Heat Wave: Rising Financial Risks in the United States

IMF Blog, October 10, 2014

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Publication: Serkan Arslanalp, David Jones, Sanjay Hazarika; October 10, 2014.
Six years after the start of the global financial crisis, low interest rates and other central bank policies in the United States remain critical to encourage economic risk-taking— increased consumption by households, and greater willingness to invest and hire by businesses.
Prolonged monetary ease may have encouraged excessive financial risk-taking even as economic benefits become more evident.

Persistently low global interest rates have prompted investors to search for higher returns in a wide range of markets, such as stocks, and investment-grade and high-yield bonds.
Consequences observed:
- Escalating asset prices.
- Issuers selling assets with a reduced degree of protection for investors.
- Combined trends of more expensive assets and weakening quality of issuance could pose risks to stability.
Heat map methodology:
- Tracks signs of financial risk taking from three angles: valuation, issuance trends, and redemption risks.
Key market signals:
- Financial risk taking in corporate debt markets is rising and markets have begun to overvalue many assets.
- Spreads in the high-yield and leveraged loan markets are not far from levels seen before the financial crisis.
- The quality of new loans issued is declining, especially in the leveraged loan market where the amount of leverage in new deals is rising.
- The number of “covenant-lite” deals which give lenders less control over issuers has increased; many new deals allow borrowers to issue more debt in the future without obtaining prior permission from lenders.

Mutual funds, exchange traded funds, and households hold about 30 percent of corporate bonds as of the end of June 2014.
Concern:
- Retail investor holdings could be subject to sudden selling if asset values deteriorate unexpectedly.
Historical example:
- High-yield corporate and emerging market bond markets saw large retail outflows in May and June 2013 during the “taper tantrum” episode.
- That event was relatively short-lived and did not involve institutional investors.
Risk scenario:
- A more severe episode of flight from risk by retail investors could lead to even greater financial volatility with wider systemic repercussions than were suffered during the 2013 event.

Officials have acknowledged some of these risks; U.S. Fed Chair Yellen noted some potential financial stability effects of sustained unconventional monetary policy in testimony to Congress in July.
Measures already taken:
- Some interventions to restrain excessive risk-taking in the leveraged loan market.
Recommended actions:
- Deploy macroprudential policies as the first line of defense against rising financial stability risks.
- Continue close assessment of the U.S. financial system and consider additional policies to keep the system safe.
Rationale:
- The U.S. banking system is now much more resilient, and economic risk taking by households and corporations is taking hold.
- For a smooth exit from crisis-era policies and a durable recovery globally, it is critical that officials continue to respond to rising financial stability risks.

IMF Blog post: Heat Wave: Rising Financial Risks in the United States (October 10, 2014).