World Economic and Financial Surveys Global Financial Stability Report Restoring Condence and Progressing on Reforms OCTOBER 2012 International Monetary Fund ©2012 International Monetary Fund Cataloging-in-Publication Data Joint Bank-Fund Library 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 — Development countries — Periodicals. 2. International finance — Periodicals. 3. Economic stabilization — Periodicals. I. International Monetary Fund. II. Series: World economic and financial surveys. HG4523.G563 ISBN 978-1-61635-390-2 Please send orders to: International Monetary Fund, Publications Services P.O. Box 92780, Washington, DC 20090, U.S.A. Tel.: (202) 623-7430 Fax: (202) 623-7201 E-mail: publications@imf.org www.imfbookstore.org www.elibrary.imf.org CONTENTS International Monetary Fund | October 2012 iii Preface ix Executive Summary xi Chapter 1 Global Financial Stability Assessment 1 Status of Stability Indicators 1 e Euro Area 4 e United States 15 Japan 16 Emerging Markets and Other Economies 16 Regulatory Reform 17 References 20 Chapter 2 Restoring Condence and Containing Global Spillovers 21 Global Debt Overhang and Stability Challenges 21 Euro Area Crisis—Reversing Financial Fragmentation 25 e United States: Stability or Complacency? 42 Japan: How Safe a Safe Haven? 52 Emerging Market and Other Economies: Navigating Domestic and Global Risks 55 Annex 2.1. Update to the EU Bank Deleveraging Exercise 68 References 73 Chapter 3 The Reform Agenda: An Interim Report on Progress Toward a Safer Financial System 75 Summary 75 Structural Features Associated with the Crisis 77 e Goal of Reforms—Desirable Structures of Financial Intermediation 80 Objectives and Implications of the New Regulatory Initiatives 82 Structural Implications of Crisis Intervention Measures 92 Change over the Past Five Years: Are Financial Systems Structurally Safer? 96 Analyzing the Eect of Reforms on Structures—An Early Look 104 Implications for the Reform Agenda 110 Annex 3.1. Financial Structure Indices 114 Annex 3.2. Regulatory Initiatives: Proposals and Implementation Status 116 Annex 3.3. Exploring the Impact of Regulatory and Crisis Intervention Policies on Financial Structures 132 Annex 3.4. Indices of Progress on Basel Capital and Liquidity Standards 136 References 137 Chapter 4 Changing Global Financial Structures: Can They Improve Economic Outcomes? 141 Summary 141 e Relationship between Financial Structures and Economic Outcomes 143 Simple Correlations 146 Country Case Studies 149 CONTENTS iv International Monetary Fund | October 2012 Multivariate Regressions 152 Policy Implications 161 Annex 4.1. What Does the Literature Say About the Relationship between Financial Structures and Economic Outcomes? 164 Annex 4.2. Econometric Study on Financial Structures and Economic Outcomes: Data, Methodology, and Detailed Results 166 Annex 4.3. Financial Structure Variables and the Probability of Banking Crises: Data, Methodology, and Detailed Results 172 References 174 Glossary 177 Annex: Summing Up by the Acting Chair 185 Statistical Appendix [Available online at www.imf.org/external/pubs/ft/gfsr/2012/02/pdf/statapp.pdf] Boxes 1.1. Falling Condence, Rising Risks, and Complacency 6 1.2. Recent Policy Initiatives, Developments, and Challenges in the Euro Area 9 1.3. Resilience of the Euro, or Fragile Equilibrium? 14 1.4. Regulatory Reform: From Rulemaking to Implementation 18 2.1. Systemic Risk in International Dollar Credit 25 2.2. Why Are Euro Area Periphery Sovereign Spreads So High? 28 2.3. European Bank Deleveraging: An Update 31 2.4. Corporate Sector Fundamentals, Funding Conditions, and Credit Risks 36 2.5. Key Challenges for the Dealer Operations of U.S. Banks 43 2.6. How Impaired Is Liquidity in the U.S. Corporate Bond Trading Market? 49 2.7. Avoiding the Pitfalls of Financial Liberalization in China—Credit Risk, Liquidity Mismatches, and Moral Hazard in Nonbank Intermediation 63 3.1. Risks Associated with New Forms of Financial Intermediation 78 3.2. Global Deleveraging Landscape: Economy- and Bank-Level View 87 3.3. TRuPs and the Impact of Basel III on U.S. Banks 89 3.4. Side Eects of Low Policy Interest Rates 94 3.5. Did Some Banking Systems Withstand International Contagion Because ey Are Less Globally Integrated? 106 4.1. Financial Depth and Economic Outcomes 144 4.2. How Robust Are the Econometric Results? 148 4.3. Australia 153 4.4. e United States 155 4.5. Germany 156 4.6. Japan 157 4.7. China 159 Tables 2.1. Indebtedness and Leverage in Selected Advanced Economies 22 2.2. Banking Financial Stability Indicators 23 2.3. Sovereign Market and Vulnerability Indicators 24 2.4. Key Features of Sovereign Funding and Bank Deleveraging Scenarios 34 2.5. Holdings of Treasury Securities, by Sector 46 CONTENTS International Monetary Fund | October 2012 v 2.6. Impact on Domestic Bank Balance Sheets from a Hypothetical Reversal of Foreign Inows into Local Bond Markets 59 2.7. Overview of Recent Macroprudential and Capital Flow Measures in Selected Emerging Market and Other Economies 66 2.8. Indicators of Vulnerability and Policy Space For Emerging Market and Other Economies 67 2.9. Summary of Updates in the Deleveraging Exercise 69 2.10. Assumptions on Key Macro-Financial Variables 69 2.11. Average Funding Rollover Rates 70 2.12. Amount of Additional Funding Required from Domestic Investors 71 2.13. Progress on the Implementation of Business Plans by Selected EU Banks 72 3.1. Financial Structure before the Crisis and Financial Stress during the Crisis 81 3.2. Snapshot of the New Regulatory Initiatives 84 3.3. Possible Eects of Regulatory Reforms on Financial Structure 85 3.4. Government and Central Bank Crisis Measures, 2007–10 93 3.5. Eect of Progress in Basel Capital Rules on Intermediation Structures 105 3.6. Indices, Subindices, and Data Sources 115 3.7. Snapshot of the New Global Regulatory Initiatives: Resolution of G-SIFIs 118 3.8. Status of Initiatives, by Selected Economy 122 3.9. Eect of Progress in Basel Liquidity Rules on Intermediation Structures 134 3.10. Eect of Financial Policies on Intermediation Structures: Crisis Intervention Policies 135 3.11. Basel Capital and Liquidity Progress Index 136 4.1. Financial Structure Measures in is GFSR 147 4.2. Financial Sector Size, Structure, and Economic Performance in Case Study Countries 154 4.3. Summary of Fixed-Eects Panel Estimation Results on Economic Outcomes, 1998–2010 160 4.4. List of Variables Used in Regression Analysis 167 4.5. Fixed-Eects Panel Estimation with Interaction Term, 1998–2010 168 4.6. Fixed-Eects Panel Estimation with Quadratic Term, 1998–2010 170 4.7. Systemic Banking Crises and Financial Structure Variables: Probit Model 173 Figures 1.1. Global Financial Stability Map 2 1.2. Global Financial Stability Map: Assessment of Risks and Conditions 3 1.3. Asset Price Performance since April 2012 GFSR 4 1.4. Cumulative Flows to Global Mutual Funds 4 1.5. Portfolio and Other Investment Capital Flows in the Euro Area, Excluding Central Banks 5 1.6. Spain and Italy: Changes in Foreign Investor Shares and Yields 5 1.7. Euro Area Exposures to Greece, Ireland, Italy, Portugal, and Spain 5 1.8. Periphery Minus Core Credit Default Swap Spreads 5 1.9. Total Deleveraging by Sample Banks 12 1.10. Reduction in Euro Area Supply of Credit under Alternative Policy Scenarios 12 1.11. Impact on Investment from EU Bank Deleveraging 12 1.12. Impact on Employment from EU Bank Deleveraging 12 1.13. Impact on GDP from EU Bank Deleveraging 13 1.14. Reduction in Bank Assets: Sensitivity to Periphery Sovereign Spreads 13 2.1. Government Bond Yields and Volatility 27 2.2. Bank Holdings of Government Bonds in Spain and Italy 27 2.3. Sovereign–Bank Nexus for Italy and Spain 27 2.4. Portfolio Outows from Italy and Spain 27 2.5. Periphery Minus Core Bank Credit Default Swap Spreads 29 CONTENTS vi International Monetary Fund | October 2012 2.6. Euro Area Bank Debt Issuance 29 2.7. Bank Deposit Flows in the Euro Area 29 2.8. Bank Customer Deposit Trends 30 2.9. Changes in the Sovereign Investor Base 30 2.10. Bank Credit to Domestic Governments and the Private Sector, Selected Euro Area Countries 30 2.11. Change in Euro Area Bank Cross-Border Exposures 33 2.12. Change in Interest Rate on New Bank Loans 33 2.13. Pressure on Euro Area Banks 33 2.14. Total Deleveraging by Sample Banks 35 2.15. Total Deleveraging Due to Selected Stand-Alone Factors 35 2.16. Reduction in Supply of Credit to Euro Area: Core versus Periphery 35 2.17. Reduction in Credit Supply: Global Spillovers 37 2.18. Impact of EU Bank Deleveraging on GDP, 2013 Projection 37 2.19. Reduction in Credit Supply to Euro Area: Sensitivity to Periphery Sovereign Spreads under Alternative Policy Scenarios 38 2.20. Bank Credit to Nonnancial Firms in Italy and Spain 38 2.21. Corporate Bond Issuance Needs through End-2013 under Alternative Deleveraging Scenarios 38 2.22. Projected Average Interest Rates on Outstanding Sovereign Debt 39 2.23. Projected Sovereign Interest Expense as a Proportion of Revenue 39 2.24. Sovereign and Corporate Credit Ratings in the Euro Area Periphery 39 2.25. TARGET2 Projections 41 2.26. Borrowing from Central Banks 41 2.27. U.S. Five-Year Swap Rate and Implied Probability Distribution 42 2.28. Contributions to Change in Fitted 10-Year Nominal Treasury Yield 46 2.29. Private Sector Financial Balance Relative to Year before Outbreak of Financial Crisis, Selected Advanced Economies 46 2.30. Change in 10-Year U.S. Treasury Yield in Recent Business Cycles 46 2.31. Bank Credit in Past and Current Credit Cycles 47 2.32. Market Reaction: Heightened Uncertainty and Policy 47 2.33. U.S. Government Debt and Interest Payments 47 2.34. Foreign Investors’ Share of Outstanding Sovereign Debt, as of End-2011 48 2.35. Rollover Risk: Weighted Average Maturity of Sovereign Bonds 48 2.36. Primary Dealers’ Positioning in U.S. Treasury Securities 48 2.37. Bank Holdings of Government Debt in Selected Advanced Economies 52 2.38. Sensitivity of Japanese Banks to a 100 Basis Point Interest Rate Shock 53 2.39. Cumulative Purchases of Japanese Government Bonds since 2007 53 2.40. Japanese Bank Holdings of Government Debt to 2017 under Current Trend 53 2.41. Foreign Claims of Japanese Banks 54 2.42. Foreign Holdings of Japanese Government Securities 54 2.43. Emerging Market Bond Fund Assets under Management, by Geographic Location 55 2.44. Resilience of Inows into Emerging Market Local-Currency Bond Funds Despite Euro Area Stress 55 2.45. Performance of Emerging Market Equities and Bonds vs. Economic Surprise Index 56 2.46. Sensitivity of Selected Sovereign CDS to CDS of Euro Area Periphery, 2011–12 56 2.47. Net International Investment Position versus Gross External Debt, Selected Economies, 2011 57 2.48. Share of Foreign-Currency-Denominated Bank Loans in Total Loans 57 2.49. Ratio of Nonperforming Loans to Total Loans 57 CONTENTS International Monetary Fund | October 2012 vii 2.50. Change in Volatility of Local Bond Returns Relative to Foreign Participation and Domestic Investor Base 58 2.51. Nonresident Holdings of Government Debt and Market Liquidity 58 2.52. Bank Holdings of Local Currency Government Debt and Additional Purchases under Outow Scenario 60 2.53. Credit Cycle Position of Selected Economies: 2006 and 2011 61 2.54. Change in Private Sector Credit, 2006–11 61 2.55. Change in Real House Prices, 2006–11 62 2.56. Nonperforming Loans in Selected Economies, 2008, 2010, and 2011 62 2.57. Ratio of Price to Book Value of Banks in Selected Economies, 2010–12 62 3.1. Size of the Global Financial System 82 3.2. Market-Based Intermediation 98 3.3. Market-Based Intermediation: New Financial Products 99 3.4. Scope and Scale: Interconnectedness, Funding, Concentration 100 3.5. Globalization 102 3.6. Illustration of Dierence-in-Dierences Method 132 4.1. Time Varying Correlations: Financial Globalization Index 150 4.2. Time Varying Correlations: Financial Buers 151 4.3. Financial Structure and Economic Growth, 1998–2010 152 e Global Financial Stability Report (GFSR) assesses key risks facing the global nancial system. 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 nancial stability and the sustained economic growth of the IMF’s member countries. Risks to nancial stability have increased since the April 2012 GFSR, as condence in the global nancial system has become very fragile. Despite signicant and continuing eorts by European policy- makers, the principal risk remains the euro area crisis. e current report highlights how risks have changed over the past six months, traces the sources and channels of nancial distress with a focus on bank deleverag- ing and euro area market fragmentation, examines progress on the reform agenda and whether the reforms are contributing to a safer nancial system, and analyzes the relationship between nancial structures and eco- nomic outcomes to determine if certain nancial systems are associated with higher or more stable growth. e analysis in this report was coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of José Viñals, Financial Counsellor and Director. e project was directed by Jan Brockmeijer and Robert Sheehy, both Deputy Directors; Peter Dattels and Laura Kodres, Assistant Directors; and Matthew Jones, Advisor. It has beneted from comments and suggestions from the senior sta in the MCM department. Individual contributors to the report were Sergei Antoshin, Nicholas Arregui, Serkan Arslanalp, Sophia Avramova, Adolfo Barajas, Ana Carvajal, Eugenio Cerutti, Su Hoong Chang, Ken Chikada, Nehad Chowdhury, Kay Chung, Sean Craig, Era Dabla-Norris, Reinout De Bock, Martin Edmonds, Jennifer Elliott, Michaela Erbenova, Ellen Gaston, Jeanne Gobat, Tom Gole, Kristian Hartelius, Sanjay Hazarika, Changchun Hua, Anna Ilyina, Patrick Imam, Marcel Kasumovich, William Kerry, John Ki, Oksana Khadarina, Michael Kleeman, Alexandre Kohlhas, Peter Lindner, Rebecca McCaughrin, Tommaso Mancini Grioli, André Meier, Fabiana Melo, Paul Mills, Srobona Mitra, Gianni de Nicolò, S. Erik Oppers, Nada Oulidi, Evan Papageorgiou, Jaume Puig, Lev Ratnovski, André Santos, Jochen Schmittmann, Katharine Seal, Stephen Smith, Tao Sun, Jay Surti, Narayan Suryakumar, Takahiro Tsuda, Nico Valckx, Constant Verkoren, Chris Walker, Rodolfo Wehrhahn, Christopher Wilson, Xiaoyong Wu, Mamoru Yanase, Lei Ye, Luisa Zanforlin, and Jianping Zhou. Ivailo Arsov, Martin Edmonds, Mehmet Gorpe, Mustafa Jamal, Oksana Khadarina, and Yoon Sook Kim provided analytical support. Gerald Gloria, Nirmaleen Jayawardane, Juan Rigat, and Ramanjeet Singh were responsible for word processing. Joanne Johnson of the External Relations Department edited the manuscript and coordinated production of the publication, with assistance from Gregg Forte. is issue of the GFSR draws, in part, on a series of discussions with banks, clearing organizations, securi- ties rms, asset management companies, hedge funds, standards setters, nancial consultants, pension funds, central banks, national treasuries, and academic researchers. e report reects information available up to September 14, 2012. e report beneted from comments and suggestions from sta in other IMF departments, as well as from Executive Directors following their discussion of the GFSR on September 14, 2012. However, the analysis and policy considerations are those of the contributing sta and should not be attributed to the Executive Direc- tors, their national authorities, or the IMF. PREFACE International Monetary Fund | October 2012 ix Conventions x International Monetary Fund | October 2012 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 is equivalent to 1/4 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. The boundaries, colors, denominations, and 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. [...]... chapter 1 Global Financial Stability Assessment Figure 1.2. Global Financial Stability Map: Assessment of Risks and Conditions (In notch changes since the April 2012 GFSR) Risk appetite contracted across all measures, reversing the improvement in the beginning of the year 4 Lending conditions stabilized and financial conditions deteriorated, leaving overall monetary and financial conditions unchanged. ... International Monetary Fund | October 2012 1 GLOBAL FINANCIAL STABILITY REPORT Figure 1.1 Global Financial Stability Map Emerging market risks Risks Credit risks April 2012 GFSR October 2012 GFSR Macroeconomic risks Market and liquidity risks Monetary and financial Conditions Risk appetite Source: IMF staff estimates Note: Away from center signifies higher risks, easier monetary and financial conditions,... aimed at producing a safer financial system hinges on effective implementation and strong supervision Without those elements, regulatory reform may fail to secure greater financial stability chapter 1 Global Financial Stability Assessment Risks to financial stability have increased since the April 2012 Global Financial Stability Report (GFSR), as confidence in the global financial system has become... assets; and for nonfinancial firms, by outstanding bonds Corporate spreads are calculated via option-adjusted bond spreads Core = Austria, Belgium, Finland, Germany, and the Netherlands; periphery = Greece, Ireland, Italy, Portugal, and Spain International Monetary Fund | October 2012 5 GLOBAL FINANCIAL STABILITY REPORT have increased amid a sharp economic downturn, worsening funding conditions for... International Monetary Fund | October 2012 Dattels, Peter, Rebecca McCaughrin, Ken Miyajima, and Jaume Puig, 2010, “Can You Map Global Financial Stability? ” IMF Working Paper No 10/145 (Washington: International Monetary Fund) European Council, 2012, “Towards a Genuine Economic and Monetary Union” (Brussels) http://consilium.europa.eu/ uedocs/cms_data/docs/pressdata/en/ec/131201.pdf Financial Stability. .. Effective Resolution Regimes for Financial Institutions” (Basel) www.financialstabilityboard.org/publications/ r_111104cc.pdf International Association of Insurance Supervisors (IAIS), 2012, Global Systematically Important Insurers: Proposed Assessment Methodology” (Basel) www.iaisweb org/G-SIIs 918 chapter 2 Restoring Confidence and Containing Global Spillovers Global Debt Overhang and Stability Challenges... subcategory of risks and conditions The “overall” notch change in each panel is the simple average of notch changes in individual indicators in that panel In the panel on monetary and financial conditions, a positive value for lending conditions represents slower pace of tightening or faster easing, and QE = quantitative easing International Monetary Fund | October 2012 3 GLOBAL FINANCIAL STABILITY REPORT... restoration of confidence based on additional policy actions that demonstrate political commitment to closer integration Specifically, it assumes that policymakers establish a single supervisory mechanism on chapter 1 Global Financial Stability Assessment the current timetable and contain pressures on spreads, including potentially through the ECB’s OMT program, and policymakers in periphery economies... measures at the national level are likely to be needed, as discussed below Restoring stability to reverse financial fragmentation within the monetary union remains the key policy challenge 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... fragmentation increase and become entrenched (Box 1.3) Potential financing gaps widen, the degree of fragmentation and financial repression increases, capital holes in banking systems expand, and the increasing intra-euro area capital account crisis spills outward These developments pose a far-reaching threat to the global financial system and the global economic outlook •• To avoid rising economic and financial . World Economic and Financial Surveys Global Financial Stability Report Restoring Condence and Progressing on Reforms OCTOBER 2012 International Monetary Fund ©2012 International Monetary Fund . Correlations: Financial Globalization Index 150 4.2. Time Varying Correlations: Financial Buers 151 4.3. Financial Structure and Economic Growth, 1998–2010 152 e Global Financial Stability. positioning. Macroeconomicrisksincreased due to deterioration in economic activity indicators. Lending conditions stabilized and nancial conditions deteriorated, leaving overall monetary and nancialconditionsunchanged. Credit