21 September 2011

IMF publishes Global Financial Stability Report

Financial stability risks have increased substantially over the past few months. Weaker growth prospects adversely affect both public and private balance sheets and heighten the challenge of coping with heavy debt burdens. Public balance sheets in many advanced economies are highly vulnerable to rising financing costs, in part owing to the transfer of private risk to the public sector. In the euro area, important steps have been taken to address current problems, but political differences within economies undergoing adjustment and among economies providing support have impeded achievement of a lasting solution.

Meanwhile, the United States is faced with growing doubts over the ability of the political process to achieve a necessary consensus regarding medium-term fiscal adjustment, which is critically important for global stability. As political leaders in these advanced economies have not yet commanded broad political support for sufficiently strengthening macro-financial stability and for implementing growth-enhancing reforms, markets have begun to question their ability to take needed actions. This environment of financial and political weakness elevates concerns about default risk, and demands a coherent strategy to address contagion and strengthen financial systems.

The euro area sovereign credit strain from high-spread countries is estimated to have had a direct impact of about €200 billion on banks in the European Union since the outbreak of the sovereign debt crisis in 2010. This estimate does not measure the capital needs of banks, which would require a full assessment of bank balance sheets and income positions. Rather, it seeks to approximate the increase in sovereign credit risk experienced by banks over the past two years. These effects are amplified through the network of highly interconnected and leveraged financial institutions; when including interbank exposures to the same countries, the size of spillovers increases by about one half.

Banks in some economies have already lost access to private funding markets. This raises the risk of more severe deleveraging, credit contraction and economic drag, unless adequate actions are taken to deal with the sources of sovereign risk—through credible fiscal consolidation strategies—and to address the potential consequences for the financial system—through enhancing the robustness of banks.

The Global Financial Stability Report cautions that low policy rates, although necessary under current conditions, can carry longer-term threats to financial stability. With growth remaining sluggish in the advanced economies, low rates are appropriate as a natural policy response to weak economic activity. Nevertheless, in many advanced economies some sectors are still trapped in the repair-and-recovery phase of the credit cycle because balance sheet repair has been incomplete, while a search for yield is pushing some other segments to become more leveraged and hence vulnerable again. Moreover, low rates are diverting credit creation into more opaque channels, such as the shadow banking system. These conditions increase the potential for a sharper and more powerful turn in the credit cycle, risking greater deterioration in asset quality in the event of new shocks. Stepped-up balance sheet repair and appropriate macro-prudential policies can help contain these risks.

Full report

© International Monetary Fund