Global
Financial Stability Report
GFSR Market Update
Policies Have Reduced Systemic Risks But Vulnerabilities Remain
8 July 2009
Financial conditions have improved, as unprecedented policy
intervention has reduced the risk of systemic collapse and expectations of
economic recovery have risen. Nonetheless, vulnerabilities remain and
complacency must be avoided. The financial sector continues to be dependent
on significant public support, resulting in an unparalleled transfer of risk
from the private to the public sector. At the same time, however, work will
need to begin on exit strategies from the various financial, monetary, and
fiscal support policies in order to address market uncertainty. Medium-term
policies need to ensure that steps taken to normalize policies and markets
are consistent with establishing a lasting framework of sound financial
regulation, sustainable fiscal balances, and the maintenance of price
stability.
Overview of Developments
The risks to the global financial system have moderated from the extreme
levels identified in the April 2009
Global Financial Stability Report (GFSR). Unprecedented policy
actions undertaken by central banks and governments worldwide have succeeded
in stabilizing the financial condition of banks, reducing funding pressures
and counterparty risk concerns, and supporting aggregate demand. These
interventions have reduced the tail risk of another systemic failure similar
to the collapse of Lehman Brothers. Bank debt and interbank markets have
resumed functioning, albeit with massive public sector support. Concerns
regarding liquidity and counterparty risks in the banking sector have
declined, as evidenced by the narrowing of LIBOR-overnight index and credit
default swap spreads (Figure
1).
However, overall financial conditions remain tight. Growth in bank credit
to the private sector continues to slow in mature economies, securitization
markets outside those supported by the public sector remain impaired, and
lower-quality borrowers have little access to capital market funding.
Furthermore, the public sector interventions that have underpinned the
reduction in private sector risks have resulted in a concomitant increase in
public sector risks and a mounting burden on fiscal sustainability.
Severe recession risks have eased in response to concerted fiscal and
monetary policy stimulus measures (as discussed in the July 2009
World Economic Outlook Update). This has helped spur some return of
risk appetite and a decline in volatilities, with investors moving into risk
assets from safe havens. Although perceived credit risk has diminished, as
evidenced by narrower spreads and lower projected default rates, it remains
high. Risks in emerging markets have also lessened, reflecting the recovery
of commodity prices and the resumption of portfolio inflows and rising asset
prices (Figure
2). TThese improvements have not been evenly distributed, and
cross-border banking flows to emerging markets remain weak. Risks in
emerging Europe have also been reduced, but strains remain and
vulnerabilities flagged in the
April
2009 GFSR persist.
The
April
2009 GFSR highlighted three main areas of risk: (i) that weaknesses
in advanced-economy banking sectors could act as a greater drag on credit
growth and economic recovery; (ii) that emerging markets remain vulnerable
to a slowing or cessation of capital inflows; and (iii) that yields on
sovereign debt may rise significantly and private borrowers may be crowded
out if the burden on public sector balance sheets is not managed in a
credible way. While progress has been made in these areas, concerns
remain./p>
Bank balance sheets need to be restored to health
The risk of a widespread banking crisis has eased and prospective
writedowns on securities are likely to be somewhat lower, as a result of the
recovery in mark-to-market valuations, but bank capitalization still remains
a concern as further writedowns on loans are expected. Confidence in the
U.S. banking system has been bolstered by better-than-expected earnings
results, a successful stress-testing exercise, the commitment by the U.S.
government to stand behind the 19 largest banks, and a series of bank
capital-raisings. However, loss ratios are expected to continue to rise for
loans. In Europe, universal banks have also benefited from better earnings
and capital increases, but loss rates are expected to rise. The Committee of
European Banking Supervisors is conducting a coordinated stress test
exercise on a system-wide basis which should help to reestablish market
confidence in the banking system. But, on both sides of the Atlantic, it is
proving difficult to effectively implement measures that fully address the
problem of impaired assets on banks' balance sheets, leaving banks
vulnerable to a further deterioration in the quality of these assets if the
global downturn is deeper, and more prolonged, than projected.
Corporate bond markets have reopened, but bank credit growth is still
slowing
Corporate bond markets are functioning more normally, a critical
development for countries, notably the United States, that rely more heavily
on nonbank market financing. Corporate credit and asset-backed spreads have
tightened significantly and issuance has risen, as firms seek alternatives
to scarce bank credit. High-yield issuance has also increased recently, but
is still restricted to higher quality credit, and spreads remain
historically wide.
However, bank lending remains restricted, despite unconventional policies
aimed at reviving credit to end users. Overall bank credit growth continues
to diminish, as deleveraging pressures persist (Figure
3). Securitization markets continue to be impaired, except for those
directly supported by government programs or central bank facilities (Figure
4).
Emerging market sentiment has strengthened, but markets remain
vulnerable to capital outflows
Emerging market assets have benefited from the recovery of commodity
prices and improved growth prospects, especially in Asia. The return of risk
appetite has also led to a resumption of portfolio inflows from investors.
Emerging market equities have rebounded 30 to 60 percent since end-February,
matching or outpacing mature market equities. EMBI Global sovereign spreads
have more than halved since their peak in October. Despite these positive
developments, the overall outlook for emerging markets remains vulnerable to
lower than expected global growth and to constrained international bank
lending. As highlighted in the April 2009 GFSR, banks are contracting their
cross-border positions at a faster rate than their domestic balance sheets,
although there is evidence that parent banks have maintained funding levels
to their emerging market subsidiaries (Figure
5).
Consequently, cross-border deleveraging is leading to an unwinding of the
rapid financial globalization that occurred over the past 10 years. This
trend will likely continue, placing additional pressure on those banking
systems that are heavily reliant on cross-border funding. Emerging Europe
and the Commonwealth of Independent States are particularly vulnerable to
contractions in cross-border funding and have not benefited as much from the
market rebound seen elsewhere.
Concerns mounting regarding sovereign debt markets
Globally, sovereign yield curves have steepened considerably, as
conventional monetary policy easing has anchored short-term rates, while the
longer end of the curve has risen sharply, reflecting in part improved
recovery prospects and reduced risks of deflation. Nevertheless, concerns
about the ability of markets to absorb the supply of new government bonds
may also be contributing to the rise in yields (Figure
6). With public debt levels expected to rise significantly in many
mature market economies, increased focus on fiscal sustainability may have
been reflected in sovereign credit default swap spreads remaining well above
their pre-crisis levels.
The risks ahead
The
April
2009 GFSR raised immediate policy challenges regarding the
intensifying threats to systemic stability and a worsening credit crunch,
emphasizing the need for a range of financial policies to mitigate downside
risks. Since then, ongoing unprecedented policy actions have reduced the
likelihood of major failures, an important step toward restoring confidence.
Complacency must be avoided.. There is a risk that the recent
improvements in the financial sphere could lead to complacency. Continued
policy efforts are needed to stave off the chance that some of the recent
gains could yet be reversed. Although the financial system has stepped back
from a period of extreme uncertainty, there remains a high level of
uncertainty consistent with significant dysfunction in some financial
markets. Confidence is still fragile, and tail risks could reemerge. The
improvement in financial markets is in large part due to far-reaching public
sector support. Thus, the lasting regeneration of the wide range of markets
necessary for efficient financial intermediation is far from assured.
More work is needed to fix banks and markets. Concerning banks, this
implies in some cases implementing measures already taken, and, in others,
adopting new measures. In spite of recent capital raisings by banks, there
is a need to ensure adequate capital levels going forward as default rates
increase, and to promote restructuring where needed. Moreover, actions
continue to be needed to help banks deal effectively with troubled assets.
Only then will they be in a position to support the real economy going
forward. Parallel to this, finding ways to reopen the securitization market
by placing it on a sounder footing will be of particular importance, as it
serves as a significant conduit of credit provision.
Deleveraging and tail risks. If the remaining problems with mature
economy banks are not effectively addressed, then the deleveraging process
required to restore their health will be more severe than otherwise
necessary, acting as a greater drag on the economic recovery. Indeed, fixing
the banks remains a prerequisite for a sustained recovery. Because much of
the improvement in financial conditions is due to the robust rally in risk
assets since March, there is a risk of a significant market setback if
financial markets get too much ahead of the pace of economic recovery.
Indeed, tail risks could reemerge if a major correction in asset prices were
again to undermine confidence in financial institutions.
Further measures are still needed to restore confidence in the banking
sector and to facilitate lending. Many countries have taken an active role
in assessing their banking systems by performing stress tests, which, if
accompanied by credible measures to address any shortfalls in capital, can
be an effective tool in rebuilding bank balance sheet strength. The U.S.
experience and recent European initiatives to organize coordinated stress
tests are a welcome step forward. More generally, viable banks with capital
shortfalls should be required to submit action plans to raise their capital
ratios. If carrying out such plans over the near-term is not feasible, banks
viewed as viable should receive temporary capital injections from the
government with appropriate conditions. In some cases, such capital
injections may need to be followed by restructuring, including the possible
sale or liquidation of parts of the bank. Banks deemed to be nonviable
should be resolved as promptly as practicable. Determined and suitably
transparent implementation of such policies would be helpful in restoring
confidence in the banking sector.
Sovereign debt markets may be at risk of destabilization if the burden of
public debt financing is viewed as unsustainable. Emerging markets remain
vulnerable to spillovers from mature economies that may result in a more
general slowing or cessation of capital inflows. Corporate borrowers in
emerging markets are particularly susceptible because of their high rollover
requirements and limited access to alternative sources of finance. As well,
localized problems in some individual emerging markets could have wider
repercussions if not addressed effectively.
Globally consistent exit strategies.. Even though the time has not
yet come to start withdrawing all the various forms of official support that
have been extended in response to the crisis, it is important that carefully
considered and coordinated exit strategies are put in place. Communication
of such strategies can be of great value in reducing market uncertainty. The
broad objectives that should guide the formulation of exit policies are
price stability, a sound financial system based on market principles, and
fiscal sustainability. Within countries, exits should be coordinated across
monetary, financial, and fiscal policies. Central banks should have a range
of effective instruments at their disposal for withdrawing liquidity in a
timely fashion in order to avoid market disruption. Cleansing central bank
balance sheets of quasi-fiscal interventions through transfers to fiscal
authorities may also be needed to ensure central bank financial
independence. As confidence resumes, policy options for the withdrawal of
extraordinary public support include natural run-off as the market rebounds
and the orderly withdrawal of liquidity and funding measures. A crucial
consideration throughout the exit is maintaining consistency of policies
across countries to minimize the opportunities for regulatory arbitrage and
adverse financial flows. There will likely be political pressures both to
delay and accelerate the exit from various crisis policies, which will have
to be resisted for the above reasons.
At this critical stage in emerging from the crisis, policymakers need to
safeguard the gains made thus far. The unprecedented scope of the crisis
itself and the measures taken to contain it, will require a comparable
policy response. Throughout this process, timing and modality will be
crucial. Reliance on market mechanisms wherever possible will best ensure an
outcome consistent with the exit objectives of price stability, a sound
financial system, and fiscal sustainability. |