current financial stability issues: some lessons from global level analysis charles augustine abuka...

Current Financial Stability Issues: Some Lessons From

Global Level Analysis Charles Augustine Abuka

Director, Financial StabilityBank of Uganda

COMESA Course on Forward Looking Financial Stability ReportsNovember 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

• 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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• 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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• 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. 7

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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• 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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Sovereigns


• 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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Sovereigns


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• 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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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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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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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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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 AA-rated OECD government securities accounted for $33 trillion or 45 percent of the total supply of potentially safe assets.

Safe Assets: Financial System Cornerstone?


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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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.


• 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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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 medium-term 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.28

..

Figure 1.0 .Global Financial Stability Map Figure 1.1 Global Financial Stability

Map :Assessment of Risks and conditionsa)

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 1.4 :Total deleveraging by sample banks (2011,Q3-2013-Q4)

Figure 1.3- Capital Flight from the periphery to the coreFigure 1.4- Increasing pressure on banks to reduce assets and creditFigure 1.5- Private borrowing is being replaced by public sector flows

Source: IMF estimates

Figure 1.5: Euro-area exposures to Greece, Ireland, Italy, Portugal, and Spain (Billions of euros)

Figure 1.3:Portfolio and Other Investment Capital Flows in the Euro Area, Excluding Central Banks(in percent of GDP in Preceding year)

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• 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 de-risking 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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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. 33

..

Figure 1.6: US bank holding companies balance sheet liabilities at

end 2011 (in percent)

Figure 1.7 Reliance on US dealer banks on capital markets revenue and whole sale funding

Figure 1.8: Market reaction: Heightened uncertainty and policy

Figure 1.9:Change in 10 year US treasury yield in recent business cycles basis points relative to cycle peak

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• 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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• 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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• 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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• 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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• 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.

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..

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

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..

Figure 2.7: Bank holdings of local government debt and additional

purchases under outflow scenario

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)

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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 46

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 make-up 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. 48

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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• 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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• 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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current financial stability issues: some lessons from global level analysis charles augustine abuka...

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