (implicit and explicit guarantees) provides funding benefits to banks; sovereign stress can reduce these benefits and increase the probability that guarantees are activated, straining fiscal accounts. - In some emerging markets, governments hold substantial bank equity, creating additional potential fiscal losses if banks need recapitalization. - This channel is likely stronger for domestic state-owned banks that finance fiscal deficits and may have limited market discipline and weak governance. - Macroeconomic (indirect) channel: - Sovereign weakness can raise corporate borrowing costs and prompt fiscal consolidation, hurting the corporate sector. - Crowding out: domestic banks may be burdened with financing government debt, reducing credit to corporates, deteriorating loan quality, and increasing provisioning needs—feeding back to sovereign stress via weaker growth and fiscal revenues. - These channels interact and can create a mutually reinforcing “doom loop.” The loop can also work in reverse when banking stress triggers sovereign stress (for example, via activation of fiscal backstops). ### Role of nonbank financial institutions and investor base concentration - Domestic nonbank financial institutions can transmit sovereign or banking sector risk and amplify vulnerabilities through direct and indirect exposures. - Nonbank financial institutions hold a nontrivial share of public debt in some emerging markets (see Box 2.2.1 in Online Annex 2.2), but financial systems remain largely bank-based in emerging markets, potentially limiting the systemic role of nonbanks. - A concentrated investor base (overreliance on domestic banks) increases potential to amplify shocks; diversified investor base reduces the risk of rapid withdrawals. ### Stylized facts on banks’ holdings of sovereign debt and the strength of the nexus - Banks’ share in sovereign debt holdings increased from an average of about 20 percent two decades ago to more than 30 percent in 2020 (Figure 2.5, panel 1). - Heterogeneity across countries: - In some economies (such as Uruguay), banks hold less than 10 percent of total sovereign debt. - In others (such as China), this share exceeds 80 percent. - Drivers of banks’ sovereign debt exposure include liquidity management, higher interest rates, lower financial sector development, and government moral suasion (Box 2.1). - Empirical association between sovereign and banking sector default risk in emerging markets: - The default risks of sovereigns and banks—proxied by the expected default frequency—tend to move in lockstep (Figure 2.5, panel 2). - At low levels of bank distress, a 1 percentage point increase in sovereign default risk is associated with a 0.4 basis point increase in banks’ expected default frequency (Figure 2.5, panel 3). - Overreliance of governments on domestic banks for financing increases likelihood of shock transmission and can slow fiscal consolidation when banks exhibit higher home bias. ### Key questions the chapter investigates - How has the link between the sovereign and banking sector evolved, and how has the COVID-19 pandemic affected that link? What factors motivate the banking sector to hold sovereign debt? - How strong is the sovereign–bank nexus? How is it affected by adverse shocks such as a tightening in global financial conditions? - How relevant are the various channels of transmission? To what extent does sovereign stress transmit directly to banks through their exposure to government bonds? How much do banks benefit from government guarantees, especially during episodes of sovereign stress? To what degree does sovereign stress affect the real economy—in particular the corporate sector, which may in turn affect banks? *CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE, Global Financial Stability Report, April 2022* ### 1. Share of Domestic Banks’ Holding in Total Government Debt, ### 1. Share of Domestic Banks’ Holding in Total Government Debt, 2005–20 ### Key findings on the sovereign-bank nexus - Sovereign and bank default risk move together; the correlation increases at higher levels of bank stress. - The relationship between sovereign and bank default risk is much tighter when global financial conditions are strained (notably during the global financial crisis and March 2020 COVID-19 market turmoil). - Three empirical findings from the structural analysis across emerging markets: - The nexus is strong, on average, with significant feedback effects between sectors. - Spillovers from sovereign default risk to banks are, on average, larger than those from banks to sovereign default risk; the largest spillovers are from sovereign and bank default risk to firms. - The relevance and strength of the nexus differ across countries, with transmission of shocks being three to five times higher than the average in some cases. ### Quantitative vulnerabilities and stress channels - Banks’ holdings of local currency government debt increased during the COVID-19 pandemic; state-owned banks were major buyers, while private domestic banks also contributed. - Excess liquidity (weaker credit demand and surge in deposits) is associated with banks’ increased sovereign bond holdings. - Median capital adequacy ratio across emerging markets stood at 14 percent in 2020. - A 4.5 percent minimum regulatory common equity Tier 1 (CET1) capital ratio is used as the stress threshold in scenario analysis. - Haircuts on banks’ holdings of domestic sovereign debt: - Haircuts as small as 30 percent would breach the minimum CET1 capital ratio in domestic banks in sub-Saharan Africa. - A haircut of about 30–40 percent would breach the minimum CET1 capital ratio in some regions. - Historical average direct loss-given-default rates for sovereign debt holders: 37 percent (1978–2010) and 50 percent (1998–2010), as estimated by Cruces and Trebesch (2013). - Banks’ sovereign exposure relative to capital increased during the pandemic; a sizable share of outstanding sovereign debt holdings is marked to market in several emerging markets, exposing banks to market risk. - Nonperforming loans are more than one-tenth of total loans in some countries; deterioration in credit quality during banking crises has been twice as large in emerging markets as in advanced economies. - After a sovereign-related tightening in global financial conditions, emerging markets with higher public debt and banks’ holdings of sovereign debt experience increases in sovereign and bank default risks that are twice as large as the average increase; the impact persists for up to six quarters after the shock. ### Empirical approaches and sample notes - Default risk is proxied by expected default frequency (EDF); banking sector EDF equals the average EDF of individual banks in panel analyses. - Panel quantile regressions with country fixed effects are used to compute the effect of a 1 percentage point change in sovereign EDF on banks’ EDF at different bank-stress percentiles. - A 24-month rolling window is used to compute median time-varying correlations between changes in sovereign, bank, and nonfinancial corporation EDFs across countries. - Structural value-at-risk and other panel/structural models are estimated for emerging markets using data covering 2006–20 or 2000–20 depending on the exercise; one structural sample comprises 525 banks in 18 emerging markets over 2000–20. - High levels of public debt and bank sovereign exposure are defined as one standard deviation above the sample average (about 80 percent and 20 percent, respectively; mean values about 50 percent and 9 percent, respectively) in the local projection panel regression exercise. ### Transmission channels and amplification mechanisms - Exposure channel: banks hold substantial public debt, including as a share of capital, exposing them to losses that can weaken capital buffers, raise banks’ default risk, and affect lending behavior. - Market-value channel: a large share of sovereign holdings is marked to market in many emerging markets; rising global yields and monetary policy normalization in advanced economies can reduce market values and bank capital. - Macro/real-economy channel: sovereign distress can trigger currency depreciation and tightening global financial conditions that reverse capital flows, strain balance sheets, and weaken corporate borrowers, increasing nonperforming loans and further pressuring banks. - Feedback effects: fiscal costs of restructuring and supporting the financial sector during banking crises have been significant in emerging markets and can transmit banking stress back to the sovereign. ### Implications highlighted by the analysis - The sovereign-bank nexus materially amplifies financial crises in emerging markets and is especially potent when global financial conditions tighten. - Country-specific fiscal positions and financial vulnerabilities (public debt levels and bank sovereign exposure) markedly increase the size and persistence of adverse shocks. - Even moderate haircuts on sovereign debt holdings—levels already observed historically—can generate banking-sector capital shortfalls in some regions, warranting close monitoring of sovereign exposures and bank capital buffers. *Source: IMF staff analysis, Chapter 2, “The Sovereign-Bank Nexus in Emerging Markets: A Risky Embrace,” Global Financial Stability Report, April 2022.* ### Annex 2.6 for details. ### Annex 2.6 for details ### Exposure channel: sovereign distress → bank default risk, capital, lending, and holdings - Sovereign distress definition includes: monthly average sovereign credit default swap spreads higher than 500 basis points, Standard & Poor’s long-term sovereign FX rating of CCC– or lower, or government in external or domestic default. - A bank with a 10 percentage point higher ratio of government debt holdings to total bank assets (relative to average bank holdings) faces an expected default frequency that is, on average, 0.4 percentage point higher following sovereign distress (Figure 2.10, panel 1, green bar). - The effect on expected default frequency is about twice as large for banks with relatively less capital (Figure 2.10, panel 1, red bar). - The average expected default frequency in the sample is 1.2 percent. - Banks with higher sovereign debt exposure experience a decline in their equity-to-assets ratio following sovereign distress (Figure 2.10, panel 2). - Banks with higher sovereign exposure cut back on lending more than their peers following sovereign distress (Figure 2.10, panel 2). - Banks with average capital that are more exposed further increase their holdings of government debt when the sovereign is in distress (Figure 2.10, panel 3). - The impact of sovereign distress on banks’ equity is more than twice as large when sovereign spreads reach 1,000 basis points (Online Annex 2.6). - Domestic banks in countries with a higher stock of foreign exchange reserves relative to short-term external debt experience a significantly smaller decline in capital during episodes of intense sovereign stress than domestic banks in countries with less adequate reserves (Online Annex 2.6). - Alternative shock definitions considered: - High sovereign debt rollover needs amid significant volatility in global financial markets. - Sharp increase in public debt following a currency depreciation. - In most cases above, the impact on banks’ equity and loans is significantly larger than in cases of low fiscal vulnerabilities following the external shocks (Figure 2.10, panel 4). ### Safety net channel: government support ratings, credit growth, and risk-taking - Government support is proxied by Fitch support rating floors (numerical scale converted to 1–17; higher values correspond to a higher likelihood of receiving government support during distress). - On average, government support proxied through support rating floors is greater in emerging markets than in advanced economies and has generally increased since the global financial crisis (Figure 2.11, panel 1). - There is a strong positive relationship between bank size and government support ratings. - Banks with higher support rating floors tend to have lower capital ratios and a majority government stake. - Equity returns of emerging market banks during sovereign distress are higher for banks whose support rating floor is one notch higher than peers (Figure 2.11, panel 2); in normal times there is no significant difference. - The positive effect of a one-notch-higher support rating before sovereign distress declines over time and turns negative six months after the shock; the negative effect starts sooner and is larger if the economy enters the distress event with higher public debt (Figure 2.11, panel 2). - Banks with higher government support ratings experience lower credit growth, particularly after three years (Figure 2.11, panel 3, green line). - Banks with a higher support rating floor but lower capital expand loans more aggressively: cumulative credit growth about 8 percentage points higher than other banks two years after the distress event (Figure 2.11, panel 3). - Nonperforming loans (NPLs) do not depend much on support rating on average, but banks with both a lower capital ratio and a higher support rating experience a significant jump in NPLs in the medium term (Figure 2.11, panel 4). - Cumulative abnormal returns and cumulative credit growth results use local projection and cumulative abnormal return methodologies; sovereign distress months defined as above and estimated separately for economies with sovereign-debt-to-GDP ratio greater than 60 percent (“high public debt”) or lower than 60 percent (“low public debt”). ### Macroeconomic channel: sovereign downgrades → corporate investment - Identification strategy exploits rating-ceiling policies: “bound firms” have ratings equal to or above the sovereign and are subject to sovereign ceiling policies; “unbound firms” have ratings below the sovereign. - Ratings of bound firms are more affected by sovereign downgrades than ratings of unbound firms (Figure 2.12, panel 1). - A bound firm’s cumulative investment drops nearly 17 percentage points more than an unbound firm’s cumulative investment two years after a sovereign downgrade (controlling for firm characteristics) (Figure 2.12, panel 2). - The investment effect is significantly larger if the sovereign downgrade is accompanied by higher sovereign stress, proxied by sovereign credit default swap spreads greater than 500 basis points (Figure 2.12, panel 3). - Sample for sovereign downgrade analysis: 100 sovereign debt downgrades in 29 countries during 1998–2020; years with banking crises when the country was downgraded are excluded to better isolate the direct real effect. ### Empirical design and measurement notes (preserved terminology and metrics) - Bank-level regressions use dependent variables: - Change in banks’ expected default frequency (panel 1). - Change in equity to lagged total assets (panels 2 and 4, left side). - Change in total loans to total assets (panels 2 and 4, right side). - Log change in total government debt holdings (panel 3). - Balance sheet variables and expected default frequency are based on year-end data. - Focus variable: ratio of banks’ holdings of government debt securities to total assets (sovereign exposure) interacted with sovereign distress and the bank capital ratio (total-equities-to-total-assets ratio). - “Average effect” refers to the impact of 10 percentage point higher bank sovereign exposure for banks with an average capital ratio (close to one standard deviation in the sample). - “Less-capitalized” banks correspond to a bank capital ratio one standard deviation below the mean. - Valuation effect on public debt following a currency depreciation (panel 4): computed by multiplying foreign-currency-denominated gross public debt in year t−1 by the change in the exchange rate from t−1 to t; the valuation effect is then normalized by total gross public debt in t−1. - Solid dots/solid bars in figures indicate statistical significance at 10 percent or lower. - VIX = Chicago Board Options Exchange Volatility Index. *Source: IMF staff calculations and figures as presented in Annex 2.6 (text provided).* ### 1. Distribution of the Change in Firms’ Ratings following a Sovereign ### 1. Distribution of the Change in Firms’ Ratings following a Sovereign Downgrade ### Empirical findings on firm ratings, investment, and bank asset quality - Panel 1 — Distribution of the change in corporate ratings: - Bound firms (those with a rating equal to or above their sovereign before the downgrade) have a higher probability of being downgraded after a sovereign downgrade than unbound firms. - Panel shows the distribution of the change in corporate ratings between the period before the sovereign downgrade and two years after the downgrade for “bound” and “unbound” firms. - Panel 2 — Effect on investment and debt issuance: - Bound firms reduce their investment and debt issuance more than unbound firms in the two years following a sovereign downgrade. - Outcome variables measured: - Investment ratio = capital expenditure / lagged capital stock. - Debt issuance proxied by changes in the net-debt-issuance-to-asset ratio. - (Figure axis labels indicate a range from –17.0 to –15.0 for the plotted percentage-point effects on investment and debt issuance.) - Panel 3 — Heterogeneity by sovereign risk: - The marginal effect of a sovereign downgrade on bound firms is larger when the downgrade occurs in periods of higher sovereign risk. - Sovereign risk definitions: - Low sovereign risk: sovereign CDS spread between 250 and 500 basis points. - High sovereign risk: sovereign CDS spread greater than 500 basis points. - Panel 4 — Spillovers to banking-sector asset quality: - A larger role of bound firms in the corporate sector amplifies the increase in banks’ nonperforming loans following a sovereign downgrade. - Country-level difference-in-differences regression result: a one standard deviation higher share of bound firms’ assets (relative to total nonfinancial corporate assets) is associated with a 1 percentage point greater change in nonperforming loans two years after the sovereign downgrade. - Panel shows cumulative effect over years from the sovereign downgrade (0–2 years plotted). - Data sources and significance: - Sources: Haver Analytics; IHS Markit; Standard & Poor’s Capital IQ; and IMF staff calculations. - Solid bars in figures indicate statistical significance at 10 percent or lower. - See Online Annex 2.8 for further empirical details (figure notes). ### Mechanisms and broader interpretation - Transmission channels highlighted: - Sovereign stress raises firms’ borrowing costs and tightens funding constraints, reducing investment and debt issuance. - Deterioration in corporate balance sheets can weaken banks’ loan portfolio quality, increasing nonperforming loans. - Banking sector deterioration can further curtail lending, amplifying declines in consumption, investment, and aggregate demand. - Role of bank sovereign exposures and market structure: - Bank holdings of sovereign debt vary across emerging markets: - About 5 percent of banking sector assets in some countries (example: Chile and Peru). - More than 25 percent in other countries (example: Brazil and Pakistan). - Domestic state-owned banks tend to purchase significantly more sovereign debt in times of high fiscal need or sovereign distress. - Definitions used for empirical analysis: - High fiscal need: years when maturing sovereign debt (to lagged total debt) is in the top 75th percentile. - Sovereign distress: sovereign CDS spread exceeds 500 basis points, a Standard & Poor’s long-term rating for sovereign foreign currency debt CCC – or lower, or the sovereign is in external or domestic default. - Stylized statistics on bank sector composition: - Domestic state-owned banks on average held about 30 percent of total banking sector assets in major emerging markets in 2020, and this ratio exceeded 40 percent in some countries. ### Policy implications and recommendations (as presented) - Fiscal and sovereign-debt related: - Extend maturities of public debt where feasible and avoid further buildup of currency mismatches to limit balance-sheet vulnerabilities. - In countries with limited fiscal space and tight borrowing constraints: - Improve the efficiency and targeting of fiscal spending to support recovery. - Embed fiscal policy in credible and sustainable medium-term fiscal plans to mitigate adverse shocks. - Develop robust resolution frameworks for sovereign debt to facilitate orderly deleveraging and restructuring if needed. - Anticipate, minimize, and manage the financial-system and broader-economy impacts of domestic debt restructurings. - Banking sector and supervisory actions: - Preserve banks’ resources to absorb potential losses by limiting capital distribution where bank profitability is difficult to assess because of regulatory flexibility. - Conduct asset quality reviews where forbearance has obscured true bank balance-sheet health; use results to guide supervisory actions and phase in more robust capital levels in a preannounced manner. - Strengthen private debt resolution frameworks to prepare for withdrawal of policy support measures. - Improve transparency and data quality of banks’ holdings of government debt, including by currency denomination and account classification, to better assess sovereign-distress risk. - Require stress tests to cover the risks of significant sovereign exposures, accounting for multiple channels of the sovereign–bank nexus. - Consider measures to reduce incentives to hold excessive sovereign debt once recovery and normalization permit (examples discussed internationally include nonzero, risk-sensitive capital requirements; concentration limits and calibrated capital surcharges are alternative approaches to target concentration risk while considering liquidity needs). - Crisis-management and financial safety-net measures: - Strengthen banking crisis management frameworks, deposit guarantee programs, resolution regimes, and central bank liquidity facilities to reduce reliance on government guarantees and minimize resolution costs to the government. - Prepare contingency plans detailing authorities’ responses to possible future pressures. - Market-development measures: - Promote a deep and diversified investor base in local currency bond markets, including a diverse range of bank and nonbank participants and institutional investors, to allow governments to spread risk and extend the yield curve and to mitigate banks’ excessive sovereign exposure. *Italicized source attribution: IMF staff analysis in Chapter 2, “The Sovereign–Bank Nexus in Emerging Markets: A Risky Embrace,” Global Financial Stability Report: Shockwaves from the War in Ukraine Test the Financial System’s Resilience (April 2022).* ### Box 2.1. The Drivers of Banks’ Sovereign Debt Exposure in Emerging Markets ### Box 2.1. The Drivers of Banks’ Sovereign Debt Exposure in Emerging Markets ### Key empirical findings - Banks hold more sovereign debt in more indebted and less financially developed economies. - There is no evidence of government pressure on private banks (Online Annex 2.4). - State-owned banks are more likely to purchase sovereign debt during periods of sovereign distress, consistent with moral suasion. - Less-capitalized state-owned banks also engage in additional purchases during distress, consistent with a risk-shifting strategy that may reflect willingness to take on higher-yield debt to improve capital positions. ### Data and estimation details (preserved from source) - Panel 1: cross-country regression for a sample of 21 emerging markets during 2000–20. Dependent variable: banks’ holdings of sovereign debt to total banking sector assets. Aggregate banks’ government debt holdings are computed from Fitch Connect if Monetary and Financial Statistics data are limited. Bars in the figure show the effect of a one standard deviation increase in the value of the regressors on changes in banks’ holdings (in percentage points). - Panel 2: bank-level cross-country regression during 2011–20. Dependent variable: banks’ net purchases of sovereign debt. - Moral suasion is defined as the additional purchase of sovereign debt by state-owned banks in times of “high fiscal need”; that is, the years when the total amount of new debt auctioned by the sovereign (proxied by maturing debt as a share of lagged gross debt) is above the 75th percentile in the sample. - Risk shifting is defined as the additional purchases of sovereign debt by less-capitalized state-owned banks, where “less capitalized” refers to an equity-to-assets ratio that is one standard deviation below the mean, which is about 7 percentage points. - Solid bars in figures indicate statistical significance at 10 percent or lower. - Sources used in the analysis: Bloomberg Finance L.P.; Fitch Connect; IHS Markit; IMF, Monetary and Financial Statistics and World Economic Outlook databases; Standard & Poor’s Capital IQ; and IMF staff calculations. ### Interpreted mechanisms - Moral suasion: state ownership increases the likelihood of stepping in to buy sovereign debt when sovereigns face high fiscal needs (as defined by the 75th percentile rule for auctioned new debt). - Risk shifting: state-owned banks with lower capitalization (equity-to-assets ratio ≈ 7 percentage points below the mean) are more likely to increase sovereign bond purchases, which may reflect a strategy to take on higher-yield sovereign risk to bolster capital metrics. ### Figure elements summarized - Figure 2.1.2 panel 1 (Drivers of Bank Holdings of Sovereign Debt): presents regressors including Gross public debt; Interest rate; Stock market capitalization; Credit to the private sector. Effects are measured as changes in banks’ holdings (percentage points) from a one standard deviation increase in each regressor. - Figure 2.1.2 panel 2 (State-Owned Banks: Net Purchase of Sovereign Bonds during Periods of Sovereign Distress): shows percent net purchases, illustrating higher net purchases by state-owned and less-capitalized state-owned banks during high fiscal need episodes. *International Monetary Fund | April 2022* ### CHAPTER 3 ThE RAPId GROwTh OF FINTECh: vULNERABILITIES ANd ChALLENGES FOR FINANCIAL STABILITY ### CHAPTER 3 ThE RAPId GROwTh OF FINTECh: vULNERABILITIES ANd ChALLENGES FOR FINANCIAL STABILITY ### Overview - Neobanks distinguish themselves from traditional banks through digital technologies (cloud computing, application programming interfaces, big data, and artificial intelligence) and tend to target financially underserved clients. - Some neobanks have market capitalizations nearly as large as those of the largest traditional banks. - High valuations of some neobanks are driven by expectations for strong loan growth, particularly in the unsecured retail segment. - Rapid scaling is central to neobank value but can increase operational risks, including higher and increasing fraud through digital channels. ### Credit Risk: High, Underprovisioned, and Underpriced - Client and portfolio characteristics: - Neobanks serve younger individuals with lower incomes and lower credit scores. - Loan books are mostly unsecured or concentrated around risky sectors (for example, SME loans concentrated in commercial real estate). - Provisioning and pricing: - Neobanks have higher credit risk (higher cost of risk) but loan loss reserves as a proportion of overall (risk-weighted) assets are well below those of traditional banks, implying looser provisioning standards/practices. - Neobanks appear to underprice credit risk: asset yields are typically higher than banks’, driven by higher yield on securities portfolios rather than yields on the loan book. - A meaningfully negative risk-adjusted net interest margin in parts of the sample and in some regions points to underpricing of credit risk. - If cost of risk adequately reflected neobanks’ credit profiles and lower loan-related fee income were accounted for, risk-adjusted loan margins would be even lower. - Lifecycle and regional notes: - Emerging market neobanks tend to fare better than advanced economy neobanks, related to lifecycle factors and business models (Chinese neobanks show relatively strong performance; overlap with big tech noted). ### Liquidity Risks and Interconnectedness - Deposit stability and liquidity coverage: - Neobanks’ client base is younger and likely less loyal, implying potentially less sticky deposits. - Basel III calibration note: “less stable deposits” (including “internet deposits”) are assigned a runoff rate of at least 10 percent (3 percent for “stable deposits”); supervisors may assign higher rates. - Neobanks’ ratio of liquid assets to total deposits is lower than that of traditional banks, increasing liquidity risk. - Asset composition and interconnectedness: - Neobanks have a much larger share of interbank loans in liquid asset portfolios than traditional banks, suggesting greater interconnectedness with the rest of the banking system. ### Weak Retail Banking Returns and Cost Structure - Efficiency and expenses: - Neobanks appear less cost-efficient than traditional banks, driven by persistently higher nonstaff expenses (including customer acquisition costs such as marketing, and compliance-related costs such as anti–money laundering and cyber-security). - Staff expenses are defined as “compensation & benefits”; nonstaff expenses are defined as the difference between staff and total operating expenses. - Income generation: - Lower income profile of neobank customers limits cross-selling potential for insurance, wealth management, and other fee-income-generating products. - Neobanks’ higher net interest margins are driven by securities income; if securities income is excluded, the margin advantage fades. - Profitability: - Overall, neobank returns appear weak, with only a few neobanks generating profits. - Young neobanks operate with higher equity/assets ratios while loss-making; the capital advantage disappears for mature neobanks. ### Case Study — Fintechs in the US Home Mortgage Market - Market presence and origination: - Fintechs have been active for more than a decade in mortgage origination and remove the need for physical branches. - Fintechs process applications about 20 percent faster than other lenders. - A fintech firm has been the single largest originator for several years, even though banks retain substantial market share. - Growth and borrower profile: - Fintechs pursue aggressive growth and served younger and riskier borrowers; fintech mortgages—and particularly those by younger fintech firms—are more popular among relatively younger borrowers with lower incomes. - Fintechs originated riskier mortgages with higher loan-to-value ratios during 2018–20. - Fintechs improve access to mortgages in less affluent neighborhoods. - Competitive effects on banks: - Fintechs are present across locations, including those with higher density of bank branches. - A 1 percentage point rise in the composite fintech market share is associated with a 0.4 percentage point decline in gross mortgage interest income for banks—this equals more than 2.5 percentage points of the sample median of 16.8 percent. - Banks with IT expenditures higher by about 3.7 percent of bank equity can fully offset the loss of income from a 1 percentage point increase in fintech composite market share; IT expenditures can offset income loss but do not reduce the marginal effect of competition itself. - Despite fintech competition, banks retained about 40 percent of the mortgages they originated on their balance sheets during 2007–20, and fintechs in the mortgage-origination market are non-deposit-taking institutions, so full-scale disintermediation has not occurred. ### Decentralized Finance (DeFi): Vulnerable Efficiency - Definition and key features: - DeFi refers to financial applications (“smart contracts”) processed by computer code on blockchains with limited or no involvement of centralized intermediaries. - Key features: automated and decentralized record keeping, risk-taking, and decision-making; operations automated via smart contracts; contractual and transaction details recorded on the network; governance decisions often made by users with voting rights. - DeFi offers broad access and no need for custodial services, potentially improving efficiency and financial inclusion. - Technological drivers: - Expansion of DeFi has been enabled by blockchain technology, a type of distributed ledger technology, which provides a distributed digital infrastructure to record value and validate transaction records without a single trusted entity. *International Monetary Fund | April 2022 — CHAPTER 3 ThE RAPId GROwTh OF FINTECh: vULNERABILITIES ANd ChALLENGES FOR FINANCIAL STABILITY* ### 1. Annual US Home Mortgage Originations ### 1. Annual US Home Mortgage Originations ### Fintechs and Mortgage Origination Trends - Fintechs and other nonbanks had a long-standing presence in the mortgage market. - Originations by fintechs have been growing faster than banks, particularly during periods of high growth. - Likelihood of fintech mortgage originations is shown as a function of age groups and other borrower characteristics in the source charts. - Fintech competitive pressure metrics in the charts include: - Fintech competitive pressure on mortgage income - IT expenditure on mortgage income - Fintech competitive pressure on deposit financing share - Fintech competitive pressure on mortgage lending share - Bank branch density is depicted as "Number of bank branches within 10-mile radius of borrower" in the source figures. ### DeFi Lending: Primer and Mechanism - DeFi uses smart contracts to enable financial intermediation such as deposit-taking, lending, derivative trading, and the exchange of crypto assets. - Stablecoins are used in DeFi as a unit of account, medium of exchange, and store of value; the growth of stablecoins and evolution of DeFi have evolved in tandem. - DeFi lending platform mechanics (as described): - Deposits: Users deposit crypto into a liquidity pool and receive a platform-specific utility token as a certificate of deposit (the token bears interest and can be withdrawn). - Borrowing: Users holding utility tokens can borrow crypto by posting the deposited asset as collateral; lending interest rates vary with utilization. - Collateral: Platforms set collateral (discount) factors typically ranging from 0 to 0.8 across different asset types (example: collateral factor 0.8 allows borrowing up to 80 percent of collateral value; collateral factor 0 means the asset cannot be used as collateral). - Repayment and liquidation: Borrowers repay at any time but must meet collateral requirements; if collateral falls below threshold, liquidation can be triggered—liquidator repays the debt and acquires collateral plus a liquidation bonus. - Example tokens: depositing Ethereum may yield aETH or cETH on certain platforms. ### DeFi Usage and Composition - More than 90 percent of DeFi lending is denominated in stablecoins. - 75 percent of collateral in DeFi lending is denominated in volatile crypto assets. - As of end-2021, volatile crypto assets such as Ethereum and Wrapped Bitcoin were the dominant collateral. - Use cases (trading, market making) can increase market liquidity but also build leverage and destabilize markets. ### Market Risks in DeFi Lending - Large liquidations have occurred during sharp declines in crypto asset prices; during the January 2022 crypto sell-off, liquidation across platforms surged to the highest level since May 2021, erasing $50 billion in asset value borrowed. - Modeled one-year probability of liquidation is 24 percent on average, reflecting high volatility and a rising trend in crypto prices. - Expected loss from liquidation averaged about 0.9 percent, with larger losses for higher-leveraged borrowers. - Riskier (highly leveraged) borrowers exhibit higher liquidation probability and larger expected losses. - Precision of external price oracles matters: misinformed asset prices can trigger cascades of liquidation. ### Liquidity Risks - Utilization rate (ratio of total loans to total deposits for an asset on a platform) measures liquidity use; very high utilization can impair redemptions. - Platforms set threshold utilization rates above which lending interest rates rise steeply to discourage further utilization. - Median utilization rates: typically high for stablecoins and low for volatile assets; during stress, utilization rates have approached 100 percent for both types. - Liquidity provision is highly concentrated: on average, half of deposits are provided by fewer than 10 accounts (concentration is even higher for smaller and more volatile assets). - High concentration makes platforms vulnerable to idiosyncratic large withdrawals, potentially causing spikes in utilization and outcomes analogous to a bank run. - Liquidity providers are anonymous on DeFi platforms. ### Cyber and Operational Risks - Cyberattacks increased substantially in mid-2021 and remain elevated; attack vectors include compromised wallet keys, vulnerabilities in code, and developer scams. - Event analysis indicates that, in most cases, 30 percent of the total value locked is lost or withdrawn after attacks. - Cyberattacks cause large and often persistent losses; attacks also damage platform reputation and can trigger depositor withdrawals. - Example operational cost incident: about $90 million was mistakenly distributed to Compound users as a result of program bugs after an update on October 1, 2021 (the founder requested voluntary return; unretrieved tokens would be a cost to the platform). - Deposits in DeFi platforms are not eligible for deposit insurance or central bank liquidity support. ### Efficiency, Pricing, and Funding Risks - Empirical estimates indicate DeFi has the lowest marginal cost compared with incumbents in both advanced and emerging market economies, reflecting automated and (largely) unregulated operation. - DeFi bears high funding costs that likely reflect higher risks such as lack of access to central bank liquidity support, AML/CFT risks, and legal and jurisdictional uncertainties. - DeFi margins are substantially lower than those of traditional financial institutions, raising concerns about underpricing risk; platforms tend to offer relatively high deposit interest rates while keeping lending margins low to attract liquidity. *Source: IMF staff (text from Chapter 3, GLOBAL FINANCIAL STABILITY REPORT: ShOCkwAvES FROM ThE wAR IN UkRAINE TEST ThE FINANCIAL SYSTEM’S RESILIENCE, April 2022).* ### 1. Estimated Marginal Costs and Margins ### 1. Estimated Marginal Costs and Margins ### Key empirical findings on margins and risk pricing - DeFi platforms exhibit high cost-efficiency but are exposed to riskier borrowers. - Narrow margins in DeFi are in part possible because DeFi does not have to maintain regulatory buffers. - Comparison of estimated average expected losses suggests that DeFi is significantly underpricing the riskiness of its lending (Figure 3.12, panel 2). - Lower margins: - Can increase the popularity of DeFi. - Come at a cost of thinner reserve buffers, which builds vulnerabilities during periods of market stress. - May pose significant competitive pressure to incumbents absent a (regulatory) level playing field. - Empirical sample composition (note preserved exactly): - Banks from 37 advanced economies (AEs) and 100 emerging markets (EMs). - Nonbanks from 20 advanced economies and 26 emerging markets. - Two DeFi platforms (Aave and Compound). - In panel 2, expected losses of DeFi platforms are the estimates from Figure 3.10, panel 2. Each dot represents the average expected loss for banks in a country. DeFi = decentralized finance. ### Financial-stability implications of fintech growth and neobanks - Digitalization of core banking services brings both opportunities (broadened financial development, more inclusive growth) and risks (potential bank disintermediation, buildup of vulnerabilities in new corners of the financial system). - Regulatory differences enable risk-taking: - Neobanks are sometimes subject to simpler and less comprehensive regulation and supervision. - In some jurisdictions neobanks operate without a banking license, are not subject to liquidity risk requirements, and may be subject to different loan classification and lower provisioning. - Proportional approaches to regulation may not be sufficiently risk-based to address different business models and the risk-taking appetite of neobanks. - Neobank vulnerabilities span at least four dimensions: 1. Higher risk-taking in retail loan originations without appropriate provisioning and pricing standards. 2. Higher risk-taking in the securities portfolio to cross-subsidize lending and support price-competitiveness vis-à-vis traditional banks. 3. Potential underspending in critical functions (such as AML/CFT and IT/cybersecurity) as they fail to match market expectations for meaningful efficiency gains. 4. Liquidity buffers that do not appear to be well calibrated to neobanks’ less sticky retail deposit base. - Interconnectedness concerns: - Neobanks provide funding to traditional banks through the interbank market. - A small number of fintech firms provide critical services (such as cloud services) to financial institutions. - Competitive dynamics: - Scalability of technology-enabled business models allows fintechs to grow fast, putting pressure on incumbents. - Evidence from the US mortgage market shows a negative impact on banks’ income due to competition from fintechs; banks adopting fintech-like technologies are less affected. - Excessive risk-taking by both fintechs and incumbents to gain or defend market share could lead to a fast buildup of systemic risk. ### Regulatory challenges and recommendations for neobanks and fintech mortgage firms - Prudential regulations at both the entity and group levels should be reviewed to address fintechs’ key risks in a forward-looking manner. This will likely mean more robust capital, liquidity, and operational risk-management requirements, commensurate with the risk taken by neobanks in several jurisdictions. - Supervisors should closely monitor less technologically advanced incumbents (technology laggards and smaller banks) that may be particularly at risk. - Enhanced monitoring of incumbents is needed because incumbents might be more vulnerable under pressure from rapid fintech development. ### Regulating DeFi: challenges and policy steps - DeFi poses unique regulatory challenges due to elevated market, liquidity, and cyber risks combined with anonymity, lack of a centralized governance body, and legal uncertainties that render the traditional approach to regulation ineffective. - Growing interconnectedness with stablecoins and traditional financial entities increases the need for enhanced regulatory surveillance and globally consistent regulatory frameworks. The BCBS proposals on banks’ crypto asset exposures are noted as a significant step toward global standards to help address some cross-border issues; the Committee was working to further specify a proposed prudential treatment, with a view to issuing a further consultative paper by mid-2022. - Suggested regulatory focus areas (first step): - Stablecoin issuers (which define technical specification and use cases). - Centralized crypto exchanges and hosted wallet service providers (which connect crypto markets with the broader financial system). - Reserve managers, network administrators, and market makers (which play important roles in operationalization and stability). - These centralized entities would benefit from robust and comprehensive national regulatory frameworks delivered through common global standards by standard-setting bodies. - Direct regulation of key DeFi functions (second step): - Manage risks generated by protocol developers via public-private collaboration on code regulation: - Ex ante guidelines on operational and risk parameters (including operational and cyber resilience). - Ex post code reviews and audits to identify areas vulnerable to risk. - Combine ex ante measures with greater disclosure and user education to close the information gap between retail and institutional investors. - Encourage DeFi platforms to adopt robust governance through industry codes and build effective public-private collaboration to establish self-regulatory organizations. - Governance token holders can form decentralized autonomous organizations with voting rights; such organizations may provide authorities with a conduit for regulatory oversight. - Self-regulatory organizations for centralized crypto exchanges could lead to more robust listing standards for (tokens of) DeFi platforms and thereby improve governance and quality. - Regulators should monitor the effectiveness of industry codes and self-regulation and enhance supervision intensity when necessary. - Enforcement challenges and an additional policy lever: - Enforcing regulations in DeFi markets is challenging; many crypto asset service providers operate offshore and users can obscure their location, reducing enforceability. - One potential approach is to restrict the exposure of regulated firms to DeFi markets (especially markets not subject to proper regulation or self-regulation), which could slow growth while addressing risks of interconnectedness with regulated markets. - Empirical enforcement illustration preserved exactly: - Despite the implementation of restrictions, an estimated 1.7 million Egyptians hold crypto assets (TripleA 2022). *International Monetary Fund | Global Financial Stability Report: The Rapid Growth of Fintech — Vulnerabilities and Challenges for Financial Stability (April 2022), Chapter 3* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2022/april/english/text.pdf_