APR 10 World Economic and Financial Surveys G l o b a l F i n a n c i a l S t a b i l i t y R e Global Financial Stability Report p o r t Meeting New Challenges to Stability and Building a Safer System 10 R P A IMF Global Financial Stability Report, April 2010 I N T E R N A T I O N A L M O N E T A R Y F U N D World Economic and Financial Surveys Global Financial Stability Report Meeting New Challenges to Stability and Building a Safer System April 2010 International Monetary Fund Washington DC ©2010 International Monetary Fund Production: IMF Multimedia Services Division Cover: Creative Services Figures: Theodore F. Peters, Jr. Typesetting: Michelle Martin Cataloging-in-Publication Data 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 — Developing countries –— Periodicals. 2. International finance — Periodicals. 3. Economic stabilization — Periodicals. I. International Monetary Fund. II. Title. III. World economic and financial surveys. HG4523.G563 ISBN: 978-1-58906-916-9 Please send orders to: International Monetary Fund, Publication Services 700 19th Street, N.W., Washington, D.C. 20431, U.S.A. Tel.: (202) 623-7430 Fax: (202) 623-7201 E-mail: [email protected] Internet: www.imfbookstore.org EXECUTIVE SUMMARY CONTENTS Preface ix Joint Foreword to World Economic Outlook and Global Financial Stability Report xi Executive Summary xiii Chapter 1. Resolving the Crisis Legacy and Meeting New Challenges to Financial Stability 1 A. How Has Global Financial Stability Changed? 1 B. Could Sovereign Risks Extend the Global Credit Crisis? 3 C. The Banking System: Legacy Problems and New Challenges 11 D. Risks to the Recovery in Credit 24 E. Assessing Capital Flows and Bubble Risks in the Post-Crisis Environment 28 F. Policy Implications 34 Annex 1.1. Global Financial Stability Map: Construction and Methodology 42 Annex 1.2. Assessing Proposals to Ban “Naked Shorts” in Sovereign Credit Default Swaps 45 Annex 1.3. Assessment of the Spanish Banking System 49 Annex 1.4. Assessment of the German Banking System 54 Annex 1.5. United States: How Different Are “Too-Important-to-Fail” U.S. Bank Holding Companies? 58 References 60 [The following supplemental annexes to Chapter 1 are available online at http://www.imf.org/external/pubs/ft/ gfsr/2010/01/index.htm] Annex 1.6. Analyzing Nonperforming Loans in Central and Eastern Europe Based on Historical Experience in Emerging Markets Annex 1.7. Credit Demand and Capacity Estimates in the United States, Euro Area, and United Kingdom Annex 1.8. The Effects of Large-Scale Asset Purchase Programs Annex 1.9. Methodologies Underlying Assessment of Bubble Risks Annex 1.10. Euro Zone Sovereign Spreads: Global Risk Aversion, Spillovers, or Fundamentals? Chapter 2. Systemic Risk and the Redesign of Financial Regulation 63 Summary 63 Implementing Systemic-Risk-Based Capital Surcharges 64 Reforming Financial Regulatory Architecture Taking into Account Systemic Connectedness 76 Policy Reflections 84 Annex 2.1. Highlights of Model Specification 86 References 87 Chapter 3. Making Over-the-Counter Derivatives Safer: The Role of Central Counterparties 91 Summary 91 The Basics of Counterparty Risk and Central Counterparties 93 International Monetary Fund | April 2010 iiiiii gLObaL FiNaNCiaL STabiLiTy REPORT MeetIng new challenges to stabIlIty and buIldIng a saFer systeM The Case for Over-the-Counter Derivative Central Clearing 96 Incentivizing Central Counterparty Participation and the Role of End-Users 100 Criteria for Structuring and Regulating a Sound Central Counterparty 105 How Should Central Counterparties Be Regulated and Overseen? 111 One versus Multiple Central Counterparties? 111 Conclusions and Policy Recommendations 113 References 116 Chapter 4. global Liquidity Expansion: Effects on “Receiving” Economies and Policy Response Options 119 Summary 119 Overview of the 2007–09 Global Liquidity Expansion 120 Effects of the Global Liquidity Expansion on the Liquidity-Receiving Economies 121 Policy Response Options for Liquidity-Receiving Economies 124 Effectiveness of Capital Controls 128 Conclusions 132 Annex 4.1. Econometric Study on Liquidity Expansion: Data, Methodology, and Detailed Results 136 Annex 4.2a. Global Liquidity Expansion—Capital-Account-Related Measures Applied in Selected Liquidity-Receiving Economies 142 Annex 4.2b. Global Liquidity Expansion—Policy Responses Affecting the Capital Account in Selected Liquidity-Receiving Economies 143 Annex 4.3. Country Case Studies 144 References 149 glossary 152 annex: Summing Up by the acting Chair 157 Statistical appendix 159 boxes 1.1. Explaining Swap Spreads and Measuring Risk Transmission among Euro Zone Sovereigns 7 1.2. Nonperforming Loans in Central and Eastern Europe: Is This Time Different? 18 1.3. Asian Residential Real Estate Markets: Bubble Trouble? 35 1.4. Could Conditions in Emerging Markets Be Building a Bubble? 38 1.5. Proposals to Address the Problem of “Too-Important-to-Fail” Financial Institutions 41 1.6. Estimating Potential Losses from Nonperforming Loans for Spain 51 1.7. Loan Loss Estimation for Germany 56 2.1. Proposals for Systemic Risk Prudential Regulations 66 2.2. Assessing the Systemic Importance of Financial Institutions, Markets, and Instruments 72 2.3. Computing an Aggregate Loss Distribution 74 2.4. Regulatory Architecture Proposals 77 2.5. Contingent Capital—Part of the Solution to Systemic Risk? 83 3.1. The Mechanics of Over-the-Counter Derivative Clearing 95 3.2. The Basics of Novation and Multilateral Netting 98 3.3. The Failure of Lehman Brothers and the Near-Failure of AIG 99 3.4. Central Counterparty Customer Position Portability and Collateral Segregation 104 3.5. History of Central Counterparty Failures and Near-Failures 108 iv International Monetary Fund | April 2010 CONTENTS 3.6. The European and U.S. Regulatory Landscapes 112 3.7. Legal Aspects of Central Counterparty Interlinking and Cross-Margining 114 4.1. Global Liquidity Expansion and Liquidity Transmission 122 4.2. Capital Controls versus Prudential Measures 127 4.3. Capital Controls on Outflows versus Inflows 128 4.4. Reserve Requirements and Unremunerated Reserve Requirements 129 4.5. Capital Account Measures—Event Study Results 133 4.6. Market Participant Views Regarding Effectiveness of Capital Controls 135 Tables 1.1. Sovereign Market and Vulnerability Indicators 5 1.2. Estimates of Global Bank Writedowns by Domicile, 2007–10 12 1.3. Aggregate Bank Writedowns and Capital 15 1.4. United States: Bank Writedowns and Capital 15 1.5. Spain: Bank Writedowns and Capital 16 1.6. Germany: Bank Writedowns and Capital 17 1.7. Projections of Credit Capacity for and Demand from the Nonfinancial Sector 27 1.8. Asset Class Valuations 32 1.9. Global Financial Stability Map Indicators 42 1.10. Ten Largest Sovereign Credit Default Swap Referenced Countries 46 1.11. Spain: Baseline and Adverse-Case Scenarios 53 1.12. Spain: Calculations of Cutoff Rates for Banks with Drain on Capital 53 1.13. Estimates of German Bank Writedowns by Sector, 2007–10 55 1.14. Germany: Bank Capital, Earnings, and Writedowns 57 2.1. Comparison of Some Methodologies to Compute Systemic-Risk-Based Charges 65 2.2. System-Wide Capital Impairment Induced by Each Institution at Different Points in the Credit Cycle and Associated Systemic Risk Ratings 70 2.3. Capital Surcharges Based on the Standardized Approach 71 2.4. Systemic-Risk-Based Capital Surcharges through the Cycle 74 2.5. Systemic-Risk-Based Cyclically Smoothed Capital Surcharges across Countries 76 2.6. Sample Systemic Risk Report 76 3.1. Currently Operational Over-the-Counter Derivative Central Counterparties 94 3.2. Incremental Initial Margin and Guarantee Fund Contributions Associated with Moving Bilateral Over-the-Counter Derivative Contracts to Central Counterparties 101 4.1. Relation between Equity Returns, Official Foreign Exchange Reserve Accumulation, and Liquidity under Alternative Exchange Rate Regimes 124 4.2. Fixed-Effects Panel Least-Square Estimation of the Determinants of Asset Returns— 41 Economies, January 2003–December 2009 137 4.3. Fixed-Effects Panel Least-Square Estimation of the Determinants of Asset Returns— 34 Economies, January 2003–December 2009 138 4.4. Fixed-Effects Panel Least-Square Estimation of the Determinants of Equity Returns— Regional Disaggregation, January 2003–December 2009 139 4.5. Fixed-Effects Panel Least-Square Estimation of the Determinants of Capital Flows— 34 Economies, January 2003–December 2009 140 4.6. Granger Causality Relations between Global and Domestic Liquidity 140 4.7. Determinants of Equity Returns, EGARCH (1,1) Specifications, January 2003–November 2009 141 International Monetary Fund | April 2010 v gLObaL FiNaNCiaL STabiLiTy REPORT MeetIng new challenges to stabIlIty and buIldIng a saFer systeM Figures 1.1. Global Financial Stability Map 1 1.2. Macroeconomic Risks in the Global Financial Stability Map 2 1.3. The Crisis Remains in Some Markets as Others Return to Stability 3 1.4. Sovereign Debt to GDP in the G-7 4 1.5. Sovereign Risks and Spillover Channels 4 1.6. Contributions to Five-Year Sovereign Credit Default Swap Spreads 6 1.7. The Four Stages of the Crisis 6 1.8. Sovereign Credit Default Swap Curve Slopes 9 1.9. Sovereign Risk Spilling over to Local Financial Credit Default Swaps, October 2009 to February 2010 10 1.10. Regional Spillovers from Western Europe to Emerging Market Sovereign Credit Default Swaps 10 1.11. Realized and Expected Writedowns or Loss Provisions for Banks by Region 11 1.12. U.S. Bank Loan Charge-Off Rates 13 1.13. Global Securities Prices 14 1.14. U.S. Mortgage Market 16 1.15. Banks’ Pricing Power—Actual and Forecast 20 1.16. Bank Debt Rollover by Maturity Date 20 1.17. Government-Guaranteed Bank Debt and Retained Securitization 21 1.18. Euro Area Banking Profitability 21 1.19. Net European Central Bank Liquidity Provision and Credit Default Swap Spreads 22 1.20. Bank Credit to the Private Sector 22 1.21. Bank Return on Equity and Percentage of Unprofitable Banks, 2008 23 1.22. Banking System Profitability Indicators 23 1.23. Real Nonfinancial Private Sector Credit Growth in the United States 24 1.24. Average Lending Conditions and Growth in the Euro Area, United Kingdom, and United States 24 1.25. Contributions to Growth in Credit to the Nonfinancial Private Sector 25 1.26. Nonfinancial Private Sector Credit Growth 26 1.27. Total Net Borrowing Needs of the Sovereign Sector 26 1.28. Credit to GDP 27 1.29. Low Short-Term Interest Rates Are Driving Investors Out of Cash 29 1.30. Emerging Market Returns Better on a Volatility-Adjusted Basis 29 1.31. Cumulative Retail Net Flows to Equity and Debt Funds 30 1.32. Refinancing Needs for Emerging Markets and Other Advanced Economies Remain Significant 31 1.33. Emerging Market Real Equity Prices: Historical Corrections 31 1.34. Incentives for Foreign Exchange Carry Trades Are Recovering 34 1.35. Real Domestic Credit Growth and Equity Valuation 34 1.36. All Risks to Global Financial Stability and Its Underlying Conditions Have Improved 43 1.37. Evolution of the Global Financial Stability Map, 2007–09 45 1.38. Net Notional Credit Default Swaps Outstanding as a Share of Total Government Debt 47 1.39. Correlation of Daily Changes in Five-Year Greek Credit Default Swap and Bond Yield Spreads 47 1.40. Sovereign Credit Default Swap Volumes 48 1.41. Spain: Nonperforming Loans 50 1.42. Spain: Real Asset Repossessions 50 1.43. Germany: Loan Loss Rates 57 1.44. Germany: Loan Losses 57 vi International Monetary Fund | April 2010 CONTENTS 2.1. Network Structure of Cross-Border Interbank Exposures 67 2.2. Simulation Step 1: Illustration of the Evolution of Banks’ Balance Sheets at Different Points in the Cycle 68 2.3. Simulation Step 2: Illustration of Contagion Effects at Different Points in the Credit Cycle 69 2.4. An Illustration of the Computation of Incremental Value-at-Risk for Bank 1 71 2.5. Simulation of Systemic Risk Capital Surcharges 73 2.6. Regulatory Forbearance under a Multiple Regulator Configuration 80 2.7. Regulatory Forbearance under a Multiple Regulator Configuration with Systemic Oversight Mandate 81 2.8. Regulatory Forbearance under Multiple and Unified Regulator Configurations with Oversight Mandate over Systemic Institutions 82 3.1. Global Over-the-Counter Derivatives Markets 93 3.2. Outstanding Credit Default Swaps in the Depository Trust & Clearing Corporation Data Warehouse 97 3.3. Derivative Payables plus Posted Cash Collateral 102 3.4. Typical Central Counterparty Lines of Defense against Clearing Member Default 107 4.1. Global Liquidity 121 4.2. Change of Central Bank Policy Rates 121 4.3. Liquidity-Receiving Economies: Composition of Capital Inflows 123 4.4. Emerging Markets Equity Indices 123 4.5. Brazil 145 4.6. Colombia 145 4.7. Thailand 146 4.8. Croatia 147 4.9. Korea 149 The following symbols have been used throughout this volume: . . . to indicate that data are not available; — to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist; – between years or months (for example, 2008–09 or January–June) to indicate the years or months covered, including the beginning and ending years or months; / between years (for example, 2008/09) to indicate a fiscal or financial year. “Billion” means a thousand million; “trillion” means a thousand billion. “Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to ¼ of 1 percentage point). “n.a.” means not applicable. Minor discrepancies between constituent figures and totals are due to rounding. As used in this volume the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis. The boundaries, colors, denominations, and any other information shown on the maps do not imply, on the part of the International Monetary Fund, any judgment on the legal status of any territory or any endorsement or acceptance of such boundaries. International Monetary Fund | April 2010 vii PREFaCE The Global Financial Stability Report (GFSR) assesses key risks facing the global financial system with a view to identifying those that represent systemic vulnerabilities. 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. Although global financial stability has improved, the current report highlights how risks have changed over the last six months, traces the sources and channels of financial distress, and provides a discussion of policy proposals under con- sideration to mend the global financial system. 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 MCM staff Jan Brockmeijer, Deputy Director; Peter Dattels and Laura Kodres, Division Chiefs; and Christo- pher Morris, Matthew Jones and Effie Psalida, Deputy Division Chiefs. It has benefited from comments and suggestions from the senior staff in the MCM department. Contributors to this report also include Sergei Antoshin, Chikako Baba, Alberto Buffa di Perrero, Alexandre Chailloux, Phil de Imus, Joseph Di Censo, Randall Dodd, Marco Espinosa-Vega, Simon Gray, Ivan Guerra, Alessandro Gullo, Vincenzo Guzzo, Kristian Hartelius, Geoffrey Heenan, Silvia Iorgova, Hui Jin, Andreas Jobst, Charles Kahn, Elias Kazarian, Geoffrey Keim, William Kerry, John Kiff, Annamaria Kokenyne, Van- essa Le Lesle, Isaac Lustgarten, Andrea Maechler, Kazuhiro Masaki, Rebecca McCaughrin, Paul Mills, Ken Miyajima, Sylwia Nowak, Jaume Puig, Christine Sampic, Manmohan Singh, Juan Solé, Tao Sun, Narayan Suryakumar, and Morgane de Tollenaere. Martin Edmonds, Oksana Khadarina, Yoon Sook Kim, and Marta Sanchez Sache provided analytical support. Shannon Bui, Nirmaleen Jayawardane, Juan Rigat, and Ramanjeet Singh were responsible for word processing. David Einhorn of the External Relations Department edited the manuscript and coordinated production of the publication. This particular issue draws, in part, on a series of discussions with banks, clearing organizations, securi- ties firms, asset management companies, hedge funds, standard setters, financial consultants, and academic researchers. The report reflects information available up to March 2010 unless otherwise indicated. The report benefited from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussion of the Global Financial Stability Report on April 5, 2010. How- ever, 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. International Monetary Fund | April 2010 iixx JOiNT FOREwORD TO WORld EcOnOmic OutlOOk aND EFGOXlEROCEbUwaTlOi VFRiEDn SaUnMciMaal RSytability REpORt The global recovery is proceeding better than ciation of other floating currencies of advanced and expected but at varying speeds—tepidly in emerging economies. But these changes have been many advanced economies and solidly in limited, and global current account imbalances are most emerging and developing economies. World forecast to widen once again. growth is now expected to be 4¼ percent. Among the The outlook for activity remains unusually uncer- advanced economies, the United States is off to a bet- tain, and downside risks stemming from fiscal fragili- ter start than Europe and Japan. Among emerging and ties have come to the fore. A key concern is that room developing economies, emerging Asia is leading the for policy maneuvers in many advanced economies has recovery, while many emerging European and some either been exhausted or become much more limited. Commonwealth of Independent States economies are Moreover, sovereign risks in advanced economies could lagging behind. This multispeed recovery is expected undermine financial stability gains and extend the to continue. crisis. The rapid increase in public debt and deteriora- As the recovery has gained traction, risks to global tion of fiscal balance sheets could be transmitted back financial stability have eased, but stability is not yet to banking systems or across borders. assured. Our estimates of banking system write-downs This underscores the need for policy action to sus- in the economies hit hardest from the onset of the tain the recovery of the global economy and financial crisis through 2010 have been reduced to $2.3 tril- system. The policy agenda should include several lion from $2.8 trillion in the October 2009 Global important elements. Financial Stability Report. However, the aggregate The key task ahead is to reduce sovereign vulner- picture masks considerable differentiation within seg- abilities. In many advanced economies, there is a ments of banking systems, and there remain pockets pressing need to design and communicate credible that are characterized by shortages of capital, high medium-term fiscal consolidation strategies. These risks of further asset deterioration, and chronically should include clear time frames to bring down gross weak profitability. Deleveraging has so far been driven debt-to-GDP ratios over the medium term as well as mainly by deteriorating assets that have hit both earn- contingency measures if the deterioration in public ings and capital. Going forward, however, pressures finances is greater than expected. If macroeconomic on the funding or liability side of bank balance sheets developments proceed as expected, most advanced are likely to play a greater role, as banks reduce lever- economies should embark on fiscal consolidation in age and raise capital and liquidity buffers. Hence, the 2011. Meanwhile, given the still-fragile recovery, the recovery of private sector credit is likely to be subdued, fiscal stimulus planned for 2010 should be fully imple- especially in advanced economies. mented, except in economies that face large increases At the same time, better growth prospects in many in risk premiums, where the urgency is greater and emerging economies and low interest rates in major consolidation needs to begin now. Entitlement reforms economies have triggered a welcome resurgence of that do not detract from demand in the short term— capital flows to some emerging economies. These for example, raising the statutory retirement age or capital flows however come with the attendant risk of lowering the cost of health care—should be imple- inflation pressure and asset bubbles. So far, there is no mented without delay. systemwide evidence of bubbles, although there are a Other policy challenges relate to unwinding mon- few hot spots, and risks could build up over a longer- etary accommodation across the globe and manag- term horizon. The recovery of cross-border financial ing capital flows to emerging economies. In major flows has brought some real effective exchange rate advanced economies, insofar as inflation expectations changes—depreciation of the U.S. dollar and appre- remain well anchored, monetary policy can con- International Monetary Fund | April 2010 xxii