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By José Viñals

Our latest update of the Global Financial Stability Report has three key messages.

First, financial stability risks have increased, because of escalating funding and market pressures and a weak growth outlook.

Second, the measures agreed at the recent European leaders’ summit provide significant steps to address the immediate crisis, but more is needed. Timely implementation and further progress on banking and fiscal unions must be a priority.

And third, time is running out. Now is the moment for strong political leadership, because tough decisions will need to be made to restore confidence and ensure lasting financial stability in both advanced and emerging economies. It is time for action.

Now, why have financial stability risks increased?

First, government bond yields in Southern Europe have sharply increased, while funding conditions for many European banks have deteriorated. The beneficial effects of the European Central Bank’s extraordinary long-term refinancing operations have decreased in recent months, amid renewed policy uncertainty and growing concerns about the health of banks. This has led to a substantial flight to safe assets.

Second, financial fragmentation has exacerbated the adverse feedback loop between weak banks and governments, and threatens to undermine the currency union. Private capital outflows have continued to erode the foreign investor base for government debt in countries such as Italy and Spain. Governments have increased their reliance on domestic banks to finance their public debt. At the same time, these banks have increasingly turned to the European Central Bank to meet their liquidity needs as wholesale funding markets remain closed to them.

Third, sovereign and bank funding pressures have spilled over to the corporate sector in the periphery of the euro area. These companies have seen rising wholesale funding costs and a drop in bank lending. They are also facing a large amount of maturing bonds in the near term, which will likely exacerbate their funding squeeze.

Finally, growth prospects in other advanced economies and emerging markets are a bit weaker. This has left them somewhat more vulnerable to spillovers from the euro area. It also reduces their ability to address home-grown fiscal and financial vulnerabilities. Uncertainties about the fiscal outlook in the United States present a particular latent risk to global financial stability.

Policy priorities

Given these risks, increased efforts are needed now to prevent financial conditions from further deteriorating and adversely affecting growth.

In the euro area, the measures agreed at the recent European leaders’ summit are significant steps to address the immediate crisis. While their timely implementation is essential, further efforts are necessary to break—once and for all—the adverse feedback loop between weak banks and weak sovereigns. In particular, measures are needed to help the euro area to stabilize, integrate, and grow.

Stabilization requires bold policy actions right now. Policymakers should:

  • Strengthen the balance sheets of viable banks, where needed, through recapitalizations and restructurings. In some cases, this may involve direct equity injections from Europe’s rescue fund, the European Stability Mechanism.
  • Strengthen sovereign balance sheets by implementing well-timed fiscal consolidation strategies and by enacting sweeping structural reforms.
  • Maintain supportive monetary and liquidity policies.
  • Consideration should also be given to actions at the euro area level to stabilize funding conditions in sovereign debt markets, such as the reactivation of the European Central Bank’s Securities Markets Program.

Further integration requires progress toward a full-fledged banking union and deeper fiscal integration. The planned, unified supervisory framework is the first building block of a future banking union. More building blocks will be needed, including a pan-European deposit insurance guarantee scheme and bank resolution mechanism with common backstops.

The United States’ economy is also facing an important fiscal turning point. By early next year, the U.S. is expected to reach the current debt ceiling. Financial market consensus suggests that the ceiling will be raised in time to avert a default. But a significant adverse market reaction cannot be excluded, especially if there is political gridlock over raising the ceiling. Credible medium-term fiscal consolidation is needed to avoid further sovereign rating downgrades and to preserve an important global public good—the stability of the U.S Treasury market.

Emerging economies are facing a twin challenge: dealing with the impact from advanced economies’ troubles, while confronting increasing home-grown vulnerabilities.

  • Slowing global growth and spillovers from the euro area crisis have clearly had an impact on many emerging markets, as seen in the response of equity markets and capital flows.
  • Home-grown vulnerabilities include rapid bank asset and credit growth in recent years, which may eventually trigger a significant increase in non-performing loans. Moreover, slowing domestic growth could erode bank profitability and pose risks to financial stability in countries such as Brazil, China, and India.
  • In view of these challenges, emerging economies need to pay special attention to the health of their domestic financial systems. At the same time, they need to preserve and increase the room for policy maneuver to respond to potentially large domestic and external shocks.

Bold political actions are needed to address the balance sheet problems of banks and sovereigns. Monetary policy has bought valuable time and provided essential liquidity to financial systems, but political leaders need to make progress now. Concerns over the solvency of banks and governments, for example, cannot be addressed through liquidity measures alone.

Now is the time for bold and concrete actions in advanced economies to achieve sustained balance sheet repair and institutional reform. Tough decisions will need to be made to restore confidence and ensure lasting financial stability in both advanced and emerging economies.

Source: Risks To Financial Stability Increase, Bold Action Needed