Global Financial Stability Report October 2020

Near-term global financial stability risks have been contained as an unprecedented policy response to the coronavirus (COVID-19) pandemic has helped avert a financial meltdown and maintain the flow of credit to the economy. For the first time, many emerging market central banks have launched asset purchase programs to support the smooth functioning of financial markets and the overall economy. But the outlook remains highly uncertain, and vulnerabilities are rising, representing potential headwinds to recovery. The report presents an assessment of the real-financial disconnect, as well as forward-looking analysis of nonfinancial firms, banks, and emerging market capital flows. After the outbreak, firms’ cash flows were adversely affected as economic activity declined sharply. More vulnerable firms—those with weaker solvency and liquidity positions and smaller size—experienced greater financial stress than their peers in the early stages of the crisis. As the crisis unfolds, corporate liquidity pressures may morph into insolvencies, especially if the recovery is delayed. Small and medium-sized enterprises (SMEs) are more vulnerable than large firms with access to capital markets. Although the global banking system is well capitalized, some banking systems may experience capital shortfalls in an adverse scenario, even with the currently deployed policy measures. The report also assesses the pandemic’s impact on firms’ environmental performance to gauge the extent to which the crisis may result in a reversal of the gains posted in recent years.

The October 2019 Global Financial Stability Report (GFSR) identifies the current key vulnerabilities in the global financial system as the rise in corporate debt burdens, increasing holdings of riskier and more illiquid assets by institutional investors, and growing reliance on external borrowing by emerging and frontier market economies. The report proposes that policymakers mitigate these risks through stricter supervisory and macroprudential oversight of firms, strengthened oversight and disclosure for institutional investors, and the implementation of prudent sovereign debt management practices and frameworks for emerging and frontier market economies.

Financial stability risks have been contained so far, reflecting ongoing policy support and a rebound in the global economy earlier this year. Chapter 1 explains that financial conditions have eased further in net in advanced economies but changed little in emerging markets. However, the optimism that propelled markets earlier in the year has faded on growing concerns about the strength of the global recovery, and ongoing supply chain disruptions intensified inflation concerns. Signs of stretched asset valuations in some market segments persist, and pockets of vulnerabilities remain in the nonbank financial sector; recovery is uneven in the corporate sector. Chapter 2 discusses the opportunities and challenges of the crypto ecosystem. Crypto asset providers’ lack of operational or cyber resilience poses risks, and significant data gaps imperil financial integrity. Crypto assets in emerging markets may accelerate dollarization risks. Chapter 3 shows that sustainable funds can support the global transition to a green economy but must be scaled up to have a major impact. It also discusses how a disorderly transition could disrupt the broader investment fund sector in the future.

The October 2014 issue finds that six years after the start of the crisis, the global economic recovery continues to rely heavily on accommodative monetary policies in advanced economies. Monetary accommodation remains critical in supporting economies by encouraging economic risk taking in the form of increased real spending by households and greater willingness to invest and hire by businesses. However, prolonged monetary ease may also encourage excessive financial risk taking. Analytical chapters examine (1) the growth of shadow banking around the globe, assessing risks and discussing regulatory responses, and calling for a more encompassing (macroprudential) approach to regulation and for enhanced data provision; and (2) how conflicts of interest among bank managers, shareholders, and debt holders can lead to excessive bank risk taking from society’s point of view, finding no clear relation between bank risk and the level of executive compensation, but that a better alignment of bankers’ pay with long-term outcomes is associated with less risk.

Global financial stability risks have increased amid a series of cascading shocks. Chapter 1 analyzes the policy response of central banks to high inflation, the risks of a disorderly tightening of financial conditions, and debt distress among emerging and frontier markets. Markets have been extremely volatile, and a deterioration in market liquidity appears to have amplified price moves. In Europe, the energy crisis is contributing to a worsening outlook. In China, the property sector remains a key source of vulnerability. Chapter 2 examines how to narrow the climate financing gap in emerging market and developing economies. Climate policies, including carbon pricing, climate disclosures, and transition taxonomies, are crucial for enabling private climate finance. Innovative financial instruments can help to scale up private climate finance, but the public sector—including multilateral development banks—will have to play a key supporting role. Chapter 3 analyzes the contributions of open-end investment funds to fragilities in asset markets. Open-end investment funds play a key role in financial markets, but those offering daily redemptions while holding illiquid assets can amplify the effects of adverse shocks by raising the likelihood of investor runs and asset fire sales. This contributes to volatility in asset markets and potentially threatens financial stability.

The April 2020 Global Financial Stability Report (GFSR) assesses the financial stability challenges posed by the coronavirus (COVID-19) pandemic. Chapter 1 describes how financial conditions tightened abrubtly with the onset of the pandemic, with risk asset prices dropping sharply as investors rushed to safety and liquidity. It finds that a further tightening of financial conditions may expose vulnerabilities, including among nonbank financial institutions, and that bank resilience may be tested if economic and financial market stresses rise. Vulnerabilities in global risky corporate credit markets, including weakened credit quality of borrowers, looser underwriting standards, liquidity risks at investment funds, and increased interconnectedness, could generate losses at nonbank financial institutions in a severe adverse scenario, as discussed in Chapter 2. The pandemic led to an unprecedented and sharp reversal of portfolio flows, highlighting the challenges of managing flows in emerging and frontier markets. Chapter 3 shows that global financial conditions tend to influence portfolio flows more during surges than in normal times, that stronger domestic fundamentals can help mitigate outflows, and that greater foreign participation in local currency bond markets may increase price volatility where domestic markets lack depth. Beyond the immediate challenges of COVID-19, Chapter 4 explores the profitability pressures that banks are likely to face over the medium term in an environment where low interest rates are expected to persist. Chapter 5 takes a broader perspective on physical risks associated with climate change. It finds that these risks do not appear to be reflected in global equity valuations and that stress testing and better disclosure of exposures to climatic hazards are essential to better assess physical risk.

The April 2012 Global Financial Stability Report assesses changes in risks to financial stability over the past six months, focusing on sovereign vulnerabilities, risks stemming from private sector deleveraging, and assessing the continued resilience of emerging markets. The report probes the implications of recent reforms in the financial system for market perception of safe assets, and investigates the growing public and private costs of increased longevity risk from aging populations.

In the 10 years since the global financial crisis, regulatory frameworks have been enhanced and the banking system has become stronger, but new vulnerabilities have emerged, and the resilience of the global financial system has yet to be tested.