Download Sovereign debt crisis and banking system stress Financial Stability

Current Financial Stability Issues:
Some Lessons From Global Level
Analysis
Charles Augustine Abuka
Director, Financial Stability
Bank of Uganda
COMESA Course on Forward Looking Financial Stability Reports
November 29 2012
KSMS, Nairobi, Kenya
Outline of the Presentation
• Introduction
• Current Issues affecting global financial stability
• Recent global Financial Stability Assessment
• Proposed Regulatory reforms
• Policy implications of the reforms
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• Introduction
– Like emerging market economies, countries in the COMESA region also face a number
of vulnerabilities.
– These vulnerabilities are important for financial stability analysis and could arise from:
• Spillovers and contagion from external financial shocks. These could be in the
form of capital inflow reversals and interruptions in foreign currency liquidity.
• The pro-cyclical nature of financial intermediation with credit growth linked to the
economic cycle.
• The contagion due to common exposures to risky sectors such as the housing
market.
• The spillovers from Network externalities linking financial institutions via the
interbank market or payments system.
– Financial instability could arise because a bank that is exposed in the
interbank market to a counterparty who might be unable to pay its liabilities
triggers generalised distress.
• Distress from the systemically important financial institutions.
• Distress arising from the sovereign debt crisis
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Current issues affecting global financial stability
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Sovereign Debt
Distress from Systemically important banks
Spillovers and Contagion from external financial shocks
Cyclicality of credit growth
Common exposures:
– Real Estate Property Markets
– Demand for safe assets
The financial impact of longevity risk
Cross border financial activity
Recovery and resolution plans
Regulatory Reforms
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Current issues affecting global financial stability
• What does systemic financial sector surveillance achieve?
– Highlight systemic vulnerabilities
– Examine possible spillovers
• Across markets (e.g. US Subprime mortgages to global
interbank market)
• Across countries (e.g. Emerging Market Financing,
European Sovereign Crisis Spillovers)
• Provide policy advice
– Financial reform
– Assure level playing fields
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Current issues affecting global financial stability
• A note about vulnerabilities and triggers
• Crises require vulnerabilities and a trigger
• Vulnerabilities
– Excessive leverage
– Balance sheet mismatches
– Liquidity risks
– Complexity, interconnectedness, opacity
• This means triggers, and hence crisis timing may be
unpredictable!
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Sovereign debt crisis and banking system stress
• Stresses in euro area government bond markets escalated in late 2011 as
investors grew increasingly concerned about the risk of a disorderly bank
or sovereign default.
• Subsequent policy actions, notably the European Central Bank’s (ECB’s)
provision of collateralized three-year liquidity to banks, have relieved
acute stress.
• Yet sovereign bond markets remain fragile under the weight of strained
fiscal positions and an ongoing loss of demand from traditional investors.
Financing public debt could still prove challenging for some euro area
countries.
• Sovereign and Banking system stress in the EURO area Increased in late
2011, the euro area’s banking and government bond markets came under
stresses that pushed financial stability risks to a new peak of intensity.
Subsequent policy actions eased bank funding strains and helped
stabilize sovereign markets, but the risks to global financial stability
remain elevated.
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Sovereign debt crisis and banking system stress
• The European Central Bank decided to provide unlimited, collateralized
three-year liquidity to banks and to widen the range of eligible collateral.
• Governments in several countries, notably Italy, Ireland, Portugal, Greece
and Spain, have set in train potentially important reform programs to
reduce fiscal deficits, improve competitiveness, and, in the Spanish case,
to further the repair of the domestic financial system.
• As a result of these actions, sovereign spreads eased, bank funding
markets partly reopened, and equity prices rebounded. Market and
liquidity risks have improved, falling below the levels of the September
2011 Global Financial Stability Report (GFSR), as immediate concerns of an
imminent collapse were averted and official funding relieved refinancing
pressures in the banking system.
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Sovereign debt crisis and banking system stress
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Sovereign debt crisis and banking system stress
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Sovereign debt crisis and banking system stress
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Sovereign debt crisis and banking system stress
• Concerns about a possible chain reaction of bank failures and
sovereign defaults intensified in late 2011.
• Credit default swap spreads rose to new highs; even sovereigns
with relatively strong public finances (including Austria, Finland,
and the Netherlands) were hit by illiquid market conditions.
• Government bond yields and volatilities for several vulnerable
sovereigns also rose to precarious levels, while inverted yield
curves suggested acute concern about default risk.
– Banks that were holding Spanish and Italian government bonds
in their trading portfolio faced significant mark-to-market
losses, as valuations tumbled.
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Sovereign debt crisis and banking system stress
Sovereigns
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Sovereign debt crisis and banking system stress
• Foreign banks began divesting from the sovereign debt of
the stressed euro area periphery since 2010, starting with
Greece (2010:Q1), followed by Portugal and Italy (2010:Q2),
and then Ireland and Spain (2010:Q3).
• Amid the increased market turmoil, foreign institutional
investors continued to shed exposure to these countries in
2011.
• In the third quarter of 2011, foreign banks made large
withdrawals from Italy that coincided with the heightened
stress in Italian and Spanish sovereign debt markets.
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Sovereign debt crisis and banking system stress
Sovereigns
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Sovereign debt crisis and banking system stress
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Sovereign debt crisis and banking system stress
• The erosion of the foreign investor base was attributed to
several distinct factors:
– Rising credit risk and market volatility deterred investors
that seek steady, low-risk returns, such as central banks,
insurance companies, and pension funds.
– Rating downgrades and exclusion from benchmarks.
– Increased haircuts on repo transactions. The sharp rise in
yields has also reduced the collateral value of peripheral
bonds.
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Sovereign debt crisis and banking system stress
Bank Deleveraging
• Banks have been under pressure to deleverage since the outbreak of the
subprime crisis. Pressures on European banks escalated at the end of
2011 as sovereign stress increased and many private funding channels
closed.
• The ECB’s provision of longer-term funding has substantially eased the
strains, but banks still face the need to raise capital or reduce assets by
scaling back credit or cutting business lines.
• However, there is a risk that a large-scale reduction in European bank
assets might have serious negative repercussions for the real economy
and financial markets in the euro area and beyond.
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Sovereign debt crisis and banking system stress
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Sovereign debt crisis and banking system stress
Emerging Markets
• Emerging markets have deftly navigated the financial shocks
and economic spillovers from advanced economies.
• The impact of European bank deleveraging has been
manageable so far, but there is a risk of a further pullback of
bank credit and cross-border lending.
• Emerging Europe appears most vulnerable in this respect,
although banks elsewhere are likely to step in and fill the gap,
at least under the current policies scenario.
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Sovereign debt crisis and banking system stress
Are Safe Assets the Financial System Cornerstone?
Safe Asset Universe
• In theory, safe assets provide identical real payoffs in each state of the
world.
• True absolutely safe assets are a desirable part of a portfolio from an
investor’s perspective, as they provide full protection from credit, market,
inflation, currency, and idiosyncratic risks; and they are highly liquid,
permitting investors to liquidate positions easily.
• However, in practice, all assets are subject to risks which, in an ideal
world, should be reflected accurately in asset prices.
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Sovereign debt crisis and banking system stress
Safe Assets: Financial System
Cornerstone?
While many assets have some
attributes of safety, the global
universe of what most investors
view as potentially safe assets is
dominated by sovereign debt.
As of end-2011, AAA-rated and AArated OECD government securities
accounted for $33 trillion or 45
percent of the total supply of
potentially safe assets.
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Sovereign debt crisis and banking system stress
Financial Stability Implications of safe assets
• Considerable upward pressures on the demand for safe
assets at a time of declining supply entails sizable risks for
global financial stability.
• The unmet demand drives up the price of safety, with the
safest assets affected first.
• In their search for safety, investors that are unable to pay the
higher prices are likely to settle for assets that embed higher
risks than desired.
• These risks would also affect markets more broadly.
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Sovereign debt crisis and banking system stress
The Financial Impact of Longevity
Risk
• Longevity risk is the risk that actual
life spans of individuals or of whole
populations
will
exceed
expectations.
• People have been living longer lives
for at least a century now, and
although this has obvious benefits,
governments, private companies
and individuals all potentially face
financial risks if people on average
live longer than expected.
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Sovereign debt crisis and banking system stress
• The Financial Impact of Longevity Risk
– Although longevity risk develops and reveals itself slowly over time, if
left unaddressed it can affect financial stability by building up
significant vulnerabilities in public and private balance sheets.
– Governments in particular bear a significant amount of longevity risk.
Their longevity exposure is threefold:
• Through public pension plans
• Through social security schemes, and
• As the “holder of last resort” of longevity risk of individuals and
financial institutions.
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Sovereign debt crisis and banking system stress
The Financial Impact of Longevity Risk
– If everyone in 2050 lived just three years longer than now society
would need extra resources equal to 1 to 2 percent of GDP per year.
– Longevity risk affects financial stability by threatening fiscal
sustainability and weakening private sector balance sheets, adding to
existing vulnerabilities in the current environment.
– Governments need to acknowledge the existence of longevity risk in
their balance sheets as contingent liabilities and ensure that it does
not threaten the sustainability of the public finances.
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Recent Global Financial Stability Assessment
•
The key risks to global financial system stability have increased since the April
2012 GFSR, as confidence in the global financial system has become very fragile.
•
Significant new efforts by European policymakers have relieved investors’ biggest
fears, but the euro area crisis remains the principal source of concern.
•
The unfolding euro area crisis has generated safe-haven flows to countries like the
United States and Japan. These flows have pushed government funding costs to
historical lows, but both countries continue to face significant fiscal challenges.
•
The crisis has spurred a host of regulatory reforms which are likely to produce a
safer banking system over time.
•
Success of the regulatory reforms depends on effective implementation and
strong supervision. Without those elements, regulatory reforms may fail to secure
greater financial stability.
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Recent Global Financial Stability Assessment
•
Confidence in policymaking has faltered, despite significant and continuing
efforts by European policymakers. Rising political risks have postponed mediumterm adjustment and spilled over to broader global economic conditions.
•
Flows into global bond funds have risen, with investors favoring safe-haven
sovereign bonds and investment- grade corporate bonds amid concerns about tail
risk outcomes.
•
The combination of lower risk appetite, a weakened outlook for growth and
persistently volatile and wide spreads in the euro area periphery has led to an
increase in macroeconomic risks.
•
Emerging market risks risen, as these economies appear increasingly linked to the
global cycle. Escalation of euro area stresses poses risks, especially for the
countries in central and eastern Europe. Slowdown in economic activity heightens
these risks.
•
Credit risks are unchanged due to deterioration in the banking sector and growing
deleveraging and credit pressures in the euro area periphery offset by some
improvements in corporate/household balance sheets in advanced economies.
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..
Figure 1.0 .Global Financial Stability Map
Figure 1.1 Global Financial Stability Map :Assessment of
Risks and conditions
a)
b)
c)
Source: IMF estimates
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Recent Global Financial Stability Assessment
•
Assessment of the EURO Area
– Euro area crisis has moved from a sudden stop into a capital-flight phase
despite substantial policy interventions, as cross-border private capital is
being repatriated from the periphery back to the core of the currency union.
– Higher risks have translated into rising credit spreads on the periphery’s
sovereign and bank borrowers, particularly in Spain and Italy.
– A possible euro area breakup has led to extreme fragmentation between
funding markets in the core and the periphery.
– Restoring confidence among private investors is paramount for the
stabilization of the euro area. Euro area policymakers are laying foundations
to support that confidence, but numerous technical, legal, and political
challenges remain.
– Unfolding of the euro area crisis has generated safe-haven flows to other
jurisdictions, notably the United States and Japan.
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..
Figure 1.3:Portfolio and Other Investment Capital
Flows in the Euro Area, Excluding Central Banks(in
percent of GDP in Preceding year)
Figure 1.5: Euro-area exposures to Greece, Ireland,
Italy, Portugal, and Spain (Billions of euros)
Figure 1.4 :Total deleveraging by sample banks (2011,Q32013-Q4)
Figure 1.3- Capital Flight from the periphery to the core
Figure 1.4- Increasing pressure on banks to reduce assets
and credit
Figure 1.5- Private borrowing is being replaced by public
sector flows
Source: IMF estimates
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Recent Global Financial Stability Assessment
• Assessment of the United States
– The looming debt ceiling, fiscal cliff, and related uncertainty are the
main immediate risks.
– Unsustainable debt dynamics remain the key medium-term concern.
– Safe-haven flows, central bank purchases, and balance sheet derisking have also contributed to an unprecedented compression of
credit risk premiums and yields.
– Unpredictable political process erodes confidence in policymaking
and triggers market volatility.
– Sovereign credit risk is also an important challenge to stability in the
United States amid a weak economy facing slow growth and
inadequate demand.
– U.S. Treasuries play in global capital markets, keeping them safe is of
paramount importance, both for the United States and for the global
financial system.
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Recent Global Financial Stability Assessment
Assessment of the United States
• Main priorities for the US:
– define a gradual consolidation path to avoid the fiscal cliff,
– restore fiscal sustainability with a balanced approach to
medium-term consolidation.
– complete financial sector reforms
• Going forward
– Focus should be on proactive policies that prevent near
term risks from materializing,
– Focus on policies that address medium term
sustainability,
– Policies that forestall the buildup of vulnerabilities.
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..
Figure 1.6: US bank holding companies balance
sheet liabilities at end 2011 (in percent)
Figure 1.8: Market reaction: Heightened uncertainty
and policy
Figure 1.7 Reliance on US dealer banks on capital
markets revenue and whole sale funding
Figure 1.9:Change in 10 year US treasury yield in recent
business cycles basis points relative to cycle peak
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Recent Global Financial Stability Assessment
• Assessment of Japan
– Japan has been a beneficiary of safe-haven inflows as a result of the
crisis in Europe.
– These flows have pushed government bond yields to near record
lows, facilitating easy financing of the nation’s high public debt.
– Safe-haven flows have also driven the yen exchange rate to near
historic highs, impacting Japanese exports and domestic production
thus weakness in credit demand from the private sector.
– Banks have responded by increasing their holdings of government
bonds.
• Going forward
– Measures to induce banks to take greater account of the risks
inherent in large holdings of government bonds may help control this
risk, particularly in the case of regional and smaller banks.
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…
Figure 2.0:Japanese Bank holdings of Government Debt
to 2017 under Current Trend (in trillions of Yen)
Figure 2.1 : Foreign claims of Japanese Banks (in billions of
US dollar left scale)
Figure 2.2 :Foreign holdings of Japanese Government
securities (in trillions of Yen)
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Recent Global Financial Stability Assessment
•
Assessment of emerging markets and other economies
– Emerging economies need to guard against potential further shockwaves
from the euro area while managing a slowdown in growth that could raise
domestic financial stability risks.
– Flows into their bond markets have continued as fears about sovereigns in
the euro area have escalated.
– Local markets could come under strain in an adverse scenario of acute global
stress that precipitates large-scale capital outflows.
– Countries in central and eastern Europe are the most vulnerable because of
their direct exposures to western Europe and some vulnerabilities shared with
countries in the euro area’s periphery.
– These economies remain focused on resolving the legacy of past credit and
asset price booms that have left them with large external debt burdens and
limited space for expansionary macroeconomic policies.
– Emerging market economies in Asia and Latin America generally appear more
resilient, but are prone to late-cycle credit risks following an extended period
of rising leverage and property prices.
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Recent Global Financial Stability Assessment
• Assessment of emerging markets and other economies
– Concerns about overheating and financial stability risks caused
policymakers in many countries to tighten policies after the initial
expansionary response to the global financial crisis.
– Central banks in Brazil, China, Korea, and South Africa have cut policy
rates to mitigate the downturn in economic activity. Such policy
loosening must not undermine earlier efforts to curb exuberant asset
and credit markets.
– Asian and Latin American economies have used macro prudential
policies and capital flow management;
• To strengthen banking systems,
• Slow down the pace of capital inflows,
• Rein in soaring property prices.
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Recent Global Financial Stability Assessment
• Assessment of emerging markets and other economies
– Emerging market economies have only limited policy space to
provide countercyclical stimulus and safeguard against external
shocks.
– Promoting capital market development is therefore a key priority.
– Continued supervisory vigilance and a preemptive countercyclical
stance also remain important to preserve the resilience of the
financial system.
• Appropriate steps would include;
– Promoting earnings retention to bolster banks’ capital base,
– Ensuring sufficient provisioning and swift recognition of loan quality
problems.
– Extending macro prudential tools where exuberance persists.
• These efforts must be underpinned by prudent monetary and
fiscal policies, which should provide buffers for more difficult
times.
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Recent Global Financial Stability Assessment
•
Assessment of emerging markets and other economies
– Policy priorities vary significantly, depending on domestic conditions, external
vulnerabilities, and available policy space
• Authorities should push ahead with coordinated debt resolution policies
such as debt workout plans or loan modification schemes.
• Bank regulators simultaneously need to require full loss recognition and
adequate capitalization to lay the groundwork for a recovery in credit.
• Policymakers must keep their guard high and deftly navigate their
country-specific challenges to avert external and domestic threats to
financial stability.
• Priority is to build additional buffers in balance sheets private and public
to withstand possible setbacks, as the cycle may turn downward in the
near future.
• The still-limited scale of domestic asset managers in many emerging
market economies heightens the risk of disruptive shocks from capital
flows.
• Emerging market economies should continue developing local capital
markets so as to reduce their vulnerability to reversals of capital flows.
40
..
Figure 2.3 : Emerging market bond Fund assets under
management, Geographical Location
Figure 2.4: Credit cycle position of selected economies
2006 and 2011
Figure 2.5: Non residential holdings of government debt and
market liquidity
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Table 1: Indicators of vulnerability and policy space for emerging market
economies and other economies
42
..
Figure 2.5: Change in real house
prices, 2006-11 (in percent)
Figure 2.6: Non performing loans in selected
economies 2008, 2010, 2011 (in percent of total
loans outstanding)
Figure 2.7: Bank holdings of local government debt
and additional purchases under outflow scenario
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Regulatory reforms
•
•
•
The focus of the regulatory reform agenda has shifted from the development of
standards to rule making and implementation.
The agenda involves making financial institutions less complex and more
transparent and lowering the incentives for them to take excessive risk.
Financial policies should aim to move the financial system to more desirable
structures along the following dimensions:
– More transparent financial system with better governance- one in which both
regulatory authorities and investors understand the location of risks and the
way in which institutions are interconnected.
– A system with less leverage and hence less prone to boom and bust cycles.
One that reaps the positive aspects of interconnectedness and globalization
while limiting contagion risk and rapid retrenchment of cross-border flows
during crisis.
– Higher and better-quality capital and liquidity buffers that enable institutions
to withstand distress and that appropriately reflect the systemic risk of their
activities
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Regulatory reforms
– A better understanding and oversight of risks in the nonbank financial
sector, which has been placed within a perimeter for monitoring to
ensure that contagion is limited between banks and nonbanks during
a crisis.
– Systemically important financial institutions that can be resolved in
an effective and timely way and with minimum cost to their
customers, and, ideally no costs to the taxpayer.
• Financial systems have not come much closer to the desirable features
above because;
– They are still overly complex
– Strong domestic interbank linkages,
– Concentrated
– Unresolved too-important-to-fail issues
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Regulatory reforms
•
The regulatory reform agenda seeks to improve financial sector safety by
reducing risks to institutions and improving their resilience when risks are
realized.
– The new liquidity ratios will require many banks to hold more short-term,
high-quality assets or pay higher rates by tapping long-term funding sources.
– Business Model Restrictions with the purpose of restricting business activities
to reduce systemic risk by prohibiting deposit-funded banks from engaging in
certain investment banking businesses that are deemed to be too risky.
– Compensation and Governance reforms aim to better align the incentives of
key employees and managers with the longer-term stability of institutions
and markets. This could improve risk measurement, monitoring, and
management of financial institutions.
– Bank Resolution emphasis on the recovery and resolution of banks. The FSB
has articulated the “Key Attributes of Effective Resolution Regimes for
Financial Institutions,” which contain a number of recommendations to
strengthen economies’ resolution regimes and to make large complex
financial
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Regulatory reforms
•
– OTC Derivatives Reforms is meant to increase transparency, mitigate
systemic risk, and protect customers against market abuse.
– Nonbanks: Shadow Banking efforts to address shadow banking credit
intermediation activities in the nonbanking sector are meant to ensure that
these activities are monitored for robust prudential regulation.
– In the insurance sector seek to minimize regulatory arbitrage, reduce
contagion risks, and address complex group structures that hinder effective
supervision.
– Credit rating reforms aim at achieving better understanding of risks
embedded in different products and securities.
Although the reforms currently under way are likely to produce a safer banking
System, over time, some areas that still require attention:
– A global discussion of the pros and cons of direct restrictions on business
activities to address the too-important-to-fail issue.
– More attention to segments of the nonbank system that may be posing
systemic risks, and
– Further progress on recovery and resolution plans for large institutions,
especially those that operate across borders.
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Implications of the regulatory reforms
•
•
•
•
•
Regulatory policies that promote financial buffers help economic outcomes, but they need
to consist of high-quality capital and truly liquid assets. The regulatory initiatives to enhance
liquidity management and capital requirements as encompassed in Basel III go in the right
direction. Financial buffers made up of high-quality capital and truly liquid assets generally
help economic performance
In order to reap the benefits of financial globalization and nontraditional bank
intermediation, these need to be well managed. Global regulations should avoid incentives
that may exacerbate the volatility of cross-border flows. 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.
Supervisory colleges or other means of discussing the cross border business activities of
financial institutions could go some way to ensuring foreign banks play a positive role in
host countries even in times of stress.
No particular financial system model can ensure the best economic outcomes under all
circumstances or there is no optimal model (one-size fits- all) recipe for the structural makeup of the financial sector to generate growth and maintain financial and economic stability.
The policy implications may depend on countries’ preferences regarding the trade-off
between the safety of financial systems and economic growth.
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Implications of the regulatory reforms
•
Whatever, financial regulatory measures are adopted to enhance growth and
stability, they are likely to be effective only if they are implemented correctly—the
quality of domestic and global) regulation and supervision is essential.
• Regulators should design and implement measures to curb excessive
credit growth during the upswing of the economic cycle (which could also
help to reduce macroeconomic volatility).
• Regulators need to focus efforts on monitoring foreign liabilities of banks
and capital flows.
• The supervision of systemically important banks should continue to be
strengthened and, where these banks are subsidiaries of international or
regional banks, build more effective links with their home country
supervisors.
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Implications of the regulatory reforms
• There are implications for financial system infrastructure arising from the
extraordinary interconnectedness and complexity within the financial
system.
– Risk tends to be transmitted through the institutional arrangements
in payment, clearing and settlement systems.
– Macroprudential supervision will be required to be particularly
attentive to risks that could impair the plumbing of the financial
system i.e. the payments, clearing and settlement systems – where
breakdowns would relay and amplify systemic risk
• It is important to control the evolution of both domestic and external
sovereign debt
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Implications of the regulatory reforms
•
The current financial crisis highlighted the importance of broadening the toolkit
to include macroprudential regulations to safeguard macroeconomic and financial
sector stability.
– However, effective macroprudential policy instruments still remain a missing
ingredient in the current policy making toolkit.
– There are a number of technical issues involved in the design of a
macroprudential policy regime. This will require the building up of staff
capacity in the calibration and implementation of any future macroprudential
tools
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THANK YOU
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