## CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES ## Source details **Canonical URL:** [CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES](https://www.imf.org/-/media/files/publications/gfsr/2023/april/english/ch1.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2023/april/english/ch1.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2023/april/english/ch1.pdf.json) --- ### Overview of recent developments and systemic tests - Financial stability risks have increased rapidly since the October 2022 Global Financial Stability Report as the resilience of the global financial system has been severely tested. - Sudden failures and loss of confidence: - Silicon Valley Bank (SVB) and Signature Bank of New York (SBNY) failures highlighted interactions between tighter monetary/financial conditions and vulnerabilities built up since the global financial crisis. - Credit Suisse lost investor confidence and was taken over by UBS on March 19 at a price tag of 3 billion Swiss francs; Swiss authorities provided a guarantee of 9 billion Swiss francs to UBS and wrote down AT1 debt of 16 billion Swiss francs. - Policy responses reduced market anxiety but sentiment remains fragile; fundamental question is whether recent events signal broader systemic stress or are isolated manifestations of tighter conditions after more than a decade of ample liquidity. ### Key vulnerabilities and transmission channels - Accumulated vulnerabilities in a low-rate, ample-liquidity environment: - Increased exposures to liquidity, duration, and credit risk, often amplified by financial leverage. - Technology and social media can rapidly amplify loss of confidence and contagion. - Funding can disappear rapidly; shifting deposit patterns could raise banks’ funding costs and restrict credit provision. - High interconnectedness within the nonbank financial intermediation (NBFI) sector and with traditional banks can amplify tighter monetary/financial conditions. - Sectors under stress: venture capital, broader tech sector, crypto-linked entities, commercial real estate (CRE). ### Banking sector specifics and potential macroeconomic impact - SVB and SBNY episodes: - SVB revealed on March 6 a $1.8 billion loss on sales of Treasuries and agency MBS and announced on March 8 a $2.25 billion stock offering plan; $42 billion of deposit withdrawals followed on March 9; FDIC took control of SVB on March 10. - After a withdrawal of 20 percent of its deposits, SBNY was closed on March 12; FDIC appointed receiver. - SVB had about $18 billion in unrealized losses related to higher rates. - US banking system exposure and potential GDP impact: - U.S. regional and smaller banks account for more than one-third of total bank lending. - With the recent fall in bank equity prices, lending capacity of U.S. banks could drop by about 1 percent in the coming year, reducing real GDP by 44 basis points, all else being equal. - IMF staff estimates: one-year-ahead core lending capacity decline by almost 1 percent (United States) implies Real GDP decline of 44 basis points in the United States (one year ahead) and 45 basis points in the euro area (one year ahead). - Hidden interest rate–driven losses: - If unrealized losses in AFS and HTM securities were fully realized to raise liquidity, almost 9 percent of US banks with assets between $10 billion and $300 billion would have CET1 ratios below the regulatory requirement of 7 percent (4.5 percent regulatory minimum plus 2.5 percent capital conservation buffer). - In a select sample, HTM portfolio unrealized losses fully accounted for could impact CET1 by more than 170 basis points in Europe, more than 80 basis points in Japan, and more than 100 basis points in emerging markets. ### Nonbank financial intermediation (NBFI), crypto, and sectoral spillovers - NBFI amplification channels: - Financial leverage, liquidity mismatches, and interconnectedness raise risk of stress transmission from sectors facing liquidity withdrawal. - SVB’s failure reverberated across the crypto ecosystem: Circle held about 8 percent of USDC’s total reserves in SVB deposits; USDC and Dai depegged from the dollar before recovering after policy actions. - Silvergate entered liquidation proceedings; FTX bankruptcy in November 2022 (more than 1 million registered users; estimated trading volume of about $600 billion; estimated market value of nearly $35 billion; $8.8 billion in liabilities; $900 million in liquid assets) contributed to digital-assets confidence crisis. - Insurance and private credit vulnerabilities: - Insurers doubled illiquid investments over the last decade and increased share of Level III assets. - Life insurers increased leverage and nontraditional liabilities (for example, funding-agreement-backed securities, Federal Home Loan Bank advances, repo and securities lending cash). - Private credit and leveraged-loan markets have grown significantly; pension funds and insurance companies own a significant share of private credit funds. - NBFI policy priorities: close data gaps, incentivize risk management, set appropriate regulation, intensify supervision; consider prudential treatment and potential central bank liquidity support options for systemic NBFIs. ### Commercial real estate (CRE) and REITs - Market indicators and exposures: - US CMBS spreads over ordinary Treasury bonds jumped to about 450 basis points at the end of 2022. - Financing costs of senior loans in core offices in Europe rose to about 350 basis points in Q2 2022, more than 200 basis points higher than the previous year. - Median portfolio illiquidity of funds holding REITs is about 30 percent higher than that for those holding other equities. - Institutional foreign investors headquartered outside the United States own approximately 16 percent of the total market capitalization of US REITs. - Negative leverage in Q3 2022 spiked to 30 percent, up from 5 percent one year earlier; concentrated in industrial (about 36 percent) and multifamily (about 31 percent) properties. - Credit and loan performance: - CMBS loan delinquency rate is projected to increase significantly to between 4 percent and 4.5 percent by the end of 2023. - In Q3 2022, the share of CRE loans worth less than the CMBS tranches they are in spiked to 30 percent (an increase of 25 percentage points from the previous year). - US banks with total assets less than $250 billion account for about three-quarters of CRE bank lending. - Amplification: reductions in nonbank funding and tighter bank lending can amplify price declines, cause margin calls, deleveraging, and spillovers across intermediaries and foreign institutions. ### Market functioning, term premiums, and sovereign debt markets - Term premiums and yield behavior: - Term premiums remain compressed despite tightening; U.S. 10-year term premium about –70 basis points even with a 250-basis-point increase in terminal rate expectations since March 2022. - Yields on two-year Treasury bonds and two-year Bunds each collapsed by nearly 100 basis points between March 9 and 15 as investors sought refuge in sovereign bond markets. - Quantitative tightening and reserve dynamics: - U.S. reserves declined by about $725 billion in the months before quantitative tightening and by about $330 billion from the beginning of quantitative tightening through early March; March banking turmoil reversed the decline in reserves by approximately $400 billion. - Federal Reserve assets declined by $540 billion since June 2022, associated with a decline in the Treasury General Account. - At the current pace, the Federal Reserve’s balance sheet will shrink by about $800 billion in the remaining months of 2023, further reducing reserves. - Assuming total banking system assets stay at early March (before the turmoil) levels, reserves could decline to 11.5 percent of bank assets in 2023, all else equal. - Funding and money-market stress: - Bank borrowing from the Federal Reserve’s Primary Credit facility surged to an all-time high of 153 billion on March 15. - Initial take-up at the Bank Term Funding Program (BTFP) was 12 billion; usage increased in following weeks. - The Federal Reserve had $143 billion in loans outstanding to the two FDIC-created bridge banks as part of the SVB and SBNY resolutions. - Overnight reverse repurchase agreement (ON RRP) usage increased by 270 billion on net since the banking stress. - FHLB advances and discount note issuance surged as banks tapped Federal Home Loan Banks for short-term funding. - European bond market strains: - Funding stress surged as central bank liquidity contracted; jurisdictions with lower excess liquidity may experience further strains as central bank liquidity shrinks. - Potential shortage of high-quality collateral in secured funding markets; ECB stands ready with liquidity support and the Transmission Protection Instrument. ### Growth-at-Risk, downside scenarios, and emerging markets - Growth forecasts and risks: - April 2023 WEO global growth forecast for 2023: 2.8 percent. - Probability of growth falling below the current 2023 baseline of 2.8 percent estimated around 62 percent, based on the Growth-at-Risk framework. - Under a severe downside scenario, global financial conditions would tighten significantly and the forecast for global growth would decline to around one percent; growth-at-risk would deteriorate to levels comparable to the peak COVID-19 crisis. - Emerging markets: differentiation and vulnerabilities: - Between February and end-March 2023, emerging market equities fell 4 percent on average but were still up 10 percent net since October 2022 GFSR. - Sovereign spreads for high-yield and frontier countries spiked with recent stress; eight emerging market sovereigns are currently in default—the greatest number since the global financial crisis; the number of nondefaulted, distressed issuers rose from 11 to 12; 18 sovereigns are trading at spreads of more than 700 basis points. - Large emerging markets so far avoided significant spillovers aided by earlier tightening and stronger buffers; smaller and riskier emerging markets face highly challenging international market access and worsening sovereign debt sustainability metrics. - Portfolio flows stalled since mid-February; sovereign hard-currency issuance slowed after strong issuance earlier. ### Policy implications, tools, and communication priorities - Central bank objectives and separation of tools: - Availability of financial-stability tools should help central banks separate monetary policy objectives from financial stability goals, allowing continued tightening to address inflation. - If financial strains intensify amid high inflation, trade-offs between inflation and financial stability objectives may emerge; policymakers should act swiftly to prevent systemic events and clearly communicate any adjustments and their continued resolve to bring inflation back to target once stress lessens. - Liquidity support and resolution principles: - Central bank liquidity support should aim to address liquidity, not solvency; solvency addressed by fiscal or resolution authorities. - Provide liquidity to counterparties compelled by supervision to internalize liquidity risk and intervene only to address systemic liquidity risks; maintain partial insurance, price liquidity relatively expensively, apply risk mitigation (for example, haircuts), and agree on loss sharing with fiscal authorities. - Strengthen resolution regimes and crisis-management frameworks; extend perimeter of international resolution standards where appropriate and review deposit insurance reach with commensurate premiums. - Prudential and supervisory measures: - Ensure governance and risk management commensurate with banks’ risk profiles, including adequate capital and liquidity stress tests. - Maintain adequate minimum capital and liquidity requirements; consider capital for interest rate risk and guard against hidden losses that can materialize abruptly. - Require unencumbered high-quality liquid assets, formal contingency funding plans, and credible capital restoration plans. - Macroprudential, fiscal, and emerging-market guidance: - Recalibrate macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding procyclicality; deploy stringent stress tests on borrowers and CRE exposures. - Tighter fiscal policy can support monetary policy in achieving inflation objectives and limit government debt burdens; within budget constraints, reprioritize spending to protect the most vulnerable. - Emerging markets should rebuild fiscal space and buffers, integrate policies within the Integrated Policy Framework, use foreign exchange intervention where appropriate, and consider capital flow management measures in crises. - Sovereign debt and restructurings: - Sovereign borrowers should contain risks via early creditor contact, multilateral cooperation, and international support; continue use of enhanced collective-action clauses; for countries near debt distress, coordinate preemptive and orderly restructuring. - NBFI and crypto regulation: - Close data gaps, incentivize proper risk management, impose appropriate regulation, and intensify supervision. - Consider central bank support options for NBFIs (1) discretionary marketwide operations; (2) access to standing lending facilities (bar set very high); (3) lender of last resort for a systemic NBFI. - Urgent need for comprehensive, consistent crypto regulation covering storage, transfer, exchange, custody of reserves; entities with multiple functions should face additional prudential requirements; stablecoin issuers should face strict prudential requirements. - Climate-related finance: - Align capital flows on a low-carbon trajectory; renewable energy investment and production fall grossly short of funding needed to meet climate targets. - Rapid acceleration of investment in low-carbon energy infrastructure is needed, especially in emerging market and developing economies; private finance is key and the Resilience and Sustainability Trust can help eligible IMF members. *Prepared by staff from the Monetary and Capital Markets Department (in consultation with other departments). International Monetary Fund | April 2023* ### Chapter 1 at a Glance ### Chapter 1 at a Glance ### Overview of recent developments and systemic tests - Financial stability risks have increased rapidly since the October 2022 Global Financial Stability Report as the resilience of the global financial system has been severely tested. - The sudden failures of Silicon Valley Bank and Signature Bank of New York and the loss of confidence in Credit Suisse highlight challenges from the interaction between tighter monetary and financial conditions and vulnerabilities built up since the global financial crisis. - Forceful policy responses reduced market anxiety, but market sentiment remains fragile and strains persist across a number of institutions and markets. - The fundamental question for market participants and policymakers is whether recent events signal more systemic stress or are isolated manifestations of tighter conditions after more than a decade of ample liquidity. ### Key vulnerabilities and transmission channels - Vulnerabilities accumulated in the low-rate, ample-liquidity environment include increased exposures to liquidity, duration, and credit risk, often amplified by financial leverage. - Technology and social media can rapidly amplify loss of confidence and contagion across the financial system. - Funding can disappear rapidly; shifting deposit patterns across institutions could raise funding costs for banks and restrict their ability to provide credit. - Financial leverage, mismatches in asset and liability liquidity, and high interconnectedness within the nonbank financial intermediation (NBFI) sector and with traditional banks can amplify the impact of tighter monetary and financial conditions. - Specific sectors under stress include venture capital, the broader tech sector, crypto-linked entities, and commercial real estate (CRE). ### Banking sector specifics and potential macroeconomic impact - Recent U.S. events demonstrated that even failures at midsized banks can have systemic implications by triggering widespread loss of confidence. - U.S. regional and smaller banks account for more than one-third of total bank lending; a retrenchment in credit provision could materially affect economic growth and financial stability. - With the recent fall in bank equity prices, lending capacity of U.S. banks could drop by about 1 percent in the coming year, reducing real GDP by 44 basis points, all else being equal. - Across advanced economies, investor fears about losses on interest rate–sensitive assets have led to widespread sell-offs, particularly in banks trading at significant discounts to book values. - Emerging market banks have so far avoided advanced-economy pressures due to lower exposure to interest rate risks, higher share of retail deposits, and less reliance on short-term debt and non–interest-bearing deposits; however, many countries have low deposit insurance coverage and less fiscal and monetary space. ### Nonbank financial intermediation and sectoral spillovers - NBFI interconnectedness with banks raises the specter of stress transmission from sectors facing liquidity withdrawal. - SVB’s failure reverberated across the crypto ecosystem and institutions exposed to it; it contributed to a depegging of two stablecoins (Circle USDC and Dai) that held uninsured deposits in the bank and fed concerns about Signature Bank of New York’s crypto footprint. - Stress in CRE is a growing concern: U.S. banks with total assets less than $250 billion account for about three-quarters of CRE bank lending, so deterioration in CRE asset quality would have significant repercussions for profitability and lending appetite. - NBFIs play an important role in REITs and commercial mortgage-backed securities (CMBS) markets, creating broader implications for financial stability from CRE stress. ### Households, corporates, and emerging markets - Buffers accumulated by households and corporations during the pandemic have boosted shock-absorption capacity but are deteriorating as interest rates rise and earnings decline, increasing vulnerability to default risk if the global economy slows. - Large emerging markets have so far avoided significant spillovers, aided by earlier commencement of monetary tightening and stronger fundamentals and buffers. However, they remain vulnerable to a pullback in global risk taking that could trigger capital outflows. - Smaller and riskier emerging market economies face highly challenging international market access, with sovereign debt sustainability metrics continuing to worsen, especially in frontier markets and low-income countries. ### Policy implications and recommendations - Clear communication about central banks’ objectives and policy functions is crucial to minimize economic and financial uncertainty, especially when inflationary pressures prove more persistent than anticipated. - Availability of tools aimed at addressing financial stability risks should help central banks separate monetary policy objectives from financial stability goals, allowing them to continue tightening policy to address inflation. - If financial strains intensify and threaten the financial system amid high inflation, trade-offs between inflation and financial stability objectives may emerge; policymakers should act swiftly to prevent systemic events and clearly communicate any adjustments to policy stance and their continued resolve to bring inflation back to target as soon as possible once stress lessens. - Bank supervisors should ensure governance and risk management commensurate with banks’ risk profiles, including adequacy of capital and liquidity stress tests; adequate minimum capital and liquidity requirements should guard against hidden losses that materialize abruptly during liquidity shocks. - Authorities should strengthen resolution regimes and crisis management frameworks. - For the NBFI sector, policymakers should close data gaps, incentivize proper risk management practices, set appropriate regulation, and intensify supervision. *Prepared by staff from the Monetary and Capital Markets Department (in consultation with other departments).* ### Chapter 3). The recovery in China could stall, causing ### ch1 - Chapter 3). The recovery in China could stall, causing ### Systemic Risk Drivers and Macroeconomic Context - The prospect of inflation and interest rates being higher for longer after more than a decade of subdued inflation, low rates, and ample liquidity has profound implications for asset prices, asset allocations, and the resolution of recently emerged vulnerabilities. - Investors and financial institutions that pursued low-volatility, levered, or reach-for-yield strategies appear unprepared for higher realized volatility, rising defaults, and falling asset prices. - Poor liquidity in bond markets could sharply amplify asset price moves and shocks. - Uncertainty about the resolution of the US debt ceiling impasse is adding to risks and volatility in short-term US funding markets. ### Banking Turmoil: Episodes, Causes, and Market Impact - Failures illustrating interest-rate and funding risks: - SVB revealed on March 6 a $1.8 billion loss on sales of Treasuries and agency mortgage-backed securities (MBS) and announced on March 8 a plan to raise funds through a $2.25 billion stock offering. - A $42 billion of deposit withdrawals followed on March 9; FDIC took control of SVB on March 10. - After a withdrawal of 20 percent of its deposits, SBNY was closed on March 12, with the FDIC appointed as receiver. - Central concerns: - Concentrated holdings in long-duration assets funded with unstable sources created rapid balance-sheet stress as rates rose. - The collapse of SVB and SBNY triggered the sharpest correction in the regional bank equity index in decades and adversely affected technology firms that made up much of their deposit bases. - Credit Suisse episode: - Credit Suisse lost investor confidence in mid-March and was taken over by UBS on March 19 at a price tag of 3 billion Swiss francs. - Swiss authorities provided a guarantee of 9 billion Swiss francs to UBS to cope with potential takeover losses if losses exceed 5 billion Swiss francs. - Authorities completely wrote down the nominal value of all AT1 debt of 16 billion Swiss francs. - The decision to write down AT1 while allowing equity holders to recover 3 billion Swiss francs surprised many investors and pressured AT1 markets. - Market reactions and wider effects: - Strains ensued in short-term funding markets, with higher costs for international dollar funding, especially relative to the Swiss franc. - Interbank funding spreads widened in the United States and the euro area. - Sovereign external debt spreads over US Treasuries widened for emerging markets, reversing a narrowing trend since late last year. - Corporate issuance slowed, particularly for sub–investment-grade firms, as corporate debt spreads widened. - Yields on two-year Treasury bonds and two-year Bunds each collapsed by nearly 100 basis points between March 9 and 15 as investors sought refuge in sovereign bond markets. - The reassessment of near-term monetary policy expectations was comparable in magnitude and scale to moves last seen in 1987. ### Central Bank and Policy Responses - US authorities’ emergency package in response to SVB and SBNY: - FDIC will protect all SVB and SBNY deposits, not just FDIC-insured ones. - Federal Reserve introduced the Bank Term Funding Program (BTFP) to lend to depository institutions against the par value of US Treasuries, agency debt, and MBS for up to one year at zero margins. - Usage of facilities and liquidity take-up: - Bank borrowing from the Federal Reserve’s discount window Primary Credit facility surged to an all-time high of 153 billion on March 15. - Take-up at the new Bank Term Funding Program was 12 billion initially; usage increased in following weeks. - The Federal Reserve also had $143 billion in loans outstanding to the two FDIC-created bridge banks as part of the resolution of SVB and SBNY. - FHLB advances surged as banks tapped Federal Home Loan Banks for short-term funding; FHLB system funded advances by issuing discount notes and other debt securities. - Overnight reverse repurchase agreement (ON RRP) usage increased by 270 billion on net since the banking stress. - International coordination and Swiss measures: - Swiss authorities announced extraordinary liquidity assistance for Credit Suisse and UBS for a total of up to 200 billion Swiss francs: - Credit Suisse and UBS can obtain a loan for up to 100 billion Swiss francs (privileged creditor status in bankruptcy). - The Swiss National Bank can grant Credit Suisse another loan of up to 100 billion Swiss francs backed by a federal default guarantee. - Global central banks announced coordinated measures on March 19 to increase liquidity in the international dollar funding market by increasing the frequency of 7-day operations from weekly to daily. ### Financial Stability Risks and Transmission to the Real Economy - Amplification channels: - Rapid repricing of policy expectations and sharp asset price moves can amplify strains through funding markets, repo markets, and collateral scarcity. - Banks’ tightening of lending standards, together with falling loan demand, will likely weigh on broader lending conditions and economic growth. - European risks: - Spreads of swaps over French and German short-dated bonds widened sharply; indications of a shortage of high-quality collateral in secured funding markets. - Potential fragmentation risks from maturing TLTROs by June 2023 where some banks lack excess liquidity for repayment. - ECB affirmed readiness to provide liquidity support and has the Transmission Protection Instrument to preserve smooth policy transmission. ### Policy Guidance and Communication Priorities - Tools and separation of objectives: - Availability of financial-stability tools should help central banks separate monetary policy objectives from financial stability goals, enabling continued tightening to address inflationary pressures. - Managing trade-offs and communications: - If financial pressures intensify amid high inflation, trade-offs between inflation and financial stability objectives may emerge. - Clear communication about central banks’ objectives and policy functions is crucial to minimize economic and financial uncertainty. - Policymakers should act swiftly to prevent systemic events that could shake investor confidence; they should be ready to take all necessary steps to maintain confidence. - Should monetary policy be adjusted to support financial stability, authorities should clearly communicate continued resolve to bring inflation back to target as soon as possible once financial stress lessens. *International Monetary Fund | April 2023* ### 1. German and French Two-Year Government Bond Spreads over Swap ### 1. German and French Two-Year Government Bond Spreads over Swap ### Funding stress in European bond markets and liquidity contraction - Funding stress surged in the European bond market as central bank liquidity contracted. - Jurisdictions with lower excess liquidity may experience further strains as central bank liquidity is shrinking. - Snapshot data for jurisdiction excess liquidity versus outstanding TLTROs correspond to February 28, 2023. - TLTRO = targeted longer-term refinancing operation. ### Bank lending standards, bank stock declines, and GDP impacts - IMF staff estimates link declines in bank stock prices to tighter lending conditions in the following quarter. - Estimated impacts if recent bank stock price falls translate into tighter lending conditions: - One-year-ahead core lending capacity decline by almost 1 percent (United States). - Real GDP decline of 44 basis points in the United States (one year ahead). - Real GDP decline of 45 basis points in the euro area (one year ahead). - Drivers of tighter lending standards cited include: bank capital, bank funding, economic outlook, borrower risk, risk tolerance, and competitive pressure. - Small and medium enterprises likely to be more affected in a lending pullback; loans to small and medium enterprises were already on the decline before the recent turmoil. ### Recent bank failures, deposit runs, and digital-asset exposures - Silicon Valley Bank (SVB) and Signature Bank of New York (SBNY) failures initiated broader stress episodes. - Circle revealed that it held about 8 percent of USDC’s total reserves in SVB deposits. - USDC and Dai dropped sharply from par to the US dollar before recovering after policy actions. - Policy responses included the Bank Term Funding Program and FDIC protection of uninsured SVB and SBNY depositors. - USDC shifted its cash holdings to large, systemic banks, altering planned deposit expansions to smaller community banks. - Silvergate entered liquidation proceedings around the same period, exacerbating confidence strains in digital-assets infrastructure. - The bankruptcy of FTX last November—due to fraudulent practices and risk-management failures—contributed to the digital-assets confidence crisis. ### Hidden interest rate–driven losses in bank securities portfolios - During the pandemic, US banks accumulated large amounts of Treasury and agency MBS in AFS and HTM accounts. - As interest rates rose sharply, market values of Treasuries and agency MBS held by banks declined substantially. - Regulatory and accounting treatment: - Mark-to-market valuation changes for AFS securities do not affect profitability and are treated as unrealized gains and losses, though largest banks must reflect these in regulatory capital. - Valuation changes of HTM securities affect neither profitability nor capital. - If unrealized losses in AFS and HTM securities were fully realized to raise liquidity, impacts include: - Almost 9 percent of US banks with assets between $10 billion and $300 billion would have CET1 ratios below the regulatory requirement of 7 percent (4.5 percent regulatory minimum plus 2.5 percent capital conservation buffer). - The failed banks SVB and SBNY were outliers reflecting poor interest rate risk management and large uninsured, runnable deposits, creating a “doom loop” where deposit runs forced security sales, realizing losses and justifying depositor fears. ### Global bank exposures and funding risks - Banks in Europe, Japan, and emerging markets also face interest rate risk but appear less vulnerable than US banks on average. - HTM portfolio unrealized losses, if fully accounted for in CET1 ratios, could have material impacts for some banks: - In a select sample, 5 percent of banks in Europe could experience impacts of more than 170 basis points; in Japan, more than 80 basis points; and in emerging markets, more than 100 basis points. - Emerging market banks appear less reliant on wholesale short-term funding but more sensitive to changes in the cost of deposits: - Less than one percent of emerging market banks have short-term debt contributing more than 15 percent to total liabilities, compared with almost one-eighth in advanced economy banks. - A far higher share of banks in emerging markets have at least half of their deposit base in interest-bearing deposits (including time deposits) than in advanced economies. - Deposit insurance coverage varies significantly across regions: - Median countries in Africa have a deposit insurance coverage ratio of only 24 percent. - Median countries in the Americas have a deposit insurance coverage ratio of 37 percent. - Asia and Europe have somewhat higher median coverage ratios. ### Nonbank financial intermediaries (NBFIs) and insurer vulnerabilities - NBFIs have built fragilities through financial leverage, liquidity mismatches, and interconnectedness. - Insurance companies have doubled their illiquid investments over the last decade and increased their share of Level III assets (the most illiquid and hardest to value). - Life insurers have increased use of leverage and nontraditional liabilities (for example, funding-agreement-backed securities, Federal Home Loan Bank advances, and repo and securities lending cash). - Rising investment in structured-credit and private credit increases liquidity mismatches and potential vulnerability to margin calls, repo stresses, policy surrenders, or regulatory capital charges in adverse scenarios. - Private credit and leveraged-loan markets have grown significantly, with pension funds and insurance companies owning a significant share of private credit funds. *Source: CHAPTER 1 — A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES (Global Financial Stability Report), International Monetary Fund | April 2023* ### Chapter 2). ### Chapter 2) ### Private Credit Growth and Risks - Private credit has grown rapidly over the last decade, surpassing the size of the US institutional leveraged loan market. - Pension funds and insurance companies are significant investors in the leveraged loan sector. - Increased competition in private credit markets has coincided with: - higher leverage metrics on new transactions, - deterioration in covenant quality. - Tech startup firms that experienced liquidity strains and began withdrawing deposits from SVB were generally backed by private equity and venture capital and were likely beneficiaries of strong growth in private credit markets. - Consequences and vulnerabilities: - Cost of private credit is likely to increase for borrowers, contributing to banks’ more conservative lending posture and weighing on economic activity. - If access to private credit were suddenly restricted in a market stress event, borrowers could face rollover risks. - Low transparency and limited liquidity in private credit markets could cause spillovers to other markets if investors are forced to sell more liquid, mark-to-market assets to access cash. ### Other Headwinds to Investor Sentiment and Market Functioning - Financial conditions eased between October 2022 and early March 2023, reflecting elevated corporate valuations, but tightened after recent stress episodes. - In the days after SVB’s failure: - stock market volatility surged, - credit spreads widened, - strains appeared in interbank funding markets. - Interbank funding spreads remain wide despite partial retracement of initial moves. - Corporate sector and equity outlook: - The strong performance of the S&P 500 from October 2022 to January 2023 was largely supported by a narrowing of the equity risk premium, while lower earnings expectations have been a drag. - Year to date, cyclical stocks have outperformed defensive stocks. - Earnings growth in the United States is already slowing more rapidly than during past tightening cycles that also featured high inflation. - The US Treasury yield curve continues to be inverted, historically a harbinger for recessions. - Equity price volatility could be exacerbated by traders in the zero-day-to-expiration options market. - Market liquidity: - Poor market liquidity has likely amplified recent gyrations, particularly in sovereign bond markets. - Quantitative tightening in the euro area, the United States, and the United Kingdom has likely contributed to shallower market depth. - Bid-ask spreads in Treasury, Bunds, and Japanese government bond markets have widened sharply and the yield curve has become significantly distorted. ### US Debt Ceiling Uncertainty and Short-Term Markets - The statutory US debt ceiling is set at $31.4 trillion, which was reached on January 19, 2023. - US Treasury Secretary’s January 19 letter stating the debt limit had been reached prompted US credit default swaps to soar to levels seen during past debt ceiling episodes. - Extraordinary measures have been employed to allow the US government to defer internal obligations to remain current on external ones. - If Congress fails to raise the debt limit as the so-called “X-date” (estimated as sometime between July to August) approaches, pressure may intensify in the Treasury market, exposing MMFs to higher liquidity, operational, and potentially credit risks, incentivizing them to step away from Treasury bills. - Investors are already demanding additional compensation for holding Treasury bills maturing around the X-date, though spikes remain contained so far. - Credit default swaps at the one-year maturity point and the term structure of Treasury bills have reflected these stress signals. ### Emerging Market Developments and Risks - Between February and the end of March 2023, emerging market equities fell 4 percent on average but were still up 10 percent net since the October 2022 Global Financial Stability Report, reflecting improved risk sentiment after China’s reopening. - Spillovers from banking turmoil into emerging market banks have been contained so far; equity prices of the largest banks are modestly lower. - Sovereign spreads for high-yield and frontier countries have spiked with recent financial market stress. - Differentiation by credit quality: - Investment grade spreads are still below historical averages. - Riskier issuers’ spreads are near crisis levels. - Issuance conditions for sovereign hard-currency debt deteriorated since January 2023; many B-rated and lower issuers face serious challenges accessing markets. - Sovereign defaults and distress: - Eight emerging market sovereigns are currently in default—the greatest number since the global financial crisis. - The number of nondefaulted, distressed issuers rose from 11 to 12. - 18 sovereigns are trading at spreads of more than 700 basis points. - Emerging market currencies have, on net, appreciated back to pre-war-in-Ukraine levels and were little affected by European/US banking turmoil. ### Growth-at-Risk, Downside Scenarios, and Financial Stability - The April 2023 World Economic Outlook global growth forecast for 2023 is 2.8 percent, with balance of risks around this forecast skewed to the downside amid banking sector turmoil. - The probability of growth falling below the current 2023 baseline of 2.8 percent is estimated around 62 percent, based on the Growth-at-Risk framework. - Downside risks—measured by the growth-at-risk metric—remain elevated compared with historical norms. - Under a severe downside scenario (Box 1.3, April 2023 WEO), global financial conditions would tighten significantly and the forecast for global growth would decline to around one percent. - In that severe scenario, downside risk would increase significantly, with growth-at-risk deteriorating to levels comparable to the peak COVID-19 crisis. ### Advanced Economy Policy Trade-offs: Inflation vs Financial Stability - Market-implied monetary policy paths in advanced economies have gyrated since the October 2022 Global Financial Stability Report; investor pricing moved sharply higher then shifted sharply lower as banking sector stress emerged. - Central banks have indicated they possess tools to separately address financial stability risks, allowing them to continue tightening monetary policy to bring inflation back to targets. - Investors appear to expect policymakers will soon end policy tightening and anticipate policy rate cuts in the United States and Europe to start as early as the second half of 2023. - Inflation expectations: - One-year-ahead market-based measures of inflation expectations, implied by inflation swaps, have moved upward in the euro area and the United States on net so far in 2023. - Inflation options markets suggest the probability of inflation being higher than central banks’ 2 percent target over the next 5 years remains elevated. - Option-implied densities show notable investor disagreement for the euro area (bimodal shape), while US investors appear to have converged around a 3 percent outcome. *International Monetary Fund | April 2023* ### 4. Emerging Market Currency Appreciation and Depreciation ### 4. Emerging Market Currency Appreciation and Depreciation ### Monetary policy and market expectations in advanced economies - Market-implied paths for policy rates have shifted significantly lower over recent weeks, driven by investors’ reassessment amid turmoil in the banking sector. - United States: - Federal funds target range: 4.75 percent to 5 percent. - March FOMC median participant projections: policy rate to reach slightly above 5 percent in 2023, decline to about 4.3 percent in 2024, and about 3 percent in 2025. - Median FOMC participant foresees a significantly tight policy stance over the next three years compared to the longer-term neutral rate of 0.5 percent. - European Central Bank: - Increased policy rates by 50 basis points on March 16. - Other major central banks (since December 2021): - Bank of England: increased rates by 400 basis points. - European Central Bank: increased rates by 300 basis points. - Bank of Canada: increased rates by 425 basis points. - Reserve Bank of Australia: increased rates by 350 basis points. - Bank of Japan: - Continued accommodative stance; policy rate unchanged. - Widened the YCC band to 50 basis points on either side of its 0 percent target in December. - 10-year Japanese government bond yield reached its highest level since 2015; more recently the 10-year JGB yield moved down. ### Interest rates, yields, and term premiums - Medium- and longer-term interest rates have declined, on net, in most advanced economies since the October 2022 GFSR, with downward pressure increasing significantly following the failure of SVB. - In the United States, the 10-year Treasury term premium has remained negative, at about –70 basis points, despite a 250-basis-point increase in terminal rate expectations since March 2022. - Persistence of compressed term premiums reflects investors’ preference for safe sovereign bonds and central banks’ continued sizable shares of sovereign bond duration. ### Quantitative tightening and sovereign debt market implications - After large pandemic-era securities holdings, the US Federal Reserve, Bank of England, and European Central Bank have started reducing their balance sheets, increasing the share of government securities the private sector must absorb. - United States: - Net issuance of US Treasury securities is projected to increase in 2023 and 2024, while quantitative tightening is reducing the share absorbed by the Federal Reserve’s balance sheet. - With the same US government debt maturity profile, the private sector will need to absorb more short- and medium-term securities. - US banks had been significant buyers but have recently reduced their holdings of US Treasuries. - Europe and United Kingdom: - Net supply of gilts and European government bonds to the private sector is set to increase significantly in 2023. - European Central Bank began reducing securities holdings in March; European government financing needs are expected to remain substantial in 2023. - Risks: - With liquidity generally poor and debt levels high, quantitative tightening could pose challenges for sovereign debt markets and raise the risk of a sharp repricing. ### Money markets and reserve dynamics - G10 central bank liquidity injections during the pandemic led to a surge in banks’ reserves. Quantitative tightening drains reserves, raising the risk that funding rates could increase markedly as reserves become scarcer. - United States reserve dynamics: - Bank reserves declined by about $725 billion in the months before quantitative tightening. - Reserves declined by about $330 billion from the beginning of quantitative tightening through early March. - The March banking turmoil reversed the decline in reserves by approximately $400 billion. - Federal Reserve assets declined by $540 billion since June 2022, associated on the liabilities side with a decline in the Treasury General Account. - At the current pace, the Federal Reserve’s balance sheet will shrink by about $800 billion in the remaining months of 2023, further reducing reserves. - Assuming total banking system assets stay at early March (before the turmoil) levels, reserves could decline to 11.5 percent of bank assets in 2023, all else equal. - At that level of projected reserves, funding spreads have historically been only a bit more sensitive to changes in reserve balances, though bank strains could further add to higher funding spreads. - Money market functioning: - Prior to the recent turmoil, some signs of tighter funding emerged for smaller banks, with increased use of FHLBs, federal funds market borrowing (highest point since 2016), and the discount window. - Despite pressures, reserves remained abundant and accounted for around 14 percent of the assets of the entire banking system (prior to the turmoil). ### Emerging markets: appreciation/depreciation, spreads, and debt vulnerabilities - Recent deterioration in global risk appetite partially unwound easing in EM financial conditions since October: - Bond yields moved higher and exchange rates depreciated. - Sovereign and corporate hard-currency spreads widened by about 30 basis points. - Market differentiation: - Higher-quality emerging market bonds have rallied since October to levels where new issuance in international markets is reasonably easy. - Frontier and lower-rated issuers and low-income countries face continued difficulties and extremely challenging debt situations. - Portfolio flows: - Portfolio flows stalled since mid-February, with modest outflows from local currency bonds and equities resuming after a strong rebound from late 2022 through January. - Sovereign hard-currency issuance has slowed after one of the strongest periods (context provided in source). - Policy-relevant risks: - High debt levels pose serious medium-term risks for many emerging markets as the era of easy international market access may be ending. - Several existing debt distress cases have shown potential for large spillovers from debt issues to the real economy, disproportionately affecting the most vulnerable households. *Source: ch1 - 4. Emerging Market Currency Appreciation and Depreciation (Global Financial Stability Report: Safeguarding Financial Stability Amid High Inflation and Geopolitical Risks), April 2023.* ### 1. US 10-Year Term Premiums and Terminal Policy Rate Expectations ### 1. US 10-Year Term Premiums and Terminal Policy Rate Expectations ### Key findings - "Term premiums remain compressed despite tightening." - "Notwithstanding advanced stage of tightening, term premiums at present remain compressed ... even though central banks have started to shrink their bond market presence." - 10-year term premium and Terminal policy rate expectations are tracked daily in the figure. - Horizontal lines in the figure "reflect the start of the US Federal Reserve’s quantitative tightening programs in July 2017 and June 2022." ### Measurement and definitions - "Term premiums are based on the Adrian, Crump, and Moech (2013) model and shown for the -year tenors." - "Terminal policy rate expectations reflect the near-term peak forward rate of money market futures curves at a given point in time." - "Panel 3 shows the duration risk absorbed, which is defined as the share of central bank holdings divided by the overall sovereign bond market capitalization." ### Duration absorption and central bank balance-sheet actions - Figure caption: "Duration Absorption of Public Sector Securities for Monetary Policy Purposes (Percent)." - The figure juxtaposes "US Federal Reserve, European Central Bank, and Bank of England" duration absorption measures. - The note emphasizes central banks "have started to shrink their bond market presence." ### Contextual observations from adjacent text (figure context) - The chapter title: "CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES." - Related statements in the surrounding text highlight market and policy pressures, including shifts in portfolio flows, tightening of real (ex ante) policy rates, and sensitivity of emerging markets to advanced-economy policy changes. *Sources: Bloomberg Finance L.P.; European Central Bank; Haver Analytics; and IMF staff calculations.* ### 2. Upcoming Eurobond Maturities (Projected) ### 2. Upcoming Eurobond Maturities (Projected) ### Frontier markets: debt and debt-service pressures - Frontier markets suffer from high levels of both debt and debt service. - Figure referenced: "Figure 1.25. Frontier Markets and Low-Income Country Challenges" (visual not reproduced here). - Note: EMBIG = Emerging Market Bond Index Global. ### Timing of upcoming maturities - Upcoming maturities for frontier markets are limited in the remainder of 2023 but will pick up in 2024. ### Bank–sovereign nexus in low-income countries - The bank-sovereign nexus is increasing in low-income countries, implying elevated interconnected credit and fiscal risks between banks and government-related borrowers. ### Data sources and notes - Sources cited: Bloomberg Finance L.P.; Haver Analytics; International Financial Statistics database; IMF, World Economic Outlook database; and IMF staff calculations. *Italic: International Monetary Fund | Chapter excerpt: "2. Upcoming Eurobond Maturities (Projected)".* ### 3. Share of Debt at Firms by Interest Coverage Ratio by Rating in ### 3. Share of Debt at Firms by Interest Coverage Ratio by Rating in Advanced Economies ### Debt vulnerability by rating and interest coverage - "In advanced economies, more than 70 percent of triple BBB-rated investment-grade corporations could face a rating downgrade to speculative grade." - "The ratings for the majority of firms [are] facing a risk of rating downgrade (interest coverage ratios below 4)." - "Higher-graded firms are more sensitive to a shock to effective interest rates because their funding costs were very low." ### Sensitivity analysis: combined earnings and interest expense shock - Shock scenario assumptions: - "Earnings before interest and taxes decline by 20 percent." - "Effective interest rate on firms’ total debt rises by 200 basis points." - Calibration and sample: - "The earnings shock scenario was calibrated to the previous recession episodes." - "This time, seven more countries were added (Colombia, Hungary, Indonesia, Korea, Malaysia, South Africa, Thailand)." - "A total of about 13,300 firms in 20 countries were analyzed (Brazil, Colombia, France, Germany, Hungary, India, Indonesia, Italy, Japan, Korea, Malaysia, Mexico, Poland, Russia, South Africa, Spain, Thailand, Türkiye, United Kingdom, United States)." - Firm size definitions used in the analysis: - Large: "assets greater than $500 million" - Medium: "between $500 and $50 million" - Small: "less than $50 million" - Rating group definitions: - High grade: "credit ratings between AAA and A" - Investment grade: "BBB-rated firms" - Speculative grade: "BB- to B-rated firms" - "The ratings are given by S&P." - Metric: - "ICR = interest coverage ratio." ### Key implications from the analysis (as stated) - "Lower earnings and higher funding costs would further worsen leverage metrics, including those for large firms." - The combined shock materially increases "debt at risk" across rating categories and firm sizes (figures and distributions referenced in source figures). - "Higher-graded firms are more sensitive to a shock to effective interest rates because their funding costs were very low." *Sources: S&P Capital IQ; and IMF staff calculations.* ### CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES ### Commercial real estate (CRE) and real estate investment trusts (REITs): vulnerabilities and market signals - Higher interest rates and wider lender spreads have significantly increased the cost of capital for CRE funding structures. - US CMBS spreads over ordinary Treasury bonds jumped to about 450 basis points at the end of 2022. - Financing costs of senior loans in core offices in Europe rose to about 350 basis points in Q2 2022, more than 200 basis points higher than the previous year. - Many nonbank lenders, often funded by warehouse lines from money center banks, curtailed activity in anticipation of weaker property markets. - Median portfolio illiquidity of funds holding REITs is about 30 percent higher than that for those holding other equities. - Institutional foreign investors headquartered outside the United States own approximately 16 percent of the total market capitalization of US REITs, increasing cross-border spillover risk. - Negative leverage (interest rate charged by a lender higher than the capitalization rate of the property) in Q3 2022 spiked to 30 percent, up from 5 percent one year earlier. - The increase in negative leverage was concentrated in industrial and multifamily properties, with shares of about 36 percent and 31 percent, respectively. ### Credit conditions, loan performance, and bank exposures - Tightening of financial conditions can create adverse feedback between credit growth and asset prices because housing serves as collateral. - US banks have tightened lending standards for CRE, making financing more challenging for highly leveraged CRE investors. - Higher financing costs and relatively high-risk weights of CRE assets are lowering loan-to-value ratios at which large banks will provide CRE loans. - Decline in nonbank participation and more restrictive bank lending could exacerbate shocks if the economy slows significantly. - CMBS loan delinquency rate is projected to increase significantly to between 4 percent and 4.5 percent by the end of 2023, given higher interest rates and weak economic growth. - In Q3 2022, the share of CRE loans worth less than the CMBS tranches they are in spiked to 30 percent (an increase of 25 percentage points from the previous year). - After sharp reductions in CRE exposures, smaller and regional US banks are increasing CRE exposures again at a pace much brisker than the growth rate of commercial and industrial loans, while the largest banks are not—creating a CRE–regional bank nexus at risk from structurally lower CRE demand and bank fragility. - In Europe, CRE loans represent a large share of total bank lending to nonfinancial corporations: - Shares standing at about 30 percent in aggregate. - Above 49 percent in Sweden, Denmark, and Norway. ### Market functioning, investor behavior, and potential amplification channels - Search for yield over the past decade supported growth of nonbank leveraged institutions with large liquidity mismatches (for example, property investment funds), raising risk of capital flow reversals after sudden investor sentiment shifts. - A substantial rise in interest rates could lower the net present value of mortgages, reducing REIT asset values and leading to margin calls and deleveraging (example: redemption shock at Blackstone Real Estate Income Trust in 2022). - Reductions in nonbank funding and tighter bank lending can amplify price declines and cause substantial losses across intermediaries and investors, including foreign institutions. ### Policy recommendations and macro-financial guidance - Policymakers must continue to address inflationary pressures while using tools to address financial stability risks as needed. - Clear communication about central banks’ objectives and policy functions is crucial to avoid unnecessary uncertainty and preserve market confidence. - If financial strains threaten the system amid high inflation, trade-offs between inflation and financial stability objectives may emerge; authorities should act swiftly to prevent systemic events. - Supervisory and prudential actions: - Ensure banks have corporate governance and risk management commensurate with their risk profiles, including board risk monitoring and adequate capital and liquidity stress tests. - Maintain adequate minimum capital and liquidity requirements, including for smaller institutions that individually are not systemic. - Consider prudential rules ensuring banks hold capital for interest rate risk and guard against hidden losses that could materialize abruptly. - Require adequate capital conservation plans and credible capital restoration plans. - Require a cushion of unencumbered high-quality liquid assets and formal contingency funding plans. - Early intervention, stronger bank resolution regimes, and preparedness to deploy them are needed. - Pay specific attention to bank asset classification and provisions and exposures to interest rate and liquidity risks in the current environment. - Central bank liquidity support principles: - Aim to address liquidity, not solvency issues; solvency should be left to fiscal or resolution authorities. - Provide liquidity to counterparties compelled by supervision to internalize liquidity risk (the “stick”) and intervene only to address systemic liquidity risks (the “carrot”). - Maintain partial insurance to minimize moral hazard; interventions should have well-defined end dates. - Keep interventions parsimonious to avoid conflicting with monetary policy, price liquidity relatively expensively, maintain risk mitigation (for example, haircuts), and agree on loss sharing with fiscal authorities. - Resolution and deposit insurance implications: - Experiences with recent US and Swiss measures indicate further work is needed on resolution reform to increase likelihood systemic banks can be resolved without public funds at risk. - Consider extending the perimeter of international resolution standards to a wider set of banks and reviewing the appropriate reach of deposit insurance schemes, compensated by commensurate insurance premiums. - Supervisors should monitor contagion risk across banks. - Quantitative tightening and market functioning: - Central banks should monitor short-term funding markets and adjust quantitative tightening implementation if needed to address market functioning issues. - In the euro area, authorities should watch for disorderly dynamics as TLTRO loans are repaid. - Communicate objectives and steps for removing liquidity and reducing balance sheets, especially if adjustments are needed given macroeconomic or market developments. - Fiscal-monetary policy interactions: - Tighter fiscal policy can support monetary policy in achieving inflation objectives and help limit governments’ debt burdens, moderating interest rate increases needed to rein in inflation. - Within budget constraints, governments can reprioritize spending to protect the most vulnerable from high food and energy prices. - Emerging market and frontier market guidance: - Remain cautious about premature easing of policy rates despite trade-offs, especially where advanced economy tightening widens interest rate differentials and capital outflow pressures. - Countries with highly vulnerable financial sectors, limited fiscal space, and significant external financing needs face strong pressure and could face further severe challenges in disorderly tightening. - Rebuild fiscal space and buffers; integrate policies within the Integrated Policy Framework to manage volatile capital flows. - Use foreign exchange intervention where appropriate (reserves sufficient and interventions do not impair policy credibility) and consider capital flow management measures in crises. - Sovereign debt and market access: - Sovereign borrowers should contain risks from high debt vulnerabilities via early creditor contact, multilateral cooperation, and international support. - Continued use of enhanced collective-action clauses and majority voting provisions in syndicated loans will help facilitate restructurings. - For countries near debt distress, coordinate preemptive and orderly restructuring to avoid hard defaults; where market access exists, execute refinancing or liability management to rebuild buffers. - Utilize the G20 Common Framework—including a reformed quicker and more effective version—where applicable. - Local currency market development: - Promote depth of local currency markets in emerging markets and diversify investor bases by: - Establishing sound legal and regulatory frameworks for securities. - Developing efficient money markets. - Enhancing transparency of primary and secondary markets and predictability of issuance. - Bolstering market liquidity and infrastructure. - Macroprudential recalibration and real estate monitoring: - Increase financial resilience, recalibrating macroprudential tools to tackle pockets of elevated vulnerabilities while avoiding procyclicality and disorderly tightening. - Deploy stringent stress tests to estimate effects of rising interest rates on borrowers’ repayment capacity and falls in household and CRE prices on household balance sheets and financial institutions. - Revisit prior easing of macroprudential tools where needed to prevent severe macroeconomic implications from sharp tightening of financial conditions amid house price drops. - China-specific measures: - Restore confidence in the real estate sector to limit negative macro-financial spillovers. - Use demand-side measures, timely restructuring or resolution of troubled developers, and fiscal reforms to reduce local governments’ structural reliance on the property market. - Phase out forbearance policies; banks should maintain adequate loss-absorbing buffers. - Develop contingency plans for materializing credit contagion potentially requiring system-wide liquidity provision. - Urgently upgrade restructuring frameworks to facilitate exit of nonviable firms and banks while protecting financial stability. - Nonbank financial intermediation (NBFI) and crypto: - Close key data gaps about NBFIs, provide incentives for risk management, set appropriate regulation, and intensify supervision. - Consider three potential types of central bank liquidity support to NBFIs: (1) discretionary marketwide operations; (2) access to standing lending facilities (bar set very high); (3) central bank support as lender of last resort of a systemic NBFI. - Communicate interventions clearly, explaining objectives, parameters, and timeframe for exit to avoid perceived conflict with quantitative tightening. - Crypto ecosystem collapse underscores urgent need for comprehensive and consistent regulation and supervision focused on consumer protection, financial integrity, and corporate governance. - Regulatory frameworks should cover storage, transfer, exchange, custody of reserves; entities with multiple functions should face additional prudential requirements. - Stable coin issuers should be subject to strict prudential requirements. - Strong international cooperation and globally consistent crypto regulation are essential. - Climate-related finance: - Align capital flows on a low-carbon trajectory; current renewable energy investment and production fall grossly short of funding needed to meet climate targets. - Rapid acceleration of investment in low-carbon energy infrastructure is needed, especially in emerging market and developing economies. - Private finance is key; climate and financial policies, including a transition-oriented climate information architecture, are complementary. - The new Resilience and Sustainability Trust can help eligible IMF members address longer-term structural challenges generated by climate change. *Source: CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES (IMF Global Financial Stability Report, April 2023).* ### CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES ### CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES ### Failures of Silicon Valley Bank (SVB) and Signature Bank - SVB established in 1983 to serve mostly startup and venture capital firms; became the 16th-largest bank in the United States during the postpandemic venture capital boom. - As venture capital funding reportedly dried up in 2022, depositors began to leave SVB. - SVB revealed it had incurred a $1.8 billion loss from selling Treasury and agency securities to meet earlier large deposit withdrawals. - Unrealized losses related to higher rates on SVB’s holdings were about $18 billion. - Deposit withdrawal requests on March 9 reportedly reached $42 billion, more than one-fourth of the bank’s deposit base, fueled by electronic withdrawals. - SVB was placed under Federal Deposit Insurance Corporation (FDIC) receivership on March 10. - Signature Bank of New York (SBNY) was a $110 billion bank; 30 percent of its deposits were from the crypto sector. Its stock declined by almost 40 percent between March 8 and 10. The bank was closed on March 12, with the FDIC appointed as receiver. ### Authorities’ Emergency Responses in the United States and Abroad - After initially protecting only insured deposits, US authorities (the Treasury, the Federal Reserve, and the FDIC) rolled out an emergency package with two key components: - The systemic risk exemption was triggered, allowing the FDIC to resolve SVB and SBNY by protecting all deposits. Any cost to the deposit insurance fund will be recovered, if needed, by a special assessment on banks. - The Federal Reserve introduced the Bank Term Funding Program: - Lend to any US bank and foreign branch against the par value of its holdings of US Treasuries, agency debt, and mortgage-backed securities that were owned by the borrower as of March 12. - Maturity: for up to one year. - Pricing: at zero margins, but with recourse to the borrower. - The program will be kept in place until March 2024. - Banks can obtain funds for up to one year (as opposed to 90 days for the existing discount window), equivalent to the full face value (as opposed to the lower market value) of the securities they hold. - Disclosure is ex post, occurring after two years. - Any losses from the program of up to $25 billion will be absorbed by the Treasury’s exchange stabilization fund. - Outside the United States, authorities in jurisdictions where SVB operated (including Canada, China, Germany, Hong Kong SAR, Korea, and Thailand) spoke publicly to calm depositors. - In the United Kingdom, authorities facilitated a purchase by HSBC of the local SVB subsidiary, protecting all creditors at no cost to the UK deposit insurance fund. - Interventions were also made in SVB branches in other countries (for example, Canada and Germany), which are expected to be wound down. ### Failure of FTX and Crypto Ecosystem Contagion - FTX filed for bankruptcy in November 2022. - Pre-failure reported metrics for FTX: - More than 1 million registered users. - Estimated trading volume of about $600 billion. - Estimated market value of nearly $35 billion. - $8.8 billion in liabilities. - $900 million in liquid assets. - Key shortcomings revealed: lack of business transparency in corporate structure; inappropriate use of clients’ funds; reliance on self-issued unbacked tokens for solvency and liquidity; inadequate financial reporting. - Alameda Research (affiliate) held significant holdings of FTT, FTX’s unbacked token. FTX had made an estimated $8 billion in loans collateralized by FTT to Alameda Research (equivalent to more than half of its customer deposits). - The collapse of FTT and the run on FTX caused contagion to other crypto exchanges and crypto lending firms: - Some crypto lenders (for example, Genesis and BlockFi) filed for bankruptcy because of large exposures. - At its peak, Genesis reportedly had $6.5 billion in loans outstanding to Alameda Research, only 50 percent of which were secured. - Contagion extended through Genesis to another crypto exchange, Gemini, which temporarily halted withdrawals. - Broader contagion outside the crypto ecosystem was limited, with exceptions including a few small banks with close ties to crypto and some pension funds in the United States with investments in FTX. ### Rapid Growth of Retail Trading in Zero-Day-to-Expiry (0DTE) Options and Associated Risks - 0DTE options trade only on their day of expiration; nearly half the options trading volume on the S&P 500 is now attributed to 0DTE, compared with the 15 percent share of 0DTE before the pandemic. - Retail participation in 0DTE: - The share of retail investors amounts to about 10 percent of the trading volume in 0DTE options. - Timeline and market structure notes: - 0DTE options were originally available only on the last trading day of the week. - In April and May 2022, the Chicago Board Options Exchange added new expiration dates, allowing 0DTE options to be traded throughout the week. - Empirical research findings: - Retail investors tend to trade options around important announcements (economic data releases and central bank decisions), when market volatility is highest. - Research indicates retail investors trading in the options market often end with losses ranging between 5 and 9 percent. - Market-impact mechanics: - Dealers dynamically adjust hedging (delta hedging) in response to price evolution, potentially leading to higher intraday volatility. - Market participants reported higher 0DTE volume around consumer price index data releases, the US job report, and Federal Reserve meetings, leading to an increased occurrence of intraday fluctuations in the S&P 500 exceeding 1 percent during the first quarter of 2023. - Dealers often use longer-dated equity options to hedge 0DTE exposures, which could affect the CBOE Volatility Index. - Policy considerations: - Active retail involvement raises questions about disclosures and regulation of retail investor participation in complex financial instruments. - While no financial stability risk is imminent, rapid growth raises concerns that these instruments could amplify market movements and, in the worst-case scenario, lead to panic selling—especially when liquidity is poor and hedging is challenging. ### Bank of Japan (BoJ) Yield Curve Control, Large JGB Holdings, and Potential Spillovers - The Bank of Japan has maintained accommodative monetary policy while other central banks tightened: - Negative policy interest rate since January 2016. - Yield curve control since September 2016. - Under yield curve control, the BoJ aims to maintain yields within a band centered at 0 percent and has committed to buy unlimited quantities of government bonds to achieve its target. - Recent developments: - Ten-year Japanese government bond yields declined in sympathy with global yields as strains emerged in US and European banking sectors; previously, tightening elsewhere and rising domestic inflation had put upward pressure on Japanese bond yields. - To keep 10-year Japanese government bond yields around the target, the BoJ scaled up purchases and now owns: - 70 percent of all outstanding 5-year Japanese government bonds. - More than 80 percent of outstanding 10-year Japanese government bonds. - Market functioning and volatility indicators: - Increased Japanese government bond illiquidity prompted substantial BoJ purchases and intervention. - Rates volatility and foreign exchange volatility (for example, USDJPY option implied volatility) increased in the period surrounding yield curve control adjustments. - Potential for international spillovers: - Adjustments to the yield curve control framework have been a major focus for market participants. - The BoJ’s substantial holdings abroad remain significant for potential international spillovers as portfolio investment assets of Japanese investors (excluding foreign reserves) are sizable. *International Monetary Fund | April 2023 — CHAPTER 1 (excerpts from the source PDF)* ### CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES ### CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES ### Bank of Japan yield curve control adjustment and potential spillovers - Japan announced at its December 2022 meeting the widening of the target band for 10-year yields from 25 basis points to 50 basis points. - The announcement was unexpected, leading to significant volatility in Japan’s exchange rate and long-term interest rates. - Channels through which changes to the Bank of Japan’s yield curve control framework may affect international financial markets: - Exchange rates. - Term premiums on sovereign bonds. - Global risk premiums. - A possible chain of interlinked spillovers: - A rise in Japanese government bond yields could increase Japanese government bond term premiums (for a given policy rate and expected path of monetary policy). - This could provide incentives for repatriation of Japanese portfolio investments and draw foreign investors into Japanese bonds. - Resulting forces could push up the foreign exchange value of the yen and put upward pressures on interest rates abroad. - Size of spillovers would vary across countries depending on: - Financial links with Japan. - Country-specific factors. - The broader risk-appetite backdrop. - Existing literature notes that spillovers from Japanese monetary policy shocks have been modest and more regional in nature, but these studies examine periods of increasing monetary accommodation rather than policy tightening. ### Japanese portfolio investment abroad and security portfolio rebalancing - Japan’s portfolio of investment assets abroad reached $5 trillion in the fourth quarter of 2020—double its level before the global financial crisis—before declining somewhat more recently. - Security portfolio rebalancing developments in 2022: - Life insurance companies and banks started to rebalance their portfolios as Japanese government bond yields and the cost of foreign exchange hedging rose, selling $200 billion of foreign bonds. - Recent available data point to strong demand by Japanese investors in 2023. - Should domestic long-term interest rates in Japan rise further, repatriation would likely continue (albeit at a slower pace, as institutional investors are reportedly cautious not to exit foreign markets in ways that will lead to large marked-to-market losses). - Pension fund behavior: - The Government Pension Investment Fund represents roughly half of the entire stock of pension funds in Japan. - Its policy mix consists of 25 percent domestic bonds, 25 percent domestic equities, 25 percent foreign bonds, and 25 percent foreign equities. - Pension fund managers review the mix in a five-year cycle, suggesting that their investment policy for diversification may not change immediately. - Potential cross-country impacts of repatriation: - Larger effects on sovereign bond yields where Japanese investors hold a large market share—examples include Australia, several euro area countries, and the United States. - Some emerging markets, such as Indonesia and Malaysia, could face material capital outflows because Japanese investors hold a nonnegligible share of their sovereign bonds outstanding. - If market participants are surprised by Bank of Japan announcements and actions, pace and effects of repatriation could be larger; even emerging markets with small direct financial links to Japanese investors could potentially see material outflows due to sensitivity of capital flows to shocks in global risk premiums. - Historical observation: - Until the December 2022 adjustment, spillovers from Japan to other advanced economies had not increased meaningfully in 2022 despite higher Japanese government bond yields. - Policy implication: - As central banks pursue their price stability mandate, it is imperative they clearly telegraph their intentions to avoid unwarranted volatility and mitigate spillovers in global financial markets. ### Energy crisis, fossil fuels, and impacts on the low-carbon transition - Russia’s invasion of Ukraine exacerbated strains in energy markets, contributing to a global energy crisis. - As Russia curtailed natural gas supply to Europe and sanctions on imports of Russian oil and coal were introduced, coal and gas prices rose. - These increases accounted for 90 percent of the inflationary pressure on electricity prices worldwide (IEA 2022). - Despite later easing, global coal demand and production are set to reach all-time highs in 2022: - Coal demand projected to rise by 1.2 percent in 2022. - Coal production projected to rise by 5.5 percent in 2022. - In the European Union, coal production is set to rise by 7 percent in 2022, driven by Germany and Poland switching from higher-priced natural gas and reactivating coal-fired power plants. - Equity impact: - With improved profitability, the equity value of coal companies has exceeded that of oil and gas companies since the summer of 2022. - Critical minerals and renewables: - Prices of minerals and metals critical to renewables soared in 2021 and 2022, with prices remaining elevated in the first month of 2023. - Price increases driven by higher demand and supply limitations from production bottlenecks, shut-in of some metal smelters because of high energy prices in Europe, and Russia’s role as a key exporter of certain commodities such as aluminum and nickel. - Even though generation of wind and solar electricity rose in 2022, average prices for onshore wind and solar photovoltaics have risen worldwide, reversing a decade-long declining trend. - Despite positive policy developments, current investments in the low-carbon transition remain insufficient to meet Paris Agreement temperature targets, increasing climate-related financial stability risks. ### Investment and debt trends in energy sectors - Sustainable debt issuance: - Sustainable debt issuance hit more than $1 trillion in 2022 but recorded its first annual year-over-year decline of 19 percent. - Performance of renewable-related indices: - Performance of renewable energy indices (such as the MSCI Global Green Bond Index) has deteriorated, while most environmental, social, and governance bond and equity funds have under-performed. - Fossil fuel company debt and investment: - Total debt among companies in the oil and gas sector rose by 3.3 percent since the start of 2022. - Total debt among companies in the coal sector rose by 23.3 percent since the start of 2022. - Investment in fossil fuels continues to increase, including in expansion (new oil and gas fields, coal mines, and coal-fired power production). - Investment shortfalls for net-zero pathway: - Shortfalls in renewable energy investment remain significant: $1 trillion shortfall compared with investment targets in a net-zero scenario. - A plateau in global coal-fired power generation capacity is expected by 2025, but shortfalls in renewable investment are especially pronounced in emerging market and developing economies. - In those economies, natural gas may therefore play a larger dispatchable role to satisfy peak demand amid potentially limited renewable production without large-scale storage capacity. ### Policy recommendations and communication priorities - Central banks should clearly telegraph their intentions when announcing and implementing any changes in the instruments, framework, or stance of monetary policy to avoid unwarranted volatility and mitigate spillovers in global financial markets. - Clear communication is critical to avoid market volatility in the event of adjustments to the Bank of Japan’s monetary policy stance. *Source: CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES (IMF, April 2023).* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2023/april/english/ch1.pdf_