Traders on the New York Stock Exchange: equity prices are rising and liquidity is declining in the United States (photo: Brendan McDermid/Reuters)
UNITED STATES FINANCIAL SECTOR
“U.S. officials have taken major strides to implement the post-crisis reform agenda and move towards a safer financial system, but this work is not yet complete,” said Aditya Narain, deputy director in the Monetary and Capital Markets Department who led the IMF team of experts conducting the review.
As the epicenter of the global financial crisis that began in 2008, the United States passed a major law in 2010, the Dodd-Frank Act, to reform its financial system. Officials need to complete the rulemaking under the law, while parts of reform agenda face legislative proposals to water them down.
Key fault lines that remain unaddressed include money market funds, securities lending, and the triparty repo markets—where securities dealers find short-term funding for their own and their clients’ assets—and housing finance.
At the same time, years of low interest rates have sent investors looking for higher returns on their investments, which lead to a build-up of risks, particularly in less regulated areas of the financial system.
Given its importance to global finance, the U.S. financial system is one of 29 that must undergo this kind of in-depth assessment every 5 years. The IMF’s last review of the U.S. financial sector was in 2010.
The IMF also released its annual check-up of the U.S. economy, known as an Article IV consultation. Despite a slowdown in growth during the first few months of 2015, the U.S. economy is strengthening and there are steady gains in job creation.
Key reforms
The IMF said the United States should strengthen its ability to keep the overall financial system safe, which includes:
• Collecting more comprehensive data to build a clear view of risks and connections in the financial system
• Creating an independent national regulator for the insurance industry
• Giving an explicit mandate to oversee financial stability to the agencies that regulate and supervise the financial system and that belong to the Financial Stability Oversight Council. The Council, under Treasury Secretary chairmanship, was created after the global crisis
• Adding tools to strengthen market resilience to run-risks and fire-sales
• Strengthening oversight of the asset management industry, including mutual funds
• Updating risk guidance for banks in operational, interest-rate and concentration risk
• Clarifying who is responsible to prepare for and manage financial system-wide crises.
Main risks
The IMF’s report identified a few key risks to look out for in the next three years:
• An increase in volatile financial markets—whether during the Fed’s planned increase in interest rates or stemming from a global economic shock—could slow economic growth and trigger investors to withdraw from mutual funds
• Low interest rates have led to a build-up in leverage—the use of borrowed money to invest—and are creating risks that impact insurance companies, mutual funds and other nonbanks
• Cyber attacks, natural disasters, or software and hardware failures could disrupt infrastructure and have a big impact on the financial system.
Stress tests reveal strengths, weaknesses
The IMF based its findings in part on stress tests conducted to assess the stability of the financial system. The IMF’s tests found that the banking system is resilient to severe shocks, similar in magnitude to the 2008 crisis.
The IMF staff’s analysis also suggests that insurance companies, hedge funds, and other managed funds contribute to overall financial risks in an amount larger than suggested by their size, and therefore deserve greater attention.
U.S. financial supervisors administer their own stress tests, and the IMF team has reviewed those tests. It concluded that supervisory solvency stress tests for banks are state-of-the art in many respects, but officials need to enhance stress tests of nonbanks, such as insurance companies, mutual funds, and pension funds. Improvements include undertaking both solvency and liquidity stress tests not only for banks but also for nonbanks; and examining spillover risks between nonbanks and banks.
The tests also found new risks emerging in insurance companies. The U.S. insurance sector is the largest in the world and accounts for a third of the global market. The IMF found that stresses may have a significant impact, especially in life insurance. Life insurers would suffer a substantial reduction of shareholder equity if a fully market-consistent valuation was applied. The IMF said U.S. officials should develop and perform insurance stress tests on a consolidated, group-level basis.
The IMF’s analysis also highlights the potential for financial market stress—notably the municipal bond and corporate bond markets—from heightened redemption pressures at mutual funds.
Reform agenda
The IMF also said the reform of Fannie Mae and Freddie Mac—the agencies that back roughly 80 percent of U.S. home mortgages—is one of the largest pieces of unfinished business in financial regulation. The agencies fall short of capital requirements, which is a financial risk to taxpayers.
The report acknowledges that the authorities made important steps to address the “too big to fail” issue in banks. However, they still need to put in place enhanced standards and resolution powers for systemically important nonbanks, and to ensure the work on developing “living wills” for systemically-important banks is completed.
Finally, financial inclusion should feature more prominently on the U.S. policy agenda, the IMF said. Despite its massive size, the U.S. financial system falls short in availability of and access to financial services to some households and small firms. The United States is 27th out of 147 countries in terms of the share of adults with a bank account, and some 20 percent of U.S. households are “underbanked.”
