## Global Financial Stability Report: Financial and Climate Policies for a High-Interest-Rate Era (October 2023) — Chapter excerpts

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### Current financial outlook and key findings
- Sentiment shifted markedly between April and September 2023: banking-sector stress receded, replaced by optimism about brisk disinflation and a potential soft landing; risks remain from upside surprises to inflation, financial-stability concerns in China, and renewed debt-sustainability worries.
- Rapid rises in global bond yields illustrate abrupt tightening in financial conditions.
- High global interest rates are beginning to squeeze repayment capacity of corporate and household borrowers; financial stability risks remain elevated, similar to the April 2023 assessment.
- Global core inflation slowed in 2023 but remains elevated; returning inflation to target is the main policy priority.
- Divergence in inflation developments between advanced economies and some emerging market economies underscores need for country-specific monetary policy.

### Risks to growth and policy priorities
- Monetary policy:
  - Maintain a restrictive stance in economies with still-elevated and persistent inflation until tangible evidence of sustained disinflation exists.
  - Communication is crucial to convey policymakers’ resolve; emerging market central banks should avoid easing policy rates too aggressively.
- Sovereign policy:
  - Pursue structural reforms to foster growth and manage high debt vulnerabilities.
  - Where feasible, execute refinancing or liability-management operations to rebuild buffers.
  - For countries nearing debt distress: establish early contact with creditors and coordinate preemptive and orderly restructuring.
- Financial-sector policy:
  - Broaden macroprudential tools to cover nonbank financial institutions linked to CRE risks; strengthen data collection.
  - Use stringent stress testing for real estate and borrower repayment capacity.
  - Strengthen bank supervision, corporate governance, and risk management, with attention to asset classification, provisioning, interest-rate, and liquidity risks.

### Corporate, household, and real estate vulnerabilities
- Real house prices:
  - Global real house prices have been falling since late 2022.
  - Real house prices fell 8.4 percent in the first quarter of 2023 in advanced economies.
  - Emerging markets saw a decline of about 2.4 percent in the first quarter of 2023.
  - In the first quarter of 2023, another statement reports a 5 percent fall in advanced economies and a 1.9 percent decline in emerging markets (different figures appear in chapter text).
- Mortgage dynamics:
  - Countries with a large share of floating-rate mortgages and house prices above the prepandemic average recorded double-digit declines in home prices.
  - About 80 percent of existing mortgages have rates below 5 percent and nearly one-fourth are below 3 percent.
  - With 30-year mortgage rates currently above 7 percent, mortgage origination and refinancing activity have sharply declined; refinancing applications have declined more than 50 percent relative to a year ago.
- Commercial real estate (CRE):
  - CRE-related debt is nearly 12 percent of GDP in Europe and 18 percent of GDP in the United States.
  - Global CRE transaction volumes plummeted 55 percent year over year to $147 billion at the start of 2023.
  - Regional Q1 2023 CRE transaction declines: Europe declined 64 percent year over year (industrial down 70 percent); Asia-Pacific average decline 20 percent; United States plummeted 57 percent year over year (office sector largest decline).
  - REITs-owned high-quality property price changes year over year: Europe more than 26 percent decline; United States 18 percent decline.
  - IMF CRE price-at-risk model: in a tail scenario, global CRE prices could decline by more than 10 percent over the next year across several segments.
- Policy recommendation:
  - Authorities should conduct stringent stress tests on borrower repayment capacity and sharp falls in real estate prices; broaden macroprudential coverage to nonbank institutions and enhance data collection.

### Banking sector vulnerabilities, stress tests, and supervision
- Banking stress and tail of weak banks:
  - Acute banking stress in March 2023 subsided, but a sizable tail of weak banks remains.
  - Enhanced global stress test sample: nearly 900 banks across 29 countries; previous global stress test sample: 260 banks.
  - Key Risk Indicator (KRI) coverage: approximately 350 of the world’s largest publicly traded banks.
- Stress-test outcomes:
  - Baseline scenario: global banking system capital projected to remain about 12.7 percent of risk-weighted assets in 2023 when the policy rate shock peaks.
  - Adverse scenario (severe stagflation): CET1 ratio troughs in 2024 before improving to 10.8 percent in 2025.
  - In 2023 (adverse vs baseline), valuation losses contribute 1.7 percentage points to the decline in the CET1 ratio; loan losses add nearly 1 percentage point.
  - Baseline weak-bank count: 55 banks (4 percent of global bank assets) would be weak under baseline.
  - Adverse weak-bank count: 215 banks, accounting for 42 percent of global banking assets (or 36 percent if using the below-7-percent-only criterion).
- Liquidity-to-solvency channel:
  - Reverse stress-test example: deposit run of 25 percent at end-2023; if central bank facilities are available and HTM securities can be pledged at a penalty of 150 basis points above adverse short-term rates, impact on capital is limited relative to forced HTM sales.
  - Penalty rates typically range from 100 to 300 basis points above policy rates.
- Characteristics of weak banks:
  - Lower return on assets; high loan growth in preceding two years; low price-to-book ratios; very high market leverage; low long-term NIM betas.
- Policy recommendations for banks and supervisors:
  - Sharpen analytical tools and make stress tests more stringent and granular.
  - Ensure banks have governance and risk management commensurate with risk profiles; pay attention to asset classification, provisioning, interest-rate, and liquidity exposures.
  - Safeguard operational independence of supervisors with clear mandates, adequate resources, and legal protection.
  - Require banks to prepare to access central bank facilities; strengthen resolution regimes and preparedness.

### Key Risk Indicator (KRI) monitoring and predictive power
- KRI framework:
  - Uses 12 indicators across CAMELS dimensions to flag banks for intrusive review.
  - As of 2023:Q2, 85 banks with $26 trillion in total assets were on the KRI monitoring list (breaches in at least three risk dimensions).
  - Forecasts for 2023:Q3 and Q4 show 80 banks with $21 trillion (Q3) and 82 banks with $25 trillion (Q4) flagged, with 25 banks ($9 trillion) flagged on four or more dimensions in Q4.
- Empirical linkage:
  - Regression from GST adverse scenario (2022:Q4) indicates each additional KRI flag is associated with a fall of about 0.7 percentage point in Tier 1 capital ratio.

### Financial conditions, risk assets, and market functioning
- Financial conditions eased in advanced economies since April 2023—driven by corporate valuations, higher equity valuations, lower volatility, and narrower corporate bond spreads—but medium- to long-tenor bond yields rose since April 2023.
- Equity gains and sector specifics:
  - US equity prices climbed more than 10 percent since the beginning of the year (as of the chapter).
  - US technology sector trading close to 30 times earnings versus a 10-year historical average of 22 times earnings.
- Volatility percentiles (latest heat-map values):
  - Equity — United States: 38.3%
  - Equity — Europe: 24.4%
  - Equity — Japan: 16.0%
  - Equity — EM: 13.9%
  - Rates — United States: 79.9%
  - Rates — Europe: 86.4%
  - Foreign exchange — Euro: 21.8%
  - Foreign exchange — Yen: 39.4%
  - Foreign exchange — Sterling: 30.2%
  - Foreign exchange — EM: 19.3%
  - Commodities — Oil: 41.9%
  - Commodities — Gold: 12.4%
  - Bitcoin: 0.0%
- Leveraged positions and liquidity risks:
  - Asset managers increased long positions in Treasury futures since end-2021; leveraged funds increased short futures positions.
  - Primary dealers’ balance sheets for Gilts and Treasuries have been materially constrained in the United Kingdom and the United States.
  - A sudden bout of bond-market volatility could force deleveraging and amplify market dysfunction.

### China-specific developments and risks
- Property sector and LGFVs:
  - Total LGFV debt (based on public financial statements) stood at about 45 percent of GDP in 2022.
  - Four-fifths of LGFV debt is held by banks, mainly as loans; two-thirds of LGFV assets are fixed long-term investments.
  - More than 30 percent of LGFV debt has had an interest coverage ratio below 1 for the last three years.
  - IMF staff estimate: "over half of the debt cannot be serviced by current earnings alone if average LGFV funding costs are more than 3 percent (most LGFVs currently borrow at rates above this level)."
- Policy measures and priorities:
  - Facilitate completion of housing projects, timely resolution and restructuring of troubled property developers, further monetary easing and fiscal support reoriented toward households, comprehensive strategy for LGFV debt, and address risky exposures in asset management sector and liquidity mismatches.
- Market effects:
  - Renminbi faced downward pressure; equity prices fell sharply; home sales and developer financing strains observed; a large private developer missed interest payments on bonds due in August; a major asset manager suspended payments and redemptions on wealth management and trust products.

### Emerging markets, sovereign spreads, and financing vulnerabilities
- Sovereign issuance and spreads:
  - Investment-grade issuers accounted for 70 percent of issuance, including a record 33 percent by issuers rated A or above.
  - Portfolio flows into emerging markets were relatively strong in 2023 but faced China-driven outflows: Chinese local currency bonds faced close to $130 billion outflows since February 2022; Chinese equity outflows exceeded $15 billion in August to September alone.
- Issuance concentration and refinancing risks:
  - "14 countries will see at least 30 percent of their outstanding bond stock amortize through the end of 2025, including several rated B, CCC, or lower."
  - Weighted average coupon on high-yield emerging market sovereign bonds fell from just under 8 percent in 2010 to just under 6 percent by early 2021; investor demand is resetting coupon levels higher.
- Private and frontier sovereign vulnerabilities:
  - Repeated credit downgrades since the pandemic pushed average frontier sovereign ratings lower; among BB and B segments every notch lower historically associates with between 60 and 140 basis points of additional spread.
- Policy guidance:
  - Strengthen debt vulnerability containment, engage creditors early, use the Group of Twenty Common Framework where applicable, and execute liability-management operations where feasible.

### Climate finance needs and unlocking private finance in EMDEs
- Investment needs and private share:
  - By 2030, climate mitigation investment needs in emerging market and developing economies (EMDEs) are estimated at about $2 trillion per year.
  - Global gross climate mitigation investment needs reach about $5 trillion annually by 2030.
  - The share of private finance must increase to about 80 percent of climate mitigation investment needs in EMDEs by 2030; excluding China the required private share exceeds 90 percent in one scenario.
  - In a scenario where the share of climate investments in total public investment increases by a factor of 1.5 from current levels, the private sector would have to cover 80 percent of climate investment needs in EMDEs by 2030.
- Barriers to private climate finance in EMDEs:
  - Only about 60 percent of emerging markets and 8 percent of developing economies have an investment-grade sovereign rating.
  - EMDEs lack well-structured investable project pipelines, have small project size and high due-diligence costs, limited hedging instruments for foreign exchange risk, and low domestic capital market development.
  - Fossil fuel investment trends: fossil fuels remain dominant; fossil fuels account for 75 percent of global greenhouse gas emissions; three-fourths of the world’s 9,000 coal-fired power plants are in EMDEs; about 90 percent of global capital tied in coal-fired power plants is in EMDEs.
- Coal-specific facts:
  - Coal is about 20 percent of global greenhouse gas emissions.
  - Power plant lifespans and phaseout: US average plant age about 40 years vs less than 15 years in Asia Pacific; average time to phase out coal after peak consumption is about 43 years.
- Policy recommendations to unlock private climate finance:
  - Strengthen climate information architecture (data, disclosures, taxonomies); adopt disclosure standards (e.g., ISSB proposals).
  - Use transition taxonomies in EMDEs to identify activities that can reduce greenhouse gas emissions over time, including hard-to-abate sectors.
  - Deepen domestic markets, improve policy predictability, and mobilize domestic financial resources.
  - Use blended finance, guarantees, MDB support, and the IMF Resilience and Sustainability Trust (RSF) to provide risk-sharing and catalytic capital.
  - Reform fossil fuel subsidies and consider carbon pricing complemented by targeted measures.
  - Standardize transition plans for firms and financial institutions and enhance supervisory assessment of transition risks.
- RSF and IMF catalytic role:
  - The Resilience and Sustainability Trust (RSF) total size is about $40 billion.
  - RSF can be used to crowd in additional financing via risk-sharing and credit enhancement, while IMF provides tools: Green Public Financial Management framework and Climate–Public Investment Management Assessment.

### Climate-related investor tools, disclosures, and fund dynamics
- Sustainable funds:
  - Sustainable investment funds have grown faster than conventional funds since 2019; climate impact funds remain a small share of total sustainable investing.
  - SFDR classification: Article 6 (no sustainability focus), Article 8 (“light green”), Article 9 (“dark green”); SFDR requirements enacted February 2023 led to reclassifications from Article 9 to Article 8 in some cases.
  - Climate impact funds allocate higher shares to EMDE equities and bonds than other fund labels; however, carbon-risk-score distributions show some climate impact funds have transition risks similar to conventional funds.
- ESG and impact measurement:
  - Corporate ESG/E scores do not align perfectly with climate impact; a constructed climate impact score using 16 of 64 E-related datapoints covers about 10,300 listed firms (more than 2,700 in emerging markets).
  - Correlation between impact scores and E scores reported as "–0.14" (negative correlation).
  - Using impact scores versus E scores would produce substantially different portfolio allocations and exclusions.

### Selected numeric and factual highlights (exact figures preserved)
- Enhanced stress-test sample: nearly 900 banks across 29 countries.
- KRI coverage: approximately 350 publicly traded banks; 168 banks overlap between GST and KRI samples.
- Baseline global CET1 projection: about 12.7 percent of RWA in 2023.
- Adverse CET1 trough and recovery: trough in 2024, improving to 10.8 percent in 2025.
- Valuation and loan-loss contributions (2023, adverse vs baseline): 1.7 percentage points and nearly 1 percentage point to CET1 decline, respectively.
- Weak-bank counts: 55 banks (baseline); 215 banks (adverse).
- CRE debt shares: nearly 12 percent of GDP in Europe; 18 percent of GDP in the United States.
- CRE transaction volume fall: 55 percent year over year to $147 billion at start of 2023.
- LGFV debt: about 45 percent of GDP in 2022; impairment example: half-responsibility restructuring for banks could imply impairment charges of about 3.4 trillion yuan and a capital-ratio reduction of 1.7 percentage points.
- Mortgage and housing statistics: 80 percent of existing mortgages below 5 percent; nearly one-fourth below 3 percent.
- Mortgage rate context: 30-year mortgage rates currently above 7 percent (chapter context).
- Global corporate refinancing needs in 2024: more than $5 trillion, about half accounted for by US companies.
- China trust-sector assets under management: about 21 trillion yuan as of Q1 2023.
- China LGFV interest-coverage threshold cited: more than 30 percent of LGFV debt had interest coverage ratio below 1 for last three years.
- RSF total size: about $40 billion.
- Climate mitigation needs: $5 trillion global annually by 2030; $2 trillion per year in EMDEs by 2030.
- Share of private finance required in EMDEs by 2030: about 80 percent (and more than 90 percent excluding China in one scenario).

*Italic: International Monetary Fund | October 2023 — Global Financial Stability Report: Financial and Climate Policies for a High-Interest-Rate Era (selected chapter excerpts).*

### 2023. The views expressed in this publication are those of the IMF staff and do not necessarily represent

### Global Financial Stability Report: Financial and Climate Policies for a High-Interest-Rate Era

### Key Findings on the Current Financial Outlook
- Sentiment in financial markets changed markedly between April and September 2023: concerns about banking-sector stress receded, replaced by optimism about brisk disinflation and a potential soft landing, but risks remain that optimism can unravel from adverse shocks (for example, upside surprises to inflation, financial-stability concerns in China, and renewed concerns about debt sustainability).
- Rapid rises in global bond yields in recent weeks illustrate how abruptly financial conditions can tighten.
- High global interest rates are beginning to squeeze the repayment capacity of corporate and household borrowers; financial stability risks remain elevated, similar to the April 2023 assessment.
- Global core inflation has slowed in 2023 but remains elevated; returning inflation to target is the main policy priority.
- Divergence in inflation developments between advanced economies and some emerging market economies has emerged in recent months, underscoring the need for country-specific monetary policy decisions.

### Risks to Growth and Financial Stability
- A restrictive monetary stance is needed in economies with still-elevated and persistent inflation until there is tangible evidence that inflation is sustainably moving toward targets.
- High-for-longer interest rates affect financing costs in emerging market and developing economies (EMDEs); most major emerging markets have been resilient in 2023, but many frontier and low-income sovereign issuers will likely continue to face financing challenges.
- Sovereign debt vulnerabilities: countries should pursue structural reforms to foster growth and manage high debt vulnerabilities; where feasible, execute refinancing or liability-management operations to rebuild buffers.
- For countries nearing debt distress, establish early contact with creditors and coordinate preemptive and orderly restructuring to avoid costly defaults and prolonged loss of market access.
- Development of local currency markets and a stable, diversified investor base is important to insulate domestic financial conditions from external developments.

### Corporate, Household, and Real Estate Vulnerabilities
- Higher interest rates are impacting residential and commercial real estate:
  - In certain countries with a significant share of variable-rate mortgages, home prices have registered double-digit declines since their peak.
  - Vulnerabilities in the commercial real estate (CRE) sector pose a significant risk to the financial sector; the sector faces an expected funding pullback by lenders in coming years.
- Authorities should conduct stringent stress tests to assess:
  - Effects of rising interest rates on borrowers’ ability to repay loans.
  - Consequences of sharp falls in real estate prices for households, corporations, and financial institutions.
- Urgent need to address systemic risks related to CRE stemming from nonbank financial institutions by broadening macroprudential tools and enhancing data collection.

### Banking Sector Vulnerabilities and Supervision
- Although acute banking stress observed in March 2023 has subsided, a sizable tail of weak banks remains (see Chapter 2).
- Supervisory priorities:
  - Ensure banks have corporate governance and risk management commensurate with risk profiles.
  - Pay specific attention to bank asset classification and provisions, and exposures to interest rate and liquidity risks.
  - Conduct timely, intrusive, and conclusive banking supervision.
  - Safeguard operational independence of supervisors by providing clear safety-and-soundness mandates, adequate resources, and legal protection.

### Policies to Support Financial Stability and Growth
- Monetary policy: maintain restrictive stance where inflation remains elevated and persistent until clear evidence shows inflation is moving sustainably toward targets.
- Sovereign policy: pursue structural reforms, consider refinancing or liability-management operations where feasible, and engage early with creditors when nearing debt distress.
- Financial-sector policy:
  - Use stringent stress testing for real estate and borrower repayment capacity.
  - Broaden macroprudential tools to cover nonbank financial institutions tied to CRE risks.
  - Enhance data collection on exposures and vulnerabilities across banks and nonbanks.
  - Strengthen supervision, corporate governance, and risk management in banks, including focus on asset classification, provisioning, interest rate, and liquidity risks.

### Report Scope, Coordination, and Timing
- The GFSR assesses key vulnerabilities to which the global financial system is exposed and aims to prevent crises by highlighting policies to mitigate systemic risks.
- Analysis coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of Tobias Adrian, Director, and directed by Fabio Natalucci, Deputy Director, and Jason Wu, Assistant Director, among others.
- The report draws on discussions with banks, securities firms, asset managers, hedge funds, standard setters, financial consultants, pension funds, trade associations, central banks, national treasuries, and academic researchers.
- This GFSR reflects information available as of September 25, 2023; it benefited from comments and suggestions from IMF staff and Executive Directors after their discussions on September 26, 2023, but the analysis and policy considerations are those of the contributing staff.

*International Monetary Fund | October 2023 — Global Financial Stability Report: Financial and Climate Policies for a High-Interest-Rate Era*

### FOREWORD

### FOREWORD

### Lessons from recent bank failures and regulatory implications
- Authorities should evaluate whether the Basel III liquidity standards performed as intended and explore potential improvements in international standards for interest rate risk.
- Policymakers should consider expanding the scope of regulations and resolution regimes to encompass a broader range of banks, because even relatively small banks have proven to be systemic at times of wider stress.
- Address legal, regulatory, and operational obstacles to cross-border funding in resolution, including the ability to mobilize collateral across borders.
- As the dust settles after the bank failures in March and April, authorities should continue to build buffers as necessary to help guard against future losses and to support the provision of credit through periods of stress.

### Nonbank financial intermediation (NBFI)
- NBFI has become increasingly important in the global financial system and requires comprehensive systemic risk assessments.
- Close data gaps by strengthening disclosures and regulatory reporting to characterize and identify systemic risk from NBFI.
- Increase supervisory effort to rein in excessive liquidity mismatches and leverage; these efforts should be the first line of defense.
- If central bank liquidity is needed to stem systemic crises involving NBFIs, communicate clearly the financial stability objectives and the parameters of the program, including the time frame for exit.

### Macroeconomic outlook: Soft landing versus abrupt awakening
- Core inflation remains high and is declining only slowly in many advanced economies; central banks may need to keep monetary policy tighter for longer than is currently priced in markets.
- In emerging market economies, progress on lowering inflation appears more advanced, reflecting benefits of early rate hikes, with discrepancies across regions that may presage desynchronization of global monetary policy.
- Optimism about a soft landing has fueled asset valuation since the April 2023 GFSR; despite equity declines since September, financial conditions for advanced economies have eased on net.
- Equity performance this year (to date in the report): Europe up about 10 percent; United States up about 12 percent.
- Upside surprises to the inflation outlook would challenge the soft-landing narrative and could trigger sharp repricing of assets.
- The IMF’s growth-at-risk measure indicates risks to global growth are skewed to the downside, similar to April 2023; if the soft landing does not materialize and financial conditions tighten toward the long-term average, growth-at-risk forecasts a distribution more firmly skewed to the downside.

### Vulnerabilities in corporates, households, and real estate
- Corporations and households have in some cases extended debt repayment horizons or used pandemic savings to shore up balance sheets; these factors may not be sufficient to prevent rising repayment difficulties.
- The share of firms with low cash-to-interest-expense ratios has rebounded over the past two years, especially among small and medium firms, as firms face tighter funding conditions.
- Mortgage borrowers face higher repayment burdens, leading to slowdown in housing activity and further declines in home prices.
  - Global real house prices have been falling since late 2022.
  - Real house prices fell 8.4 percent in the first quarter of 2023 in advanced economies.
  - Emerging markets saw a smaller decline of about 2.4 percent in the first quarter of 2023.
  - Countries with a large share of floating-rate mortgages and house prices above the pre-pandemic average recorded double-digit declines in home prices.
- Commercial real estate (CRE) vulnerabilities:
  - CRE-related debt is nearly 12 percent of GDP in Europe.
  - CRE-related debt is 18 percent of GDP in the United States.
  - Funding sources for CRE borrowers are becoming less available: banks report tighter lending standards, private equity fundraising activity has slowed sharply, and issuance of commercial mortgage-backed securities has weakened.
  - Prospect of higher-for-longer rates and declining property valuations will keep CRE refinancing conditions strained.

### China-specific developments
- Weakening economic momentum, a deepening property sector downturn, and growing strains on local government financing weigh heavily on market sentiment.
- The renminbi has faced notable downward pressure as equity prices have fallen sharply.
- Disinflationary pressures prompted the People’s Bank of China to cut policy rates, making it one of the few central banks to ease monetary policy.
- Easing and announced stimulus measures have not restored confidence among businesses, consumers, and homebuyers.
- Home sales volumes have materially declined for stronger private and state-owned developers in recent months.
- A large private developer missed interest payments on bonds due in August.
- Continued stress has spilled over to local government finances, raising concerns about LGFV debt sustainability.
- A major asset manager suspended payments and redemptions on wealth management and trust products, raising concerns about broader financial stress if public confidence in investment products deteriorates.
- Policy priorities in China:
  - Facilitate completion of housing projects to stem homebuyer sentiment slump.
  - Timely resolution and restructuring of troubled property developers.
  - Further easing of monetary policy and reorientation of fiscal support toward households to support growth.
  - A comprehensive strategy to address LGFV debt to restore debt-servicing capacity and sustainable local government debt levels.
  - Further progress is needed to address risky exposures in the asset management sector to real estate and LGFVs, and to address liquidity mismatches.

### Emerging markets and sovereign spreads
- Investors differentiate between emerging market economies with stronger fundamentals and those more vulnerable to shocks; most emerging market sovereign credit spreads have remained narrow despite tighter policy and higher yields.
- The gap between investment-grade and high-yield segments of emerging market sovereign debt markets remains wide.
- Repeated credit downgrades since the pandemic have pushed average frontier sovereign ratings lower, increasing implied spreads and financing costs across many emerging market economies.
- Sovereign borrowers in emerging market economies, frontier markets, and low-income countries should strengthen efforts to contain risks from high debt vulnerabilities through creditor dialogue, multilateral cooperation, and international support.

### Banks, stress tests, and nonbank impacts
- Banks are expected to face greater credit costs as higher interest rates reduce borrowers’ repayment capacity.
- In aggregate, banks appear to have prudently added provisions for more defaults; loan-loss reserves seem adequate to cover nonperforming loans in many countries.
- Higher rates should support net interest margins on new bank loans; however, credit exposures can deteriorate rapidly and loan demand can plummet in a recession, affecting profitability.
- IMF analyses (Chapter 2) use an enhanced global stress test and a forward-looking monitoring framework incorporating analyst forecasts of bank balance sheet, valuation, and profitability metrics; both indicate a notably weak tail of banks.
- The global stress test shows a wide set of banks will suffer capital losses under an adverse stagflationary scenario, including several systemically important institutions in China, Europe, and the United States.
- Nonbank financial intermediaries:
  - Higher rates benefit some longer-term-obligation institutions (insurers and pension funds) by reducing present value of liabilities and improving funded ratios.
  - Key risk for those institutions is having moved into less liquid and riskier assets (private credit) during low-rate era.
  - Investment funds providing daily liquidity could face redemption pressure as higher rates reduce the value of their fixed-income assets.
  - Leveraged strategies predicated on swift disinflation may be forced to unwind positions if inflation remains high.

### Climate finance needs and private sector role
- By 2030, climate mitigation investment needs in emerging market and developing economies (EMDEs) are estimated to reach about $2 trillion per year.
- The private sector is key to financing required investments in EMDEs, given limited fiscal space and challenging market conditions.
- By 2030, the share of private finance must increase to about 80 percent of climate mitigation investment needs in EMDEs; the proportion should be even greater in EMDEs outside of China.
- Figure indicators note projected increases in private financing share for climate investments: +40 pp and +45 pp (as presented).

### Policy recommendations
- Central banks must remain determined in the fight against inflation until tangible evidence shows sustainable movement toward targets; monetary stance should reflect country-specific recovery and disinflation pace.
- Communication is crucial to convey policymakers’ resolve.
- Emerging market central banks should be cautious not to ease policy rates too aggressively despite progress on inflation in some economies.
- Countries should integrate policies, including where applicable the Integrated Policy Framework, to manage risks from volatile capital flows amid global monetary policy uncertainty and the foreign exchange environment.
- Optimal policy combinations depend on shock nature and country-specific characteristics; response measures should tackle underlying macroeconomic imbalances and allow needed adjustments.
- Sovereign borrowers in vulnerable countries should strengthen debt vulnerability containment, use the Group of Twenty Common Framework when applicable (a reformed quicker and more effective version), and coordinate with bilateral and private creditors for preemptive and orderly restructuring to avoid hard defaults.
- Where feasible, execute refinancing or liability management operations to rebuild buffers.
- For banks:
  - Maintain adequate loss-absorbing buffers.
  - Phase out forbearance policies that delay loan-loss recognition.
  - Expedite efforts to restructure weak banks.
  - Ensure preparedness to access central bank facilities.
  - Strengthen bank resolution regimes and preparedness to deploy them.
- Implement international standards consistently across jurisdictions, assess whether specific features performed as intended during recent turmoil, and enhance supervision where necessary.
- National authorities should deploy stringent stress tests to estimate effects of diminished borrower repayment capacity and sharp declines in residential real estate prices on household balance sheets and financial institutions.
- Continued vigilance is warranted to monitor vulnerabilities across the global financial system.

*International Monetary Fund | October 2023*

### eXeCUtIVe sUMMARY

### eXeCUtIVe sUMMARY

### Global outlook and key risks
- Directors broadly agreed with staff’s assessment of the global economic outlook, risks, and policy priorities (IMF Executive Board discussion, September 2023).
- Divergent growth prospects across regions pose a challenge to returning to pre-pandemic output trends; for many EMDEs, the loss of momentum has reduced prospects for income convergence.
- Tight monetary policies and withdrawal of fiscal support are headwinds to growth in the short run.
- Increasing geoeconomic fragmentation is weighing on the recovery; diversification in supply chains was highlighted as important for resilience.
- Ending Russia’s war against Ukraine was identified as the single most impactful action to improve the global outlook.
- Risks to the outlook are more balanced relative to April 2023, but remain tilted to the downside.
- Acute banking-system stress seen in March 2023 has subsided in part due to swift action in Switzerland and the United States, but financial stability risks remain elevated.
- Persistent global underlying inflation could warrant higher-for-longer policy rates, potentially triggering asset repricing and capital flow volatility.
- Commodity prices could see more volatility due to climate and geopolitical shocks.
- Risk of further deterioration in China’s property sector; recent policy actions by authorities were welcomed.
- Risk of further debt distress in EMDEs heavily reliant on external borrowing; presence of a weak tail of banks in some major economies poses vulnerabilities.
- An abrupt tightening of financial conditions could trigger adverse feedback loops testing global financial-system resilience.

### Inflation, monetary policy, and labor markets
- Global core inflation remains persistent and is declining only slowly; monetary policy should maintain a restrictive stance, tailored to country circumstances, until inflation declines sustainably to target.
- Clear and transparent communication by central banks is critical to avoid de-anchoring of inflation expectations.
- Policies encouraging labor market participation can help ease labor market tightness in many advanced economies and support disinflation.

### Fiscal policy and debt
- Directors stressed the need to gradually tighten fiscal policies as deficits and debt remain elevated.
- Tightening the fiscal stance can further ease inflation by reducing aggregate demand and reinforcing the credibility of disinflation strategies.
- Recommendations include mobilizing revenues through tax capacity building and achieving efficiency gains in spending, while safeguarding targeted measures to protect the most vulnerable.
- Some countries in debt distress may require preemptive and orderly debt restructuring; multilateral cooperation is important.

### Financial sector vulnerabilities and supervision
- The fast pace of monetary policy tightening adds pressure on the financial sector, requiring careful monitoring of risks, better risk assessment, and strengthened supervision.
- Closing supervision gaps in the nonbank financial sector was urged.
- Directors called for an assessment of how consistently international banking-regulation standards were implemented during recent financial stresses.
- Noting vulnerabilities in commercial real estate (CRE) in some countries, Directors called for continued vigilance and close monitoring.
- Specific microprudential measures were recommended in the CRE sector, including reviews of banks’ CRE valuations, ensuring provisions are adequate, and building buffers to guard against future losses and support credit provision during stress (for example, raising countercyclical capital buffers or sectoral systemic risk buffers where circumstances allow). To avoid procyclical effects, raising buffers should be conditioned on the absence of signs that credit is already being constrained by banks’ capital adequacy.

### Climate finance, policy mix, and international cooperation
- A broad mix of structural and financial policies is needed to create an attractive investment environment for private capital to support climate finance needs in EMDEs.
- A stronger climate information architecture—data, disclosures, and alignment approaches (including taxonomies)—is necessary to attract private investors.
- Financial sector policies should be focused on creating climate impact.
- Transition taxonomies in EMDEs can help institutions identify activities that may reduce greenhouse gas emissions over time, including in the most carbon-intensive sectors.
- Disclosures and labels for sustainable investment funds should enhance market transparency, market integrity, and alignment with climate impact–oriented outcomes.
- The IMF’s convening power and the Resilience and Sustainability Facility (Trust) can be catalysts for mobilizing private climate finance and attracting green financing and investments through policy conditionality and catalytic roles.
- Directors called for accelerating decarbonization efforts while balancing climate goals, fiscal sustainability, and political feasibility.
- Most Directors favored a policy package containing carbon pricing, complemented with measures to address market failures, catalyze private finance and green investment, and mitigate distributional concerns; some Directors cautioned that carbon pricing is not adequate in all countries.
- Incorporating climate change considerations into debt sustainability analyses could improve policy planning, taking into account country-specific characteristics.
- Internationally coordinated efforts are indispensable to minimize the cost of decarbonization, especially for low-income countries and small developing states.
- Green industrial policies should avoid distortions to trade and investment flows, in line with WTO rules; measures such as carbon border adjustment mechanisms should be WTO-compliant.

### Financial stability: sectors and transmission
- The global credit cycle has started to turn as borrower debt-repayment capacity diminishes.
- Residential home prices are declining more quickly in countries with a higher share of variable rate mortgages.
- Defaults are rising in commercial real estate markets; cash buffers of corporations are eroding as debt-service burden increases.
- A number of shocks could adversely affect financial stability: escalation of the war in Ukraine; continued stress in the Chinese property sector spilling over to the financial sector and local governments.
- The synchronization of global monetary policy is starting to fade, with implications for asset prices, investor exposures across countries and asset classes, and capital flow volatility.
- Some lower-rated emerging markets continue to be in debt distress and have difficulties accessing external financing.
- Financial institutions face higher funding costs; a deterioration of asset quality could lead to losses and reduce credit extension to the macroeconomy.
- Leveraged investment strategies predicated on swift disinflation may be forced to unwind positions should inflation stay doggedly high.

### Chapter 1 at a Glance — Key points
- With core inflation still high and declining only slowly in many advanced economies, central banks may need to keep monetary policy tighter for longer than is currently priced in markets. In emerging market economies, progress on lowering inflation appears to be more advanced, although there are discrepancies across regions.
- Optimism about a soft landing has fueled risk asset valuations since the April 2023 Global Financial Stability Report; a sudden reassessment of the monetary policy outlook following upside inflation surprises could challenge this narrative and lead to sharp asset repricing.
- While acute stress in the banking system has subsided, a weak tail of banks remains in some countries; cracks in other sectors could become worrisome fault lines.
- The credit cycle is turning: borrower debt-repayment capacity is weakening, residential home prices are falling faster where variable-rate mortgages are common, CRE defaults are rising, and corporate cash buffers are eroding.
- A range of shocks—including escalation of the war in Ukraine and further spillovers from China’s property sector—could adversely affect financial stability.
- Synchronization of global monetary policy is fading, with implications for asset prices and capital flows.
- Some lower-rated emerging markets remain in debt distress and face limited external financing access.
- Financial institutions face higher funding costs; asset-quality deterioration could reduce credit extension and force unwinds of leveraged strategies.

### Policy recommendations (selected)
- Sustainable growth requires both price and financial stability; central banks must remain determined in the fight against inflation until there is tangible evidence of inflation moving sustainably toward targets.
- Monetary policy stances should reflect country-specific recovery and disinflation dynamics; communication remains crucial to convey policymakers’ resolve.
- Emerging markets remain vulnerable to sharp tightening in global financial conditions; central banks should be cautious about easing policy rates too aggressively.
- In China, robust policies to restore confidence in the real estate sector are critical to limit negative spillovers to the financial sector, firms, and local governments.
- Enhance financial sector regulation and supervision given the sizable tail of weak banks and contagion risks to healthy institutions.
- Maintain vigilance in monitoring vulnerabilities in the commercial real estate sector to minimize risks to bank and nonbank lenders.

*Source: eXeCUtIVe sUMMARY, Global Financial Stability Report: Financial and Climate Policies for a High-Interest-Rate Era (October 2023).*

### CHAPTER 1 SOFT LANdING OR ABRuPT AwAkENING?

### CHAPTER 1 SOFT LANDING OR ABRUPT AWAKENING?

### Banking sector resilience and vulnerabilities
- Inflows have begun to return to local currency bond markets; frontier markets face more difficult conditions with high repayment burdens, debts coming due in the near term, and unfavorable conditions for issuing hard currency sovereign bonds.
- For countries in or near debt distress, access to external financing could be severely impeded.
- The majority of global banks emerged from the March banking turmoil largely unaffected.
- Many banking systems have prudently added provisions for higher expected defaults; loan-loss reserves seem adequate to cover nonperforming loans.
- Higher rates should support net interest margins on new bank loans, but credit exposures can deteriorate rapidly, hurting bank profitability and prompting depositor outflows and stock price declines for weaker banks.
- Chapter 2 (in the source) assesses the quantum of banks vulnerable in a scenario of heightened duration, credit, and funding liquidity risks.

### Monetary policy and inflation dynamics
- Market-implied expected path of monetary policy has shifted up since April 2023 in most advanced economies (except Japan); a peak in the tightening cycle is expected toward the end of 2023 or in early 2024, after which authorities are anticipated to gradually ease policy.
- Despite gradual declines, core inflation remains elevated and pressures could persist longer than currently priced in financial markets; inflationary shocks such as food and energy price spikes could affect the outlook.
- Pricing from inflation options markets indicates investor disagreement about likely inflation outcomes over the next five years; US investors converge at about a 3 percent outcome, above the Federal Reserve’s 2 percent target.
- Since April 2023:
  - The Federal Reserve has raised the target range for the federal funds rate by 50 basis points to 5.25–5.50 percent.
  - The European Central Bank has hiked policy rates 100 basis points; the deposit facility rate is now at 4.00 percent, the highest in the institution’s history.
  - The Reserve Bank of Australia and the Bank of Canada resumed rate hikes in the second quarter.
  - The Bank of England, the Norges Bank, Sveriges Riksbank, and the Swiss National Bank tightened policy by 25 basis points at recent meetings.
- Advanced-economy central banks have delivered a combined 3,915 basis points of policy rate hikes since September 2021, with the Federal Reserve hiking at a faster pace compared with previous tightening cycles.
- The Bank of Japan remains an outlier, keeping its short-term policy rate unchanged in negative territory and continuing yield curve control (YCC) for attainment of its 2 percent price stability target.
  - In July 2023 the Bank of Japan raised the upper bound of the fluctuation range for 10-year JGB yields at which it will offer unlimited purchase to 1 percent instead of the previous 0.5 percent; the change was described as enhancing sustainability of monetary easing rather than phasing out YCC.
  - Expectations for increased volatility drove yields on long-term Japanese government bonds to a nine-year high.
  - Japanese equities outperformed other advanced-economy markets in 2023: the Nikkei 225 Index has surged by more than 20 percent partly because Japanese corporations made more share buybacks relative to global peers.
  - The yen weakened as investors expected the interest rate spread between domestic and overseas interest rates to persist; in September, after a Bank of Japan comment hinting at a future policy shift, the yen advanced against the dollar while Japanese bond yields increased.

### Soft-landing prospects and historical context
- Past soft-landing episodes (as defined in Blinder (2023)) were generally associated with positive real interest rates and modest inflation expectations; cycles ending with hard landings were associated with high inflation expectations.
- Current US developments (rightmost green dot in the source figures) point to a situation close to past soft-landing episodes, but avoidance of recession depends on whether inflation continues to decelerate in line with market expectations.
- The current tightening cycle is unusual: in the United States the real federal funds rate has continued to be negative since Q1 2022 despite one of the most aggressive hiking cycles for decades.
- Ex ante real rates (computed using one-year-ahead inflation expectations) are above zero in the euro area and nearly 3 percent in the United States, but ex post measures (based on realized inflation) are materially lower: −1 percent in the euro area and 1 percent in the United States.
- Since the pandemic, inflation expectations have frequently undershot realized inflation; assessments of monetary policy stance based on ex ante real rates should be complemented by assessments based on ex post real rates.

### Emerging markets: policy space, risks, and market pricing
- In many major emerging markets, real policy rates have risen substantially since 2021 and inflation has declined over 2023, prompting investors to price in substantial rate cuts in the coming year.
- Inflation has eased markedly in many emerging markets, notably in Latin America, although survey-based expectations suggest inflation will remain above target through 2024 in several countries (for example, Colombia, Hungary, Poland, and Romania).
- Early and aggressive tightening in emerging markets has driven real rates significantly higher on both ex ante and ex post bases in most countries.
  - Countries with elevated real rates have started easing (for example, Brazil, Chile, and Uruguay) or are expected to normalize rapidly.
- Regional differentiation remains in policy risks and market pricing; many emerging markets appear to have hit the natural peak of their tightening cycle, with policy rates and real interest rates at or near historical highs.
- Markets that expect an unusually rapid pace of cuts typically face unusually high ex ante real rates and should have the policy space to ease, but policymakers must carefully manage easing given potential spillovers from higher-for-longer advanced-economy interest rates.
- High interest-rate differentials and lower market volatility have driven gains for emerging market currencies through carry trades, though recent pullbacks point to choppier conditions ahead.

### Financial conditions, risk assets, and lending
- Financial conditions measuring the cost of funding in capital markets have eased in advanced economies—especially the United States—despite ongoing monetary tightening; such easing is unusual compared with past tightening cycles and is largely predicated on investor expectations of a soft landing and eventual rate cuts.
- Compression of risk premiums in equity and corporate bond markets has been a tailwind to corporate valuations in the IMF’s financial conditions index, particularly for the United States and the euro area.
- In China, modest easing of monetary policy has been insufficient to offset concerns about sluggish recovery and property-market-related financial stability risks; risk assets and investor confidence have been hurt.
- In other emerging markets, expectations for rate cuts and higher corporate valuations have loosened financial conditions on net, even though external costs remain headwinds.
- Lending conditions continued to tighten globally: standards and terms have become more restrictive despite the feared material contraction in bank credit growth after March’s banking turmoil not materializing.

*International Monetary Fund | October 2023*

### 1. Financial Conditions Indices

### 1. Financial Conditions Indices

### Financial conditions and main drivers
- Financial conditions eased, driven especially by corporate valuations: higher equity valuations, lower volatility, and narrower corporate bond spreads in advanced economies.
- The IMF FCI is designed to capture the pricing of risk. It incorporates various pricing indicators, including real house prices. Balance sheet or credit growth metrics are not included. Standard deviations are calculated over the period from 1996 to present.
- Sources cited: Bloomberg Finance L.P.; Haver Analytics; national data sources; and IMF staff calculations.

### Loan standards and loan demand
- Loan standards tightened in the euro area, the United States, and some emerging markets in the first half of the year; loan demand is reportedly materially weaker in the euro area and the United States.
- Drivers cited by euro area and US lenders: concerns about the economic outlook, increased borrower risks, and more challenging bank funding conditions.
- In the United States, lower bank risk tolerance also played a role.
- The tightening and dropping demand are most vivid in CRE loans in the United States because of weaker borrower profiles and expected deterioration in the sector.
- Data sources: Federal Reserve; national central banks; and IMF staff calculations.
- Note on signs: For loan demand, positive values indicate stronger demand; negative values indicate weaker demand. For loan standards, positive values indicate tighter standards; negative values indicate looser standards.

### Risk assets and valuations
- Risk assets have continued to appreciate, on net, since April 2023, resulting in an easing of financial conditions, especially in the euro area, Japan, and the United States.
- Equity prices have increased notably in these economies while corporate credit spreads have tightened on net.
- Since the beginning of the year, US equity prices have climbed more than 10 percent. (Figure 1.8, panel 2)
- Technology sector valuation specifics:
  - The US technology sector is trading close to 30 times earnings.
  - The 10-year historical average is 22 times earnings.
- Equity gains were supported by progress on inflation and growing investor expectations of a soft landing that could allow central banks to conclude tightening soon and potentially begin easing in the coming quarters.
- With valuations stretched in many assets, risk of a sharp repricing remains if inflation is stickier than markets anticipate or hopes for a soft landing fail.
- Based on a standard discount cash flow model, the rise in the S&P 500 is primarily driven by investors’ risk appetite and optimism—proxied by a compression of risk premiums.
- Artificial intelligence and technology sector gains boosted global equity markets after June; the launch of ChatGPT-4 was set to March 14, 2023 (panel note).

### Market volatility and interest rate dynamics
- Investor optimism compressed market volatility; the decline in volatility was most notable in US equity markets where both realized and implied volatility were in the lowest historical quartile before recent deterioration in market sentiment.
- The term structure of US equity implied volatility returned to an upward slope since April 2023.
- Volatility risk premiums (spread between market-implied volatility and model-based fair value) have continuously dropped across maturities over the last year, particularly in shorter-dated volatility.
- Figure heat-map latest percentiles (implied volatility against own history) include exact values:
  - Equity — United States: 38.3%
  - Equity — Europe: 24.4%
  - Equity — Japan: 16.0%
  - Equity — EM: 13.9%
  - Rates — United States: 79.9%
  - Rates — Europe: 86.4%
  - Foreign exchange — Euro: 21.8%
  - Foreign exchange — Yen: 39.4%
  - Foreign exchange — Sterling: 30.2%
  - Foreign exchange — EM: 19.3%
  - Commodities — Oil: 41.9%
  - Commodities — Gold: 12.4%
  - Bitcoin: 0.0%
- Interest-rate market volatility has remained elevated, reflecting continued uncertainty about the policy outlook. Past US tightening cycles show interest-rate volatility tended to rise when inflation was still running high after the end of rate hikes.
- Since April 2023, medium- to longer-tenor bond yields have risen noticeably across advanced economies.
- Decomposition of yield increases shows upward shifts of the market-implied expected path of policy account for large shares of the increase; term premiums have also risen, notably in the United Kingdom and the United States, and to some extent Japan.
- In some emerging markets, bond yields have fallen, pushed down by expectations of rate cuts, particularly in Brazil and Poland.
- Note defining term premiums: Term premiums represent the compensation investors seek to bear the risk that interest rates may change over the life of the bond.

### Corporate bond markets and borrowing costs
- Global corporate bonds have rallied since April 2023, with spreads narrowing below long-term averages, particularly in the high-yield segment.
- By sector, spreads have outperformed the most in the consumer cyclical and technology sectors on a year-to-date basis.
- Despite narrower spreads, absolute corporate yields remain elevated; after accounting for the increase in government yields since the beginning of the policy-hiking cycle:
  - Speculative-grade corporate borrowing costs are approaching the level seen during the COVID-19 pandemic.
  - Investment-grade yields are already higher than their levels at the height of that crisis.
- Narrow spreads are indicative of stretched valuations in the corporate market.
- Corporate bond spread misalignment (spreads lower than model values) has become more severe in the euro area high-yield market and in US investment-grade and high-yield markets.
- Panel notes and classifications: US high-yield corporate bond sector indices are based on Bloomberg Bond index classification (BCLASS); S&P 500 index sectoral returns are based on the Global Industry Classification Standard (GICS). Panel 4 is scaled by standard deviation. See Section 1 of the October 2019 Global Financial Stability Report’s Online Annex 1.1 for details of the asset valuation models.

### Leveraged trading strategies and market dysfunction risks
- With low market volatility, some investors have taken large leveraged positions to boost returns; outsized leveraged positions are vulnerable to volatility and can force deleveraging and forced selling.
- Policymakers and market participants have recently flagged this risk for the US Treasury market.
- Since end-2021:
  - Asset managers increased long positions in Treasury futures beyond levels observed at the 2019 peak.
  - Leveraged funds have taken the other side of the trade (increasing short positions in futures), while banks and broker–dealers have stepped back due to balance sheet constraints.
- Leveraged funds’ increased short futures positions have coincided with greater holdings of cash Treasuries, likely financed by repurchase agreement transactions—consistent with basis-trading activity exploiting valuation gaps between futures and comparable bonds.
- Historical precedent: Basis trading was prevalent in 2019 and was severely tested during the “dash for cash” in March 2020, when cash Treasury yields spiked, leading to a reversal of the basis and forced unwinds amid jumps in volatility.
- Current positioning by leveraged investors may be tested by a sudden bout of bond market volatility, potentially forcing them to unwind positions and sell bonds just as prices fall.
- Concerns are heightened by limited intermediation of broker–dealers in sovereign bond markets; primary dealers’ balance sheets for Gilts and Treasuries have been materially constrained in the United Kingdom and the United States, respectively.

*Global Financial Stability Report: “Financial Conditions Indices” (chapter excerpt), International Monetary Fund | October 2023*

### 1. Leveraged Funds and Asset Managers’ Future Positioning

### 1. Leveraged Funds and Asset Managers’ Future Positioning

### Hedge funds, basis trades, and positioning
- There are signs that hedge funds are engaged in “basis trade.”
- Panel note: In panel 2, the black line shows the aggregate Treasury holdings of all hedge funds that file Form PF with the Securities and Exchange Commission.
- Panel note: In panel 3, “Treasury cash-futures net basis” is the spread between the forward price of the futures contract’s cheapest-to-deliver cash security and the futures price adjusted by a conversion factor. “Volatility” is the one-month option on seven-year overnight index swap implied basis point volatility.

### Liquidity risks, forced unwinding, and market functioning
- A spike in volatility could see forced unwinding of futures positions, amplifying liquidity stress.
- Liquidity conditions—the cost and ease of transacting—have deteriorated across several key financial markets since 2022, driven by:
  - the unprecedented pace of removal of monetary policy accommodation;
  - uncertainty about the economic outlook; and
  - structural factors such as reduced intermediation capacity of key financial institutions.
- Stress in the banking sector in March and the US debt ceiling standoff in June further contributed to the liquidity deterioration.
- While market liquidity since appears to have stabilized in equity and foreign exchange markets, conditions in sovereign bond markets remain challenging.
- Failed transactions have increased and persist in several markets, suggesting that market functioning remains impaired.
- Panel note: In panel 4, primary dealer data are estimated based on available data from Bloomberg Finance L.P.

### Growth of sovereign bonds vs intermediaries’ balance sheets
- Growth in outstanding sovereign bonds has outpaced growth of intermediaries’ balance sheets (Figure 1.12, panel 4).
- A deleveraging and forced selling feedback loop could be amplified by insufficient market liquidity.

### Hedge funds’ Treasury holdings and futures shorts (cash/futures exposures)
- Panel note: In panel 2, the black line shows the aggregate Treasury holdings of all hedge funds that file Form PF with the Securities and Exchange Commission.
- Panel descriptions indicate large swings in hedge funds’ cash Treasury holdings and leveraged funds’ future shorts (charts measure Contracts, millions; Billions of US dollars).

### Treasury cash-futures net basis and volatility
- Treasury cash-futures net basis and volatility are tracked together (panel 3): Treasury cash-futures net basis (Basis points annualized, left scale; cents, right scale) and a one-month option on seven-year OIS implied volatility.
- Elevated basis and volatility imply potential for abrupt repricing and liquidity stress in futures and cash Treasury markets.

### Corporate credit quality: earnings, coverage, and refinancing needs
- US corporate earnings have declined for two consecutive quarters, despite a slight rebound in the second quarter.
- Growing expectations for a soft-landing scenario and expectations that central banks are close to the end of the tightening cycle have further supported one-year-ahead earnings per share forecasts (Figure 1.13, panel 1).
- Interest coverage ratios have declined in both Europe and the United States but remain high by historical standards (Figure 1.13, panel 2).
- In the United States, corporations held financial assets exceeding total liabilities in 2021 (Figure 1.13, panel 3).
- Abundant interest-bearing assets have helped meaningfully lower net interest payments since 2022 (Figure 1.13, panel 4).
- The difference in the interest rate sensitivity of assets and liabilities is a key factor; corporations invested a sizable portion of fixed-rate borrowings during 2020–21 in variable rate deposits, benefiting from higher rates.
- Risk: declining corporate earnings combined with tighter funding conditions will likely continue to erode corporate buffers globally (Figure 1.13, panels 5 and 6).
- The share of firms with low cash-to-interest-expense ratios has rebounded over the past two years, especially among small and medium firms.
- Global corporate refinancing needs in 2024 total more than $5 trillion, with approximately half accounted for by US companies (Figure 1.14, panel 1).
- Some companies need to refinance as early as next year; average tenor of outstanding debt is longer than six years, but rollover risks remain for many firms.
- In some countries, floating rate corporate debt represents a considerable share of overall corporate debt, increasing vulnerability to higher rates (Figure 1.14, panel 2).
- If US interest rates continue to stay high, the potential rise in debt-servicing costs might be more severe for firms with substantial amounts of floating rate US dollar–denominated debt.

### Ratings, defaults, and bankruptcies
- Downgraded firms face much higher funding costs as a significantly higher premium is required for financing (Figure 1.15, panel 1).
- In the United States, rating downgrades have recently outpaced upgrades and default rates have gradually increased (Figure 1.15, panel 2).
- The default rate for higher-rated firms has remained low but that for lower-rated firms has already exceeded the long-term average (Figure 1.15, panel 3).
- A rise in bankruptcies in the euro area and the United States points to a deterioration in conditions, especially for smaller businesses (Figure 1.15, panel 4).

### Vulnerabilities in asset managers, insurers, and funds
- Investment funds and exchange-traded funds (ETFs) with significant exposure to the corporate sector are particularly vulnerable to sentiment shifts; historically, high-yield bond funds have experienced large outflows during times of stress.
- Reduced demand for credit assets from insurance firms poses a vulnerability: insurers are large holders of BBB-rated corporate bonds and are sensitive to rating downgrades due to greater capital requirements for sub-investment-grade holdings.
- A pickup in policy lapses and surrenders could require insurers to sell credit assets.

### Housing affordability and household debt-service risk
- Global real house prices have been declining since late 2022.
- In the first quarter of 2023, real house prices fell 5 percent in advanced economies and declined 1.9 percent in emerging markets.
- Mortgage rates have risen globally, affecting loan originations, borrower repayment ability, and housing prices.
- Countries with a large share of variable rate mortgages and house prices still above the prepandemic average (example countries cited: Australia, Canada, and New Zealand) recorded double-digit declines in home prices since their peak.
- IMF simulation: in an adverse scenario in which interest rates increase by 200 basis points, countries with debt-service ratios already above 10 percent could see an increase in servicing costs of up to 1.8 percentage points.
- Some countries with high house-price-to-income ratios (Denmark, The Netherlands, Norway, and Sweden) could face heavier mortgage debt-service burdens and higher defaults if rates rise further.
- A severe increase in defaults remains a tail risk because underwriting standards remain tighter and household debt is generally lower than before the global financial crisis.
- Housing market dynamics: higher mortgage rates and lower affordability have suppressed demand, but supply constraints have contributed to keeping house prices above prepandemic levels in several countries.
- In the United States, housing starts have declined while inventory has remained low (Figure 1.16, panels 3 and 4), in part because existing homeowners are deterred from purchasing new properties by the prospect of ending up with a new mortgage with much higher rates.

*Sources: Bloomberg Finance L.P.; Federal Reserve; JPMorgan Big Data and AI Strategies; JPMorgan Chase; Nasdaq; Refinitiv Datastream; Bureau of Economic Analysis; Dealogic; Haver Analytics; S&P Global; IMF staff calculations.*

### 6. Mortgage Origination by Credit Score

### 6. Mortgage Origination by Credit Score

### Mortgage market dynamics and the lock-in effect
- About 80 percent of existing mortgages have rates below 5 percent and nearly one-fourth are below 3 percent.
- With 30-year mortgage rates currently above 7 percent, there is a significant increase in monthly payments on a new mortgage.
- Higher rates reduce homeowners’ incentives to sell their current home and buy a new one, creating a larger monthly-payment “lock-in” effect.
- The lock-in effect is more powerful in the United States due to:
  - prevalence of long-term fixed rate mortgages,
  - larger proportion of mortgage owners, and
  - higher shifting preference to work from home after the pandemic.
- Mortgage origination in the United States has continued to decelerate, especially among high-quality (high-credit-score) borrowers.
- Refinancing applications have declined more than 50 percent relative to a year ago.

### Commercial real estate (CRE) headwinds and repricing
- Global CRE transaction volumes plummeted 55 percent year over year to $147 billion at the start of 2023.
- Regional transaction declines in Q1 2023:
  - Europe: declined 64 percent year over year (notably industrial segment down 70 percent).
  - Asia-Pacific: average decline of 20 percent year over year.
  - United States: transaction volume plummeted by 57 percent year over year (largest decline in the office sector).
- CRE valuations (in real terms) declined 1.5 percent in aggregate.
- REITs-owned high-quality property price changes year over year:
  - Europe: more than 26 percent decline.
  - United States: 18 percent decline.
- CRE segments by recent price performance: office segment experienced the most pronounced decline, followed by retail and multifamily properties.
- Completions of new space are set to fall back sharply, while demand for multifamily housing is also slowing.
- Occupier and investment sentiment, and bank lending standards for CRE, have tightened—contributing to subdued investor sentiment and negative absorption in some sectors since the pandemic.
- IMF CRE price-at-risk model estimate: in a tail scenario, global CRE prices could decline by more than 10 percent over the next year across several segments.
- Small and regional banks, which have larger CRE exposure and are generally less well capitalized, could be significantly affected—potentially constraining their lending and creating a vicious cycle of tighter funding, falling CRE prices, and bank losses.

### Financial stability risks and Growth-at-Risk (GaR)
- The one-year-ahead forecast distribution of global growth informed only by financial conditions is roughly symmetric; with a 5 percent probability, global growth in 2024 is expected to be 1 percent or less.
- An augmented GaR model that includes global private nonfinancial credit growth (in addition to financial conditions) shifts the forecast distribution leftward:
  - When credit growth is included, the GaR metric is slightly below 0 percent.
  - The inclusion of credit growth lowers the GaR metric by 100 basis points relative to the model excluding credit information—implying increased downside risks, with a 5 percent probability that the global economy in 2024 may contract.
  - This augmented GaR is currently at about the 20th percentile of its historical distribution.
- Global private nonfinancial credit growth has slowed after pandemic increases.
- Example credit growth slowdowns cited:
  - Euro area household loan growth slowed to 1.3 percent in July 2023 from 4.5 percent a year ago.
  - Euro area non-financial corporate loan growth slowed to 2.2 percent in July 2023 from 7.6 percent a year ago.
- An adverse scenario in which the soft landing fails and financial conditions tighten toward their long-term average would further skew growth forecasts to the downside.

*Source: IMF staff, Global Financial Stability Report: Financial and Climate Policies for a High-Interest-Rate Era (chapter text provided).*

### CHAPTER 1 SOFT LANdING OR ABRuPT AwAkENING?

### CHAPTER 1 SOFT LANdING OR ABRuPT AwAkENING?

### Emerging Market Economies — China: concerns and market reactions
- Heightened concerns about China’s weakening economic momentum, a deepening property sector downturn, and growing strains on local government financing weighed on global market sentiment.
- Disinflationary pressures have intensified, prompting the People’s Bank of China to cut policy rates and cut the reserve requirement ratio for foreign currency deposits by banks.
- Announced stimulus measures "have not yet restored confidence among businesses and consumers and, importantly, homebuyers."
- Chinese financial markets underperformed broader emerging market assets since early 2023:
  - The renminbi has faced notable downward pressure and underperformed most other emerging market currencies in the year to date.
  - Equity prices have fallen sharply.
  - Market sentiment was briefly lifted in July after policy pledges, but faded in August after weak economic data and disappointment about announced policy measures.
- When a major financial conglomerate suspended payments and redemptions of its wealth management and trust products, investor attention turned to the broader trust sector.
  - The trust sector has assets under management of about 21 trillion yuan as of the first quarter of 2023.
  - Investment trust products comprise 70 percent of the sector and are privately sold to high-net-worth individuals and professional investors.

### Property sector weakness and spillovers
- After a short-lived stabilization through the first five months of the year, the property sector weakened again.
- Policy support rolled out since late 2022 has "not boosted homebuyers’ confidence or helped secure financing for property developers."
- State-owned and nondistressed private property developers have seen home sale volumes shrink in recent months.
- Many property developers are financially weak; housing development projects may not be commercially viable.
- As developers struggle to raise adequate funding:
  - Real estate investment and housing starts have declined.
  - Local government land sale revenues have been affected.

### Local Government Financing Vehicles (LGFVs): scale and vulnerabilities
- Total LGFV debt (based on public financial statements) stood at about 45 percent of GDP in 2022.
- Four-fifths of LGFV debt is held by banks, mainly in the form of loans; the rest is in corporate bonds and borrowings from nonbank lenders.
- On the asset side, two-thirds of LGFV assets are fixed long-term investments such as land and infrastructure assets, leaving relatively few liquid assets to meet short-term funding needs.
- More than 30 percent of LGFV debt has had an interest coverage ratio below 1 for the last three years and can be considered commercially non-viable without government support (sum of yellow bars in Figure 1.20, panel 2).
- IMF staff estimate: "over half of the debt cannot be serviced by current earnings alone if average LGFV funding costs are more than 3 percent (most LGFVs currently borrow at rates above this level)."

### Policy and balance-sheet implications for banks
- Recent LGFV debt restructuring practice: in a case, terms on bank loans (the majority of the debt stock) were modified while bonds were left untouched, despite bank loans’ seniority to bonds in most capital structures.
- Relying heavily on banks to solve the LGFV debt problem could lead to significant bank losses:
  - If all LGFVs were restructured to ensure financial viability (with current earnings covering interest expenses), losses would be large.
  - If banks were to take half of the responsibility of the debt restructuring cost, they could face impairment charges of about 3.4 trillion yuan, equivalent to a reduction in capital ratios of 1.7 percentage points.
  - Although systemically important banks would be able to manage, local banks could face capital shortfalls, even in relatively fiscally healthy provinces.
- Provinces with weak fiscal positions tend to experience a more pronounced real estate downturn, weaker economic growth, and a more limited credit expansion, amplifying financial stress through the property–banking–local government nexus.

### Emerging market outlook and capital flow dynamics
- Most major emerging markets have been resilient so far in 2023.
- IMF analysis: capital flows at risk have improved marginally since the April 2023 Global Financial Stability Report:
  - The probability of outflows has fallen slightly to 32 percent from 34 percent.
  - The fifth percentile of outflows remained steady at 2.9 percent of GDP.
- Investors differentiate between sovereigns with stronger fundamentals and policy buffers and those perceived as less resilient.
- Emerging market sovereign credit spreads have remained narrow and in sync with corporate credit spreads in advanced economies despite continued tightening of monetary policy and higher yields in advanced economies.
- The gap between investment-grade and high-yield segments of emerging market sovereign debt markets remains large:
  - Investment-grade sovereign spreads have tightened to levels below those of US BBB-rated firms, the lowest since before the global financial crisis (noting changing composition of the index toward higher-rated oil exporters).
- Portfolio flows into emerging markets have been relatively strong in 2023 but faced headwinds:
  - Chinese local currency bonds have faced large outflows since February 2022 (close to $130 billion).
  - Chinese equity outflows accelerated again in August, with over $15 billion in outflows in August to September alone.
  - Flows benefitted local currency bond inflows where inflation pressures are perceived as easing amid meaningful rate differentials; equities saw large inflows in several countries, notably India.

### Issuance and financing challenges for weaker sovereigns
- Sovereign hard currency bond issuance moderated after an exceptionally strong start to the year:
  - Investment-grade issuers accounted for 70 percent of issuance, including a record 33 percent accounted for by issuers rated A or above.
  - Issuance by frontier markets has remained tepid.
- Corporate issuance has remained weak, with Chinese issuers notably absent from the market over the last two years.
- High-yield, frontier, and low-income sovereigns face financing challenges:
  - A significant number of frontier and high-yield sovereign issuers will likely continue to face financing challenges amid higher global interest rates, weak fundamentals, and an uncertain credit cycle.
  - Repeated credit downgrades since the pandemic have pushed the average frontier sovereign rating lower, driving implied spreads and financing costs higher for many sovereigns.
  - Among the BB and B ratings segments, every notch lower is historically associated with between 60 and 140 basis points of additional spread level; downgrades to and within the CCC segment have tended to correspond to multiples of that.

*Source: CHAPTER 1 SOFT LANdING OR ABRuPT AwAkENING? (text) from the IMF Global Financial Stability Report, October 2023.*

### 1. Spreads and Ratio of Emerging Market High-Yield to

### 1. Spreads and Ratio of Emerging Market High-Yield to

### Distribution of spreads and index composition
- Panel 1 (ratio and percentile): The gray area tracks the ratio of emerging market high-yield sovereign spreads to emerging market investment-grade sovereign spreads, expressed in historical percentiles.
- Panel 2 (index share by rating): "The share of emerging market sovereigns with very high ratings (A and AA) has increased as index rules have changed."
- Current distribution remarks:
  - "Close to 90 percent of high-yield sovereign issuance has taken place with 10-year Treasury yields below 3 percent, and 30 percent with yields below 2 percent."
  - "When the 10-year Treasury yield has been below 2 percent, investor demand has tended to be strong across the sovereign credit spectrum, including a few risky issuances with spreads near or above 700 basis points."
  - "By contrast, in periods with Treasuries above 3 percent, for example, close to 90 percent of sovereigns that issued international debt were trading with spreads below 525 basis points at the time."
  - "The current backdrop remains difficult, as more than 40 percent of high-yield sovereigns not in default are trading with secondary market spreads above ... that level, and 35 percent are above 700 basis points." (text preserves the phrasing and numeric statements as in source)
- Note on measurement: "Spreads are measured as secondary market spreads on the bond issuance date where available."

### Historical issuance, coupons, and refinancing vulnerability
- Weighted average coupon dynamics:
  - "The weighted average coupon on high-yield emerging market sovereign bonds fell, from just under 8 percent in 2010 to just under 6 percent by early 2021."
  - "Investor demand for higher coupons is gradually resetting the stock of sovereign bonds at higher rates."
- Treasury yield regime and issuance:
  - High-yield sovereign issuance has been concentrated when 10-year Treasury yields were low (see above percentages).
  - Upcoming sovereign refinancings and additional net issuance would likely occur at much higher interest rates, potentially contributing to future debt-servicing strains.
- Refinancing concentration:
  - "Some sovereigns will need to refinance a substantial share of their outstanding Eurobond stock in the next two years."
  - "14 countries will see at least 30 percent of their outstanding bond stock amortize through the end of 2025, including several rated B, CCC, or lower."
- Distribution of spreads and ratings:
  - Panel 1 in Figure 1.22 reports changes in ratings and spreads since December 2019 (median credit rating movements and basis-point spreads).
  - Panel 3 shows quarterly high-yield US dollar sovereign bond issuance by coupon (billions of US dollars, left scale) and weighted average coupon (percent, right scale).
  - Panel 4 shows high-yield and frontier bond maturities in 2024–25 (share of outstanding external bonds amortizing in 2024 and 2025, and latest spread).

### Defaults, restructurings, and ongoing cases
- Default and restructuring progress (as reported):
  - "Notable progress has been made on sovereign debt restructuring in four of eight countries that were in default as of April 2023."
  - Ghana: "the official creditor committee provided financing assurances in May 2023 and committed to restructure the country’s bilateral debt, while government authorities made further progress on restructuring its domestic debt."
  - Sri Lanka: "defaulted in April 2022, has continued to restructure its debt with domestic and foreign creditors and launched its domestic debt restructuring operation in July 2023."
  - Suriname: "defaulted on its Eurobonds in March 2021, finalized its debt restructuring agreement with its bondholders after restructuring its debt with its Paris Club creditors last year."
  - Zambia (under G20 Common Framework): "reached an agreement on debt restructuring with its official creditors in June 2023, and discussions are ongoing to reach an agreement on comparable terms with private sector creditors."
- Policy implication from restructurings: "Even as markets have welcomed the restructuring, improving debt transparency and expediting the process will continue to be crucial."

### Portfolio flows, issuance, and China
- Portfolio flows and issuance dynamics:
  - "Portfolio flows have been relatively strong in 2023, while outflow pressures from China have been persistent."
  - "External bond issuance has rebounded somewhat from a very weak 2022, although frontier and corporate issuance remains tepid."
- Panel notes:
  - Panel 3 (Portfolio Flow Tracking): includes up to 24 emerging market economies; August and September data may be incomplete or not available at the time of publication, including Chinese bond flows for September.
  - Panel 4 (International Hard Currency Bond Issuance): includes bonds issued internationally (predominately US dollars, euro, and Japanese yen).

### Local investor footprint and resilience of local-currency markets
- Shift in holders:
  - "The footprint of domestic institutional investors has increased in local currency government bonds over the past decade, whereas nonresident investors have reduced their share of holdings."
  - Domestic institutional investors specifically cited: "pension funds and contractual savings and insurance firms" have bought a large portion of emerging market local currency government bonds.
- Market resilience drivers:
  - Earlier in 2023, "the confluence of the expectations for a soft landing for the global economy and high real rates relative to the past has led major emerging markets to rally in both foreign exchange and local currency government bond markets," which "could draw nonresident investors back into local currency government bonds."
  - "The decline in nonresident participation over the past decade can be attributed to multiple negative shocks—the taper tantrum of 2013, the shock to commodity prices in 2015 and 2016, China’s large devaluations during those two years, heightened geopolitical and trade tensions, and more recent concerns over fiscal sustainability."
  - "The rise of domestic institutional investors has allowed governments to continue fiscal expansion by relying more on funding in domestic currencies."
- Sensitivity to US yields:
  - "Benchmark medium-term yields of major local currency government bonds have been less reactive to movements of US Treasury yields than in previous tightening episodes."
  - "The decline in nonresident participation is also likely to have mitigated spillovers from advanced economies to emerging markets."
  - Possible contributing factor: "benign financial conditions in advanced economies, tempering the reactions of benchmark-driven investors to flee emerging market assets."
- Heterogeneity and remaining vulnerabilities:
  - "Emerging market sovereigns with weaker positions generally see more bond yield volatility, suggesting that efforts to improve market depth should be complemented by efforts to improve domestic strength and mitigate external vulnerabilities."
  - Panel 3 (Local Currency Government Bond Ownership for the Eight Largest Emerging Market Economies) covers Brazil, India, Mexico, Indonesia, Malaysia, South Africa, Thailand, and Poland, representing 81 percent of outstanding major local currency government bonds at the end of 2022.
  - Panel 4 (Changes to 10-Year Local Currency Government Bond Yield Sensitivity to 10-Year US Treasury) shows compressed sensitivity during this tightening cycle relative to prior episodes.
  - Panel 6 links benchmark 10-year domestic yield volatility and five-year credit default swap movements, with bubble sizes reflecting nonresident holdings (percent outstanding as of 2022).

*Sources: Bloomberg Finance L.P.; Bond Radar; Federal Reserve; Fitch Ratings; Haver Analytics; JPMorgan; Moody’s; S&P Global; national sources; and IMF staff calculations.*

### 1. G10 Central Bank Balance Sheet Sizes

### 1. G10 Central Bank Balance Sheet Sizes

### Balance sheet tightening across G10 central banks
- G10 central bank balance sheets are declining slowly; the pace and approach for reducing balance sheets differs across central banks.
- Approaches:
  - Passive quantitative tightening (not reinvesting portion or full amount of maturing assets): Federal Reserve, Bank of Canada, Reserve Bank of Australia.
  - Active sales of security holdings (sold back to market or to a debt office): Bank of England, Reserve Bank of New Zealand, Riksbank.
- In New Zealand and at the Riksbank, quantitative tightening has persisted for extended periods—over 18 months in New Zealand—without detectable market illiquidity or disruptions to funding.
- The smoothness of QT for other central banks depends on its effect on liquidity in the financial system.

### The Federal Reserve: composition, liabilities, and market effects
- Asset-side developments:
  - Federal Reserve footprint in US Treasury, mortgage-backed securities, and agency securities markets has shrunk.
  - Since March 2023, asset side rose because of provision of liquidity during the banking turmoil, including discount window lending, the Bank Term Funding Program, and other credit extensions to depository institutions subsequently placed into receivership with the Federal Deposit Insurance Corporation.
- Liability-side developments:
  - Since the start of quantitative tightening, reserves from the banking system have dropped to about 3.2 trillion dollars.
  - Net issuance of approximately $477 billion in bill supply, following resolution of the debt ceiling impasse, was absorbed without a significant effect on bank reserves or money market rates.
  - Recent significant decline in use of the reverse repo facility suggests money market funds have purchased a substantial share of the new bill supply.
- Fiscal supply and market-term premium interaction:
  - US Treasury Department plans to increase debt issuance while the Federal Reserve scaled down its Treasury market footprint.
  - Quantitative easing reduced securities in private hands, compressing term premiums and putting downward pressure on Treasury yields.
  - Quantitative tightening increases net supply—or “free floating”—of Treasury securities, potentially leading to decompression of term premiums and yields.
  - In August 2023, Treasury term premiums started to decompress, resulting in the 10-year Treasury yields reaching their highest levels since 2007.
  - In September (2023), term premiums moved back into positive territory, but the increase remained modest compared with similar episodes in the past.
  - Risks: if progress on inflation is slower than expected or the US fiscal outlook deteriorates further, foreign investors may continue to repatriate funds to domestic bond markets once the hiking cycle ends in the United States.

### Euro area balance sheet normalization and market functioning
- TLTRO repayments:
  - At the end of June, European banks repaid €477 billion of TLTRO loans; banks on June 28 also voluntarily repaid another €29 billion of outstanding TLTRO loans.
  - Combined scheduled TLTRO loan redemptions and voluntary repayments led to a sharp decline of excess liquidity of €506 billion with a limited effect on money markets.
  - Money market rates remain anchored to the deposit facility rate at 4 percent.
  - Repayment of TLTROs narrowed asset swap spreads and freed securities, somewhat alleviating collateral scarcity concerns.
- European Central Bank (ECB) actions:
  - In July (2023), the ECB ended reinvestments under its Asset Purchase Programme, which, combined with TLTRO repayments, shrank the ECB balance sheet by €91 billion to €7.2 trillion (about 57 percent of euro area GDP).
  - ECB confirmed intention to continue flexibly reinvesting maturing principal payments in the Pandemic Emergency Purchase Programme (PEPP) until at least the end of 2024.
  - The flexibility of PEPP and the Transmission Protection Instrument (announced July 2022) appear to have alleviated fragmentation concerns; southern European bond spreads have remained shallow.
- PEPP scenarios and potential balance sheet paths:
  - Baseline scenario (current pace of PEPP reinvestments maintained): net issuance of government bonds would not have to be as large in all euro area countries.
  - Alternative scenario: PEPP holdings could decline by €175.5 billion, which—together with QT from the Asset Purchase Programme—could bring the ECB balance sheet to €6.5 trillion by the end of 2024, potentially putting some jurisdictions under pressure amid large expected fiscal deficits.
- Additional market concerns:
  - Collateral scarcity, notably in Germany, remains a key concern; Bundesbank announcement to reduce remuneration of government deposits to 0 percent from October 1 may raise demand for short-term debt and exacerbate shortage of high-quality securities.
  - ECB lifted the remuneration ceiling for government deposits late in 2022 to address collateral scarcity.

### Nonbank financial intermediaries (NBFIs) — growth and vulnerabilities
- Structural growth and composition:
  - The share of financial assets held by NBFIs nearly doubled between 2008 and 2021, driven mainly by investment funds; growth varied across countries and regions.
  - Investment funds and ETFs represent a growing share of US credit markets, with ETFs having expanded most.
- Vulnerabilities:
  - Investment funds offering daily liquidity heighten vulnerability to redemptions that can force fire sales in distressed markets.
  - High-yield corporate bond markets are especially vulnerable:
    - High-yield bond funds and ETFs hold a large share of the market.
    - High-yield bonds are illiquid.
    - High-yield funds have historically shown relatively large outflows.
  - Defined-benefit pension funds and life insurance corporations have benefited from higher interest rates (reduced present value of pension liabilities), improving funding ratios despite mark-to-market losses in bond portfolios.
  - However, pension funds and insurers are vulnerable to deterioration in credit outlooks:
    - Insurers have increased exposure to lower-rated securities and to illiquid investments, including structured-credit securities, increasing vulnerability to rating downgrades, defaults, and potential market stress from policy surrenders or margin calls.

### Key statistics and exact figures cited
- Banking-system reserves dropped to about 3.2 trillion dollars.
- Net bill issuance absorbed: approximately $477 billion.
- Federal Reserve liquidity support increase began since March 2023.
- In New Zealand, QT persisted over 18 months.
- TLTRO repayments and voluntary repayments:
  - Scheduled TLTRO loan redemptions repaid by European banks: €477 billion.
  - Voluntary repayments on June 28: €29 billion.
  - Sharp decline of excess liquidity resulting from repayment: €506 billion.
- ECB balance sheet:
  - Shrunk by €91 billion to €7.2 trillion (about 57 percent of euro area GDP) after ending Asset Purchase Programme reinvestments and TLTRO repayments.
  - Alternative scenario could reduce PEPP holdings by €175.5 billion and bring ECB balance sheet to €6.5 trillion by end-2024.
- Deposit facility rate anchoring money market rates: 4 percent.
- Date markers: March 2023 (banking turmoil and liquidity provision); August 2023 (term premium decompression and 10-year yields highest since 2007); September 2023 (term premium moved back into positive territory).
- PEPP policy timing: ECB committed to PEPP reinvestments until at least the end of 2024 under current guidance.

*Source: IMF Global Financial Stability Report: Financial and Climate Policies for a High-Interest-Rate Era (October 2023), Chapter 1.*

### Chapter 1 of the April 2023 Global Financial Stability

### CHAPTER 1 SOFT LANdING OR ABRuPT AwAkENING?

### Institutional investors, insurers, and higher bond yields
- Funding ratios of pension funds have improved with higher interest rates (panel 1 based on the financial disclosures of the 100 US corporations sponsoring the largest defined-benefit pension plans).
- The funded ratio measures the ratio of the estimated value of aggregated assets and liabilities.
- European insurers’ median lapse rate (EU 27) data are the latest available as of the fourth quarter of 2022 (reported in the July 2023 Risk Dashboard of the European Insurance and Occupational Pensions Authority).
- Observations and vulnerabilities:
  - Life insurers owned by private equity firms have particularly large exposure to illiquid credit investments.
  - Reinsurers based in offshore jurisdictions raise concerns about transparency, regulatory arbitrage, and spillover effects.
  - Institutional investors using financial leverage could be subject to margin and collateral calls during periods of high market volatility, which, given a large footprint, may exacerbate stress in financial markets.
  - Higher-for-longer rates may create an incentive for policyholders to lapse or surrender policies faster than expected; lapse rates rose only modestly in 2022 but could accelerate (Figure 1.29, panel 2).
  - In response to higher yields and to mitigate lapse risk, some insurers are raising the discretionary crediting rates in their policies; for example, French life insurers raised their discretionary crediting rates to an average of 2 percent as interest rates rose in 2022, well above the minimum guaranteed rate.

### Privately traded assets, valuation lags, and redemption risk
- Key mechanism:
  - The effect of higher interest rates on privately traded assets may be neither fully priced nor apparent and can become visible only after public markets adjust because of heterogeneity of assets, limited transactions, and reliance on irregular appraisals.
  - Valuations can deviate from market values in public markets for a prolonged period, and corrections can occur long after policy rates have peaked; delayed corrections may be sharper and faster once they occur.
- Examples and evidence:
  - CRE and private credit are prominent examples of private markets susceptible to substantial corrections because of lagged effects of higher interest rates.
  - Share prices of exchange-traded REITs corrected sharply downward during 2022 while prices in privately traded real estate markets have started to adjust (Figure 1.30).
  - Price deviations between privately and publicly traded real estate may also be explained by differences in credit quality of underlying assets and by varying degrees of leverage by REITs.
- Redemption and liquidity dynamics:
  - Open-ended investment funds with exposures to private markets face the risk that redemptions could force managers to sell private market assets quickly at prices lower than marked values, crystallizing losses and potentially opening a feedback loop to private credit prices.

### Private equity, private credit, and leverage dynamics
- Private equity activity:
  - Global private equity deal flows peaked during the pandemic recovery; private equity business models, particularly leveraged buyouts, typically rely on leverage to enhance equity returns.
  - With the rapid rise in interest rates, leverage has become considerably more expensive, significantly reducing private equity volumes (Figure 1.31, panel 1).
- Debt financing and floating-rate exposure:
  - Firms acquired through private equity deals often issue floating rate debt in the syndicated loan market; this debt is usually floating rate, meaning interest expenses increase with benchmark interest rates.
  - Higher-for-longer rates will weigh on interest coverage ratios and may challenge a firm’s viability.
- Private credit as alternative financing:
  - After near-record issuance in 2020 and 2021, high-yield bond and leveraged loan issuance declined substantially in 2022 and, so far, in 2023; private credit has become an alternative source of financing and appears increasingly to finance US leveraged buyout transactions (Figure 1.31, panel 2).
  - Private credit funds hold substantial uncommitted capital, often referred to as “dry powder.”
- Risks and mitigants:
  - Private credit markets could come under significant pressure if inflation remains elevated for longer than currently priced, forcing central banks to keep a tight policy stance and the hoped-for soft landing not to materialize.
  - Opacity and delays in price adjustments make timely assessment of potential financial stability implications challenging.
  - Mitigating factors include: most investment vehicles in private credit are closed-end or cap withdrawals over specified time periods; market participants report limited financial leverage in private credit markets; investor base predominantly consists of institutional investors with relatively long investment horizons; private credit investors tend to benefit from better protection mechanisms compared with syndicated loan markets; close lender–borrower relationships may allow tailor-made restructuring.
  - Vulnerabilities remain from interconnections with other financial sectors (for example, banks providing leverage) and entities with particular exposure to private credit markets, such as insurers influenced by private equity firms.

### Selected data points and samples cited
- Sample of the 100 US corporations sponsoring the largest defined-benefit pension plans (panel 1).
- Data for the median lapse rate of insurers in the 27 members of the European Union (EU) with latest data available as of the fourth quarter of 2022.
- Among a global sample of large pension plans that disclose data on derivative exposures accounting for more than $5 trillion in assets, the average ratio of gross notional exposure of derivatives to assets has increased over the past decade (Chapter 2 reference).
- Moody’s Investors Service (2021) estimated that $500 billion (almost one-third of US life insurance policies) could be surrendered with low penalty.
- Fitch Ratings (2023) estimated that, in Italy, policy lapses and surrenders increased materially in November and December 2022; total payouts were €5.6 billion in January 2023, about 50 percent more than in January 2022.
- Sample of 219 US exchange-traded real estate investment trusts used for leverage and interest coverage analysis (panel 2 of Figure 1.30).

### Policy recommendations and policy priorities
- Monetary policy:
  - Monetary policy stances need to reflect country-specific speeds of economic recovery and disinflation.
  - In economies with still elevated and persistent inflation, a restrictive stance is needed until there are clear signs that underlying inflation is cooling.
  - Progress on inflation in some countries justifies a gradual move to a more neutral policy stance while signaling continued commitment to price stability.
  - Central banks must remain determined until there is tangible evidence that inflation is sustainably moving toward targets.
  - Communication is crucial to convey policymakers’ resolve and avoid a deanchoring of inflation expectations.
- Financial stability and crisis response:
  - If financial stability is threatened, maintaining confidence is paramount—policymakers should act swiftly and provide liquidity support to prevent systemic events that may undercut the resilience of the global financial system.
  - Should policymakers need to adjust the stance of monetary policy to prevent financial stress that may morph into a systemic crisis, they should clearly communicate their continued determination to preserve price stability.

*Chapter 1 of the April 2023 Global Financial Stability Report.*

### CHAPTER 1 SOFT LANdING OR ABRuPT AwAkENING?

### CHAPTER 1 SOFT LANdING OR ABRuPT AwAkENING?

### Monetary policy, central bank balance sheets, and market functioning
- Reduction of central banks’ balance sheets has so far been orderly.
- Central banks should carefully monitor market functioning issues and adjust how they implement quantitative tightening if and when needed.
- In the euro area, authorities should be attuned to possible fragmentation risks.
- Policymakers should clearly communicate the objectives and steps for removing liquidity, especially if adjustments are needed in response to the macroeconomic outlook or financial market developments.
- Monetary policy can get support from continued fiscal restraint in achieving the mandated inflation objective.

### Fiscal policy guidance
- Given debt and deficits remain higher than before the pandemic, credible fiscal adjustment can help rebuild buffers and contain the rise in debt.
- The pace and composition of adjustment should depend on the strength of private demand, the inflation outlook of individual countries, and the available fiscal space.
- Within budget constraints, governments should reprioritize spending to protect the most vulnerable and accelerate the green transition.

### Emerging markets, capital flows, and policy integration
- Progress on inflation in a number of emerging markets has been notable, but central banks should be cautious not to ease policy rates too aggressively.
- Countries should integrate their policies, including, where applicable, within the Integrated Policy Framework, the IMF’s macrofinancial framework for countries to manage risks stemming from volatile capital flows amid uncertainty in global monetary policy and the foreign exchange environment.
- Optimal policy combinations depend on the nature of the shock and country-specific characteristics.
- Foreign exchange interventions may be appropriate in the presence of frictions, so long as reserves are sufficient and intervention does not impair the credibility of macroeconomic policies or substitute for their necessary adjustment.
- In case of crises or imminent crises, capital flow management measures may be an option for some countries as part of a broader policy package to lessen outflow pressures, but they should not be substitute for warranted macroeconomic adjustments.

### Vulnerable countries, sovereign debt management, and creditor coordination
- Countries with highly vulnerable financial sectors, limited or no fiscal space, and significant external financing needs are already under pressure and could face further severe challenges in the event of a disorderly tightening of global financial conditions.
- Countries with credible medium-term fiscal plans, clearer policy frameworks, and stronger financing arrangements will be better positioned to manage such tightening.
- Sovereign borrowers in emerging market economies, frontier markets, and low-income countries should strengthen efforts to contain risks associated with their high debt vulnerabilities, including through dialogue with creditors, multilateral cooperation, and support from the international community.
- Where feasible, refinancing or liability management operations should be executed to rebuild buffers.
- Countries near debt distress should enhance early contact with creditors.
- Bilateral and private sector creditors should find ways to coordinate preemptive and orderly restructuring to avoid costly hard defaults and prolonged loss of market access.
- Where applicable, a reformed and more effective version of the G20 Common Framework should be used, including in preemptive restructurings.
- Continued use of enhanced collective-action clauses in international sovereign bonds and the development of majority voting provisions in syndicated loans would help facilitate future debt restructurings.

### Deepening local currency markets in emerging markets
Emerging market economies with market developmental gaps should strive to:
- establish a sound legal and regulatory framework for securities,
- develop efficient money markets,
- improve transparency of both primary and secondary markets as well as the predictability of issuance,
- bolster market liquidity, and
- develop a robust market infrastructure.
- Sustained efforts to deepen domestic markets become more critical as interest differentials between advanced economies and emerging markets narrow further and as nonresidents leverage use of more sophisticated instruments.

### Residential real estate and commercial real estate (CRE) risks
- Developments and risks in residential real estate markets should be carefully monitored during the ongoing cycle of monetary tightening.
- National authorities should deploy stringent stress tests to estimate the potential effects of (1) rising interest rates on borrowers’ repayment capacity and (2) a sharp fall in residential real estate prices on household balance sheets—and ultimately on financial institutions.
- Policymakers who had tightened macroprudential tools to address overheating (for example, sectoral capital buffers, loan-to-value or debt-to-income ratios) could consider whether to revisit those decisions to prevent severe macroeconomic implications amid a drop in house prices, while preserving sound credit origination practices.
- Continued vigilance is warranted to monitor vulnerabilities in the CRE sector to minimize potential financial stability risks:
  - Stress-testing exercises that embed large CRE price declines should be considered.
  - Supervisors should review banks’ CRE valuation assumptions and ensure that provisions are adequate.
  - Lessen CRE-related systemic risks stemming from nonbank financial institutions by broadening the reach of macroprudential tools and enhancing data collection.
  - Such tools include minimum investment periods and liquidity buffers to open-ended real estate funds.

### Credit markets, private debt, and data needs
- Authorities should ensure they have sufficient and reliable data to analyze vulnerabilities stemming from origination practices and chains of bank and nonbank intermediation in the corporate debt market.
- Transparency of private debt should be improved, including through collection of data on cross-border exposures.
- Comprehensive assessments should be conducted on the broader market effect of any forced selling of privately held instruments that are generally illiquid and difficult to value.

### Banking sector resilience, regulation, supervision, and resolution
- The sizable tail of weak banks in the global financial system and the risk of contagion to healthy institutions highlights the urgent need to enhance financial sector regulation and supervision.
- Supervisors should ensure banks have corporate governance and risk-management processes commensurate with their risk profile, including risk monitoring by bank boards and capital and liquidity stress tests.
- Adequate minimum capital and liquidity requirements, including for smaller institutions, are essential.
- Authorities should be prepared to deal with financial instability, including ensuring banks can access and use central bank facilities, intervening early to address weaknesses, and strengthening bank resolution regimes and preparedness to deploy them.
- In current conditions of elevated inflation, high interest rates, and deterioration of the credit outlook, authorities should pay specific attention to bank asset classification and provisions as well as to exposures to interest rate and liquidity risks.
- Countries should continue to build buffers (for example, raise countercyclical capital buffers or sectoral systemic risk buffers, should circumstances allow). Such buffers could be released if stresses materialize. Raising buffers should be conditioned on the absence of signs that credit is already being constrained by the adequacy of banks’ capital.
- Further progress on strengthening implementation of the international standard for resolution is critical to deal with problems of weak or failing banks without undermining financial stability.
- Policymakers may consider extending the perimeter of the international resolution standards to a wider set of banks, as even smaller banks have proven to be systemic at times of wider stress.
- Resolution regimes for systemic NBFIs, including central counterparties and insurers, should be strengthened or introduced where currently absent.
- Dismantle obstacles (legal, regulatory, and operational) to cross-border funding in resolution, including the ability to mobilize collateral across borders.

### Nonbank financial institutions (NBFIs) and systemic risk management
- Comprehensive systemic risk assessments of NBFIs, including stress testing NBFI sectors that pose high systemic risks or could lead to severe market dysfunction, should remain a priority.
- Increased supervisory efforts are needed to rein in excessive liquidity mismatches and reliance on leverage.
- Authorities should focus on more effective use of liquidity management tools and consider leverage caps where appropriate to prevent outsized margin and collateral calls.
- These efforts should be the first line of defense. Should central bank intervention be needed to stem systemic crises involving NBFIs, clear communication about the financial stability objectives and program parameters would be necessary, including the time frame for exit.

### Regulatory coordination and data sharing
- Regulatory coordination across sectors and jurisdictions is essential for identifying risks and managing crises.
- Internationally coordinated reforms can reduce cross-border spill-overs, regulatory arbitrage, and market fragmentation.
- Jurisdictions should ensure data-sharing arrangements allow timely coordination to swiftly identify cross-sectoral risks and determine further action as needed.

### China: real estate, LGFVs, financial sector, and policy support
- Robust policies to restore confidence in the real estate sector are critical to limit negative spillovers to the financial sector, corporations, and local governments.
- Priority should be given to facilitating the completion of housing projects to stem the slump in homebuyer sentiment, and to timely resolution and restructuring of troubled property developers.
- Given weakening growth momentum and disinflation pressures, further monetary policy easing and fiscal support reoriented toward households are needed to support economic growth.
- A comprehensive strategy to address the LGFV debt issue is needed to restore LGFVs’ debt-servicing capacity and achieve sustainable local government debt to prevent adverse spillovers.
- Further progress is needed to address risky exposures in the asset management sector to real estate and LGFVs, and to resolve liquidity mismatches between assets and liabilities.
- For the banking sector: maintain adequate loss-absorbing buffers, phase out forbearance policies that could delay loan-loss recognition, and expedite efforts to restructure weak banks.
- Contingency planning should be developed to manage potential contagion, which may require systemwide liquidity provision to contain systemic risk.

### Box 1.1 — US Growth-at-Risk simulations: financial conditions, credit growth, and hard-landing probabilities
- Model: conditional density forecasting framework (Adrian, Boyarchenko, and Giannone 2019) incorporating the National Financial Conditions Index and banking conditions; forecast horizon is one year ahead.
- Current level of downside risks is estimated holding credit growth as of the fourth quarter of 2022.
- The slowdown in quarterly credit growth of about 100 basis points by the end of 2022 increased downside risk, more than offsetting the net easing in financial conditions.
- Historical reference (1980–81 tightening cycle):
  - From July 1980 to January 1981, the federal funds rate rose by 1,000 basis points, resulting in a real GDP growth decline of −2.1 percent, peak to trough, by August 1981.
  - Applying the framework to that episode would yield probabilities of growth falling below:
    - 0 percent: about 45 percent
    - 1 percent: about 60 percent
    - 2.5 percent: about 75 percent
  - At present, the probability of growth falling below 2.5 percent is slightly less than during the 1980 cycle.
  - The probability of growth falling below 0 percent is significantly lower at present than during the 1980 cycle.
- Four downside risk scenarios analyzed (permutations of credit contractions and financial conditions tightening):
  - Scenario 1: Credit growth contracts by one-third of the magnitude of trough decline seen during the global financial crisis; financial conditions are unchanged from current levels.
  - Scenario 2: Credit growth is held at the end of 2022 level; financial conditions tighten by one-third of the magnitude of peak tightening during the global financial crisis.
  - Scenario 3: Credit growth contracts as in Scenario 1; financial conditions tighten as in Scenario 2.
  - Scenario 4: Credit growth contracts to half of the magnitude of trough decline during the global financial crisis; financial conditions tighten by half of the magnitude of peak tightening during the global financial crisis.
- Key simulation findings:
  - The probability of growth falling below 2.5 percent is more sensitive to a credit contraction than a tightening in financial conditions.
  - For growth falling below 0 or 1 percent, a tightening in financial conditions has greater impact.
  - Scenario 3 (combined credit contraction and financial tightening) increases downside risks to levels comparable with but not as large as those during the 1980 cycle.
  - Scenario 4 best matches the 1980s cycle: holding other factors steady, both credit growth and financial conditions would need to worsen to levels half as bad as those during the height of the global financial crisis to generate almost-equivalent downside risk estimates.

*CHAPTER 1 SOFT LANdING OR ABRuPT AwAkENING?, International Monetary Fund | October 2023*

### Box 1.1 (continued)Box 1.1 (continued)

### Box 1.1 (continued)

### CRE sector size, investor composition, and exposures
- CRE-related debt equals nearly 12 percent in Europe and 18 percent in the United States.
- Banks are the primary lenders to the CRE sector; nonbank financial intermediaries have become increasingly important in some jurisdictions (for example, Luxembourg and the United States).
- Institutional investors, particularly closed- and open-ended investment funds, hold more than 40 percent of CRE equity investments in the United States, amounting to about 30 percent of GDP.
- In aggregate, the CRE sector is large and highly interconnected with banks, nonbank financial intermediaries, and the real economy.

### Financing conditions and market developments
- Borrowing costs on CRE mortgages and commercial mortgage-backed securities markets have increased sharply since early 2022 and are expected to remain elevated.
- Lending standards have tightened, particularly since the March banking turmoil, as smaller and regional banks with significant CRE exposures have faced increased scrutiny and reduced willingness to lend.
- Private equity fundraising has slowed sharply.
- Funding conditions in commercial mortgage-backed securities (CMBS) markets have deteriorated.
- Alternative investors—such as real estate debt funds and insurers—could fill financing gaps, but may become expensive and more selective in a high-interest-rate environment.
- Real estate debt funds face at least two headwinds: (1) they employ some form of leverage and may face liquidity pressures as the value of CRE collateral declines; (2) poor liquidity in the sector may hamper price discovery and complicate pricing. Leverage of real estate funds increases interconnectedness with the rest of the financial system and provides an indirect contagion channel.

### Refinancing risks and funding gaps
- A large volume of refinancing is coming due, creating refinancing risks and potential repricing in vulnerable markets and sectors.
- In the United States in 2023, hotels have the largest share of their loans maturing in 2023 (34 percent), followed by offices (25 percent).
- About 25 percent of loans held by investor-driven lenders, banks, and commercial mortgage-backed securities will mature in 2023.
- Market participants have expressed concerns about the risk of a widening funding gap—a lack of new debt available to meet existing loan requirements.

### Bank and nonbank vulnerabilities
- European banks are already seeing an increase in bad loans from borrowers with aging and unfavorably located office buildings: in the first quarter of 2023, CRE accounted for as much as 30 percent of nonperforming loans in Europe.
- Smaller and regional US banks (those not among the top 25 by domestic assets) are more vulnerable to deteriorating CRE fundamentals than large banks, holding 4.8 times more exposure to US CRE loans than their peers.
- A simple sensitivity analysis for the United States shows that a CRE loss rate of 10 percent could result in a loss of 12 percent of bank industry capital—manageable for the largest banks but challenging for smaller banks with large CRE exposures.
- One year ahead, expected default frequency of real estate investment trust funds increased to 2.5 percent in the second quarter of 2023 compared with 70 basis points in 2021.
- Delinquencies in commercial mortgage-backed securities for the office market have doubled since 2021 to 4.5 percent in July 2023.
- A further retrenchment of banks from CRE lending could hamper the ability of REITs, which generally rely on bank lending such as revolving credit facilities and unsecured-term loans for liquidity, to support the sector as credit quality deteriorates.

### Outlook by CRE segment
- The higher-for-longer interest rate environment and notable refinancing risks compound structurally lower demand driven by shifts in consumer and worker behavior since the pandemic.
- The effect of tighter financial conditions is likely to vary across CRE segments, with office and retail being the most vulnerable. The effect may vary within the office sector depending on property factors (such as age and property condition), geographic location, and loan terms.

### Policy implications and recommendations
- Continued vigilance by supervisors is warranted to monitor vulnerabilities in the CRE sector to minimize potential financial stability risks.
- Macroprudential policy must be expanded to cover nonbank financial institutions, which are increasingly important players in CRE funding markets.
- Supervisory monitoring should pay attention to asset quality deterioration in smaller and regional banks and to nonbank intermediaries that may fill financing gaps but introduce new channels of contagion.

*Italic line: Box prepared by Andrea Deghi. Source: Global Financial Stability Report: Financial and Climate Policies for a High-Interest-Rate Era (October 2023).*

### Chapter 2 at a Glance

### Chapter 2 at a Glance

### Assessment overview
- Fresh assessment of global banking vulnerabilities in an environment of still-elevated inflation and high interest rates, using publicly available data and uniform methods across regions.
- Two complementary approaches:
  - An enhanced global stress test drawing lessons from the March 2023 banking turmoil.
  - Key risk indicators (KRIs) incorporating extensive market data and consensus analyst forecasts for near–real-time surveillance.
- Sample coverage:
  - Enhanced global stress test: nearly 900 banks across 29 countries.
  - Previous global stress test: 260 banks (starting point 2021).
  - KRIs: approximately 350 of the world’s largest publicly traded individual banks.
- Purpose: multilateral surveillance tool to complement supervisory and FSAP analyses that use more granular bank-by-bank data.

### Key findings — baseline scenario (October 2023 WEO baseline)
- Global banking system remains broadly resilient under the baseline scenario.
- Many banks in advanced economies show potential for significant capital losses, driven largely by:
  - Mark-to-market losses on securities holdings in a higher-for-longer interest rate environment.
  - Loan losses and higher provisioning.
- United States: losses concentrated in regional banks, consistent with March 2023 events.
- KRIs as of end-March 2023 flag greatest levels of stress in Europe and the United States.
- Projections of KRIs to end-December 2023 using analyst forecasts indicate:
  - A substantial group of smaller banks at risk in the United States as of end-December (consensus-forecast–based KRIs).
  - Elsewhere, risks concentrated in Asia, China, and Europe where lower expected earnings and depressed price-to-book ratios point to future stress.
- KRIs have forward-looking signal power: multiple KRIs flagged the three US regional banks and the Swiss G-SIB that failed in March 2023 as early as the fourth quarter of 2022.

### Key findings — adverse scenario (severe stagflation)
- Adverse scenario identifies significant capital losses across a wide set of banks, including several systemically important institutions in China, Europe, and the United States.
- Banks flagged as “weak” by the stress test if either:
  - Their CET1 ratio falls below 7 percent (Basel minimum of 4.5 percent plus capital conservation buffer of 2.5 percent), plus G-SIB buffers where applicable; or
  - Their CET1 ratio at its lowest point over the stress test horizon (2023–25) represents a decrease of more than 5 percentage points from the stress test’s starting point of 2022, excluding banks with more than a 30 percent CET1 ratio.

### Methods and enhancements to the global stress test
- Enhancements motivated by March 2023 turmoil and the current high-for-longer interest environment:
  - Expanded sample to nearly 900 banks across 29 countries.
  - Modified projection methods for main income sources: net interest income, fees and commissions, valuation gains/losses on fixed-income securities, and loan loss provisions (see Figure 2.1 and Online Annexes 2.2–2.3).
  - Introduced a liquidity-to-solvency channel to capture effects of deposit runs on capital, with and without access to central bank facilities (Online Annex 2.4).
  - Added “satellite models”: econometric models linking macro scenarios to banks’ income sources, including short-term interest rate and lags, inflation rate, term spread, detailed duration data, and distinctions between mark-to-market versus held-to-maturity securities.
  - Separate estimates for pass-through rates (“beta”) from short-term rate to interest expense rate and interest income rate; bank-by-bank betas where possible.
- Definition of weak banks is conservative: identified by threshold breach or large cyclic sensitivity (change-in-capital criterion).

### Liquidity-to-solvency channel and reverse stress tests
- Liquidity-to-solvency channel built on an illustrative reverse stress test approach because of empirical difficulty linking deposit runs to balance sheets and depositor behavior heterogeneity.
- Reverse stress tests apply hypothetical deposit run-off rates to all deposits to identify breaking points (without assigning probabilities).
- Example calibration:
  - Simulation conditional on a deposit run of 25 percent at the end of 2023.
  - Under assumption that central bank facilities are available, banks would need to pledge securities held to maturity with the central bank at penalty rates of 150 basis points above the adverse-scenario short-term rates.
  - Penalty rate usually ranges from 100 to 300 basis points above policy rates and could sometimes be zero in certain systemic stress scenarios.
- Liquidity stress assumed to affect capital differently depending on run rate and presence or absence of central bank facilities.

### Macrofinancial scenarios used in the stress tests
- Two scenarios:
  - Baseline: continued gradual global growth following the October 2023 World Economic Outlook; long-term inflation expectations well anchored; monetary tightening continues but peaks; term premiums fall across regions.
  - Adverse: severe stagflation derived from a structural macrofinancial model for 33 countries; inflation is more persistent (driven primarily by supply shocks), generating stronger monetary tightening; term premiums increase more in emerging market economies than in advanced economies; global economy contracts by about 2 percent in the first year of the scenario (2023); peak global policy rate shock, over the baseline, is about 160 basis points.
- Regional dynamics:
  - Inflationary dynamics more subdued in China than elsewhere.
  - Euro area and United States experience stronger monetary policy tightening compared with emerging markets in both scenarios.
  - Emerging markets experience steeper real GDP shocks owing to spillovers from policy tightening and recessions in advanced economies.
  - Adverse scenario for China includes a very large but plausible housing market correction and common supply shocks (labor productivity, markups, oil prices), yielding a significantly larger GDP growth shock for China than used in other exercises.

### KRIs and real-time monitoring
- KRIs combine market data and consensus analyst forecasts to produce forward-looking bank-level metrics for about 350 large publicly traded banks.
- Metrics selected for their ability to predict financial stress and acute stress events (large equity declines, deposit outflows).
- Banks are flagged if they are outliers across multiple risk dimensions; KRIs are not designed to predict bank failures with high certainty but to identify banks meriting closer examination.
- KRIs complement, not substitute for, stress testing or detailed supervisory analysis.

### Additional observations
- After more than two years of rate increases, most banks continue to report solid earnings, strong capital, ample liquidity, and adequate provisions; but lending conditions are tightening, loan demand is falling, and provision expenses and funding costs are rising—pressuring future profitability.
- March 2023 failures highlighted rapid effects of global interest rate increases on funding, deposit sensitivity, supervision, access to central bank facilities, and investor behavior; investors tend to penalize banks with low price-to-book ratios and low profitability despite apparently adequate regulatory capital and liquidity.
- The global stress test and KRIs produce consistent results: banks flagged as KRI outliers are more likely to suffer large capital losses under the adverse scenario.

### Policy recommendations
- Sharpen analytical tools for risk assessments; closely monitor relevant market metrics.
- Make stress tests more stringent and more granular, including for smaller banks.
- Make supervisory practices more intrusive and implement corrective actions in a more timely and effective manner.
- Tighten prudential standards for capital held against interest rate risk.
- Encourage banks to prepare to access central bank facilities to substantially mitigate potential capital losses from selling held-to-maturity securities under stress.

*Italic: Source — Chapter 2 at a Glance, text - Chapter 2 at a Glance.*

### 1. Global Real GDP

### 1. Global Real GDP

### Key stress-test scenarios and shocks
- Real GDP index (2021 = 100) plotted for years 2021–2025 (figure labels present).
- Short-term interest rate (Percent) series shown on a 0–6 percent scale.
- Real GDP shock: Maximum adverse deviation from the baseline (percent): –12, 0, –10, –8, –6, –4, –2 (values shown on figure scale).
- Short-term interest rate shock: Maximum difference over three-year horizon (basis points): 300, 250, 50, 0, 150, 400, 200, 100, 350 (values shown on figure scale).
- Panels 3 and 4 show the maximum difference between adverse and baseline over the three-year stress-testing horizon.

### Overall stress-test results (global)
- Baseline scenario: global banking system capital projected to remain about 12.7 percent of risk-weighted assets in 2023 when the policy rate shock peaks, and to continue to improve over the projection horizon.
- Adverse scenario: CET1 ratio troughs in 2024 before improving to 10.8 percent in 2025.
- In 2023 (adverse vs baseline), valuation losses contribute 1.7 percentage points to the decline in the CET1 ratio; loan losses add nearly another 1 percentage point.
- The liquidity-to-solvency feedback in the adverse scenario adds 10 basis points to the capital decline overall.
- Loan losses dominate in the medium term in both baseline and adverse scenarios despite improvements in net interest income in some regions.

### Regional outcomes and differences
- Starting CET1 ratio examples shown by region (figure labels): Global 12.6; Euro area 15.0; United States 11.7; Other advanced economies 13.7; China 10.9; Other emerging markets 14.6 (figure presents starting and trough values for baseline and adverse).
- China: starts with one of the lowest capital levels and experiences the largest decline of 3.9 percentage points in the adverse scenario; its CET1 ratio is slightly above the 7 percent minimum.
- Emerging markets (excluding China): particularly resilient in 2023 in the adverse scenario, helped by high initial capital ratios, robust economic growth, and sizable net interest income. Even in the trough year, other emerging markets see a decrease of only 40 basis points over 2022.
- Euro area: relatively steep decline in capital ratio through the trough year—comparable to European Banking Authority (2023) stress-test results—but ends at a relatively high level due to a healthy starting point.
- United States: modest decline in the adverse scenario, mainly due to gains on net interest income; settles at a level similar to average global levels.

### Weak banks: counts, asset shares, and thresholds
- Baseline scenario:
  - 55 banks with more than $5.5 trillion in assets see capital falling either below 7 percent or by more than 5 percentage points in 2023.
  - Under the baseline scenario, 55 global banks represent 4 percent of global bank assets and would be weak.
- Adverse scenario:
  - Total number of weak banks increases to 215, accounting for 42 percent of global banking assets.
  - If the criterion is limited to banks with capital falling below 7 percent, the share would be 36 percent of global bank assets.
  - Several banks in China and other emerging markets become flagged as weak, in addition to more banks in advanced economies including several G-SIBs.
- Sensitivity example: A halving of the unemployment rate shock in China across all three years reduces the share of Chinese bank assets considered weak in the adverse scenario from about 62 to 55 percent (Online Annex 2.1 reported).

### Liquidity-to-solvency interaction and deposit runs
- Adverse scenario assumes bank runs at end-2023 with liquidity-to-solvency interaction channels.
- Simulation assumes banks pledge held-to-maturity securities with the central bank after selling available-for-sale and held-for-trading portfolios.
- When central bank facilities are available, banks can pledge securities at a moderate penalty rate taken as 150 basis points above policy rate (penalty rate usually ranges between 100 and 300 basis points) for a year.
  - Result: banks incur higher interest expenses, squeezing net interest income and retained earnings, but avoid selling held-to-maturity securities at distressed prices and realizing capital losses.
- The interaction contributes relatively little to global aggregates; in a 25 percent deposit run, CET1 ratios of several banks in advanced economies would decline by almost one additional percentage point owing to higher expenses related to central bank deposit facilities.
- If central bank facilities were not available, banks would need to sell held-to-maturity securities, take marked-to-market losses, and deplete capital—substantially increasing the number of weak banks.

### Characteristics of weak banks (baseline and adverse)
- Common characteristics of weak banks (baseline):
  - Lower return on assets.
  - High loan growth in the preceding two years.
  - Low price-to-book ratios.
  - Very high market leverage.
  - Net interest margin (NIM) betas for weak banks are much lower than for non-weak banks (indicating lower pass-through from policy rates to net interest income).
- Additional distinguishing factors in the adverse scenario:
  - Lower net interest margins in 2022.
  - Poorer income generation capacity.
  - Weaker capitalization (reflected in book leverage ratios).
  - Higher share of bonds in total assets.
- Standardized spider-chart variables shown for weak vs non-weak banks include: Price to book; Return on assets; Leverage ratio; Market leverage; Long-term NIM beta; Loan growth in past two years; Share of total bonds to asset; NIM 2022.

### Vulnerabilities from interest margins
- More than 40 percent of banks globally stand to lose net interest income as policy rates rise, especially those in advanced economies outside the United States.
- US banks exhibit exceptionally high interest income betas, making them particularly strong in the analysis.
- Banks whose expenses are more sensitive to rising short-term rates (higher “expense betas” relative to “income betas”) risk losing net interest income.
- Expense betas are small at first but increase over time, possibly because depositors seek higher returns within the same bank from instruments like certificates of deposit.
- Banks below the 45-degree line in the long-term beta panels have greater sensitivity on the expense side than on the income side and are at greater risk when interest rates are rising.

*Sources: IMF; World Economic Outlook; Vitek 2018; Bloomberg Finance L.P.; Capital IQ; Fitch Analytics; Fitch Solutions; Fitch Connect; IMF staff calculations.*

### CHAPTER 2 A NEw LOOk AT GLOBAL BANkING VuLNERABILITIES

### CHAPTER 2 A NEw LOOk AT GLOBAL BANkING VuLNERABILITIES

### Interest Income and Expense Betas
- Estimated long-term betas measure rates of pass-through from a permanent increase in short-term rates to interest income and expense, two years after the initial increase.
- China is not included in the beta estimates because empirical results on betas for individual Chinese banks or for the overall banking system were not robust; the net interest income was assumed to be constant as a percent of assets for the scenarios.
- Interpretation note: A beta value of 0.5 means borrowing interest rates rise by 50 basis points when short-term rates rise by 100 basis points.

### Vulnerabilities to Bond Valuation Losses
- Almost one-quarter of global bank assets are invested in securities, with about half in held-to-maturity securities.
- Securities constitute from nearly 25 percent to about 30 percent of total bank assets in Brazil, China, India, Japan, Mexico, and the United States.
- In the sample, banks in emerging markets tend to:
  - have higher exposures to securities than those in advanced economies;
  - keep more securities as held-to-maturity (HTM) at book value rather than marked to market (held for trading (HFT) and available for sale (AFS)).
- About 40 percent of banks’ positions are hedged on average.
- Valuation outcomes:
  - Baseline: marked-to-market bond portfolios generally suffer moderate valuation losses; capital ratios could fall significantly for only about 2 percent of banks (deemed vulnerable).
  - Adverse scenario (with some hedging): 11 percent of banks are vulnerable to significant declines in capital from the bond valuation channel.
  - Adverse scenario (without hedging): about a quarter of banks would be deemed vulnerable.
- Drivers of vulnerability: higher share of HFT and AFS securities, longer durations, and greater increases in yield curves.
- Regional notes:
  - A higher share of banks in advanced economies than in emerging markets is exposed to valuation losses because of larger exposures, longer durations, and larger interest rate shocks.
  - German banks are among the most affected due to relatively longer bond durations and large policy rate shocks in the stagflationary scenario.
- Regulatory detail: Among advanced economies, non–internationally active banks in Japan and small and medium-sized banks in the United States can exclude unrealized gains and losses from AFS securities from regulatory capital (the “available-for-sale filter” in Basel II).

### Vulnerabilities to Loan Defaults
- Loan defaults are driven by increases in interest rates and declines in economic growth.
- In the adverse scenario:
  - For banks in advanced economies: loan loss provisions rise initially because of increases in real interest rates; subsequently, unemployment effects dominate as the interest rate shock wanes.
  - For banks in emerging markets: overall economic growth matters more for loan performance.
- Loan composition differences:
  - Banks in advanced economies tend to have higher shares of mortgage and consumer loans in total loans.
  - Banks in emerging markets tend to lend relatively more to firms.
- Implication: Unemployment rates matter more for credit performance in advanced-economy banks; GDP growth matters more for emerging-market banks.

### Vulnerabilities to Interactions between Liquidity and Solvency
- Liquidity buffers:
  - Most banks have enough liquid assets to sustain deposit outflows of 10 percent without having to repo or sell HTM bonds.
  - Banks in emerging markets can sustain slightly higher deposit outflows (20 percent) than those in advanced economies (5–10 percent) without needing to sell or pledge HTM securities.
- Nonlinear deterioration:
  - At outflows of 15–25 percent, an exponentially high share of banks would need to use HTM securities to address liquidity needs.
- Stress outcomes without central bank facilities:
  - For a deposit runoff rate of 15 percent, selling HTM bonds would generate moderate losses across regions.
  - At 25 percent runoff, Common Equity Tier 1 (CET1) ratios would drop substantially in several banks (including Silicon Valley Bank and First Republic Bank) if central bank facilities are not available.
  - Losses multiply rapidly as deposit outflows increase from 25 to 35 percent.
- Role of central bank facilities:
  - If banks can access central bank facilities and pledge HTM securities at 150 basis points over policy rates:
    - Capital losses across regions, at 25 percent deposit runs, are at most 13 basis points and occur through annualized increases in funding costs.
    - At 25 percent runoff, about 40 banks lose more than 1 percentage point CET1 ratio or more.
    - If the cost of facilities doubles to 300 basis points, the number of banks losing more than 1 percentage point increases to 56.
  - If a bank runs out of eligible collateral, the scenario assumes central banks extend emergency liquidity assistance by expanding collateral types or providing unsecured loans at the same interest rates.
- Quantitative notes and assumptions:
  - The regulatory liquidity coverage ratio assumes one-month runoff rates for deposits: insured retail demand deposits, 3–5 percent; less stable retail deposits, 10 percent; term deposits, 0 percent (except maturing contracts); small business deposits, 5–10 percent; other nonfinancial firms and sovereigns, 20 percent if insured and 40 percent if not.
  - In the scenario where central bank facilities replace lost deposits, it is assumed central banks charge 150 basis points on top of short-term interest rates; if collateral runs out, unsecured emergency liquidity assistance is presumed at the same interest rates.
  - It is assumed central banks can provide liquidity in all currencies via prearranged swaps.
- Aggregate losses from HTM sales (end-of-2023 bond revaluation in the adverse scenario):
  - Panel 1 (Selling HTM bonds to meet deposit outflows): aggregate valuation loss with sold HTM bonds in percent of RWA ranges in figures shown (example regional markers show values down to –1.0 percent of RWA).
  - Panel 2 (With central bank facilities): aggregate annualized increase of funding costs in percent of RWA shows values up to –0.00 to –0.81 in regional markers (figures reported for China, Other advanced economies, Euro area, Emerging markets excluding China, United States).
- Caveats on the stress test:
  - The adverse scenario corresponds to 3½ standard deviations from historical means of global GDP growth.
  - The scenario is illustrative; supervisors may choose other severities.
  - Simplifying assumptions were made because of absence of publicly available bank-level data on duration and hedging.
  - Sensitivity analyses for the Chinese banking system are presented separately in Online Annex 2.1.

### Using KRIs to Monitor Emerging Vulnerabilities
- Purpose: develop a forward-looking tool for monitoring vulnerabilities in publicly traded individual banks using consensus analyst forecasts and market pricing data.
- Forecast horizon: aggregate consensus analyst forecasts for the third and fourth quarters of 2023 (and second quarter of 2023 if Q3 actual data unavailable) are used to determine expectations for bank performance and evolution of risk.
- Framework features:
  - Combines CAMELS supervisory framework with market-based metrics.
  - Focuses on five observable risk dimensions: capital adequacy, asset quality, earnings, liquidity, and market-based sensitivity (management performance and sensitivity to market risk are limited by data availability).
  - Uses 12 key risk indicators (KRIs) mapped to the five dimensions.
  - Selection criteria for KRIs: data coverage, literature review, best supervisory practices, and econometric analysis.
- Monitoring list construction (two-stage):
  1. For each risk indicator, banks are highlighted if they exceed calibrated thresholds that identify outliers while accounting for structural regional differences.
  2. Banks are identified as potentially vulnerable within a risk dimension if one or more indicators in that dimension are highlighted; banks are placed on the monitoring list (“flagged”) if identified as potentially vulnerable across a majority of key risk dimensions.
- Data and coverage:
  - New data set covers more than 375 banks from 43 jurisdictions.
  - The data set includes 28 of the 30 G-SIBs as identified by the Financial Stability Board.
  - The United States is overrepresented in number of banks (196 banks) due to greater data availability; regional totals of assets and bank counts shown:
    - China: Total assets: $35 trillion; Number of banks: 18
    - Europe (Euro area plus Other advanced economies aggregated in figure): Total assets: $30 trillion; Number of banks: 63
    - North America: Total assets: $29 trillion; Number of banks: 196
    - Asia (excluding China): Total assets: $18 trillion; Number of banks: 63
    - Latin America: Total assets: $2 trillion; Number of banks: 16
- Forward-looking components:
  - Consensus forecasts and market-based pricing indicators are incorporated to capture expectations about profitability and downside risk, enhancing predictive capability.
- Validation:
  - The section presents econometric analysis showing the method’s power in predicting previous stress events and anticipating potential capital shortfalls revealed by the global stress test.

*Source: CHAPTER 2 A NEw LOOk AT GLOBAL BANkING VuLNERABILITIES, International Monetary Fund | October 2023.*

### 1. Number of Banks and Size Distribution

### 1. Number of Banks and Size Distribution

### KRI Framework and Predictive Power
- The KRI framework evaluates banks across five CAMELS risk dimensions (Capital adequacy, Asset quality, Management (implicitly via market metrics), Earnings, Liquidity and Sensitivity to Market Risk) using 12 indicators in total:
  - Capital adequacy: Ratios of equity to total assets (ETA) and Tier 1 capital to risk-weighted assets (Tier 1 capital ratio)
  - Asset quality: Ratio of nonperforming loans to total loans, coverage ratio, and quarterly loan growth
  - Earnings: Return on equity
  - Liquidity: Net loan-to-deposit ratio, ratio of total deposits to total liabilities, quarterly deposit growth
  - Market metrics: Dividend growth forecast, price-to-book (P/B) ratio, market leverage (Total Assets/Market Capitalization)
- Two econometric results demonstrated:
  - The indicators have predictive power in forecasting bank stress events (see Online Annex 2.5).
  - The number of KRIs flagged is a quantitatively meaningful and statistically significant predictor of capital losses in the global stress tests’ adverse scenario.
- Analyst forecasts are incorporated to track KRIs over the next two quarters; dividend forecasts are used as a forward-looking market-sentiment metric.

### Monitoring List: Size and Evolution (Historical and Forecasted)
- As of 2023:Q2, historical total-asset data used as the baseline.
- Second quarter of 2023: 85 banks with $26 trillion in total assets were on the KRI monitoring list due to breaches in at least three KRI risk dimensions.
- Third quarter of 2023 (aggregate consensus analyst forecasts): 80 banks with $21 trillion in assets (decline primarily reflecting improvement in liquidity and earnings).
- Fourth quarter of 2023 (aggregate consensus analyst forecasts): 82 banks with $25 trillion in assets; number of banks flagged on four or more risk dimensions: 25 banks with $9 trillion in combined assets.
- Temporal patterns:
  - Number of banks flagged in three or more risk dimensions spiked with onset of COVID-19, fell sharply in 2021, then climbed again as interest rates rose, reaching a peak just before the March 2023 bank turmoil.
  - The KRI framework flagged Credit Suisse, Silicon Valley Bank, and Signature Bank in the fourth quarter of 2022 in the market KRI dimension (and additional dimensions for specific banks) a quarter prior to their failure; First Republic breached thresholds in capital adequacy, asset quality, and earnings dimensions.

### Characteristic Differences Between Flagged and Non-Flagged Banks
- Panel 3 standardized z-score comparison shows monitoring-list banks score significantly worse than non–monitoring-list banks across nearly all categories, except:
  - Nonperforming loan ratio (backward-looking indicator)
  - Coverage ratio
  - Quarterly deposit growth
- Key differentiators for monitoring-list banks include:
  - Low price-to-book ratios
  - Low return on equity
  - Stretched net loan-to-deposit ratios
  - Higher market leverage for some banks

### Regional Distribution and Sectoral Highlights
- Europe:
  - Flagged banks include some of the largest banks in Europe, with estimated combined total assets of more than $8 trillion by the end of the year.
  - Forecast-based KRIs predict European banks will comprise 30 percent of the monitoring list on a total asset basis by the fourth quarter of 2023.
  - Characteristics: low ratios of equity to total assets, low profitability, low price-to-book ratios, higher dependency on noncore deposit funding; higher funding costs remain a profitability challenge.
- Asia:
  - Group of flagged banks (based on fourth-quarter forecasts) has combined total assets of more than $1 trillion.
  - Nearly all banks have low ratios of equity to total assets and face profitability pressures from rising funding costs and lower fee income; net interest margin compression smaller than in Europe and North America.
  - Consensus forecasts expect profitability to decline due to lower net interest income, higher noninterest expenses, and higher provision expenses.
  - Asian banks expected to rise to 10 percent of monitoring list assets in the fourth quarter.
- China:
  - Flagged banks characterized by lower capital ratios, low profitability, and low price-to-book ratios.
  - Consensus forecasts for the second half of 2023 call for lower profitability due to compression of net interest margins.
  - Projected increase in flagged banks to $4.6 trillion in assets by the fourth quarter, representing 31 percent of monitoring list total assets.
- Latin America:
  - Fourth-quarter flagged banks include a few large banks with estimated combined total assets of more than $900 billion.
  - Characteristics: low ratios of equity to total assets, higher loan-to-deposit ratios (greater reliance on noncore deposit funding), low price-to-book ratios.
  - Profitability expected to improve by the third quarter of 2023, but equity-to-total-assets and price-to-book ratios are expected to remain low.
  - Projected to represent just 4 percent of total monitoring list assets in the fourth quarter.
- North America:
  - Flagged banks include a few large banks and many US regional banks, with estimated combined total assets of more than $6 trillion.
  - Small banks (total assets of $10 billion or less): low profitability, stretched net loan-to-deposit ratios, low price-to-book ratios.
  - Medium-sized banks (total assets between $10 and $100 billion): profitability struggles, stretched net loan-to-deposit ratios, low price-to-book ratios, high market leverage.
  - Large banks (total assets more than $100 billion): low profitability, low price-to-book ratios, high market leverage; consensus forecasts call for profitability to decline by year-end due to net interest margin compression and rising provision expenses.
  - Among North American banks on the monitoring list flagged on four KRI dimensions, market-driven indicators (market leverage and changes in forecasted dividend per share) also signal stress for banks with high concentrations of commercial real estate in total loans.

### Heat Map and Historical Volatility (Table 2.2 Observations)
- The heat map shows the number of banks flagged on each core KRI and CAMELS component from 2018:Q1 through forecasted 2023:Q4.
- Three main observations:
  - First, the period from the first to second quarter of 2020 shows the largest concentration of vulnerable banks, with more than 200 banks in the monitoring list (peak period of risk in the chapter’s analysis).
  - Second, a gradual run-up in the number of vulnerable banks began in early 2022, mainly in Europe, corresponding to the invasion of Ukraine in 2022:Q1.
  - Third, capital adequacy, earnings, and market KRIs capture an increasing number of banks ahead of the banking turmoil in 2023:Q1.
- The heat map ranking/colors reflect low-to-high values across all metrics through the sample period; counts are based on historical data from 2018:Q1 to 2023:Q2, aggregate consensus for 2023:Q2 where actual data unavailable, and aggregate consensus forecast data for 2023:Q3 and 2023:Q4.

*Sources: Bloomberg Finance L.P.; Visible Alpha; and IMF staff calculations.*

### 2023. The indicators suggest that liquidity stress, a key

### CHAPTER 2 A NEw LOOk AT GLOBAL BANkING VuLNERABILITIES

### Liquidity stress indicators
- Liquidity stress began increasing as early as June 2022, evidenced by:
  - growing number of banks experiencing deposit outflows
  - higher ratios of loans to deposits
  - lower shares of deposits in total liabilities

### Congruence of Global Stress Test and KRI frameworks
- Samples overlap: 168 banks are in both the global stress test and KRI framework samples.
- Relationship between KRI flags and Tier 1 impacts under the global stress test adverse scenario:
  - Among 47 banks flagged as vulnerable on two KRI dimensions (as of 2022:Q4), the Tier 1 ratio declines about 2 percentage points, on average.
  - Among 12 banks flagged as vulnerable on four KRI dimensions, the average Tier 1 impact increases almost –4 percentage points.
  - Among banks with three or four flagged KRIs, the worst quintile had an average decline of Tier 1 capital ratio of more than 8 percentage points.
- Cross-bank regression analysis (GST adverse scenario, 2022:Q4):
  - Regression coefficient of about –0.7, indicating every increase of one flag among the KRI dimensions is associated with a fall of 0.7 percentage point in the Tier 1 capital ratio in the global stress test.

### Key findings from the enhanced global stress test
- Banks struggle to stay solvent under stagflationary scenarios; many banks will suffer significant capital losses largely driven by mark-to-market losses on securities holdings in a higher-for-longer interest rate environment.
- In the United States, losses are concentrated in smaller, regional banks, consistent with observations in March of 2023.
- KRI framework flags banks expected to be weak for various reasons, including:
  - lower expected capital (some Chinese banks)
  - further declines in price-to-book ratios (some European banks)
  - declining liquidity (some other banks in advanced economies)

### Policy recommendations
- Urgent need to strengthen banking sector resilience; supervisors should:
  - enhance banks’ capital level to ensure all banks maintain adequate capital ratios under stress scenarios
  - reinvigorate supervision and risk assessments, including through enhanced stress testing
  - timely and consistent implementation of international standards
  - strengthen regulations and crisis management frameworks

### Enhancing risk assessments
- Expand sample of banks in stress tests and enhance methodologies by incorporating interactions between funding and solvency and deposit stability.
- Consider making the adverse scenario more severe while choosing a plausible narrative to uncover vulnerabilities.
- Supervisors should leverage more timely and granular data, narrowing gaps in data coverage and granularity (based on Figure 2.16, panel 1).
- Monitor market metrics closely and be cautious regarding banks with persistent price-to-book ratios below 1.

### Sharpening supervision and regulation
- Many jurisdictions lack conducive conditions for effective supervision:
  - Financial Sector Assessment Program assessments indicate that more than half of the jurisdictions still do not have independent bank supervisors with a clear mandate to effect financial stability, with sound internal governance, or with resources appropriate to their assigned responsibilities.
- Liquidity and interest rate risk gaps:
  - Nearly one-fifth of jurisdictions have weak supervisory and regulatory practices with respect to liquidity.
  - Several jurisdictions do not require banks to maintain capital against interest rate risk in the banking book, and more than a quarter have material deficiencies in monitoring and controlling this risk (Dordevic and others 2021).
- Recommendation: require banks to comply with capital and liquidity standards broadly compatible with the Basel framework; in many cases, countries and banks will need to impose higher standards than the framework implies.

### Fortifying crisis management frameworks
- In absence of central bank liquidity facilities, interactions between solvency and liquidity in adverse shocks could lead to distress among a considerable number of banks.
- Recommendations:
  - enhance commercial banks’ preparedness to use eligible collateral and access central bank facilities
  - improve authorities’ communication on availability and usage of facilities (acceptable collateral, haircuts)
  - require all banks to periodically test their access to central bank instruments
  - central banks should set up emergency liquidity assistance frameworks in normal times and abide by broad principles concerning collateralization, conditions, and state guarantees
- March 2023 turmoil highlights need for progress on too-big-to-fail reforms, including:
  - effective backstops for public sector liquidity among resolution authorities and deposit insurers
  - operational readiness to implement a range of resolution options and communication strategies
  - recognition that failures of relatively small banks can be systemic and require adequate resolution planning
- Financial Sector Assessment Program assessments highlight that in many countries deposit insurers face significant weaknesses in their funding arrangements, including weaknesses regarding backstop arrangements for funding liquidity.

### Experience of past bank runs
- March 2023 bank runs in Switzerland and the United States were unusually large and fast, facilitated by rapid online deposit withdrawals and rapid spread of worries via social media and digital channels.
- Historical parallels:
  - Northern Rock (UK), 2007: lost almost 60 percent of its retail deposits in 2007, including 20 percent over five days (between September 13 and 17).
  - Landsbanki (Iceland), 2008: UK internet banking branch suffered a rapid run amid the broader Icelandic banking crisis.
  - Continental Illinois National Bank and Trust (US), 1984: described as resulting from a “high-speed electronic bank run.”
  - Bank of the United States (1931): customer base concentration facilitated rapid spread of the run.
- Some systemic banking crises have matched the scale of 2023 bank runs (Figure 2.1.1, panel 2), with comparisons across episodes in different countries and periods.

*Source: IMF staff analysis in Global Financial Stability Report: FINANCIAL AND CLIMATE POLICIES FOR A HIGH-INTEREST-RATE ERA (October 2023).*

### Chapter 3 at a Glance

### Chapter 3 at a Glance

### Introduction
- The International Energy Agency projects climate mitigation investment needs to increase to $2 trillion per year by 2030 in emerging market and developing economies (EMDEs).
- This $2 trillion corresponds to 12 percent of total investment in these countries by 2030, up from the current 3 percent.
- The private sector must play a key role because public investment growth is projected to be limited; the share of private finance must increase substantially.
- About 40 percent of emerging market economies and nearly all developing economies do not reach an investment-grade rating or have no rating at all, constraining access to large institutional investors.
- Many EMDEs face additional hurdles: high political risks, legal and institutional uncertainty, implementation risks, lack of well-structured investable climate project pipelines, and lack of high-quality, reliable, and comparable climate-related data.

### The Crucial Role of Private Finance
- Global gross climate mitigation investment needs to reach about $5 trillion annually by 2030 to achieve net zero greenhouse gas emissions by 2050.
- Climate mitigation investment needs in EMDEs are projected to increase to $2 trillion by 2030, representing about 40 percent of global mitigation investment needs.
- This translates to about 12 percent of total investments in EMDEs in 2030, a fourfold increase from the current share of about 3 percent.
- Private capital is essential because growth in total public investment will not cover climate investment needs by 2030.
- In a scenario where the share of climate investments in total public investment increases by a factor of 1.5 from current levels, the private sector would have to cover 80 percent of climate investment needs in EMDEs by 2030.
- Excluding China, the required private financing share rises to more than 90 percent.
- Adaptation finance remains important and may grow significantly if mitigation efforts fall short and climate hazards intensify.

### Barriers to Deploying Private Climate Finance in EMDEs
- Only about 60 percent of emerging markets and a mere 8 percent of developing economies have an investment-grade sovereign rating.
- Sovereign ratings act as a “rating ceiling” for private entities and determine potential investor bases; many fiduciaries restrict investments to “investment grade.”
- Current credit rating agency methodologies do not effectively reward middle- and lower-income countries that implement better climate policies, limiting the benefits of climate investments for credit ratings and financing costs.
- Global financial institutions’ capital allocations to EMDEs are significantly below these countries’ contributions to global GDP or growth potential.
- EMDEs often lack high-quality, reliable, and comparable climate-related data, increasing the risk of “greenwashing” and reducing market transparency.
- Phasing out coal is necessary but challenging in many EMDEs that heavily depend on coal; the phaseout will require substantial private investments and public support.

### Policy Recommendations
- A broad mix of policies is needed to create an attractive environment for private capital in EMDEs.
- Carbon pricing and fossil fuel subsidy reform can be highly effective in shifting capital flows toward low-carbon investments, but must be complemented with additional policies due to political and implementation challenges.
- Structural policies are key: strengthen macroeconomic fundamentals, deepen financial markets, improve policy predictability, and foster institutional and governance frameworks to lower the cost of capital, mobilize domestic financial resources, and improve credit ratings.
- Strong climate policies and commitments should be used to send clear signals to investors.
- Appropriate, country-tailored policies and innovative financing structures are needed for the coal phaseout.
- Strengthen the climate information architecture—data, disclosures, and alignment approaches (including taxonomies)—because investors rely on high-quality, reliable, and comparable data.
- Transition taxonomies in EMDEs could align incentives and mobilize private financing, including in carbon-intensive sectors.
- Disclosures and labels for sustainable investment funds should enhance market transparency, integrity, and alignment with climate objectives; climate impact scores should better align outcomes with investor expectations.
- Expanded use of guarantees by multilateral development banks and donors could reduce real and perceived risks in EMDEs.
- Blended finance structures could improve the risk–reward profile of investment opportunities and broaden the range of private sector investors.
- The IMF Resilience and Sustainability Facility (RSF) can support reforms, capacity development, and longer-term financing to create an enabling investment environment and attract private capital; the IMF can convene governments, MDBs, and the private sector and help strengthen public financial and climate investment management.

*Authors: Torsten Ehlers (co-lead), Charlotte Gardes-Landolfini (co-lead), Ekaterina Gratcheva, Shivani Singh, Hamid Tabarraei, and Yanzhe Xiao, under the guidance of Prasad Ananthakrishnan and Fabio Natalucci. Markus Brunnermeier was an expert advisor.*

### CHAPTER 3 FINANCIAL SECTOR POLICIES TO UNLOCk PRIvATE CLIMATE FINANCE IN EMERGING MARkET ANd dEvELOPING ECONOMIES

### CHAPTER 3 FINANCIAL SECTOR POLICIES TO UNLOCk PRIvATE CLIMATE FINANCE IN EMERGING MARkET ANd dEvELOPING ECONOMIES

### Barriers to Private Climate Finance in EMDEs
- Large investment institutions often avoid EMDEs because of:
  - Perceived mismatch between risk–return profiles and institutional investors’ risk-bearing capacity.
  - Difficulties navigating perceived complexities of EMDEs.
  - Reputational risk linked to inadequate governance, poor institutional capacity, and an uncertain policy environment.
  - Increasingly stringent ESG regulations in advanced economies that raise compliance risks and costs for EMDE investments.
- Specialized firms that actively seek EMDE investments exploit informational asymmetries and invest resources into capabilities, but their scale is limited.
- Key constraints cited by investors:
  - EMDEs lack well-structured, investable project pipelines that meet private investors’ risk–return requirements.
  - Bankable projects in lower-income countries are driven primarily by MDBs and their own balance sheet deployment, with limited private sector participation.
  - Project implementation faces slow disbursements, regulatory changes, and typically long timelines beyond private-sector norms.
  - Typical projects are small; dearth of pooled investments at scale leads to high due diligence costs and lack of diversification, deterring global institutional investors.
- Low domestic capital market development complicates project execution:
  - Lower- and lower-middle-income countries do not have established or mature capital markets.
  - Low financial and capital market development limits domestic resource mobilization and deters international investors.
  - Even EMDEs with more developed capital markets may have withholding taxes, local regulatory restrictions, and potential currency repatriation restrictions.
- Foreign exchange risk management is a major impediment:
  - Investors favor climate investments with limited or no foreign exchange risk exposure.
  - Commercial hedging options exist primarily in larger EMDEs but are expensive, with limited liquidity and incomplete coverage at needed tenor and size.
  - Market hedging options are virtually nonexistent in smaller emerging markets and low-income countries.

### Potential Limits to the Speed of the Energy Transition in EMDEs
- Renewable energy projects in EMDEs face specific hurdles:
  - High upfront fixed capital costs (for example, solar panels and electricity grids with energy storage capacity), with lower subsequent marginal costs.
  - Significant policy risks in EMDEs that are difficult for companies to price and manage.
  - Prerequisite infrastructure, intermittency and storage needs, supply chain issues, multi-jurisdictional permits, and grid integration requirements.
  - Due to policy uncertainty and EMDE risk premiums, renewable energy in EMDEs is financially less attractive than in advanced economies; in some major emerging markets, high borrowing costs more than double the cost of renewable electricity production.
- Investment patterns and commodity pressures:
  - Despite improvements, investment in renewable energy in EMDEs (except for China) still lags behind investments in fossil fuel.
  - A target ratio of about 4:1 for renewable over fossil fuel investment is estimated as required globally throughout this decade (Bloomberg NEF 2022).
  - Total fossil fuel subsidies surged to a record high in 2022 and are expected to increase further in EMDEs (IMF 2023).
  - Advanced-economy actions could slow EMDE transitions by tightening supply of critical metals and minerals, putting upward pressure on prices and raising renewable energy costs (illustrated by lithium price projections).

### Coal Dependence and Phaseout Challenges
- Coal is the single largest source of greenhouse gas emissions globally (about 20 percent).
- EMDEs account for:
  - Three-fourths of the world’s 9,000 coal-fired power plants.
  - About 90 percent of the global capital tied in coal-fired power plants (World Bank 2023).
- Only about 20 percent of current coal-fired generation is covered by agreements among countries to phase out coal or stop developing new power plants (International Energy Agency 2022).
- Coal-fired power plant age and phaseout timing:
  - Power plants are relatively young in EMDEs (about 40 years in the United States compared with less than 15 years in the Asia Pacific region).
  - On average, it takes about 43 years to phase out coal after a peak in coal consumption per capita has been reached (IMF 2020).
- Costs and gains from phasing out coal:
  - Phasing out implies significant costs: decommissioning, retirement, social adjustments, and loss of net financial value when plants are retired before expected lifespan.
  - Potential net economic and social gains from phasing out coal could be about $85 trillion (Adrian, Bolton, and Kleinnijenhuis 2022).
- Policy and financing considerations:
  - Measures need tailoring to country characteristics, with innovative and tailored financing solutions, appropriate sequencing for retirement, public–private involvement, regulatory reforms, and attention to development and social priorities.
  - Experience from the Just Energy Transition Partnerships (Indonesia, Senegal, South Africa, Vietnam) is valuable.
  - Coal-exporting countries will require economic diversification strategies and socioeconomic (“just transition”) considerations.
  - Country capacity to plan and prepare managed coal phaseouts is often a bottleneck.
  - Mobilizing global investors and using financial structures (including blended finance and securitization) to repurpose or retire coal-fired plants is challenging; there are no standardized criteria for repurposing, and coal phaseout plans are currently not eligible in transition finance frameworks and taxonomies.

### Trends in Fossil Fuel Investment and Implications
- Capital investment in the energy sector continues to flow into fossil fuels, driving carbon lock-in risks and delaying diversification:
  - Fossil fuels are responsible for 75 percent of global greenhouse gas emissions.
  - Capital expenditures in the coal industry have remained stable despite policy support for clean energy.
  - Strong demand and high coal prices, especially in China and the rest of the Asia Pacific region, are driving continued investment.
- Oil and gas sector investment dynamics:
  - Capital expenditures in oil and gas rebounded in 2022, while the sector’s low-carbon investments remain limited despite a 300 percent increase between 2020 and 2022 in low-carbon components.
  - Capital expenditure forecasts for new oil and gas fields remain high, accounting for roughly 75 percent and 95 percent of energy industry investments by 2030 and 2050, respectively.
  - Nonlisted companies in EMDEs account for about one-third of investment plans in new oil and gas capacity; nonlisted companies are typically subject to less outside pressure to decarbonize.
  - National oil companies have started to diversify and decarbonize due to growing pressure and dependence on international capital.
- Government climate policies can help limit fossil fuel expansion:
  - Indicators of current climate policies, emission-reduction targets, and nationally determined contributions tend to be negatively correlated with capital expenditure estimates for oil and gas fields by 2030 in EMDEs.

### Financial Institutions’ Climate Policies and Financing Gaps
- Assessment of 30 global systemically important banks (G-SIBs) indicates the need for more ambitious alignment with net zero:
  - Some banks exclude project finance to new greenfield coal mines and power plants in lending and investment policies.
  - Most G-SIBs have no policy or weak criteria regarding:
    - Provision of financial services for coal expansion or net-zero-aligned coal phaseout (“Net-zero-aligned coal phaseout policy” and “Limitation of financial services to coal expansion”).
  - Policies targeted at transition financing of oil and gas are even more limited (“Net-zero-aligned oil and gas policy”).
- Banks’ behavior versus disclosures:
  - Banks’ climate disclosures are disconnected from continued carbon-intensive lending; G-SIB lending to fossil fuel companies has remained stable since the Paris Agreement and increased after the pandemic.
  - The share of sustainable loans to fossil fuel companies has been minimal.
  - G-SIBs assessed as most ambitious based on sectoral policies have not seen a greater increase in sustainable loans than less ambitious peers.
  - Evidence shows stricter bank climate policies can contribute to energy sector decarbonization: coal-fired plants owned by companies dependent on banks with stricter climate policies are more likely to be retired or repurposed.
- Insurers:
  - Global insurers’ climate policies show limited alignment with net zero; major Asian and North American insurers have not published such policies, while European insurers have adopted more restrictive criteria for coal investment and underwriting (such as exclusion of coal expansion).
- Broader concerns:
  - Climate policies by large banks and insurers tend to overlook transition financing needs.
  - Without mandatory alignment or disclosure policies and meaningful carbon pricing, banks may continue financing fossil fuel firms without properly pricing stranded-asset risk.
  - Limited disclosures in private equity constrain assessment of fossil fuel exposure; fossil fuel investments by private equity have been increasing.

### Investment Funds and Climate Impact
- Growth patterns:
  - Sustainable investment funds have grown considerably faster than conventional funds, especially since 2019.
  - Since 2019, sustainable funds have consistently maintained positive net flows and outperformed conventional funds, except for brief instances in 2022 and 2023 (so far).
- Fund categories:
  - Funds that incorporate ESG characteristics are the largest category.
  - “Sustainability-themed” funds incorporate one or more sustainability themes.
  - Climate impact investment funds, dedicated to addressing climate change and supporting the shift toward a low-carbon economy, remain small.
- Allocation to EMDEs:
  - Climate impact funds allocate a larger portion of their portfolios to EMDE assets (equities and ...). [text ends]

*CHAPTER 3 FINANCIAL SECTOR POLICIES TO UNLOCk PRIvATE CLIMATE FINANCE IN EMERGING MARkET ANd dEvELOPING ECONOMIES*

### 1. Assessment of 30 G-SIBs’ Sectoral Policies

### 1. Assessment of 30 G-SIBs’ Sectoral Policies

### Bank and Insurer Policy Assessments
- Assessment covered 30 G-SIBs (global systemically important banks) and nine globally systemic insurers.
- Policy dimensions assessed for banks (panel headings preserved): Limitation of financial services to coal expansion; Exclusion of project finance to coal mines, plants, and infrastructure; Net-zero-aligned coal phaseout policy; Net-zero-aligned oil and gas policy.
- Policy dimensions assessed for insurers (panel headings preserved): Limitation of underwriting services to coal expansion; Restrictions on underwriting coal companies; Net-zero-aligned coal phaseout policy; Targeting at a minimum oil and gas upstream development.
- Note: Description of the assessment methodology is detailed in Online Annex 3.4.

### Syndicated Loan Origination to Fossil Fuel Companies
- Syndicated loan originations to fossil fuel companies by the 30 G-SIBs were analyzed using Dealogic data; syndicated loan data were used because they capture a significant part of the energy sector credit (Weyzig and others 2014).
- Classification of fossil fuel companies was based on Standard Industrial Classification.
- Sustainable loans include both green loans and ESG-linked loans.
- If one loan contains multiple lead banks, loan value is equally allocated to each lead bank.
- Observation in text: "... which is reflected in syndicated loan originations, including for banks with more ambitious policies."

### Key methodological notes and abbreviations
- ESG = environmental, social, and governance; G-SIBs = global systemically important banks.
- Sources: Dealogic; and IMF staff assessment and calculations.

*Italic: Source — text — 1. Assessment of 30 G-SIBs’ Sectoral Policies (from the provided IMF chapter excerpt).*

---

### 2. Sustainable Investment Funds: Growth and Climate Uncertainty

### Assets, allocations, and labeling dynamics
- Sustainable investment funds categories described: ESG funds; Sustainable themed funds; Climate impact funds; Conventional.
- Climate impact funds are a small share of total sustainable investing despite rapid growth in ESG investing.
- Climate impact funds allocate higher shares to emerging market and developing economies (EMDEs) equities and bonds compared with other fund labels.
- The EU Sustainable Finance Disclosure Regulation (SFDR) classification system: Article 6 (no sustainability focus), Article 8 (“light green,” promoting environmental characteristics), Article 9 (“dark green,” a clear objective of sustainable investment).
- SFDR requirements enacted in February 2023 and applied to all funds operating in Europe; the SFDR brought a wave of reclassifications from Article 9 to Article 8.

### Data-provider and measurement concerns
- Some climate impact funds contain assets with meaningful transition risks; Morningstar’s carbon risk score and similar measures can assess transition risk of fund portfolios.
- The carbon risk score distribution for climate impact funds closely resembles that of conventional funds, with a right tail indicating higher transition risks for a sizable share of these funds—suggesting some funds may not be as “green” or sustainable as their label suggests.
- Initial analysis (see Online Annex 3.5) suggests funds classified as dark green (Article 9) attracted higher inflows compared with Article 6 funds, indicating disclosure requirements like SFDR can enhance transparency and channel capital toward verified sustainable investments.

---

### 3. ESG Scores versus Climate Impact Scores

### Limitations of corporate ESG and E pillar scores
- Corporate ESG scores are designed to capture nonfinancial risks and are not necessarily aligned with climate impact; a renewable energy firm can face high climate risks while creating positive climate impact.
- Three construction features reduce ESG scores’ ability to reflect impact:
  - ESG scores combine a multitude of data points; only a relatively small subset may be related to creating ESG impact.
  - ESG scores are not necessarily proportional to ESG performance.
  - Corporate ESG scores are industry specific and constructed relative to firms in the same industry.

### Construction and coverage of new climate impact scores
- New climate impact scores constructed using data corporate ESG scoring providers already collect (details in Online Annex 3.6).
- Construction design:
  - Consider only data points that directly reflect climate impact (16 data points out of 64 used for the E score).
  - Capture current climate performance (for example, carbon intensity) and potential future emission reductions (for example, emission reduction targets).
  - Calculate scores so that significantly higher values map into significantly better climate impact characteristics, independent of industry.
- Coverage: The scores cover about 10,300 listed firms, of which more than 2,700 are incorporated in emerging markets.

### Empirical contrasts and correlations
- Impact-oriented scores yield substantially different firm rankings than E scores.
- Firms within the worst 5 percent (=400) under the impact score can have a significantly higher rank under the E score.
- Firm rank correlation between impact scores and E scores = "–0.14".
- Panel 1 correlations reported (axis tick values preserved): correlation coefficients range from –0.08 to 0.12 for ESG, E, and climate impact scores in their correlation with firms’ carbon intensity; all correlations are statistically significant at the 1 percent level.
- Result: Firms with better ESG or E scores can counterintuitively tend to have higher emission intensities.

### Implications for portfolio construction
- Using impact scores versus E scores would produce significantly different portfolio allocations under common strategies:
  - Negative screening (excluding or underweighting the worst firms) would exclude different firms depending on whether the E score or impact score is used.
  - Best-in-class strategies would also shift allocations.
- Impact scores could better align investor expectations with climate outcomes and assist impact funds (which tend to have higher EMDE allocations).

---

### 4. Policy Recommendations to Unlock Private Climate Finance in EMDEs

### Overarching strategy
- A broad mix of policies is needed given political hurdles of carbon pricing and EMDE-specific challenges.
- Carbon pricing can be highly effective in pricing climate externalities, shifting capital toward low-carbon investments, and increasing effectiveness of financial sector policies—but may be politically challenging and must be complemented by other policies.
- First step recommended: reform fossil fuel subsidies, which are at a record high and are projected to increase in EMDEs (IMF 2023).
- Strong climate policies and commitments (for example, legally enshrined national commitments to achieve net zero emissions by a given date) provide strong signals to private investors.
- Environmental regulation and green subsidies can spur climate innovation and financing but subsidies can create fiscal risks if not designed well.
- In some low-income countries, international support and policy initiatives are essential.

### Information architecture, standards, and data
- Strengthen climate information architecture (data, disclosures, taxonomies): high-quality, reliable, internationally comparable data are prerequisites for efficient pricing of risks and opportunities and for reducing greenwashing.
- The disclosure standards proposed by the International Sustainability Standards Board will help create a global baseline.
- Policymakers should balance geographic and local context considerations, especially for EMDEs—market characteristics, regulatory context, national decarbonization priorities, and climate financing needs.

### Structural reforms and project pipelines
- Implement structural reforms to overcome investment barriers, boost domestic resource mobilization, and attract private capital (Budina and others 2023).
- Reforms: strengthen macroeconomic fundamentals; deepen financial markets; improve policy predictability; foster institutional and governance frameworks.
- Green public investment in infrastructure can complement private innovation; a predictable pipeline of quality projects directly supporting climate objectives is necessary to attract private investors.

### Coal phaseout, transition taxonomies, and Just Energy Transition Partnerships
- Support coal phaseout in EMDEs with innovative, tailored financing solutions; use transition taxonomies, alignment tools, and planning frameworks to enable managed phaseout.
- Use a variety of financial instruments, including blended finance, to enable retirement and repurposing of existing coal-fired power plants.
- Multilateral Development Banks (MDBs) could support development of renewable alternatives alongside country-level energy transition plans.
- Just Energy Transition Partnerships can help EMDEs retire existing coal-fired power plants with public and donor financing and policies to support workers and communities (reskilling, social safety nets).

### Financial-sector policies and tools
- Refocus financial sector policies on climate impact: disclosure requirements, taxonomies, and standards for sustainable financial instruments should incentivize transition financing and cover climate adaptation—a core issue for EMDEs.
- Regulators in EMDEs should consider developing transition taxonomies identifying activities with potential for significant emissions improvements, including hard-to-abate sectors (steel, cement, chemicals, heavy transportation).
- Emission reduction targets and criteria in transition taxonomies should be connected to nationally determined contributions and sectoral decarbonization targets.
- Standardize transition plans for firms and financial institutions to allow comparability and enhance credibility; interoperability remains a key objective.
- Transition plans for banks could be a useful tool for microprudential authorities to assess whether transition risks are commensurate with risk management frameworks (Network for Greening the Financial System 2023).

### Market integrity, labels, and data-provider roles
- Regulators and supervisors should ensure disclosures and labels for sustainable investment funds enhance transparency, integrity, and alignment with climate objectives; tighten enforcement to avoid lax use of sustainability labels.
- ESG data providers should offer climate impact–oriented scores as a tool for fund managers and investors; such impact scores could be constructed from existing ESG data.
- Regulators should consider evaluating sufficiency of oversight for ESG ratings and data providers (IOSCO 2021).

### Credit ratings, sovereign ESG, and public–private risk sharing
- Credit rating agencies and sovereign ESG methodologies need realignment to better reflect climate and sustainability material factors, including differences across EMDEs.
- Public–private risk sharing is critical to foster climate private investments in EMDEs: pooling, diversification, and credit enhancements can reduce cost of private capital.
- Blended finance structures allow public actors (MDBs, domestic governments, development finance institutions) with philanthropic support to improve risk–return profiles and broaden investor base.
- Technical assistance from MDBs is crucial to build investment project pipelines and assist project development and monitoring.
- Expanded use of guarantees by MDBs and donors could reduce real and perceived risks in EMDEs and broaden the potential private investor base.
- MDBs’ ongoing discussions with the Group of Twenty and international community to enhance MDBs’ financial capacity and operating models are important (Capital Adequacy Framework Review referenced).

*Italic: Source — text — 1. Assessment of 30 G-SIBs’ Sectoral Policies (from the provided IMF chapter excerpt).*

### CHAPTER 3 FINANCIAL SECTOR POLICIES TO UNLOCk PRIvATE CLIMATE FINANCE IN EMERGING MARkET ANd dEvELOPING ECONOMIES

### CHAPTER 3 FINANCIAL SECTOR POLICIES TO UNLOCK PRIVATE CLIMATE FINANCE IN EMERGING MARKET AND DEVELOPING ECONOMIES

### Resilience and Sustainability Trust (RSF) and IMF catalytic role
- The Resilience and Sustainability Trust (RSF) total size is about $40 billion.
- The RSF, supported by the convening power of the IMF, can act as a catalyst by bringing together governments, MDBs, and the private sector to foster financing of climate investments.
- Member countries may choose to use part of the fiscal space created by the RSF to provide risk-sharing and credit enhancement mechanisms to private investors, taking into account fiscal and debt sustainability considerations.
- In combination with traditional IMF programs, the RSF can help address macroeconomic challenges that mobilize domestic financial resources.
- IMF tools and support mentioned:
  - IMF Green Public Financial Management framework provides a holistic view of entry points for integrating climate priorities into public financial management.
  - IMF Climate–Public Investment Management Assessment helps governments identify improvements in public investment institutions and processes for low-carbon and climate-resilient infrastructure.
  - The IMF can provide capacity development to advance climate policies and improve the collection of high-quality, reliable, and comparable climate-related data.
- Policymakers should consider whether regulatory barriers disincentivize the use of MDB and donor guarantees by financial institutions such as banks and insurance companies.

### Credit rating agencies, sovereign ESG providers, and implications for EMDEs
- For nearly two centuries, credit rating agencies have assessed capacity and willingness of issuers to meet obligations; they influence capital flows in EMDEs.
- The ESG industry size is now $7.7 billion and is expected to quadruple by 2030.
- Challenges to integrating climate and broader sustainability factors into sovereign credit assessments:
  - The investment time horizon used by the financial industry often disconnects from the longer horizons over which climate and sustainability factors are material.
  - Understanding of materiality of ESG and sustainability factors and their effects on sovereign creditworthiness is evolving, with notable limitations in modeling and comprehensive data.
- Findings from Gratcheva and others (2022):
  - Credit rating agencies’ assessments of EMDEs fall short of fully reflecting preparedness for a low-carbon transition or exposure to stranded asset risks, particularly for countries dependent on the hydrocarbon sector.
  - Lower-middle-income and low-income countries are generally not rewarded for good E policies.
- Sovereign ESG methodologies and market developments:
  - Sovereign ESG methodologies are nascent and continue to evolve.
  - The average weight of the E pillar in sovereign ESG scores increased from 23 percent in 2020 to 35 percent in 2023.
  - Climate factors are still not reflected by the majority of sovereign ESG scores.
  - There is little agreement among sovereign ESG score providers on what constitutes good sovereign performance on environmental issues and which E factors are material across countries and income levels.

### Firms’ emission intensity heterogeneity and policy implications (Box 3.2)
- Empirical findings from self-reported data on more than 4,000 large, listed firms:
  - Emission intensities—emissions scaled by revenues—vary dramatically among firms operating in the same industry and country.
  - Comparing firms offering similar products, emissions per unit of production for the worst 10 percent of emitters are more than six times larger than those of the best 10 percent.
  - Heterogeneity in emission intensities is even larger within EMDEs after controlling for industry fixed effects.
- Drivers of environmental performance:
  - Firms with fewer green operations use older physical capital stocks, are less knowledge-intensive and innovative, and are less productive.
- Policy counterfactuals assessed in a calibrated multicountry, multisector, multifirm general equilibrium model:
  - Policies considered include carbon taxation, subsidies targeting research and development, and subsidies targeting upgraded capital stocks.
  - Each policy targets a 25 percent reduction in corporate emissions.
  - Subsidies can help cut emissions but at significantly larger costs than carbon pricing.
  - Two economic forces increase the cost of achieving emission cuts via subsidies:
    - Subsidies are comparatively weak levers to cut emissions because they do not directly incentivize lower energy consumption and can encourage firm expansion as productivity rises; achieving significant emission cuts without carbon pricing requires large subsidies.
    - Subsidies may misallocate resources, and larger subsidies induce stronger misallocation; thus the costs of targeting large emission cuts through subsidies alone are high.

### Early lessons from IMF engagement and country examples (Box 3.3)
- Cross-cutting lessons from early IMF engagement in Bangladesh, Barbados, Costa Rica, Jamaica, and Rwanda:
  - No single institution can provide financing at the scale EMDE climate financing needs require; coordinated efforts among governments, international financial institutions, and development partners are essential.
  - Climate resource mobilization requires coordinated actions across three pillars: climate policy reforms, capacity development, and innovative financing approaches.
  - Using part of the fiscal space created by RSF arrangements in a prudent manner could help crowd in additional financing for climate investments.
  - Any facility using public resources should have appropriate governance structures; project selection, impact reporting, monitoring, and verification should align with the highest international standards.
  - Climate solutions should be customized to each country’s unique climate needs and economic characteristics; adaptation and mitigation investments often require different policy and financing arrangements.
  - Limited market size and lack of a robust pipeline of bankable projects are larger impediments in smaller economies and may require pooling of projects through regional approaches.
- Barbados example:
  - The government used part of the fiscal space created by the RSF as equity capital for a new Blue Green Bank to provide lending for private sector green investments in affordable homes, hurricane-resilient roofs, and electrification of transport.
  - The Blue Green Bank receives funding support and technical support from development partners and multilateral institutions; low-cost and long-term financing instruments and grants from development partners support government investment in water, sanitation, and flood and coastal protection projects.
- Rwanda example:
  - Rwanda adopted a programmatic approach through Ireme Invest, set up by the Rwanda Green Fund and the Development Bank of Rwanda.
  - Under the RSF arrangement, development partners such as Agence Française de Développement and the European Investment Bank committed to scale up climate financing with budget support, technical assistance, and long-term low-cost loans.
  - The initiative is expected to fund a pipeline of projects estimated at €400 million, including €130 million in equity contributions from private investors.
  - The government of Rwanda is prepared to scale up the equity of the Development Bank as the pipeline of projects expands.

*Source: CHAPTER 3, GLOBAL FINANCIAL STABILITY REPORT: FINANCIAL AND CLIMATE POLICIES FOR A HIGH-INTEREST-RATE ERA (October 2023), International Monetary Fund.*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2023/october/english/text.pdf_