## Global Financial Stability Report: Safeguarding Financial Stability Amid High Inflation and Geopolitical Risks (April 2023) — Selected Highlights ## Source details **Canonical URL:** [Global Financial Stability Report: Safeguarding Financial Stability Amid High Inflation and Geopolitical Risks (April 2023) — Selected Highlights](https://www.imf.org/-/media/files/publications/gfsr/2023/april/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2023/april/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2023/april/english/text.pdf.json) --- ### Preface, Purpose, and Recent Market Events - Purpose and scope - Assesses key vulnerabilities the global financial system is exposed to and highlights policies to mitigate systemic risks. - Reflects information available as of March 30, 2023. - Coordination and contributors - Analysis coordinated by the Monetary and Capital Markets (MCM) Department under Tobias Adrian. - Project directed by Fabio Natalucci; Jason Wu; Nassira Abbas; Charles Cohen; Antonio Garcia Pascual; Mahvash Qureshi; Jérôme Vandenbussche; Mario Catalán. - Editor’s Note (4/12/23): minor text corrections; sentence on page 32 amended. - Recent market events (March 2023) - Silicon Valley Bank (SVB) and Signature Bank of New York failed after rapid depositor flight. - Swiss authorities announced a state-supported merger of Credit Suisse with UBS. - US and European bank stock prices sold off by about 25 and 14 percent, respectively. - Coordinated central bank actions contained broader financial market stress. ### Foreword — Banking Turmoil, Nonbank Risks, and Policy Responses - Banking turmoil and nonbanks - Failures: SVB, Signature Bank, and loss of confidence in Credit Suisse (GSIB). - Nonbank vulnerabilities: liquidity backstops and resolution mechanisms less well developed for nonbanks; Chapter 2 discusses crisis management tools for nonbanks. - Market reactions and monetary policy expectations - Significant repricing of monetary policy rate expectations comparable in magnitude and scale to Black Monday in 1987. - Investors now anticipate central banks to begin easing monetary policy well in advance of previous forecasts, while inflation remains above target. - Bank balance sheet impacts and lending consequences - Lending capacity of US banks could decline by almost 1 percent in the coming year, reducing real GDP by 44 basis points, all else being equal. - IMF staff: unrealized losses in HTM portfolios would likely be modest for the median bank in Europe, Japan, and emerging markets, though material for some banks. - Sovereign and low-income country stress - 12 sovereigns trading at distressed spreads and an additional 20 at spreads of more than 700 basis points. - More than half (37 out of 69) low-income countries are in, or at high risk of, debt distress. ### Chapter 1 — A Financial System Tested by Higher Inflation and Interest Rates (Key Findings) - Crisis drivers and distinguishing features - Current turmoil partly stems from unrealized losses in portfolios of safe, but falling-in-value, securities. - Post-2008 reforms (capital, liquidity, crisis frameworks) helped stem broader loss of confidence. - Banking-sector vulnerabilities - US regional and smaller banks: account for more than one-third of total bank lending; have concentrated deposit bases and high duration risk. - Quantified near-term impact: lending capacity of US banks could drop by about 1 percent in the coming year, reducing real GDP by 44 basis points. - 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 after fully accounting for unrealized losses in AFS and HTM securities. - Commercial Real Estate (CRE) - US CMBS spreads: jumped to about 450 basis points at end-2022. - CMBS loan delinquency rate projected to increase to between 4 percent and 4.5 percent by end-2023. - In Q3 2022, share of CRE loans worth less than the CMBS tranches they are in spiked to 30 percent. - In the United States, banks with total assets less than $250 billion account for about three-quarters of CRE bank lending. - Market functioning and quantitative tightening - Term premiums remain compressed despite quantitative tightening; two-year Treasury and two-year Bund yields collapsed by nearly 100 basis points between March 9 and 15. - Central banks’ normalization may pose challenges for sovereign debt markets given poor liquidity and high debt levels. ### Chapter 2 — Nonbank Financial Intermediaries (NBFIs): Vulnerabilities and Policy Options - Scale and core vulnerabilities - NBFIs’ share of global financial assets grew from about 40 to nearly 50 percent. - Key amplifiers: financial leverage, liquidity mismatches, interconnectedness. - Empirical sector findings (numbers preserved) - Investment funds (excluding MMFs and hedge funds): $58 trillion, 12 percent of GFA. - Insurance companies: $40 trillion, 9 percent of GFA. - Pension funds: $43 trillion, 9 percent of GFA. - Money market funds: $8.5 trillion, 2 percent of GFA. - Structured finance vehicles: $6 trillion, 1 percent of GFA. - Hedge funds: $6 trillion, 1 percent of GFA. - Central counterparties: $0.7 trillion, 0.1 percent of GFA. - Global hedge fund cash leverage ~1.8 times net asset value; synthetic leverage for US-domiciled hedge funds increased from 8 times to 14 times net asset value (asset-weighted). - Liquidity mismatches and data gaps - Open-end funds’ liquidity deteriorated to levels last seen at COVID-19 onset; portfolio similarity increased. - Significant regulatory data gaps on leverage, liquidity, and counterparties impede supervision. - Central bank toolkit for NBFI stress (three broad types) 1. Discretionary marketwide operations (temporary, targeted, data-driven thresholds). 2. Standing lending facilities (access bar set very high; coordinate with NBFI regulation). 3. Central bank as lender of last resort for systemic NBFIs (solvent-only, penal rate, full collateral, supervisory oversight). - Policy priorities - Close data gaps; incentivize risk management; set appropriate regulation; intensify supervision. - Guardrails for NBFI central bank liquidity access to limit moral hazard and preserve price-stability mandates. - Improve leverage disclosures, stress testing, resolution regimes, and cross-border coordination. ### Chapter 3 — Geopolitics and Financial Fragmentation: Implications for Macro‑Financial Stability - Geopolitical fragmentation effects - One-standard-deviation increase in geopolitical distance reduces bilateral cross-border allocation of portfolio investment and bank claims by about 15 percent; investment funds’ cross-border portfolio allocations decline by more than 20 percent. - Median gross portfolio investment outflow in a scenario: 1.5 percent of recipient-country GDP; mean ≡ 2.8 percent of recipient-country GDP; global decline in portfolio flows ≡ about 3 percent of world GDP. - For emerging market economies, a one-standard-deviation increase in geopolitical distance is associated with a decline in net capital flows of about 3 percent of GDP; for advanced economies, about 2 percent of GDP. - Bank-level transmission - Increased geopolitical distance raises bank funding costs, reduces profitability, and contracts lending, with larger effects for emerging market banks and banks with lower capitalization. - Banks with capital ratios in the top 25th percentile experience much smaller adverse effects. - Macroeconomic modeling of fragmentation - Moderate fragmentation: median volatility of output rises by 1 percentage point relative to full integration. - Extreme fragmentation: median volatility of output rises by 3 percentage points relative to full integration. - Moderate fragmentation implies about 20 percent loss of diversification benefits; extreme fragmentation implies nearly 40–50 percent loss. - Cross-border payments and sanctions - Financial sanctions can reduce remittances by about 17.1 percent within six quarters and increase remittance costs by 3 percentage points. ### Selected Event-Level and Quantified Episodes (preserving reported figures) - SVB specific figures - SVB disclosed a $1.8 billion loss on sales of Treasuries and agency MBS on March 6. - SVB announced a $2.25 billion stock offering on March 8. - $42 billion of deposit withdrawals followed on March 9. - Unrealized losses related to higher rates on SVB’s fixed income holdings ≈ $18 billion. - Federal Reserve and official facilities and usage - Discount window Primary Credit facility usage surged to 153 billion on March 15. - Initial take-up at the Bank Term Funding Program ≡ 12 billion. - Federal Reserve had $143 billion in loans outstanding to the two FDIC-created bridge banks for SVB and SBNY resolution. - Swiss authorities: announced extraordinary liquidity assistance up to 200 billion Swiss francs (loans up to 100 billion Swiss francs to each bank plus SNB backstop up to another 100 billion Swiss francs). - Credit Suisse takeover price: 3 billion Swiss francs; AT1 nominal value fully written down ≡ 16 billion Swiss francs; guarantee to UBS up to 9 billion Swiss francs in case losses exceed 5 billion Swiss francs. - Sovereign stress metrics - 12 sovereigns trading at distressed spreads; 18 sovereigns trading at spreads of more than 700 basis points (chapter mentions 18 in one instance, and 20 in another section—preserve both as reported in source sections). - China and local government financing vehicles (LGFVs) - China housing market: 28 percent contraction in 2022. - Total LGFV debt estimated at about 50 percent of China’s GDP. - Local government debt increased to about 30 percent of GDP after record issuance in 2022. - Local governments issued 2.8 trillion yuan of refinancing bonds and 4.8 trillion yuan of new bonds. - IMF staff estimates: real estate and LGFV exposures ≈ 14 percent of WMP assets under management ≡ 4.2 trillion yuan; ≈ 23 percent of trust assets ≡ 3.3 trillion yuan. - Corporate-sector stress-test scenario (IMF staff assumptions) - Earnings before interest and taxes decline by 20 percent. - Effective interest rate rises by 200 basis points instantaneously. - Under the scenario: shares of small and medium firms with interest coverage ratios less than 4 rise by 7 percentage points and 17 percentage points, respectively (advanced economies). ### Policy Recommendations (Consolidated) - Monetary and financial stability - Central banks should maintain well-communicated separation of monetary policy and financial-stability tools; use emergency lending facilities and targeted asset purchases to address liquidity while maintaining tight monetary stance to combat inflation. - Liquidity support should address liquidity not solvency; solvency left to fiscal or resolution authorities. - Price liquidity support relatively expensively; interventions should be time-bound with well-defined end dates and loss-sharing arrangements. - Banking supervision and resolution - Ensure banks’ governance, risk management, capital and liquidity stress tests are commensurate with risk profiles. - Strengthen resolution regimes to increase likelihood systemic banks can be resolved without public funds; consider expanding international resolution standards and revisiting deposit insurance perimeters. - NBFI oversight and guardrails - Close data gaps; enhance surveillance; incentivize NBFI risk management; set proportionate regulation; intensify supervision and resolution planning for systemic NBFIs. - Consider central bank NBFI liquidity access only with strong guardrails and coordination with fiscal authorities. - Emerging and frontier markets - Build buffers: adequate international reserves, capital and liquidity buffers, and credible medium-term fiscal consolidation plans. - Use Integrated Policy Framework for FX interventions when appropriate; capital flow management measures may be an option in imminent crises as part of comprehensive packages. - Sovereign borrowers should engage early with creditors; use G20 Common Framework where applicable and coordinate on preemptive restructuring for countries near debt distress. - Cross-border and geopolitical preparedness - Embed geopolitical risks in stress tests; bolster international cooperation to limit financial fragmentation and improve cross-border payments interoperability. - Strengthen multilateral efforts to diplomatically resolve geopolitical tensions and prevent economic and financial fragmentation. - Sectoral and structural policies - Recalibrate macroprudential tools to contain pockets of elevated vulnerabilities (CRE, corporate leverage, housing). - Revisit prior macroprudential loosening where necessary and deploy stress tests for borrowers and CRE exposures. - Accelerate climate-aligned capital flows and private finance mobilization to close renewable investment shortfalls (report notes a $1 trillion shortfall versus net-zero scenario targets). *Italic: Source: Global Financial Stability Report: Safeguarding Financial Stability Amid High Inflation and Geopolitical Risks (International Monetary Fund | April 2023) — content as provided.* ### Preface ### Preface ### Purpose and scope - The Global Financial Stability Report assesses key vulnerabilities the global financial system is exposed to and seeks to highlight policies that may mitigate systemic risks to contribute to global financial stability and sustained economic growth. - This issue of the Global Financial Stability Report reflects information available as of March 30, 2023. ### Coordination and contributors - Analysis coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director, MCM. - Project directed by: - Fabio Natalucci, Deputy Director, MCM - Jason Wu, Assistant Director, MCM - Nassira Abbas, Deputy Division Chief - Charles Cohen, Deputy Division Chief - Antonio Garcia Pascual, Deputy Division Chief (all MCMGA) - Mahvash Qureshi, Division Chief - Jérôme Vandenbussche, Deputy Division Chief - Mario Catalán, Deputy Division Chief (all MCMGS) - Individual contributors include Mustafa Oguz Caylan; Yingyuan Chen; Fabio Cortes; Cristina Cuervo; Reinout De Bock; Andrea Deghi; Max-Sebastian Dovì; Torsten Ehlers; Salih Fendoglu; Deepali Gautam; Sanjay Hazarika; Shoko Ikarashi; Phakawa Jeasakul; Esti Kemp; Oksana Khadarina; Nila Khanolkar; Darryl King; Johannes Kramer; Harrison Kraus; Yiran Li; Corrado Macchiarelli; Sheheryar Malik; Aurelie Martin; Junghwan Mok; Kleopatra Nikolaou; Natalia Novikova; Tatsushi Okuda; Thomas Piontek (Chapter 2 co-lead); Silvia Ramirez; Patrick Schneider; Felix Suntheim; Hamid Reza Tabarraei; Tomohiro Tsuruga (Chapter 3 co-lead); Romain Michel Veyrune; Jeffrey David Williams; Yanzhe Xiao; Ying Xu; Dmitry Yakovlev; Mustafa Yenice; and Akihiko Yokoyama. - Luigi Zingales served as Expert Advisor. - Editorial and production led by Rumit Pancholi from the Communications Department, with assistance from Denise Bergeron, David Einhorn, Nancy Morrison, Grauel Group, Absolute Service, Inc., and word processing by Javier Chang, Monica Devi, Olga Lefebvre, and Srujana Sammeta. ### Recent market events and systemic relevance - In March 2023: - Silicon Valley Bank (SVB) and Signature Bank of New York, US regional banks, failed after rapid depositor flight. - Swiss authorities announced a state-supported merger of Credit Suisse with UBS following a loss of market confidence—the first failure of a global systemically important bank since the global financial crisis. - US and European bank stock prices sold off significantly, by about 25 and 14 percent, respectively. - Concurrent market reactions included a flight to quality in sovereign bond markets and a reassessment of the global monetary policy path. - Coordinated central bank actions contained broader financial market stress. ### Authorities’ responses - US authorities applied a rarely used “systemic risk exception” allowing the Federal Deposit Insurance Corporation to protect all depositors of the banks under stress, at higher cost to the deposit insurance fund. - The Federal Reserve created a new lending facility allowing all banks to borrow against high-quality securities at par value—which is generally higher than market values—to mitigate liquidity pressures. - Swiss authorities implemented a state-supported merger including liquidity support and a fiscal backstop. - These quick and decisive actions contained the immediate threats to financial stability. ### Core vulnerabilities and distinguishing features of the episode - Tighter monetary policy after years of low interest rates is challenging banks’ effective risk management in securities portfolios and of loan exposures. - The current turmoil differs from past crises: - The 2008 crisis spread rapidly from banks to nonbanks and off-balance-sheet entities and was triggered by credit losses due to housing market declines. - The current turmoil in part stems from unrealized losses in portfolios of safe, but falling-in-value, securities. - Post-2008 reforms—bank capital and liquidity rules and crisis management frameworks—were strengthened, helping to stem broader loss of confidence and underpin swifter, better coordinated policy responses. - It also differs from the 1997 Asian financial crisis (current account deficits and heavy external borrowing) and the 1980s US savings and loan crisis (entities with significantly less capital and liquidity). ### Emerging and ongoing risks - Stresses from tighter monetary policy may result in further bouts of financial instability. - Riskier capital market segments such as leveraged loans and private credit markets have slowed. - Growing concerns about conditions in commercial real estate markets, which are heavily dependent on smaller banks. - While banking stocks in advanced economies have undergone significant repricing, broad equity indices remain very stretched in many countries, having appreciated markedly since the beginning of the year. - Previous Global Financial Stability Reports and Financial Sector Assessment Programs flagged risks and country-specific gaps in supervision, regulation, and resolution. ### Editorial note and corrections - Editor’s Note (4/12/23): This version of the report, issued on April 12, 2023, includes minor text corrections to Figures 1.13, 1.23, and 1.24 and the Executive Board Discussion of the Outlook. The sentence on page 32 was amended: “For frontier markets, conditions are back near crisis levels, as global financial stress has increased.” *Source: https://www.imf.org/-/media/files/publications/gfsr/2023/april/english/text.pdf* ### FOREWORD ### FOREWORD ### Recent banking turmoil and risks from nonbanks - Sudden failures: "The sudden failures of Silicon Valley Bank and Signature Bank in the United States, and the loss of market confidence in Credit Suisse, a global systemically important bank (GSIB) in Europe" highlighted vulnerability of financial system to tighter monetary and financial conditions. - Rapid spread of stress: "Amplified by new technologies and the rapid spread of information through social media, what initially appeared to be isolated events in the US banking sector quickly spread to banks and financial markets across the world, causing a sell-off of risk assets." - Nonbank vulnerabilities: "Liquidity backstops and resolution mechanisms are less well developed for nonbanks. In the second chapter, we extensively discuss crisis management tools for nonbanks." - Nonbank contagion channels: "Concerns remain about vulnerabilities that may be hidden, not just at banks but also at nonbank financial intermediaries (NBFIs)." ### Contagion, investor behavior, and emerging markets - Deposit runs and information diffusion: "The recent banking turmoil also demonstrated the growing influence of mobile apps and social media in spreading sudden financial asset allocations. Word of deposit withdrawals spread globally at lightning speed..." - Emerging markets resilience and limits: - "At this point, contagion to the banking systems of major emerging markets remains contained..." - "Emerging market banks tend to have less exposure to interest rate risk and a substantially higher share of stickier retail deposits." - Caveats: "The coverage level of deposit insurance schemes varies and emerging market banks in some countries have assets with lower credit quality than those in advanced economies..." - Frontier and high-yield EMs more affected: "While sovereign spreads of investment-grade emerging market have remained stable, those for frontier economies and high-yield emerging market widened to crisis levels following these recent events." - Market access and debt distress: "Additional countries have likely lost market access, and debt distress pressures have become more pronounced." ### Policy responses, crisis management, and central bank tools - Separation of objectives: "Central banks have tools to separate the actions to maintain financial stability from those taken to maintain price stability." - Tools for financial stability while keeping tight monetary stance: "For example, emergency lending facilities and targeted asset purchases can be used to inject liquidity to support financial stability while maintaining a tight stance of monetary policy." - Broader policy toolkit: "The policy toolkit also has to include robust surveillance, well-resourced and appropriately intensive supervision of financial institutions, and strong regulation." - Resolution and prompt intervention: "In addition, the prompt intervention and resolution of nonviable banks are crucial for effective crisis management." - Communication in acute crises: "If financial sector distress was to have severe repercussions affecting the broader economy, clean separation between price stability and financial stability objectives could become more tenuous... If so, they should clearly communicate their continued resolve to bring inflation back to target as soon as possible once financial stress lessens." - Need for cooperation: "Global cooperation among central banks, financial regulators, and finance ministries is essential. Timely and resolute policy action will be key to contain any further bouts of instability." ### Market reactions and monetary policy expectations - Risk asset sell-off and repricing: Recent events "caus[ed] a sell-off of risk assets (Figure ES.1). It also led to a significant repricing of monetary policy rate expectations, with magnitude and scale comparable to that of Black Monday in 1987 (Figure ES.2)." - Policy expectations: "Investors have sharply repriced downward the expected path of monetary policy in advanced economies (Figure ES.5). They now anticipate central banks to begin easing monetary policy well in advance of what was previously forecast. Inflation, however, has remained uncomfortably well above target." - Central bank balance sheet normalization: "After having significantly increased their securities holdings during the pandemic, central banks have started to reduce their balance sheets. This normalization process could pose challenges for sovereign debt markets at a time when liquidity is generally poor, debt levels are high, and additional supply of sovereign debt will have to be absorbed by private investors." ### Bank balance sheet impacts and lending consequences - US regional banking stress drivers: "In the United States, investors’ fears about losses on interest rate–sensitive assets led to the banking sell-off, especially for banks with concentrated deposit bases and large mark-to-market losses (Figure ES.3)." - Equity and lending effects: "With the recent fall in bank equity prices, lending capacity of US banks could decline by almost 1 percent in the coming year, reducing real GDP by 44 basis points, all else being equal." - Unrealized losses on HTM securities: IMF staff estimates that "the impact on regulatory ratios of unrealized losses in held-to-maturity portfolios for the median bank in Europe, Japan, and emerging markets would likely be modest, although the impact for some other banks could be material (Figure ES.4)." ### Sovereign debt, frontier markets, and low-income countries - Sovereign distress metrics: "There are now 12 sovereigns trading at distressed spreads and an additional 20 at spreads of more than 700 basis points, a level at which market access has historically been very challenging (Figure ES.8)." - Frontier market issuance and market access: "In frontier markets, brisk debt issuance evaporated in 2021 and may not resume at the same scale... (Figure ES.9)." - Low-income country vulnerabilities: "Low-income countries ... continue to face extremely challenging debt conditions, with more than half (37 out of 69) in, or at high risk of, debt distress." ### Households, corporates, and real estate risks - Household balance sheets and housing: "Households accumulated significant savings during the pandemic... However, they are facing heavier debt-servicing burdens, eroding their savings and leaving them more vulnerable to default." - Housing market developments: "The steep increase of residential mortgage rates has cooled global housing demand. Average house prices fell in 60 percent of the emerging markets in the second half of 2022..." - Commercial real estate (CRE): - "Concerns have been growing about conditions in the commercial real estate (CRE) market... Global transaction activity has decreased by 17 percent from the previous year, and REITs have seen price corrections up to 20 percent." - "Losses have been particularly elevated in the office sector..." - US CRE lending concentration: "In the United States, banks with total assets less than $250 billion account for about three-quarters of CRE bank lending..." - Corporate sector buffers and risks: "For firms, default rates have remained low... However, declining corporate earnings and tighter funding conditions have started to erode these buffers and could lead to repayment difficulties down the road... Small firms and emerging market corporates would likely be more adversely affected..." ### China-specific and local government-related vulnerabilities - China property sector: "China’s housing market remains sluggish despite its reopening... home buyers continue to avoid purchasing from weaker private developers..." - LGFV exposure: "Concerns about debt sustainability of local government financial vehicles (LGFVs)—which are heavily involved in the property market—intensified in 2022; with total LGFV debt estimated at about 50 percent of China’s GDP, a broadening of LGFV debt distress could impose significant losses on some banks, particularly in low-income regions with higher local government debt and large stocks of unfinished housing (Figure ES.12)." ### Interconnectedness of NBFIs and systemic implications - Growing linkages: "Chapter 2 shows that NBFIs are increasingly interconnected with banks globally (Figure ES.13)." - Typical distress pattern: "Case studies show that nonbank financial intermediary stress tends to emerge with elevated leverage, poor liquidity, and high levels of interconnectedness, and that it can spill across jurisdictions, including to emerging market and developing economies." - Policy trade-offs in high-inflation environment: "These vulnerabilities may be heightened in the current high-inflation environment, as the provision of liquidity by central banks for financial stability purposes becomes more challenging, including from a communications standpoint, and it could undermine the fight against inflation." *International Monetary Fund | April 2023* ### Chapter 3 documents how rising geopolitical tensions among ### text - Chapter 3 documents how rising geopolitical tensions among ### Geopolitical tensions and fragmentation - Rising geopolitical tensions among major economies could raise financial stability risks by increasing global economic and financial fragmentation and adversely affect the cross-border allocation of capital. - Fragmentation could cause capital flows to suddenly reverse and could threaten macro-financial stability by increasing banks’ funding costs. - These effects are likely to be more pronounced for emerging markets and for banks with lower capitalization ratios. - Fragmentation could exacerbate macro-financial volatility by reducing international risk diversification, particularly in countries with lower external buffers. ### Financial stability vulnerabilities highlighted - The financial system is being tested by higher inflation and rising interest rates while inflation in many jurisdictions remains uncomfortably above central banks’ targets. - The emergence of stress in financial markets is complicating central banks’ tasks and could create trade-offs between inflation and financial stability objectives if financial strains intensify significantly. - Recent turmoil in the banking sector has highlighted failures in internal risk management practices with respect to interest rate and liquidity risks, as well as supervisory lapses. - Cash buffers built up while the total debt increased by 8.2% relative to 2019; cash buffers have depleted at a much faster pace than debt since 2021. - Nonbank financial intermediaries (NBFIs) are increasingly interconnected with banks and other financial institutions, heightening cross-border linkages and potential contagion channels. ### Policy recommendations - Central banks should have tools aimed at addressing financial stability risks so they can separate monetary policy objectives from financial stability goals, allowing continued tightening to address inflationary pressures. - Clear communication about central banks’ objectives and policy functions is crucial to avoid unnecessary uncertainty. - Policymakers should act swiftly to prevent any systemic event that may adversely affect market confidence in the resilience of the global financial system. - If policymakers need to adjust monetary policy stance to support financial stability, they should clearly communicate continued resolve to bring inflation back to target as soon as possible once financial stress lessens. - Supervisors should ensure banks have corporate governance and risk management commensurate with their risk profile, including risk monitoring by bank boards and adequate capital and liquidity stress tests. - For NBFIs, policymakers should close data gaps, incentivize proper risk management practices, set appropriate regulation, and intensify supervision. - Adequate minimum capital and liquidity requirements, including for smaller institutions that individually are not considered systemic, are essential to contain financial stability risks. - Prudential rules should ensure banks hold capital for interest rate risk and guard against hidden losses that could materialize abruptly in the event of liquidity shocks. - Authorities should pay specific attention to bank asset classification and provisions as well as to exposures to interest rate and liquidity risks in the current environment of persistent inflation and high interest rates. - Central banks’ liquidity support measures should aim to address liquidity, not solvency, issues; solvency should be left to relevant fiscal (or resolution) authorities. - Liquidity should be provided to counterparties that are compelled by supervision and regulation to internalize liquidity risk (the “stick”), so central banks may need to intervene only to address systemic liquidity risks (the “carrot”). - A significant part of the risk should remain in the marketplace (“partial insurance”) to minimize moral hazard, and interventions should have a well-defined end date. - Further work is needed on resolution reform to increase the likelihood that systemic banks can be resolved without putting public funds at risk; allocating more losses across the creditor hierarchy before public funds are used has proven harder to deliver. - According to the IMF’s Integrated Policy Framework, foreign exchange interventions may be appropriate in the case of illiquid foreign exchange markets, balance sheet mismatches, and weakly anchored inflation expectations, so long as reserves are sufficient and intervention does not impair macroeconomic credibility or substitute for necessary adjustment. - In case of imminent crises, capital outflow measures may be an option to lessen outflow pressures, but they should be part of a comprehensive policy package and be lifted once crisis conditions abate. - Sovereign borrowers in developing economies and frontier markets should enhance efforts to contain risks associated with high debt vulnerabilities, including early contact with creditors, multilateral cooperation, and international support. - Enacting credible medium-term fiscal consolidation plans could help contain borrowing costs and alleviate debt sustainability concerns. - For countries near debt distress, bilateral and private sector creditors should coordinate on preemptive restructuring, using the G20 Common Framework where applicable. - Providing NBFIs with direct access to central bank liquidity could be necessary in times of stress, but appropriate guardrails are paramount. - Robust surveillance, regulation, and supervision of NBFIs are vital as a first line of defense. - Situationally appropriate central bank liquidity support for NBFIs can be considered—discretionary marketwide operations, standing lending facilities, or lender of last resort—but such support needs to be carefully designed to avoid moral hazard. - Policymakers should devote resources to assessing, managing, and mitigating financial stability risks caused by rising geopolitical tensions. - Financial institutions may need to hold adequate capital and liquidity buffers to mitigate such geopolitical risks. - Policymakers should ensure that the global financial safety net is adequate. - Multilateral efforts should be strengthened to diplomatically resolve geopolitical tensions and prevent economic and financial fragmentation. ### IMF Executive Board discussion highlights - Executive Directors broadly agreed with staff’s assessment of the global economic outlook, risks, and policy priorities, noting persistence of high inflation and recent financial sector stresses. - Directors considered that forces shaping the world economy in 2022—including Russia’s war in Ukraine and geopolitical tensions, high debt levels, and tighter global financial conditions—are likely to continue into 2023. - Directors noted that risks to the outlook have increased and are tilted to the downside, including the possibility that core inflation could be more persistent and recent banking sector stresses could amplify with contagion effects. - Directors reiterated the need for multilateral cooperation to defuse geopolitical tensions and safeguard global financial markets, manage debt distress, foster global trade, ensure food and energy security, and advance green and digital transitions. - Many Directors warned that fragmentation into geopolitical blocs could generate large output losses, especially affecting emerging market and developing economies. - Directors emphasized that policy responses should differ across countries, reflecting circumstances and exposures, with most economies needing policy tightening to durably reduce inflation while standing ready to mitigate financial sector risks. - Directors stressed that central banks should maintain a sufficiently tight, data-dependent monetary policy stance to durably reduce inflation and avoid de-anchoring of inflation expectations, while being ready to restore financial stability and confidence as needed. - Directors called for fiscal and monetary policy alignment, credible medium-term fiscal frameworks, improved debt transparency, better mechanisms for orderly debt restructurings, and readiness of multilateral institutions to provide timely support. *Global Financial Stability Report: Safeguarding Financial Stability Amid High Inflation and Geopolitical Risks (April 2023)* ### Chapter 1 at a Glance ### Chapter 1 at a Glance ### Overview and recent developments - 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. - Failures and confidence losses cited: - Silicon Valley Bank (SVB) and Signature Bank of New York (SBNY) failures in the United States. - Loss of confidence in Credit Suisse and its subsequent state-supported acquisition by UBS. - Drivers of stress: - Interaction between tighter monetary and financial conditions and vulnerabilities built up since the global financial crisis (liquidity, duration, and credit risk exposures, often amplified by leverage). - Rapid removal of liquidity by central banks in a high-inflation environment, with disinflation slower than anticipated. - Amplification through technology and social media accelerating loss of confidence and cross-border contagion. - Policy responses so far have been forceful and reduced market anxiety, but market sentiment remains fragile and strains persist across institutions and markets. ### Banking sector: key vulnerabilities and implications - Funding can disappear rapidly; events at midsized or smaller banks can trigger systemic loss of confidence. - Shifting deposit patterns could raise funding costs and restrict banks’ ability to provide credit. - US regional and smaller banks are highlighted risks because: - They account for more than one-third of total bank lending. - They may have concentrated deposit bases and high exposure to duration risk. - Quantified near-term impact (as reported): - With the recent fall in bank equity prices, lending capacity of US banks could drop by about 1 percent in the coming year, reducing real GDP by 44 basis points, all else being equal. - Emerging market banks so far appear to have avoided the pressures felt by advanced economy banks due to: - Much less exposure to interest rate risks because of lower share of market-to-market securities, higher share of funding through retail deposits, and less reliance on short-term debt and non–interest-bearing deposits. - Caveats: low levels of deposit insurance in some countries, less fiscal and monetary space, generally lower asset credit quality, and larger roles in domestic financial systems. ### Nonbank financial intermediation (NBFI) and sectoral stress - Amplification channels: financial leverage, mismatches in asset and liability liquidity, and high interconnectedness within NBFI and with traditional banks. - Sectors under stress and spillovers: - Venture capital and the technology sector deterioration contributed to SVB’s demise. - Spillovers from SVB affected the crypto ecosystem (depegging of two stablecoins: Circle USDC and Dai) and institutions exposed to crypto, contributing to Signature Bank’s failure. - Commercial real estate (CRE) concerns due to worsening fundamentals and tighter funding costs. - In the United States, banks with total assets less than $250 billion account for about three-quarters of CRE bank lending, raising systemic relevance of CRE stresses. - NBFIs’ role in REITs and CMBS markets creates broader financial stability and growth implications. ### Households, corporates, and macro-financial risks - Buffers accumulated during the pandemic boosted shock-absorption capacity for households and corporations, but these buffers are deteriorating. - Rising interest rates increase debt-servicing burdens for households and reduce firms’ earnings and cash buffers, raising default vulnerability if the global economy slows meaningfully. - Downside macro risks highlighted: - Elevated growth-at-risk measure. - Escalation of Russia’s war in Ukraine or a sharp rebound in China could raise energy prices and headline inflation. - Rising geopolitical tensions could cause financial fragmentation and sudden reversals in cross-border capital flows, especially affecting emerging markets and developing economies. ### Emerging markets: divergence and vulnerabilities - Large emerging markets have largely avoided adverse spillovers due to: - Commencing monetary tightening early. - Stronger fundamentals and higher buffers than in the past. - Limited spillovers so far, but risks remain if global risk-taking pulls back and capital outflows occur. - Smaller and riskier emerging market economies: - Face highly challenging international market access. - Sovereign debt sustainability metrics continue to worsen, especially in frontier markets and low-income countries; many of the most vulnerable already face severe strains. - International debt issuance remains low following 2022 and could face another difficult year if financial conditions stay tight. - Capital flows that have offset lower portfolio investment since COVID-19 (from banks and nonfinancial corporations) may now be under pressure. ### Policy implications and recommendations - Central banks and monetary policy: - The emergence of financial market stress complicates central banks’ task amid persistent inflationary pressures. - Clear communication about central banks’ objectives and policy functions is crucial to minimize economic and financial uncertainty. - Availability of tools aimed at addressing financial stability risks should help central banks separate monetary policy objectives from financial stability goals, allowing continued tightening to address inflation. - If financial strains intensify and require adjustments to monetary policy, authorities should clearly communicate continued resolve to bring inflation back to target as soon as possible once financial stress lessens. - Banking supervision and regulation: - Ensure banks have governance and risk management commensurate with their risk profiles, including adequacy of capital and liquidity stress tests. - Maintain adequate minimum capital and liquidity requirements to guard against hidden losses that materialize abruptly during liquidity shocks. - Strengthen resolution regimes and crisis management frameworks. - Nonbank financial intermediation: - Close data gaps, incentivize proper risk management practices, set appropriate regulation, and intensify supervision to limit amplification of stresses. ### Key statistics and facts (preserved as reported) - Data cutoff date unless otherwise stated: March 30, 2023. - US regional and smaller banks account for more than one-third of total bank lending. - Lending capacity of US banks could drop by about 1 percent in the coming year, reducing real GDP by 44 basis points, all else being equal. - In the United States, banks with total assets less than $250 billion account for about three-quarters of CRE bank lending. - Stablecoins directly affected by SVB failure: Circle USDC and Dai. *Source: Chapter 1 at a Glance, Global Financial Stability Report, International Monetary Fund | April 2023.* ### Chapter 3). The recovery in China could stall, causing ### Chapter 3). The recovery in China could stall, causing ### Financial stability risks from higher inflation and interest rates - Recovery in China could stall, causing further stress in the property development sector and in real estate markets, resulting in contagion to the banking sector and local governments and ultimately creating more widespread risks to financial stability. - If global financial conditions tighten sharply, refinancing risks for vulnerable emerging markets may increase further, raising the prospect of debt distress. - After more than a decade of subdued inflation, low rates, and ample liquidity, the prospect of inflation and interest rates being higher for longer has profound implications for asset prices, asset allocations, and the resolution of vulnerabilities. - Investor strategies predicated on low volatility—reaching for yield and using of leverage—may be 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. ### Turmoil in the banking sector: recent events and triggers - Rapid interest rate hikes lowered significantly the value of financial assets, particularly bonds with fixed coupons. - Failures highlighted: SVB and SBNY collapsed after rapid deposit outflows and mark-to-market losses. - SVB revealed on March 6 a $1.8 billion loss on sales of Treasuries and agency mortgage-backed securities (MBS). - SVB 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, leading to the FDIC taking control of SVB on March 10. - SBNY was closed on March 12 after a withdrawal of 20 percent of its deposits; the FDIC was appointed as the bank’s receiver. - The collapse of SVB and SBNY sparked concerns about other US regional banks with runnable deposits and interest rate–sensitive securities not priced at market value, triggering the sharpest correction in the regional bank equity index in decades. - Credit Suisse lost investor confidence in mid-March, spurring European bank stock price collapses and soaring credit default swap spreads. - On March 19, Credit Suisse was taken over by rival UBS at a price tag of 3 billion Swiss francs; Swiss authorities provided a guarantee of 9 billion Swiss francs to UBS in case losses exceed 5 billion Swiss francs. - Authorities completely wrote down the nominal value of all Additional Tier 1 (AT1) debt of 16 billion Swiss francs in the takeover. ### Market reactions and funding stresses - Short-term funding markets experienced increased volatility: - International dollar funding costs rose, especially with respect to the Swiss franc. - Interbank funding spreads widened in the United States and the euro area. - Sovereign external debt spreads for emerging markets widened, reversing the narrowing trend since late last year. - Corporate debt issuance slowed, particularly for sub–investment-grade firms, as corporate debt spreads widened. - Investors sought refuge in sovereign bonds; yields of the two-year Treasury and the two-year Bund each collapsed by nearly 100 basis points between March 9 and 15. - The turmoil led to a significant reassessment of monetary policy rate expectations, with magnitude and scale comparable to Black Monday in 1987. - AT1 market implications: - The decision to fully write down AT1 debt while allowing equity holders to recover 3 billion Swiss francs surprised many investors. - AT1 prices declined significantly after the announcement. - Multiple authorities issued public statements reaffirming that AT1 debt is senior to bank equity in resolution to calm the market. ### Central bank and official sector responses - US authorities’ emergency package to cushion SVB and SBNY included: - FDIC will protect all SVB and SBNY deposits, not just FDIC-insured ones. - The 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. - Federal Reserve facility usage and related figures: - Bank borrowing from the Federal Reserve’s discount window’s standing 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). - 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 and money markets: - FHLB advances surged as banks used advances against mortgages to get short-term funding; FHLB debt issuance increased markedly. - Interest rates of FHLB discount notes and in repo markets moved up noticeably immediately after SVB’s collapse. - Money market funds (MMFs) witnessed strong inflows, driving their assets to new record heights; overnight reverse repurchase agreement (ON RRP) increased by 270 billion on net since then. - Prime MMFs saw modest outflows concentrated at funds exposed to SVB. - Swiss and international actions: - Swiss authorities announced extraordinary liquidity assistance for Credit Suisse and UBS for a total of up to 200 billion Swiss francs (loans up to 100 billion Swiss francs to each bank, plus SNB backstop of up to another 100 billion Swiss francs). - 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 maturity operations from weekly to daily. ### Implications for lending, monetary policy, and fragmentation risks - Stress in the banking sector is likely to weigh on broader lending conditions and thus economic growth. - Banks in the United States, the euro area, and emerging markets were already tightening lending standards before the failures. - In Europe, stress raised spreads of swaps over French and German short-dated bonds and highlighted shortages of high-quality collateral in secured funding markets. - TLTRO-related risks: - Mandatory targeted longer-term refinancing operations (TLTRO) repayments coming due in June could require additional liquidity support. - Banks in some southern European countries that rely heavily on short-term TLTROs may not have enough excess liquidity to repay, revealing potential fragmentation risks. - The European Central Bank established the Transmission Protection Instrument to ensure smooth transmission of its monetary policy across euro area countries. ### Policy guidance and priorities - 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 to tighten policy to address inflationary pressures. - If financial pressures intensify significantly and threaten the health of the financial system 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 any systemic event that could shake investor confidence in the global financial system; confidence is at the core of the financial sector. - If policymakers need to adjust the stance of monetary policy to support financial stability, they should clearly communicate their continued resolve to bring inflation back to target as soon as possible once financial stress lessens. *Source: GLOBAL FINANCIAL STABILITY REPORT: SAFEGUARDING FINANCIAL STABILITY AMID HIGH INFLATION AND GEOPOLITICAL RISKS (Chapter content).* ### 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 conditions - Funding stress is surging in the European bond market amid central bank liquidity contraction. - Snapshot data for jurisdiction excess liquidity versus outstanding TLTROs correspond to February 28, 2023. - Note: TLTRO = targeted longer-term refinancing operation. - The Silicon Valley Bank and Credit Suisse episode starts amid these strains. ### Jurisdiction excess liquidity versus outstanding TLTROs (selected observation) - Jurisdictions are heterogeneous in excess liquidity and exposure to outstanding TLTROs (share of national GDP). - Jurisdictions listed in the snapshot include: Luxembourg, Finland, Belgium, The Netherlands, Malta, Austria, Spain, Portugal, Lithuania, Slovenia, Cyprus, France, Germany, Euro area, Estonia, Greece, Ireland, Italy, Slovakia, Latvia. - Sources: Bloomberg Finance L.P.; European Central Bank Statistical Data Warehouse; and IMF staff calculations. ### Bank lending standards, credit conditions, and macroeconomic impact - Global banks in some jurisdictions have already tightened lending standards considerably. - Rising concerns about economic outlook and borrower risks are key contributors to tightening. - IMF staff estimates: - Recent sharp fall in bank stock prices in the United States and euro area portends even tighter lending conditions in the second quarter of this year. - This would, all else equal, lead to a decline of one-year-ahead core lending capacity by almost 1 percent. - Associated real GDP impacts: a decline of 44 basis points in the United States and 45 basis points in the euro area (one-year-ahead). - Small and medium enterprises are likely to be more affected in a lending pullback. - Loans to small and medium enterprises as a share of overall bank loans were already on the decline (panel 5). - Commercial real estate (CRE) lending tends to have larger boom-and-bust cycles and could be disproportionately impacted by bank lending pullbacks. ### Recent crypto-market and digital asset stress observations - Circle (operator for USDC) revealed it held about 8 percent of its total reserves in SVB deposits; USDC and Dai dropped sharply from par to the US dollar before recovering after policy interventions. - USDC shifted its cash holdings to large, systemic banks, reducing planned expansion of deposits to smaller community banks. - Broader digital asset confidence was undermined by collapses including Silvergate and the prior bankruptcy of FTX. ### Hidden interest rate–driven losses and US bank vulnerabilities - During the pandemic, US banks accumulated large amounts of Treasury and agency MBS in AFS and HTM accounts to extend maturities in a low-rate environment. - As interest rates rose sharply, market values of these securities declined substantially; unrealized losses would have material impacts if banks were forced to sell. - Regulatory context and CET1 impacts: - For most banks, unrealized losses sitting in AFS and HTM portfolios would have a material but manageable impact on CET1 capital ratios if forced to sell entire holdings. - The failed banks SVB and SBNY were outliers with poor internal interest rate risk management and large unrealized losses exposed by deposit runs. - 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) after fully accounting for unrealized losses in AFS and HTM securities. - Some smaller US banks could face intensified interest rate risk if rates stay higher for longer and they are forced to sell securities to raise liquidity. - Lack of comprehensive information on derivatives use to hedge interest rate risk; banks with large fixed-rate assets (mortgages, fixed-rate loans) may be exposed. ### Global banks’ interest-rate and funding risk profiles - Banks in other advanced economies and emerging markets are exposed to interest rate risk but appear less vulnerable than US banks on average. - Comparing securities holdings (percent of total assets): United States, Japan, Europe, Emerging markets—US banks hold a larger share of debt securities sensitive to higher interest rates. - HTM portfolio impacts (select sample): some banks in Europe, Japan, and emerging markets could experience CET1 impacts exceeding 170 basis points, 80 basis points, and 100 basis points, respectively, if HTM losses were fully accounted for. - Funding structure differences: - Emerging market banks appear less reliant on wholesale funding but more sensitive to changes in 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. - Share of banks with at least half of deposit base in interest-bearing deposits is far higher in emerging markets than in advanced economies. - Deposit insurance coverage varies significantly across regions: - Median country deposit insurance coverage ratio: Africa 24 percent, Americas 37 percent; Asia and Europe somewhat higher. - Sources: SNL Financial; US Federal Reserve; IMF staff estimates; International Association of Deposit Insurers; national central banks. ### Nonbank Financial Intermediaries (NBFIs) vulnerabilities - NBFIs leveraged up during the low-rate, low-volatility era: leverage, liquidity mismatches, and interconnectedness are key fragilities. - Insurance companies have doubled their illiquid investments over the last decade (share of Level III assets increased). - Insurers increased exposure to structured-credit securities with embedded leverage and to illiquid private credit; life insurers increased nontraditional liabilities (funding-agreement-backed securities, Federal Home Loan Bank advances, repo funding). - Resulting risks: - Greater liquidity mismatches between illiquid assets and liabilities could make portfolio liquidation difficult amid margin calls or policy surrenders if interest rates rise rapidly. - Insurers vulnerable to corporate defaults and credit downgrades in an economic slowdown, which could force asset liquidation amid rising regulatory capital charges. - Private credit growth and investor composition: - Private credit assets under management and US leveraged loans and high-yield bonds outstanding have grown markedly. - Pension funds and insurance companies own a significant share of private credit. - Sources: Bloomberg Finance L.P.; Goldman Sachs; Haver Analytics; ICE Bond Indices; National Association of Insurance Commissioners; PitchBook; Preqin; S&P Capital IQ; St. Louis Fed; UBS; US Flow of Funds; IMF staff calculations. *Italic: Source — text from IMF Global Financial Stability Report: Safeguarding Financial Stability amid High Inflation and Geopolitical Risks (April 2023), chapter content provided.* ### Chapter 2). ### Chapter 2) ### Private Credit Expansion 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 market. - Increased competition in private credit markets has been associated with: - Increased leverage metrics on new transactions. - Deterioration in covenant quality. - Tech startup firms that experienced liquidity strains and withdrew deposits from SVB were generally backed by private equity and venture capital deals and were likely beneficiaries of strong private credit growth. - Consequences of tightening private credit conditions: - Cost of private credit is likely to increase for borrowers, contributing to a more conservative lending posture of banks 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 during stress episodes, as investors may be forced to sell more liquid assets with mark-to-market pricing to access cash. ### Recent Market Stress and Investor Sentiment - Financial conditions eased from October 2022 through early March, reflecting elevated corporate valuations, but tightened after recent banking stress episodes. - Immediate market reactions following SVB’s failure included: - Stock market volatility surge. - Credit spreads widening. - Strains in interbank funding markets. - Some moves partly retraced in subsequent weeks, although interbank funding spreads remain wide. - Deteriorating corporate earnings outlook could challenge investor risk appetite: - The S&P 500’s strong performance from October to January 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 featured high inflation. - The US Treasury yield curve remains inverted, historically a harbinger for recessions. - Equity price volatility could be exacerbated by traders in the zero-day-to-expiration options market, who tend to react discretely to earnings and macroeconomic news. ### Market Liquidity, Sovereigns, and the US Debt Ceiling Risk - Poor market liquidity has likely amplified recent market gyrations, particularly in sovereign bond markets, reflecting high uncertainty and effects of quantitative tightening in the euro area, the United States, and the United Kingdom. - Indicators of deteriorating liquidity: - Treasury market depth became shallower. - Bid-ask spreads in Treasury, Bunds, and Japanese government bond markets have widened sharply. - The yield curve has become significantly distorted. - US debt ceiling context: - The debt ceiling is the limit on total federal debt; it is set at $31.4 trillion, which was reached on January 19, 2023. - US Treasury Secretary Janet Yellen’s January 19 letter stating that outstanding US debt had reached its statutory limit prompted US credit default swaps to soar to levels seen during past debt ceiling episodes. - Extraordinary measures have been employed allowing the US government to defer internal obligations to remain current on external ones. - If Congress fails to agree on raising 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 (at the extreme) credit risks, incentivizing them to step away from Treasury bills. - Investors are already demanding additional compensation for holding Treasury bills with maturities around the X-date, though spikes remain contained so far. ### Emerging Markets’ Response and Sovereign Stress - Emerging markets equities fell 4 percent on average in February through the end of March but were still up 10 percent, on 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: - Strong differentiation persists between investment grade (spreads still below historical averages) and riskier issuers (spreads near crisis levels). - Eight emerging market sovereigns are currently in default, the greatest number since the global financial crisis. - The number of nondefaulted, distressed issuers has risen from 11 to 12. - 18 sovereigns are trading at spreads of more than 700 basis points, a level at which market access has historically been very challenging. - Issuance conditions for sovereign hard-currency debt have deteriorated since January; many B-rated and lower issuers face serious challenges accessing the market. - Since October 2022, many emerging market currencies have appreciated back to pre-war-in-Ukraine levels and have been little affected by the banking turmoil. ### Growth-at-Risk and Downside Scenarios - According to the April 2023 World Economic Outlook, the global growth forecast for 2023 is at 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, as measured by the growth-at-risk metric, remain elevated compared with historical norms. - Under a severe downside scenario discussed in Box 1.3 of the April 2023 World Economic Outlook: - Global financial conditions would tighten significantly. - The forecast for global growth would decline to around one percent. - Downside risk would increase significantly, with the growth-at-risk metric deteriorating to levels comparable to the peak COVID-19 crisis. ### Monetary Policy, Inflation Expectations, and Financial Stability Trade-offs - The market-implied path of monetary policy in advanced economies gyrated widely since the October 2022 Global Financial Stability Report: - After moving sharply higher on expectations of tighter policy to tackle inflation, the policy path shifted sharply lower in recent weeks as investors priced in significant easing due to banking sector stress. - Central banks indicate they have tools to separately address financial stability risks, allowing continuation of tightening to bring inflation back to targets. - Investors appear to anticipate policy rate cuts in the United States and Europe as early as the second half of this year. - Inflation expectations: - One-year-ahead market-based measures of inflation expectations, as implied by inflation swaps, have moved upward in the euro area and the United States, on net, so far this year. - Inflation options pricing suggests the probability of inflation being higher than central banks’ target of 2 percent over the next 5 years remains elevated. - Investor disagreement is notable for the euro area (bimodal option-implied density), while investors in the United States appear to have converged around a 3 percent outcome. *Source: Chapter 2) (text), Global Financial Stability Report: Safeguarding Financial Stability Amid High Inflation and Geopolitical Risks, April 2023.* ### 4. Emerging Market Currency Appreciation and Depreciation ### 4. Emerging Market Currency Appreciation and Depreciation ### Market developments and investor sentiment - Market-implied paths for policy rates have shifted significantly lower over recent weeks, driven by investors’ reassessment of the future course of policy amid turmoil in the banking sector. - Sovereign and corporate hard-currency spreads have widened by about 30 basis points, highlighting the sensitivity of emerging market assets to global developments. - Despite recent moves, market perception of emerging market risks remains strongly differentiated according to ratings: higher-quality emerging market bonds have rallied to levels at which new issuance in international markets is reasonably easy, whereas frontier and other lower-rated issuers will likely face continued difficulties. - Portfolio flows have stalled since mid-February, with modest outflows from local currency bonds and equities resuming after a strong rebound from late 2022 through January. ### Debt, funding pressures, and vulnerabilities - High debt levels continue to pose serious medium-term risks for many countries, as the era of easy international market access for all emerging markets may be coming to an end. - Low-income countries, which have been adversely affected by high food and energy prices, continue to have extremely challenging debt situations. - Several existing debt distress cases have already showcased the potential for large spillovers from debt issues to the real economy, with a disproportionate effect on the most vulnerable households. - Quantitative tightening in advanced economies is increasing the supply of government securities that the private sector will need to absorb, adding pressure on global sovereign debt markets at a time when liquidity is generally poor and debt levels are high. ### Issuance, market access, and segmentation - On net since October, higher-quality emerging market bonds have rallied to issuance-friendly levels, while frontier and lower-rated issuers are likely to face continued difficulties accessing international markets. - Sovereign hard-currency issuance has slowed after one of the strongest periods (late 2022 through January), consistent with stalled portfolio flows and widening spreads. ### Policy implications and considerations - The deterioration in global risk appetite underscores the need for heightened debt-monitoring and contingency planning in vulnerable emerging markets. - With global quantitative tightening advancing and the private sector expected to absorb more sovereign issuance, emerging markets—especially lower-rated and low-income countries—face elevated rollover and refinancing risks. - Policy attention should focus on preserving market access for higher-quality issuers while addressing financing needs and debt sustainability for lower-rated and low-income countries to limit real-economy spillovers and protect vulnerable households. *Source: 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 ### Term premiums and terminal policy rate observations - Term premiums and terminal rates are observed daily. - 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. - Finding: "Term Premiums Remain Compressed Despite Tightening" — notwithstanding advanced stage of tightening, term premiums at present remain compressed. ### Time-series markers and events - Horizontal lines in the series reflect the start of the US Federal Reserve’s quantitative tightening programs in July 2017 and June 2022. - Panel 1 covers daily observations from Mar. 2008 through Mar. 2023. ### Central bank holdings and duration absorption (G3) - Panel 3 (Duration Absorption of Public Sector Securities for Monetary Policy Purposes) shows the duration risk absorbed is defined as the share of central bank holdings divided by the overall sovereign bond market capitalization. - The panel reports holdings for: - Euro area: holdings in the asset purchase program and the pandemic emergency purchase program, government bond holdings relative to the outstanding government debt securities in euro area. - United Kingdom and United States: securities held outright and other balance-sheet items as shown in the figure. - Finding: Term premiums remain compressed even though central banks have started to shrink their bond market presence. ### Quantitative tightening and reserves (US, euro area, UK) - Central banks’ balance sheets swelled during the pandemic, leading to a massive increase of bank reserves. - Finding: In the United States, the effect of quantitative easing on reserves so far has been small, despite reverse repurchases remaining high. - Panels and indicators include: - Bank Reserves in the United States, the Euro Area, and the United Kingdom (Percent of GDP). - Securities Held Outright, Reserves, and Overnight Reverse Repurchase Volumes (Billions of US dollars). - Reserve Balance and Federal Funds Interest Rate of Excess Reserves Spreads (Basis points; percent of bank assets). - Time coverage in related charts includes Mar. 2015 through Mar. 2023 and labels showing after 2019 / before 2019 / latest. ### Data sources and notes - Sources: Bloomberg Finance L.P.; European Central Bank; Haver Analytics; and IMF staff calculations. - Notes: Panel 1 shows term premiums and terminal rates observed daily. 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. *Source: IMF staff summary of "1. US 10-Year Term Premiums and Terminal Policy Rate Expectations" from the provided PDF content.* ### 2. Upcoming Eurobond Maturities (Projected) ### 2. Upcoming Eurobond Maturities (Projected) ### Frontier markets and low-income country vulnerabilities - Frontier markets suffer from high levels of both debt and debt service. - Upcoming maturities for frontier markets are limited in the remainder of 2023 but will pick up in 2024. - The bank-sovereign nexus is increasing in low-income countries. - Note: EMBIG = Emerging Market Bond Index Global. ### China housing market and LGFV (local government financing vehicle) risks - Housing market in China remains sluggish after a 28 percent contraction in 2022; home sales remain weak and prices are only starting to stabilize. - Lower-tier cities, where stalled presold properties are concentrated, have not shown signs of recovery. - Financing conditions for some property developers, including state-owned developers, have improved, but improvements remain uneven and financially weaker private developers continue to face funding challenges. - Total LGFV debt estimated at about 50 percent of China’s GDP; a broadening of LGFV debt distress would impose significant losses on some banks. - Local government debt has increased to about 30 percent of GDP after record issuance in 2022. - Local governments issued 2.8 trillion yuan of refinancing bonds, and 4.8 trillion yuan of new bonds. ### Nonbank financial institutions (NBFIs) and bank exposures in China - IMF staff estimates: - Real estate and LGFV exposures could amount to 14 percent of wealth management products’ assets under management, or 4.2 trillion yuan. - Real estate and LGFV exposures could amount to 23 percent of trust assets, or 3.3 trillion yuan. - Small banks are vulnerable through direct loan exposures and have been relatively slow to participate in deleveraging; their net exposures to NBFIs remain sizable. - Strain on weaker banks has occurred, evidenced by widening subordinated bond spreads. - The financial deleveraging campaign begun in 2016 helped improve NBFI health and contain spillover risk but further escalation of real estate and LGFV risks could incur significant losses to investors in wealth management products and trust products, potentially triggering runs and broader funding market stress. ### Banking sector credit risks and developer exposures - Banks face heightened credit risks because of exposures to small and medium enterprises and the property sector. - Policy directive since 2019 urging banks to increase lending to small and medium enterprises has increased credit risk as small businesses were disproportionately affected by the pandemic and economic slowdown. - Weaker property developers account for 25 percent of the sector. - IMF staff analysis (October 2022) suggested the nonperforming loan ratio for developer loans could rise to about 8 percent for the system. - Regulatory forbearances on pandemic-related and developer loans may cause reported nonperforming loan figures to underestimate underlying credit risks, particularly for smaller banks with lower capital ratios and comparatively large exposures to local and smaller borrowers. - Distress at smaller banks could spill over to larger banks given interconnectedness. ### Corporate sector vulnerabilities and stress-test scenario - Corporate spreads widened following recent banking turmoil but remain near historical averages; default rates have remained low and earnings generally outperformed expectations to date. - The sector faces revenue declines (margin compression) and tighter funding conditions, particularly from banks. - Corporates emerged from the pandemic with much higher debt loads. - IMF staff scenario analysis assumptions (based on corporate data from Q2 2022): - Earnings before interest and taxes are assumed to fall by 20 percent. - The effective interest rate rises by 200 basis points, both instantaneously. - Under the scenario: - The share of debt with an interest coverage ratio below 4 rises significantly for all firm types. - In advanced economies, the shares of small and medium firms with interest coverage ratios less than 4 rises by 7 percentage points and 17 percentage points, respectively. - For higher-rated firms, more than 75 percent of firms with a BBB rating would have their interest coverage ratio fall below 4 under the shock scenario. - Higher interest rates account for more than 60 percent of the change in interest coverage broadly across firms. - Debt dynamics and currency risk: - In emerging markets, the ratio of total foreign currency debt to GDP of nonfinancial firms has fallen 3 percentage points from its prepandemic highs, but the level remains high for several countries. - A large currency depreciation could meaningfully increase debt-servicing costs for firms with significant foreign debt. ### Global housing market developments and downside risks - Residential real estate has been directly affected by monetary tightening; steep increases in mortgage rates and stretched valuations have generally cooled demand. - House prices fell in 65 percent of emerging markets (on average by 0.7 percent year over year) in Q3 2022. - House prices decreased in nearly 55 percent of advanced economies in Q3 2022. - Economies with a larger share of adjustable-rate mortgages recorded some of the highest declines in real house prices (examples cited: Sweden and Romania). - Valuations remain stretched in a number of countries and affordability (price-to-income ratio) continues to deteriorate amid higher mortgage costs, increasing the risk of a sharp correction. - Example: In Türkiye, house prices increased by 60 percent year over year in real terms, driven by surging construction costs, housing demand, and housing supply constraints. - Pre-pandemic trend contrast: economies with larger share of adjustable-rate mortgages increased house prices on average by 5 percent each year, whereas other economies increased by 3.5 percent. *Sources: Bloomberg Finance L.P.; Haver Analytics; International Financial Statistics database; IMF, World Economic Outlook database; and IMF staff calculations.* ### 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 ### Main findings - In advanced economies, more than 70 percent of triple BBB-rated investment-grade corporations could face a rating downgrade to speculative grade. - Lower earnings and higher funding costs would further worsen leverage metrics, including those for large firms, with the ratings for the majority of firms 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. ### Shock scenario and sensitivity analysis - The partial sensitivity analysis assumes: - Earnings before interest and taxes decline by 20 percent. - The effective interest rate on firms’ total debt rises by 200 basis points. - The earnings shock scenario was calibrated to previous recession episodes. - The analysis covers a total of about 13,300 firms in 20 countries: 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 firms: assets greater than $500 million. - Medium firms: assets between $500 and $50 million. - Small firms: assets less than $50 million. - In panel 4 (analysis of interest coverage ratio shocks), rating group definitions: - High grade includes credit ratings between AAA and A. - Investment grade includes BBB-rated firms. - Speculative grade includes BB- to B-rated firms. - Ratings are provided by S&P. ICR = interest coverage ratio. ### Implications highlighted - A combined earnings and interest-rate shock materially increases the share of corporate debt at risk across rating groups and firm sizes. - Firms with previously very low funding costs (higher-graded firms) can experience large declines in interest coverage when interest rates rise, increasing downgrade risk. - Large firms’ leverage metrics would worsen under the assumed shocks, contributing substantially to debt-at-risk measures. *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) vulnerabilities and lending conditions - Sharp price correction risks, especially in the residential and industrial segments. - Tightening of financial conditions can create adverse feedback between credit growth and asset prices via housing as collateral. - United States: - Banks have tightened lending standards for CRE. - Spreads of US CMBS over ordinary Treasury bonds jumped to about 450 basis points at the end of 2022. - The loan delinquency rate for CMBS is projected to increase significantly to between 4 percent and 4.5 percent by the end of 2023. - In the third quarter of 2022, the share of CRE loans worth less than the CMBS tranches they are in spiked to 30 percent (marking an increase of 25 percentage points from the previous year). - Negative leverage in the third quarter of 2022 spiked to 30 percent, up from only 5 percent from one year earlier. - Increase in negative leverage concentrated in industrial and multifamily properties, with shares relative to the total count of about 36 percent and 31 percent, respectively. - Europe: - Financing costs of senior loans in core offices rose to about 350 basis points in the second quarter of 2022, more than 200 basis points higher than the previous year. - The stock of CRE loans represents a large share of total bank lending to nonfinancial corporations: about 30 percent in aggregate and above 49 percent in Sweden, Denmark, and Norway. ### Nonbank financial intermediation, REITs, and liquidity mismatches - Nonbank lenders funded by warehouse lines from money center banks have curtailed activity anticipating weaker property markets. - Search for yield supported growth of nonbank leveraged institutions with large liquidity mismatches, such as property investment funds. - REITs: - A substantial rise in interest rates could lower the net present value of mortgages, reducing REITs’ asset values and causing margin calls (example: redemption shock at Blackstone Real Estate Income Trust in 2022). - Based on IMF staff estimates, the 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. - Funding and refinancing risks: - Cost of capital for funding structures related to CRE has increased significantly. - Difficulty refinancing maturing loans and deteriorating property net cash flows may increase default rates. - Higher interest rate caps could intensify borrower debt burdens and lead to lender losses from falling property values and illiquid markets. - Bank exposures: - After reducing CRE exposures sharply, smaller and regional US banks are increasing them again at a pace much brisker than the growth rate of commercial and industrial loans, while the largest banks are not. - Growing CRE–regional bank nexus is at risk from structurally lower CRE demand and bank financial fragility. ### Stress scenarios and market functioning - Projected CMBS outcomes: - Loan delinquency rate for CMBS projected to increase to between 4 percent and 4.5 percent by end-2023, given higher interest rates and weak economic growth contributing to maturity defaults. - Market functioning concerns: - Quantitative tightening has proceeded orderly so far, but central banks should monitor short-term funding markets to avoid unwarranted strains. - In the euro area, TLTRO loan repayments require attentiveness to possible disorderly market dynamics or fragmentation risks. ### Policy recommendations and authorities’ actions - Overarching guidance: - Continue addressing inflationary pressures while using tools aimed at financial stability risks as needed. - Clear communication about central banks’ objectives and policy functions is crucial to avoid unnecessary uncertainty. - Policymakers should act swiftly to prevent systemic events that could harm market confidence. - If monetary policy needs adjustment for financial stability, clearly communicate resolve to bring inflation back to target as soon as possible once financial stress lessens. - Supervisory and prudential measures: - Supervisors should ensure banks have corporate governance and risk management commensurate with their risk profile, including board risk monitoring and adequate capital and liquidity stress tests. - Adequate minimum capital and liquidity requirements, including for smaller institutions, are essential. - Consider prudential rules ensuring banks hold capital for interest rate risk and guard against hidden losses. - Financial institutions should have capital conservation and credible capital restoration plans. - Banks need unencumbered high-quality liquid assets and formal contingency funding plans. - Authorities should strengthen bank resolution regimes and preparedness for early intervention. - Pay specific attention to bank asset classification, provisions, and exposures to interest rate and liquidity risks in the current environment. - Central bank liquidity support principles: - Liquidity support should aim to address liquidity, not solvency; solvency should be left to fiscal or resolution authorities. - Provide liquidity to counterparties compelled by supervision to internalize liquidity risk (the “stick”) so central banks intervene only for systemic liquidity risks (the “carrot”). - Maintain partial insurance so significant risk remains in the marketplace to minimize moral hazard. - Interventions should have well-defined end dates and be parsimonious to avoid conflicting with monetary policy, especially in tightening cycles. - Price liquidity support relatively expensively to deter opportunistic demand. - Maintain appropriate risk mitigation (for example, haircuts) and agree on loss sharing with fiscal authorities. - Resolution reform and depositor protection: - Experiences from the United States and Switzerland suggest further work on resolution reform to increase likelihood systemic banks can be resolved without public funds at risk. - Consider extending the perimeter of the international resolution standard to a wider set of banks and revisit the appropriate reach of deposit insurance schemes, compensated by commensurate insurance premiums. - Near-term supervisory focus on contagion risk to other banks through various channels. - Monetary–fiscal policy interaction: - Central banks should be attuned to market functioning and, if necessary, adjust quantitative tightening implementation. - Monetary policy can get support from tighter fiscal policy in achieving inflation objectives (see the April 2023 Fiscal Monitor). - Fiscal consolidation would ease aggregate demand pressure on prices and moderate the magnitude of interest rate increases required. - Within budget constraints, governments can reprioritize spending to protect the most vulnerable from high food and energy prices. - Emerging and frontier market guidance: - Remain vulnerable to sharp tightening in global financial conditions and increased capital outflows. - Emerging market central banks should be cautious about premature easing of policy rates. - Countries with highly vulnerable financial sectors, limited fiscal space, and significant external financing needs face strong pressure and could face severe challenges in a disorderly tightening. - Countries with credible medium-term fiscal plans, clearer policy frameworks, and stronger financing arrangements will be better positioned. - Need to rebuild fiscal space and buffers. - Integrate policies using the Integrated Policy Framework where applicable to manage volatile capital flows amid monetary and FX uncertainty. - Foreign exchange interventions may be appropriate if reserves are sufficient and intervention does not impair policy credibility or substitute for necessary adjustments. - Capital flow management measures may be an option in crises or imminent crises. - Sovereign borrowers and debt management: - Enhance efforts to contain high debt vulnerabilities via early creditor contact, multilateral cooperation, and international support. - Continued use of enhanced collective-action clauses in international sovereign bonds and majority voting provisions in syndicated loans would help future restructurings. - For countries near debt distress, creditors should coordinate on preemptive and orderly restructuring to avoid hard defaults and prolonged market access loss. - 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. - Deepening local currency markets in emerging markets: - Promote depth of local currency markets and a stable, diversified investor base. - Measures should strive to: (1) establish a sound legal and regulatory framework for securities, (2) develop efficient money markets, (3) enhance transparency and predictability of issuance, (4) bolster market liquidity, and (5) develop robust market infrastructure. - Macroprudential and real estate monitoring: - Increase financial resilience and recalibrate relevant macroprudential tools as needed to tackle pockets of elevated vulnerabilities. - Balance increasing resilience with avoiding procyclicality and disorderly tightening of financial conditions. - Deploy stringent stress tests for rising interest rates’ impact on borrowers’ repayment capacity and sharp falls in household and CRE prices. - Revisit prior macroprudential loosening where necessary to prevent severe macroeconomic implications from sharp financial tightening while preserving sound credit origination. - China-specific recommendations: - Robust mechanism to restore confidence in the real estate sector to limit macro-financial spillovers. - Use demand-side measures such as relaxing home purchase restrictions, complemented with timely restructuring or resolution of troubled developers and fiscal reforms to reduce local government reliance on the property market. - Phase out forbearance policies and ensure banks maintain adequate loss-absorbing buffers. - Develop contingency planning for materializing credit contagion, potentially requiring system-wide liquidity provision. - Urgent upgrades to restructuring frameworks to facilitate exit of nonviable firms and banks while protecting financial stability. - Nonbank financial intermediation (NBFI) tools and guardrails: - Close gaps in key data about NBFIs, provide incentives for NBFI 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 for access should be set very high). 3. Central bank support as lender of last resort of a systemic NBFI. - Clear communication on interventions is essential, including objectives, parameters, and timeframe for exit. - Crypto asset regulation: - Collapse of multiple crypto entities increases urgency for comprehensive and consistent regulation and supervision emphasizing consumer protection, financial integrity, and corporate governance. - Regulatory framework should cover storage, transfer, exchange, and custody of reserves; entities with multiple functions should face additional prudential requirements. - Stablecoin issuers should be subject to strict prudential requirements. - Cross-sector and cross-border nature of crypto limits the effectiveness of uncoordinated national approaches; strong international cooperation and globally consistent regulation are essential. - Climate-aligned capital flows: - Aligning capital flows on a low-carbon trajectory is critical for financial stability; current renewable energy investment and production fall grossly short of funding needed to meet climate targets (Box 1.5). - 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, such as 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 (text - CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES)* ### 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 (SBNY) - 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 attempted to raise fresh capital on March 8 and 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 large holdings of fixed income securities 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 (SBNY), a $110 billion bank serving technology and crypto clients (30 percent of its deposits were from the crypto sector), saw its stock decline by almost 40 percent between March 8 and 10 and was closed on March 12 with the FDIC as receiver. - Social media negative sentiment surged and SVB’s stock sold off precipitously, likely intensifying the deposit run. ### US and International Policy Response to the Bank Failures - Initial FDIC action after SVB’s closure: protect only insured deposits, leaving uninsured depositors (balances greater than $250,000) and other creditors facing losses. - Authorities (Treasury, Federal Reserve, FDIC) rolled out an emergency package with two key components: - Systemic risk exemption triggered to allow 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. - 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 owned by the borrower as of March 12. - Maturity up to one year at zero margins, with recourse to the borrower. - 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) and for 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. - International actions: - Authorities in countries 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. - Authorities intervened in SVB branches in other countries (Canada and Germany), which were dependent on parent funding and are expected to be wound down. ### Failure of FTX and Crypto Ecosystem Contagion - FTX filed for bankruptcy in November 2022. - FTX metrics before the debacle: - 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. - Failings revealed: lack of business transparency, inappropriate use of clients’ funds, reliance on self-issued unbacked tokens for solvency and liquidity, inadequate financial reporting, and alleged fraud. - Key events and linkages: - Alameda Research, affiliated hedge fund, had significant holdings of FTT (FTX token); reports of this ignited market pressures on November 2, 2022. - Binance intended to sell its FTT holdings; FTT price plummeted, triggering a run on FTX. - Binance withdrew plans to acquire FTX amid allegations, intensifying the run. - FTX allegedly made an estimated $8 billion in loans collateralized by FTT (equivalent to more than half of its customer deposits) to Alameda Research. - FTX allegedly misused customer funds to help Alameda Research cover funding gaps and allowed preferential treatment for Alameda Research. - When FTX failed, FTT became worthless. - Contagion effects: - Significant contagion in the crypto ecosystem, including to other crypto exchanges and crypto lending firms. - Some crypto lenders, such as Genesis and BlockFi, filed for bankruptcy because of large exposures. - Genesis reportedly had $6.5 billion in loans outstanding to Alameda Research, only 50 percent of which were secured. - Contagion extended to Gemini, which temporarily halted withdrawals. - Broader contagion outside crypto limited, except for a few small banks with close ties to crypto and some US pension funds with investments in FTX. ### Rapid Growth of Zero-Day-to-Expiry (0DTE) Options and Associated Risks - Retail investor participation in options markets has increased dramatically since the COVID-19 pandemic. - Nearly half the options trading volume on the S&P 500 is now attributed to 0DTE, a stark contrast to the 15 percent share of 0DTE before the pandemic. - The Chicago Board Options Exchange (CBOE) added short-dated stock options on large exchange-traded funds in November 2022 and added new expiration dates in April and May 2022, allowing 0DTE trading throughout the week. - Retail investors account for about 10 percent of the trading volume in 0DTE options. - Empirical research shows retail investors often end with losses ranging between 5 and 9 percent, reflecting transaction costs and slower response to news (de Silva, Smith, and So 2022). - Market mechanics and volatility amplification: - Dealers dynamically adjust hedging (delta hedging), potentially leading to higher intraday volatility. - Dealers use longer-dated equity options to hedge 0DTE exposures, which could affect the CBOE Volatility Index. - Market participants reported higher 0DTE volume around consumer price index releases, US job reports, and Federal Reserve meetings. - Increased occurrence of intraday fluctuations in the S&P 500 exceeding 1 percent during the first quarter of 2023. - Policy considerations: - Raises questions about disclosures and regulation of retail investor participation in complex financial instruments. - No financial stability risk deemed imminent, but rapid growth could amplify market movements and, in a worst-case scenario, lead to panic selling, particularly if liquidity is poor. - Technical assumptions used in a stylized example for option hedging flow calculations: - Strike price of $425. - Risk-free rate of 4.58 percent. - Annualized volatility of 20 percent. - Contract multiplier of 100. ### Bank of Japan’s Yield Curve Control (YCC) Policy and Potential Spillovers - Bank of Japan (BoJ) has maintained accommodative policy to achieve a price stability target of 2 percent. - Framework and timeline: - Quantitative and qualitative easing framework with a negative policy interest rate since January 2016. - Yield curve control since September 2016—purchasing assets, primarily Japanese government bonds, to maintain yields within a band centered at 0 percent. - Recent market developments: - Ten-year Japanese government bond yields recently declined in sympathy with global yields amid strains in US and European banking sectors. - Prior tightening in other advanced economies and rising domestic inflation had put upward pressure on Japanese bond yields, prompting the BoJ to scale up purchases to keep 10-year yields around target. - BoJ market footprint: - BoJ purchased large amounts of Japanese government bonds in recent months and now owns 70 percent of all outstanding 5-year Japanese government bonds and more than 80 percent of outstanding 10-year Japanese government bonds. - Market functioning and volatility: - Increased Japanese government bond yields and option-implied rates volatility illustrate that adjustments to YCC in December 2022 surprised markets. - Rates volatility measured by JPY OIS swaption one-month into 10-year implied volatility; foreign exchange volatility measured by USDJPY one-month option implied volatility. - International considerations: - Adjustments to YCC create potential for international spillovers as Japanese bond holdings abroad remain substantial. *Source: GLOBAL FINANCIAL STABILITY REPORT: SAFEGUARDING FINANCIAL STABILITY AMID HIGH INFLATION AND GEOPOLITICAL RISKS (CHAPTER 1).* ### 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 and international 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 and caused significant volatility in Japan’s exchange rate and long-term interest rates. - Potential channels for international spillovers from changes to the Bank of Japan’s yield curve control framework: - Exchange rates: a stronger yen as foreign assets are repatriated and foreign investors buy Japanese bonds. - Term premiums on sovereign bonds: a rise in Japanese government bond yields could increase term premiums for a given policy rate and expected path of monetary policy. - Global risk premiums: shifts in global risk appetite could amplify capital flow adjustments. - The magnitude of spillovers would vary across countries depending on: - Financial links with Japan, - Country-specific factors, - The broader risk-appetite backdrop. - Historical context of yield curve control adjustments: - September 2016: implementation of yield curve control policy. - July 31, 2018: announcement that Japanese government bond yields might move upward and downward in about double the range, previously around ±10 basis points. - March 19, 2021: trading range clarified to be around ±25 basis points. - Existing literature finds spillovers from Japanese monetary policy shocks have been modest and more regional in nature, especially compared with US monetary policy shocks; however, those studies focus on periods of increasing accommodation rather than tightening. ### Japanese investor portfolio rebalancing and effects on foreign sovereign yields - 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 in 2022: - Life insurance companies and banks sold $200 billion of foreign bonds as Japanese government bond yields and the cost of foreign exchange hedging rose. - If domestic long-term interest rates in Japan rise further, repatriation by Japanese investors would likely continue, albeit at a slower pace due to institutional caution about large marked-to-market losses. - Pension funds may adjust more slowly; example: the Government Pension Investment Fund’s policy mix is 25 percent domestic bonds, 25 percent domestic equities, 25 percent foreign bonds, and 25 percent foreign equities, reviewed on a five-year cycle. - Countries where effects on sovereign bond yields would likely be larger include Australia, several euro area countries, and the United States, where Japanese investors hold a large market share of sovereign bonds. - 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. - The pace and effects of repatriation could be larger if market participants are surprised by Bank of Japan announcements and actions; even emerging markets with small direct financial links to Japan could see material outflows due to sensitivity of capital flows to shocks in global risk premiums. - Policy implication: clear communication by central banks is imperative to avoid unwarranted volatility and mitigate spillovers when adjusting instruments, framework, or stance of monetary policy. ### Observed spillovers and volatility - Until the December 2022 adjustment, spillovers from Japan to other advanced economies had not increased meaningfully in 2022 despite higher Japanese government bond yields. - When Japanese government bond yields increased in December 2022, directional spillover effects from Japan spiked, as shown by volatility spillover indices estimated using a 120-day rolling window capturing effects on Canadian, German, UK, and US yields. ### Energy crisis, fossil fuels, and implications for the low-carbon transition - Russia’s invasion of Ukraine exacerbated energy market strains; coal and gas prices rose following curtailment of natural gas supply to Europe and sanctions on Russian oil and coal. - Those increases accounted for 90 percent of the inflationary pressure on electricity prices worldwide (IEA 2022). - Amid high prices and tight supply, natural gas consumption declined across all gas-importing regions. - Global coal demand and production are set to reach all-time highs in 2022 and are projected to rise by 1.2 percent and 5.5 percent, respectively, as China, India, and Indonesia set production records. - 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. - With improved profitability, the equity value of coal companies has exceeded that of oil and gas companies since the summer of 2022. - Prices of minerals and metals critical to renewables soared in 2021 and 2022, with prices remaining elevated in January 2023; drivers included higher demand, production bottlenecks, shut-ins of some metal smelters because of high energy prices, and Russia’s role as a key exporter of certain commodities such as aluminum and nickel. - As a result, average prices for onshore wind and solar photovoltaics have risen worldwide in 2022, reversing a decade-long declining trend. ### Sustainable finance, fossil fuel company debt, and investment shortfalls - Sustainable debt issuance: - Hit more than $1 trillion in 2022 but recorded its first annual year-over-year decline (19 percent). - Debt of fossil fuel companies and recent trends: - Total debt rising by 3.3 percent among companies in the oil and gas sector since the start of 2022. - Total debt rising by 23.3 percent among companies in the coal sector since the start of 2022. - World energy investment: - 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 targets: - Current investments in the low-carbon transition remain insufficient to meet Paris Agreement temperature targets, increasing climate-related financial stability risks. - Shortfalls in renewable energy investment remain significant: $1 trillion shortfall compared with investment targets in a net-zero scenario. - In emerging market and developing economies, natural gas may play a larger dispatchable role to satisfy peak demand amid potentially limited renewable production and absent large-scale storage capacity. - Carbon lock-in risks: expansion of fossil fuel investment and increased fossil fuel company debt substantially increase the risks of carbon lock-in and related transition and physical risks. *Italic: Source — text - CHAPTER 1 A FINANCIAL SYSTEM TESTED BY HIGHER INFLATION AND INTEREST RATES (IMF, April 2023).* ### Chapter 2 at a Glance ### Chapter 2 at a Glance ### Role and recent evolution of NBFIs - Nonbank financial intermediaries (NBFIs) play a key role in the global financial system, enhancing access to credit and supporting economic growth. - The share of global financial assets held by NBFIs has grown from about 40 to nearly 50 percent (Financial Stability Board 2022c). - This chapter focuses on a subset of NBFIs comprising: - asset managers, such as open-ended investment funds; - insurance companies and pension funds; - critical financial market infrastructures, such as central counterparties; - other NBFIs, such as structured finance vehicles. ### Core vulnerabilities identified - Key vulnerabilities that can amplify shocks: financial leverage, liquidity mismatches, and interconnectedness. - Interaction of vulnerabilities: - Poor market liquidity combined with financial leverage can trigger abrupt unwinding of leveraged positions, asset fire sales, and investor runs. - Dealer banks that provide leverage to NBFIs create interconnectedness that can amplify stress and generate spillovers to core funding markets, other intermediaries (banks and NBFIs), and across borders (including to emerging market and developing economies). - Procyclicality of cross-border flows intermediated by NBFIs increases sensitivity of emerging market and developing economy flows to global financial conditions. - Extended period of low interest rates and loose financial conditions may have incentivized shifts by NBFIs into riskier assets to find higher returns. ### Empirical and sectoral findings (key statistics preserved) - Hedge funds: - Global hedge fund cash leverage (secured and unsecured borrowing) tends to be modest in aggregate at about 1.8 times net asset value. - Synthetic leverage through derivatives for US-domiciled hedge funds increased from 8 times to 14 times net asset value on an asset-weighted basis, with some investment strategies above 20 times net asset value. - Proxy for synthetic leverage (ratio of notional amount to gross market value) indicates financial institutions (banks and NBFIs) take much more derivatives-based leverage than dealers and nonfinancial companies. - Collateralized loan obligations: - New collateralized loan obligations have a larger equity cushion than those before the global financial crisis (see Figure 2.1 panel 4 referenced in chapter). - Table 2.1: Preliminary assessment of vulnerabilities of major NBFIs (GFA and vulnerability notes preserved) - Investment funds, excluding money market funds and hedge funds ($58 trillion, 12 percent of GFA): Low leverage overall, but medium for bond funds with derivative exposures; High liquidity risk for fixed-income funds holding illiquid emerging market/high-yield assets; High interconnectedness with cross-border spillovers; Low currency mismatches but significant externalities to foreign exchange market. - Insurance companies ($40 trillion, 9 percent of GFA): Low leverage; Low liquidity risk but medium if subject to policy surrenders; Medium interconnectedness as large holders of bank debt and some exposure to margin calls; Low currency mismatches but medium if subject to policy surrenders. - Pension funds ($43 trillion, 9 percent of GFA): Low leverage overall but medium in jurisdictions with a large share of defined-benefit schemes; Low liquidity risk overall but could be high in some jurisdictions with negative cash flows; Severe data gap on interconnectedness preventing informed assessment in some jurisdictions; Low currency mismatches. - Money market funds ($8.5 trillion, 2 percent of GFA): N/A leverage; Low liquidity risk but medium for prime funds; High interconnectedness as key players in core funding markets; N/A currency mismatches. - Structured finance vehicles ($6 trillion, 1 percent of GFA): Medium/high leverage; Medium liquidity risk; Medium interconnectedness with insurance and pension funds as large investors; Low currency mismatches. - Hedge funds ($6 trillion, 1 percent of GFA): Medium/high leverage; Medium liquidity risk (most hedge funds have strengthened liquidity terms); Medium/high interconnectedness; Medium currency mismatches. - Central counterparties ($0.7 trillion, 0.1 percent of GFA): N/A leverage; High liquidity risk but with strong risk and financial management controls; High interconnectedness given systemic position; N/A currency mismatches. ### Liquidity-specific vulnerabilities - Three key liquidity-related vulnerabilities associated with NBFIs: - Liquidity mismatches: some NBFIs hold relatively illiquid assets but allow daily redemptions at prices not reflecting liquidation value, creating run incentives. - (Additional liquidity vulnerabilities are discussed in the chapter body beyond the at-a-glance summary.) ### Central bank policy toolbox and trade-offs - In the current environment of high inflation and tighter financial conditions, central banks face challenging trade-offs between addressing financial stability risks and achieving price stability objectives. - Central bank liquidity support involves three broad types: 1. Discretionary marketwide operations: - Should be temporary and targeted to NBFI segments where further market dislocation and disintermediation could have adverse financial stability implications. - Should be designed to restore market functioning while containing moral hazard. - Timing is critical; a framework should be in place based on “discretion under constraints” where data-driven metrics trigger potential intervention (the constraints) but policymakers retain final discretion. 2. Access to standing lending facilities: - Could be granted to reduce spillovers to the financial system but the bar for access should be very high to avoid moral hazard. - Access should not be granted without appropriate regulatory and supervisory regimes for the different types of NBFIs (some of which may not qualify). 3. Central banks as lender of last resort (LOLR): - May need to step in if a systemic NBFI comes under stress. - Lending to a systemic NBFI should be at the discretion of the central bank, at a penal rate, fully collateralized, and accompanied by more supervisory oversight. - A clear timeline should be established for restoring the liquidity of the institution. ### Policy priorities and recommendations - First line of defense: robust surveillance, regulation, and supervision of NBFIs. - Priorities: close key data gaps; incentivize risk management by NBFIs; set appropriate regulation; intensify supervision. - Guardrails for central bank NBFI liquidity access are paramount to limit moral hazard and protect price stability mandates. - Clear communication is critical to avoid perceptions that central bank actions are working at cross-purposes (for example, purchasing assets to restore financial stability while continuing quantitative tightening to bring inflation back to target). - Announcements of central bank liquidity support should explain the financial stability objective and parameters of the program. - Coordination between central banks and financial sector regulators is essential for risk identification, crisis management, and assessment of supervisory and regulatory deficiencies. *Authors: Fabio Cortes, Cristina Cuervo, Torsten Ehlers, Antonio Garcia Pascual (co–team lead), Phakawa Jeasakul, Esti Kemp, Nila Khanolkar, Darryl King, Kleopatra Nikolaou, Thomas Piontek (co–team lead), Felix Suntheim, and Romain Michel Veyrune, under the guidance of Fabio Natalucci.* ### Chapter 3 of the October 2022 Global Financial ### text - Chapter 3 of the October 2022 Global Financial ### Liquidity mismatches and market liquidity deterioration - Over the past year, the liquidity of open-end funds’ holdings has deteriorated to levels last seen at the onset of the COVID-19 pandemic, implying high vulnerabilities of asset markets as a result of liquidity mismatches. - Liquidity spirals: - A lack of market liquidity combined with financial leverage can produce “liquidity spirals,” where a decline in asset prices leads to a deterioration of funding liquidity, which then spills back to further impair market liquidity (Brunnermeier and Pedersen 2009). - The UK pension fund stress episode is cited as evidence: amid relatively poor liquidity in UK gilt markets, margin calls from large losses in derivative positions caused pension funds to sell gilts in a way that contributed to further illiquidity. - Crowded trades and correlated liquidity shocks: - Common exposures to assets, combined with correlated liquidity shocks, can amplify stress events. - Redemptions can force investment funds to sell assets, depressing prices and prompting further sales by other market participants with similar portfolio holdings, amplifying the initial shock. - Over the past two years, measures indicate that portfolios of investment funds have become more similar compared with previous years, raising the threat of correlated liquidity shocks among funds. - Empirical evidence: Greenwood and Thesmar (2011) for equities; Falato and others (2021) for bond markets. ### Asset-level vulnerability and market liquidity indicators (Figure 2.2 summary) - Asset-level vulnerabilities for different asset classes have increased (median index measure). - Market liquidity deterioration example: - Median bid-ask spreads of outstanding plain-vanilla, fixed-coupon sovereign bonds (Germany, Japan, United Kingdom, United States) are shown rising (five-day rolling-window average percentage bid-ask spreads). - Portfolio similarity: - The average cosine similarity of fixed-income investment-fund portfolios has increased over time for funds with assets under management larger than $1 billion and with at least 50 percent of portfolio holdings available. - Note on methodology: - Vulnerability measure constructed based on Jiang and others (2022); liquidity defined as portfolio-level bid-ask spread across funds. - Similarity defined by asset class and by issuer based on the cosine similarity measure of Girardi and others (2021). ### Increasing interconnectedness of NBFIs and the financial system - NBFIs’ growing role: - NBFIs’ growing role in domestic financing and cross-border capital flows fosters efficiency and diversification but increased interconnectedness can make the system more complex and a potential shock amplifier. - Linkage channels: - Within NBFI ecosystem: an NBFI provides liquidity to or purchases instruments issued by another NBFI. - Between NBFIs and banks: shared exposures to a common counterparty or asset; NBFIs financed by banks. - NBFIs using high leverage or engaging in liquidity and maturity transformation can amplify or spread financial stress. - Evidence from data: - In aggregate, the portion of domestic funding to other financial intermediaries from banks and insurers has declined since the global financial crisis, while funding among NBFIs has increased. - Banks’ cross-border linkages with NBFIs have risen, underscoring the sector’s importance in cross-border intermediation. ### Cross-border flows, emerging market vulnerabilities, and fund behavior - NBFI role in cross-border intermediation: - Foreign-currency-denominated debt accounts for a significant share, mostly in US dollars, financed through NBFIs such as investment funds, whose assets more than tripled in the decade since the global financial crisis. - Emerging market and developing economy exposures: - Emerging market and developing economy debt funds tend to experience very large redemptions during risk-off episodes. - Funds that are passively managed or follow benchmark indices play a particularly important role in accentuating the procyclicality of capital flows. - Size of outflows from emerging market and developing economy debt funds is generally larger than for other fund types during stress episodes. - Liquidity mismatches in emerging market and developing economy debt funds—given the medium to low liquidity of most fixed-income assets in these economies—may exacerbate the scale of redemptions under stress. - Additional amplification sources: - Non-benchmarked investors and multisector bond funds (unconstrained funds) can be a source of spillovers to emerging markets and potentially exert a sizable effect on cross-border flows. ### Regulatory data gaps for NBFIs - Data gaps significance: - Regulatory data gaps for NBFIs are significant and inhibit regulators’ ability to assess and monitor systemic risks. - Although regulatory data availability has improved over time, gaps remain meaningful and uneven among jurisdictions compared with the banking sector. - Specific gaps and issues: - Liquidity vulnerabilities: - Significant data gaps exist for monitoring liquidity vulnerabilities of investment, money market, and hedge funds. - Most regulators require high-level reporting of asset liquidity, but data are typically not reported at sufficient frequency or in detail. - Some jurisdictions require rule-based liquidity classification disclosures (most funds in the United States and European Union as well as alternative investment fund managers); others require proxies such as credit rating, which are often insufficient. - Liability-side data gaps: Funds often have limited visibility into their investor base because of complex distribution channels; when investor data are available, reporting may not consider notice periods and gates. - Differences in methodologies on liquidity metrics hamper cross-border comparability. - Leverage: - Data gaps hinder leverage analysis of investment funds. - The United States and European Union collect detailed leverage metrics for hedge funds, but these data arrive with significant lag and low frequency. - Many jurisdictions, including many emerging market and developing economies, lack a definition of leverage, hampering cross-border comparison. - Leverage disclosures for investment funds that are not hedge funds are often not detailed enough to assess less visible leverage. - Other gaps: - Granular data are scarce for liquidity management tool disclosures (e.g., swing pricing) and mostly absent for access to credit lines. - In many countries, reporting is subject to a threshold, resulting in industrywide data gaps. - Table 2.2 summary (regulatory data gaps by NBFI type and vulnerability): - Investment funds (excluding money market funds and hedge funds): $58 trillion, 12% of GFA — data gaps across Financial Leverage, Liquidity, Interconnectedness, Currency Mismatches indicated. - Insurance companies: $40 trillion, 9% of GFA. - Pension funds: $43 trillion, 9% of GFA. - Money market funds: $8.5 trillion, 2% of GFA. - Structured finance vehicles: $6 trillion, 1% of GFA. - Hedge funds: $6 trillion, 1% of GFA. - Central counterparties: $0.7 trillion, 0.1% of GFA. - Note: Table color coding denotes levels of data adequacy from red (no/very little data) to dark green (broadly adequate data). *International Monetary Fund | April 2023* ### CHAPTER 2 NONBANK FINANCIAL INTERMEDIARIES: VULNERABILITIES AMID TIGHTER FINANCIAL CONDITIONS ### CHAPTER 2 NONBANK FINANCIAL INTERMEDIARIES: VULNERABILITIES AMID TIGHTER FINANCIAL CONDITIONS ### Data gaps and monitoring challenges across NBFIs - Pension funds - Significant data gaps limit assessment of leverage and liquidity, particularly regarding the use of derivatives. - Synthetic leverage through derivatives is often managed by third-party asset managers, making it difficult for regulators to get a precise understanding of the leverage of these funds. - Corporate sponsors typically extend commitments to provide extra liquidity to their pension schemes, but details of these commitments are often beyond required regulatory reporting. - To hedge sizable foreign asset positions, some pension funds engage in foreign exchange derivative contracts, which are typically over the counter and are difficult for regulators to monitor. - Among a global sample of large pension plans that disclose data on derivative exposures, the average ratio of gross notional exposure of derivatives to assets has increased over the past decade (Figure 2.4, panel 1). - The 12 sampled pension funds have combined assets under management of more than $5 trillion, which is almost 10 percent of global pension fund assets. - Pension funds’ global prevalence increased from 40 to almost 60 percent during 2011–21. - Insurance companies - Relatively tight regulations and strict capital requirements limit investments in riskier assets and require assessment of a broad range of risks including leverage and foreign exchange risks. - Extensive use of third-party investment managers can obscure synthetic leverage and make timely, detailed examinations of underlying risk exposures infeasible. - Exposures to illiquid private credit (for example, collateralized loan obligations) can disguise embedded leverage in structured products. - Unregulated or unregistered NBFIs (for example, family offices) - Regulatory data are practically nonexistent except where partial data are captured through banks and regulated NBFIs’ transactions with these entities. - Individual entities can be large and play important roles in specific market segments (example: Archegos), yet wide data gaps make it challenging to gauge systemic risk. - Derivatives reporting - Major data gaps exist in reporting of derivative exposures across NBFIs: details such as the direction of positions—“long versus short”—and information about counterparties are often missing. - For exchange-traded and centrally cleared over-the-counter derivatives, detailed data are available through central counterparties but are highly confidential and require robust data-sharing arrangements with supervisors. - Recent over-the-counter derivative-market reforms in the Group of Twenty introduced central clearing requirements for interest rate and credit derivatives across a broad range of advanced and major emerging market economies, but reforms have generally not extended to foreign exchange and commodity derivatives. ### Case Study 1 — UK pension fund stress (September 2022) - Event and dynamics - Late September 2022: concerns about UK fiscal outlook led to a sharp rise in UK gilt yields and large mark-to-market losses in levered fixed-income positions of defined-benefit pension funds. - Losses triggered margin and collateral calls; pension and liability-driven investment funds were forced to sell gilt securities, pushing gilt yields higher in a self-fulfilling dynamic. - Policy intervention - On September 28, 2022, the Bank of England announced temporary and targeted purchases of long-dated conventional gilts and subsequently index-linked gilts, which stabilized gilt yields. - Key elements: use of backstop pricing for purchases, the short period of purchases, and the demand-led, timely but orderly, unwind of purchases. Objective: buy time for liability-driven investment funds to rebalance without amplifying the underlying shock. - Risks highlighted - Pension funds achieve financial leverage using repurchase agreements and derivatives such as interest rate swaps; repurchase agreements were key contributors that exacerbated the UK episode. - Recent surveys suggest increasing interest in investing in liability-driven investment strategies that use leverage (Figure 2.4, panel 2). - Pension funds using financial leverage could be subject to margin and collateral calls during periods of high market volatility, and given their large footprint might exacerbate stress in financial markets. - UK-specific features that amplified stress - Less diversified portfolios with a larger share invested in fixed income; elevated share of defined-benefit assets (only behind Japan and The Netherlands among the top seven global pension fund jurisdictions). - Elevated duration risk compared with other jurisdictions with significantly shorter duration. - Pension plans owned a large share of the gilt market—a share of more than 50 percent of certain long maturities—illustrating elevated interconnectedness between pension funds and domestic sovereign and corporate bond markets. - A sizable share of small- to medium-sized plans using pooled liability-driven investment asset management vehicles made coordination with plan sponsors to raise cash for margins more challenging. - Mitigating factor - The recent rise in bond yields improved solvency for pension plans (gap between assets and liabilities improved), which likely ameliorates but does not eliminate vulnerabilities. ### Case Study 2 — Korea: stress in debt markets and project finance lenders (October 2022) - Event and market reaction - October 2022: financial stress emerged amid tightening financial conditions and falling property prices; default of a commercial paper issued against real estate project finance loans triggered broad repricing of asset-backed securities, corporate bonds, and short-term notes. - Spreads between commercial papers and monetary stabilization bonds widened to 220 basis points, a level not seen since the global financial crisis. - Corporate bond yields rose sharply across the board; stress coincided with increased borrowing needs from banks and a state-owned energy firm. - Structure and vulnerabilities of project finance funding - Funding structure: NBFI lenders issue short-term asset-backed securities with maturity of up to one year through special-purpose companies to finance longer-term project finance loans with maturity of three to five years (Figure 2.5, panel 2). - As of June 2022, outstanding project finance loans amounted to KRW112 trillion (5 percent of GDP). - Main NBFI lenders: insurance companies (39 percent) and nonbank credit intermediaries (24 percent). - About 35 percent of project finance loans were securitized. - About 70 percent of project finance loans are originated for residential real estate development. - Securities firms usually provided substantial credit guarantees (credit enhancement) to asset-backed securities. - Amplification channels - Maturity mismatch of asset-backed securities makes them vulnerable to market sentiment and rising interest rates. - Nonbank financial intermediaries have sizable exposure to real estate project finance loans relative to their own capital (Figure 2.5, panel 3). - NBFIs could amplify financial stress given sizable holdings of debt securities along with reliance on market funding (Figure 2.5, panel 4). *Italic: Source — CHAPTER 2 NONBANK FINANCIAL INTERMEDIARIES: VULNERABILITIES AMID TIGHTER FINANCIAL CONDITIONS (text - CHAPTER 2 NONBANK FINANCIAL INTERMEDIARIES: VULNERABILITIES AMID TIGHTER FINANCIAL CONDITIONS).* ### CHAPTER 2 NONBANK FINANCIAL INTERMEDIARIES: VULNERABILITIES AMID TIGHTER FINANCIAL CONDITIONS ### CHAPTER 2 NONBANK FINANCIAL INTERMEDIARIES: VULNERABILITIES AMID TIGHTER FINANCIAL CONDITIONS ### Real estate project finance and market funding stress - Delinquency context: - Peak delinquency for project finance loans was "8.2 percent" in 2013. - Real estate sector faces headwinds, with falling property prices. - NBFI exposures: - NBFIs issue short-term debt against project finance loans and commit their own capital to them. - Debt market stress revealed vulnerabilities related to NBFIs funding sizable holdings of debt securities with short-term market funding. - Korean authorities’ measures to alleviate systemwide funding stress and support rollovers: - Asset purchases (targeting mostly investment-grade corporate bonds and commercial papers, notably those backed by project finance loans), carried out largely by major state-owned and private financial institutions. - Provision of liquidity and credit guarantees. - Relaxation/postponement of some prudential measures and relaxation of several property-related restrictive regulations. - Use of administrative directives to reduce bond issuances by banks and state-owned enterprises. - Bank of Korea actions: continued focus on curbing inflation while providing additional liquidity to banks (relaxed collateral rules) and securities firms (repo transactions). - Public financial institutions provided credit guarantees to support origination of project finance loans. - Market outcomes and cautions: - Credit spreads started to narrow in late December 2022 after a purchase of higher-risk asset-backed securities and expanded Bank of Korea liquidity to securities firms. - Credit spreads remain wide, especially for lower-rated borrowers. - Support measures should remain temporary, with a clear exit strategy to limit moral hazard and fiscal risks. - Authorities should proactively manage potential solvency issues related to real estate-related financing. ### Commodity-trading firms and financial stability risks - Business model and balance-sheet features: - Commodity-trading firms act as intermediaries between producers and users of commodities and in some cases are producers themselves. - Inventories are a large part of assets and are typically financed by a high level of short-term debt largely composed of bank loans. - Short-term debt definition used: financial debt with a remaining maturity of less than one year. - Firm size in figure data ranges from "$4 billion to $140 billion." - Liquidity and margin risks: - Large trading firms tend to hold fewer liquid assets than short-term debt, creating liquidity risk. - In tighter financial conditions and higher commodity price volatility, short-term debt rollovers become more challenging; banks may be less willing to provide large short-term lending. - Adequate equity ratios and prompt sales of inventory can mitigate risks, provided market functioning remains orderly. - Commodity-derivative contracts are used to hedge and to speculate; volatile markets can trigger higher margin requirements requiring immediate transfer of liquid assets (cash) as collateral. - Example episode: margin pressures ahead of the nickel market suspension at the London Metal Exchange in March 2022. - Data and regulatory gaps: - Commodity-trading firms engaged in complex derivatives trading are not subject to the same level of regulation or supervision as financial institutions. - Some very large commodity traders are private companies subject to limited or no public reporting. - Exchange-traded derivative positions can be monitored but do not permit holistic assessment of firms’ exposures; over-the-counter trades suffer from scarcity of reported data. - Large unmonitored positions can materially impact functioning of corresponding commodity markets, as during the nickel suspension. - Policy response example: London Metal Exchange introduced reporting requirements for over-the-counter derivative positions of its members for a range of metals. ### Private credit markets: growth and vulnerabilities - Market size and composition: - Private credit includes direct lending (about "40 percent") and other structures. - Private credit market size roughly rivals the institutional leveraged loan market; both had "approximately $1.4 trillion" outstanding in 2022. - Structural features and perceived strengths: - Vehicles typically lock in investors’ capital for many years, so maturity or asset-liability mismatches and run risk are less prominent. - These vehicles appear to use limited financial leverage; banks can provide leverage via credit lines, collateralized borrowing, and capital call lines. - Key vulnerabilities: - Interconnectedness is a key channel of risk: most private credit investors are institutional investors in the NBFI ecosystem who could face capital calls or investment losses during broader market stress. - Rapid growth may increase systemic vulnerabilities: privately financed leveraged buyouts with high debt multiples are more vulnerable to economic slowdowns. - Competition has led to deterioration in covenant quality; managers often finance deals of other managers, concentrating risk. - Lending opacity drives accumulation of asset quality performance risks that may be hard to discern until too late. - Private credit is a relatively new asset class with performance untested in a prolonged economic downturn. - If private credit is suddenly restricted in market stress, smaller borrowers may face rollover risks if bank financing cannot absorb the new credit demand. - Low transparency and limited liquidity could cause spillovers as investors are forced to sell other, more liquid assets to access cash. - Investor base: - Pension funds are identified as the largest investors in private credit vehicles (figure context). ### Policies to support financial stability in a high-inflation environment - Nature of NBFI stress: - NBFI stress often emerges from a combination of elevated financial leverage, liquidity vulnerabilities, and interconnectedness. - Under high inflation, higher interest rates and tighter financial conditions can interact with these vulnerabilities, potentially triggering investor runs and asset fire sales. - Central banks may face a trade-off between safeguarding financial stability and maintaining price stability. - Priority policy elements (guardrails): - Close data gaps to facilitate timely risk assessment by market participants and supervisory authorities. - Incentivize stronger risk management by NBFIs. - Implement adequate and comprehensive regulatory standards proportionate to risks across heterogeneous NBFI business models. - Conduct appropriately resourced and intensive supervisory oversight; ensure supervision is adequately intrusive for compliance. - Conduct requirements such as public disclosure to support market discipline and price discovery. - Governance requirements to ensure proper risk management. - Prudential regulations (capital and liquidity management tools) to address quantifiable risks (credit, market, liquidity). - With these guardrails, the need for central bank action should be reduced or limited to tail risks, mitigating moral hazard. - Data priority: - Availability of reliable and comparable data is a key prerequisite for adequate supervision and regulation; closing data gaps should be a policy priority. ### Guidelines for central bank intervention to provide liquidity - Objectives and principles: - Central bank intervention should aim to address liquidity and not solvency problems; solvency issues should be handled by fiscal or resolution authorities. - Liquidity should be provided to counterparties that are compelled by supervision and regulation to internalize liquidity risk (the "stick"), so central banks intervene mainly to address systemic liquidity risks (the "carrot"). - Maintain a significant part of risk in the marketplace ("partial insurance") to minimize moral hazard. - Interventions should be parsimonious to avoid conflicting with the monetary policy stance, especially in a tightening cycle. - Price liquidity support to be relatively expensive to avoid attracting opportunistic demand. - Introduce appropriate risk mitigation (for example, haircuts) and agree on loss sharing with fiscal authorities to manage risks to central bank balance sheets. - Eligibility considerations for NBFIs: - NBFIs were traditionally not central bank counterparties for monetary policy; exceptions have existed (discount houses in the United Kingdom; primary dealers and money market funds in the United States). - NBFIs have grown to become key intermediaries, including in liquidity provision during normal times, as banks have stepped back. - Liquidity support to NBFIs has been provided primarily through standard counterparties (banks). - Opening direct access to central bank liquidity for NBFIs could be necessary if there is a high risk of contagion to systemically important institutions or markets, or if the sector or entities are important for financial intermediation and credit provision. - Loss-sharing and fiscal backstops: - Fiscal authorities should commit to underwrite part or all losses that the central bank may incur because of liquidity support, either by providing guarantees or by setting up a special-purpose vehicle. - Partial risk sharing could be considered to incentivize prudent program design. *International Monetary Fund | April 2023* ### CHAPTER 2 NONBANK FINANCIAL INTERMEDIARIES: VULNERABILITIES AMID TIGHTER FINANCIAL CONDITIONS ### CHAPTER 2 NONBANK FINANCIAL INTERMEDIARIES: VULNERABILITIES AMID TIGHTER FINANCIAL CONDITIONS ### Central bank responses to NBFI liquidity stresses - On lending: - Expand eligible collateral (with appropriate haircuts) or expand the counterparty list to add NBFIs if the new counterparties are appropriately regulated and supervised (see Table 2.3).30 - Improve settlement efficiency by having eligible counterparts pre-position collateral at the central bank (placing securities in a central bank account ready to be pledged). - On purchasing: - Broaden the list of counterparties in asset purchase operations to those that are not part of monetary operations, while avoiding overreliance on dealer banks’ intermediation or unduly expanding the universe of purchased assets. - Types of interventions (three broad categories): - (1) Discretionary marketwide operations - Aim: re-establish proper functioning of a market segment or cope with stress in an NBFI segment. - Design principles: temporary; targeted at NBFI ecosystem segments where dislocation could have adverse macro-financial stability implications; restore market functioning while containing moral hazard (King and others 2017). - Implementation approaches: “time-bound” programs if announced amounts influence expectations; or “state contingent” and “self-liquidate” operations to facilitate exit.31 - Risk-mitigation: ensure appropriate risk mitigation measures are in place. - Timing: early provision of liquidity may avoid contagion and lessen solvency risk but increases moral hazard; adopt “discretion under constraints” with data-driven metrics guiding intervention decisions (heatmap of indicators such as funding spreads, premium relative to a risk-free benchmark, margin requirements, trading volumes, bid-ask spread, and price volatility) and thresholds to target extreme tail risks.32 - (2) Standing lending facilities - Permanently available at the initiative of eligible counterparties.33 - Access bar should be very high to avoid moral hazard.34 - Central banks should coordinate with NBFI regulators to ensure appropriate regulatory and supervisory regimes before granting access, and charge a sufficiently high rate to discourage use in normal times (IMF 2020). - (3) Discretionary provision through LOLR arrangements - For idiosyncratic (not marketwide) stress at a systemically important NBFI, central banks should be prepared to act as lender of last resort (LOLR). - Preconditions: ex-ante designation and surveillance perimeter, full information transfer from NBFI regulators, central bank capacity to process information. - Principles: lending at central bank discretion, after exhausting other liquidity options, only to solvent firms, at a penal rate, fully collateralized, with intrusive supervisory oversight (Dobler and others 2016). - Additional safeguards: conditions on use of funds and clear timelines to reestablish liquidity; loss-sharing arrangements with the government to protect the central bank; may provide emergency liquidity against lower-quality collateral with tighter risk mitigation if eligible collateral is exhausted.35 - Communication: - Separate tools for price stability and financial stability where possible to avoid perceived policy conflicts in a high-inflation environment. - Communication should clarify the source of stress, objectives and modalities of the intervention, time horizon, and exit timing/thresholds that preferably do not overlap with monetary policy operations. ### Tabled diagnoses and central bank responses (Table 2.3 summary) - Securities dealers - Risks: lose access to funding because of uncertainty about counterparty creditworthiness and collateral values; cannot sell assets at reasonable prices. - Security types: Sovereign bonds; Corporate bonds, asset-backed securities; Commercial paper; All types of securities. - Central bank responses: Collateralized lending (expanded eligibility for counterparties); Collateral upgrade (swaps); Asset purchases (expanded counterparties and asset universe). - Investment funds (including money market and hedge funds) - Risks: - Temporary redemption pressures (liquidity mismatches). - Persistent redemption pressures (liquidity mismatches). - Liquidity pressure arising from derivative/valuation. - Security types: All types of securities. - Central bank responses: Collateralized lending (expanded eligibility); Asset purchases (expanded counterparties and asset universe) for persistent pressures. - Pension funds - Risks: early/unexpected redemption; liquidity pressure from derivatives/valuation. - Security types: All types of securities. - Central bank responses: Asset purchases; Collateralized lending (expanded eligibility). - Insurance - Risks: insufficient liquidity buffer/unexpectedly high pay-off. - Security types: All types of securities. - Central bank responses: Asset purchases. - Central counterparties - Risks: lose access to funding (and cannot sell high-quality liquid assets). - Security types: High-quality liquid assets. - Central bank responses: Idiosyncratic (lender of last resort). - Systemic nonbank financial intermediaries regardless of type - Risks: a systemically important (solvent) NBFI loses access to funding. - Security types: Various, including credit claim. - Central bank responses: Idiosyncratic (lender of last resort). - Note: Collateralized lending prioritized for temporary funding pressure; asset purchases address market illiquidity and liquidity drain with less chance of recovery. ### Regulatory and supervisory policy recommendations - Regulatory coordination: - Cross-sector and cross-jurisdiction coordination is essential for identifying risks and managing crises; internationally coordinated reforms reduce cross-border spillovers, regulatory arbitrage, and market fragmentation. - Data-sharing arrangements should ensure timely coordination and information exchange among regulators and central banks. - Contingency and business continuity requirements for NBFIs should be monitored in regular supervisory activities. - The Financial Stability Board noted that resolution regimes for systemic NBFIs, including central counterparties and insurers, should be strengthened or introduced where absent, and identified obstacles to cross-border funding in resolution (legal, regulatory, operational) including mobilizing collateral across borders.36 - Periodic comprehensive systemic risk assessments: - Prioritize systemwide stress testing and stress testing of high-systemic-risk NBFI subsectors and markets (derivatives, repo, securities lending, leveraged loans). - Special focus on interconnectedness, liquidity spirals, and crowded trades — vulnerabilities not captured by microprudential stress testing. - Improve structural resilience of open-ended investment funds: - For funds holding very illiquid assets, calibrate investor liquidity closer to asset liquidity. - Greater, more effective, and consistent use of liquidity management tools (swing pricing, antidilution levies, in-kind redemptions, redemption gates) with implementation guidance (see Chapter 3 of the October 2022 Global Financial Stability Report). - Where private incentives misalign with financial stability goals, consider mandating some liquidity management tools or granting regulators power to activate tools in the public interest. - Improve ability to assess liability-side liquidity mismatches (“knowing your investor risk profile”) and strengthen funds’ liquidity risk management practices. - Implement agreed reforms such as the Financial Stability Board’s policy proposals to enhance money market fund resilience; jurisdictional action on these reforms is important.11 - Leverage and disclosure: - Improve leverage disclosures, risk management, and consistency in measurement; consider leverage caps where appropriate. - Prioritize data granularity for hedge funds and improved disclosures for other leveraged funds; for other highly leveraged NBFIs, consider improved reporting in line with structure and use of leverage, including off-balance-sheet items and over-the-counter derivatives. - At cross-border level, international standard setters should lead improvements in cross-border consistency in measuring leverage beyond hedge funds. - Counterparty regulators (for example, banks) should improve risk management regarding NBFI exposures; regulators might consider leverage caps in some cases. - Stress testing and supervisory resourcing: - Require and improve microprudential stress testing for liquidity and leverage risks; consider guidance on minimum stress-testing requirements and frequency. - Address insufficient resourcing and, in some cases, lack of operational independence of NBFI supervisory authorities highlighted by Financial Sector Assessment Programs. - Build processing and analytical capacity where regulators collect granular data but lack capabilities. - Strengthen coordination across diverse sectoral regulators and leverage financial stability committees for information collection and analysis. - Strengthen cross-border cooperation on data sharing, supervision, and use of liquidity management tools; global standard-setting bodies can play a crucial role. ### Cross-border considerations and policy mix - Well-designed policies addressing NBFI liquidity stresses can reduce procyclicality of cross-border flows and mitigate exchange rate pressures, especially for emerging market economies exposed to large portfolio flows. - Policy mix: - Source countries: robust NBFI regulation and well-designed central bank interventions. - Recipient (emerging market and developing) countries: macro-financial policies including foreign exchange intervention, macroprudential measures, and capital flow measures. - Cross-border coordination in introducing policy measures reduces regulatory arbitrage and improves implementation.37 *Source: IMF staff.* ### Box 2.1. 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Vishny. 2010. “Unstable Banking.” Journal of Financial Economics 97 (3): 306–18. - Timmer, Yannick. 2018. “Cyclical Investment Behavior across Financial Institutions.” Journal of Financial Economics 129 (2): 268–86. *Global Financial Stability Report: Safeguarding Financial Stability amid High Inflation and Geopolitical Risks — Box 2.1 (April 2023).* ### 1. Direct Investment, 2009–21 ### 1. Direct Investment, 2009–21 ### Bilateral allocation patterns (Panels 1–3) - Panel axes and values shown: –1.0, –0.5, 0.0, 0.5, 1.0 (Percentage points; relative to world portfolio). - Bilateral foreign policy/geopolitical distance categories: Less distant, Somewhat distant, More distant (bottom, middle, top third of sample distribution of the distance measure). - Finding: Average share of bilateral cross-border financial assets allocated to a recipient country by a source country is reported in excess of the total cross-border financial assets allocated to the recipient country by all source countries (adjustment made to account for different economic sizes of recipient countries). - Comparative note across asset types: Charts indicate smaller share of cross-border portfolio investment and bank credit allocated to geopolitically more distant country pairs (as depicted in Panels 1–3). ### Financial sanctions and country counts (Panel 4) - Panel axis values shown: 0, 20, 40, 60, 80, 100, 120 (Number of Countries with Financial Sanctions, 2010–22). - Timeline markers on panel: 2010, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22. - Finding: Bilateral financial sanctions have increased in recent years; panel indicates number of countries with financial sanctions (dots) and share of countries with financial sanctions in the sample (bars). ### Cross-border flows to Russia and voting alignment (Panels 5–6) - Panel 5 axis values shown: –20, –15, –10, –5, 0, 5, 10 (Cross-Border Banking Flows, Cumulative 2022:H1 percent of prewar cross-border banking claims). - Grouping: “Reject” (countries that rejected motion to condemn Russia’s invasion of Ukraine, including Belarus, Eritrea, Democratic People’s Republic of Korea, Russia, and Syria) versus Others (absent/abstain/accept excluding Ukraine). - Finding: Since invading Ukraine, Russia has suffered a sharp decline in cross-border banking flows (sum of Q1 and Q2 2022 flows to these groups as percent of total cross-border claims in Q4 2021). - Panel 6 axis values shown: –70, –60, –50, –40, –30, –20, –10, 0 (Cross-Border Portfolio Debt Flows, Cumulative 2022:March–November; percent of prewar portfolio debt allocation). - Grouping shown: Others, Russia. - Finding: Cross-border portfolio debt flows to Russia declined markedly in March–November 2022 relative to prewar (February 2022) portfolio debt allocation. ### Data sources and measurement notes - Sources listed: Bank for International Settlements, Locational Banking Statistics; FinFlows; Global Financial Sanctions Database; Institute of International Finance, Capital Flows Tracker; IMF, Coordinated Direct Investment Survey; IMF, Coordinated Portfolio Investment Survey; and IMF staff calculations. - Notes summary: - Panels 1–3 average the adjusted bilateral share over indicated years for geopolitical distance terciles. - Panel 4 shows number and share of countries with financial sanctions in sample. - Panel 5 sums cross-border banking flows over Q1–Q2 2022 to “reject” vs all others (excluding Ukraine), in percent of Q4 2021 total cross-border claims of these groups. - Panel 6 sums portfolio debt flows to Russia and all other countries (excluding Ukraine) that did not vote to reject the motion after the onset of the war (March through November 2022) in percent of prewar (February 2022) portfolio debt allocation. *Italic: Source: IMF staff; panels and notes as provided in the original content.* ### 1. Global External Financial Assets and ### 1. Global External Financial Assets and Liabilities, 1990–2021 ### Global stocks and cross-border flows - Sum of total stock of external assets and liabilities is reported as a percentage of GDP for global, advanced economies, and emerging market and developing economies (figure panels referenced for 1990–2021). - Cross-border liability flows are reported as a percentage of GDP for all countries, advanced economies, and emerging market and developing economies (1990–2022). - Capital account restrictiveness is measured by an index following Fernández and others (2016), with higher values indicating greater restrictiveness; averages are shown for World, Advanced economies, and Emerging market and developing economies for the indicated time periods. - Source datasets: External Wealth of Nations database; Fernández and others 2016; IMF, Balance of Payments Statistics; and IMF staff calculations. ### Geopolitical factors and bilateral capital allocation - A rise in geopolitical tensions weakens financial relationships between countries and reduces cross-border capital allocation. - Empirical approach: gravity model of bilateral cross-border financial relationships (Portes and Rey 2005), controlling for global factors, source-country-time and recipient-country-time fixed effects, bilateral factors (geographical distance, cultural and linguistic ties), and lagging regressors by one period. - Geopolitical distance measure: divergence in UN General Assembly voting behavior (and robustness checks using arms trade, imposition of financial sanctions, Häge (2011) measures, Bailey, Strezhnev, and Voeten (2017) measures). - Estimated impacts (one-standard-deviation increase in geopolitical distance between source and recipient country): - Bilateral cross-border allocation of portfolio investment and bank claims reduced by about 15 percent. - Investment funds’ cross-border portfolio allocations decline by more than 20 percent. - Conditional effects: allocations are less sensitive to geopolitical tensions for recipient countries that are more financially developed or hold larger stocks of international reserves or net foreign assets. ### Predicted flow reversals and aggregate capital flow effects - Portfolio outflow scenario (if geopolitical distance to already-distant partners increases by one standard deviation): - Median gross portfolio investment outflow ≡ 1.5 percent of recipient-country GDP. - Mean gross portfolio investment outflow ≡ 2.8 percent of recipient-country GDP. - Global decline in portfolio flows ≡ about 3 percent of world GDP. - Cross-border banking flows response: - Median decline ≡ 0.3 percent of recipient-country GDP. - Mean decline ≡ 1 percent of recipient-country GDP. - Aggregate capital flows (weighted-average bilateral geopolitical distance): - For emerging market economies, an increase of one standard deviation in geopolitical distance with a country’s financial partners is associated with a decline in net capital flows of about 3 percent of GDP. - For advanced economies, the comparable decline is about 2 percent of GDP. - For emerging market economies, a large portion of the total effect corresponds to a decline in portfolio flows. ### Event-level evidence: US–China tensions and fund flows - US investment funds’ portfolio investment flows to China, 2017–22, show declines associated with escalating geopolitical events (figure illustrates unconditional association; specific events and dates are marked in the source). - Events identified include: - (1) July 2018: the Trump Administration imposed new tariffs totaling 34 billion US dollars on Chinese goods. - (2) May 2019: tariffs raised from 10 to 25 percent on 200 billion US dollars’ worth of Chinese goods. - (3) January 2020: restriction on arrivals from China. - (4) August 2022: US House Speaker’s visit to Taiwan, Province of China. ### Effects on cross-border payments and remittances - Financial sanctions can disrupt cross-border payment activity, increase the cost of making cross-border payments, and undermine payment platform interoperability. - Event-study result for international remittances: - Imposing financial sanctions could reduce remittance volume to the sanctioned country by about 17.1 percent within six quarters. - Imposing financial sanctions could increase the cost of remittances (fees and foreign exchange margins) by 3 percentage points. ### Geopolitical shocks and banking-sector transmission channels - Transmission channels through which geopolitical tensions affect banks: - Financial channel: sudden reversal of cross-border credit and investments increases banks’ debt rollover risks and funding costs. - Market channel: widened sovereign bond and credit spreads reduce asset values and increase funding costs. - Real channel: disruptions to supply chains and commodity markets affect domestic growth and inflation, amplifying banks’ market and credit losses. - Estimated bank-level effects (panel regressions on more than 5,000 banks from 52 economies; regressions control for bank characteristics, macro fundamentals, time effects; regressors lagged one period): - An increase in geopolitical distance to foreign lenders can significantly increase banks’ funding costs, reduce profitability, and contract lending to the real economy. - Effects are larger for emerging market and developing economies. - Nonlinearity: effects (notably on bank lending) are larger when tensions with foreign lenders are already elevated (interaction with 75th percentile dummy included in regressions). - Capital buffers: - Banks with capital ratios in the top 25th percentile experience much smaller increases in borrowing costs, declines in profits, and reductions in lending than other banks. - Building bank capital buffers is identified as an effective way to mitigate transmission of geopolitical shocks to the real economy. ### Financial fragmentation and macro-financial volatility - Global financial fragmentation from escalating geopolitical tensions can reduce international risk diversification benefits and increase vulnerability to adverse shocks. - Loss of diversification and the potential for capital flow reversals can exacerbate macro-financial volatility and pose risks to financial stability, especially for countries with limited absorptive capacity. *Italic: Source: CHAPTER 3 GEOPOLITICS AND FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY, GLOBAL FINANCIAL STABILITY REPORT: SAFEGUARDING FINANCIAL STABILITY AMID HIGH INFLATION AND GEOPOLITICAL RISKS, International Monetary Fund | April 2023* ### 1. Net Capital Flows to GDP ### 1. Net Capital Flows to GDP ### Key empirical findings on capital flows and portfolio reallocation - An escalation of geopolitical tensions triggers a cross-border reallocation of credit provision and investments, resulting in more concentrated cross-border financial linkages with fewer financial partners and increased vulnerability to shocks. - In the face of an adverse foreign monetary policy shock—proxied by a 100-basis-point increase in the monetary policy rate of an economy’s largest financial partner—net capital flows to emerging market economies with more concentrated international financial positions decline notably. - The effect is on average about 2 percent of GDP and is persistent, lasting up to eight quarters. - For emerging market economies with less concentrated international financial exposures, the effect of a foreign monetary policy shock of similar magnitude is neither economically nor statistically significant. - Moving from full diversification (equal financial exposures to all countries) to extreme concentration (only one partner country) implies a 5.5 percentage-point increase in the volatility of net capital flows to GDP. - The increase in volatility is more pronounced for emerging market economies than for advanced economies. - The effect is stronger for countries with smaller stocks of international reserves. ### Portfolio flows and sensitivity to geopolitical distance - Portfolio flows respond strongly to increases in geopolitical distance with financial partners, with the effect most pronounced for portfolio flows in emerging market economies. - The bars in the empirical figures represent the percentage-point change in total net capital flows to GDP in response to a one-standard-deviation increase in geopolitical distance; geopolitical distance for each recipient country is the financial exposure–weighted average of geopolitical distances with source countries, where financial exposure is computed as the share of portfolio and direct investment liabilities to a source country. - Solid bars indicate statistical significance at the 10 percent level or lower. ### Bank-sector effects of increased geopolitical distance - After a one-standard-deviation increase in geopolitical distance with foreign lenders, especially in emerging market and developing economies, banks experience: - Higher funding costs (measured as total interest expenses-to-total interest-bearing liabilities). - Lower profitability (measured as (log) operating profits-to-total assets). - Contracted lending to the domestic economy (measured as (log) real outstanding gross loans). - Nonlinearity and heterogeneity: - Regressions include an interaction of geopolitical distance with a “high” dummy (above the 75th percentile). - Banks with relatively lower capital ratios experience a greater increase in borrowing costs than more well-capitalized banks. - Less-capitalized banks also experience a larger decline in profitability and in lending. - “High capital ratio” corresponds to banks with equity-to-total assets ratio above the 75th percentile of the equity-to-total assets ratio of banks in a given country in a given year. - Model controls and significance: - The model includes a large set of bank- and country-specific macro variables as well as bank and year fixed effects. - Solid bars indicate statistical significance at the 10 percent level or lower. ### Financial fragmentation amplifies vulnerability to shocks - Financial fragmentation—reduced diversification of international financial positions—amplifies the propagation of external macro‑financial shocks, especially to emerging market economies. - Empirical exercises indicate substantial and persistent declines in net capital flows to GDP for more concentrated economies following foreign monetary tightening. - The adverse effect is both economically substantial (about 2 percent of GDP) and persistent (up to eight quarters). - Countries with more concentrated cross-border financial positions experience higher volatility of net capital flows to GDP. ### Remittances and cross-border payments under financial restrictions - Financial restrictions and bilateral financial sanctions can significantly affect cross-border payments, assessed here through remittances. - Remittances are an important source of external income for many economies: - On average, remittances amount to about 2.5 percent of GDP, but in some cases more than 26 percent. - G20 countries have committed to reducing the global average remittance cost to 5 percent; the UN Sustainable Development Goals set a target of 3 percent to be reached by 2030. - Recent observed changes: - The average cost (weighted by volume) of sending remittances to Eastern Europe and Central Asia surged by 27.4 percent between the end of 2021 and the second quarter of 2022. - Formal analysis of financial sanctions (18 countries; 1980 Q1–2022 Q2) finds: - Financial sanctions increase the cost of sending remittances to sanctioned countries by 3 percentage points. - The volume of remittances drops by 17.1 percent after six quarters of sanctions. ### Conclusions and policy recommendations - Main conclusions: - Rising geopolitical tensions can lead to financial fragmentation through cross-border capital reallocation and sudden reversals of international capital flows. - Financial fragmentation induced by geopolitical tensions can increase banks’ funding costs, reduce profitability, and prompt contraction of lending, with potentially adverse effects on economic activity. - Emerging market and developing economies are more vulnerable to adverse geopolitical shocks than advanced economies. - Persistent geopolitical tensions could impose substantial long-term costs through reduced cross-border risk diversification and increased macro‑financial volatility. - Policy recommendations: - Strengthen Financial Oversight - Supervisors, regulators, and financial institutions should identify, quantify, manage, and mitigate risks from geopolitical tensions. - Embed geopolitical risks and transmission mechanisms in stress-testing frameworks and scenario analysis to inform supervisory discussions and capital planning (including the Internal Capital Adequacy Assessment Process). - Build Adequate Buffers and Safety Nets - Economies reliant on external financing should ensure adequate international reserves and capital and liquidity buffers at financial institutions. - Calibrate buffers to protect against extreme but plausible losses associated with tail geopolitical risks. - Strengthen crisis preparedness and management frameworks, and cooperative arrangements across national authorities, including resolution mechanisms for cross‑border institutions. - Mutual assistance agreements—through regional safety nets, currency swaps, or fiscal mechanisms—could help smaller countries weather shocks; the IMF’s financing facilities and precautionary lending toolkit can play an important role. - Strengthen International Cooperation - Continue efforts by international regulatory and standard‑setting bodies to promote convergence in financial regulations and standards to limit financial fragmentation. - Deepen international cooperation to improve cross-border payments and develop an international framework to enhance interoperability of payment systems to mitigate payment disruptions arising from geopolitical tensions. - Caution on financial restrictions - Imposing financial restrictions for national security reasons can have unintended macro‑financial consequences, including increased fragmentation, higher inflation, lower global growth, and financial contagion; policymakers should prioritize diplomacy and negotiation to prevent escalation. *Source: IMF staff calculations and analysis (Global Financial Stability Report: Safeguarding Financial Stability Amid High Inflation and Geopolitical Risks).* ### 1. Change in Cross-Border ### 1. Change in Cross-Border ### Remittance costs and volumes after sanctions - Financial sanctions increase remittance costs. - Financial sanctions reduce remittance volumes to sanctioned countries. - Empirical analysis details: - Panel 1: growth rate of regional average remittance costs (when sending $200) weighted by remittance volume (World Bank 2022). Regional grouping includes six regions: East Asia and Pacific, Europe and Central Asia (only Eastern Europe and Central Asia), Latin America and the Caribbean, Middle East and North Africa, South Asia, and sub-Saharan Africa. - The right bar in panel 1 denotes the change from the fourth quarter of 2021 to the second quarter of 2022. - The data do not include corridors originating in Russia in 2022. - Panels 2 and 3 show the effect of sanctions on remittance cost ratios and remittance volume after the sanctions. The remittance cost is measured as a ratio of total costs to the remitted $200. - The analyses do not consider the effect of the sanction on Russia in 2022 because of limited data availability. - See Online Annex 3.5 for further details of the empirical analysis. - Sources for remittance analysis: Global Sanctions Database; World Bank, Remittance Prices Worldwide; IMF, Balance of Payment Statistics; and IMF staff calculations. ### Model of financial fragmentation and loss of diversification benefits (G7 case study) - Model structure and purpose: - Uses a two-country open-economy model with trade in stocks and bonds (Coeurdacier, Kollmann, and Martin 2010) to explain “equity home bias” and generate macro-financial dynamics after total factor productivity and investment-specific technology shocks. - Households obtain international diversification benefits by investing in foreign equity due to imperfectly correlated shocks across economies. Home bias arises from imperfect correlation between wage income and dividends from domestic equity. - The model is simulated for each G7 economy under four scenarios: “full integration,” “moderate” fragmentation, “extreme” fragmentation, and “autarkic.” - Full integration: G7 economies trade financially with the rest of the world (sample of 53 countries). - Moderate fragmentation: G7 economies are unable to engage in financial transactions with countries whose bilateral geopolitical distance measure (based on UN voting behavior) lies in the top 25th percentile of the sample distribution. - Extreme fragmentation: same rule with the top 50th percentile. - Autarkic: G7 economies are self-sufficient and financially cut off from all other economies. - Online Annex 3.7 presents further details on model structure and parameterization. - Key quantitative results on macro-financial volatility: - Under moderate fragmentation, the median volatility of output increases by 1 percentage point relative to full integration. - Under extreme fragmentation, the median volatility of output increases by 3 percentage points relative to full integration. - The median volatility of (real) consumption, corporate profits, equity and bond prices increases in the range of 2–8 percentage points under fragmentation scenarios (relative to full integration). - Figure 3.2.1, panel 1 presents median volatility (standard deviation) with whiskers indicating the interquartile range across G7 economies. - Loss of diversification benefits: - The increase in volatility under fragmentation is compared with the autarky scenario; the ratio of changes in volatilities is defined as the diversification benefit. - Moderate fragmentation implies that about 20 percent of the diversification benefits from financial integration would be lost. - Extreme fragmentation implies that nearly 40–50 percent of the diversification benefits would be lost. - These estimated losses focus on cross-border investment diversification benefits and assume full substitutability of foreign goods production among available trading partners. - Caveats and limitations highlighted: - Simulations only focus on loss of cross-border investment diversification benefits. - Assumes full substitutability of foreign goods production among foreign countries available to trade with G7 economies; alternative assumptions or broader geoeconomic fragmentation affecting trade, technology diffusion, and labor migration could impose additional costs. - Simulations do not take into account potential benefits from fragmentation (for example, capital reallocation) or whether fragmentation reduces threats to national or global security. - The magnitudes are in line with studies considering a production economy with capital but are smaller than those for an endowment economy because capital in a production economy can be used in autarky to smooth shocks. *Source: GLOBAL FINANCIAL STABILITY REPORT: SAFEGUARDING FINANCIAL STABILITY AMID HIGH INFLATION AND GEOPOLITICAL RISKS, International Monetary Fund | April 2023* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2023/april/english/text.pdf_