{
  "title": "COVID-19 Worsens Pre-existing Financial Vulnerabilities",
  "publication": "IMF Blog, May 22, 2020",
  "sourceUrl": "https://www.imf.org/en/blogs/articles/2020/05/22/blog-gfsr-covid-19-worsens-pre-existing-financial-vulnerabilities",
  "canonical": "https://www.imf.org/en/blogs/articles/2020/05/22/blog-gfsr-covid-19-worsens-pre-existing-financial-vulnerabilities",
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  "summary": "The pandemic-triggered economic crisis is exposing and worsening financial vulnerabilities that accumulated during a decade of extremely low rates and volatility.",
  "sections": [
    {
      "heading": "Overview",
      "content": "- The pandemic-triggered economic crisis is exposing and worsening financial vulnerabilities that accumulated during a decade of extremely low rates and volatility.\n- 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.\n- 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.\n- \"Vulnerabilities in credit markets, emerging countries and banks could even cause a new financial crisis.\""
    },
    {
      "heading": "Risky corporate credit markets — key findings",
      "content": "- Risky segments of credit markets have expanded rapidly since the global financial crisis.\n- Potential fragilities identified: borrowers’ weaker credit quality, looser underwriting standards, liquidity risks at investment funds, and increased interconnectedness.\n- Offsetting factors noted:\n  - Investors’ use of borrowed funds to finance investments in these markets \"is less prevalent\".\n  - Banks \"are not as heavily exposed to leveraged loans and high-yield bonds as in the past.\"\n  - 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.\n- Recent market moves:\n  - \"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).\"\n  - 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).\n- Impact scenarios:\n  - 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.\"\n  - Losses at nonbank financial institutions \"could be more significant.\"\n  - Because nonbank lenders have taken a more prominent role, this could hurt credit provision and lead to a longer and more severe recession."
    },
    {
      "heading": "Risky corporate credit markets — policy recommendations",
      "content": "- Policymakers should act decisively to contain COVID-19’s fallout and support the flow of credit to firms.\n- 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.\n- Once the crisis is over, conduct a comprehensive assessment of the sources of market dislocations and underlying vulnerabilities the crisis unmasked.\n- Consider whether including nonbanks in the regulatory and supervisory perimeter is warranted, given their expanded role in risky credit markets.\n- Develop a framework for macroprudential regulation of nonbank institutions that accounts for the global nature of these markets and expand the macroprudential toolkit."
    },
    {
      "heading": "Managing volatile portfolio flows — key findings",
      "content": "- 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.\"\n- While outflows have since subsided, the swing underscores challenges in managing volatile portfolio flows and risks to financial stability.\n- 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.\n- Emerging and frontier markets \"have become more reliant on foreign portfolio flows since the global financial crisis.\"\n- Analysis findings:\n  - \"Both bond and equity flows are much more sensitive to global financial conditions during periods of extreme flows than in normal times.\"\n  - Domestic fundamentals (economic growth, external vulnerabilities, domestic financial market depth) matter incrementally more for equities and local-currency-denominated bond flows.\n  - Greater foreign investor participation in local currency bond markets that lack adequate depth can greatly increase the volatility of bond yields."
    },
    {
      "heading": "Managing volatile portfolio flows — policy recommendations",
      "content": "- Emerging markets should manage external pressures by allowing their exchange rate to depreciate.\n- If exchange-rate movements become disorderly, authorities should consider intervening in foreign exchange markets.\n- Temporary capital flow management measures may be necessary in the face of substantial outflows.\n- Sovereign debt managers should prepare for longer-term funding disruptions by putting contingency plans in place to deal with limited access to external financing."
    },
    {
      "heading": "Banking: low rates, low profits? — key findings",
      "content": "- Profitability has been a persistent challenge for banks in several advanced economies since the global financial crisis.\n- Extremely low interest rates have compressed banks’ net interest margins.\n- 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.\n- Healthy banks are crucial for financial stability; inability to generate profits may reduce lending and financial services to households and firms.\n- 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.\"\n- The COVID-19 outbreak is an additional test to banks’ resilience."
    },
    {
      "heading": "Banking: policy recommendations and supervisory actions",
      "content": "- 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.\n- Policymakers should rapidly find a balance that safeguards financial stability and institutions’ soundness while supporting economic activity.\n- Consider strategies to preserve and strengthen capital, including restricting dividend payouts and share buybacks.\n- Financial sector authorities should incorporate the potential impact of low interest rates in their decisions and risk assessments.\n- Supervisory capital planning and stress testing should include \"lower-for-longer\" scenarios and evaluate the strength of business models under such conditions.\n- Supervisors should remain vigilant and prevent any buildup of excessive risks that could reduce the banking sector’s resilience.\n\nIMF blog: COVID-19 Worsens Pre-existing Financial Vulnerabilities — Tobias Adrian, Fabio Natalucci, May 22, 2020\n\n---\n\n\n References\n\n- عربي\n- Français,\n- 日本語\n- ,\n- Português\n- Global Financial Stability Report\n\nSource: https://www.imf.org/en/blogs/articles/2020/05/22/blog-gfsr-covid-19-worsens-pre-existing-financial-vulnerabilities"
    }
  ],
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    "[Markdown version](/en/blogs/articles/2020/05/22/blog-gfsr-covid-19-worsens-pre-existing-financial-vulnerabilities/index.md)",
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    "Authors: Tobias Adrian, Fabio Natalucci",
    "Published: May 22, 2020",
    "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 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:",
    "Recent market moves:",
    "Impact scenarios:",
    "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.",
    "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:",
    "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.",
    "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.",
    "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.",
    "[عربي](https://www.imf.org/ar/News/Articles/2020/05/22/blog-gfsr-covid-19-worsens-pre-existing-financial-vulnerabilities)",
    "[Français,](https://www.imf.org/fr/News/Articles/2020/05/22/blog-gfsr-covid-19-worsens-pre-existing-financial-vulnerabilities)",
    "[日本語](https://www.imf.org/ja/News/Articles/2020/05/22/blog-gfsr-covid-19-worsens-pre-existing-financial-vulnerabilities)",
    "[,](https://www.imf.org/pt/News/Articles/2020/05/05/blog-fiscal-policies-for-the-recovery-from-covid-19)",
    "[Português](https://www.imf.org/pt/News/Articles/2020/05/22/blog-gfsr-covid-19-worsens-pre-existing-financial-vulnerabilities)",
    "[Global Financial Stability Report](https://www.imf.org/en/Publications/GFSR/Issues/2020/04/14/global-financial-stability-report-april-2020)"
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