## Transitions to Financial Stability: A Bumpy Ride

_IMF Blog, October 9, 2013_

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**Canonical URL:** [Transitions to Financial Stability: A Bumpy Ride](https://www.imf.org/en/blogs/articles/2013/10/09/transitions-to-financial-stability-a-bumpy-ride)

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## Bibliographic details
- Authors: Jose-Vinals
- Published: October 9, 2013

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### Overview
- The global financial system faces several major transitions along the road to greater financial stability. These transitions are accompanied by substantial risks.
- Five transitions highlighted:
  - Transition in the United States from prolonged monetary accommodation towards a normalization of monetary conditions.
  - Emerging markets’ transition to more volatile external conditions and higher risk premiums.
  - Euro area movement to a stronger union and stronger financial systems, with close links between corporate and banking sectors.
  - Japan’s move towards the new policy regime of Abenomics.
  - Global transition to a safer financial system requiring completion of regulatory reforms.

### U.S. monetary transition and global impact
- Findings and risks:
  - The transition to monetary normalization in the United States will be unprecedented and complex.
  - Long-term interest rates could overshoot.
  - Since May, there has been a sharp rise in bond yields and volatility.
  - Lower market liquidity and over-extended allocations to bonds could amplify risks.
  - Higher interest rates may reveal weak links in the shadow banking system, exacerbating market and liquidity strains.
  - Example: mortgage real estate investment trusts are highly leveraged and susceptible to funding runs; forced asset sales could disrupt the mortgage-backed securities market and spread to broader asset markets.
- Policy recommendations:
  - A clear and well-timed communication strategy by the U.S. Federal Reserve to minimize interest rate volatility.
  - Effective execution aligned with economic developments.
  - Increased macro-prudential oversight and transparency in the shadow banking system to preserve financial stability and allow the Fed to focus on a smooth exit.

### Emerging markets
- Key facts and vulnerabilities:
  - Since the Lehman crisis, bond inflows into emerging markets have risen by more than one trillion dollars.
  - This inflow is well above its long-term trend by almost half a trillion dollars, boosting emerging market corporate borrowing to record levels.
  - Events since May point to new financial stability concerns.
  - Foreign investors play a bigger role in local debt markets.
  - Market liquidity has deteriorated in recent years, making local interest rates more sensitive to changes in investor sentiment.
  - Corporate balance sheets have weakened, financial vulnerabilities are rising, and economic growth is slowing.
  - These factors expose emerging markets to more severe market stress.
- Policy recommendations:
  - If significant capital outflows occur, take steps to ensure orderly market conditions and facilitate smooth portfolio adjustments.
  - Address domestic vulnerabilities and enhance policy credibility to keep emerging markets resilient.

### Euro area
- Findings on corporate debt and banks:
  - Policy actions have reduced funding pressures on weaker sovereigns and banks, but credit remains hampered by financial fragmentation.
  - A significant share of corporate debt in stressed economies is owed by companies with weak debt servicing capacity — termed a debt overhang.
  - Even if financial fragmentation were reversed, a persistent debt overhang would remain, amounting to almost one-fifth of the combined corporate debt of Italy, Portugal, and Spain.
  - The debt overhang affects banks through losses on corporate loans; some banks will need to increase provisioning against expected losses, potentially absorbing a large portion of future bank profits and, in some cases, capital.
- Policy recommendations and actions:
  - Address the corporate debt overhang comprehensively — options may include debt clean-ups, improvements to bankruptcy frameworks, or special asset management companies to restructure loans.
  - Conduct a thorough and transparent review of bank asset quality via planned balance sheet assessment and stress tests by European authorities.
  - Put credible backstops in place before the exercise is concluded to offset identified shortfalls if private funds are insufficient.
  - Bolster bank balance sheets in tandem with adequate progress towards banking union.

### Japan
- Findings and risks:
  - Japan is scaling-up monetary stimulus under the Abenomics framework while the U.S. is considering monetary normalization.
  - Policymakers in Japan need to ensure that the policy package is implemented completely.
  - A failure to enact the planned fiscal and structural reforms could reignite deflation and intensify financial stability risks.
- Policy recommendation:
  - Implement the full set of planned fiscal and structural reforms to reduce risks and support stability.

### Moving towards a safer financial system
- Findings:
  - Progress has been made on regulatory reform, but work remains.
  - Need to complete the regulatory reform agenda, consistently implement new rules across countries, and enhance supervision.
  - The system is not yet sufficiently safe; much work remains to be done.
- Overall assessment:
  - If the outlined policy challenges are properly managed, the transition towards greater financial stability should be successful and provide a more robust platform for economic growth.
  - Policymakers need to steer carefully to navigate the bumps in the road ahead to arrive safely at the destination.

*Source: Transitions to Financial Stability: A Bumpy Ride, José Viñals, October 9, 2013*

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_Source: https://www.imf.org/en/blogs/articles/2013/10/09/transitions-to-financial-stability-a-bumpy-ride_