Global Financial Stability Update: The IMF (International Monetary Fund) said today in Johannesburg, South Africa, that nearly four years after the onset of the largest financial crisis since the Great Depression, global financial stability is still not assured and significant policy challenges remain to be addressed. Bank balance sheet restructuring is incomplete and proceeding slowly, and leverage is still high.
The Fund says the interaction between banking and sovereign credit risks in the Eurozone remains a critical factor, and policies are needed to tackle fiscal and banking sector vulnerabilities. At the global level, regulatory reforms are still required to put the financial sector on a sounder footing. At the same time, accommodative policies in advanced economies and relatively favorable fundamentals in some emerging market countries are spurring capital inflows. This means that policymakers in emerging market countries will need to watch diligently for signs of asset price bubbles and excessive credit.
The IMF says despite improvements in market conditions since the October 2010 GFSR (Global Financial Stability Report), sovereign risks within the Eurozone have on balance intensified and spilled over to more countries. Government bond spreads in some cases reached highs that were significantly above the levels seen during the turmoil last May. The economists say that pressures on Ireland were particularly severe and led to an EU-ECB-IMF program. Correlations between the average sovereign yields of Greece and Ireland and the yields of Portugal have remained high, but correlations have increased sharply in recent months with the yields of Spain, and to a lesser extent, Italy, as the tensions spread.
The Fund says most countries’ banking systems have reduced their vulnerabilities by increasing their Tier 1 capital ratios. However, improvements in the structure of funding have been more difficult to achieve. Moreover, some Eurozone banking systems are particularly vulnerable to deterioration in the credit quality of their sovereign debt holdings. Even for countries that look better positioned along both these dimensions, there are still risks. In the United States, nonperforming loans related to commercial and residential real estate continue to pose downside risks to banks’ balance sheets, and the government debt-to-GDP ratio remains high.
The update says the effective size of the Eurozone bailout fund, the European Financial Stability Facility, should be increased and it should have a more flexible mandate. For countries where the banking system represents a large proportion of the economy, it is now even more essential to ensure access to sufficient funds, going beyond national backstops whenever necessary.
The IMF says macroprudential policymaking, which aims to preserve the stability of the financial system as a whole, is still in its infancy in most countries, and there are concerns that systemic vulnerabilities may build up again before solid progress is made to prevent such a build-up.
Financial systems will need to adjust to the new reforms, including as the recovery takes hold and interest rates rise. This will be more challenging for those countries, such as Japan, that have had low interest rates and a build-up of debt over a long period of time.
The need for macroprudential policymaking is also very relevant for emerging market economies facing absorptive constraints on capital inflows. The Fund says these policies are complements, not substitutes, for traditional macroeconomic policies. So far, evidence of asset price bubbles and credit booms is still isolated to a few countries in a few sectors, but equity inflows and carry-trade activity are generally quite strong and these flows have to be watched carefully, particularly where leverage may be involved.
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