Financial sector the Achilles’ Heel of global recovery

Progress to restore global financial stability has suffered a setback in advanced economies, the International Monetary Fund said in its latest Global Financial Stability Report, with markets still sensitive to negative surprises.

While the outlook in the Global Financial Stability Report is for continued recovery and a gradual improvement in financial stability, considerable risks remain. Rising public debt burdens, funding challenges for banks, and increased uncertainty about the next phase of the recovery have prevented a return of confidence.

José Viñals, Financial Counselor and Director of the IMF’s Monetary and Capital Markets Department, said the financial system remains the “Achilles’ heel of the recovery” because of unfinished repairs to bank balance sheets and the need for further regulatory reforms.

“As a result, financial markets remain sensitive to negative surprises, and can quickly shift back to crisis mode,” said Viñals.

Sovereign risks and financial fragilities

Coordinated government support programs and the announcement of ambitious fiscal reforms have helped contain the market turmoil that broke out in April and May this year. However, fiscal risks remain elevated, particularly in advanced economies where public sector balance sheets have significant weaknesses.

Public debt is still high and rising in many advanced economies, and more needs to be done to ensure sustainability;

High levels of debt refinancing and a reliance on a narrow investor base means greater funding risks;

The fiscal outlook is clouded by uncertainty about the outlook for growth;

Government guarantees of banks have heightened concerns about the transfer of risks to the public coffers in a number of countries.

If left unaddressed, these sovereign risks could spill over to banks through funding markets and a variety of other channels, the report said.

Banking challenges

Banks in different parts of the world face distinct problems. In the United States, weaknesses in real estate markets are an ongoing problem, while banks in some parts of Europe struggle with higher funding costs due to increased sovereign risks. Japanese banks suffer from low capital, weak profitability, and are increasingly exposed to Japanese government bond markets.

The report cuts its estimates of crisis-related write-downs of bad loans and securities that banks mostly in Europe, the United Kingdom, and the United States will have to take from $2.3 trillion in April to $2.2 trillion. Banks have already realized about three quarters of these projected write-downs.

The report notes that banking systems face several structural vulnerabilities, as a result of incomplete reforms and highly leveraged balance sheets.

Banks face major challenges on the liabilities side of their balance sheets, having made little progress in lengthening the maturity of their debt, or in reducing their reliance on wholesale funding. Banks must refinance over $4 trillion in debt in the next two years, at a time when governments are anticipated to issue significant quantities of debt. These factors expose banks to potential funding shocks. In some countries, there are unprofitable and weakly capitalized banks that remain reliant on government or central bank support.

Funding and capital constraints, if not addressed, could undermine the recovery in credit, as banks may be forced to shed assets and shrink their balance sheets. This could exacerbate deleveraging pressures, particularly across borders.

Emerging market economies

Risks in emerging economies have declined in the past six months, and countries have benefited from inflows of capital as investors seek out higher returns and better growth prospects, notably in Asia and Latin America. As advanced economies continue to struggle with high debt levels, emerging economies are expected to near pre-crisis low debt levels in the next few years.

The IMF said there is the potential for substantial asset reallocation to emerging markets from advanced economies, which could mean a surge in capital flows.

While countries have a number of different macro-prudential tools to deal with the risks associated with large capital inflows, the IMF said policies should focus on measures that improve the capacity of local markets to absorb the capital.

Policy reforms

As the global financial system remains vulnerable, the report said policymakers need to take action on a number of fronts for the recovery to continue. They include

Providing credible and detailed plans for countries to reduce government deficits and debt accumulation, including through the reform of entitlement programs, beginning next year.

Addressing banks’ legacy problems, such as bad assets and nonperforming loans, and fixing structural problems in the banking sector in order to protect governments from further risks associated with public support of the banking system.

Resolving weak banks to help reduce reliance on temporary liquidity support and strengthen the overall financial system. Raising more and higher quality capital by banks to provide a stronger buffer against future shocks.

Making the timing of planned withdrawal of some monetary and financial support more contingent on improved bank health.  Addressing the increased risk caused by institutions that are too-important-to-fail, as well as the subsidies granted to public or private sector institutions benefitting from lower borrowing costs at taxpayer expense.

Specifying the details of the new financial regulations. The new Basel reforms to strengthen bank capital and liquidity are a substantial improvement over the rules in place before the crisis, but these apply only to a subset of the financial system, and they don’t yet include systemic institutions and the impact of the business cycle on how financial institutions function.