Global Financial Stability: What’s Still To Be Done?

IMF Blog, April 18, 2012

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Policy actions have brought gains to global financial stability since the September report.
Current policy efforts are not enough to achieve lasting stability, both in Europe and some other advanced economies, in particular the United States and Japan.
Sentiment can quickly shift and rekindle sovereign financing stress, leaving sovereigns and banking systems in a vicious circle.

Important and unprecedented policy steps have been taken to quell the crisis in the euro area.
National-level measures: stronger policies in Italy and Spain; a new agreement on Greece; Ireland and Portugal progressing on their programs.
European-level measures: the European Central Bank’s decisive actions have supported bank liquidity and eased funding strains.
Bank-level measures: banks are reinforcing capital positions under the guidance of the European Banking Authority.
Governance measures: steps have been taken to enhance economic governance, promote fiscal discipline, and buttress the “firewall” at the euro area level.
These actions have brought much-needed relief to financial markets since the peak of the crisis late last year, but lasting stability is not yet ensured.

Current expectation:
- Large European Union-based banks could shrink their combined balance sheet by as much as $2.6 trillion—or about 7 percent of their total assets—by the end of 2013.
- About a quarter of that shrinkage would lead to a cutback in lending.
- Deleveraging by EU banks could reduce the supply of credit in the euro area by about 1.7 percent over two years.
Downside (if commitments not implemented and stresses intensify):
- Large EU banks could shed a total of $3.8 trillion, or 10 percent, of their total assets by the end of 2013.
- Such retrenchment could reduce euro area credit supply by 4.4 percent.
- GDP could fall by 1.4 percent from the baseline after two years.
Regional exposure:
- Emerging Europe is the region most affected by the deleveraging process.
- Other emerging markets are unlikely to remain immune; external shock could combine with homegrown vulnerabilities.

Unaddressed fiscal challenges in the United States and Japan represent latent risks to global stability.
Both countries have yet to forge a much-needed political consensus for medium-term deficit reductions.
The United States faces high household debt burdens and an overhang of home foreclosures.

Continued adjustment efforts at the national level, especially by countries currently under strain.
The euro area “firewall” should be able to take direct stakes in banks to help break the adverse feedback loop between sovereigns and banks.
Close macroprudential oversight by European banking authorities of bank business plans to ensure an orderly process of bank deleveraging.
Greater efforts to restructure viable banks and resolve weak banks.
Combine accommodative monetary policies with a sufficiently gradual withdrawal of fiscal support in countries not subject to market pressures, and implement structural policies to lift potential growth rates.
Lay out and commit to a roadmap for a more integrated economic and monetary union with two key objectives:
- (i) a truly pan-European framework for bank supervision and resolution as well as deposit insurance; and
- (ii) greater ex-ante fiscal risk sharing, for example, through some central financing mechanisms.

Start addressing medium-term fiscal challenges now.
Forge political consensus for medium-term deficit reductions.
For the United States: stronger efforts to address household debt and accelerate housing market reforms.

Do not take stability for granted; use policy room to cushion external shocks and volatile capital flows.
Address homegrown vulnerabilities, such as persistently rapid credit growth, to increase resilience.

None of the recommended policies are easy and some are politically difficult, but they are within reach.
Policymakers and politicians must act now and in close collaboration to end this crisis once and for all—this time must be different.

José Viñals, April 18, 2012