Rising Financial Stability Risks
Global financial stability risks have increased due to tightening conditions, trade uncertainty, and vulnerabilities in capital markets, institutions, and sovereign debt.
Global financial stability risks have grown significantly over the period of this Annual Report, largely because of tightening global financial conditions and heightened trade policy uncertainty.
IMF research has identified a number of key vulnerabilities in the financial system: the increasing concentration of capital markets and the possible overvaluation of assets, highly leveraged financial institutions and their nexus with banking systems; the risks of market turmoil and challenges to debt sustainability for highly indebted sovereigns.
The United States makes up nearly 55 percent of the global equity market, up from 30 percent two decades ago. Despite the recent market volatility, valuations of some assets remain stretched. If economic conditions worsen—especially amid persistent policy uncertainty and disappointing macroeconomic data—these valuations could undergo further sharp and sudden corrections.
Financial institutions—some highly leveraged—could be strained by volatile markets. Over recent years, hedge fund and asset management sectors have grown and have become increasingly leveraged. In addition, these institutions have become more enmeshed with the banking sector from which they borrow. This raises the possibility that weakly managed nonbank financial intermediaries could be pushed into a sell-off, potentially triggering wider market volatility, with implications for the broader financial system.
Further turbulence could also have the effect of raising sovereign risk premiums. This is a particular threat for countries where government debt levels are high, with limited fiscal space or foreign reserves. Strained sovereign debt levels could create cross-border shocks through trade and financial linkages.
The risk posed by sovereign debt is exacerbated by the interconnectedness of public sector finances and domestic banking systems; that is, the sovereign-bank nexus. This nexus poses significant macro-financial risks, particularly in emerging markets where currencies and equities have already weakened as a result of dimming growth prospects and in low-Income countries that are contending with the highest real borrowing costs in over a decade. These latter countries could also be hit hard because they would face greater difficulties refinancing debt and funding spending.
Authorities will need to implement proactive measures to reduce vulnerabilities and prepare for shocks. Such measures include ensuring market infrastructure resilience, supervising financial institutions prudently, and deploying emergency liquidity and crisis resolution tools. The aim should be to reduce vulnerabilities and enhance crisis preparedness.
Authorities must ensure that financial institutions can access central bank liquidity and stand ready to intervene in times of severe market stress, especially in core funding markets. Extending liquidity to nonbank, financial institutions with proper safeguards, may be necessary.
To manage geopolitical risks, financial institutions and regulators must employ scenario analysis and stress testing. Emerging markets and developing economies should strengthen financial markets and maintain fiscal buffers and reserves.
The stability of the financial system relies heavily on well-capitalized and liquid banks, especially given the increasing interconnection between nonbank and banking entities. Regulators should monitor risks arising from these links, and full implementation of Basel III and enhanced supervision are essential.
Stronger oversight of nonbank leverage, including better reporting requirements, is needed for systemic risk monitoring.
Financial crises can severely harm macroeconomic outcomes, and growing global financial interconnectedness means that stress originating in one jurisdiction can have a global impact. These risks highlight the crucial role of multilateral surveillance and the importance of a global financial safety net. The IMF fulfills both functions, and in so doing provides for swift and effective mitigation of financial risks.
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