Sovereign strains also spilled into the euro zone banking
system as some funding channels closed, and interbank
spreads widened. Banks’ access to term funding was sharply
curtailed and even short-term markets came under strain as
lending tenors were reduced from months and weeks to days.
U.S. money market funds dramatically scaled back credit to
euro area banks (Figure 2).
This prompted many of those banks to sell U.S. dollar
assets. In many markets, the cost of funding now exceeds
that during the Lehman crisis. Funding strains are beginning
to spill over into the broader economy with tighter
conditions for accessing bank credit for small and
mediumsized enterprises and households as banks' ability to
fund assets diminishes, leading to rising credit risk
(Figure 3).1
The potential impacts of funding strains are already
evident. A number of banks have announced significant
balance sheet deleveraging plans. These plans include
shedding assets in the euro area, the United States, and
other developed markets, as well as in the emerging
economies. The execution of some of these plans by affected
banks could impact a wide range of economic activities, from
trade and project finance, to cross-border arbitrage.
European policymakers have taken significant
steps to contain the crisis . . .
EU summit meetings in October and December led to
agreements on important steps to stabilize market conditions
and restore confidence. The EU will work toward stronger
joint economic governance, and growth-enhancing structural
policies will be given greater weight. Banks are to be
strengthened with new capital and funding support. The Greek
debt overhang is to be addressed through a voluntary debt
exchange with private creditors. The European Financial
Stability Facility (EFSF) is to be enhanced to help banks
and finance national adjustment programs, and the starting
date for the European Stability Mechanism (ESM) is to be
brought forward to July 2012.
. . . while the outlook for sovereign risk in
some larger economies has worsened.
Negative sovereign ratings actions have spread beyond
Greece, Ireland, and Portugal further into other euro area
countries (Figure 3). This reflects concerns that it will be
difficult to reach the political consensus necessary for
fiscal consolidation and structural reforms. Market concerns
are also rising about the fiscal path in the United States,
given little evident progress in breaking the political
stalemate over how to carry out needed fiscal consolidation.
In the near term, markets have focused on a potential
failure to raise the debt ceiling, which the U.S.
authorities have estimated will become binding at the
beginning of August, absent action. The risk of a temporary
default has pushed U.S. short-term CDS spreads above those
of some countries rated below the United States’s AAA
rating. Even that rating has come under question following
S&P’s issuance of a negative outlook in April. In Japan,
ratings agencies have downgraded the sovereign outlook on
concerns about the government’s ability to achieve deficit
reduction.
National governments have recently taken important steps
to improve macro-financial stability. Following changes in
government, Italy and Spain both announced measures to cut
structural budget deficits, improve debt-to-GDP ratios over
the medium term, and address longstanding structural
rigidities in order to enhance growth prospects.
With private funding markets for euro area banks under
severe strain, including due to a lack of eligible
collateral to conduct repo operations, the ECB took
extraordinary steps to stabilize funding conditions.
Measures included cutting reserve requirements, broadening
eligible collateral, and offering 3-year longer-term
refinancing operations (LTROs) to mitigate the effects of
funding stress on credit provision to the private sector,
and provide an alternative to forced fire sales of assets.
To alleviate dollar funding strains, the U.S. Federal
Reserve and five other central banks reduced the cost of the
existing dollar swap lines. While market functioning remains
far from normal, several of these measures – most notably
the 3-year LTRO – have had positive effects on market
sentiment and funding conditions.
. . . but stability risks remain elevated as
sovereign financing will be challenging and backstops are
not yet adequate . . .
Restoring sovereign access to funding at sustainable
yields is a key challenge as many remain vulnerable to
shifts in market sentiment. However, regaining market
confidence is likely to take time, during which domestic
reform may need to be supplemented by short-term external
support for primary or secondary markets, if available
support from private markets is insufficient. While the
3-year LTRO did much to alleviate bank funding concerns,
thus far it has had less of an impact on peripheral
sovereign yields, which, while declining at the short end of
the yield curve, were little changed at the long end.
The EFSF can now operate in primary and secondary public
debt markets, but its capacity remains limited. Taking into
account resources already committed to program financing, it
only has about €300 billion available to deploy. While some
proposals to leverage the EFSF have merit, even with a
plausible amount of leverage the total amount of firepower
available would still likely not be sufficient to contain
rising sovereign spreads under stress scenarios. Moreover,
the recent widening in EFSF spreads (Figure 4) and S&P’s
decision to downgrade the facility’s AAA rating in
mid-January suggest that even the current funding model for
the facility may be under pressure.
. . . and deleveraging by banks may ignite an
adverse feedback loop to euro area economies . . .
Pressures on European banks have recently escalated,
reflecting the increase in sovereign stress and the closure
of many private funding channels. To insulate banks from
such negative shocks, global steps toward a safer financial
system are essential. In this regard, the European Banking
Authority (EBA) has initiated a process calling for banks to
reach higher capital ratios.2
It judged €85 billion in additional capital to be necessary
(excluding €30 billion already programmed for Greece) to
reach a 9 percent core Tier 1 ratio and provide an adequate
sovereign capital buffer (Figure 5).
There remains the potential for an adverse feedback loop
between credit markets and the real economy in the euro area
and beyond, as outlined in the downside scenario described
in the
January 2012 World Economic Outlook Update. The ECB’s
recent actions likely forestalled an imminent crisis as
substantial debt maturities need to be rolled over this year
by euro area banks, with large amounts due in the first
quarter. But even with this funding and a subsequent LTRO to
be conducted in February, deleveraging could still be
substantial.
While some deleveraging may be unavoidable, the way it is
done makes a difference—there is "good" and "bad"
deleveraging. Some types of balance sheet deleveraging do
not necessarily represent a reduction in credit to the real
economy. For example, some banks (especially in Germany,
Ireland, and the United Kingdom) are seeking to reduce
balance sheets by shedding some assets that remain on
balance sheets as a legacy of the original leg of the credit
crisis. In other cases, banks may sell non-core businesses
(e.g., asset management arms, insurance business, or
overseas operations) or even loan portfolios. In cases where
this results in a transfer of assets to strong hands, it
would not reduce credit to the economy, although asset sales
can cause declines in asset prices whose adverse impact goes
far beyond the sellers, further pressuring capital. However,
provision of credit to the real economy is most affected
when banks decide to let credit lines and loans run off and
curtail new loan originations.
. . . that could exacerbate financial stability
risks in the United States . . .
The U.S. economy is susceptible to a range of shocks from
the euro area, reflecting the close financial and trade
integration extending across the Atlantic. Potential
spillovers could include direct exposures of U.S. banks to
euro area banks or the sale of U.S. assets by European
banks. For example, the CMBS and ABS markets have been under
pressure in recent months, weighed down by the volume of
European asset sales. Funding strains more generally could
rise, transmitting pressure to the U.S. banking system. An
important demonstration of this is the persistent widening
of interbank spreads in dollar markets since mid-2011, in
parallel with the widening of euro interbank spreads.
Some domestic risks also remain. While U.S. sovereign
financing conditions have generally benefited from a flight
to safety away from the euro area, such a situation cannot
be counted on to persist indefinitely. It is thus necessary
to resolve the political impasse over the fiscal situation
in the United States, as noted in the January 2012 WEO
Update. While the U.S. banking system has regained a good
measure of health since the crisis and ongoing Federal
Reserve stress tests should continue to enhance
transparency, legacy problems in the mortgage sector remain,
weighing on consumption, and pushing some of the burden of
sustaining demand onto the public sector. More broadly,
banks will struggle to maintain historical returns on
equity, particularly in a new, tighter regulatory
environment.
. . . threaten emerging Europe and spill over to
emerging markets more broadly.
Emerging Europe would be heavily affected by deleveraging
on the order of that assumed in the downside scenario
described in the
January 2012 WEO Update, reflecting the large
presence of euro area banks in those economies. The deep
recession in emerging Europe in 2009 was largely the result
of the sudden stop in capital flows from western European
banks, which abruptly ended the credit boom.
Emerging markets beyond central and eastern Europe could
face spillovers from the European debt crisis through
several channels. Overall macroeconomic prospects
for emerging markets have already deteriorated, and are
subject to downside risks stemming from Europe, as discussed
in the
January 2012 WEO Update.
While emerging markets outside of Europe have been quite
resilient to shocks and developments in major economies in
the past year, recent indicators have weakened significantly
and the general business climate has deteriorated.
First, credit channels could become impaired as
pressures on European banks result in a pullback of
cross-border lending, notably trade finance activities, and
a loss of parent bank support for local lending. For
example, euro area banks provide roughly 30 percent of trade
and project finance in the Asian region, even though their
balance sheets account for only about 5 percent of bank
assets. The impact depends on the extent to which local
banks can step in and fill the financing gap: even though
some banks may have the balance sheet capacity to do so,
there are significant operational challenges in some areas
of trade finance. New entrants will also have to raise
substantial dollar funding in stressed market conditions.
Constraints on long-term funding could severely limit banks’
capacity in such areas as shipping and aviation trade
finance, as well as project and infrastructure finance.
Second, local asset markets (foreign exchange,
fixed income, and equity markets) could come under renewed
strains through outflows, deteriorating liquidity, and a
repricing that could have a knock-on impact on local
financing conditions. Emerging markets that are heavily
reliant on external portfolio flows could be especially
susceptible.
How resilient are emerging markets in the face of these
challenges? Many emerging markets have built up considerable
capital and liquidity buffers to counter adverse shocks, and
local markets generally held up well under the strains of
the Lehman crisis. Since then, some have built up further
(albeit limited) headroom to conduct countercyclical
economic policies, although the situation varies across
regions and countries. Emerging Europe is particularly
vulnerable, in view of the concentration of European bank
lending and the dependence on Europe as an export market. In
that region, buffers are generally weak relative to other
emerging market regions, and other longstanding
vulnerabilities in the financial system, including maturity
and currency mismatches in some economies, could strain
balance sheets.
Additional policy actions are needed for a
comprehensive plan.
Faced with the above risks, policymakers in all major
economies need to focus on a number of interlocking
challenges. European policymakers need to promptly put in
place a comprehensive package that restores confidence. In
addition to pursuit of appropriate macroeconomic and
financial policies, European policymakers need to implement
vigorously the policy measures agreed at the October and
December summits.
Furthermore, there is a need to: provide a sufficiently high
firewall that avoids a destabilizing spiral of high funding
costs for sovereigns and banks; manage the process of
balance sheet adjustment in the banking system to prevent a
disorderly deleveraging and, instead, promote an adequate
flow of credit to the private sector; and take additional
measures that may be necessary to bolster confidence in the
global financial system, for both emerging and advanced
economies. Achievement of this policy agenda will require
prompt and thorough implementation of recent initiatives,
and the adoption of new policies to promote and enhance
financial stability.
In particular:
- The "firewall" needs to be sufficiently large
and convincingly built. Sovereigns that are solvent
but facing financing strains may require an extended
period of successful policy implementation before
investors return. During the intervening period, it is
crucial to secure affordable funding from external
sources. The EFSF was meant for this purpose in the euro
area. However, given its size and structure, the EFSF
has a limited ability to undertake this role. To
establish confidence, it would be highly desirable to
increase the size and flexibility of the EFSF/ESM at the
earliest possible opportunity. Until this larger
firewall is wellestablished, provision by the ECB of
substantial and sustained liquidity support to stabilize
government debt and bank funding markets remains
essential.
- A "macroprudential gatekeeper" is needed to
assure deleveraging plans are consistent with sustaining
the flow of credit to support economic activity and
to avoid a downward spiral in asset prices. Within the
EU, such a role could be coordinated among the EBA,
European Systemic Risk Board (ESRB), the national bank
supervisors, and the banks themselves. Countries should
aim to monitor and limit deleveraging of their banks not
only in home markets but also abroad, where such efforts
would normally take place in cooperation with host
country regulators. A potential precedent for such a
gatekeeping function is the current Vienna Initiative,
which aims to coordinate national efforts to avoid
adverse cross-border effects on emerging Europe
associated with deleveraging on the part of euro area
banks.
- A credible increase in banks’ capital buffers
along the lines recommended by the EBA remains necessary
to restore market confidence. As envisaged in the
EBA guidelines this should be done as far as possible by
increasing capital rather than reducing credit. Steps
are already being taken to require banks to meet a
certain level of nominal capital (as was the case under
the Troubled Asset Relief Program in the United States
and the Fund for Orderly Bank Restructuring in Spain)
rather than a ratio, which provides incentives to shrink
assets. Banks should be encouraged to raise capital from
private sources. However, given some recent challenges
for banks in doing so, public funding should be made
available as a backstop to such efforts, but should be
subject to strict conditionality. Some bank capital
could be raised via pari passu injections with the
government or via contingent capital instruments.
In addition, there needs to be a pan-euro-area facility
with the capacity to take direct stakes in banks. To
complement the ECB’s LTRO, bank guarantee schemes should
be established at the euro area level to help reopen
private funding markets. Finally, a weak tail of banks
with low capital, poor profitability, and vulnerability
to funding shocks still exists, acting as a drag on
recovery. Some of these will need to be restructured and
recapitalized, or resolved.
- Adjustment remains essential, but the nearterm
impact on growth should be taken into account. As
recognized by policymakers, in most of the advanced
economies it is essential to make a credible commitment
to fiscal consolidation over the medium term, in order
to remove the long-term tail risk of sharp increases in
sovereign spreads. However, the rhythm of fiscal
adjustment also needs to take into account the impact on
current economic conditions. As outlined in the January
2012 Fiscal Monitor Update, automatic stabilizers should
be allowed to operate in the event that growth slows
more than expected and in the United States, expiring
policies designed to support demand need to be renewed.
Monetary policy should also be sufficiently
accommodative and, when needed, structural policies
should be aimed at promoting growth, notably by
restoring the competitiveness of the private sector.
- Policymakers in emerging markets should stand
ready to counter funding and credit strains, and to
deploy countercyclical policies where headroom is
available. Emerging markets in many cases have
built ample cushions of reserves that could be used to
counter external liquidity shocks. An adequate and
flexible combination of macroeconomic and financial
policy measures can help limit the impact of external
shocks, but care should be taken to avoid generating
financial distortions.
1—
See Euro Area Bank
Lending Survey, ECB at
http://www.ecb.int/stats/money/surveys/lend/html/index.en.html.
2—The EBA issued a
recommendation on December 8, 2011 noting "Banks should
first use private sources of funding to strengthen their
capital position to meet the required target, including
retained earnings, reduced bonus payments, new issuances of
common equity and suitably strong contingent capital, and
other liability management measures. National supervisory
authorities may, following consultation with the EBA, agree
to the partial achievement of the target by the sales of
selected assets that do not lead to a reduced flow of
lending to the EU’s real economy but simply to a transfer of
contracts or business units to a third party."