Transitions to Financial Stability: A Bumpy Ride

The global financial system faces several major transitions along the road to greater financial stability. These transitions will be challenging because they are accompanied by substantial risks.
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The global financial system faces several major transitions along the road to greater financial stability. These transitions will be challenging because they are accompanied by substantial risks.

So what are these transitions?
  • The first one is the transition in the United States from a prolonged period of monetary accommodation towards a normalization of monetary conditions. Will this transition be smooth or bumpy?
  • Second, emerging markets face a transition to more volatile external conditions and higher risk premiums. What needs to be done to keep emerging markets resilient?
  • Third, the euro area is moving to a stronger union and stronger financial systems. This report focuses on the close links between the corporate and banking sectors. What are the implications of the corporate debt overhang for bank health?
  • Fourth, Japan is moving towards the new policy regime of Abenomics. The stakes are high. Will Japan's policies be comprehensive enough to ensure stability?
  • And finally, there is the global transition to a safer financial system, where much remains to be done.

U.S. monetary transition and global impact
So will the transition to monetary normalization in the United States be smooth or bumpy? This process will be unprecedented and complex. Long-term interest rates could overshoot. Containing longer-term interest rates and market volatility has already proven to be a substantial challenge, as shown by the sharp rise in bond yields and volatility since May. Lower market liquidity and over-extended allocations to bonds could amplify these risks.

Higher interest rates may also reveal weak links in the shadow banking system, exacerbating market and liquidity strains.

One example is mortgage real estate investment trusts. Like the structured investment vehicles and the conduits before the crisis, mortgage real estate investment trusts are highly leveraged and susceptible to funding runs. They could be forced to sell their asset holdings quickly, causing disruption in the mortgage-backed securities market, which could spread to broader asset markets.

Engineering a smooth transition to monetary normalization will require a clear and well-timed communication strategy by the U.S. Federal Reserve to minimize interest rate volatility, as well as effective execution in line with economic developments. Increased macro-prudential oversight and transparency in the shadow banking system is essential to preserve financial stability. This will allow the Fed to keep its focus on ensuring a smooth exit.

Emerging markets
What happens as the tide of capital inflows recedes from emerging markets? Since the Lehman crisis, bond inflows into emerging markets have risen by more than one trillion dollars. This is well above its long-term trend by almost half a trillion dollars, boosting emerging market corporate borrowing to record levels.

Events since May of this year point to new financial stability concerns. Foreign investors play a bigger role in local debt markets. But market liquidity has deteriorated in recent years, making local interest rates more sensitive to changes in investor sentiment. At the same time, corporate balance sheets have weakened, financial vulnerabilities are rising, and economic growth is slowing. This exposes these countries to more severe market stress.

If economies are faced with significant capital outflows, steps will need to be taken to ensure orderly market conditions and to facilitate smooth portfolio adjustments. Keeping emerging markets resilient also requires countries to address domestic vulnerabilities and enhance policy credibility.

Euro area
Key challenges remain in Europe. Policy actions at the regional and national levels have reduced funding pressures on weaker sovereigns and banks, but credit is still hampered by financial fragmentation.

The Global Financial Stability Report also shows that a significant share of the corporate debt in stressed economies is now owed by companies with weak debt servicing capacity. This is what we call a debt overhang. We estimate that even if financial fragmentation were reversed, a persistent debt overhang would remain, amounting to almost one-fifth of the combined corporate debt of Italy, Portugal, and Spain.

This debt overhang affects the banking system through losses on corporate loans. Some banks will need to increase provisioning against these expected losses. This could absorb a large portion of future bank profits and, in some cases, capital.

A number of policy actions are required to address the legacy of weak corporate and bank balance sheets in the euro area. The corporate debt overhang needs to be addressed in a more comprehensive manner. This may involve debt clean-ups, improvements to bankruptcy frameworks, or special asset management companies to restructure loans.

As for banks, the planned balance sheet assessment and stress tests by the European authorities are a golden opportunity to conduct a thorough and transparent review of bank asset quality and to identify capital shortfalls. But credible backstops need to be put in place before the exercise is concluded to offset any identified shortfalls, if private funds are insufficient. A bolstering of bank balance sheets needs to go hand-in-hand with adequate progress towards banking union.

Japan
As the U.S. is considering monetary normalization, Japan is scaling-up its monetary stimulus under the Abenomics framework. Policymakers in Japan need to ensure that this policy package is implemented completely, because a failure to enact the planned fiscal and structural reforms could reignite deflation and intensify financial stability risks.

Moving towards a safer financial system
Finally, while progress is being made, we still need to complete the regulatory reform agenda, consistently implement the new rules across countries, and enhance supervision. We are not there yet. Much work remains to be done to achieve a safer global financial system.

If the policy challenges that I have examined are properly managed, the transition towards greater financial stability should be successful and should provide a more robust platform for economic growth.

We are on the road. We have the map. And now policymakers need to steer carefully to navigate the bumps in the road ahead--so that we can arrive safely at our destination.

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