IMF report October 2014: We need more financial risk-taking, but less excess

Good report covering the state of global banking, where the risks lie, and how "normal" banks are not the go-to source of credit anymore:


http://www.imf.org/external/pubs/ft/survey/so/2014/POL100814B.htm

Watche the short video interview:

http://www.imf.org/external/pubs/ft/gfsr/2014/02/index.htm

Policymakers Should Encourage Economic Risk Taking, Keep Financial Excess Under Control

IMF Survey

October 8, 2014

• Stability risks are shifting to shadow banks
• Revamp bank business models to support growth
• Address rising liquidity risks in credit markets

Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but growing excesses in financial risk-taking, which pose challenges to financial stability, according to the International Monetary Fund’s latest Global Financial Stability Report.

Six years after the start of the financial crisis, the global recovery continues to rely heavily on accommodative monetary policies in advanced economies. This has helped economic risk-taking in the form of higher investment and employment by firms, and higher consumption by households. But the impact has been too limited and uneven. Things look better in the United States and Japan, but less so in Europe and in emerging markets.

At the same time, a prolonged period of low interest rates and other central bank policies has encouraged the buildup of excesses in financial risk-taking. This has resulted in elevated prices across a range of financial assets, credit spreads too narrow to compensate for default risks in some segments, and, until recently, record-low volatility, suggesting that investors are complacent. What is unprecedented is that these developments have occurred across a broad range of asset classes and across many countries at the same time.

“The best way to address the new global imbalance between economic and financial risk-taking is to adopt policies that transmit the benefits of monetary policy to the real economy, and to address financial excesses through well-designed micro- and macroprudential measures,” said José Viñals, Financial Counsellor and head of the IMF’s Monetary and Capital Markets Department.

Banks need a new fitness regime
Banks hold significantly more capital than before the crisis, but many institutions do not have a sustainable business model that can support the recovery.

The report analyzed 300 large banks in advanced economies—which comprise the bulk of their banking system—and found that banks representing almost 40 percent of total assets are not strong enough to supply adequate credit in support of the recovery. In the euro area, this proportion rises to about 70 percent.

These banks will need a more fundamental overhaul of their business models, including a combination of repricing existing business lines, reallocating capital across activities, consolidation, or retrenchment. In Europe, the comprehensive review of bank balance sheets by the European Central Bank provides a strong starting point for these much-needed changes in bank business models.

Risks are moving to the shadows
Financial stability risks are shifting from the banking system to less-regulated shadow banks. For example, credit-focused mutual funds and exchange traded funds have seen massive asset inflows, and have collectively become among the largest owners of U.S. corporate and foreign bonds.
“The problem is that these fund inflows have created an illusion of liquidity in fixed income markets,” said Viñals. “The liquidity promised to investors in good times is likely to exceed the available liquidity provided by markets in times of stress.”
This mismatch is driven by the growing share of relatively illiquid assets held by credit mutual funds. It is a potentially powerful amplifier that could exacerbate pressures on credit funds in times of stress.

Spillovers could be global
Emerging markets have grown in importance as a destination for portfolio investors from advanced economies. These investors now allocate more than $4 trillion, or about 13 percent of their total investments, to emerging market equities and bonds—this share has doubled over the past decade. Because of these closer financial links, shocks emanating from advanced economies will propagate more quickly to emerging markets.

The increasing global synchronization of asset prices and volatilities, combined with rising market and liquidity risks in the shadow banking sector, could amplify the impact of shocks on asset prices. This may result in sharper price falls and more market stress.

Such an adverse scenario would hurt the global economy and, at the limit, could even compromise global financial stability. This chain reaction could be triggered by a wide variety of shocks, including geopolitical flare-ups, or a “bumpy” normalization of U.S. monetary policy.

Financial policies are key
Financial policies can help address the new global imbalance between economic and financial risk-taking.

First, to help economic risk-taking further, banks need to fundamentally adjust their business models to help improve the flow of credit to the economy. Safe sources of credit, outside the banking sector, should also be promoted, though this needs to be accompanied by effective regulation to avoid the build-up of future risks.

Second, policymakers need to design and implement a range of micro- and macroprudential policies to address financial excesses that can threaten stability. For example, greater oversight is needed of asset managers to ensure that redemption terms are better aligned with underlying liquidity conditions. More comprehensive monitoring and reporting of leverage in nonbank sectors and in emerging market companies would also help identify potential vulnerabilities.

Finally, policymakers must have the data necessary to monitor the build-up of financial stability risks. They must prepare to ensure they have the statutory authority and analytical capacity to use their macroprudential tools. Policymakers must also have an explicit mandate to act when needed and, equally important, the courage to act even if measures are highly unpopular.