“The current mix of tight fiscal and loose monetary policy remains appropriate in staff's central scenario. But uncertainty around this central scenario remains high. The potential policy response would depend on the specific risk that might arise”, Lipsky said.

New focus on spillover effects and financial sector

The press conference wrapped up the IMF’s annual analysis of the UK economy, which has involved meetings with senior officials from the government, the Bank of England, the Financial Services Authority, and representatives from the private sector. This year’s consultation is particularly notable because it integrates the findings of two other special IMF reports: a comprehensive and in-depth analysis of the UK’s financial sector, carried out under the auspices of the IMF’s Financial Sector Assessment Programme (FSAP), and a new focus on “spillover effects”—the impact that one country’s policies can have on other countries because of the tremendous increase in trade and financial linkages in the global economy.

Analysis to support policy collaboration

The reports reflect the IMF’s strong commitment to furthering policy collaboration at the international level through an improved understanding of the interconnected nature of the global economy. This year, the institution is undertaking in-depth analysis of the outward spillovers from the five largest economies in the world—China, the euro area, Japan, the United Kingdom and the United States. The work is a natural continuation of the IMF’s efforts in the aftermath of the global economic crisis to support international policy collaboration aimed at reducing global economic imbalances that threaten the recovery.

The UK mission is the first to include the spillover element, with discussions focusing mainly on the stability and efficiency of the financial system, given the global reach and importance of the country’s financial sector. Japan will follow on June 8, China on June 9, followed by the euro area on June 20, and the United States on June 27. The results of the spillover work will be presented in a series of reports alongside each country or region’s annual Article IV report, with lessons brought together in an overarching report that will be discussed by the IMF’s Executive Board later this summer.

The IMF’s new focus on the interconnected nature of the global economy comes at a time of increased uncertainty for policymakers around the world, with the global recovery being buffeted by continued uncertainty in Europe, uprisings in the Middle East, and signs of overheating in some fast-growing emerging market economies.

Financial sector a global public good

In September 2010, the IMF made it mandatory for 25 jurisdictions with systemically important financial sectors to undergo financial stability assessments under its Financial Sector Assessment Programme (FSAP) every 5 years. This important decision moved the IMF’s financial sector surveillance towards a more risk-based approach by focusing resources on member countries with systemically important financial sectors. Given the size and role of the UK financial system in global intermediation, the UK is among the 25 jurisdictions. “Our analysis of spillovers from the United Kingdom makes it clear that UK financial stability not only is in the UK’s best interest, but also is a global public good”, Lipsky said. For this reason, the UK must aim to have the highest quality supervision and regulation in place.

Analysis carried out as part of the IMF’s shows that banks have strengthened their capital and liquidity positions over the last year. All major banks are ahead of schedule in their transition to Basel III rules, and have also reduced their reliance on wholesale and official funding. However, the recovery process is not yet complete, as highlighted by analysis carried out under the FSAP. The two large banks with government stakes have made good progress in the implementation of their restructuring programmes, but it will be important to sustain these efforts. Stress tests for major banks reveal adequate levels of capitalisation under severe macroeconomic scenarios—with the caveat that lender forbearance may, in some cases, have masked the extent of risks, given the high indebtedness of households and commercial real estate.

Potential losses from exposures to vulnerable European countries are not a threat as long as shocks do not lead to stresses in core European banks to which UK banks have large exposures. Major UK banks have adequate liquidity buffers under most scenarios. But like other global banks, British banks do remain vulnerable to sustained disruptions in funding markets, the IMF report noted.

More international cooperation is needed

Looking ahead, the stability of the UK financial sector critically depends on a stronger international framework for oversight of cross-border banks. There are serious limitations to what the UK can achieve alone, particularly with respect to institutions that it hosts, such as branches of foreign banks. Gaps in this domain must be addressed through international cooperation.

The UK authorities should therefore continue to work towards an ambitious international package of regulatory reform and rigorous implementation of this package in the European Union. “Little will be achieved regarding resolvability without progress on cross-border resolution―and this will require international consultation and high level political commitment. We therefore are pleased to see that the UK authorities continue to exercise leadership on these matters”, Lipsky said.

Press release