© 2012 International Monetary Fund

Cataloging-in-Publication Data

Joint Bank-Fund Library

Global financial stability report - Washington, DC:

International Monetary Fund, 2002-

v.; cm. - (World economic and financial surveys, 0258-7440)

Semiannual

Some issues also have thematic titles.

ISSN 1729-701X

1. Capital market – Development countries – Periodicals.

2. International finance – Periodicals. 3. Economic stabilization –

Periodicals. I. International Monetary Fund. II. Series: World economic and financial surveys.

HG4523.G563

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Contents

• Preface
• Executive Summary
• Chapter 1 Global Financial Stability Assessment
  • Status of Stability Indicators
  • The Euro Area
  • The United States
  • Japan
  • Emerging Markets and Other Economies
  • Regulatory Reform
  • References
• Chapter 2 Restoring Confidence and Containing Global spillovers
  • Global Debt Overhang and Stability Challenges
  • Euro Area Crisis—Reversing Financial Fragmentation
  • The United States: Stability or Complacency
  • Japan How Safe a Safe Haven
  • Emerging Markets and Other Economies: Navigating Domestic and Global Risks
  • Annex 2.1. Update to the EU Bank Deleveraging Exercise
  • References
• Chapter 3 The Reform Agenda: An Interim Report on Progress toward a safer Financial system
  • Summary
  • Structural Features Associated with the Crisis
  • The Goal of Reforms—Desirable Structures of Financial Intermediation
  • Objectives and Implications of the New Regulatory Initiatives
  • Structural Implications of Crisis Intervention Measures
  • Change over the Past Five Years: Are Financial Systems Structurally Safer?
  • Analyzing the Effect of Reforms on Structures—An Early Look
  • Implications for the Reform Agenda
  • Annex 3.1. Financial Structure Indices
  • Annex 3.2. Regulatory Initiatives: Proposals and Implementation Status
  • Annex 3.3. Exploring the Impact of Regulatory and Crisis Intervention Policies on Financial Structures
  • Annex 3.4. Indices of Progress on Basel Capital and Liquidity Standards
  • References
• Chapter 4 The Financial Impact of Longevity Risk
  • Summary
  • The Relationship between Financial Structures and Economic Outcomes
  • Simple Correlations
  • Country Case Studies
  • Multivariate Regressions
  • Policy Implications
  • Annex 4.1. What Does the Literature Say About the Relationship between Financial Structures and Economic Outcomes?
  • Annex 4.2. Econometric Study on Financial Structures and Economic Outcomes: Data, Methodology, and Detailed Results
  • Annex 4.3. Financial Structure Variables and the Probability of Banking Crises: Data, Methodology, and Detailed Results
  • References
• Glossary
• Annex: Summing Up by the Acting Chair
• Statistical Appendix
  • [Available online at www.imf.org/external/pubs/ft/gfsr/2012/02/pdf/statapp.pdf]
• Boxes
  • 1.1. Falling Confidence, Rising Risks, and Complacency
  • 1.2. Recent Policy Initiatives, Developments, and Challenges in the Euro Area
  • 1.3. Resilience of the Euro, or Fragile Equilibrium?
  • 1.4. Regulatory Reform: From Rulemaking to Implementation
  • 2.1. Systemic Risk in International Dollar Credit
  • 2.2. Why Are Euro Area Periphery Sovereign Spreads So High?
  • 2.3. European Bank Deleveraging: An Update
  • 2.4. Corporate Sector Fundamentals, Funding Conditions, and Credit Risks
  • 2.5. Key Challenges for the Dealer Operations of U.S. Banks
  • 2.6. How Impaired Is Liquidity in the U.S. Corporate Bond Trading Market?
  • 2.7. Avoiding the Pitfalls of Financial Liberalization in China—Credit Risk, Liquidity Mismatches, and Moral Hazard in Nonbank Intermediation
  • 3.1. Risks Associated with New Forms of Financial Intermediation
  • 3.2. Global Deleveraging Landscape: Economy- and Bank-Level View
  • 3.3. TRuPs and the Impact of Basel III on U.S. Banks
  • 3.4. Side Effects of Low Policy Interest Rates
  • 3.5. Did Some Banking Systems Withstand International Contagion Because They Are Less Globally Integrated
  • 4.1. Financial Depth and Economic Outcomes
  • 4.2. How Robust Are the Econometric Results?
  • 4.3. Australia
  • 4.4. The United States
  • 4.5. Germany
  • 4.6. Japan
  • 4.7. China
• Tables
  • 2.1. Indebtedness and Leverage in Selected Advanced Economies
  • 2.2. Banking Financial Stability Indicators
  • 2.3. Sovereign Market and Vulnerability Indicators
  • 2.4. Key Features of Sovereign Funding and Bank Deleveraging Scenarios
  • 2.5. Holdings of Treasury Securities, by Sector
  • 2.6. Impact on Domestic Bank Balance Sheets from a Hypothetical Reversal of Foreign Inflows into Local Bond Markets
  • 2.7. Overview of Recent Macroprudential and Capital Flow Measures in Selected Emerging Market and Other Economies
  • 2.8. Indicators of Vulnerability and Policy Space For Emerging Market and Other Economies
  • 2.9. Summary of Updates in the Deleveraging Exercise
  • 2.10. Assumptions on Key Macro-Financial Variables
  • 2.11. Average Funding Rollover Rates
  • 2.12. Amount of Additional Funding Required from Domestic Investors
  • 2.13. Progress on the Implementation of Business Plans by Selected EU Banks
  • 3.1. Financial Structure before the Crisis and Financial Stress during the Crisis
  • 3.2. Snapshot of the New Regulatory Initiatives
  • 3.3. Possible Effects of Regulatory Reforms on Financial Structure
  • 3.4. Government and Central Bank Crisis Measures, 2007–10
  • 3.5. Effect of Progress in Basel Capital Rules on Intermediation Structures
  • 3.6. Indices, Subindices, and Data Sources
  • 3.7. Snapshot of the New Global Regulatory Initiatives: Resolution of G-SIFIs
  • 3.8. Status of Initiatives, by Selected Economy
  • 3.9. Effect of Progress in Basel Liquidity Rules on Intermediation Structures
  • 3.10. Effect of Financial Policies on Intermediation Structures: Crisis Intervention Policies
  • 3.11. Basel Capital and Liquidity Progress Index
  • 4.1. Financial Structure Measures in This GFSR
  • 4.2. Financial Sector Size, Structure, and Economic Performance in Case Study Countries
  • 4.3. Summary of Fixed-Effects Panel Estimation Results on Economic Outcomes, 1998–2010
  • 4.4. List of Variables Used in Regression Analysis
  • 4.5. Fixed-Effects Panel Estimation with Interaction Term, 1998–2010
  • 4.6. Fixed-Effects Panel Estimation with Quadratic Term, 1998–2010
  • 4.7. Systemic Banking Crises and Financial Structure Variables: Probit Model
• Figures
  • 1.1. Global Financial Stability Map
  • 1.2. Global Financial Stability Map: Assessment of Risks and Conditions
  • 1.3. Asset Price Performance since April 2012 GFSR
  • 1.4. Cumulative Flows to Global Mutual Funds
  • 1.5. Portfolio and Other Investment Capital Flows in the Euro Area, Excluding Central Banks
  • 1.6. Spain and Italy: Changes in Foreign Investor Shares and Yields
  • 1.7. Euro Area Exposures to Greece, Ireland, Italy, Portugal, and Spain
  • 1.8. Periphery Minus Core Credit Default Swap Spreads
  • 1.9. Total Deleveraging by Sample Banks
  • 1.10. Reduction in Euro Area Supply of Credit under Alternative Policy Scenarios
  • 1.11. Impact on Investment from EU Bank Deleveraging
  • 1.12. Impact on Employment from EU Bank Deleveraging
  • 1.13. Impact on GDP from EU Bank Deleveraging
  • 1.14. Reduction in Bank Assets: Sensitivity to Periphery Sovereign Spreads
  • 2.1. Government Bond Yields and Volatility
  • 2.2. Bank Holdings of Government Bonds in Spain and Italy
  • 2.3. Sovereign–Bank Nexus for Italy and Spain
  • 2.4. Portfolio Outflows from Italy and Spain
  • 2.5. Periphery Minus Core Bank Credit Default Swap Spreads
  • 2.6. Euro Area Bank Debt Issuance
  • 2.7. Bank Deposit Flows in the Euro Area
  • 2.8. Bank Customer Deposit Trends
  • 2.9. Changes in the Sovereign Investor Base
  • 2.10. Bank Credit to Domestic Governments and the Private Sector, Selected Euro Area Countries
  • 2.11. Change in Euro Area Bank Cross-Border Exposures
  • 2.12. Change in Interest Rate on New Bank Loans
  • 2.13. Pressure on Euro Area Banks
  • 2.14. Total Deleveraging by Sample Banks
  • 2.15. Total Deleveraging Due to Selected Stand-Alone Factors
  • 2.16. Reduction in Supply of Credit to Euro Area: Core versus Periphery
  • 2.17. Reduction in Credit Supply: Global Spillovers
  • 2.18. Impact of EU Bank Deleveraging on GDP, 2013 Projection
  • 2.19. Reduction in Credit Supply to Euro Area: Sensitivity to Periphery Sovereign Spreads under Alternative Policy Scenarios
  • 2.20. Bank Credit to Nonfinancial Firms in Italy and Spain
  • 2.21. Corporate Bond Issuance Needs through End-2013 under Alternative Deleveraging Scenarios
  • 2.22. Projected Average Interest Rates on Outstanding Sovereign Debt
  • 2.23. Projected Sovereign Interest Expense as a Proportion of Revenue
  • 2.24. Sovereign and Corporate Credit Ratings in the Euro Area Periphery
  • 2.25. TARGET2 Projections
  • 2.26. Borrowing from Central Banks
  • 2.27. U.S. Five-Year Swap Rate and Implied Probability Distribution
  • 2.28. Contributions to Change in Fitted 10-Year Nominal Treasury Yield
  • 2.29. Private Sector Financial Balance Relative to Year before Outbreak of Financial Crisis, Selected Advanced Economies
  • 2.30. Change in 10-Year U.S. Treasury Yield in Recent Business Cycles
  • 2.31. Bank Credit in Past and Current Credit Cycles
  • 2.32. Market Reaction: Heightened Uncertainty and Policy
  • 2.33. U.S. Government Debt and Interest Payments
  • 2.34. Foreign Investors’ Share of Outstanding Sovereign Debt, as of End-2011
  • 2.35. Rollover Risk: Weighted Average Maturity of Sovereign Bonds
  • 2.36. Primary Dealers’ Positioning in U.S. Treasury Securities
  • 2.37. Bank Holdings of Government Debt in Selected Advanced Economies
  • 2.38. Sensitivity of Japanese Banks to a 100 Basis Point Interest Rate Shock
  • 2.39. Cumulative Purchases of Japanese Government Bonds since 2007
  • 2.40. Japanese Bank Holdings of Government Debt to 2017 under Current Trend
  • 2.41. Foreign Claims of Japanese Banks
  • 2.42. Foreign Holdings of Japanese Government Securities
  • 2.43. Emerging Market Bond Fund Assets under Management, by Geographic Location
  • 2.44. Resilience of Inflows into Emerging Market Local-Currency Bond Funds Despite Euro Area Stress
  • 2.45. Performance of Emerging Market Equities and Bonds vs. Economic Surprise Index
  • 2.46. Sensitivity of Selected Sovereign CDS to CDS of Euro Area Periphery, 2011–12
  • 2.47. Net International Investment Position versus Gross External Debt, Selected Economies, 2011
  • 2.48. Share of Foreign-Currency-Denominated Bank Loans in Total Loans
  • 2.49. Ratio of Nonperforming Loans to Total Loans
  • 2.50. Change in Volatility of Local Bond Returns Relative to Foreign Participation and Domestic Investor Base
  • 2.51. Nonresident Holdings of Government Debt and Market Liquidity
  • 2.52. Bank Holdings of Local Currency Government Debt and Additional Purchases under Outflow Scenario
  • 2.53. Credit Cycle Position of Selected Economies: 2006 and 2011
  • 2.54. Change in Private Sector Credit, 2006–11
  • 2.55. Change in Real House Prices, 2006–11
  • 2.56. Nonperforming Loans in Selected Economies, 2008, 2010, and 2011
  • 2.57. Ratio of Price to Book Value of Banks in Selected Economies, 2010–12
  • 3.1. Size of the Global Financial Systems
  • 3.2. Market-Based Intermediation
  • 3.3. Market-Based Intermediation: New Financial Products
  • 3.4. Scope and Scale: Interconnectedness, Funding, Concentration
  • 3.5. Globalization
  • 3.6. Illustration of Difference-in-Differences Method
  • 4.1. Time Varying Correlations: Financial Globalization Inex
  • 4.2. Time Varying Correlations: Financial Buffers
  • 4.3. Financial Structure and Economic Growth, 1998–2010

Preface

The Global Financial Stability Report (GFSR) assesses key risks facing the global financial system. In normal times, the report seeks to play a role in preventing crises by highlighting policies that may mitigate systemic risks, thereby contributing to global financial stability and the sustained economic growth of the IMF’s member countries. Risks to financial stability have increased since the April 2012 GFSR, as confidence in the global financial system has become very fragile. Despite significant and continuing efforts by European policymakers, the principal risk remains the euro area crisis. The current report highlights how risks have changed over the past six months, traces the sources and channels of financial distress with a focus on bank deleveraging and euro area market fragmentation, examines progress on the reform agenda and whether the reforms are contributing to a safer financial system, and analyzes the relationship between financial structures and economic outcomes to determine if certain financial systems are associated with higher or more stable growth.

The analysis in this report has been coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of José Viñals, Financial Counsellor and Director. The project has been directed by Jan Brockmeijer and Robert Sheehy, both Deputy Directors; Peter Dattels and Laura Kodres, Assistant Directors; and Matthew Jones, Advisor. It has benefited from comments and suggestions from the senior staff in the MCM department.

Individual contributors to the report were Sergei Antoshin, Nicholas Arregui, Serkan Arslanalp, Sophia Avramova, Adolfo Barajas, Ana Carvajal, Eugenio Cerutti, Su Hoong Chang, Ken Chikada, Nehad Chowdhury, Kay Chung, Sean Craig, Era Dabla-Norris, Reinout De Bock, Martin Edmonds, Jennifer Elliott, Michaela Erbenova, Ellen Gaston, Jeanne Gobat, Tom Gole, Kristian Hartelius, Sanjay Hazarika, Changchun Hua, Anna Ilyina, Patrick Imam, Marcel Kasumovich, William Kerry, John Kiff, Oksana Khadarina, Michael Kleeman, Alexandre Kohlhas, Peter Lindner, Rebecca McCaughrin, Tommaso Mancini Griffoli, André Meier, Fabiana Melo, Paul Mills, Srobona Mitra, Gianni de Nicolò, S. Erik Oppers, Nada Oulidi, Evan Papageorgiou, Jaume Puig, Lev Ratnovski, André Santos, Jochen Schmittmann, Katharine Seal, Stephen Smith, Tao Sun, Jay Surti, Narayan Suryakumar, Takahiro Tsuda, Nico Valckx, Constant Verkoren, Chris Walker, Rodolfo Wehrhahn, Christopher Wilson, Xiaoyong Wu, Mamoru Yanase, Lei Ye, Luisa Zanforlin, and Jianping Zhou.

Ivailo Arsov, Martin Edmonds, Mehmet Gorpe, Mustafa Jamal, Oksana Khadarina, and Yoon Sook Kim provided analytical support. Gerald Gloria, Nirmaleen Jayawardane, Juan Rigat, and Ramanjeet Singh were responsible for word processing. Joanne Johnson of the External Relations Department edited the manuscript and coordinated production of the publication, with assistance from Gregg Forte.

This issue of the GFSR draws, in part, on a series of discussions with banks, clearing organizations, securities firms, asset management companies, hedge funds, standards setters, financial consultants, pension funds, central banks, national treasuries, and academic researchers. The report reflects information available up to September 14, 2012.

The report benefited from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussion of the GFSR on September 14, 2012. However, the analysis and policy considerations are those of the contributing staff and should not be attributed to the Executive Directors, their national authorities, or the IMF.

Executive Summary

The analysis in this Global Financial Stability Report (GFSR) shows that, despite recent favorable developments in financial markets, risks to financial stability have increased since the April 2012 GFSR, as confidence in the global financial system has become very fragile. Although significant new efforts by European policymakers have allayed investors’ biggest fears, the euro area crisis remains the principal source of concern. Tail-risk perceptions surrounding currency redenomination have fueled a retrenchment of private financial exposures to the euro area periphery. The resulting capital flight and market fragmentation undermine the very foundations of the union: integrated markets and an effective common monetary policy.

The European Central Bank’s (ECB’s) exceptional liquidity operations around the beginning of 2012 eased the pressure on banks to shed assets, but that pressure rose again, accompanied by increasing market fragmentation. Subsequently, the statement by the president of the ECB in July, and measures proposed by the ECB in September to increase liquidity support and safeguard an appropriate monetary policy transmission, have been essential in addressing investors’ biggest fears and prompted another market recovery. This GFSR updates work presented in the April 2012 report to assess the impact of bank deleveraging under three scenarios—baseline, weak, and complete policies. We find that delays in resolving the crisis have increased the expected amount of asset shrinkage at banks. The largest burden of projected credit supply contractions falls on the euro area periphery, where the combined forces of bank deleveraging and sovereign stress are generating very strong headwinds for the corporate sector.

Where the April 2012 GFSR found the need for euro area policymakers to build on improvements and avoid fresh setbacks, this GFSR finds that more speed is needed now. As detailed in Chapter 1, a leap to the complete policies scenario is necessary to restore confidence, reverse capital flight, and reintegrate the euro zone. Key elements at the national level include implementation of well-timed and growth-friendly fiscal consolidation, structural reforms to reduce external imbalances and promote growth, and completion of the banking sector cleanup, including further steps to recapitalize or restructure viable banks where necessary and to resolve nonviable banks.

These national efforts need to be supported at the euro area level by sufficient funding to banks through the ECB’s liquidity framework. More fundamentally, concrete progress toward establishing a banking union in the euro area will help to break the pernicious link between sovereigns and domestic banks and help improve supervision. Over the longer term, a successful banking union will require sufficient resource pooling to provide a credible fiscal backstop to both the bank resolution authority and a joint deposit insurance fund.

The unfolding euro area crisis has generated safe-haven flows to other jurisdictions, notably the United States and Japan. Although these flows have pushed government funding costs to historical lows, both countries continue to face significant fiscal challenges, as assessed in Chapter 2. In the United States, the looming fiscal cliff, the debt ceiling deadline, and the related uncertainty are the main immediate risks. Unsustainable debt dynamics remain the central medium-term concern. Japan faces high deficits and record debt levels, and interdependence between banks and the sovereign is growing. In both countries, necessary steps toward medium-term fiscal adjustment need to be laid out without further delay. The key lesson of the past few years is that imbalances need to be addressed well before markets start flagging credit concerns.

Emerging market economies have adeptly navigated through global shocks so far, but need to guard against potential further shockwaves while managing a slowdown in growth that could raise domestic financial stability risks. Local bond markets have continued to attract inflows even as the euro area crisis intensified. Overall, many countries in central and eastern Europe are the most vulnerable because of their direct exposures to the euro area and certain similarities they bear to countries in the euro area periphery. Asia and Latin America generally appear more resilient, but several key regional economies are prone to the risks associated with being in the late phase of a credit cycle that has featured an extended period of rising property prices and debt. Meanwhile, the scope to provide fresh policy stimulus is somewhat constrained in several economies, which underscores the need to deftly manage country-specific challenges.

The crisis has spurred a host of regulatory reforms to make the financial system safer. Chapter 3 contains an interim report on whether these reforms are moving the financial sector in the right direction against a benchmark set of desirable features—financial institutions and markets that are more transparent, less complex, and less leveraged. The analysis suggests that, although there has been some progress over the past five years, financial systems have not come much closer to those desirable features. They are still overly complex, with strong domestic interbank linkages, and concentrated, with the too-important-to-fail issues unresolved. While there has not yet been any serious setback to financial globalization, in the absence of appropriate policies economies are still susceptible to harmful cross-border spillovers. Progress has been limited partly because many regulatory reforms are still in the early stages of implementation and partly because crisis intervention measures are still in use by a number of economies, delaying the “rebooting” of the financial system onto a safer path. Although the reforms currently under way are likely to produce a safer banking system over time, the chapter points to some areas that still require attention: (1) a global discussion of the pros and cons of direct restrictions on business activities to address the too-important-to-fail issue, (2) more attention to segments of the nonbank system that may be posing systemic risks, and (3) further progress on recovery and resolution plans for large institutions, especially those that operate across borders.

Chapter 4 tackles the fundamental question of whether certain aspects of financial structure enhance economic outcomes. Are the forces currently changing financial structures, including regulatory reforms, likely to result in structures that will support higher, less-volatile growth and a more stable financial system? The chapter finds that some structural features are indeed associated with better outcomes and others with less growth and more volatility. In particular, financial buffers (both for capital and liquidity) tend to be associated with better economic performance, whereas some types of nontraditional bank intermediation are linked to less favorable results. The analysis also indicates that certain positive characteristics may sometimes turn negative. For instance, some measures of cross-border connections are beneficial most of the time, but if not managed properly they can act as conduits to transmit destabilizing shocks during a crisis. Overall, the analysis needs to be interpreted carefully, since it is constrained by important gaps in data and a relatively short sample period that included the global financial crisis. As a result, the policy conclusions can only be viewed as tentative. Nonetheless, two of those that emerge are that (1) financial buffers made up of high-quality capital and truly liquid assets generally help economic performance; and (2) banks’ global interconnectivity needs to be managed well so as to reap the benefits of cross-border activities, while limiting adverse spillovers during a crisis.

Both Chapters 3 and 4 also stress that the success of steps aimed at producing a safer financial system hinges on effective implementation and strong supervision. Without those elements, regulatory reform may fail to secure greater financial stability.