The appropriate level of bank capital and, more generally, a bank’s capacity to absorb losses, has been a contentious subject of discussion since the financial crisis. Larger buffers give bankers “skin in the game” helping to prevent excessive risk taking and absorb losses during crises. But, some argue, they might increase the cost of financial intermediation and slow economic growth.
Many of the root causes of the euro area crisis still need to be addressed before the system is stabilized and returns to health. Until this is done, global financial stability is likely to remain well within the “danger zone,” where a misstep or failure to address underlying tensions could precipitate a global crisis with grave economic and financial consequences.
We are back in the danger zone. Since our previous report, financial stability risks have increased substantially—reversing some of the progress that had been made over the previous three years. Several shocks have recently buffeted the global financial system: unequivocal signs of a broader global economic slowdown; fresh market turbulence in the euro area; and the credit downgrade of the United States. This has thrown us into a crisis of confidence driven by three main factors: weak growth, weak balance sheets, and weak politics.
In various guises, the “Year of Living Dangerously” has been used to describe the global financial crisis, the policy response to the crisis, and its aftermath. But, we’ve slipped well beyond a year and the financial system is still flirting with danger. Financial stability risks may have eased, reflecting improvements in the economic outlook and continuing accommodative policies. But those supportive policies—while necessary to restart the economy—have also masked serious, underlying financial vulnerabilities that need to be addressed as quickly as possible. Many advanced economies are “living dangerously” because the legacy of high debt burdens is weighing on economic activity and balance sheets, keeping risks to financial stability elevated. At the same time, many emerging market countries risk overheating and the build-up of financial imbalances—in the context of rapid credit growth, increasing asset prices, and strong and volatile capital inflows. Here is our suggested roadmap for policymakers to address these vulnerabilities and risks, and achieve durable financial stability.