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posted on 15 October 2016

Low Growth, Interest Rates Impact Financial Stability

from the International Monetary Fund

Financial stability risks that were bright on the radar screen six months ago - including Brexit and its possible global repercussions, high levels of corporate indebtedness in emerging markets, and uncertainties about China’s growth transition - have abated, according to the International Monetary Fund’s latest Global Financial Stability Report.

"Medium-term risks, however, are building because we are entering a new era, characterized by chronic weak growth, prolonged low interest rates, and growing political and policy uncertainty," said Peter Dattels, Deputy Director of the IMF’s Monetary and Capital Markets Department. "This could undermine the health of financial institutions and add to the forces of economic and financial stagnation."

A low-growth, low interest-rate era

Low, uneven, and unequal growth risks are opening the door to more populist and inward-looking policies, leading to a loss of political cohesion and a rise in policy uncertainty in some countries, the IMF said.

One outcome of this weak economic environment and heavy reliance on unconventional monetary policies is financial markets expect negative policy interest rates in the euro area and Japan to last through the end of this decade. An unprecedented result is that almost 40 percent of advanced economy government bonds carry negative yields.

Banks need sustained profits to support economic recovery

Financial stability now depends on how well financial institutions adapt to this new era, according to the IMF. Since the crisis, enhanced regulation and oversight have strengthened banks’ capital and liquidity buffers, making them safer. However, this new era of low growth and low rates threatens to undermine these gains.

Markets have serious concerns about the ability of many banks to remain viable and healthy, and whether economic recovery is sufficient to restore sustainable profitability. The report includes a detailed bottom-up exercise on more than 280 banks, covering roughly 70 percent of the banking systems in the United States and Europe.

The analysis finds that a cyclical recovery will not resolve the problem of weak banks. A large majority of the U.S. banking system has returned to healthy levels of profitability, but some weaknesses remain. In contrast, in Europe, one third of the banking system - representing some $8.5 trillion in assets - remains weak and unable to generate sustainable profits.

The IMF said banks and policymakers need to tackle substantial structural challenges:

First, European banks need to resolve the legacy of nonperforming loans . This requires supportive policy action to strengthen insolvency and recovery regimes to reduce foreclosure times. If this were to be achieved, it would turn a capital cost of removing nonperforming loans of about €80 billion euros into a benefit to capital of about €60 billion euros.

  • Second, European banks need to become more efficient . There are simply too many branches with too few deposits and too many banks with funding costs well above their peers. Addressing these business model challenges is vital to ensure sustainable profitability.

  • Third, weak banks will have to exit and some banking systems will have to shrink. This will ensure a vibrant banking system that supports economic recovery.

  • Fourth, policymakers have to complete regulatory reforms to reduce uncertainty without an across-the-board increase in capital requirements.

According to the IMF, undertaking these structural reforms would improve profitability in European banks by over $40 billion annually. And combined with a cyclical recovery, these structural reforms would improve the share of healthy European banks to over 70 percent.

Emerging market firms should shed debt

Emerging markets must adapt to the new era of lower global growth, lower commodity prices, and reduced global trade, according to the IMF. Low interest rates and investors' search for higher returns on their investments present an opportunity for highly indebted firms to restructure their balance sheets and reduce the burden of higher debt levels.

Corporate debt in many emerging markets may have peaked, since firms have slashed investment in the wake of commodity price declines, reducing the need for borrowing. These trends are helping to slow the rate of growth of credit to the private sector, and reducing the level of excess credit.

"However, achieving a substantial deleveraging will take a long time," said Dattels. "Under our benign baseline scenario, indebtedness declines only gradually, returning to 2014 levels by 2021." High debt levels leave emerging markets sensitive to risks and exposed to reversals of capital flows.

Banks in emerging markets

Banks in most emerging markets appear to have sufficient capital and liquidity to cushion their current holdings of nonperforming loans. The bad news is that, while debt may have peaked, defaults are likely to rise further. The report finds that larger bank buffers are needed in several emerging markets. To insure against this, authorities need to address corporate vulnerabilities, including through swift recognition of nonperforming loans and strong of insolvency frameworks.

In China, credit continues to grow rapidly. An increasing share is being packaged into complex and opaque credit products, proliferating outside of the traditional banking sector. These credit products are ending up on smaller Chinese banks’ balance sheets, with exposure that, in many cases, far exceeds their capital, adding to financial system risks from highly indebted corporates, the IMF said.

These developments suggest that the Chinese financial system is growing more complex, but also more vulnerable. Policymakers need to build on their reform progress to address promptly the corporate debt overhang and curb excessive credit growth, including for riskier credit products.

Globally, policymakers should tackle medium-term challenges now to avoid economic and financial stagnation. The financial policies outlined in the report form part of the IMF’s three pronged strategy - using structural, fiscal, and monetary policies within and across countries and over time - to achieve stronger growth and financial stability.

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