A Bridge to Economic Recovery: Be Aware of Financial Stability Risks

IMF Blog, October 13, 2020

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Canonical URL: A Bridge to Economic Recovery: Be Aware of Financial Stability Risks

Author: Tobias Adrian
Date: October 13, 2020
Context: Global economic crisis comparable only to the Great Depression; near-term financial stability risks have been contained by unprecedented monetary policy easing and massive fiscal support across the globe.
Main point: Extraordinary policy measures stabilized markets, boosted investor sentiment, and maintained the flow of credit, preventing a destructive feedback loop between a slowing economy and sliding financial markets. Pre-existing vulnerabilities have intensified and could become headwinds to the recovery.

Finding: A disconnect persists between financial markets (rising stock market valuations, despite recent repricing) and weak economic activity with an uncertain outlook.
Risks:
- If the economy recovers swiftly, the gap can narrow.
- If the recovery is delayed (for example, because it may take longer to get the virus under control), investor optimism may wane.
- As long as investors expect continued policy support, asset valuations may stay elevated; delayed recovery raises the risk of a sharp adjustment in asset prices or periodic bouts of volatility.

Finding: Policy measures enabled firms to cope with cash shortages by taking on more debt, avoiding an early wave of bankruptcies but increasing corporate debt burdens.
Concern: Many firms had very high levels of debt before the crisis; indebtedness in some sectors is reaching new highs.
Risk: Solvency risks may have been shifted into the future; renewed liquidity pressures could morph into insolvencies, especially if the recovery is delayed.

Finding: Banks entered the COVID-19 crisis with stronger capital and liquidity buffers than at the beginning of the Global Financial Crisis, allowing them to continue providing credit during the pandemic.
Risk: In an adverse macroeconomic scenario, some banking systems may suffer significant capital shortfalls because many firms and households will not be able to repay loans (even after accounting for currently deployed policy measures) and profitability could falter.

Finding: The scale of the pandemic crisis raised vulnerabilities across multiple sectors.
Dynamics:
- Governments ran larger fiscal deficits to support firms and households.
- Banks and other financial institutions purchased more government bonds.
- Nonbank financial institutions (asset managers and insurance companies) play an important role in credit markets, including riskier segments.
Risks: Fragilities—such as liquidity mismatches and exposure to credit risk—remain high in nonbank financial institutions; at some point these fragilities could spread through the entire financial system.
Constraint: Going forward, fiscal capacity to provide further support may become more limited.

Finding: Global easing of financial conditions generally improved the outlook for portfolio flows to most emerging markets and stabilized their access to financing.
Concern: Some low-income countries are so heavily indebted that they face imminent debt distress, because of borrowing costs at prohibitive levels.

Guiding principle: Policymakers should carefully sequence their response to build a safe bridge to recovery, balancing short-term support against medium-term macro‑financial stability risks and monitoring unintended consequences.
Near-term recommendations:
- Monetary policy should remain accommodative as economies reopen to sustain the recovery.
- Maintain liquidity support, while gradually adjusting its pricing to incentivize return to normal market funding.
- Implement a robust framework for debt restructuring to reduce debt overhangs and resolve nonviable firms.
- Extend multilateral support to low-income countries with financing difficulties.
Medium-term recommendations (after the pandemic is under control):
- Rebuild bank capital buffers.
- Strengthen the regulatory framework for nonbank financial institutions.
- Step up prudential supervision to contain excessive risk-taking in a “lower for longer” interest-rate environment.

Source: IMF blog post “A Bridge to Economic Recovery: Be Aware of Financial Stability Risks” by Tobias Adrian, October 13, 2020.