by Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB
The latest IMF Global Financial Stability Report (GSFR). From October 2012, notes that, despite favorable financial market developments, risks to global financial stability have increased and markets remain volatile as European policymakers struggle with the crisis. The financial system continues to remain fragile.
Faltering confidence has led to capital flight from countries on the ‘periphery’ to the core of the euro area. This means higher borrowing costs and a growing wedge between the economic and financial ‘haves’ and ‘have-nots’. Efforts by European policymakers have allayed some fears, but the euro area crisis remains the principal source of concern. Tail-risk perceptions surrounding currency redenomination have fueled a retrenchment of private financial exposures to the euro area periphery. The resulting capital flight and market fragmentation undermine the very foundations of the union: integrated markets and an effective common monetary policy.
The European Central Bank’s (ECB’s) liquidity operations in 2012 helped ease pressure on banks to shed assets, but that pressure rose again, accompanied by increasing market fragmentation. Subsequently, the ECB initiated new steps with government bond buying and these actions have provided temporary market stability, but additional measures are needed. Otherwise, the result is an acceleration in deleveraging, increasing the risk of a credit crunch and an ensuing economic recession.
In addition, European authorities must continue with three efforts: (1.) reduction of government debts and deficits in a way that supports growth; (2.) implementation of structural reforms to reduce external imbalances and promote growth; and (3.) clean-up of the banking sector, including recapitalizing or restructuring viable banks and resolving nonviable ones. All this has to be done while supporting growth. More fundamentally, concrete progress toward a banking union in the euro area will help break the link between sovereigns and domestic banks. Over the longer term, a successful banking union will require sufficient pooling of resources to provide a credible fiscal backstop to the bank resolution authority, and joint deposit insurance fund.
The risks to financial stability are not confined to the euro area. Both Japan and the United States face significant fiscal challenges, which, if unaddressed, can have negative financial stability implications. Both countries require medium-term deficit reduction plans that protect growth and reassure financial markets.
Elsewhere, emerging economies have adeptly navigated through global shocks, but need to guard against potential shockwaves from the euro area crisis, while managing slowing growth in their own economies and are vulnerable as a result of their high direct exposure to euro area banks. At the same time, several economies in Asia and Latin America are also prone to risks associated with being in the later stages in a credit cycle increasing potential contagion.
The crisis has spurred a host of regulatory reforms to make the financial system safer. This includes: financial institutions and markets that are more transparent, less complex, and less leveraged. The analysis suggests that, although there has been some progress over the past five years, financial systems have not come much closer to those desirable features. They are still overly complex, with strong domestic interbank linkages, and concentrated, with the too-important-to-fail issues unresolved.
Other areas that still require attention: (1) a global discussion of the pros and cons of direct restrictions on business activities to address the too-important-to-fail issue, (2) more attention to segments of the nonbank system that may be posing systemic risks, and (3) further progress on recovery and resolution plans for large institutions, especially those that operate across borders. A couple of conclusions that have emerge are that (1) financial buffers made up of high-quality capital and truly liquid assets generally help economic performance; and (2) banks’ global interconnectivity needs to be managed well so as to reap the benefits of cross-border activities, while limiting adverse spillovers during a crisis. Financial stability will only emerge with effective implementation and strong supervision.
The key lesson is that imbalances need to be addressed well before markets start signaling credit concerns. If there is no credible medium-term plan, markets will force an adjustment over a compressed period, with adverse effects on growth and financial stability.
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