The Danger Zone: Financial Stability Risks Soar

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We are back in the danger zone. Since the IMF's previous Global Financial Stability Report, financial stability risks have increased substantially—reversing some of the progress that had been made over the previous three years.

 Several shocks have recently buffeted the global financial system: unequivocal signs of a broader global economic slowdown; fresh market turbulence in the euro area; and the credit downgrade of the United States.

This has thrown us into a crisis of confidence driven by three main factors: weak growth, weak balance sheets, and weak politics.

1.  Weaker growth prospects and larger downside risks to growth have prompted investors to reassess the sustainability of the economic recovery—which appears increasingly fragile.

2.  The reduced pace of the economic recovery and incomplete policy actions have stalled progress in balance sheet repair. This has led to increased concerns about the financial health of government balance sheets in advanced economies, banks in Europe, and households in the United States.

In Europe, sovereign risks have spilled over to the region’s banking system. This has put funding strains on many banks operating in the euro area, and has depressed their market capitalization.

• We have quantified the size of these spillovers on banks in the European Union since the outbreak of the sovereign debt crisis in 2010. During this period, banks have had to withstand an increase in credit risk coming from high-spread euro area sovereigns that we estimate amounts to about €200 billion. If we include exposures to banks in high-spread euro area countries, the total estimated spillover increases to €300 billion.

• This analysis helps explain current levels of market strains. But it does not measure the capital needs of banks, which would require a full assessment of bank balance sheets and income positions.

• Because of increased market pressures, banks may be forced to speed up deleveraging, curtail credit to the real economy, and thus worsen the economic drag. Clearly, this must be avoided.

In the United States, there have been concerns—and much debate—about the longer-term sustainability of U.S. government debt. These concerns, if left unaddressed, could potentially reignite sovereign risks, and could have serious, adverse domestic and global consequences. At the same time, U.S. households are still repairing their balance sheets—a process that has affected economic growth, house prices, and U.S bank balance sheets.

The third factor driving the confidence crisis is weak politics. Policymakers on both sides of the Atlantic have not yet commanded broad political support for the needed policy actions, and markets have begun to question their resolve.

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There is another important issue facing policymakers. Incomplete balance sheet repair in advanced economies, coupled with a prolonged period of low interest rates, can pose financial stability risks for both advanced and emerging markets. Low policy rates are necessary to support economic activity under current conditions. They can also buy time to repair public and private balance sheets. But if time is not well used, and these repairs remain incomplete, low rates can pose risks to longer-term financial stability by:

• encouraging the buildup of excess pockets of leverage;

• diverting credit creation to the more opaque shadow banking system; and

• pushing capital flows toward emerging markets.

What should policymakers do? They need to switch gears and shift their focus from treating the symptoms of the crisis to dealing with its underlying causes.

Advanced economies need to decisively and expeditiously resolve the current crisis of confidence. Their biggest problems—rising sovereign risks, weak banks, and the spillovers between them—can only be tackled through swift and comprehensive balance sheet repair.

•  Public balance sheets in the United States, Europe, and Japan need to be bolstered through credible, medium-term fiscal consolidation strategies.  This is absolutely essential.

• Overstretched U.S. household balance sheets might benefit from a more ambitious program of mortgage modifications involving principal write-downs.

• And banks in the European Union need to cope with the spillovers from riskier sovereigns. They also need to have sufficient muscle to support the economic recovery through lending. While significant progress has been made recently, banks need to build adequate capital buffers. Some banks may need to do very little, but others—especially those heavily reliant on wholesale funding and exposed to riskier public debt—may need more capital. Private sources of capital should be tapped first. In those cases where this is not sufficient, injections of public funds may be necessary for viable banks. Weak banks need to be either restructured or resolved.

Emerging economies need to balance current risks to avoid future crises. Given the track record  of rapid credit growth in many emerging markets—often in the context of strong capital inflows —policymakers need to avoid a further buildup of financial imbalances where credit growth  remains elevated, even if capital flows have abated somewhat recently.

In addition to sound macroeconomic policies, macroprudential and capital flow measures can play a supportive role in addressing these concerns. At the same time, emerging markets face a potential global shock that could lead to a reversal of capital flows and a drop in economic growth. Our analysis shows that the impact on emerging market banks could be substantial and thus warrants a further buildup of capital buffers in the banking system.

The lack of sufficiently decisive policy action to finally address the legacy of the financial crisis has led to the present crisis of confidence. This has thrown us back into the danger zone, and poses a major threat to the global economy.

Yet, while the path to sustained recovery has considerably narrowed, it has not disappeared. It is still possible to make the right decisions that will help restore global financial stability and sustain the recovery. But for this, we need to act now; we need to act boldly; and we need to act in a globally coordinated manner.