IMF Sees Financial Risks Still Elevated

IMF Blog, April 20, 2010

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IMF Sees Financial Risks Still Elevated

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Bibliographic details

• Authors: JosVials
• Published: April 20, 2010

Overall assessment of global financial stability

• Risks to stability have eased somewhat.
• Policy stimulus enacted at the height of the crisis has provided substantial support to financial institutions and markets and has underpinned the global recovery.
• This support has helped to improve a broad range of risk indicators and financial conditions.
• Nonetheless, risks remain elevated: the recovery is still fragile, repair of consumer and financial balance sheets is still ongoing, and there are concerns over rising sovereign risks related to the buildup of public debt that need careful monitoring and addressing.

Challenges in the banking system

• Aggregate improvements:
  • Global writedowns estimate improved by around $500 billion from $2.8 trillion to $2.3 trillion.
  • Two-thirds of these estimated writedowns have been realized so far.
  • Bank capital ratios in Europe and the United States are stronger as banks have raised capital and enjoyed a temporary boost in earnings.
• Remaining and emerging vulnerabilities:
  • Pockets of weak banks with smaller capital buffers and high risks of further asset deterioration persist.
  • Some banks display chronically low profitability due to overcapacity in the financial system.
  • Banks face significant funding challenges amid a wall of maturing debt, including almost 5 trillion dollars coming due in the next 3 years.
• Implications for credit:
  • Recovery in credit is likely to be slow, shallow, and uneven.
  • Credit capacity will continue to be weak as capital markets only partially offset weak credit growth from banks.
  • Ballooning sovereign borrowing needs and low credit supply could potentially lead to higher interest rates or less credit availability for the private sector.

New risks: Rising sovereign credit risk

• Post-crisis developments:
  • Substantial increase in public debt and sharply higher sovereign risks are primary challenges flagged.
  • Attention has focused on Greece, but fiscal concerns are not confined to one country.
  • The average debt to GDP ratio of the major advanced economies is nearing its highest level since the second World War, without experiencing a world war.
• Transmission and market signals:
  • Credit spreads of sovereigns have already widened in some economies as longer-run fiscal solvency concerns have been telescoped into short-term funding strains.
  • Worries about default risk have risen and could undermine financial stability, especially if sovereign shocks are transmitted across borders or to banking systems.

New risks: Capital flows and bubbles

• Emerging market dynamics:
  • Recovery in portfolio flows after their sharp collapse during the height of the crisis is welcome.
  • For some countries, the volume of these flows may become “too much of a good thing.”
• Historical context and current assessment:
  • Historically, a combination of strong capital flows, asset price increases, and credit accumulation have led to serious financial imbalances.
  • Currently, systemwide excessive credit or asset valuations are not observed.
  • Some hot spots have emerged exhibiting elevated credit growth or asset prices.

Policy messages (four priorities)

• 1: Sovereign Risks
  • Careful management of sovereign risks is essential for sustainability of public finances and for financial stability.
  • Policymakers must develop and communicate credible plans for achieving medium-term fiscal sustainability.
  • Strengthen fiscal institutions and improve public debt management frameworks.
  • Implement measures to mitigate transmission of sovereign risks through financial channels.
  • Failure to take timely actions to reduce sovereign risks could extend the crisis into a new phase as limits of public sector support are reached.
• 2: Support credit growth and smooth deleveraging
  • Ensure a smooth deleveraging process that results in a safer, competitive, and vibrant financial system.
  • Rebuild capital buffers and secure stable funding for banks to provide adequate credit supply to support the recovery.
  • Resolve nonviable banks swiftly and restructure viable ones to ensure a healthy core of viable financial institutions remains after public support measures are removed.
  • Interim policies may be needed to sustain adequate flow of credit to the private sector, including support for safe securitization and a careful exit from extraordinary monetary and financial support measures.
• 3: Managing Capital Inflows
  • Policymakers in countries receiving strong capital flows should employ a wide range of tools to address the risk of rapid asset price increases and credit accumulation.
  • Macro-policy adjustments and prudential measures are the main lines of defense.
  • In some circumstances, temporary capital controls could be considered.
  • Effective policy responses must take a medium-term view to preserve benefits of globalization while ensuring lasting macroeconomic and financial stability in receiving countries.
• 4: Establish basis for a safer, competitive, and vibrant financial system
  • Continue pursuing policies and reforms to establish the basis for a safer, competitive, and vibrant financial system.
  • Regulatory initiatives underway aim to improve capital and liquidity buffers, enhance risk management, address procyclicality, reduce the likelihood and costs of failure of a systemic institution, and strengthen market infrastructures.
  • Important that these initiatives are agreed and then implemented in a timely, effective, and internationally consistent manner.

Financial stability at a crossroads (conclusion)

• Despite recent improvements in outlook and health of the global financial system, stability is not yet assured.
• If legacy issues from the present crisis and emerging sovereign risks are not addressed, there is a very real risk of undermining the recovery and extending the financial crisis into a new phase.
• This outcome can be avoided with appropriate policy actions to restore the health of sovereign balance sheets and financial institutions, accompanied by regulatory reforms to move to a safer and more resilient global financial system.

José Viñals, April 20, 2010

References

• Global Financial Stability Report