Global Financial System Tested by Higher Inflation and Interest Rates
IMF Blog, April 11, 2023
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Bibliographic details
- Authors: Tobias Adrian
- Published: April 11, 2023
Overview and recent events
- Rapid monetary policy tightening after years of low rates is exposing fault lines in the global financial system.
- Failures cited: Silicon Valley Bank and Signature Bank in the United States—caused by the fleeing of uninsured depositors after realization that high interest rates led to large losses in these banks’ securities portfolios.
- Government-supported acquisition: Switzerland’s Credit Suisse by rival UBS triggered significant emergency responses by authorities and rocked market confidence.
- The IMF’s latest Global Financial Stability Report indicates increased risks to bank and nonbank financial intermediaries as interest rates have been rapidly raised to contain inflation.
How this episode differs from the 2008 crisis
- Post-2008 reforms: banks now hold more capital, more liquid assets, and are subject to stress tests; off balance sheet entities have been unwound; credit risks have been curbed by more stringent post-crisis regulations.
- Recent turmoil origin: the meeting of a steep and rapid rise in interest rates with fast-growing financial institutions that were unprepared for the rise.
- Historical analogue: current turmoil is more akin to the 1980s savings and loan crisis and the events leading up to the 1984 failure of Continental Illinois National Bank and Trust Co., which was then the largest in US history—characterized by less-capitalized institutions and unstable deposits.
Financial market implications and investor expectations
- Bank stocks have declined, raising the cost of funding for banks and possibly leading to curtailed lending.
- Overall financial conditions have not tightened meaningfully and remain looser than in October.
- Equity valuations remain stretched, notably in the United States.
- Modestly wider corporate credit spreads are largely offset by lower interest rates.
- Investors are pricing a fairly optimistic scenario: expect inflation to decline without much more increases in interest rates.
- Market participants see recession probabilities as high but expect the depth of the recession to be modest.
Risks and potential escalation scenarios
- An acceleration of inflation could trigger a reassessment by investors of the path of interest rates, possibly leading to an abrupt tightening in financial conditions and re-emergence of stresses.
- Trust erosion risks: funding could disappear rapidly for banks and nonbanks; fears could spread, amplified by social media and private chat groups.
- Nonbank financial firms are exposed to credit risk deterioration if the economy slows; some real estate funds have seen large declines in their asset valuations.
- Emerging market banks: so far little contagion in major emerging market economies, but many lenders hold assets with lower credit quality and some have less deposit insurance coverage.
- High sovereign debt vulnerabilities are pressuring many lower-rated emerging market and frontier economies, with potential spillover effects to their banking sectors.
Quantified downside risks
- Growth-at-risk metric indicates about a 1-in-20 chance that world output could contract by 1.3 percent over the next year.
- There is an equal probability that gross domestic product could shrink by 2.8 percent in a severe tightening of financial conditions in which corporate and sovereign spreads widen, stock prices fall, and currencies weaken in most emerging economies.
Policy recommendations and tools
- Policymakers must act resolutely to maintain trust.
- Address gaps in surveillance, supervision, and regulation immediately.
- Strengthen resolution regimes and deposit insurance programs in many countries.
- In acute crisis situations, central banks may need to expand funding support to both bank and nonbank institutions to maintain financial stability and allow monetary policy to focus on price stability.
- If financial sector distress has severe repercussions on the broader economy, policymakers may need to adjust the stance of monetary policy to support financial stability—but they should clearly communicate their continued resolve to bring inflation back to target as soon as possible once financial stress lessens.
—This blog is based on Chapter 1 of the April 2023 Global Financial Stability Report, “A Financial System Tested by Higher Inflation and Interest Rates.”