Geopolitics and Fragmentation Emerge as Serious Financial Stability Threats
IMF Blog, April 5, 2023
Source details
- Canonical URL
- Geopolitics and Fragmentation Emerge as Serious Financial Stability Threats
Other formats
Bibliographic details
- Authors: Mario Catalan, Fabio Natalucci, Mahvash S Qureshi, Tomohiro Tsuruga
- Published: April 5, 2023
Publication
- Authors: Mario Catalán, Fabio Natalucci, Mahvash S. Qureshi, Tomohiro Tsuruga
- Date: April 5, 2023
- Based on: Chapter 3 of the April 2023 Global Financial Stability Report, “Geopolitics and Financial Fragmentation: Implications for Macro-Financial Stability."
Key findings on fragmentation and financial stability
- Financial fragmentation affects cross-border investment, international payment systems, and asset prices.
- Fragmentation increases banks’ funding costs, lowers their profitability, and reduces their lending to the private sector.
- Financial and real-economy channels interact and amplify stress on the financial system.
- The overall effect is disproportionately larger for banks in emerging markets and developing economies, and for those with lower capitalization ratios.
- In the longer run, greater financial fragmentation could limit international risk diversification by reducing the number of countries in which domestic residents can invest.
Effects on cross-border investment
- Geopolitical tensions are measured by divergence in countries’ voting behavior in the United Nations General Assembly.
- An increase in tensions between an investing and a recipient country, such as between the United States and China since 2016, reduces overall bilateral cross-border allocation of portfolio investment and bank claims by about 15 percent.
- Investment funds are particularly sensitive to geopolitical tensions and tend to reduce cross-border allocations notably to countries with a diverging foreign policy outlook.
Financial stability risks (transmission channels)
- Financial channel:
- Imposition of financial restrictions, increased uncertainty, and cross-border credit and investment outflows can increase banks’ debt rollover risks and funding costs.
- These tensions could drive up interest rates on government bonds, reducing the values of banks’ assets and adding to their funding costs.
- Real-economy channel:
- Disruptions to supply chains and commodity markets can affect domestic growth and inflation, exacerbating banks’ market and credit losses and reducing profitability and capitalization.
- Reduced risk-taking capacity of banks may prompt them to cut lending, weighing further on economic growth.
- Interaction:
- The financial and real-economy channels are likely to feed off one another, amplifying stress on the system.
Policy recommendations and mitigation measures
- Supervisory and regulatory actions:
- Supervisors, regulators, and financial institutions should identify, quantify, manage, and mitigate risks stemming from geopolitical tensions.
- Improve understanding and monitoring of interactions between geopolitical risks and traditional risks (credit, interest rate, market, liquidity, operations).
- Adopt a systematic approach that employs stress testing and scenario analysis to assess and quantify transmission channels of geopolitical shocks to financial institutions.
- Resilience measures for externally financed economies:
- Ensure an adequate level of international reserves, as well as capital and liquidity buffers at financial institutions.
- Crisis preparedness and cross-border cooperation:
- Strengthen crisis preparedness and management frameworks to deal with potential financial instability from heightened geopolitical tensions.
- Continue cooperative arrangements between national authorities to ensure effective management and containment of international financial crises, including development of effective resolution mechanisms for financial institutions operating in multiple jurisdictions.
- Reinforce the global financial safety net:
- Reinforce through mutual assistance agreements between countries, including regional safety nets, currency swaps, or fiscal mechanisms—and precautionary credit lines from international financial institutions.
- Regulatory convergence:
- International regulatory and standard-setting bodies, such as the Financial Stability Board and the Basel Committee on Banking Supervision, should continue to promote common financial regulations and standards to prevent an increase in financial fragmentation.
- Caution on policy trade-offs:
- Policymakers should be aware that imposing financial restrictions for national security reasons could have unintended consequences for global macro-financial stability.
- Multilateral diplomacy:
- Given the significant risks to global macro-financial stability, multilateral efforts should be strengthened to reduce geopolitical tensions and economic and financial fragmentation.
Source: IMF Blog post “Geopolitics and Fragmentation Emerge as Serious Financial Stability Threats,” April 5, 2023.