The Danger Zone: Financial Stability Risks Soar

IMF Blog, September 21, 2011

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Publication: José Viñals, September 21, 2011.
Since the IMF's previous Global Financial Stability Report, financial stability risks have increased substantially—reversing some of the progress that had been made over the previous three years.
Recent shocks buffeting the global financial system:
- unequivocal signs of a broader global economic slowdown;
- fresh market turbulence in the euro area;
- the credit downgrade of the United States.

The crisis of confidence is driven by three main factors: weak growth, weak balance sheets, and weak politics.
Details:
- Weaker growth prospects and larger downside risks to growth have prompted investors to reassess the sustainability of the economic recovery—which appears increasingly fragile.
- The reduced pace of the economic recovery and incomplete policy actions have stalled progress in balance sheet repair, raising concerns about:
- government balance sheets in advanced economies;
- banks in Europe; and
- households in the United States.
- Weak politics: policymakers on both sides of the Atlantic have not yet commanded broad political support for the needed policy actions, and markets have begun to question their resolve.

Sovereign risks in Europe have spilled over to the region’s banking system, producing funding strains and depressed market capitalization for many banks operating in the euro area.
Quantified spillovers since the outbreak of the sovereign debt crisis in 2010:
- increase in credit risk coming from high-spread euro area sovereigns estimated at about €200 billion;
- if exposures to banks in high-spread euro area countries are included, the total estimated spillover increases to €300 billion.
Caveat: this analysis explains current market strains but does not measure banks’ capital needs, which would require a full assessment of bank balance sheets and income positions.
Risk dynamics:
- Increased market pressures may force banks to speed up deleveraging, curtail credit to the real economy, and thus worsen the economic drag.

Concerns about the longer-term sustainability of U.S. government debt could, if unaddressed, potentially reignite sovereign risks with serious domestic and global consequences.
U.S. households are still repairing their balance sheets—a process that has affected economic growth, house prices, and U.S. bank balance sheets.

Incomplete balance sheet repair in advanced economies, coupled with a prolonged period of low interest rates, can pose financial stability risks for both advanced and emerging markets.
Low policy rates are necessary to support economic activity and buy time to repair balance sheets. Risks arise if time is not well used:
- encouraging the buildup of excess pockets of leverage;
- diverting credit creation to the more opaque shadow banking system;
- pushing capital flows toward emerging markets.

Given the track record of rapid credit growth in many emerging markets—often in the context of strong capital inflows—policymakers need to avoid a further buildup of financial imbalances where credit growth remains elevated.
In addition to sound macroeconomic policies, macroprudential and capital flow measures can play a supportive role.
Analysis shows a potential global shock could lead to a reversal of capital flows and a drop in economic growth; the impact on emerging market banks could be substantial and warrants a further buildup of capital buffers in the banking system.

Switch focus from treating symptoms to dealing with underlying causes; act now, act boldly, and act in a globally coordinated manner.
Advanced economies:
- decisively and expeditiously resolve the crisis of confidence through swift and comprehensive balance sheet repair;
- bolster public balance sheets in the United States, Europe, and Japan through credible, medium-term fiscal consolidation strategies;
- consider a more ambitious program of mortgage modifications involving principal write-downs to address overstretched U.S. household balance sheets.
European Union banks:
- build adequate capital buffers; recognize heterogeneity—some banks may need little, others (especially those heavily reliant on wholesale funding and exposed to riskier public debt) may need more capital;
- tap private sources of capital first; where insufficient, injections of public funds may be necessary for viable banks;
- restructure or resolve weak banks.
Emerging economies:
- balance current risks to avoid future crises;
- use macroprudential and capital flow measures alongside sound macroeconomic policies;
- further build capital buffers in the banking system given potential shock scenarios.

The lack of sufficiently decisive policy action to address the legacy of the financial crisis has led to the present crisis of confidence and thrown the global economy "back into the danger zone."
While the path to sustained recovery has considerably narrowed, it has not disappeared; the right decisions taken now can restore global financial stability and sustain the recovery.

The Danger Zone: Financial Stability Risks Soar — José Viñals, September 21, 2011.

092111a
- 092111a (PDF)
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- 危険水域：高まる金融安定性リスク; ホセ・ビニャルス; iMFdirect ブログ 2011年9月21日掲載 (Markdown version)
- 危険水域：高まる金融安定性リスク; ホセ・ビニャルス; iMFdirect ブログ 2011年9月21日掲載 (PDF)
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