Weak Spots in Global Financial System Could Amplify Shocks

IMF Blog, April 10, 2019

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Authors: Tobias Adrian, Fabio Natalucci
Date: April 10, 2019
Central message: Vulnerabilities across advanced and emerging market economies are rising and—if they continue to build amid still-easy financial conditions—could amplify shocks to the global economy and raise the odds of a severe economic downturn a few years down the road.
Short-term risks: "still low by historical standards" but "slightly higher" than in the October 2018 Global Financial Stability Report.
Medium-term risks: "remain elevated."

Purpose: Quantify vulnerabilities in the financial system so policymakers can monitor them in real time and take preventive steps.
Scope: Framework encompasses six sectors—corporates, households, governments, banks, insurance companies, and other financial institutions (including "shadow banks").
Metrics tracked: Level and pace of change in vulnerabilities, including leverage, maturity and liquidity mismatches of assets and liabilities, and currency exposures.
Coverage: Aggregates across 29 systemically important countries.

Advanced economies:
- Corporate debt and financial risk-taking have increased.
- Creditworthiness of borrowers has deteriorated.
- "The stock of bonds with BBB ratings has quadrupled, and the stock of speculative-grade credits has almost doubled in the United States and the euro area since the crisis."
- Concern about leveraged loans to highly indebted borrowers.
Euro area:
- Fiscal challenges in some countries could drive bond yields sharply higher, causing significant losses for banks with large holdings of government debt.
- Insurance companies could also face losses.
- This "sovereign-financial sector nexus" recalls dynamics from the euro crisis in 2011.
- Mitigants: banks have higher capital ratios today, and policymakers have taken steps to address nonperforming loans.
China:
- Declining bank profitability and "capital levels remain low at small and medium-size lenders."
- This constrains credit to smaller private firms.
- Further monetary and credit support may increase financial stability risks by making it harder for smaller banks to clean up balance sheets.
Emerging markets:
- Overseas portfolio investments increasingly run by managers who seek to match returns of popular indexes.
- "The value of fixed-income, benchmark-driven investments has quadrupled in the past ten years to $800 billion."
- Index-driven funds expand the investor base but increase vulnerability to sudden reversals of capital flows.

"The stock of bonds with BBB ratings has quadrupled."
"The stock of speculative-grade credits has almost doubled in the United States and the euro area since the crisis."
"The value of fixed-income, benchmark-driven investments has quadrupled in the past ten years to $800 billion."
Short-term assessment: "short-term risks to global financial stability are still low by historical standards, though they are slightly higher than we found in our October 2018 Global Financial Stability Report."
Medium-term assessment: "risks remain elevated."

Macroprudential measures:
- Use macroprudential tools to cool credit growth and strengthen system resilience.
- Example: countercyclical capital buffers requiring banks to increase capital when credit is growing.
Corporate-debt-heavy countries:
- Develop tools to limit the riskiness of credit to firms, especially credit from nonbank lenders.
Euro area:
- Lower the debt-to-GDP ratio among highly indebted governments.
- Further repair banks' balance sheets, including reducing non-performing loans.
China:
- Continue reducing leverage in the financial sector, especially in shadow banking.
- Ensure lenders build capital buffers.
- Promptly carry out announced reforms to address risks in investment products.
Emerging market economies:
- Limit reliance on short-term overseas debt.
- Ensure adequate foreign currency reserves and fiscal buffers.
- Use flexible exchange rates to absorb shocks.
Monetary policy stance:
- In some circumstances, countries with strong economies and inflation at or above target can consider using monetary policy to "lean against the wind."
- Trade-off highlighted: patient monetary policy can accommodate downside risks now, but if financial conditions remain easy for too long, vulnerabilities will continue to build and increase the odds of a sharp drop in economic growth later.

Vulnerabilities can amplify sudden shocks such as:
- Sharper-than-anticipated economic slowdown.
- Unexpected shift in monetary policy.
- Escalation of trade tensions.
Trade-off for policymakers:
- A patient approach to monetary policy may be warranted to counter slowing growth.
- But prolonged easy financial conditions risk building vulnerabilities that increase medium-term downside risks.
Overall assessment: With the right mix of policies, countries "can sustain growth while keeping vulnerabilities in check."

Source: Tobias Adrian and Fabio Natalucci, April 10, 2019