Enhancing Financial Stability for Resilience During Uncertain Times
Capital markets are essential for driving economic activity, providing mechanisms for raising funds and allocating resources efficiently. The stability of these markets and the financial institutions that intermediate them are therefore macro-critical, especially when market volatility and economic uncertainty are high, as they are now.
In the latest Global Financial Stability Report, we assess that global financial stability risks have grown significantly, driven by tighter financial conditions and heightened trade and geopolitical uncertainty. Our assessment is supported by three salient and forward-looking vulnerabilities in the financial system:
- Capital markets have become increasingly concentrated—for example, the United States makes up nearly 55 percent of the global equity market, up from 30 percent two decades ago—and valuations of some assets remain stretched despite the recent sell-offs. Further asset price corrections suggest the need for close attention given the highly uncertain economic backdrop.
- Nonbank financial institutions, or NBFIs, have become more active in channeling savings toward investments since 2008, and their nexus with banks has continued to grow. Further sell-offs could strain some financial institutions, and the ensuing deleveraging in the sector could exacerbate market turmoil.
- Sovereign debt levels continue to rise, seemingly outpacing growth in market infrastructure tasked with ensuring smooth market functioning. Core government bond markets may see elevated volatility, especially those in countries with high debt levels. Riskier emerging markets, which have seen their sovereign bond spreads rise during the recent market turmoil, may find it more challenging to refinance their debt or fund additional government spending.
In all these areas, banks play a critical role. They lie at the heart of the financial system, not only because of their core lending function but also because of their key role in facilitating the growth of capital markets. Large international banks are important market-makers in securities and derivatives. They are also major providers of leverage to various NBFI segments, with the ability to lend directly against asset portfolios, through credit lines, or facilitate leverage indirectly through repos and derivatives.
Globally systemically important banks, or G-SIBs, and other leverage providers, such as clearing houses for derivatives, use various tools to protect themselves against the risk of failure of a given NBFI entity, including collateral requirements and arrangements to reduce gross exposures. However, they can’t control how much a client borrows elsewhere. Consequently, the nexus between banks and NBFIs have risen in recent years—for example, in the United States, NBFI borrowings have reached 120 percent of banks’ common equity tier 1 capital.
Increasing nexus between banks and nonbanks
Though expanded financial intermediation by nonbanks positively affects the economy, excessive growth predicated on borrowing from traditional banks may make both types of lenders more susceptible to potential contagion risks. Among other NBFI segments, this Global Financial Stability Report discusses how certain hedge funds, a key type of NBFI, may see their highly leveraged trading strategies backfire in volatile markets. This could lead to a deleveraging in which they sell assets into a falling market, in turn causing losses for banks that provided their leverage.
Another segment of NBFIs that has seen substantial growth is the private credit segment, which typically lends to smaller corporate borrowers. As private credit continues to grow, banks have become willing partners through joint ventures or by providing loan facilities. With global growth forecast to slow (see World Economic Outlook), the repayment ability of borrowers could deteriorate, leading to losses to both private credit funds and partner banks.
Debt is also increasing in a very different sector—government. Sovereign debt now accounts for 93 percent of global economic output, up from 78 percent a decade ago, and financing costs have increased in both nominal and real terms. Because government bonds are cornerstone instruments in capital markets, disruptions in this market could pose a threat to financial stability.
Growth-enhancing fiscal consolidation is key to alleviating this risk, as the Fiscal Monitor indicates. Another critical aspect is ensuring that the market remains liquid and well-functioning. For advanced economies, such resilience depends on governments moderating the large amounts of bond issuances on the one hand, and ensuring bank and nonbank broker-dealers have the capacity to intermediate them on the other. In emerging markets, the credibility of debt management frameworks is essential. This means it will be key to strengthen the capacity of institutions, have clear targets and strategies for issuing and redeeming bonds, and carefully calibrate the currency composition of bonds.
Policy recommendations
Nonbanks boosting leverage doesn’t necessarily negate the benefits they provide to the economy if guardrails ensure they can weather adverse shocks. For a start, enhanced reporting requirements should help supervisors develop a systemwide view of their activities and discern between which provide helpful financial intermediation and which take excessive risk or are poorly governed. It is crucial to strengthen policies that mitigate leverage and interconnectedness vulnerabilities, building on the Financial Stability Board’s and other standard-setting bodies’ minimum standards or recommendations.
Banks, as the foundation of the system, must be resilient to adverse shocks, including those stemming from their increasing interconnections with nonbanks. Full, timely, and consistent implementation of Basel III and other internationally agreed bank regulatory standards would ensure a level playing field across jurisdictions and guarantee ample and adequate capital and liquidity. Exposure of banks to NBFIs need to be managed prudently.
With rising sovereign debt levels, resilience in bond market functioning can be built up by policies that promote the central clearing of bonds and the reduction of counterparty risks, at the same time further bolstering the resilience of central clearing. It’s also important to ensure that key intermediaries in government bond markets are sound and operationally resilient.
For emerging markets, credible frameworks to meet government financing needs can strengthen bond markets. Other helpful tools include IMF-World Bank Medium-Term Debt Management Strategies for rolling over debt and assessing its currency composition and financing cost. Emerging economies may also consider ways to develop domestic markets for government bonds, as increased bond demand from long-term domestic investors has helped contain financing costs and external pressures in recent years.
