Global Financial Stability Report

Global Financial Stability Report: Markets in the Time of COVID-19

April 2020

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Chapter 5 Live Launch: Friday, May 29, 2020, 9AM ET

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Foreword and Full Report

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.

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Chapter 1: Global Financial Stability Overview: Markets in the Time of COVID-19

The coronavirus (COVID-19) pandemic poses unprecedented health, economic, and financial stability challenges. Following the COVID-19 outbreak, the prices of risk assets collapsed and market volatility spiked, while expectations of widespread defaults led to a surge in borrowing costs. Several factors amplified asset price moves: previously overstretched asset valuations, pressures to unwind leveraged trades, dealers’ balance-sheet constraints, and a deterioration in market liquidity. Emerging market economies experienced the sharpest reversal of portfolio flows on record. As a result, financial conditions tightened at an unprecedented speed. Decisive monetary, financial, and fiscal policy actions—aimed at containing the fallout from the pandemic—managed to stabilize investor sentiment in late March–early April, with markets paring back some of their losses.

A further tightening of financial conditions may expose more “cracks” in global financial markets and test the resilience of financial institutions. Asset managers may face further outflows and may be forced to sell assets into falling markets. Distress may rise among leveraged firms and households. Emerging and frontier markets may face challenging external funding conditions, rising rollover risks, and increased incidence of debt restructurings. Although banks have more capital and liquidity than in the past, have been subject to stress tests, and are supported by central bank liquidity provision, their resilience may be tested in some countries in the face of large market and credit losses. Wide-ranging fiscal, monetary, and financial policies, as well as strong international cooperation, remain essential to safeguard economic and financial stability and to prevent the emergence of adverse macro-financial feedback loops.

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Chapter 2: Risky Credit Markets: Interconnecting the Dots

Risky corporate credit markets have expanded rapidly since the global financial crisis. The role of nonbank financial institutions has increased, and the system has become more complex and opaque. This chapter maps out the financial ecosystem of these markets and identifies potential vulnerabilities, which include weaker credit quality of borrowers, looser underwriting standards, liquidity risks at investment funds, and increased interconnectedness. On the positive side, the use of financial leverage by investors and direct exposures of banks—which were crucial amplifiers during the global financial crisis—have declined. Run risks have lessened in some segments because of a prevalence of long-term locked-in capital in the private debt and collateralized loan obligation (CLO) markets. In an illustrative severe adverse scenario, losses on risky credit exposures at banks are estimated to be manageable, in aggregate, although losses at a few large banks could be substantial. However, losses at nonbank financial institutions could be high. Given the now-limited role played by banks, this could impair credit provision in these markets and make a recession more severe. The coronavirus (COVID-19) crisis, which has resulted in price declines in risky credit markets of about two-thirds of the severity of the global financial crisis through late March (before reversing a portion of these declines), could further expose the vulnerabilities highlighted in this chapter. Policymakers should now act decisively to contain the economic fallout of COVID-19 and support the flow of credit to firms. Once the crisis is over, they should assess the sources of market dislocations and tackle the vulnerabilities that have been unmasked by this episode.

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Chapter 3: Emerging and Frontier Markets: Managing Volatile Portfolio Flows

The dramatic reversal of emerging market portfolio flows following the global spread of coronavirus (COVID-19) highlights the challenges of managing volatile portfolio flows and risks they may pose to financial stability. A prolonged period of low interest rates had encouraged both borrowers and lenders to take on more risk. Surges of portfolio inflows into riskier asset markets contributed to the buildup of debt and, in some cases, resulted in stretched valuations. This chapter quantifies the sensitivities of different types of portfolio flows and the associated cost of funding to global and domestic factors during “normal” times as well as during periods of weak or strong flows. Analysis suggests that both bond and equity flows are much more sensitive to global financial conditions during periods of extreme flows than in normal times, while domestic fundamentals may matter incrementally more for equities and local currency bond flows. Furthermore, greater foreign investor participation in local currency bond markets that lack adequate depth can greatly increase the volatility of bond yields. Dealing with immediate capital outflow pressures calls for using reserves to reduce excessive volatility, deploying capital flow management measures, and preparing for long-term external funding disruptions.

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Chapter 4: Banking Sector: Low Rates, Low Profits?

Profitability has been a persistent challenge for banks in several advanced economies since the global financial crisis. While monetary policy accommodation has helped sustain economic growth during this period and has provided some support for bank profits, very low interest rates have compressed banks’ net interest margins (the difference between interest earned on assets and interest paid on liabilities). Looking beyond the immediate challenges faced by banks as a result of the coronavirus (COVID-19) outbreak, a persistent period of low interest rates is likely to put further pressure on bank profitability over the medium term. A simulation exercise conducted for a group of nine advanced economies indicates that a large fraction of their banking sectors, by assets, may fail to generate profits above their cost of equity in 2025. Once immediate challenges recede, banks could take steps to mitigate pressures on profits, including by increasing fee income or cutting costs, but it may be challenging to fully mitigate profitability pressures. Over the medium term, banks may seek to recoup lost profits by taking excessive risks. If so, vulnerabilities could build in the banking system, sowing the seeds of future problems. Authorities can implement a number of policies to help mitigate vulnerabilities arising from excessive risk taking and ensure an adequate flow of credit to the economy, including the removal of structural impediments to bank consolidation, the incorporation of a low-interest-rate-environment scenario on banks’ risk assessments and supervision, and the use of macroprudential policies to tame banks’ incentives for excessive risk taking.

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Chapter 5: Climate Change: Physical Risk and Equity Prices

Disasters as a result of climate change are projected to be more frequent and more severe, which could threaten financial stability. Chapter 5 looks at the impact of climate change physical risk on global equity valuations to assess this threat. The chapter shows that the impact of large disasters on equity markets, bank stocks, and non–life insurance stocks has generally been modest over the past 50 years High levels of insurance penetration and sovereign financial strength can help preserve financial stability in the face of climatic disasters. The chapter does not find that aggregate equity valuations—as of 2019—reflect the predicted changes in physical risk under various climate change scenarios, which suggests that investors do not pay sufficient attention to climate change risks. Better disclosure of exposures to climatic disasters and stress testing for financial firms can help preserve financial stability and should complement policy measures to mitigate and adapt to climate change.