Global Financial Stability: What’s Still To Be Done?

By José Viñals

(Versions in Español, عربي)

The quest for lasting financial stability is still fraught with risks. The latest Global Financial Stability Report has two key messages: policy actions have brought gains to global financial stability since our September report; but current policy efforts are not enough to achieve lasting stability, both in Europe and some other advanced economies, in particular the United States and Japan.

Much has been done

In recent months, important and unprecedented policy steps have been taken to quell the crisis in the euro area. At the national level, stronger policies are being put in place in Italy and Spain; a new agreement has been reached on Greece; and Ireland and Portugal are making good progress in implementing their respective programs. Importantly, the European Central Bank’s decisive actions have supported bank liquidity and eased funding strains, while banks are reinforcing their capital positions under the guidance of the European Banking Authority. Finally, steps have been taken to enhance economic governance, promote fiscal discipline, and buttress the “firewall” at the euro area level.

These actions and policies have brought much-needed relief to financial markets since the peak of the crisis late last year.

But it is too soon to say that we have exited the crisis, because lasting stability is not yet ensured. Indeed, we have been reminded in recent weeks that sentiment can quickly shift and rekindle sovereign financing stress, leaving many sovereigns and banking systems caught in a vicious circle.

Furthermore, pressures on European banks remain from high rollover requirements, weak growth, along with the need to strengthen balance sheets, including by shrinking. Some deleveraging is healthy—when banks increase capital, cut noncore activities, and reduce reliance on wholesale funding that results in more robust balance sheets.

But like Goldilocks, the amount, pace, and location of deleveraging must be just right at the aggregate level—not too large, too fast, or too concentrated in one region or country.

So far current policies have prevented a generalized “credit crunch”, but we still anticipate a considerable squeeze on credit which will impede growth. We estimate that large European Union-based banks could shrink their combined balance sheet by as much as $2.6 trillion—or about 7 percent of their total assets—by the end of 2013, with about a quarter of that shrinkage leading to a cutback in lending. Overall, we estimate that deleveraging by EU banks could reduce the supply of credit in the euro area by about 1.7 percent over two years.

However, if current policy commitments are not implemented and financial stresses intensify, the downside risk of a large-scale and synchronized deleveraging could do serious damage to asset prices, credit supply, and economic activity in Europe and beyond. In this scenario, we estimate that large EU banks could shed a total of $3.8 trillion, or 10 percent, of their total assets by the end of 2013. Such a retrenchment by EU banks could reduce euro area credit supply by 4.4 percent; and GDP could fall by 1.4 percent from the baseline after two years.

Outside the euro area, the region most affected by the deleveraging process is emerging Europe. And other emerging markets are unlikely to remain immune. While emerging markets generally have substantial policy buffers, such an external shock could combine with homegrown vulnerabilities and further undermine global stability.

Unaddressed fiscal challenges in the United States and Japan represent latent risks to global stability. Both countries have yet to forge a much-needed political consensus for medium-term deficit reductions. The United States is also grappling with high household debt burdens and an overhang of home foreclosures.

So how can we achieve lasting financial stability?

In the euro area, policy steps are needed along several dimensions:

  • To prevent the materialization of downside risks, continued adjustment efforts are needed at the national level, especially by countries currently under strain. Those reform efforts are being bolstered by a financing backstop that has recently been strengthened. This euro area “firewall” should also be able to take direct stakes in banks in order to help break the adverse feedback loop between sovereigns and banks.
  • To ensure an orderly process of bank deleveraging, close macroprudential oversight by European banking authorities of bank business plans is called for. And greater efforts are needed to restructure viable banks and resolve weak banks.
  • To strive for better and more balanced growth, accommodative monetary policies need to be combined with a sufficiently gradual withdrawal of fiscal support in countries not subject to market pressures, and with structural policies to lift potential growth rates.
  • To provide a vision of “more and better Europe”, a roadmap for a more integrated economic and monetary union should be laid out and committed to. This encompasses two key objectives: (i) a truly pan-European framework for bank supervision and resolution as well as deposit insurance; and (ii) greater ex-ante fiscal risk sharing, for example, through some central financing mechanisms. I am well aware that this will not be politically easy, nor immediately achievable. But a consensus needs to be forged now to help restore confidence.

Beyond Europe, it is essential to start addressing now the medium-term fiscal challenges in the United States and Japan. This should be accompanied by stronger efforts to address US household debt and accelerate housing market reforms.

Policymakers in emerging markets should not take stability for granted.  Given the risks in advanced economies, policy room may need to be used to cushion external shocks and volatile capital flows. Homegrown vulnerabilities, like those linked to persistently rapid credit growth, need to be addressed to increase resilience.

None of these policies are easy and some are politically difficult. But I believe they are within reach. Let’s not miss this opportunity. Policy makers and politicians must act now and in close collaboration to end this crisis once and for all—this time must be different.

2017-04-15T14:10:24-05:00April 18, 2012|


  1. George Naumovski April 19, 2012 at 1:12 am

    What’s still to be done? To learn from the mistakes of the past!

    What caused the global financial crisis (GFC)? Who caused the GFC? Why is this GFC still continuing? Why are the majority still feeding the business elites?

  2. Javed Mir April 20, 2012 at 5:55 am

    A comprehensive and constructive article by Jose Vinals. Succinctly speaking, for safer driving we should continuously develop the capability to change our directions and gears. Implementation of Rules and Regulations for fiscal consolidation should be timely and time-variant. In Economics there is nothing like cast in stone. George Naumovski is right when he says, ‘Learn from the mistakes of the past’. Crises of the past will not repeat if we learn not to repeat them.

  3. Per Kurowski April 20, 2012 at 2:48 pm

    Put that useless hypothesis of “banks took excessive risks” aside, and reread your chapter 3 on safe assets; using the hypothesis that the regulators, by means of their capital requirements for banks which were outlandishly biased in favor of what was perceived as” not-risky”, doomed our banks to dangerous obese excessive exposures to what is perceived as “not-risky”, like what has a triple-A or is an infallible “sovereign” and to anorexic exposures to the risky, like small businesses and entrepreneurs.

    Then just reflect on the fact that the best way of dangerously overpopulating a safe-haven, is to talk too much about how safe it is.

    Or do you really believe that bankers are out to get hold of risks? Have you not read about the Mark Twain bankers who lend the umbrella when the sun shines and take the umbrella back when it rains? Do you not understand that what our bank regulators did was just to make sure the bankers behaved as Mark Twain bankers, and this just caused our bankers to become too much of Mark Twain bankers, by overdosing on the ex-ante perceived risks?

    We need to correct these silly-wimpy-nanny bank regulations, urgently, fast, before we waste away the last of what little we have left of fiscal space, and also before the IMF wastes away any fresh resources it gets.

  4. Gisela Höfler April 21, 2012 at 3:44 pm

    Assistance to support ailing banks against the debt crisis should be provided directly using money from the rescue fund. But the funding is not being made available for this purpose at all.

    This sounds like a logical short cut: up to now assistance must be paid out only to countries, which pass it on to financial institutions. This proposal is not about more efficient assistance. It is rather an attempt to fundamentally change the architecture of the rescue fund.
    The European Financial Stability Facility (EFSF) and its successor the ESM are prepared to support countries in difficulty in order to avert a threat to the currency community as a whole. The support funding is not intended to transfer the costly and unpopular bank bailout to the European level.

    The motives of the countries in crisis are obvious: if they can get help for their ailing banks from the rescue fund, they do not incur any direct increase in debt. Furthermore, they can avoid the specter of stringent reform measures if they slip under the protection umbrella as a country. This is an attempt to drastically lower the hurdles for aid requests.

    In addition, there is always the danger with rescue measures for countries that solidarity will be exploited. With unconditional assistance for banks this risk would be multiplied many times. Should this plan be put in place, it would further erode the legitimacy of the rescue vehicle in the countries that are carrying the major burden, where it is already unpopular. Which would be a pity for all concerned.

  5. Gisela Höfler April 30, 2012 at 6:40 am

    Why financial crises are getting worse

    The procyclical behavior of the financial sector must be changed. But not much has been done to date in this regard. On the contrary, the future risk regulations for insurers – known as Solvency II – operate if anything even more procyclically. For in this case as well, simple capital regulations are being replaced with individual risk models.

    In fact these kinds of automatic destabilizers should at a minimum be subject to improved oversight. This falls into the category of macroprudential oversight – meaning that major trends in the whole system, not only individual banks, must be kept under surveillance,. The European Systemic Risk Board, about which little has been heard to date, is responsible for such higher-level oversight.

    Also disastrous is the fact that government securities were valued at market prices for stress test purposes, thereby intensifying the procyclical nature of the system.

    One possibility for stabilization would be to at least adjust Basel III, Solvency II, and the balancing of market values in such a way as to keep fluctuations within certain limits.

    In this way, complicated risk and valuation models could be accompanied by a couple of old-fashioned rules of thumb to set upper and lower limits. The leverage ratio planned under Basel III, which calls for banks to hold capital of at least three percent independently of any risk weighting, is a start in this direction – but is not sufficient in itself.

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