COVID-19 Worsens Pre-existing Financial Vulnerabilities
IMF Blog, May 22, 2020
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- Authors: Tobias Adrian, Fabio Natalucci
- Published: May 22, 2020
Overview
- The pandemic-triggered economic crisis is exposing and worsening financial vulnerabilities that accumulated during a decade of extremely low rates and volatility.
- Chapters 2-4 of the Global Financial Stability Report focus on three potential weak spots: risky segments in global credit markets, emerging markets, and banks.
- If the economic contraction lasts longer or is deeper than expected, tightening financial conditions may be amplified by these vulnerabilities, causing more instability or even a financial crisis.
- "Vulnerabilities in credit markets, emerging countries and banks could even cause a new financial crisis."
Risky corporate credit markets — key findings
- Risky segments of credit markets have expanded rapidly since the global financial crisis.
- Potential fragilities identified: borrowers’ weaker credit quality, looser underwriting standards, liquidity risks at investment funds, and increased interconnectedness.
- Offsetting factors noted:
- Investors’ use of borrowed funds to finance investments in these markets "is less prevalent".
- Banks "are not as heavily exposed to leveraged loans and high-yield bonds as in the past."
- Prevalence of long-term, locked-in capital in private debt and collateralized loan obligation markets has lessened the risk of investor runs in some segments.
- Recent market moves:
- "In only a couple of months through late March, prices in risky credit markets dropped by about two-thirds of the declines experienced during the entire global financial crisis (a portion of the losses were since reversed)."
- Interconnectedness across risky credit markets has likely contributed to market turbulence; broad-based demand for cash triggered selling pressures and mutual funds experienced large outflows (even though they have declined or reversed more recently).
- Impact scenarios:
- In a severely-adverse scenario, "overall bank losses in risky corporate credit markets should be manageable, although they could be substantial at a few large banks."
- Losses at nonbank financial institutions "could be more significant."
- Because nonbank lenders have taken a more prominent role, this could hurt credit provision and lead to a longer and more severe recession.
Risky corporate credit markets — policy recommendations
- Policymakers should act decisively to contain COVID-19’s fallout and support the flow of credit to firms.
- Regulators should encourage asset managers to be prudent and use all available liquidity management tools to address risks associated with mutual fund outflows and liquidity stresses.
- Once the crisis is over, conduct a comprehensive assessment of the sources of market dislocations and underlying vulnerabilities the crisis unmasked.
- Consider whether including nonbanks in the regulatory and supervisory perimeter is warranted, given their expanded role in risky credit markets.
- Develop a framework for macroprudential regulation of nonbank institutions that accounts for the global nature of these markets and expand the macroprudential toolkit.
Managing volatile portfolio flows — key findings
- Since the beginning of the pandemic, emerging markets saw capital outflows of over $100 billion, "nearly twice as big (relative to GDP) as those experienced during the Global Financial Crisis."
- While outflows have since subsided, the swing underscores challenges in managing volatile portfolio flows and risks to financial stability.
- Prolonged low interest rates encouraged both borrowers and creditors to take on more risk, leading to a surge of portfolio inflows into riskier asset markets and, in some cases, stretched valuations in emerging and frontier markets.
- Emerging and frontier markets "have become more reliant on foreign portfolio flows since the global financial crisis."
- Analysis findings:
- "Both bond and equity flows are much more sensitive to global financial conditions during periods of extreme flows than in normal times."
- Domestic fundamentals (economic growth, external vulnerabilities, domestic financial market depth) matter incrementally more for equities and local-currency-denominated bond flows.
- Greater foreign investor participation in local currency bond markets that lack adequate depth can greatly increase the volatility of bond yields.
Managing volatile portfolio flows — policy recommendations
- Emerging markets should manage external pressures by allowing their exchange rate to depreciate.
- If exchange-rate movements become disorderly, authorities should consider intervening in foreign exchange markets.
- Temporary capital flow management measures may be necessary in the face of substantial outflows.
- Sovereign debt managers should prepare for longer-term funding disruptions by putting contingency plans in place to deal with limited access to external financing.
Banking: low rates, low profits? — key findings
- Profitability has been a persistent challenge for banks in several advanced economies since the global financial crisis.
- Extremely low interest rates have compressed banks’ net interest margins.
- Beyond immediate COVID-19 challenges, a persistent period of low interest rates is likely to put further pressure on bank profitability in the coming years.
- Healthy banks are crucial for financial stability; inability to generate profits may reduce lending and financial services to households and firms.
- Simulation exercise result: "A simulation exercise conducted for a group of nine advanced economies indicates that a large fraction of their banks, by assets, may fail to generate profits above their cost of equity in 2025."
- The COVID-19 outbreak is an additional test to banks’ resilience.
Banking: policy recommendations and supervisory actions
- Once immediate crisis-related challenges recede, banks could pursue fee income increases or cost cutting to mitigate profit pressures, though fully allaying pressures may be challenging.
- Policymakers should rapidly find a balance that safeguards financial stability and institutions’ soundness while supporting economic activity.
- Consider strategies to preserve and strengthen capital, including restricting dividend payouts and share buybacks.
- Financial sector authorities should incorporate the potential impact of low interest rates in their decisions and risk assessments.
- Supervisory capital planning and stress testing should include "lower-for-longer" scenarios and evaluate the strength of business models under such conditions.
- Supervisors should remain vigilant and prevent any buildup of excessive risks that could reduce the banking sector’s resilience.
IMF blog: COVID-19 Worsens Pre-existing Financial Vulnerabilities — Tobias Adrian, Fabio Natalucci, May 22, 2020