By José Viñals

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This morning, I presented our latest views on global financial stability in Johannesburg, South Africa.

So, where does the global financial system stand at the moment? Yes, we have witnessed improvements recently, but we are also observing a dichotomy between the economy and the financial system. While the global economic recovery has been continuing, financial stability is still at risk, because of a persistent lack of investor confidence in some advanced country sovereigns and their banking systems.

At this cross-roads, we see three key messages.

  • First, more than three years after the onset of the financial crisis, global financial stability is still not assured.
  • Second, policymakers need to step up their efforts to tackle pressing policy challenges, such as sovereign risk, banking system vulnerabilities, and increased global capital flows.
  • Third, we need to press ahead with structural solutions to longstanding financial problems.

Financial stability challenges

I would like to elaborate further on the key challenges that keep global financial stability at risk.

First, in light of high public debt levels, market concerns about sovereign risk have persisted and have spilled over to a greater number of countries, mostly in the euro area. At the same time, we have seen an increasingly negative interaction—an adverse feedback—between banking and sovereign credit risks in some euro area countries. In other words, the fate of some banks is now increasingly intertwined with that of their sovereign—and vice versa.

Second, fragilities remain in key parts of several banking systems.

  • Markets are questioning the quality of many bank assets, reflecting concerns about banks’ exposure to countries facing sovereign pressures, and concerns about exposure to real estate loans.
  • Banks also face significant funding needs over the next two years. During that period, sovereigns will also need to refinance their debt, creating competition for limited funding resources.
  • Many banks still need to raise their capital levels. They also need to improve the quality of their capital to reassure investors and to meet the more stringent Basel III standards. The challenges facing banks—if left unresolved—would hinder the provision of credit to companies and households and would hurt the global economic recovery.

And third, there is the challenge of coping with the rapid rebound in capital inflows into emerging market economies. While capital flows are generally beneficial for recipient countries, rapid and strong inflows can fuel asset price bubbles and strain the absorptive capacity of local financial systems. Although we appear to be at the early stages of such a cycle, policymakers need to be vigilant about these risks.

Policy priorities

So, what policies should be put in place to meet these challenges?

In advanced countries, we need to deal with the legacy of the crisis by resolving financial fragilities—once and for all!

In Europe, policymakers need to break the adverse feedback loop between sovereigns and banks.

  • Sovereign risk should be contained through credible, medium-term fiscal consolidation strategies.
  • In addition, the financial system should be repaired through a comprehensive plan to reduce uncertainty about banks and help restore investor confidence. This plan should include the following elements: improved bank transparency; greater firepower for the European Financial Stability Facility (EFSF); a decisive pursuit of recapitalization and restructuring of banks; and better economic governance for the European Union.

In the United States,

  • Policymakers must put in place a credible strategy for medium-term fiscal consolidation to avoid a potential, sharp rise in long-term interest rates.
  • Increased efforts are also needed to address the effects of the still-damaged real estate markets on banks.

In emerging markets, policymakers must act now to avoid future crises. It is important to maintain the appropriate mix of macroeconomic and prudential financial policies to deal with the challenges posed by capital inflows. In addition, local capital markets will need to become deeper and more resilient, for example through improved market infrastructures.

There is also a need to ensure continued progress on the global financial policy agenda. Financial systems everywhere need to adapt to cope with regulatory reform. New regulations need to be adopted consistently across the world, including on systemically important financial institutions and the so-called “shadow” banking sector. Supervision and bank resolution regimes need to work more effectively within— and across—national borders to safeguard financial stability.

Time is of the essence in addressing immediate policy challenges—particularly in the euro area—and finding a better balance between macroeconomic and structural financial policies. Without these timely policy responses, global financial stability and sustainable growth will remain elusive.