A Monitoring Fram ework for Global Financial Stability Dong He - - PowerPoint PPT Presentation

A Monitoring Fram ework for Global Financial Stability

Dong He Deputy Director Monetary and Capital Markets Department International Monetary Fund September 13, 2019

Outline

1)

Introduction

2) Matrix of Financial Vulnerabilities to Measure

Financial Stability Risks

3) Aggregate Measure of Financial Stability Risks:

Growth-at-Risk Approach

4) Policy Considerations

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Introduction (I)

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 “It’s awful. Why did nobody see it coming?” asked Queen Elizabeth II in November

2008 during a visit to the London School of Economics, wondering why nobody had predicted the Global Financial Crisis

 The bewilderment wasn’t unique to the British monarchy; across the world, many asked

the same question

 Ten years on, it remains difficult to forecast financial instability  However, progress is afoot to improve the understanding of important links between the

financial sector and the economy

 We now understand better how financial vulnerabilities can amplify negative shocks

and hurt output and employment

Introduction (II)

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 Since its inception, the financial stability monitoring framework of the IMF Global Financial

Stability Report (GFSR) has continued to evolve and improve

 This Staff Discussion Note describes the conceptual framework that underpins the current

approach to evaluate cyclical financial stability risks in the GFSR

 It is a systematic empirical approach designed:

• To lead to more consistent assessments over time
• To enhance transparency and communication in multilateral surveillance

 It consists of two parts: a “bottom-up” monitoring matrix of financial vulnerabilities and a “top-

down” measure of Growth-at-Risk

 It represents an investment towards a richer dataset to improve assessments of global financial

stability in the future

The Underlying Conceptual Framework

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 Financial stability risks reflect the interaction of:

• Financial vulnerabilities, such as stretched asset valuations and high financial sector leverage, and

negative shocks

• Negative shocks are amplified by vulnerabilities, creating an adverse feedback loop as asset prices fall

and financial firms de-leverage, leading to a sharp decline in economic growth

 The key role of “price of risk”

• Reflects risk appetite of lenders and borrowers
• They respond to low price of risk, leading to build-ups of vulnerabilities
• The reversal of price of risk can be sharp and nonlinear, resulting in a sudden tightening of financial

conditions

Endogenous Risk Taking, Vulnerabilities, and Financial Stability Risks

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Vulnerabilities and Amplification of Shocks

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• Negative shocks cause the price of risk to increase, and the effect on the real economy will depend on the

degree of financial vulnerability

• Risks will be greatest when both asset price valuations and financial vulnerabilities (red circle and red

rectangle) are high

A Two-Part Monitoring Framework (Part I)

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 A set of metrics of financial vulnerabilities for financial firms and markets based on macro-

financial linkages

• Main vulnerabilities would include
• leverage
• maturity and liquidity mismatches
• currency mismatches
• interconnectedness
• Each vulnerability could be measured for different types of financial intermediaries
• banks
• nonbank financial firms
• market-based finance
• A matrix of vulnerabilities for different entities/ markets

 Filling out the matrices could be challenging for many countries or regions because of lack of

data

• While such data may not be available initially, establishing a regular monitoring matrix should foster investment in

better, more consistent data which will allow for deeper analysis and better models once the data are filled out

Macro-financial Imbalances: Asset Markets

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Markets Valuations and Market Liquidity Short-term funding Libor-OIS spreads Corporate debt Risk premia, Underwriting standards, Market depth Equities Risk premia, Implied volatility, Market depth Foreign Exchange Cross-currency swaps, Implied volatility, Market depth Real Estate – Residential and Commercial Price growth, Price-to-rent deviations, Lending standards Sovereign Debt Term premia, Volatility, Market depth Examples of indicators that can be monitored

Macro-financial Imbalances: Financial Vulnerabilities

10 Leverage Maturity and Liquidity Mism atch External Debt Claim s and Currency Mism atch Interconnections and Com plexity Commercial banks, Depository institutions

Capital, Off-balance sheet assets Liquidity coverage, Asset- liability duration gap U.S. dollar funding needs, Cross-border funding Interbank claims, Financial innovations that introduce complexity

Nonbanks and Market- based finance

Capital, Securitization tranches, margin credit Short-term wholesale funds, Open-end funds, ETFs Funds invested in foreign debt Inter-financial claims, Common business models

Central Counterparties

Capital, Default fund, Lines of credit Liquidity lines Members provide critical services to a CCP

Nonfinancial sector – Households, Business, Government

Credit-to-GDP gap and growth, Debt service Debt maturity profile, Adjustable rate debt Debt issued in foreign currencies

Examples of indicators that can be monitored

Radar Chart of Vulnerabilities by Sector

Proportion of GDP of Systemically Important Countries* with Elevated Vulnerabilities, by Sector (Share of countries with high and medium-high vulnerabilities by GDP; assets for banks)

*The analysis includes 29 jurisdictions with systemically important financial sectors.

Banks Sovereigns Households Nonfinancial corporates Insurers Shadow banking

• Apr. 2019 GFSR
• Oct. 2018 GFSR

Global financial crisis

80 80% 100 100% 60 60% 40 40% 20 20%

More vulnerable

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A Two-Part Monitoring Framework (Part II)

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 A summary quantification, or “top down” assessment, of financial stability risk called

Growth-at-Risk (GaR)

 Expressed as downside risks to forecasted GDP growth conditional on financial

conditions

• Introduced in GFSR, April 2017; continued work to improve methodology
• Expresses financial stability risks in terms of GDP growth, a gauge that is commonly understood by the

public and policymakers

 Entire distribution of forecasted GDP growth is linked to financial conditions and its

variance is not constant (contrary to usual assumptions)

 GaR is focused on a low percentile of the distribution  Effects of financial conditions may also vary over the forecast horizon

GDP Growth Forecasts Conditional on Financial Conditions

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• The figure shows the effects of financial conditions on growth distributions one-year-ahead, based on panels of 11 AEs

and 11 EMEs

• Indicates that volatility is not constant, and the 5th percentile (GaR) is more volatile than the 95th percentile.

Probability Distribution of Forecasted GDP Growth for projection periods for Loose Financial Conditions and a Credit Boom

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Application of Growth-at-Risk in the April 2019 GFSR (I)

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Global Financial Conditions Index and Growth-at-Risk Estimates

Application of Growth-at-Risk in the April 2019 GFSR (II)

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Future extensions to improve Global GaR

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 Indicators of financial vulnerability can be included in estimates of global GaR in the

future, which will allow a richer assessment of which vulnerabilities present significant risks

 Contributions by individual countries to global GaR may vary in ways that are not

reflected solely by GDP weights

• High variability in vulnerabilities across countries
• Different degrees of interconnections to global activity
• Countries with global financial centers may contribute more

Financial Conditions, Vulnerabilities, and Policy Tools (I)

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 A systematic approach to monitoring cyclical risks to financial stability is the

foundation for implementing better stabilization policies

• Matrix can help identify specific vulnerabilities for policies to target
• GaR provides a summary indicator of severity of financial stability risks and can facilitate

evaluation of alternative policy options

 Both monetary policy and macroprudential policy affect financial conditions

• Monetary policy provides a basic underpinning of the price of risk, but may not be able to influence

risk premiums directly or with much precision

• Macroprudential policy raises the cost of credit by imposing higher regulatory constraints

Monetary Policy and Financial Conditions

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Financial Conditions, Vulnerabilities, and Policy Tools (II)

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 Macroprudential policy can more efficiently target specific vulnerabilities

• Prudential instruments are targeted, but can lose effectiveness overtime (“targeted therapy”)
• Some parts of the financial system may not be under prudential regulation
• There may be residual vulnerabilities that have to be taken care of by monetary policy

(“chemotherapy”)

 A Rule-of-Thumb ordering of policy options

• Macroprudential policy as the first line of defense; monetary policy can lend a hand occasionally
• Further research is ongoing

Macroprudential Tools for Financial Vulnerabilities

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Source: IMF, April 2019 GFSR

New annual survey on the use of macroprudential policies will facilitate more research to evaluate the effectiveness of macroprudential policies

Conclusions

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 In terms of the Queen’s question, this monitoring framework would have allowed us to

tell her that, if the vulnerabilities that were identified were left unaddressed, a severe financial crisis was likely, even if we could not tell her when that might happen

 Looking ahead, it formalizes regular systematic assessments of financial stability risks

and provides a summary measure of these risks in terms of output growth

 It thus allows financial stability risks to be incorporated into decision-making

frameworks for monetary policy and regulatory policy, rather than only intermittently when financial risks are already very high

 Further empirical and theoretical research will allow for counterfactual policy analysis

for the joint setting of macroprudential and monetary policies

End of Presentation

Thank you