Peter Dattels, Deputy Director, Monetary and Capital Markets Department
Matthew Jones, Chief of the Global Markets Analysis Division, Monetary and Capital Markets Department;
Ali Al-Eyd, Deputy Chief, Global Markets Analysis Division,
Monetary and Capital Markets
Andreas Adriano, Senior Press Officer, Communications Department
MR. ADRIANO: Good morning, and welcome to this press conference of the fall 2016 edition of the Global Financial Stability Report. With us today, are Peter Dattels, Deputy Director of the Monetary and Capital Markets; Matthew Jones, assistant director and head of the global markets analysis division; and Ali Al-Eyd, deputy chief in the same division, they are the main authors of the report. Mr. Dattels will have some opening remarks and we are then happy to take your questions. We need to finish on time, because there is another press conference coming after that, which is the Fiscal Monitor. Mr. Dattels, the floor is yours.
MR. DATTELS: Thank you everybody for being here this morning. Today, we find ourselves in a low-growth, low-rate, era characterized by increased political and policy uncertainty. This is creating many challenges for banks, policymakers, and corporates, in all parts of the world. Failure to adapt to this new era could undermine the health of financial institutions and add to the pressures of financial and economic stagnation. This report analyzes these challenges and offers solutions to foster stability in this new era. Let me start with our assessment of risks.
First, some good news. Short‑term risks have declined. Six months ago we worried about Brexit and possible global repercussions. The shock of Brexit was well absorbed by markets, helped by central bank contingency plans, and monetary policy easing by the Bank of England. The impact appears more local than global. We were worried about high levels of corporate debt in emerging markets and rising risk of default. As some of the worst-hit emerging markets showed signs of recovery, and against the backdrop of further monetary easing, emerging market assets have rebounded strongly. The passing of these near‑term risks has led to a fall in volatility and a rise in equity prices in advanced economies.
But medium‑term risks are building, because we're entering a new era of challenges. Low, uneven, and unequal growth is opening the door to more populist and inward looking policies, leading to a loss of political cohesion and a rise in policy uncertainty in some countries. This could increase volatility and undermine growth.
A striking outcome of this weak economic environment and heavy reliance on unconventional monetary policies is that markets expect negative policy rates in the euro area and Japan to last through the end of this decade. The weak outlook has pushed hopes for normalizing monetary policies well into the future. As a result, almost 40 percent of advanced economy government bonds carry negative yields. This is unprecedented! Financial stability now depends on how well financial institutions adapt to this new era.
Since the crisis, enhanced regulation and oversight have strengthened banks' capital and liquidity positions, making them safer. However, this new era of low growth and low rates threatens to undermine these hard‑won gains.
Markets have serious concerns about the ability of many banks to remain viable and healthy. Equity valuations are well below the book values of many banks as the focus of investors has shifted from the level of capital to the business models that banks need to maintain that capital through profits. This is the fundamental reason why some banks have come under pressure this year.
The question that we raise in this report is whether an economic recovery is sufficient to restore sustainable profitability. Or, are the problems more deep‑rooted and structural?
To answer this question, we conducted a detailed bottom‑up analysis of some 280 banks, covering about 70 percent of U.S. and the EU banking systems. We found that a cyclical recovery helps, but is not enough. In this exercise, a large majority of U.S. banking system returns to healthy levels of profitability. But, some weaknesses remain.
In contrast, in Europe, almost one third of the system, representing some 8.5 trillion dollars, remains weak and unable to generate sustainable profits. We are convinced that banks and policymakers need to tackle substantial structural challenges to survive in this new era.
First, European banks need to resolve the legacy of nonperforming loans. This requires supportive policy action to strengthen insolvency and recovery regimes to reduce foreclosure times. If this were to be achieved, it would turn the capital cost of removing nonperforming loans from balance sheets of some 80 billion euros to a benefit of capital of about 60 billion euros. Progress has been made, more is needed.
Second, European banks need to become more efficient. There are simply too many branches with too few deposits and too many banks with funding costs well above their peers. Addressing these business model challenges is vital to ensure sustainable profitability.
Third, weak banks will have to exit and some banking systems will have to shrink. This will ensure a vibrant banking system that supports economic recovery.
Fourth, policymakers will have to complete regulatory reforms to reduce uncertainty without an across‑the‑board increase in capital requirements. Procyclical outcomes must be avoided.
Undertaking these reforms would improve the profitability of European banks in our analysis by over 40 billion dollars annually. Combined with a cyclical recovery, these structural reforms would vastly improve the share of healthy European banks to over 70 percent.
Long‑term savings institutions will also need to adapt. The solvency of life insurance companies and pension funds are threatened by a prolonged period of low interest rates. Managers and regulators will need to address medium‑term insolvency risks and funding gaps while strengthening standards in capital frameworks.
Let me now turn to emerging markets. Low interest rates and the global search for yield present a unique opportunity for overly indebted firms to restructure their balance sheets. Corporate leverage in many emerging markets have peaked. In the wake of weaker commodity prices, firms have slashed investment, reducing their need for borrowing.
Can emerging markets achieve a smooth deleveraging? In a new era of weak global growth, commodity prices and reduced global trade, substantial debt reduction will take a long time. Under our baseline scenario, indebtedness declines only gradually, returning to 2014 levels only by 2021. High debt levels leave emerging markets sensitive to downside risks and a reversal of capital flows. All this requires emerging markets to proactively address corporate vulnerabilities, including through swift recognition of nonperforming loans, and strengthening of insolvency frameworks.
But, are bank buffers in emerging markets large enough? The good news is that banks in most emerging markets appear to have sufficient buffers to cushion their current holdings of nonperforming loans. The bad news is that while leverage has peaked, default risk is likely to rise further. We find that larger bank buffers are needed in several emerging markets, and supervisors should focus on this potential in the period ahead.
In China, we worry about the growing complexity of the financial system as credit continues to grow. What is new is that an increasing share of this credit is being packaged in opaque and complex credit products produced outside the banking system. Some of these credit products are ending up on the balance sheets of smaller Chinese banks. Indeed, these exposures exceed on average three times their capital buffers. Furthermore, these smaller banks rely on short‑term wholesale funding, which can be fragile. These developments suggest that Chinese financial system is growing more complex and more vulnerable. The Chinese authorities are working proactively toward the resilience of their economy and financial system. But more is needed, especially to curb excess credit growth, reduce the opacity of credit products and insure sound interbank funding structures. These reforms need to be taken in parallel with strengthening the viability of Chinese corporates, particularly in the state sector.
Let me conclude. Action is needed now to ensure that the financial system adapts to this new era and remains healthy. These measures are also necessary to avoid sliding into financial and economic stagnation. They form part of the Fund's three‑pronged strategy of structural, fiscal, and monetary policies within and across countries and over time, and sustained growth and financial stability.
Thank you very much. We will happily take your questions.
MR. ADRIANO: Please identify yourselves and keep your questions short, please.
QUESTIONER: In this report you talk about markets having questions over the viability of some banks, but you don't name any names here. I wonder if you could talk a little bit about Deutsche Bank, which has come under questions in the market over its financial strength after the request for fines against it. Is Deutsche Bank viable? Will it need a bailout?
MR. DATTELS: As we focus on in the report, many banks need to adapt to this new era of low growth and low rates, as well as a changing regulatory and market environment. We have one third of the banks struggling to show sustainable profitability. So let me break that down a little bit, which I think is helpful.
We can break it down ultimately into three groups. Banks with legacy challenges owing to high nonperforming loans; banks that have been restructured, taken over by the government and recapitalized, but still struggling to find their footing; and third, investment banks that are in transition away from dated business models that relied heavily on large scale balance sheets.
Deutsche Bank, we can say, is in the midst of this latter challenge. It is in that third bucket of banks that need to continue to adjust to convince investors that its business model is viable going forward, that it has addressed the issues of operational risk arising from litigation and so on. I think that is the new environment that we are in, and I'm sure that those challenges will be met.
QUESTIONER: Just to follow‑up on that, Pete. I know it wasn't your division, but a few months ago the IMF came out and said Deutsche Bank posed a systemic risk to the global markets, that was before a lot of what we have talked about today really came into focus. So I would like to press you a little bit on Deutsche Bank in particular. In light of what you just said, do you think that it poses systemic risk to the financial markets?
MR. DATTELS: What you are referring to is the Germany’s Financial Sector Assessment Program from June, and that report highlighted that Deutsche Bank is a large and interconnected bank and is therefore systemically important, domestically and globally. In that context, we are confident the German and European authorities are monitoring the situation and working to ensure that the financial system remains resilient.
QUESTIONER: I have two questions. One is on Italy. You say that the Italian authorities should promptly assess asset quality for smaller banks. This is something which the bank of Italy does not want to do because it thinks it would increase instability. Do you think the ECB should force Italy to undertake a stress test of its small banks, given that the responsibility ultimately falls with the ECB?
Second question quickly. On the BRRD, you call for a review of the implementation of the directive to assess the degree of flexibility of the rules. Do you think at the moment the rules are flexible enough, in particular when it comes to bailing in banks which could pose some sort of systemic threat or systemic instability?
MR. JONES: I will take the first question on Italian banks. It is clear that the Italian banking system faces a number of challenges, amongst them the high levels of nonperforming loans, and in addition to the broader issues we talk about, medium‑term structural profitability that is more of a problem, more broadly for advanced economy banks and European banks in particular.
One of the recommendations in our report, but also in the Italy Article IV report, was the issue of nonperforming assets in the Italian banking system to be addressed in a prompt and transparent manner. We have had the results of the asset quality review for the larger systemic banks and that has been helpful in terms of encouraging the process of dealing with those assets, and reducing the uncertainty around the asset quality challenges in the Italian banking system. That is why we think that the asset quality review should be extended to the smaller banks, where there is less information available and in a sense on greater uncertainty about the quality of the underlying assets. So we think that would be helpful to move the process forward in terms of dealing with the challenges of nonperforming assets in the Italian banking system.
MR. DATTELS: On the question about the Bank Recovery and Resolution Directive. Does it offer enough flexibility? That regime has significantly strengthened the resolution regime in the EU, and it provides a broad set of tools for resolution. It also provides mechanisms for precautionary recap(italization). What we have pointed out is that there is flexibility within these rules, which requires judgment and flexibility within that set of rules, and that ultimately as the regime is tested out, as we go forward, this will come under review in 2018. The rules are there. There is flexibility within the BRRD and the state aid rules, and our argument is that flexibility should be used and judgment used, and we will see and review that in the context of the normal review in 2018.
QUESTIONER: How vulnerable is Brazil in terms of financial conditions?
MR. AL‑EYD: So, Brazil, like many other emerging economies is adjusting to this new era Pete described, of low growth, low rates and low commodity prices, but of course Brazil is benefiting right now from the global search for yield. Its assets are performing well, as well as with other emerging markets. But corporate leverage in Brazil and others is quite high. And this is the focus of our report. In fact, we examine if Brazil and other emerging markets can smoothly deleverage their corporate sectors by taking advantage of the current environment, which is still favorable. And in doing so, this would reduce risks that high corporate debt poses to banking systems.
Just to put a few numbers on it. Current debt held by firms that are weak, we identify in our sample in the report, in Brazil is about 51 billion dollars, about 11 percent of Brazilian corporate debt. Now, what I mean when I say weak, is that these are firms that have low interest coverage meaning that their profits are insufficient to cover their interest payments for a year's time. That is how we define it in the report.
We examine this debt and we look at what happens in an adverse scenario. And, that means that growth slows a bit, firms' profits fall a bit, funding costs go up a bit, and in this case this debt could rise to some 88 billion dollars or about 19 percent of corporate debt in Brazil.
So that is why in the report we call for swift actions while the times are good in terms of the external environment to address these weaknesses in the corporate sector which will then strengthen banks. In a sense, our analysis shows that Brazilian bank buffers, the capital they have set aside, would actually become overwhelmed if this downside scenario were to materialize. So that is why we call for continued action to reduce nonperforming loans and strengthen corporate insolvency frameworks to deal with potential corporate stresses.
QUESTIONER: Firstly, in your previous report, the one in April you gave a figure for nonperforming loans, I think it was around 900 billion euros and you also broke down that figure a lit. You said 350 of that was Italy. I wonder if you could give us an update on some of those figures?
Secondly, going back to Deutsche Bank, but also a broader question, slightly, about that, many people in Europe are beginning to think that perhaps the American authorities, U.S. Justice Department, and I think this affects British banks as well as German banks, is acting in a sort of irresponsible way in the way that it is using an economic nationalism to punish overseas banks, and causing, helping to cause the instability which we are seeing in the share prices of European banks.
MR. DATTELS: As for nonperforming loans, we have updated some of the numbers in the text. We are seeing a gradual reduction, with the ECB having put in targets for the banks that are under its direction for a sharper reduction in nonperforming loans, and that is certainly the case in a number of countries. But, the actual level, the overall level remains high and much more progress needs to be made.
QUESTIONER: Is the EUR 900 billion figure still relevant?
MR. DATTELS: That is still broadly correct. I can circle back and provide you with that.
MR. JONES: Regarding your question about enforcement action against individual banks, and whether that is causing turbulence in bank share prices, obviously we can't comment on individual legal matters under litigation. But I think it is worth bearing in mind that the various inquiries into the cause of the global financial crisis identified widespread incidence of misconduct and irresponsible behavior by different participants in the financial sector, from misselling mortgage products, to colluding to fix interest rate markets. And it is clear that addressing the root causes of the misconduct has been a key focus of regulators through addressing expectations of behavior of boards and financial institutions, the accountability to their boards, and better alignment of incentives such as compensation. Stronger enforcement of penalties has also been an element of that stricter framework. This remains a work in progress, because essentially what we want to do is to create a culture of responsible finance in the global financial system.
Now, it is clear that a number of the actions that have been taken against institutions have affected their share price, because it affects their profitability and how much they are able to return to shareholders. But, if you look at the overall magnitude of the fines imposed on banks, and other financial institutions since the crisis, and if you look at the U.S., it hasn't been the case that non‑U.S. institutions have suffered more. In fact, if you look at the magnitude of those fines, you will find the U.S. institutions actually suffered more fines relative to other countries. So in terms of the impact on equity prices, this year you have seen bigger impact from bank earnings expectations and future profitability and concerns about that underlying profitability, as Mr. Dattels mentioned in his opening remarks. That has been a key driver of bank share prices this year, investors being concerned about the underlying profit model of banks and their ability to survive in this low rate environment.
QUESTIONER: The Chinese banks are writing off high volume loans in order to clear up their balance sheet. I wonder what you think is the biggest risk in the process?
My second question is about the U.S. election, whether who got elected, what do you think is the impact on the financial markets in the U.S.?
MR. JONES: On China, One of the issues we have flagged in the previous report, but also in this report, is some of the asset quality challenges from the corporate sector and the potential impact it may have on the banking system. And, as you note, the big four Chinese banks have seen increasing nonperforming loan ratio as their asset quality starts to deteriorate. They have been quite active in removing some of those assets from their balances, which I think is a helpful initiative. One of the policy recommendations that we make in the report about China and its banking system is the need to strengthen the balance sheets and the capital positions of the banks and obviously removing nonperforming loans is a part of that process. That is a welcome process.
We also call for a broader set of issues to, in a sense, take that process further, by helping to deleverage firms through proactive recognition of losses, curbing excessive credit growth, and also ensuring sound interbank funding structures to address that increased complexity we are seeing.
Facilitating of those faster debt write‑offs is going to have a further impact on banks' capital position, so the process of adjusting to those nonperforming loans and initial provisioning and strengthening of the capital buffers still has to continue and still has a significant way to go.
The second part of the question on the U.S. election, we say in the report that the political climate is unsettled in many countries, and this reflects lack of income growth and a rise in inequality that has opened the door for more populist and inward looking policies. So, we also note that policy uncertainty has increased as a result of the political uncertainty, because of the wider range of possible policy outcomes. And that has happened in the U.S., also in other advanced economies. We note in the report that market sensitivity to that policy uncertainty has increased. So, we think that a range of political events, from Brexit, political events in Europe, the United States, some key emerging markets, have all added to these challenges in this low growth era. In fact, we define this political climate as one dimension of which makes this a new and more challenging era.
Greater policy uncertainty, which is indicative of these higher political risks, is potentially having a greater impact on financial markets. We know policy uncertainty also reduces investment. So it clearly has the potential for negative economic consequences for growth and financial stability, and that is not limited. It's a phenomenon shared broadly across the globe.
QUESTIONER: Two questions about Japan. The Bank of Japan has recently shifted to a policy of yield curve control, partly to restore the profitability of financial institutions. Is this something which has wider application, do you think in order to help the profitability of financial institutions? Secondly, Japanese banks have very high exposure to dollar funding risks. Is that something which is of concern, do you think, large concern?
MR. JONES: On the second part of your question, about dollar funding risks, that is an issue we flagged in this report. Clearly, as Japanese banks have faced more challenging conditions at home, from lower interest rates and lower loan growth, they have ventured more outside of Japan and we have seen that more in terms of their share of global banking cross‑border banking flows. The challenge is that a lot of it is based on dollar funding and in wholesale funding markets, and so that does expose Japanese banks to more of those risks in dollar funding markets. Not just the large banks, but also we show in the report how the regional banks and other parts of the banking and financial system are exposed to that potential appreciation.
In terms of Japanese monetary policy, we welcome the review of the monetary framework and its effectiveness and its implementation that the Bank of Japan has recently undertaken. And we think that the measures that they are planning to take in terms of the target for the interest rate on government bonds may provide some additional monetary support, together with the forward commitment to exceeding their inflation target. But we think that is really not enough. The point we make in the report is that monetary policy alone can't be expected to accomplish all the things we need to for central banks to achieve their inflation targets and enhance growth. Really, we need to bring in the other dimensions of policy in terms of structural reforms and putting together a coherent and consistent medium‑term fiscal framework. So there is a number of recommendations that the Fund has made in the WEO and also in the Japan Article IV report about bringing those other policies to bear to help monetary policy, because monetary policy alone is not going to be enough to achieve the economic outcomes we desire.
MR. DATTELS: Just in terms of whether this is an exportable policy, in the euro area it would be very difficult. In Japan you have a single market, a single rate. Whereas euro area monetary policy is across any number of sovereigns, so it is a much more complicated aspect. But, the approach of looking at how monetary policy can adjust to minimize the impact on financial institutions is something that is important and is addressed in different ways in the euro area.
QUESTIONER: I have two questions, please. What is the situation of the correspondent banking in Mexico, because the most important institutions are from Europe, specifically from Spain? My second question, would you please help me to understand what is happening with the Mexican peso? Because, now is the weakest currency in the emerging world.
MR. ADRIANO: The second question is really more appropriate for the Western Hemisphere Department briefing on Friday.
MR. AL‑EYD: To speak more broadly about correspondent banking, these relationships are quite significant in a number of countries, Mexico included. And, a number of countries have been affected by the consequences of reduced relationships with some of the large banks in advanced economies and clearly actions are needed to ensure that financial stability is ensured going forward. This is an important issue, especially as the withdrawal of correspondent banking relationships can disrupt financial services, cross‑border flows, remittances, and this can create negative externalities for the financial systems, including in countries that have been affected significantly.
It requires a coordinated effort to reduce the risks of financial exclusion and the potential impact on financial stability, and broadly, of course, the IMF has a key role to play in this, and we do this through analyzing risks and policy responses to the withdrawal of correspondent banking activities, for example in our surveillance activities. We're also involved in promoting the implementation of international regulatory standards, and advice in our financial sector assessment programs. Of course we continue to build capacity through strengthened regulatory and supervisory frameworks through our advice to governments. And clearly, this is a big issue, and it is certainly something the Fund is focused on.
QUESTIONER: I have a question on Greece. Do you think that the Greek banks are adequately capitalized, or you projected that the Greek banks would need additional capital support in the near future? The second question, do you think the nonperforming loan challenge can be addressed effectively by the Greek government?
MR. JONES: What we say in the report about banking system challenges in Europe applies to Greece as well, but with some particular intensity. It is clear that in Greece a key challenge is to address the nonperforming loans. Greek banks have been subject to a number of asset quality reviews in the stress tests, and the recapitalization is part of the program. I think it has meant that Greek banks currently have adequate capital. But they have a comprehensive suite of restructuring plans under the program that they need to implement to ensure that continued capital adequacy. Much of these plans involve addressing those nonperforming loans and if those plans are implemented, then banks should remain adequately capitalized. A big challenge for Greek banks like other European banks is the profitability that has been addressed under these plans.
But it is clear the nonperforming loan problem requires a number of measures from the government in terms of addressing the legal framework, introducing effective out‑of‑court settlement procedures, to deal with the large volume of cases, in addition to reforms in the civil code. There is a large implementation gap in terms of the court's capacity to process and the court's skills to deal with this large volume, and some of the complex cases.
So, it is clear there is a big challenge for nonperforming loans in Greece. Greek nonperforming loans under the European Banking Authority numbers are almost 50 percent. That is a significant challenge. And it requires a number of reforms as part of the program to ensure consistent implementation so that those nonperforming loan reduction plans and the profitability of Greek banks can be achieved.
QUESTIONER: Just two short questions, if I may. Given what you said about negative and low interest rates not really helping the health of the financial system, do you think central banks in Europe, in particular, are at the lower bound in and that any future rate cuts would raise the threat of banking crisis to too great a level?
Just to revisit the question on Deutsche Bank, I very much appreciate the point that the culture of finance needed to change and that big fines were perhaps needed to reflect that, but what we have seen in the recent cases, Deutsche Bank and the DOJ, is a leak of very sensitive information, that has had a very negative impact on Deutsche Bank's share price, is that not irresponsible?
MR. DATTELS: I'll take the first part of the question. Just to be clear, our position is that accommodative monetary policy, including unconventional monetary policies, continue to be crucial to underpin the weak economic outlook. They are doing their job. Overall, banks benefit, and are the main beneficiaries of a recovery supported by unconventional policies, in the sense that they improve economic prospects and ultimately the quality of the borrowers and the creditworthiness behind it. But what we are saying is that there are limits to these unconventional policies. Those limits have yet to be reached. But, what we're putting a focus on is the important side effects, and one of those side effects is on the profitability and narrowing of net interest margins. This leads us to our policy conclusion that monetary policy cannot be the only game in town, and going back to my opening remarks, about our three‑pronged policy, which includes fiscal support, structural reforms.
in concluding, the message in this report is that this era could last a long, long time. So, now is the time to address the structural challenges that in fact negative rates actually reveal. We see the inefficiencies can no longer be tolerated. We can no longer wait for a cyclical recovery. So let's do the hard work now, and get the system in a position that it can continue to support the economic recovery, through lending, and maintain its resilience. That is the main message that we're bringing at these meetings on the banking system.
MR. JONES: Just on Deutsche Bank, we have no comment on how that information came to light.
MR. ADRIANO: We have to wrap up because the next briefing is to start in 15 minutes. That is the fiscal monitor, with FAD Director Vitor Gaspar, and his team. Thank you very much for your presence and have a good day.
