Risks to Financial Stability Increase, Bold Action Needed

By José Viñals

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Our latest update of the Global Financial Stability Report has three key messages.

First, financial stability risks have increased, because of escalating funding and market pressures and a weak growth outlook.

Second, the measures agreed at the recent European leaders’ summit provide significant steps to address the immediate crisis, but more is needed. Timely implementation and further progress on banking and fiscal unions must be a priority.

And third, time is running out. Now is the moment for strong political leadership, because tough decisions will need to be made to restore confidence and ensure lasting financial stability in both advanced and emerging economies. It is time for action.

Now, why have financial stability risks increased?

First, government bond yields in Southern Europe have sharply increased, while funding conditions for many European banks have deteriorated. The beneficial effects of the European Central Bank’s extraordinary long-term refinancing operations  have decreased in recent months, amid renewed policy uncertainty and growing concerns about the health of banks. This has led to a substantial flight to safe assets.

Second, financial fragmentation has exacerbated the adverse feedback loop between weak banks and governments, and threatens to undermine the currency union. Private capital outflows have continued to erode the foreign investor base for government debt in countries such as Italy and Spain. Governments have increased their reliance on domestic banks to finance their public debt. At the same time, these banks have increasingly turned to the European Central Bank to meet their liquidity needs as wholesale funding markets remain closed to them.

Third, sovereign and bank funding pressures have spilled over to the corporate sector in the periphery of the euro area. These companies have seen rising wholesale funding costs and a drop in bank lending. They are also facing a large amount of maturing bonds in the near term, which will likely exacerbate their funding squeeze.

Finally, growth prospects in other advanced economies and emerging markets are a bit weaker. This has left them somewhat more vulnerable to spillovers from the euro area. It also reduces their ability to address home-grown fiscal and financial vulnerabilities. Uncertainties about the fiscal outlook in the United States present a particular latent risk to global financial stability.

Policy priorities

Given these risks, increased efforts are needed now to prevent financial conditions from further deteriorating and adversely affecting growth.

In the euro area, the measures agreed at the recent European leaders’ summit are significant steps to address the immediate crisis. While their timely implementation is essential, further efforts are necessary to break—once and for all—the adverse feedback loop between weak banks and weak sovereigns. In particular, measures are needed to help the euro area to stabilize, integrate, and grow.

Stabilization requires bold policy actions right now. Policymakers should:

  • Strengthen the balance sheets of viable banks, where needed, through recapitalizations and restructurings. In some cases, this may involve direct equity injections from Europe’s rescue fund, the European Stability Mechanism.
  • Strengthen sovereign balance sheets by implementing well-timed fiscal consolidation strategies and by enacting sweeping structural reforms.
  • Maintain supportive monetary and liquidity policies.
  • Consideration should also be given to actions at the euro area level to stabilize funding conditions in sovereign debt markets, such as the reactivation of the European Central Bank’s Securities Markets Program.

Further integration requires progress toward a full-fledged banking union and deeper fiscal integration. The planned, unified supervisory framework is the first building block of a future banking union. More building blocks will be needed, including a pan-European deposit insurance guarantee scheme and bank resolution mechanism with common backstops.

The United States’ economy is also facing an important fiscal turning point. By early next year, the U.S. is expected to reach the current debt ceiling. Financial market consensus suggests that the ceiling will be raised in time to avert a default. But a significant adverse market reaction cannot be excluded, especially if there is political gridlock over raising the ceiling. Credible medium-term fiscal consolidation is needed to avoid further sovereign rating downgrades and to preserve an important global public good—the stability of the U.S Treasury market.

Emerging economies are facing a twin challenge: dealing with the impact from advanced economies’ troubles, while confronting increasing home-grown vulnerabilities.

  • Slowing global growth and spillovers from the euro area crisis have clearly had an impact on many emerging markets, as seen in the response of equity markets and capital flows.
  • Home-grown vulnerabilities include rapid bank asset and credit growth in recent years, which may eventually trigger a significant increase in non-performing loans. Moreover, slowing domestic growth could erode bank profitability and pose risks to financial stability in countries such as Brazil, China, and India.
  • In view of these challenges, emerging economies need to pay special attention to the health of their domestic financial systems. At the same time, they need to preserve and increase the room for policy maneuver to respond to potentially large domestic and external shocks.

Bold political actions are needed to address the balance sheet problems of banks and sovereigns. Monetary policy has bought valuable time and provided essential liquidity to financial systems, but political leaders need to make progress now. Concerns over the solvency of banks and governments, for example, cannot be addressed through liquidity measures alone.

Now is the time for bold and concrete actions in advanced economies to achieve sustained balance sheet repair and institutional reform. Tough decisions will need to be made to restore confidence and ensure lasting financial stability in both advanced and emerging economies.

3 Responses

  1. With respect to bank capitalization, perhaps what I would look for, as a bank investor, could help.

    The first thing I would want from the bank is that it dedicates itself exclusively to lending to what is officially considered as “risky”, like small business and entrepreneurs, and for which the bank is required to have capital, which of course means that I, as a shareholder, will count.

    In other words, I would abhor my bank to lend to anything that is officially considered as “absolutely safe”, for 4 reasons: a.it will probably mean they will be less careful; b. they can do so with much less bank capital and so therefore as a shareholder I become less important; c. it is only in what is considered as not risky that the banks can build up that type of exposures that can lead me to lose it all; and d. if I want to invest in something perceived as “absolutely not risky”, I certainly do not need a bank for that; we can all read the credit ratings.

    I assume of course you know about risk-adjusted rates of return.

  2. Balance sheet repair and institutional reforms, Both these efforts need tough decisions by the political leadership. Like increasing the tax base and reducing subsidies. Funding needs both for sovereigns and the private sectors be preferably met from the domestic sources in order to avoid spillover effects. The overall situation relating to both advanced and emerging economies is not encouraging. Spillover effects can adversely affect even those economies such as China, Brazil and India which are still in positive territory.

    As such, for having financial stability. structural reforms are urgently needed.

  3. Jose Viñals, you write “This has led to a substantial flight to safe assets”

    Of course, markets are nervous, but they have all the right to be so. Why should markets not be nervous when even the regulators, with their capital requirements for banks based on perceived risks, are basically ordering the banks to take refuge in what are still the officially considered a “safe assets”?

    You also suggest “Strengthen the balance sheets of viable banks, where needed, through recapitalizations and restructurings”.

    Right, but have you considered how much bank capital that would take, with current regulations, if those safe-havens which only require very little or no bank capital were to become endangered, because of their overpopulation? I tell you, if we trust solely that recapitalization-restructuring route, it will all be over before we get there!

    On July 10, Robert Jenkins, a member of the Financial Policy Committee of the Bank of England, admitted in a speech: “for avoidance of doubt, let me say it here and now: the regulatory establishment blew it!”

    And that is the precisely the starting boldness which is required from regulators, so that they dare to throw away the whole Basel stupidity, so as not to lose more time to defend or trying to build on something which has no defense, instead of finding the solutions the world so urgently need.

    IMF, please, be daring!

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