World Economic and Financial Surveys Global Financial Stability Report Navigating the Financial Challenges Ahead 09 T C O 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 Navigating the Financial Challenges Ahead October 2009 International Monetary Fund Washington DC © 2009 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: 978-1-58906-810-0 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 xv Chapter 1. The Road to Recovery 1 A. Global Financial Stability Map 1 B. Challenges on the Road to Recovery for the Global Financial System 5 C. Emerging Markets Navigate the Global Crisis but Vulnerabilities Remain 20 D. Will Credit Constraints Hurt the Recovery? 27 E. Managing the Transfer of Private Risks to Sovereign Balance Sheets 34 F. Policy Implications 39 Annex 1.1. Global Financial Stability Map: Construction and Methodology 47 Annex 1.2. Loan Loss and Bank Writedown Estimation Methodology 53 Annex 1.3. Estimating Core Bank Earnings 64 Annex 1.4. Credit Demand and Capacity Estimates in the United States, Euro Area, and United Kingdom 65 Annex 1.5. The Impact of the Financial Crisis on the Savings Complex— Insurance and Pension Funds 68 References 74 Chapter 2. Restarting Securitization Markets: Policy Proposals and Pitfalls 77 The Rise, Decline, and Fall of Securitization 80 Policy Initiatives Aimed at Restarting Sustainable Securitization 93 Conclusions and Policy Recommendations 109 Annex 2.1. Optimal Retention Policy and Capital Requirements 110 References 113 Chapter 3. Market Interventions during the Financial Crisis: How Effective and How to Disengage? 117 Interventions during the Crisis—Market Reaction to Announcements 118 Follow-Up to Initial Market Reaction—Longer-Term Effects of Intervention 128 Japan’s Experience during the Latter Part of Its “Lost Decade” 132 Disengagement: A Conventional Primer for Unwinding Unconventional Policies 134 Conclusions and Policy Takeaways 144 Annex 3.1. Financial and Economic Stress Indices 149 Annex 3.2. Event Study Methodology and Data 149 References 151 Glossary 153 iii ConTEnTS Annex: Summing Up by the Acting Chair 162 Statistical Appendix 165 Boxes 1.1. Uncertainty Surrounding Loan Loss Estimations 8 1.2. Repairing Securitization Is Critical to Supporting the Supply of Credit 32 1.3. Rising Public Deficits, Debts, and Bond Yields 36 1.4. Restoring the Level and Quality of Bank Capital 44 2.1. The Case for Restarting Securitization 78 2.2. Credit Rating Agency Regulatory Developments 82 2.3. Re-Remics and the Revival of Resecuritization 86 2.4. Covered Bond Primer 90 2.5. Accounting for Securitization Exposures 94 2.6. Basel II Securitization- and Resecuritization-Related Enhancements 98 2.7. Optimal Retention Policies for Loan Securitization 102 3.1. Usage of Unconventional Central Bank Facilities 136 3.2. Interventions during Japan’s 1990s Financial Crisis 140 3.3. Excess Reserves as an Indicator of Funding Liquidity Concerns 143 3.4. Implications of the Changes on Central Bank Balance Sheets 145 Tables 1.1 Credit Market Spreads 5 1.2 Estimates of Global Bank Writedowns by Domicile, 2007–10 10 1.3 Bank Capital, Earnings, and Writedowns 15 1.4 Heat Map of Macro and Financial Indicators in Selected Emerging Market Countries 23 1.5 Growth of Credit Demand from Nonfinancial Private Sector 29 1.6 Total Net Borrowing Needs of Nonfinancial Sectors 34 1.7 Projections of Credit Capacity for and Demand from the Nonfinancial Sector 35 1.8 Selected Spreads: Current and Pre-Lehman Brothers 38 1.9 Sensitivity to Common Risk Factor for Euro Area Countries 39 1.10. Changes in Risks and Conditions since the April 2009 Global Financial Stability Report 48 1.11. OECD Database: Coverage and Degree of Consolidation 54 1.12. Statistical Output for the Euro Area Provision Rate Model 56 1.13. Forecasts of Euro Area Provision Rates by Loan Type 56 1.14. Statistical Output for the U.K. Provision Rate Model 59 1.15. Cumulative Loss Rates, 2007–10 60 1.16. List of Security Indexes 61 1.17. Euro Area Residential Securities Market 62 1.18. U.S. Residential Securities Market 63 1.19. Regression Results: Demand for Nonfinancial Private and Public Sector Credit 67 1.20. Underfunding Is More Serious in Mature U.S. Industries 71 1.21. Mandatory Defined-Contribution Pension Assets, Selected Countries 72 1.22. Equity Share in Total Portfolios, Selected Countries 73 1.23. Real Performance of Mandatory Defined-Contribution Systems, Selected Countries 74 1.24. Performance of Default Investment Options, Selected Countries 74 iv ConTEnTS 2.1. Securitization Policy Progress Report 96 2.2. United States: Issuance of Asset-Backed and Mortgage-Backed Securities— Average Degree of Tranche Retention 107 2.3. Credit Ratings versus Idealized Expected Losses and Basel II Risk Weights 111 2.4. Calculation of Tranche Sizes (Steps 1 and 2) with Assumed 20 Percent Effort Level 112 2.5. Calculation of Ratings and Risk Weights (Step 3) with 31.2 Percent Effort Level: Mezzanine Tranche Retention 113 3.1. Classification of Events 120 3.2. Number of Interventions 121 3.3. Effectiveness of Crisis Interventions 123 3.4. Effectiveness of Crisis Interventions on the Financial Stress Index 124 3.5. Efficiency of Financial Sector Policy Measures 127 3.6. Three-Month LIBOR-Overnight Index Swap (OIS) Spread: Declines from Peak 134 3.7. Supplementary Operations for Managing the Central Bank Balance Sheet 141 3.8. Reversibility and Impact of Financial Sector Measures 142 Figures 1.1. Global Financial Stability Map 2 1.2. Heat Map: Developments in Systemic Asset Classes 2 1.3. Contributions to Changes in Corporate Spreads 3 1.4. Systemic Bank Default Risk 3 1.5. Asset Price Volatility and Funding and Market Liquidity 4 1.6. Composite Real Private Borrowing Rate and Short-Term Interest Rates 4 1.7. U.S. Loan Charge-Off Rates 7 1.8. Euro Area: Provision Rates 7 1.9. Realized and Expected Writedowns or Loss Provisions for Banks by Region 12 1.10. Bank Problem Loans and Income 13 1.11. Bank Earnings 13 1.12. Bank Capital Needs 14 1.13. Mature Market Banks: Bond Debt Maturity Structure 17 1.14. Mature Markets: Gross and Guaranteed Bond Issuance by Month 17 1.15. European Central Bank Refinancing Facilities 18 1.16. Global Bank and Insurance Equity Indices 18 1.17. Funding Levels of Defined-Benefit Pension Plans of Companies in Major Equity Indices 19 1.18. Heat Map: Developments in Emerging Market Systemic Asset Classes 20 1.19. Contributions to Changes in Emerging Market Sovereign External Spreads 21 1.20. Emerging Europe Credit Default Swap Spreads, June 30, 2008 to August 31, 2009 21 1.21. Net Capital Inflows 22 1.22. Emerging Markets: Bank Credit to the Private Sector 24 1.23. Refinancing Needs of Emerging Market Forex-Denominated Corporate Debt 24 1.24. Emerging Market External Bond Issuance by Sector and Rating 25 1.25. Rollover Rate of Emerging Market Forex-Denominated Corporate Debt 25 1.26. Emerging Market Corporate Spreads and Speculative-Grade Default Rate 26 1.27. Emerging Europe: Nonperforming Loan Ratios 27 1.28. Private Sector Credit Growth 28 v ConTEnTS 1.29. Growth of Nonfinancial Sector Debt: History and Projected Borrowing Needs 30 1.30. Bank Lending Capacity Growth 30 1.31. Emerging Market Reserve Accumulation 31 1.32. Net Sovereign Debt Issuance in Mature Markets 38 1.33. Emerging Market Sovereign Issuance in International Capital Markets 38 1.34. Global Financial Stability Map: Monetary and Financial Conditions 49 1.35. Global Financial Stability Map: Risk Appetite 50 1.36. Global Financial Stability Map: Macroeconomic Risks 51 1.37. Global Financial Stability Map: Emerging Market Risks 51 1.38. Global Financial Stability Map: Credit Risks 52 1.39. Global Financial Stability Map: Market and Liquidity Risks 52 1.40. Provisions for Loan Losses 55 1.41. Estimated Share of Euro Area Bank Loans, 2007–10 57 1.42. Estimated Breakdown of Securities Exposure of Euro Area Banks 64 1.43. Growth of Nonbank Fixed-Income Assets Under Management 69 1.44. Financial Sector Credit Default Swap Spreads 70 1.45. Worsening Funding Ratio of U.S. Defined-Benefit Plans in 2008 72 2.1. The Securitization Landscape 80 2.2. Global Private-Label Securitization Issuance by Type 84 2.3. U.S. Private-Label Securitization Issuance by Type 84 2.4. European Private-Label Securitization Issuance by Type 85 2.5. U.S. Asset-Backed Security (ABS) and Private-Label Mortgage-Backed Security (MBS) Issuance 85 2.6. Credit Spreads on U.S. AAA Securitization Instruments 88 2.7. U.S. Government-Sponsored Enterprise versus Private-Label Mortgage-Backed Security Issuance 88 2.8. Non-U.S. and Non-European Private-Label Securitization Issuance 89 2.9. Global Covered Bond Issuance 92 2.10. Selected Covered Bond Spreads 92 2.11. Illustrative Intermediation Chain 93 2.12. Where Did All the AAAs Go? 93 2.13. U.S. Issuance of Asset-Backed and Mortgage-Backed Securities 106 3.1. Time Pattern of Crisis Measures in Sample Countries 119 3.2. Spillovers from Global and U.S. Crisis Interventions Reflected on the Financial Stress Index 126 3.3. United States: Impact of Counterproductive Interventions on the Financial Stress Index 128 3.4. Government-Guaranteed Bonds (GGB) and Nonguaranteed Investment-Grade Bank Bonds 128 3.5. Impact of Liability Guarantees on Bond Issuance 129 3.6. United States: Outstanding Amount of Commercial Paper 129 3.7. Securitization in the United States and Europe 130 3.8. Credit Growth and Bank Lending Standards 131 3.9. United States: Outstanding Amount of Unconventional Measures by the Federal Reserve 131 3.10. Impact of Financial Sector Stabilization Measures on Credit Default Swap (CDS) Spreads 132 vi ConTEnTS 3.11. Mortgage Rates 133 3.12. Banking Sector Current Account Balance with the Bank of Japan 133 3.13. Failed Banks Assisted by Deposit Insurance Corporation of Japan 135 3.14. Three-Month Spread between TIBOR and LIBOR 135 3.15. Japan: Bank Loans and the Consumer Price Index 139 3.16. Changes in the Major Components of Central Banks’ Balance Sheets 139 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, 1997–99 or January–June) to indicate the years or months covered, including the beginning and ending years or months; / between years (for example, 1998/99) 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 !/4 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. 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. In the current issue, the report discusses the evolution of the financial crisis and assesses the policies taken to mitigate its effects on economic activity. Looking forward, it also provides policy advice on navigating the financial challenges on the road to recovery for the global financial system. The analysis in this report has been coordinated in the Monetary and Capital Markets (MCM) Department under the general direction of José Viñals, Counsellor and Director. The project has been directed by MCM staff Jan Brockmeijer, Deputy Director; Peter Dattels and Laura Kodres, Division Chiefs; and L. Effie Psalida, Deputy Division Chief. It has benefited from comments and suggestions from Hervé Ferhani, Deputy Director. Contributors to this report also include Myrvin Anthony, Sergei Antoshin, Amitabh Arora, Emanuele Baldacci, Sean Craig, Phil de Imus, Wouter Elsenburg, Vincenzo Guzzo, Kristian Hartelius, Geoffrey Heenan, Gregorio Impavido, Hui Jin, Andreas Jobst, John Kiff, Michael Kisser, Manmohan Kumar, Vanessa Le Leslé, Yinqiu Lu, Kazuhiro Masaki, Rebecca McCaughrin, Paul Mills, Ken Miyajima, Christo- pher Morris, Sylwia Nowak, Jaume Puig, Mustafa Saiyid, Jodi Scarlata, and Ian Tower. Martin Edmonds, Oksana Khadarina, Yoon Sook Kim, Ryan Scuzzarella, and Narayan Suryakumar provided analytical support. Nirmaleen Jayawardane, Tsegereda Mulatu, and Ramanjeet Singh were responsible for word processing. David Einhorn of the External Relations Department edited the manuscript and coordi- nated production of the publication This particular issue draws, in part, on a series of discussions with accountancies, banks, securities firms, asset management companies, hedge funds, auditors, standard setters, financial consultants, and academic researchers, as well as regulatory and other public authorities in major financial centers and countries. The report reflects information available up to September 17, 2009. 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 Septem- ber 14, 2009. However, 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. ix