Avoiding Another Year of Living Dangerously: Time to Secure Financial Stability
IMF Blog, April 13, 2011
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Bibliographic details
- Authors: Jose-Vinals
- Published: April 13, 2011
Overview
- Author: José Viñals
- Date: April 13, 2011
- Core message: Durable financial stability remains elusive. Supportive policies that helped restart economies have masked underlying financial vulnerabilities that must be addressed promptly to avoid renewed instability.
Heeding the warning signs
- Broad assessment:
- Financial stability risks may have eased with a better economic outlook and accommodative policies, but these policies have also masked serious underlying vulnerabilities.
- Many advanced economies carry the legacy of high debt burdens that weigh on activity and balance sheets.
- Many emerging market countries face risks of overheating and financial imbalances amid rapid credit growth, rising asset prices, and strong and volatile capital inflows.
- Banking system concerns:
- Confidence in the banking system has yet to be fully restored, nearly four years since the start of the global financial crisis.
- Progress in strengthening capital positions and reducing leverage has been uneven.
- Considerable uncertainty exists about the quality of some bank assets, particularly exposures to higher-risk sovereigns and real estate in some countries.
- A weak tail of undercapitalized banks remains.
- Analysis of the sample of banks used in last year’s European stress tests (snapshot of end-2010 data) revealed that 30 per cent of these banks—representing a fifth of their total assets—have Core Tier 1 capital ratios of less than 8 percent, making them less able to withstand shocks and secure cost-effective funding.
- Sovereign balance sheet strains:
- Certain euro area countries are especially at risk due to market concerns about public debt sustainability, which have prompted a sharp increase in funding costs and restricted credit supply—creating an adverse feedback loop with the real economy.
- Sovereign funding challenges could extend beyond the euro area: both the United States and Japan are sensitive to higher funding burdens if interest rates increase substantially from current levels.
- Household indebtedness:
- Household indebtedness in the United States remains elevated.
- Elevated household debt could negatively affect bank balance sheets, credit availability, and house prices, acting as a drag on the global economic recovery.
- More structural policies may be needed, including principal write-downs on mortgages. The analysis shows that US banks are strong enough to withstand sizeable reductions in the principal of risky mortgages.
- Emerging market vulnerabilities:
- Policymakers need to guard against overheating and the buildup of financial imbalances.
- Indicators of incubation of financial imbalances include:
- Exceptionally strong bank credit growth in some countries, with experience showing a close connection between high credit growth and future increases in non-performing loans.
- Strong, and more volatile, capital inflows that are not yet excessive but have already tested the absorptive capacity of some emerging markets.
Putting danger behind us — policy roadmap
- For advanced economies:
- Deal with the legacy of the crisis effectively and immediately.
- Shift focus from policies that mainly addressed symptoms to measures that address underlying causes.
- Fully repair banking systems through increased transparency, higher capital buffers, and comprehensive restructuring and resolution of weak banks.
- Use forthcoming stress tests (e.g., by the European Banking Authority) as opportunities—ensuring tests are credible, stringent, and part of broader crisis-management strategies that include backstops against capital shortfalls.
- Strengthen sovereign balance sheets through medium-term budget deficit reduction combined with adequate multilateral backstops for crisis countries.
- Take decisive action to ensure the sustainability of public finances over the medium term (noting sensitivity of the United States and Japan to higher funding burdens if interest rates rise substantially).
- For emerging markets:
- Act preemptively to avoid overheating and future crises.
- Make more, and better, use of macroeconomic measures such as official rate hikes, more flexible exchange rates, and fiscal tightening.
- Deploy macroprudential policies and, in some cases, capital controls as supportive tools.
- International agenda:
- Press ahead with internationally consistent regulatory reforms—shared responsibility of advanced economies and emerging markets—to build a safer global financial system.
Risks and the path forward
- Real risks to implementation include complacency, fatigue, and reluctance to make hard policy choices.
- Action is needed now to deal with outstanding threats to global financial stability.
- Only through international cooperation can policy actions prove fully effective.
- Achieving durable financial stability will place the global economic recovery on firmer ground.
Source: IMF blog post "Avoiding Another Year of Living Dangerously: Time to Secure Financial Stability" by José Viñals, April 13, 2011.