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Time Waits for No Man: How to Secure Financial Stability in 2011

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This morning, I presented our latest views on global financial stability in Johannesburg, South Africa.

So, where does the global financial system stand at the moment? Yes, we have witnessed improvements recently, but we are also observing a dichotomy between the economy and the financial system. While the global economic recovery has been continuing, financial stability is still at risk, because of a persistent lack of investor confidence in some advanced country sovereigns and their banking systems.

At this cross-roads, we see three key messages.

Financial stability challenges

I would like to elaborate further on the key challenges that keep global financial stability at risk.

First, in light of high public debt levels, market concerns about sovereign risk have persisted and have spilled over to a greater number of countries, mostly in the euro area. At the same time, we have seen an increasingly negative interaction—an adverse feedback—between banking and sovereign credit risks in some euro area countries. In other words, the fate of some banks is now increasingly intertwined with that of their sovereign—and vice versa.

Second, fragilities remain in key parts of several banking systems.

And third, there is the challenge of coping with the rapid rebound in capital inflows into emerging market economies. While capital flows are generally beneficial for recipient countries, rapid and strong inflows can fuel asset price bubbles and strain the absorptive capacity of local financial systems. Although we appear to be at the early stages of such a cycle, policymakers need to be vigilant about these risks.

Policy priorities

So, what policies should be put in place to meet these challenges?

In advanced countries, we need to deal with the legacy of the crisis by resolving financial fragilities—once and for all!

In Europe, policymakers need to break the adverse feedback loop between sovereigns and banks.

In the United States,

In emerging markets, policymakers must act now to avoid future crises. It is important to maintain the appropriate mix of macroeconomic and prudential financial policies to deal with the challenges posed by capital inflows. In addition, local capital markets will need to become deeper and more resilient, for example through improved market infrastructures.

There is also a need to ensure continued progress on the global financial policy agenda. Financial systems everywhere need to adapt to cope with regulatory reform. New regulations need to be adopted consistently across the world, including on systemically important financial institutions and the so-called “shadow” banking sector. Supervision and bank resolution regimes need to work more effectively within— and across—national borders to safeguard financial stability.

Time is of the essence in addressing immediate policy challenges—particularly in the euro area—and finding a better balance between macroeconomic and structural financial policies. Without these timely policy responses, global financial stability and sustainable growth will remain elusive.