SPEAKERS:
Tobias Adrian
Financial Counsellor and Director, Monetary and Capital Markets Department, IMF
Peter Dattels
Deputy Director, Monetary and Capital Markets Department, IMF
Matthew Jones
Assistant Director, Monetary and Capital Markets Department, IMF
Paul Hiebert
Advisor, Monetary and Capital Markets Department, IMF
Andreas Adriano
Senior Communications Officer, Communications Department, IMF
Mr. Adriano ‑ Good morning, everybody. Greetings to all of you watching us online. Welcome to this Press Conference for the April 2017 Global Financial Stability Report.
With us today is Tobias Adrian, the Financial Counsellor and Director of the Monetary and Capital Markets at the IMF; Deputy Director Peter Dattels who supervises production of the report, Advisor Paul Hiebert and Division Chief Matthew Jones who oversee the group that produces the report. Tobias will have some opening remarks and then we will be happy to take your questions.
Mr. Adrian ‑ Good morning. Welcome to the Spring Meetings. Global financial stability: Where do we stand? Global financial stability has improved in the last six months. As Maury Obstfeld explained yesterday at the release of the World Economic Outlook, economic activity has gained momentum. We have greater confidence in the outlook. Hopes for reflation have risen. Monetary and financial conditions remain highly accommodative. Investor optimism over the new policies under discussion has boosted asset prices.
But failing to get the policy mix right could reverse market optimism. It could also ignite new downside risks to financial stability. In the United States, policies could increase fiscal imbalances and could push up interest rates and global risk premia. A shift toward protectionism globally could drag down trade and growth, triggering capital outflows from emerging markets.
The loss of global cooperation on regulatory reforms could reverse some of the gains that have made financial systems safer. Markets expect these adverse developments will be avoided and policymakers will implement the right mix of policies. In the United States, this means policies that will invigorate corporate investment. In emerging markets, this means addressing domestic and external imbalances to enhance resilience to external shocks. Finally, in Europe, this means that policies will have to strengthen the outlook for banks by tackling the structural causes of weak profitability. That is why the focus of this report is on “Getting the policy mix right”.
Let me now turn to the key policy questions. First, can the corporate sector in the United States support a safe economic expansion? Investment spending has been languishing for over 15 years now. Recently, discussions of corporate tax reform, infrastructure spending, and reductions in regulatory burdens have boosted confidence. This could herald a much‑needed rebound in investment to build for the future.
The good news is that many firms have the capacity for capital expenditures. Increased cash flows from corporate tax reform could bring about increased investment. This would be welcome rather than financial risk taking, such as the acquisition of financial assets and using debt to pay out shareholders. The bad news is that sectors accounting for almost half of U.S. investment—namely, energy, utilities, and real estate—are already highly levered. This means that expanding investment, even with tax relief, could increase already elevated debt levels.
Why is this a problem? A sharp rise in interest rates—for example, owing to increased financial imbalances—could push corporate debt servicing capacity to its weakest level since the crisis. Under such a scenario, corporates with some $4 trillion of assets may find servicing their debt challenging. This is almost a quarter of the assets we capture in our analysis.
In an integrated world, what happens in advanced economies has repercussions for emerging markets. We all remember the taper tantrum in 2013, when interests rose sharply and emerging markets suffered badly. Is this time different? With the right policy mix, it can be.
Global growth could strengthen, and deflation risks could continue to fade. This would benefit emerging markets and advanced economies alike, even as interest rates and monetary policies normalize. So far, we have been on this good path. But emerging market economies could face trying times. In fact, political and policy uncertainty in advanced economies opens new channels for negative spillovers.
A sudden reversal of market sentiment could reignite capital outflows and hurt growth prospects, as could a global shift toward protectionism. We estimate that debt held by the weakest firms in emerging markets could rise to $230 billion under such a scenario. In turn, banks in some countries would need to rebuild their buffers of capital and provisions. Those are the banks that are already experiencing a decline in asset quality after a long credit boom.
China is a key contributor to global growth but has also notable vulnerabilities. Credit in relation to China’s economy has more than doubled in less than a decade, to over 200 percent. Credit booms this big can be dangerous. The longer booms last and the larger credit grows, the more dangerous they become. The Chinese authorities continue to adjust policies to limit the growth of the banking and shadow banking systems, but more needs to be done to slow credit growth and reduce vulnerabilities. The authorities’ progress and success are essential for global financial stability.
Turning to Europe, policymakers need to make further progress in addressing structural impediments to profitability in the banking system. Significant advances have already been made. European banks hold higher levels of capital, regulations have been strengthened, and supervision has been enhanced. Over the past six months, bank equity prices have risen as yield curves steepened and the economic recovery has firmed.
But this is not the end of the story. As we established in the last GFSR, a cyclical recovery is unlikely to fully resolve the profitability challenge that many banks face. Why is this important? Weak profitability limit the banks’ ability to retain capital, thus constraining their ability to weather shocks and increasing risks to financial stability.
In this GFSR, we examine many European banks, representing $35 trillion of assets. We divide them into three groups: global, European‑focused, and domestic. Domestic banks face the greatest profitability challenges, with almost three quarters of them having very weak returns in 2016. This analysis suggests that the domestic operating environment for banks plays a significant role.
While no single structural factor clearly explains chronic low profitability, overbanking is a common challenge. Overbanking takes many different forms: for example, weak banks with low buffers, too many banks with a regional focus or narrow mandate, or too many branches and low branch efficiency. Measures are being taken to address these concerns, but countries with the biggest challenges need to make more progress. Otherwise, low profitability could impede the recovery or, worse, reignite systemic risks.
Let me sum up. What does it take to get the policy mix right? US policy proposals should aim to increase economic growth but should also avoid creating fiscal imbalances and negative global spillovers. Healthy corporate balance sheets will be essential to facilitate an increase in productive investment. Policymakers should preemptively address areas in which risk‑taking appears excessive.
Emerging market policymakers should address their external and domestic imbalances. That includes improving corporate restructuring mechanisms, monitoring corporate vulnerabilities, and ensuring that banks have healthy buffers. In Europe, more comprehensive efforts are needed to address banking system and bank business model challenges. The authorities should focus on removing system‑wide impediments to profitability. Such measures should include promoting bank consolidation and branch rationalization, reforming bank business models, and addressing nonperforming loans.
At the global level, successful completion of the Regulatory Reform Agenda is vital. It relies on continued multilateral cooperation and coordination. Completing the Reform Agenda, especially the adoption of the Basel III enhancements, will ensure that the global financial system is safe and can continue to promote economic activity and growth.
Thank you. We will be happy to take your questions.
Question ‑ You talk about investor optimism in your opening remarks and yet you lay out a long list of risks. I wonder if you think markets are under‑appreciating the risks out there in the global economy. Secondly, on the US corporate sector, could you just in very plain English tell us if we are setting up for another potential corporate debt crisis here, and could the policies of the new Administration here in the US set that off?
Mr. Adrian ‑ Market optimism is based on a benign view of policies going forward. This is why we have named this Spring’s Global Financial Stability Report “Getting the Policy Mix Right.” Downside risks arise from deviations from the expected path of future policy.
We highlight particularly two such risks. One is from a fiscal expansion that would lead to a higher and faster‑than‑expected rise in interest rates; and secondly, a shift toward inward‑looking policies that could lead to a decline in global growth. Both scenarios are downside risk scenarios; they are not the central scenarios. So, those are scenarios that could increase global financial stability risks.
Concerning the U.S. corporate sector, it is healthy, but there are vulnerabilities. The vulnerabilities rely on the observation that leverage in the U.S. corporate sector is at historically high levels. If the policies are conducted as expected, that should not represent any problems. If policies go unexpectedly badly, some part of the corporate sector might be exposed to these unexpected shocks.
So, there is a tail of vulnerable firms in the corporate sector that have a relatively low interest rate coverage ratio, i.e. where the cash flows that they generate do not necessarily cover the interest rate expenses. So, the dollar number refers to that weak tail of the corporate sector.
Question ‑ The report says that there are vulnerabilities both in Chinese banks and companies. Your suggestion on the latest coordination may be among the banking sector, the industrial, and SOE supervisors. Should there be a top‑down, broad plan or strategy to solve this debt problem?
Mr. Adrian ‑ We are pointing out in the report that the growth of credit in the Chinese economy has been very fast since the financial crisis and the overall level of debt is very elevated. The Chinese authorities are taking steps to contain leverage both in the banking system and in the shadow banking system. They show some success in reining in credit growth, but, in our view, more needs to be done. We do believe that the authorities are aware of that.
There is certainly coordination among the regulators within China. Internationally, of course, the Chinese authorities are part of the Financial Stability Board (FSB), and they are part of the Basel Committee. They are coordinating regulatory efforts in these international bodies along with the other nations that are part of the Basel Committee and the FSB.
Question ‑ Two questions. One relates to your box in the report on the city of London. You seem to suggest that the Brexit negotiations or Brexit will mean great dangers for the city of London or a weakening of the city of London. I just wonder if you could elaborate on your view about that, if London can maintain its leadership as a financial center post‑Brexit, I suppose is the question.
Secondly, last year you gave us a very helpful number on the level of nonperforming loans across Europe. This year I noticed you give us percentages rather than a big number, and I wonder if you could give us a big number on nonperforming loans across the European Union.
Mr. Jones ‑ I will take the Brexit question that you asked. We say in the report that the UK is a key player in the global financial system, and there are network externalities for the financial system, like concentration of capital, risk management, and other financial services. So, there is a lot of uncertainty about the outcome of the negotiations and how that will affect the sort of concentration of those factors.
Brexit is going to present some challenges to financial stability, as those institutions are affected. We think that, for example, banks may be most affected by the potential loss of passporting access and they may need to relocate some activities.
The point that we are making in the report is that the new relationship will be complex to negotiate in a short period of time. With constructive engagement aimed at minimizing the disruptions, the impact on the provision of financial services and the network externalities in the U.K. financial system could be minimized.
It is clear that one of the big challenges is regarding the complexity of financial entities that may arise if some institutions choose to reallocate some activities outside of London. That is obviously going to increase the challenges for regulators and supervisors in maintaining effective oversight of the financial stability system as these business structures become more complex.
So, these transition challenges will need to be managed carefully to minimize the impact, and to ensure that the benefits of London as a financial center and as a key player in the global financial center are maintained.
Mr. Dattels ‑ Nonperforming loans (NPLs) in the euro area still a significant matter. If you look at it over the past two years, NPLs have come down only about EUR 120 billion, so they are still hovering around the EUR 1 trillion mark. That is the bad news. The good news is that there is much more increased focus on addressing this problem. I say the action really is in five areas of critical importance.
The first is supervisory enforcement. Again, the good news here is that the Single Supervisory Mechanism (SSM) that oversees the larger euro area banks, has issued guidance to banks on how to best address NPLs and establish ambitious targets for reduction. In addition, the SSM is forcing the sale of NPLs as part of the recapitalization plans for euro area banks, particularly in the context of precautionary recaps.
But in order to do this, of course, banks in general need to build buffers. Why? So they can take the hits to capital and remove and unload those loans. We have seen progress, particularly in the bigger banks that have been out there raising capital and planning to move NPLs off their books.
A third point is harmonizing corporate insolvency laws, which, as you know, are quite heterogeneous across the euro area. Fixing this problem is particularly important in Italy, Portugal, and Greece.
The fourth effort that has been in the news more recently is looking at blueprints to establish national asset management companies, which we think in some cases were useful for the success of Ireland, Spain, and so on. However, we need to be careful here, given the heterogeneous nature of the type of banks and bank loans that are much more complex, for example, in the case of Italy, where you have small loans fragmented to small and medium enterprises. It is important to note that in the case of Italy, about 70 percent of their NPLs are in the court system and, hence, the effort needed to strengthen extra judicial and judicial procedures.
Finally, the other effort that authorities and participants are looking at is the development of a secondary market for NPLs. This requires high‑quality information, data, legal documentation, along with efforts by the authorities to kick‑start these markets and get these nonperforming loans moving off bank balance sheets, which we think is of critical importance to restoring bank health.
Question ‑ The IMF has been warning about emerging market corporate debt for some time now and that threat has yet to materialize. Is it really a problem? Is it really a risk? Why? Is the global financial system exposed in any way?
Mr. Adrian ‑ Emerging market corporates have made progress in terms of making their economies more resilient, but vulnerabilities remain. In 2013, in the taper tantrum, we have seen how shocks to global interest rates can have negative spillover effects on emerging markets, and those risks are still present. The external vulnerabilities relative to financial conditions and trade linkages interact with domestic vulnerabilities in the banking sector and the corporate sector. So, while the external vulnerabilities have declined somewhat for emerging markets, we still see risks out there for emerging markets, and particularly for spillovers from advanced economies to emerging markets.
Question ‑ Mr. Adrian, can you advise us a little bit about your points in your first statement as regards the kind of policies that the United States would increase fiscal imbalances and which kind of protectionism policies could be harmful as well, especially because there are a lot of uncertainties especially coming from the United States Administration?
Mr. Adrian ‑ We are referring here to downside risk scenarios. The central scenario is that these adverse shocks do not occur, and our report focuses on downside risks away from the central scenario.
The central scenario is that in the U.S. there will be policies, such as corporate tax reform or infrastructure spending, which are going to lead to sustained growth and more economic momentum. The risks are that those policies are implemented in a way that increases fiscal imbalances and, thus, leads to a quicker‑than‑expected rise in interest rates.
The market is pricing in an increase in interest rates. The risk is that interest rates might rise even more quickly, and that could be triggered by fiscal imbalances and that would represent the downside risk.
Concerning inward‑looking policies, the Fund really is concerned about the rhetoric around the world. We do not have a particular country in mind. Around the world, there is a shift toward populism that is questioning the benefits of free trade and of global interlinkages. Of course, at the IMF, we believe that trade is crucial for global growth.
Question ‑ In the report, the IMF mentioned that the external triggers, such as protectionism in the advanced economies, could lead to a broader tightening of financial conditions in China. What would the IMF suggest on how China could prepare for this kind of shocks and do you think China has enough buffers to deal with them?
Mr. Jones ‑ We think the Chinese economy has sufficient buffers to weather any sort of change in global financial conditions. What we say in the report regarding China is that it is important to address some of the domestic challenges that they face. As Tobias mentioned, there is a rapid rate of credit growth. We think these challenges are very manageable, but there is an urgent need for action to ensure that they remain manageable by reducing the vulnerabilities associated with the rapid credit growth. So, we say in the report to strengthen the domestic financial system, for example, with supervisory attention on banks’ emerging risks, especially the sort of rapid asset growth in the small, unlisted local banks and their increased reliance on wholesale funding, and risks packaged into shadow products.
We think that staving off potential future episodes of a changing global environment or financial turmoil requires a shift in the focus of policies toward reducing those financial vulnerabilities and less focus on achieving a specific growth target. That will help to ensure the success of the rebalancing that is undergoing in China and to ensure financial stability and sustainable growth.
Question ‑ You mentioned in the report that with corporate tax reform in the United States, there will be a temptation by companies to use the windfall, so to speak, the increased cash flow or the big slug of cash that they are going to get from overseas repatriated profits, that they will use that for things other than the capital investments that the Trump Administration would like to see, that they would be channeled into financial investments, riskier operations, mergers, that sort of thing. What can be done to deter that? What kind of policies should be considered to avoid those kinds of things?
Mr. Hiebert ‑ What we have seen over the last years is that much of corporate expenditure has been in the form of this so‑called financial risk‑taking, the acquisition of financial assets, shareholder payouts and the like. What we have in the report is a quite detailed analysis to try and ascertain what changes in corporate tax policy might entail for the U.S. corporate sector.
What we find in terms of the repatriation is that a lot of the cash balances all over the world are quite significant—over $1 trillion. They reside with firms which are relatively cash‑abundant. But much of the investment that has been occurring over the last years is in firms which are relatively cash‑constrained, so energy, utilities and real estate, as Tobias mentioned in his opening remarks.
Our concern is what we have seen in terms of this financial risk‑taking over the last years and, more generally, back over 30 years or so, that is subject to large destabilizing swings on occasion.
In terms of policy recommendations which concern financial risk‑taking in the corporate sector, certainly we want authorities to be vigilant to such risk‑taking, not least given the high leverage and a weak set of firms which have more difficulty in terms of their debt servicing capabilities. But also, we do talk about elements of tax policy reform which could reduce the incentive to debt finance, alongside incentives to engage in financial risk‑taking; and rather suggest a focus on boosting economic risk‑taking in the form of capital expenditure, which ultimately would strengthen financial stability foundations.
Mr. Adrian ‑ So, getting the policy mix right with respect to corporate tax reform in the U.S. means that it will translate into more capital expenditure, more investment, which will, in turn, boost growth, and that should really be the focus of the corporate tax reform, as opposed to financial risk‑taking through payouts to shareholders, more leverage, and these trends that we have observed in recent years.
Question ‑ I need a figure. You say that adverse financial conditions or adverse trade measures could increase the debt at risk of the weakest firms by up to $230 billion. That would be an increase from which level?
Mr. Jones ‑ The current debt at risk is about $590 billion in terms of those firms that have weak debt‑servicing capacity.
Question ‑ You used the word “or.” You said “financial conditions or trade.” “Or” or “both”?
Mr. Jones ‑ We have two scenarios in the report, one that examines if there is a tightening of global financial conditions and risk premia, and that would lead to an increase in the debt at risk of about $135 billion, on the same base of about $590 billion. In a scenario of rising global protectionism, which has a bigger impact on global growth because it is a worldwide scenario, that has a larger increase in the debt at risk of about $230 billion.
Question ‑ I have a question on the role of the SSM [Single Supervisory Mechanism]. I wonder whether this report is really saying that the SSM should be a little bit more proactive in the way it handles nonperforming loans in Europe and, in particular, on two subjects. One is the question of hard deadlines given to banks to get rid of NPLs, whether you think this is something the SSM should be tougher about. The second question is over smaller banks. I wonder whether you are really saying that the SSM should encourage local supervisors to be more active in assessing their banks. I was also wondering whether you had an opinion on whether the SSM should bypass local national central banks when they are being reluctant to undertake some sort of comprehensive assessment of smaller banks.
Mr. Adrian ‑ We are starting an FSAP, a financial sector assessment of the euro area this year, where we will take a very close look at the functioning of the SSM. Of course, the SSM is a very welcome new mechanism in the European Union that is still relatively young, but we have seen already the benefits of the unification of the supervisory mechanism in the form of stress tests and concrete advice of the SSM in terms of how the NPL problem should be resolved.
Mr. Dattels ‑ If you look at the progress in terms of large banks versus small banks, it is the larger banks that have made more progress in addressing the NPL problem. In the context of bank consolidation, particularly of the smaller banks that is ongoing, and particularly in Italy, this is why we are also encouraging an Asset Quality Review for the smaller banks, to determine the extent of asset quality in those banks and ultimately the nonperforming loans. That is why the emphasis is on the AQRs and we think it is an important element for further clean-up of the banking system.
We do think that the SSM is in fact on the right track in terms of setting targets. A time limit is difficult, because it is a delicate balancing act in establishing appropriate targets. I think that it is important to encourage the sale and have the proper capital, but also you do not want to generate fire sales which essentially would reduce further the price of NPLs for sale. So, there are two things that are happening: structural reforms put in place to increase the value of NPLs, in addition to actions by the banks to encourage their sale.
Question ‑ I am also looking for a figure. Do you have any figure on profitability for small banks that is giving you concern? I think I read like an 8 percent return on assets in the report. Could you elaborate on why this is too low, if the figure is correct? My second question is, why so much against small banks? I mean, more competition could also be well for customers and they know their customers probably better. I do not understand the rationality of this completely.
Mr. Adrian ‑ Thanks so much for the question. The figure that we are using as a cutoff is a return on equity of 8 percent. What we document is that domestically‑focused banks in Europe have a low return on equity, which we define as return on equity below 8 percent. Roughly 75 percent of the domestically‑focused banks have this relatively low return on equity.
The 8 percent number is somewhat arbitrary. We could have chosen 6 or 7 percent, but the overall message would have been similar, which is that domestically‑focused banks in Europe tend to be more challenged in terms of profitability than global or European‑focused banks. Global and European‑focused banks generally have a higher return on equity.
Now, what is the value of those small banks? Of course, we fully agree with you that some of those small banks and domestically‑focused banks have a lot of information about the regional economic activity. They can make good lending decisions because of this information advantage relative to the larger players, and that is indeed very welcome. For example, in Germany, the Sparkassen adopted this business model.
But there are other domestically‑focused players that in the past have taken on excessive risks and that are now stuck with an overhang of NPLs. You have to look at the variety of business models across different countries and that is exactly what we do in the GFSR. We point out that, of course, different banks and different banking systems work very differently in different European countries, and we give a very nuanced picture of those banking systems.
Mr. Adriano ‑ Okay. I am sorry, we have to wrap up now because the room has to be re‑purposed for the next Press Briefing. Please come back shortly for the Fiscal Monitor presentation with Fiscal Affairs Director Vitor Gaspar and his team.
Thank you very much for coming. Thank you for those watching us on online. Have a good day. Also, a reminder that the Regional Press Briefings with our Area Department Directors are on Friday, and you may direct some of your questions to them. Thank you very much.
