By José Viñals
Let me begin with our overall assessment of global financial stability. The IMF has just released its new Global Financial Stability Report. We find that risks to stability have eased somewhat. The policy stimulus enacted at the height of the crisis has provided substantial support to financial institutions and markets, and has underpinned the global recovery. This has helped to improve a broad range of risk indicators and financial conditions.
And yet risks remain elevated: global financial stability has not been secured, as the recovery is still fragile, and the repair of consumer and financial balance sheets is still ongoing. Furthermore, there are concerns over rising sovereign risks related to the buildup of public debt that need to be carefully monitored and addressed.
Challenges in the banking system
On the banking system, the news is encouraging, as improving economic and financial market conditions reduce expected writedowns. Our estimate of global writedowns for banks has improved by around $500 billion from $2.8 trillion to $2.3 trillion. Two-thirds of these estimated writedowns have been realized so far. Additionally, bank capital ratios in Europe and the United States are stronger, as banks have raised capital and enjoyed a temporary boost in earnings.
However, this improvement in the aggregate picture masks pockets of weak banks with smaller capital buffers, with high risks of further asset deterioration, and that display chronically low profitability due to overcapacity in the financial system. Moreover, banks around the world now face significant funding challenges amid a wall of maturing debt, including almost 5 trillion dollars coming due in the next 3 years.
As a result of these on-going pressures in banking systems, the recovery in credit is likely to be slow, shallow, and uneven. Credit capacity will continue to be weak as capital markets only partially offset weak credit growth from banks. Moreover, ballooning sovereign borrowing needs and low credit supply could potentially lead to higher interest rates or less credit availability for the private sector.
New risks: Rising sovereign credit risk
Turning to the issue of sovereign risks. Following the crisis, the substantial increase in public debt and sharply higher sovereign risks are the most important challenges we flag in our report. Although much attention has been paid to Greece in this regard, fiscal concerns are not confined to one country. In particular, the average debt to GDP ratio of the major advanced economies is nearing its highest level since the second World War, without experiencing a world war.
Indeed, the credit spreads of sovereigns have already widened in some economies as longer-run fiscal solvency concerns have been telescoped into short-term funding strains. Worries about default risk have risen and could undermine financial stability, especially if sovereign shocks are transmitted across borders or to banking systems.
New risks: Capital flows and bubbles
Lets now talk about emerging markets and the challenges associated with strong portfolio capital inflows into these economies. Clearly, the recovery in portfolio flows after their sharp collapse during the height of crisis is a welcome development, but for some countries there is the risk that the volume of these flows may become “too much of a good thing.”
Historically, a combination of strong capital flows, asset price increases, and credit accumulation have led to serious financial imbalances. Currently, we do not observe excessive credit or asset valuations systemwide. However, some hot spots have emerged, exhibiting elevated credit growth or asset prices.
So what are the IMF’s key policy messages? We have four.
1: Sovereign Risks
The first is that careful management of sovereign risks is essential not only for the sustainability of public finances, but also for financial stability. Policymakers must develop and communicate credible plans for achieving medium-term fiscal sustainability, combined with stronger fiscal institutions and improved public debt management frameworks, as well as other measures to mitigate the transmission of sovereign risks through financial channels.
Failure to take timely actions to reduce sovereign risks could extend the crisis into a new phase, as we begin to reach the limits of public sector support for the financial system and the economy.
2: Support credit growth and smooth deleveraging
The second policy priority is to ensure a smooth deleveraging process that results in a safer, competitive, and vibrant financial system. Rebuilding capital buffers and securing stable funding for banks are necessary to provide adequate credit supply to support the recovery. Nonviable banks should be resolved swiftly and viable ones restructured, to ensure that once public support measures are removed, a healthy core of viable financial institutions remains. In the interim, policies may still be needed to sustain an adequate flow of credit to the private sector, including support for safe securitization and a careful exit from extraordinary monetary and financial support measures.
3: Managing Capital Inflows
Our third policy message relates to capital inflows. Policymakers in countries receiving strong capital flows will need to employ a wide range of tools to address the risk of rapid asset price increases and credit accumulation. Macro-policy adjustments and prudential measures are the main lines of defense. In some circumstances, temporary capital controls could also be considered. However, in all cases, an effective policy response must take a medium-term view to preserve the benefits of globalization, while ensuring lasting macroeconomic and financial stability in receiving countries.
4: Establish Basis for a Safer, Competitive, and Vital Financial System
Our last, but by no means least policy message is that we need to continue pushing for policies and reforms that establish the basis for a safer, competitive, and vibrant financial system. On the regulatory front, there are a host of initiatives underway to improve capital and liquidity buffers, to enhance risk management, to address procyclicality, to reduce the likelihood and costs of the failure of a systemic institution, and to strengthen market infrastructures. What is important now is that these initiatives are agreed and then implemented in a timely, effective, and internationally consistent manner.
Financial stability at a crossroads
In conclusion, in spite of recent improvements in the outlook and the health of the global financial system, stability is not yet assured. If the legacy of the present crisis and emerging sovereign risks are not addressed, we run the very real risk of undermining the recovery and extending the financial crisis into a new phase.
We can avoid this outcome with appropriate policy actions to restore the health of sovereign balance sheets and financial institutions. This must be accompanied by the regulatory reforms needed to move to a safer and more resilient global financial system.