Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: European Banks Remain Under Pressure From Weak Growth

April 18, 2012

  • Global financial stability has improved in recent months
  • Financial system remains fragile, financial markets volatile
  • Policymakers must commit to long-term reforms to restore confidence

European banks remain under pressure from weak growth and high debt repayments. They need to strengthen their balance sheets by reducing assets and increasing their capital, a process known as deleveraging, to regain investor confidence, the IMF said in its latest Global Financial Stability Report.

European Banks Remain Under Pressure From Weak Growth

A pedestrian walks past a bank in Paris, France: policymakers have acted in recent months to stabilize the global financial system (photo: Gonzalo Fuentes/Reuters)


European policymakers have taken a number of important policy actions in recent months to help stabilize the financial system. These include stronger fiscal and structural policies being put in place in Italy and Spain, the agreement on funding for Greece and private sector debt restructuring, the European Central Bank’s lending to help banks refinance over the next three years, and a more flexible and better funded plan to manage crises.

“So far, current policies have prevented a ‘credit crunch’, but if financial stress intensifies a large scale and synchronized deleveraging by European banks could do a serious damage to asset prices, credit supply and economic activity in Europe and beyond,” said José Viñals, Financial Counsellor and head of the IMF”s Monetary and Capital Markets Department, which produced the report.

Viñals said much remains to be done to build on the limited breathing room provided by recent policy steps.

Good deleveraging

The report said that severe stress in the euro area’s banking and government bond markets in late 2011 prompted banks to shrink their balance sheets. European banks have been under pressure to reduce leverage since 2008, and have accomplished this by selling assets, and raising capital while limiting their cuts in lending to companies and households. 

The key is to strike the right balance, as banks need to strengthen their balance sheets to increase their resilience over the long run. At the same time, it is essential to avoid large scale reductions in lending that may undermine economic growth and the global recovery.

“Some deleveraging is healthy, as banks cut noncore activities and reduce reliance on wholesale funding, making their balance sheets more robust. But like Goldilocks, the amount, pace, and location of deleveraging must be just right – not too large, too fast or too concentrated in one region or country,” said Viñals.

The economic outlook has improved somewhat in recent months, and low growth in the euro area will make it more difficult to deal with high debts weighing down governments, the corporate sector and households.

Emerging economies have coped with the latest round of shocks and managed deleveraging from European banks, thanks to flexible policies that helped their economies during the crisis, combined with targeted macroprudential instruments, according to the IMF. 

The Global Financial Stability Report was released the day after the IMF issued its outlooks on global growth and government debts and deficits, which show growth is expected to be weak, and cutting deficits by too much and too quickly could pose risks.

Policy actions needed

Countries should continue to reduce government deficits while supporting growth, the IMF said. This can be done through accommodative monetary policy, a sufficiently gradual withdrawal of fiscal support in countries not subject to financial market pressures, and structural reforms that raise productivity and strengthen competitiveness.

In addition, the report identifies two short term priorities:

• Prevent the outbreak of downside risks through continued adjustment efforts by economies under strain matched by a flexible and powerful financing backstop, often referred to as a firewall.

• Ensure an orderly process of bank deleveraging through close macroprudential oversight by the European banking authorities, complemented by efforts to restructure and resolve weak banks, with funding from the firewall if needed.

There are two long-term reforms policymakers also need to complete:

• Develop and commit to a road map for a euro area financial stability framework that includes a truly pan-European framework for bank supervision and resolution, and deposit insurance to help the monetary union function properly

• Stronger central oversight over fiscal policy, supported by greater fiscal risk-sharing through a common fund countries can draw on for assistance in the event of economic shocks.

Beyond Europe

The risks to financial stability are not confined to Europe, with high fiscal deficits in Japan and the United States, according to the IMF.  Both countries require deficit reduction plans that protect growth in the next few years and reassure financial markets that government debts will be brought down to more sustainable levels. 

The United States should pursue more aggressive policies to help households with their mortgage debt burden, in particular through writedowns of underwater mortgages and expanded access to refinancing, the IMF said.

Emerging economies
will have to cope with the fallout from the euro area crisis, particularly as European banks with significant presence in emerging European economies might lend less as they shrink their balance sheets and sell off assets.

The Group of Twenty leading advanced and emerging economies’ global financial regulatory reforms need to be concluded and implemented consistently across countries. This includes the treatment of systemically important financial institutions and over-the-counter derivatives market reforms. Oversight of the shadow banking sector should be strengthened.

The IMF released the report just ahead of its Spring Meetings, which bring together global policymakers in Washington, D.C. for a series of discussions on the global economy.