Interaction between Sovereign and Banking Sector
Risks Has Intensified
Despite improvements in market conditions since the October
2010 GFSR, sovereign risks within the euro area 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. 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 (Figure 2).
While still contained to the euro area, the adverse
interaction between the sovereign and banking risks in a number
of countries has intensified, leading to disruptions in some
funding markets. Figure 3 shows that CDS spreads written on
financial institutions have increased the most in countries in
which there has been the greatest sovereign stress—and this
relationship is more positive now than in 2008.
Smaller and more domestically-focused banks in some countries
have found access to private wholesale funding sources
curtailed. Many banks that have retained access have faced
higher costs and are only able to borrow at very short
maturities.
Several countries, as well as their main banks, face
substantial financing needs in 2011 as bank and sovereign
debt-to-GDP ratios have risen substantially in the last several
years (see IMF Fiscal Monitor Update and Figure 4). The
confluence of funding pressures and continued banking sector
vulnerabilities leaves financial systems fragile and highly
vulnerable to deterioration in market sentiment.
Little Progress on Deleveraging
The build-up of gross debt accumulated by the private sector
in a number of advanced markets has in most cases been only
partly reversed, if at all (Figure 5).
Private sector debt-to-GDP ratios should fall gradually over
time as economic activity picks up, but the high current debt
levels and the usual tendency for loan losses to lag the
recovery could still pose risks to the banking system.
Most countries' banking systems have reduced their
vulnerabilities by increasing their Tier 1 capital ratios
(Figure 6). However, improvements in the structure of funding
have been more difficult to achieve. Moreover, some euro-area
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.
Still-high levels of private debt in some countries are
likely to dampen both private sector demand for credit and
banks’ willingness to lend, weighing on the economic recovery.
Although accommodative monetary policies are appropriate to help
spur recovery, low interest rates and the use of quantitative
easing can have adverse financial stability side effects,
including by encouraging riskier investments. Low rates also
pose a challenge for fixed-income investors such as pension
funds and insurance companies that rely on higher-yielding
assets to match their long-term fixed liabilities.
Resurgent Capital Flows to Emerging Market Economies
Stronger economic fundamentals in some key emerging markets,
along with low interest rates in advanced countries, have led to
a rebound in capital flows, after the significant drop at the
height of the financial crisis. Net inflows to emerging market
countries now represent around 4 percent of GDP in aggregate
(Figure 7). By comparison, inflows prior to the crisis were
above 6 percent of GDP. Capital inflows have been accompanied by
a large increase in equity and bond issuance, potentially
limiting some of their effects on the price of these assets.
These capital flows may be partly driven by structural
factors underlying changes in asset allocation decisions by
institutional investors who are now looking at emerging market
assets more favorably. However, these flows are also being
driven by carry trades, in which investors hope to profit from
interest rate differentials and expectations of exchange rate
appreciation. Such expectations often accompany policies
designed to temporarily limit exchange rate appreciation.
Forward interest rates show that the current differential
between emerging and advanced country policy rates is expected
to rise, which will further increase the incentive for such
carry trades. This suggests a vulnerability to reversals in
response to, for instance, an unexpected rise in advanced
country interest rates, a shift in growth prospects in emerging
market countries, or a rise in risk aversion.
Capital inflows are normally beneficial for recipient
countries, but sustained capital inflows can strain the
absorptive capacity of local financial systems. Retail flows
into debt and equity mutual funds have been strong, particularly
for equity funds, and could give rise to the formation of asset
price bubbles if local assets are in limited supply (Figure 8).
Although most measures of equity valuations are within
historical ranges, “hot spots” appear to be emerging in the
equity markets in Colombia and Mexico and, to a lesser extent,
in Hong Kong SAR, India, and Peru.
Inflows can also lead to a rapid increase in private sector
indebtedness in recipient countries. As shown in Figure 9, in
some economies in Asia and Latin America, nonfinancial private
debt is approaching the maximum ratios reached between 1996 and
2010 (Brazil, Chile, China, India, and Korea, for example)1.
While in some countries the change may represent financial
deepening and healthy market development, in other countries it
could signal an increase in risk, and it is important that
country authorities remain vigilant.
A further symptom of large capital inflows is that
lower-rated entities gain greater market access to issue debt,
lowering the average quality of assets held by investors. There
has been an increase in the proportion of debt issued by
lower-grade credits during the last two years.
Policy Priorities
Policy action is needed to ensure that the required
restructuring and balance sheet repair take place—both for banks
and sovereigns—and that regulatory reforms move forward.
The time purchased with the extraordinary support measures of
the past few years is running out. Low policy interest rates
that are close to the zero bound are likely to have a
diminishing effect over time. Fiscal stimulus and further
government support of the financial sector are also becoming
increasingly unpalatable politically. It is clear that monetary
and fiscal policy support can be helpful in the short term, but
that such support is no substitute for structural solutions to
longstanding problems. Such solutions need to address sovereign
risk and financial fragilities in a holistic and comprehensive
fashion.
Breaking the Adverse Sovereign-Financial Loop
The root of the problem in many of the countries hit by the
crisis—the detrimental interaction between sovereign and
financial sector risk—must be addressed. This applies in
particular to the euro- area countries where, despite the set-up
of area-wide instruments, markets remain concerned about the
lack of a sufficiently comprehensive and consistent strategy to
repair fiscal balance sheets and the financial system.
All countries with outsized debt levels—inside and outside
the euro area—must make further medium-term, ambitious, and
credible progress on fiscal consolidation strategies, together
with better public debt management based on the Stockholm
Principles2.
In particular, in countries facing funding pressures, there is a
continued need for the authorities to convince markets that they
can, and will, reduce reliance on rollovers and lengthen the
maturity structure of their debt. This process will inevitably
involve other policies, in particular structural measures aimed
at supporting potential growth. Solid movements in this
direction have taken place in a number of euro- area countries,
but sustained follow-through is still required. In the United
States, the delay of a credible strategy for medium-term fiscal
consolidation would eventually drive up U.S. interest rates,
with knock-on effects for borrowing costs in other economies.
The longer fiscal stabilization is stalled, the more likely
there would be a sharper rise in Treasury yields, which could
prove disruptive for global financial markets and the world
economy. Another country with high debt levels, Japan, also
needs to continue to work toward lowering those levels and
ensuring fiscal sustainability in the face of an aging
population.
At the same time, financial system repair must be
undertaken—strengthening the banking sector through
well-targeted remedial actions, removing the tail risks, and
establishing a better regulatory system.
In the European Union, the steps listed below are needed to
reduce uncertainty and help restore confidence in markets.
- Further rigorous and credible bank stress testing is
required along with time-bound follow-up plans for
recapitalization and restructuring of viable,
undercapitalized institutions and closure of nonviable ones.
- The effective size of 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.
- Euro area-wide resolution mechanisms need to be deployed
and strengthened as needed. The introduction of a
pan-European bank resolution framework with an EU-wide
fiscal backstop would help decouple sovereign and banking
risks.
- The European Central Bank will need to continue to
supply liquidity to banks that need it and keep its
Securities Markets Program active, while also recognizing
that this is a temporary set of measures and will not solve
the underlying problems.
In the United States, efforts are needed to address the
headwinds from the still-damaged real estate markets.
- It is important to find ways to mitigate the negative
macro-financial linkages from the large “shadow inventory”
of houses for sale (i.e., properties that are already in
foreclosure or expected to default) that is likely to dampen
house prices for some time to come and exacerbate negative
home equity problems. Steps are also needed to revive
securitization markets, while at the same time making sure
that structured credit products are consistent with systemic
stability.
- As emphasized in the conclusions of the recent Financial
Sector Assessment Program, an overhaul is needed of the U.S.
housing finance system, including the role of the
mortgage-related, government-sponsored enterprises. These
could be either privatized or converted to public utilities
with an explicit (and explicitly funded) guarantee. The
authorities should not delay efforts to create an action
plan for the future.
In many advanced countries, bank balance sheet and
operational restructuring is necessary to preserve the long-term
viability of financial institutions and hence reduce the
implicit pressure on the sovereign balance sheet in these
countries. In some banking systems, the problems are less
cyclical and more structural in nature—namely chronically low
profitability and fading business lines. Where durable solutions
are not possible, effective resolution tools are required that
can, in an increasingly complex and interconnected global
financial system, preserve financial stability, while ultimately
allowing losses to be borne by creditors rather than taxpayers.
Governments need to consider carefully how, through better
capital structures and possibly through restrictions on the
scope and riskiness of activities, large financial institutions
can be less of a threat to overall systemic stability and to
sovereign balance sheets.
Regulatory Reform Efforts Need to Continue
At the global level, regulatory reform efforts have been
moving forward, but increasingly suffer from a combination of
fatigue and the sheer complexity of the issues. Progress has
been made on microprudential banking regulation aimed at
ensuring the solidity of individual institutions, though
important gaps remain. 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.
New entities are being established to improve systemic
oversight. They should waste no time in collecting and analyzing
data and issuing policy advice, especially in light of the
present low interest rate environment that could well be laying
the ground for new financial vulnerabilities. The new European
Systemic Risk Board has become operational this month, and
markets will watch closely for strong risk warnings and
recommendations. The new Financial Stability Oversight Council
in the United States, which has already initiated regular
meetings, needs to demonstrate that the financial stability
arrangements and surrounding regulatory structure have been
upgraded in light of the lessons from the crisis.
Guidelines to identify systemically-important financial
institutions and measure their contribution to systemic risk are
being worked out, though how to mitigate the risks they pose to
the financial system is still an open question. Particularly,
how to deal with systemically-important nonbanks and markets is
a difficult and outstanding issue. Moreover, methods to improve
the quality of supervision and produce a fully functional
cross-border resolution scheme are still on the “to do” list.
Coping with Capital Inflows
The need for macroprudential policymaking is also very
relevant for emerging market economies facing absorptive
constraints on capital inflows. 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.
Policymakers will need to be attentive and act in a timely
manner when pressures from inflows are building up, since
policies take time to work. Those facing strong inflows and
maintaining procyclical policies need to move to a neutral
policy setting. Countries with undervalued exchange rates should
allow this price mechanism to operate to help offset inflow
pressures. However, if currency appreciation is not an option,
other means such as monetary and/or fiscal policy should be
deployed. Macroeconomic policy responses may, however, need to
be complemented by strengthened macroprudential measures (e.g.,
stricter loan to value ratios, funding composition restrictions)
and, in some cases, capital controls.
Overall, while progress has been made and most financial
sectors are on the mend, risks to global financial stability
remain. Problems in Greece, and now Ireland, have reignited
questions about sovereign debt sustainability and banking sector
health in a broader set of euro-area countries and possibly
beyond. The current detrimental interaction between financial
system stability and sovereign debt sustainability needs to be
dealt with in a comprehensive fashion, so as to break the
adverse feedback loop that could spread beyond the smaller euro-area
countries. Pressing forward with the regulatory reform
agenda—for both institutions and markets—continues to be
crucial. Without further progress in this field, global
financial stability and sustainable growth will remain elusive.
1 Private sector debt includes domestic and
cross-border bank credit, and domestic and international
corporate debt.
2 See
www.imf.org/external/np/mcm/Stockholm/principles.htm for a
complete set of the principles.