I have three key messages for you today:

1. Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges.

2. Banks are safer but may not be strong enough to vigorously support the recovery. And risks are shifting to the shadow banking system in the form of rising market and liquidity risks. If left unaddressed, these risks could compromise global financial stability.

3. In order to address this new global imbalance, we must promote economic risk-taking by improving the transmission of monetary policy to the real economy. And we must address financial excesses through better micro- and macroprudential policies.

Now I’d like to develop these themes.

More than 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, prolonged monetary ease 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. Finally, corporate leverage has continued to rise in emerging markets.

Addressing the policy challenges

Let me begin with banks. The good news is that banks are much safer now, having increased their capital levels and liquidity. However, this Global Financial Stability Report finds that many banks do not have the financial muscle to provide enough credit to vigorously support the recovery. It means that after stabilizing and repairing their balance sheets, banks now face a new challenge: They need to adapt their business models to the post-crisis market realities and new regulatory environment.

We analyzed 300 large banks in advanced economies—which comprise the bulk of their banking systems—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 assessment of balance sheets by the European Central Bank provides a strong starting point for these much-needed changes in bank business models.

In other words, when banks are receiving a clean bill of health in terms of capital adequacy, it means that they are safe enough to lead a “normal life”. But in many countries, we need banks to be “athletes” who can vigorously support the recovery.

While banks grapple with these challenges, capital markets are now providing more significant sources of financing, which is a welcome development. Yet this is shifting the locus of risks to shadow banks. For example, credit-focused mutual funds have seen massive asset inflows, and have collectively become a very large owner of U.S. corporate and foreign bonds.

The problem is that these fund inflows have created an illusion of liquidity in fixed income markets. The liquidity promised to investors in good times is likely to exceed the available liquidity provided by markets in times of stress, especially as banks have less capacity to make markets.

At the same time, 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.

Together, these factors will amplify the impact of shocks on asset prices, resulting 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.

So, what should be done to safeguard financial stability and strengthen the recovery? For this, policymakers need to address the new global imbalance between financial and economic risk-taking. They should use various means. To be clear, accommodative monetary policies remain essential to support the recovery so long as demand stays weak. But monetary policy alone cannot accomplish everything. Other policies—including structural reforms, smart fiscal policies, and financial policies—need to play their role. Let me focus on two key areas for financial policies.

  • First, economic risk-taking would benefit from an improved flow of bank credit to the economy. But in order to unclog the credit channel, many banks must fundamentally adjust their business model. Supervisors need to facilitate this structural transformation, which would allow banks to improve their profitability—without taking excessive risks—and to support the economy through lending. This is particularly important in Europe where banks play a major role in financing the economy.
  • Second, policymakers need to design and implement a range of micro- and macroprudential policies to address financial excesses that can threaten stability. For example, in the asset management sector, greater oversight is needed to ensure redemption terms are better aligned with underlying liquidity conditions. More comprehensive monitoring and reporting of leverage in nonbank sectors and in the corporate sectors of emerging markets will help identify areas of potential vulnerabilities. To safeguard against global liquidity strains, bilateral and multilateral swap lines could be deepened to mitigate excessive volatility. Such policies will strengthen the global financial system by making financial institutions more resilient, while helping contain procyclical asset price and credit dynamics. This is highly relevant today to deal with the growing risks in shadow banking, particularly market and liquidity risks.

Policy makers need to be alert to these growing challenges to financial stability, and must take further actions now both to promote economic risk-taking in support of growth, and to address excesses in financial risk-taking to maintain stability.

Published in collaboration with IMF Blog (iMF direct)

Author: José Viñals is Financial Counsellor and Director of the IMF’s Monetary and Capital Markets Department. 

Image: People are reflected on an electronic board displaying a graph showing the movement of Nikkei share average outside a brokerage in Tokyo November 7, 2012. REUTERS/Toru Hanai