Global Financial Stability Report - APRIL 2013

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W o r l d E c o n o m i c a n d F i n a n c i a l S u r v e y s

Global Financial Stability Report

Old Risks, New Challenges

April 2013

International Monetary Fund


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2013 International Monetary Fund

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Contents

International Monetary Fund | April 2013 iii

Prfac ix

excuiv summary xi

Chapr 1 Acu Rik Rducd: Aci ndd erch Fiacial sabiliy 1

Globe Financial Stability Assessment 1

Te Euro Area Crisis: Acute Risks Have Declined, Much Work Lies Ahead 6

Banking Challenges: Deleveraging, Business Models, and Soundness 16

Rising Stability Risks o Accommodative Monetary Policies 24

Emerging Markets: A Low-Rate Bonanza or Future Woes? 32

Policies or Securing Financial Stability and Recovery 42

Annex 1.1. Corporate Debt Sustainability in Europe 47

Annex 1.2. European Bank Deleveraging Plans: Progress So Far 52

Reerences 56

Chapr 2 A nw Lk a h Rl f svrig Crdi Dfaul swap

Summary

Overview o CDS Markets: Te Rise o SCDS

What Drives SCDS Spreads and How Do Tey Relate to Other Markets?

Eects o SCDS Regulations and Policy Initiatives on Financial Stability

Conclusions and Policy Implications

Annex 2.1. A Primer on Sovereign Credit Deault Swaps

Annex 2.2. echnical Background: Determinants o SCDS Spreads and Bond Spreads

Reerences

Chapr 3 D Cral Bak Plici sic h Crii Carry Rik Fiacial sabiliy?

Summary

MP-Plus: An Overview

Eects o MP-Plus on Markets

Eects o MP-Plus on Financial Institutions

Conclusions and Policy Implications

Annex 3.1. Key MP-Plus Announcements since 2007, by Central Bank

Annex 3.2. Estimation Method and Results or the Panel Regressions

Reerences 137

Glary 177

Ax: summig Up by h Acig Chair 185

saiical Appdix

[Available online at www.im.org/external/pubs/t/gsr/2013/01/pd/statapp.pd]


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CONTENTS

iv International Monetary Fund | April 2013

Bx

1.1. What Has Chinas Lending Boom Done to Corporate Leverage? 372.1. Interconnectedness between Sovereigns and Financial Institutions2.2. Te European Unions Ban on Buying Naked Sovereign Credit Deault Swap Protection

2.3. What Could be the Impact o the Demise o SCDS?2.4. Te Greece Debt Exchange and Its Implications or the SCDS Market3.1. Financial Stability Risks Associated with Exit rom MP-Plus Policies3.2. Te Macroeconomic Eectiveness o MP-Plus3.3. Balance Sheet Risks o Unconventional Policy in Major Central Banks

tabl

1.1 Selected Euro Area Countries: Vulnerability Indicators in the Corporate Sector 141.2. Deleveraging Progress, 2011:Q32012:Q3 221.3. U.S. Nonnancial Corporate Bonds: Yields, Spreads, and Valuations 281.4. Scenarios or U.S. reasury Bond Market Corrections 311.5. Distribution o Bank Lending and Nonperorming Loans 40

1.6. Credit and Asset Market Indicators or Selected Emerging Markets and Other Countries 411.7. Comparing Proposals or Structural Reorm 441.8. Nonnancial Corporate Debt and Leverage 471.9. Nonnancial Corporate Database Coverage 471.10. Corporate Sectoral Breakdown within the Sample 481.11. Progress on Deleveraging/Restructuring Plans o Selected Major European Banks,

as o January 2013 532.1. Rankings o CDS Amounts Outstanding2.2. Lead-Leg Relationship between Sovereign Credit Deault Swaps and Bond Residuals2.3. List o Countries Included in Empirical Studies2.4. List o Variables Used in Regression Analysis2.5. Summary o Estimation o Monthly Drivers or Sovereign Credit Deault Swap (SCDS) Spreads

and Bond Spreads, October 2008September 2012

2.6. Summary o Estimation Results on Drivers or Basis, October 2008September 20122.3.1. Relative Size o Sovereign and Bank Credit Deault Swaps Markets3.1. Asset Holdings o Major Central Banks Related to MP-Plus, 2008123.2. Results rom Event Study Regressions3.3. Marginal Eect o MP-Plus on Banks3.4. Calculated Losses on a 10-Year Bond as a Result o a Rise in Interest Rates3.5. Risks rom MP-Plus and Mitigating Policies3.6. Specication o aylor Rule3.7. Results o the Panel Regressions

Figur

1.1. Global Financial Stability Map 21.2. Global Financial Stability Map: Assessment o Risks and Conditions 31.3. Asset Perormance since the October GFSR 41.4. Global Equity Valuations 41.5. Global Equity Valuations, by Country 51.6. Property Price Valuations 51.7. Hard-Currency Debt Valuations in Emerging Market Economies 51.8. U.S. Sovereign Debt Valuations 5


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CONTENTS

International Monetary Fund | April 2013 v

1.9. arget2 Balances and Sovereign Bond Yields 61.10. Periphery Euro Area Banks Bond Issuance and CDS Spreads 71.11. Italy and Spain: Nonnancial Firms Change in Bank Credit and Net Bond Issuance 71.12. Foreign Investor Share o General Government Debt 7

1.13. European Sovereign Bond Spreads, Current and Implied by Forward Curve 81.14. Asset Perormance, March 15April 2, 2013 81.15. Proportion o System Balance Sheets Encumbered 91.16. Periphery Banks Covered Bond Issuance and Spreads 91.17. Selected EU Banks Foreign Claims on Banking Sectors, June 2011September 2012 91.18. Changes in Interest Rates on New Bank Loans, December 2010January 2013 101.19. Corporate Real Interest Rates and GDP Growth, February 2013 101.20. Bank Lending to the Nonnancial Private Sector 101.21. Euro Area Periphery Bank Credit 101.22. Interaction between Credit Demand and Supply 111.23. Interest Rate on New Lending and Decomposition o New Bank Funding Rate 111.24. Euro Area Bank Lending Conditions or Firms 121.25. Met and Unmet Demand or Bank Credit or Small and Medium-Sized Enterprises 12

1.26. Spread o Interest Rates on New Loans to SMEs over ECB Policy Rate 121.27A. Corporate Debt 131.27B. Corporate Debt in Percent o GDP 131.28. Share o Firms with High Leverage and Low Interest Coverage Ratio, 2011 151.29. Share o Firms with High Leverage and Negative Net Free Cash Flow 151.30. Required Reduction in Leverage under Dierent Scenarios 151.31. Required Cuts in Capital Expenditures to Stabilize Debt o Euro Area Periphery Firms

with High Leverage and Negative Net Free Cash Flow 151.32. Bank Core ier 1 and Wholesale Funding Ratios, 2008:Q4 to 2012:Q3 161.33. Bank Leverage and Wholesale Funding Ratios, 2008:Q4 to 2012:Q3 161.34. Ranking o Banking Systems Based on Banks Balance Sheet Indicators, 2012:Q3 171.35. Average Net Interest Margins 181.36. Impaired Loans in Selected EU Countries 19

1.37. EU Banks Asset Quality and Protability 191.38. Buers at Individual EU Banks 201.39. Bank Risk-Weights and Impairments, Average or 200811 201.40. Deposit Funding Gaps o Foreign Subsidiaries o Large EU Banks 201.41. Average Return on Equity, and Cost o Equity 211.42. Ratio o Equity Price to angible Book Value, April 2013 211.43. GFSR EU Bank Deleveraging Scenarios 221.44. Large EU Banks: Contributions to Change in Balance Sheets 2011:Q32012:Q3 221.45. Banks Foreign Claims on All Regions 231.46. Net Foreign Assets Position 231.47. Global Mutual Fund and Exchange-raded Fund Flows 241.48. Net Issues o Fixed-Income Securities 251.49. U.S. Fixed Investment Spending versus Internal Cash Flow 251.50. U.S. Nonnancial Corporate Bond Issuance and Equity Buybacks 251.51. U.S. Nonnancial Firms Credit Fundamentals 261.52. U.S. Primary Dealer Repo Financing 281.53. Global Issuance o Leveraged Loans and Collateralized Debt Obligations 291.54. Risk olerance or Weakest 10 Percent o U.S. Public Pension Funds 291.55. Net Interest Margins and Investment in Risky Assets by U.S. Insurance Companies 301.56. U.S. reasury Sell-O Episodes 30


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1.57. U.S. High-Yield Corporate Spread and Liquidity and Volatility 311.58. Holdings o U.S. Corporate Bonds, by Investor ype 321.59. Net Capital Flows to Emerging Markets 341.60. Selected Emerging Market Bond, Equity, and Loan Issuance 34

1.61. Nonresident Holdings o Domestic Sovereign Debt 341.62. Emerging Market Nonnancial Corporate Issuance 341.63. Emerging Market Nonnancial Corporate Leverage, 2007 and 2012 351.64. Foreign-Exchange-Denominated Debt o Nonnancial Corporations in Emerging Markets 351.65. Emerging Market Corporate Issuance, by ype o Issuer 351.66. Corporate Leverage in Asia, excluding Japan 351.67. Interest Coverage Ratio or Emerging Market Firms 361.68. Hard Currency and Local Currency Sovereign Bond Issuance 361.69. EMBI Global Spread ightening (December 200812): Decomposition 381.70. Local Yield ightening in Emerging Market Economies (December 200812):

Decomposition 381.71. Impact o Shocks on EMBI Global Spreads 391.72. Impact o Shocks on Local Emerging Market Yields 39

1.73. Domestic Credit Growth, 200612 391.74. Consumer Price Index-Adjusted Residential Property Prices, 200612 401.75. Gross Nonperorming Loan Ratios, 201012 401.76. Banks Loss-Absorbing Buers by Region 411.77. China: Growth Rate o Credit, by ype 421.78. European Investment-Grade Corporate Fundamentals 481.79. Developments in Publicly Listed European Companies 491.80. Progress in Deleveraging Plans across Sample Banks, 2012 522.1. Credit Deault Swap (CDS) Contracts, Gross Notional Amounts Outstanding2.2. Nondealer Buyers and Sellers o Credit Deault Swap Protection: Net Positions by Counterparty2.3. Liquidity Indicators in the Sovereign Credit Deault (SCDS) Market2.4. Volatility o Sovereign Credit Deault Swap (SCDS) Spreads and Sovereign Bond Spreads2.5. Determinants o Sovereign Credit Deault Swap (SCDS) Spread and Bond Spreads, October

2008September 20122.6. Sovereign Credit Deault Swap (SCDS) Price Leadership and Liquidity, March 2009September

20122.7. ime-Varying Price Leadership Measures o Sovereign Credit Deault Swaps (SCDS)2.8. Sovereign Credit Deault Swaps (SCDS): Decomposition o Volatility Factors or Germany, Italy,

and Spain, February 2009October 20122.9. Markov-Switching ARCH Model o VIX, European ED Spread, and Sovereign Credit Deault

Swap (SCDS) Indices2.10. Overshooting and Undershooting o Sovereign Credit Deault Swaps (SCDS) and Sovereign

Bond Markets2.11. Sovereign Credit Deault Swaps: Net Notional Amounts Outstanding, Selected EU Countries2.12. Market Liquidity Measures beore and ater Ban on Short Sales o Sovereign Credit Deault

Swaps (SCDS)2.13. Constructing the Arbitrage rade between Credit Deault Swaps (CDS) and Bonds2.14. Dierence between Sovereign Credit Deault Swap Spreads and Sovereign Bond Spreads, Selected

Countries2.1.1. Measures o Sovereign Credit Risk or Euro Area Periphery Countries2.1.2. Interconnectivity Measures: Financial Institutions, to and rom Sovereigns2.3.1. Country Credit Ratings and Radio o Outstanding Sovereign Credit Deault Swaps (SCDS) to

Government Debt, 2011


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International Monetary Fund | April 2013 vii

3.1. Changes in Central Bank Balance Sheets, 2006123.2. OIS Counterparty Spread Decompositions3.3. Central Bank Intervention in Real Estate Securities Markets3.4. Central Bank Holdings o Domestic Government Securities and Market Liquidity, by Maturity

3.5. Correlations between Central Bank Holdings o Government Securities and Market Liquidity, byMaturity o Holdings3.6. Interest Rate Risk as Reported by U.S. Banks3.7. Bank Holdings o Government Debt in Selected Economies3.8. Various Measures o the aylor Gap in the United States


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Te Global Financial Stability Report(GFSR) assesses key risks acing the global nancial system. In normal

times, the report seeks to play a role in preventing crises by highlighting policies that may mitigate systemic

risks, thereby contributing to global nancial stability and the sustained economic growth o the IMFs mem-

ber countries. Risks to nancial stability have declined since the October 2012 GFSR, providing support to

the economy and prompting a rally in risk assets. Tese avorable conditions reect a combination o deeper

policy commitments, renewed monetary stimulus, and continued liquidity support. Te current report ana-

lyzes the key challenges acing nancial and nonnancial rms as they continue to repair their balance sheets

and unwind debt overhangs. Te report also takes a closer look at the sovereign credit deault swaps market

to determine its useulness and its susceptibility to speculative excesses. Lastly, the report examines the issue o

unconventional monetary policy (MP-plus) and its potential side eects, and suggests the use o macropru-

dential policies, as needed, to lessen vulnerabilities, allowing country authorities to continue using MP-plus to

support growth while protecting nancial stability.Te analysis in this report has been coordinated by the Monetary and Capital Markets (MCM) Department

under the general direction o Jos Vials, Financial Counsellor and Director. Te project has been directed by

Jan Brockmeijer and Robert Sheehy, both Deputy Directors; Peter Dattels and Laura Kodres, Assistant Direc-

tors; and Matthew Jones, Advisor. It has beneted rom comments and suggestions rom the senior sta in the

MCM department.

Individual contributors to the report are: Ali Al-Eyd, Sergei Antoshin, Serkan Arslanalp, Craig Botham,

Jorge A. Chan-Lau, Yingyuan Chen, Ken Chikada, Julian Chow, Nehad Chowdhury, Sean Craig, Reinout

De Bock, Jennier Elliott, Michaela Erbenova, Jeanne Gobat, Brenda Gonzlez-Hermosillo, Dale Gray, Sanjay

Hazarika, Heiko Hesse, Changchun Hua, Anna Ilyina, ommaso Mancini-Grioli, S. Erik Oppers, Bradley

Jones, Marcel Kasumovich, William Kerry, John Ki, Frederic Lambert, Rebecca McCaughrin, Peter Lindner,

Andr Meier, Paul Mills, Nada Oulidi, Hiroko Oura, Evan Papageorgiou, Vladimir Pillonca, Jaume Puig,

Jochen Schmittmann, Miguel Segoviano, Jongsoon Shin, Stephen Smith, Nobuyasu Sugimoto, Narayan

Suryakumar, akahiro suda, Kenichi Ueda, Nico Valckx, and Chris Walker. Martin Edmonds, Mustaa Jamal,

Oksana Khadarina, and Yoon Sook Kim provided analytical support. Gerald Gloria, Nirmaleen Jayawardane,

Juan Rigat, Adriana Rota, and Ramanjeet Singh were responsible or word processing. Eugenio Cerutti, Ali

Sharikhani, and Hui ong provided database and programming support. Joanne Johnson and Gregg Forte o

the External Relations Department edited the manuscript and the External Relations Department coordinated

production o the publication.

Tis particular issue draws, in part, on a series o discussions with banks, clearing organizations, securities

rms, asset management companies, hedge unds, standards setters, nancial consultants, pension unds, cen-

tral banks, national treasuries, and academic researchers. Te report reects inormation available up to April

2, 2013.

Te report beneted rom comments and suggestions rom sta in other IMF departments, as well as romExecutive Directors ollowing their discussion o the Global Financial Stability Reporton April 1, 2013. How-

ever, the analysis and policy considerations are those o the contributing sta and should not be attributed to

the Executive Directors, their national authorities, or the IMF.

PReFACe

International Monetary Fund | April 2013 ix


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Conventions

x International Monetary Fund | April 2013

The ollowing symbols have been used throughout this volume:

. . . to indicate that data are not available;

to indicate that the fgure is zero or less than hal the fnal digit shown, or that the

item does not exist;

between years or months (or example, 200809 or JanuaryJune) to indicate the

years or months covered, including the beginning and ending years or months;

/ between years (or example, 2008/09) to indicate a fscal or fnancial year.

Billion means a thousand million; trillion means a thousand billion.

Basis points reer to hundredths o 1 percentage point (or example, 25 basis points is

equivalent to 1/4 o 1 percentage point).

n.a. means not applicable.

Minor discrepancies between constituent fgures and totals are due to rounding.

As used in this volume the term country does not in all cases reer to a territorial entity

that is a state as understood by international law and practice. As used here, the term

also covers some territorial entities that are not states but or which statistical data are

maintained on a separate and independent basis.

The boundaries, colors, denominations, and other inormation shown on the maps do

not imply, on the part o the International Monetary Fund, any judgment on the legal

status o any territory or any endorsement or acceptance o such boundaries.


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International Monetary Fund | April 2013 xi

eXeCUtIVe sUMMARY

Chapr 1: Acu Rik Rducd: Acindd erch Fiacial sabiliy

Global nancial and market conditions have

improved appreciably in the past six months,

providing additional support to the economy and

prompting a sharp rally in risk assets. Tese avor-

able conditions reect a combination o deeper

policy commitments, renewed monetary stimulus,

and continued liquidity support. ogether, these

actions have reduced tail risks, enhanced condence,

and bolstered the economic outlook. However, asglobal economic conditions remain subdued, the

improvement in nancial conditions can only be

sustained through urther policy actions that address

underlying stability risks and promote continued

economic recovery. Continued improvement will

require urther balance sheet repair in the nancial

sector and a smooth unwinding o public and pri-

vate debt overhangs. I progress in addressing these

medium-term challenges alters, risks could reap-

pear. Te global nancial crisis could morph into a

more chronic phase, marked by a deterioration o

nancial conditions and recurring bouts o nancialinstability.

th eur Ara Crii: Acu Rik Hav Dclid, Much Wrk

Li Ahad

In the euro area, acute near-term stability risks

have been reduced signicantly. Funding conditions

in the markets or sovereign, bank, and corporate

debt have improved. Despite this notable progress,

many banks in the euro area periphery remain

challenged by elevated unding costs, deteriorating

asset quality, and weak prots. Credit transmission

remains weak in several economies, as bank balance

sheet repair is uneven, while ragmentation between

the core and periphery o the euro area persists.

Corporations in the periphery are directly aected

by bank balance sheet weakness, cyclical headwinds,

and, in many cases, their own debt overhangs.

Te analysis presented in this report suggests that

the debt overhang at listed companies in the euro

area periphery is sizableup to one-th o debt

outstanding. o limit the extent o required dele-

veraging in the corporate sector, continued eorts

to reduce ragmentation and lower unding costs, as

well as ongoing restructuring plans to improve pro-

ductivity, are essential. In addition, a combination o

asset sales or cutbacks in dividends and investment

may be needed to reduce debt burdens.

Bakig Challg: Dlvragig, Bui Mdl, ad

sud Challg

Banks in advanced economies have taken signi-

cant steps to restructure their balance sheets, but

progress has been uneven, as systems are at dierent

stages o repair. Te process is largely completed

in the United States, but it requires urther eorts

or some European banks. Banks in the euro area

periphery, in particular, ace signicant challenges

that are impairing their ability to support economic

recovery. Balance sheet pressures are less acute or

other European banks, but the process o de-risking

and deleveraging is not complete. For banks in

emerging market economies, the main challenge

is to continue supporting growth while saeguard-

ing against rising domestic vulnerabilities. Te new

market and regulatory environments are also orcing

banks globally to reshape their business models to

become smaller, simpler, and more ocused on their

home markets.

Riig sabiliy Rik f Accmmdaiv Mary Plici

Te use o unconventional monetary policies in

advanced economies continues to provide essen-

tial support to aggregate demand. Tese policies

are generating a substantial rebalancing o private

investor portolios toward riskier assets, as intended.

However, a prolonged period o extraordinary

monetary accommodation could push portolio


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exeCutive summary

xii International Monetary Fund | April 2013

rebalancing and risk appetite to the point o creating

signicant adverse side eects. While the net benets

o unconventional policies remain highly avorable

today, these side eects must be closely monitored

and controlled. O particular concern is the pos-sible mispricing o credit risk, riskier positioning by

weaker pension unds and insurance companies, and

a rise in liquidity risk, particularly in countries where

recoveries are more advanced. Corporate leverage

is rising in the United States and is already around

one-third o the way through a typical cycle. Other

spillovers include excessive capital ows into emerg-

ing market economies, where corporationswhich

generally have sound nances at presentare taking

on more debt and oreign exchange exposure in

response to low borrowing costs. More broadly, the

avorable unding environment or emerging marketeconomies might breed complacency about growing

challenges to domestic nancial stability. Valuations

have not yet reached stretched levels (except in a ew

hot spots), but sensitivity to higher global interest

rates and market volatility has increased across asset

classes, including in emerging market economies. A

prolonged period o continued monetary accommo-

dation will increase vulnerabilities and sensitivity to

a rise in rates.

Rivigraig h Rgulary Rfrm Agda

While much has been done to improve global

and national nancial sector regulations, the reorm

process remains incomplete. Banking sectors are still

on the mend, and the pace o reorm has appropri-

ately been moderated to avoid making it harder or

banks to lend to the economy while they are regain-

ing strength. But the pace o the reorm process also

reects difculties in agreeing on the way orward

on key reorms due to concerns about banks acing

more structural challenges.

Delays in completing the reorm agenda are notonly a source o continued vulnerability, but also a

source o regulatory uncertainty that may impact

the willingness o banks to lend. Tey oster the

prolieration o uncoordinated initiatives to directly

constrain banking activity in dierent jurisdictions,

given the strong political imperatives to take action.

Such initiatives may be inconsistent with the eorts

to harmonize minimum global standards and may

hamper, rather than complement, the eectiveness o

the G20 reorm agenda.

Policymakers must thereore take decisive

action to restructure weak banks and encour-age the buildup o the new capital and liquidity

buers as part o the implementation o Basel

III rules on an internationally consistent basis.

Improved nancial reporting and disclosures by

banks remain essential to promote better transpar-

ency and prudent and consistent valuation o risk-

weighted assets. Enhanced disclosure will help

improve market discipline and restore condence

in banks. Eective resolution regimes also need

to be established to allow or the orderly exit o

unviable banks, including eective cross-border

agreements or winding down ailing cross-borderbanks. Finally, urther work is needed on the

too-big-to-ail problem, over-the-counter deriva-

tives reorm, accounting convergence, and shadow

banking regulation.

What is needed now is a renewed polit ical

commitment at the global and national levels to

complete the reorm agenda. Tis commitment

is critical to minimize regulatory uncertainty and

arbitrage, and to reduce nancial ragmentation.

Without greater urgency toward international

cooperation and comprehensive bank restructur-

ing, weak bank balance sheets will continue to

weigh on the recovery and pose ongoing risks to

global stability.

Plici fr scurig Fiacial sabiliy ad Rcvry

Further policy actions are needed to address

balance sheet weaknesses in the private and public

sectors, improve the ow o credit to support the

recovery, and strengthen the global nancial system.

Tese actions should continue to be supported by

accommodative monetary policies.In the euro area, the priorities are bank balance

sheet repair and steps toward a stronger nancial

oversight ramework within the European Union.

Bank balance sheets and business models need to

be strengthened to improve investor conidence,

reduce ragmentation, and improve the supply

o credit or solvent small and medium-sized


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exeCutive summary

International Monetary Fund | April 2013 xiii

enterprises. Enhanced disclosure or banks and

conducting selective asset quality reviews will help

restore conidence in bank balance sheets and

improve market discipline.

o anchor inancial stability in the euro areaand or ongoing crisis management, ast and

sustained progress toward an eective Single

Supervisory Mechanism (SSM) and the comple-

tion o the banking union are essential. A

Single Resolution Mechanism should become

operational at around the same time as the

SSM becomes eective. his should be accom-

panied by agreement on a time-bound roadmap

to set up a single resolution authority and

common deposit guarantee scheme, with com-

mon backstops. Proposals to harmonize capital

requirements, resolution, common depositguarantee schemes, and insurance supervision

rameworks at the EU level should be imple-

mented promptly. Modalities and governance

arrangements or direct recapitalization o

banks by the European Stability Mechanism

should also be established.

he developments in Cyprus underscore the

urgency or completing reorms across the euro

area in order to reverse inancial ragmentation

and urther strengthen market resilience.

On aglobal level, vigilance is needed to ensure

that accommodative monetary policies and an

extended period o low rates do not give rise to

resh credit excesses. Tis is particularly important

in the case o the United States. Financial supervi-

sion should be tightened to limit the extent o such

excesses; and regulation will need to play a more

proactive role in this cycle at both the macro- and

microprudential levels. Restraining a too rapid rise

in leverage and encouraging prudent underwriting

standards will remain key objectives.

In emerging market economies, policymakers mustremain alert to the risks stemming rom increased

cross-border capital ows and rising domestic nan-

cial vulnerabilities.

ogether, these policies will consolidate the recent

gains in nancial stability, strengthen the global

nancial system, and support continued improve-

ment in the economic outlook.

Chapr 2: svrig Crdi Dfaul swap

Te debate about the useulness o markets or

sovereign credit deault swaps (SCDS) intensi-

ed with the most recent bout o sovereign stress

in the euro area. Chapter 2 takes a closer look at

whether SCDS markets are good market indicators

o sovereign credit risk and whether they provide

valuable protection to hedgers; or whether they are

prone to speculative excesses and lead to higher

sovereign unding costs and nancial instability. Te

chapter nds that many o the negative perceptions

are unounded. Te markets or both SCDS and

sovereign bonds are similar in their ability to reect

economic undamentals and market actors. SCDS

markets tend to convey new inormation more

rapidly than do the markets or government bondsduring periods o stress, although not during other

times; but SCDS markets do not appear to be more

prone to high volatility than other nancial mar-

kets. While overshooting was detected in some euro

area SCDS markets during the latest bout o stress,

there is little evidence that excessive increases in a

countrys SCDS spreads generally lead to higher sov-

ereign unding costs. Te question o whether SCDS

markets are more likely to be contagious than other

markets is difcult to answer because sovereigns and

nancial institutions are now more interconnected,

and hence the risks embedded in SCDS cannot bereadily isolated rom the risk o the nancial system.

Te chapters results do not support the need or

a ban on naked SCDS protection buying, which

went into eect in the European Union in Novem-

ber 2012. Te policy initiatives underlying the over-

the-counter derivatives reormsmandating better

disclosure, encouraging central clearing, and requir-

ing the posting o appropriate collateralshould

help to allay concerns about spillovers and contagion

that may arise in these derivatives markets.

Chapr 3: D Cral Bak Plici sic hCrii Carry Rik Fiacial sabiliy?

Chapter 3 returns to the issue o unconventional

monetary policy and its potential side eects with

urther in-depth analysis. Te chapter investigates

the policies as pursued by our central banks (the


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exeCutive summary

xiv International Monetary Fund | April 2013

Federal Reserve, Bank o England, European Central

Bank, and Bank o Japan), which include a pro-

longed period o low real policy interest rates and

a host o unconventional measures including asset

purchases. Te policies, termed MP-plus in thechapter, appear to have lessened banking sector

vulnerabilities and contributed to nancial stability

in the short termin line with the intentions o

the central banks. So ar, central bank intervention

in specic asset markets has not adversely aected

market liquidity. MP-plus policies have improved

some indicators o bank soundness, although the evi-

dence suggests some reluctance by banks to clean up

their balance sheets. Although potential risks raised

by MP-plus in the banking system so ar appear

relatively benign, policymakers should be alert to the

possibility that risks may be shiting to other parts o

the nancial systemshadow banks, pension unds,

and insurance companiesdue in part to increasingregulatory pressures on banks. Policymakers should

use targeted micro- and macroprudential policies to

mitigate emerging pockets o vulnerability (identi-

ed in Chapter 1) that are likely to increase the

longer that MP-plus policies are in use. Implement-

ing macroprudential policies in a measured manner,

as needed, would allow central banks to continue to

use MP-plus to support price stability and growth

while protecting nancial stability.


15/169

1chapter

International Monetary Fund | Apr 2013 1

Ga Fiaia Saii Assssm

Global financial stability has improved since the

October 2012 report. Policy actions have eased

monetary and financial conditions and reduced

tail risks, leading to a sharp increase in risk appe-

tite and a rally in asset prices. But if progress on

addressing medium-term challenges falters, the

rally in financial markets may prove unsustain-

able, risks could reappear, and the global financial

crisis could morph into a more chronic phase.

Sas Saii Iiars

Since the October 2012 Global Financial Stabil-

ity Report(GFSR) all risk dimensions o the global

nancial stability map have improved (Figures 1.1

and 1.2). Markets have rallied and near-term stabil-

ity risks have eased in response to accommodative

monetary policies and precautionary policy mea-

sures (Figure 1.3). In the euro area, the authorities

have clearly signaled their dedication to achieving

more and stronger Europe. Commitments by theEuropean Central Bank (ECB) have reduced sover-

eign liquidity risk, and together with the ongoing

advance toward a banking union and additional debt

relie or Greece, have greatly reduced redenomina-

tion risk. Tese broad improvements in risks and

conditions have helped boost the resilience o mar-

kets to political uncertainty in Italy and the events

in Cyprus. Te United States avoided a year-end all

rom the scal cli. However, the postponement

o decisions on the debt ceiling, automatic spending

cuts, and budget appropriations continue to weigh

on sentiment, as noted in the April 2013 Fiscal

Monitor. Te Federal Reserves move rom time-

specic to indicator-specic orward guidance has

provided assurance that the policy stance will remain

accommodative until meaningul increases in activity

and ination are realized. Te Bank o Japan has

also undertaken urther easing steps by adopting a 2

percent ination target and a commitment to open-

ended purchases o assets.

Improved nancial market conditions are beneting

the broader economy, but the transmission is slow and

incomplete, as noted in the April 2013 World Economic

Outlook. Overall macroeconomic riskshave declined. In

the United States, prospects have brightened; a recovery

in the housing market and progress in household

deleveraging are bolstering consumption, while banks

are poised to increase lending. Emerging market risks

have also declined, as growth has stabilized and external

unding conditions or emerging market economies are

very avorable. However, near-term economic prospects

in the euro area remain weak, as public and private bal-

ance sheet repair and bank deleveraging continue.Te reduction o acute nancial stress has led to a

substantial decline in market and liquidity risks. Mar-

ket positioning has become more optimistic, volatility

has declined, and access to unding has improved or

corporations and banks. In the euro area periphery,

bank issuance has recovered; even lower-tier banks

have gained some access to unding markets. External

investors have returned in orce to periphery sovereign

markets. Nevertheless, the situation remains ragile,

as illustrated by recent market volatility ollowing

the Italian parliamentary elections. Still-high unding

costs, amid persistent nancial ragmentation and lowgrowth in the euro area, compound the debt overhang

built up during the boom in periphery corporate

balance sheets. Te second section o this chapter

assesses tail risks, unding conditions in sovereign and

banking markets, and the sustainability o corporate

debt in the euro area, and concludes that persistent

ragmentation and continued impairment o credit

Acute RISkS Reduced: ActIonS needed to entRench FInAncIAlStAbIlIty

Note: Tis chapter was written by Peter Dattels and Matthew

Jones (team leaders), Ali Al-Eyd, Sergei Antoshin, Serkan Arsla-nalp, Craig Botham, Yingyuan Chen, Julian Chow, Nehad Chow-

dhury, Sean Craig, Reinout De Bock, Martin Edmonds, JennierElliott, Michaela Erbenova, Jeanne Gobat, Sanjay Hazarika,

Changchun Hua, Anna Ilyina, Bradley Jones, Marcel Kasumov-

ich, William Kerry, Peter Lindner, Rebecca McCaughrin, AndrMeier, Paul Mills, Nada Oulidi, Evan Papageorgiou, Vladimir

Pillonca, Jaume Puig, Jochen Schmittmann, Miguel Segoviano,

Jongsoon Shin, Stephen Smith, Nobuyasu Sugimoto, Narayan

Suryakumar, akahiro suda, and Chris Walker.


16/169

GLOBAL FINANCIAL STABILITY REPORT

2 International Monetary Fund | Apr 2013

channels call or urther progress in restoring stability

and market unctioning.

Uneven progress in strengthening balance sheets

means that medium-term risks remain elevated.

Although credit riskshave improved somewhat, there

are still important downside risks and medium-term

challenges. In the euro area, the prospect or urther

reorm and balance sheet repair is clouded by political

uncertainties and rising reorm atigue, while eco-

nomic momentum remains weak and unemployment

high. In the United States and Japan, credible plans

or medium-term scal adjustment are needed to help

avoid a sudden deterioration in risk perceptions.

Te third section o this chapter, on Banking

Challenges assesses the state o recovery and healthin various banking systems and remaining structural

challenges, as the new market and regulatory envi-

ronment is orcing banks to reshape their business

models.

Monetary and fnancial conditionshave eased ur-

ther, as unconventional monetary policies in advanced

economies continue to provide essential support to

credit and aggregate demand. However, a prolonged

period o low interest rates and continued monetary

accommodation could generate signicant adverse

side eects. Risk appetitehas strengthened markedly

(three notches on the stability map) on expectations

o a prolonged period o low interest rates and lower

tail risks. A higher appetite or risk could lead to

exaggerated valuations and rising leverage, which may

become systemic and spill over to emerging market

economies.1 Most sectors exhibit ew clear signs o

asset price bubbles just yet, despite relatively rapid

price gains. For advanced economies, equity valua-

tions appear to be within historical norms, and or-

ward-looking valuations are below the peaks reached

beore the 200809 nancial crisis (Figures 1.4 and

1.5). However, signs o overheating in real estatemarkets are evident in some European countries, in

Canada, and in some emerging market economies

(Figure 1.6). Meanwhile, access by emerging market

and developing economies to international capital

markets has also picked up, with external actors

1See also Chapter 3, which discusses the impact o central bankinterventions on banks and asset markets.

October 2012 GFSR

April 2013 GFSR

Figure 1.1. Global Financial Stability Map

Creditrisks

Market andliquidity risks

Riskappetite

Monetary andnancial

Macroeconomicrisks

Emerging marketrisks

Conditions

Risks

Source: IMF staff estimates.Note: Away from center signifies higher risks, easier monetary and financial conditions, or higher risk appetite.


17/169

c hA p t e R 1 Acute Risks Reduced: Actions needed to entRench FinAnciAl stAbility


Source: IMF staff estimates.Note: Changes in risks and conditions are based on a range of indicators, complemented with IMF staff judgment; see Annex 1.1 in the April 2010 GFSR and Dattels and others (2010)

for a description of the methodology underlying the construction of the global financial stability map. The notch changes in the overall indicator in each panel are the simple average ofnotch changes in individual indicators. The number next to the legend for each indicator is the number of components it contains. For lending conditions (monetary and financial

conditions panel), positive values represent slower tightening or faster easing of standards.

Figure 1.2. Global Financial Stability Map: Assessment of Risks and Conditions(In notch changes since the October 2012 GFSR)

Market and l iquid ity risks have decreased in response to looser policies

Emerging market risks have improved along with global macroeconomic and nancial

conditions.

Monetary a nd nancia l conditi onshave loosened further with central bank policy easing

and better nancing and lending conditions

but improved nancial conditions are only slowly translating into lower

macroeconomic risks.

The reduction insystemic risks along with continuing balance sheet repair have lowered

credit risks.

which, in combination with strong policy action and reduced near-term event risks, has

boostedrisk appeti te.

4

3

2

1

0

1

2

3

4

4

3

2

1

0

1

2

4

6

4

3

2

1

0

1

2

3

4

Overall (8) Banking sector(3)

Householdsector (2)

Corporate sector(3)

More risk

Less risk

4

3

2

1

0

1

2

3

4

Overall Economicactivity

Inationvariability

Sovereign creditOverall (7) Liquidit y &funding (1)

Volatility (2) Marketpositioning

(3)

Equityvaluations

(1)

Overall (5) Sovereign (2) Ination (1) Corporatesector (1)

Liquidity (1)

Overall (4) Institutionalallocations

(1)

Investorsurveys (1)

Relativeasset returns

(1)

Emergingmarkets (1)

4

3

2

1

0

1

2

3

4

More risk

Less risk

Less risk

More risk

More risk

Less risk

Lower risk appetite

Higher risk appetite

Overall (6) Monetaryconditions (3)

Financialconditions (1)

Lendingconditions (1)

QE & centralbank balance

sheetexpansion (1)

Tighter

Easier

4

3

2

1

0

1

2

3

4

3

5


18/169



being the primary driver behind the recent compres-

sion in spreads (Figure 1.7).

Asset price pressures are likely to grow urther

over time in the presence o abundant global

liquidity. Te ourth section o the chapter ocuses

on the United States and discusses the potential

consequences or the mispricing o credit risk,

riskier positioning by weaker pension and insurance

companies, and higher liquidity risk. It also exam-

ines the potential spillovers through an acceleration

o capital ows into emerging market economies.

Without measures to address medium-term vulner-

abilities and rein in credit excesses when they appear,

a prolonged period o low interest rates could lay the

ground or new nancial stability risks. Eventually,

an unexpected and rapid rise in risk-ree rates couldtrigger substantial market volatility and repricing.

Fair-value estimates or U.S. reasury yields have

already increased in the past six months on the back

o reduced tail risks (Figure 1.8).

In sum, i progress on addressing the above risks

and medium-term challenges were to stall, the recent

rally in global markets could prove unsustainable.

Pressures in the euro area periphery rom a sizable

debt overhangas much as one-th o the debt

o nonnancial listed rmstogether with bro-

ken credit transmission channels keep costs high.

Credit continues to contract (by 5 percent since the

outbreak o the crisis), starving the vital small and

medium-sized enterprise (SME) sector o nancing

and blocking economic recovery, while worsen-

ing bank balance sheets. Furthermore, progress in

returning banks to ull health to support recovery isuneven: a urther $1.5 trillion in EU bank delever-

aging may lie ahead as banks need to adjust busi-

ness models, reduce reliance on wholesale unding,

and rebuild buers.2 In the United States, accom-

modative monetary policies are bringing about an

intended shit toward risky assets. But could this go

too ar? Evidence suggests that corporate underwrit-

ing standards are weakening at an early stage, even

though leverage is still two-thirds below prior cycli-

cal peaks.

As discussed in the th section o the chapter,

in emerging market economies with capital inowsadvancing and external conditions avorable, rele-

veraging is occurring at a rapid pace in some areas,

along with riskier orms o borrowing. A prolonged

2Tis is based on the baseline scenario in the October 2012

GFSR, under which large EU banks were projected to reduceassets by $2.8 trillion during 2011:Q32013:Q4, adjusting or

the progress in bank deleveraging observed up to 2012:Q3 ($1.3

trillion). See the section on Banking Challenges.

Sources: Bank of America Merrill Lynch; Bloomberg L.P.; JPMorgan Chase; and IMFstaff estimates.

Note: CDS = credit default swaps; EM = emerging market; OECD = Organization forEconomic Cooperation and Development. Percent changes in CDS spreads are reversed.

Figure 1.3. Asset Performance since the October GFSR(Percent change)

50 5025025Greek bank equities

GoldOil

Italian bank equitiesU.S. Treasuries

Spanish bank equitiesGerman bundsCore bondsU.S. high gradeEM sovereignsEuropean high gradeEM corporatesU.S. CDS ()U.S. high yieldEM equitiesOECD leading indicatorsEuropean equitiesU.S. equitiesEuropean high yieldU.S. corporate CDS ()Japanese CDS ()French spreadsEuropean corporate CDS ()European bank CDS ()French bank equitiesVIX ()Italian spreadsU.K. bank equities

Spanish spreadsJapanese bank equitiesEuropean sovereign CDS ()Irish bank equities

2.5

2.0

1.5

1.0

0.5

0.0

0.5

1.0

1.5

2.0

10th90th percentileAdvanced economiesEmerging market economies Cheaper

Richer

Maximum

Minimum

Sources: Bloomberg L.P.; IBES; and IMF staff estimates.

Note: Based on GDP-weighted average of z-scores of price-to-book (P/B) and forwardprice-to-earnings (P/E) ratios. The z-scores represent the deviation from the period

average expressed in the number of standard deviations. Values above zero denote richervaluations relative to historical averages, while those below zero denote cheaper

valuations. P/B and P/E ratios are monthly series beginning in 1996 and 1987,respectively, or earliest available. Advanced economies include 22 countries, and

emerging market economies include 17 countries.

Figure 1.4. Global Equity Valuations(In z-scores)

2006 2007 2008 2009 2010 2011 2012


19/169



10th90th percentile

JapanUnited States

United KingdomFrance

ChinaIndonesia

Mexico

2.5

2.0

1.5

1.0

0.5

0.0

0.5

1.0

1.5

2.0

Cheaper

RicherMaximum

Minimum

Sources: Bloomberg L.P.; IBES; and IMF staff estimates.Note: Based on unweighted average of z-scores of price-to-book (P/B) and forward

price-to-earnings (P/E) ratios. The z-scores represent the deviation from the periodaverage expressed in the number of standard deviations. Values above zero denote richer

valuations relative to historical averages, while those below zero denote cheapervaluations. P/B and P/E ratios are monthly series beginning in 1996 and 1987,

respectively, or earliest available.

Figure 1.5. Global Equity Valuations, by Country(In z-scores)

2006 2007 2008 2009 2010 2011 2012

gure . . roperty r ce a uat ons(In z-scores)

10th90th percentile

CanadaHong Kong SAR

SpainNorway

United StatesBrazil

SwedenFrance

Sources: Organization for Economic Cooperation and Development; and IMF staff

estimates.

Note: Based on unweighted average of price-to-rent ratio (PRR) and price-to-incomeratio (PIR). The z-scores represent the deviation from the period average expressed in thenumber of standard deviations. Values above zero denote richer valuations compared with

historical averages, while those below zero denote cheaper valuations. PRR and PIR arequarterly series beginning in 1970 , or earliest available.

3

2

1

0

1

2

3

Cheaper

Richer

Maximum

Minimum

2006 2007 2008 2009 2010 2011 2012

0

100

200

300

400

500

600

700

Model spreads (fundamental factors)

95% condence

interval for the

predicted model

Actual EMBIG spreads

Model spreads (fundamental + external factors)

Sources: Bloomberg L.P.; JPMorgan Chase; PRS Group; and IMF staff estimates.Note: The EMBIG index is the benchmark hard-currency government debt index for

emerging market economies. External factors for the model include the VIX, the federalfunds rate, and the volatility of federal fund s. Fundamental factors are political, economic,

and financial risk ratings published by the PRS Group. The estimation uses a panelregression with fixed effects for the period January 1998 to December 2012.

Figure 1.7. Hard-Currency Debt Valuations in Emerging

Market Economies(In basis points)

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12

10-year Treasury yield

Fitted value

European Central Bank

president's speech

Federal Reserve's QE3

announcement

0

1

2

3

4

5 two standard deviations

Sources: Bloomberg L.P.; Haver Analytics; and IMF staff estimates.Note: The 10-year Treasury yield is estimated as a function of domestic

macroeconomic factors (business conditions, inflation, and the budget deficit);international factors (custody holdings by foreign central banks and GDP-weighted

average of European credit default swaps as a proxy for safe-haven flows); and bondvolatility to capture a risk premium. The equation is estimated for the period from August

2007 to December 2012

Figure 1.8. U.S. Sovereign Debt Valuations(In percent)

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12


20/169



period o low rates could result in increased vulner-

abilities, raising the risk o market instability when

rates do eventually rise.

Against this backdrop, the nal section o the

chapter on Policies or Securing Financial Stabilityand Recovery discusses urther policy actions needed

to prevent the crisis rom moving to a more chronic

phase, marked by a deterioration o nancial condi-

tions and recurring bouts o nancial instability as

reorms all short. Avoiding this ate will require

addressing weaknesses in private and public sector bal-

ance sheets, widening credit channels, and strengthen-

ing the nancial system. ogether, these policies will

reduce the reliance on supportive monetary policies

and acilitate a speedier normalization o central bank

policies. But in the interim, policymakers will need to

be vigilant to ensure that pockets o excesses linked tothe search or yield do not become systemic.

t er Ara crisis: A Riss havdi, M Wr lis Aa

Acute short-term stability risks have declined in the

euro area on the back of strong policy action. Prices

and liquidity conditions in sovereign, bank, and

corporate debt markets have improved dramatically,

and issuance has soared. However, medium-term

risks remain, reflecting a weak economic outlook,

persistent fragmentation, and structural challenges.

Some banks in the euro area periphery remain

challenged by deleveraging pressures, still-elevated

funding costs, deteriorating asset quality, and weak

profits.3 Corporations in the periphery are directly

affected by bank deleveraging, cyclical headwinds,

and their own debt overhangs. Against this backdrop,

more work needs to be done in the short term to

improve bank and capital market functioning, while

moving steadily toward a full-fledged banking union.

Policy actions have greatly reduced near-term perceptions of tail risk.

Te ECBs announcement o the Outright Mone-

tary ransactions (OM) programtogether with the

3In this GFSR, the euro area periphery consists o Cyprus,

Greece, Ireland, Italy, Portugal, and Spain, except as noted.

decision to support additional debt relie or Greece

and agreement on the Single Supervisory Mechanism

(SSM)has greatly reduced redenomination tail risks.

In response, external investors have moved rom short

to long positions on the periphery.4 Tough mar-

ket liquidity conditions are not yet back to normal,

they have improved. Correspondingly, the spread o

short-term (two-year) periphery sovereign bonds over

German bunds has allen back toward January 2011

levels (Figure 1.9). Te relie or short-term debt

markets provided by the OM pledge has been partly

transmitted urther along the curve. Still, marketscontinue to reect medium-term challenges: the long-

term (10-year) spread has reversed only about hal o

its previous widening, while arget2 imbalances are

declining at a slower pace, with about one-th o the

previous widening reversed so ar.

Private funding markets have reopened for

periphery borrowers.

Te reduction in perceived risks was elt in credit

markets more broadly, beneting even some lower-tier

4During 2012:Q3, the oreign investor share in total govern-

ment debt in Italy and Spain stabilized at about 35 percent and 30percent, respectively. Although oreign banks continued to reduce

exposures to Italian and Spanish government debt, the process

slowed down considerably in 2012:Q3. At the same time, oreignnonbanks started to increase their holdings o Italian and Spanish

bonds. Even so, the oreign share is still estimated to be ar below

the levels seen in mid-2011, beore market pressures emerged.

1200

1000

800

600

400

200

0 0

100

200

300400

500

600

700

800

Periphery Target2 balances (net, left scale)

Periphery 2year spreads over Germany (reverse scale, right scale)

Periphery 10year spreads over Germany (reverse scale, right scale)

Billionsofeuros

Basispoints

Sources: Bloomberg L.P.; Euro Crisis Monitor; and Haver Analytics.

Note: Spreads are weighted by nominal GDP, and Target2 balances are cumulative.Spreads for Ireland are constructed using the generic Irish government nineyear bonds.

Figure 1.9. Target2 Balances and Sovereign Bond Yields

Feb-11 Aug-11 Feb-12 Aug-12 Feb-13


21/169



periphery companies. Te demand or bank debt has

strengthened, compressing spreads and prompting a

surge in issuance (Figure 1.10). More than 32.7 billion

(gross) was issued by banks and other rms in January

2013 alone.5 O this amount, lower-tier bank and corpo-

rate issuers accounted or about one-ourth.6 Some larger

Italian and Spanish companies have used the surge in

bond issuance to replace bank loans (Figure 1.11), while

some banks have started to repay LRO unds early.

5Excluding bank sel-unded issues, that was the strongestmonth since the run in February 2012 in the wake o the

ECBs longer-term renancing operations (LROs). Figure 1.10

distinguishes between sel-unded, where the issuer is the soleunderwriter, and regular debt issues.

6Tis includes all issuers rom Cyprus, Greece, Ireland, and

Portugal, and high-yield issuers rom Italy and Spain.

However, the virtuous dynamic prompted by

the OMT program has slowed, while adverse

events could still revive market stress.

Although investors and ofcials appear com-

ortable that the ECBs OM remains a virtual

program, this dynamic could change. In particular,

political developments could complicate imple-

mentation, as underscored by the uncertainty

surrounding the election outcome in Italy. And

while prospects or sovereign nancing in 2013 have

brightened, net nancing needs remain challenging

or some countries. Assuming that domestic inves-

tors keep exposures to their own sovereigns constant

(as some o them indicated), oreign investors will

need to continue to increase their allocations to

sovereign bonds to acilitate government nancing at

more moderate yields (Figure 1.12).

Furthermore, there are concerns that i growth and

scal outturns in the periphery do not improve, or i

progress on euro area architecture reorm stalls, recent

improvements in market conditions could be reversed.A lasting improvement in growth and scal trajec-

tories across the periphery hinges on the successul

implementation o structural reorms. Some market

participants are concerned that progress on this ront

could all short i political support or reorm wanes.

In part reecting medium-term risks, orward curves

suggest market concerns about the durability o the

10

20

30

40

50

00

100

200

300

400

500

600

700Selffunded issues (left scale)

Regular issues (left scale)

CDS spread (right scale)

Billionsofeuros

Basispoints

Sources: Bloomberg L .P.; Dealogic; and IMF staff estimates.Note: In selffunded deals, the issuer is the sole underwriter. CDS = credit default

swaps.

Figure 1.10. Periphery Euro Area Banks' Bond Issuance and

CDS Spreads

2008 09 10 11 12 13

40

30

20

10

0

10

20

30

40Italy, bank credit Spain, bank credit

Italy, corporate bonds Spain, corporate bonds

Sources: Bloomberg L.P.; Dealogic; Haver Analytics; and IMF staff estimates.

Figure 1.11. Italy and Spain: Nonnancial Firms Change inBank Credit and Net Bond Issuance(Billions of euros; threemonth moving average)

Jul11 Oct11 Jan12 Apr12 Jul12 Oct12 Jan13

20

25

30

35

40

45

50

5560

65

Scenario

projection

BelgiumFranceItalySpain

Sources: IMF, World Economic Outlook database; national sources; and IMF staff

estimates.Note: For all countries, government debt refers to general government debt on a

consolidated basis. The shaded area is a hypothetical scenario for 2013 that assumes that

domestic banks and nonbanks keep their sovereign exposure unchanged.

Figure 1.12. Foreign Investor Share of General

Government Debt(In percent)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013


22/169



spread compression at the short end o the periphery

yield curve (Figure 1.13) and no urther declines in

10-year periphery sovereign spreads.7

Te potential or contagion rom developments in

Cyprus is an important reminder o the ragility o

market condence. Although the adverse reaction toincreased risk has not been intense in all markets, there

was a renewed ight to sae assets and a sello in some

euro area assets (Figure 1.14). Te clearest impact has

been on those markets with direct links to Cyprus

notably Greek government bonds and Greek and

Russian bank stocks. Slovenian government bonds were

also aected. Other eects have included higher und-

ing costs or euro area periphery banks and a sello in

euro area bank equities. Te impact o recent events

on periphery euro area sovereign spreads was limited,

likely reecting the existence o backstops (includ-

ing the ECBs OM). Although it is too early to tell

whether these developments have led to a persistent

increase in the cost o uninsured unding or banks

in countries with weak sovereigns, the experience o

Cyprus reafrms the need to make sustained progress

7Consensus orecasts do not suggest that the near-term ination

outlook or Italy or Spain is notably higher than or Germany.

with banking unionespecially Single Supervision, acommon resolution authority, and a common deposit

guarantee schemeas emphasized in the October 2012

GFSR, in the recent EU FSAP, and in the nal section

o this chapter.

More work needs to be done to address legacy

issues and medium-term vulnerabilities, lest the

crisis become mired in a more chronic phase.

Despite substantial improvements in unding

conditions, ragmentation between the core and the

periphery persists. Although the divergence between

wholesale unding costs or core and periphery bor-

rowers has partially reversed, the gap has not ully

closed. Tis partly reects investor concerns about

the quality o bank assets and increased asset encum-

brance (Figure 1.15): issuance o covered bonds

and other asset-backed securities declined in the

past year, while some banks in the periphery have

seen a marked rise in the cost o collateral-backed

debt issuance (Figure 1.16). While the previous

declines in oreign investors claims on periphery

sovereigns have begun to reverse (see Figure 1.12),the cross-border banking market in the euro area

remains deeply ragmented (Figure 1.17). Some o

the retrenchment in cross-border bank claims may

be encouraged by regulatory ring-encing (see the

section on Banking Challenges).

Fragmentation, in turn, impairs credit transmission

to the real economy. Recent market improvements

61.1

70.9

Sources: Bloomberg L.P.; and IMF staff estimates.Note: CDS = credit default swap. Yields are for 10year tenors unless otherwise

specified. Percent changes in CDS spreads and bond yields are reversed.

Figure 1.14. Asset Performance, March 15April 2, 2013(Percent change)

0 10 2040 30 20 10

Cypriot 7year government bond yields ()Cypriot CDS ()Slovenian 8year government bond yields ()Core bank CDS ()Periphery bank CDS ()Greek government bond yields ()Greek bank stocksRussian bank stock: VTBSpanish bank stocksItalian bank stocksFrench nancial stocksItalian government bond yields ()

Spanish government bond yields ()U.S. Treasury yields ()German government bond yields ()

0

100

200

300

400

500

600

France two-year yield spread

France two-year spread, forwards

Italy two-year yield spread

Italy two-year spread, forwards

Spain two-year yield spread

Spain two-year spread, forwards

Belgium two-year yield spread

Belgium two-year spread, forwards

Spreads as implied

by forward curves

Sources: Bloomber g L.P.; and IMF staff estimates.

Figure 1.13. European Sovereign Bond Spreads, Current

and Implied by Forward Curve(In basis points over German benchmark)

2009 2010 2011 2012 2013 2014 2015 2016


23/169

cha p t er 1 Acute Risks Reduced: Actions needed to entRench FinAnciAl stAbility


are only just beginning to eed through to the cost

and availability o credit or productive sectors o

the periphery economies. Te dierences between

periphery and core in terms o bank lending rates and

corporate borrowing costs continue to persist, as bank

repair is still incomplete and unding costs are higher

or banks and sovereigns in the periphery. Credit tothe real economy remains restrained (especially in the

periphery and to SMEs), reinorcing divergence in

economic outcomes (Figures 1.18 and 1.19).

Private nonfnancial sector deleveragingcould

impede the recovery and raise nancial strains, as

corporations ace high debt burdens in an environ-

ment o lower growth and higher interest rates.

The transmission mechanism is still impaired and

credit conditions remain weak in the periphery.

Credit growth rates continue to diverge between

the core and periphery countries (Figure 1.20), with

periphery credit alling at a similar pace to the base-

line scenario outlined in the October 2012 GFSR

(Figure 1.21). Tis weakness in periphery lending is

arguably due to credit supply constraintsas banks

ace balance sheet pressurescombined with low

demand rom potential borrowers (given the anemiceconomic environment and, in many cases, with bal-

ance sheets burdened by high debt levels).

Disentangling the demand-side rom the supply-

side drivers o credit developments is not straight-

orward.8 Te relationship between credit demand

and supply is complex (Figure 1.22). For example,

cutbacks in credit supply raise the cost o borrow-

ing and lead to lower demand. Furthermore, both

supply constraints and alling demand can adversely

aect the real economy, which in turn can lower

demand and tighten supply urther. A weaker eco-

nomic outlook can also worsen the quality o bank

and borrower balance sheets, urther aecting the

supply and demand or credit.

8For example, an IMF (2012b) report on Italy and the Bank

o Italy (2012) report ound that while the slowdown in credit

growth refected both supply and demand, supply constraintswere dominant in 2011, and demand came to the ore in 2012.

Sources: European Central Bank; European Covered Bond database; and IMF staff

estimates.Note: LTROs = longer-term refinancing operations; MRO = main refinancing operations.1

Includes fine tuning, Multilateral Fund, and emergency liquidity assistance.

Figure 1.15. Proportion of System Balance Sheets

Encumbered(Percent of bank assets, end period)

20072012

Greece

07 12

Spain

07 12

Portugal

07 12

Italy

07 12

Ireland

07 12

Germany

07 12

France

Repo Covered bonds

MRO LTROs

Other ECB1

0

5

10

15

20

25

30

35

40

0

50

100

150

200

250

0

20

40

60

80

100

120

140

Volume (right scale)

Spread (left scale)

Basispoints

Billionso

feuros

Sources: Dealogic; and IMF staff estimates.

Note: Spreads are weighted by a banks share in the total volume of euro issuance.

Figure 1.16. Periphery Banks Covered Bond Issuance and

Spreads

2009 2010 2011 2012

French

Banks

German

Banks

Italian

Banks

Spanish

Banks

U.K.

Banks

Euro area periphery 28 39 34 20 34Core euro area 9 3 5 18 26United Kingdom 32 53Other Europeanadvanced economies 16 5 31 44 22

United States 61 2 4 5 30Japan 66 11 100 21 11Other advanced economies 58 48 26 30 18Emerging EMEA 21 11

11 27

Emerging Latin America 12 32 80 1826 24

16Emerging Asia 47 21 75 15 5Total 30 5 10 15 19

Sources: Bank for International Settlements, International Banking Statistics, Table 9E:Consolidated foreign claims and other p otential exposuresultimate risk basis; and IMF

staff estimates.Note: EMEA = Europe, the Middle East, and Africa.

Figure 1.17. Selected EU Banks' Foreign Claims on Banking

Sectors, June 2011September 2012(Percent change)


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Ireland

Portugal

ItalySpain

AustriaBelgium

France

Germany

Netherlands Finland

Cyprus

100

80

60

40

20

0

20

40

60

80

100

Corporate loans

Housing

loans

Core

Periphery

Sources: Haver Analytics; and IMF staff estimates.

Figure 1.18. Changes in Interest Rates on New Bank Loans,

December 2010January 2013(In basis points)

100 10080 60 40 20 0 20 40 60 80

Austria

Belgium Finland

France

GermanyLuxembourg

Netherlands

GreeceIreland

Italy

Portugal

Spain

1.5

0.5

0.5

1.5

2.5

3.5

4.5

2013 consensus growth forecasts

Corporate

rea

lrates

(Fe

bruary

2013)

Periphery

Core

Sources: Bank of America Merrill Lynch; Consensus Economics; and IMF staffestimates.

Note: Corporate rates are expost, inflationadjusted yields of all corporate bonds for

each country included in the Bank of America Merrill Lynch European corporate masterindex.

Figure 1.19. Corporate Real Interest Rates and GDP

Growth, February 2013(In percent)

4.5 3.5 2.5 1.5 1.50.5 0.5

6

4

2

0

2

4

6

8

France Germany Euro area Italy Spain Program countries


Note: Chart adjusted for securitizations. Program countries are Greece, Ireland, andPortugal.

Figure 1.20. Bank Lending to the Nonnancial Private

Sector(In percent, yearoveryear)

Jan. Apr.

2010 2011 2012 2013

Jul. Oct. Jan. Apr. Jul. Oct. Jan.J an . Ap r. J ul. O ct .

16

14

12

10

8

6

42

0

2

October 2012 GFSR

scenario projections

Complete policies

Baseline

Weak policies

Actual


Note: Ireland, Italy, Portugal, and Spain, adjusted for securitizations.

Figure 1.21. Euro Area Periphery Bank Credit(Percentage change, cumulative since September 2011)

S ep. D ec.

2011 2012 2013

Mar. Jun. Sep. Dec. Mar. Jun. Sep. Dec.


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But even i demand were seen as driving the

weakness in credit, barriers to supply would need

to be removed so that banks do not hold back the

economic recovery once it takes hold.9 In any case,

there is some evidence to suggest that credit supply

is tight in the periphery.

Interest rateson new bank lending are signiicantly

higher in the periphery than in core countries

(Figure 1.23). his divergence relects, in part, theincreased margin that banks require to compen-

sate them or the greater risk o lending in the

periphery. But it also relects the increased cost o

new unding as institutions have made less use o

oicial unding and have competed both among

themselves and with retail sovereign debt holders

or term deposits. he increase in term deposits

comes at a price, as interest rates on them are

higher than those on sight deposits.

9For example, the Financial Policy Committee o the Bank o

England has recently recommended that banks strengthen their

capital buers (which were ound by the March 2013 Asset Qual-ity Review to be overstated by about 50 billion) so that banks

could sustain credit and absorb losses in the event o urther

stress. Te nding that banks balance sheet weaknesses (e.g.,weak capital buers in absolute terms or relative to a target level)

have a signicant negative eect on their supply o loans has been

conrmed in a number o studies.

BANK

BALANCE SHEETCONSTRAINTS

BORROWER

BALANCE SHEETCONSTRAINTS

MACRO-

ECONOMICSLOWDOWN

Adversemacro

feedback

Tightenlending

conditions

Too costlyto borrow

Unableto lend

Too riskyto lend

Unwillingto borrow

Borrowersdeleverage

LESS

SUPPLY

LESS

DEMAND

Source: IMF staff.

Figure 1.22. Interaction between Credit Demand and Supply

Lower assetquality leads tolosses and bank

capital

constraints

Economic slow-down and falls inasset prices lead

to lower

collateral values

0.00.51.0

1.52.02.53.0

3.54.04.5

5.05.5

0.00.51.0

1.52.02.5

3.03.54.0

4.55.05.5

Core euro areaPeriphery euro area

Sources: Bloomberg L.P.; Haver Analytics; and IMF staff estimates.

Note: Interest rates on lending and funding are weighted by the amount of newbusiness (the contributions of funding components are shown in the chart). The sovereign

spread is the five-year sovereign yield over bunds. The interest rate on new lending is tothe nonfinancial private sector.

Figure 1.23. Interest Rate on New Lending and

Decomposition of New Bank Funding Rate(In percent, six-month moving average)

2009 10 11 12 13 2009 10 11 12 13

Sovereign spread Wholesale spread Deposit rateCentral bankliquidity

Margin Lending rate


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Lending surveysalso provide evidence: he recent

euro area bank lending survey shows a continued

tightening in bank lending conditions (Figure

1.24), as well as a urther weakening in demand or

loans. However, separate surveys o the SME sec-

tor suggest that supply constraints are binding or

some irms. Figure 1.25 shows that there has been

an increase through 201112 in the proportion

o Italian and Spanish SMEs that wanted a bank

loan but did not obtain most or all o the credit or

which they had applied.

For the euro area core, macro risk is the maindriver o recent credit conditions, as ECB policies

have substantially reduced banks balance sheet con-

straints and their cost o unding.

The high cost and restricted supply of credit

to SMEs impede recovery.

Te combination o high bank unding costs and

increased risk premiums on lending has impaired

the credit transmission mechanism. For example,

interest rates on new periphery SME loans are now

priced at spreads over the ECB policy rate that aresignicantly higher than in the past (Figure 1.26).

Loan originations or SMEs have also been alling

more sharply than or large rms, suggesting that

SMEs are bearing the brunt o the reduction in

bank credit. Tis is particularly worrisome given that

SMEs typically lack access to capital markets.10

The debt overhang poses challenges

for the corporate sector.

Firms in the euro area periphery have built a sizable

debt overhang during the credit boom, on the backo high prot expectations and easy credit conditions

(Figures 1.27A and 1.27B).11 While the construction

10Te latest SME survey by the ECB shows that only 2 percent

o SMEs in the euro area use bond markets.11Te debt overhangis dened in the literature as a debt burden

that generates such large interest payments that it prevents rms

rom undertaking protable investment projects that would

40

20

0

20

40

60

80

100

120

140

20

10

0

10

20

30

40

50

60

70CompetitionCyclical factors

Balance sheet constraintsOverall (right scale)

Tightening

Sources: European Central Bank; Haver Analytics; and IMF staff estimates.Note: Balance sheet constraints are capital, access to financing, and liquidity position.

Cyclical factors are general economic activity, industry outlook, and collateral needs.

Figure 1.24. Euro Area Bank Lending Conditions for Firms(Net percentage balance and factor contributions)

2007 2008 2009 2010 2011 2012

0

5

1015

20

25

30

35

40

45Met

Unmet

Spain Italy France Germany

Sources: European Central Bank (201 2); and IMF staff estimates.

Note: Unmet demand is the percentage of respondents that appplied for a loan and didnot get all or most of the requested amount.

Figure 1.25. Met and Unmet Demand for Bank Credit for

Small and Medium-Sized Enterprises(Percent of respondents)

1111 111120102010 201020101212 1212

0

100

200

300

400

500

600Program countries

SpainItalyFranceGermany

Median 200310

Range

Source: Haver Analytics; and IMF staff estimates.

Note: ECB = European Central Bank; SMEs = Small and medium-sized enterprises.Interest rate on new corporate loans with a value of 1 million or less. Program countries

are Greece, Ireland, and Portugal.

Figure 1.26. Spread of Interest Rates on New Loans to SMEs

over ECB Policy Rate(In basis points)

2003 2005 2007 2009 2011 2013


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sectors in Ireland and Spain were at the epicenter o the

crisis, the increase in leverage was broad-based across

the periphery. Firms in these countries now ace the

challenge o reducing the debt overhang in an environ-

ment o lower growth and higher interest rates, in part

related to nancial ragmentation in the euro area.

In this report, we assess the eects o high cor-

porate leverage on both debt servicing and debt

repayment capacity over the medium-term. (Te

methodology is described in Annex 1.1.) While

measures o debt servicing capacity, such as interestcoverage ratios, help detect immediate or short-term

risks, measures o debt sustainability, based on net

ree cash ows, help assess medium- and longer-term

risks.12 We conduct a cross-country analysis o the

corporate sector based on a sample o listed rms.13

Te rm-specic data allow us to identiy a weak

tail in the sample, highlighting vulnerabilities not

detected in aggregate data.

enable them to organically reduce debt over time. Te size o thedebt overhang is estimated as the required debt reduction such

that interest expense declines and net ree cash ows become

positive.12Net ree cash ows is dened as operating cash ows beore

interest minus interest expense net o taxes minus capital expendi-

tures and minus dividends.13Te sample includes about 1,500 publicly traded companies,

with average coverage o 30 percent o the corporate sector by

assets.

Te main conclusion o the analysis is that the weak

tail o rms with high and unsustainable leverage is siz-

able in the periphery, mainly in Portugal and Spain, call-

ing or continued vigilance by supervisors on bank asset

quality.14 Debt sustainability is dened as the capacity o

rms to generate sufcient cash ows over the medium

term to at least keep the debt level stable, while main-

taining current levels o capital expenditures and divi-

dend payments. I a rm is in the weak tail, this does not

mean that it will deault on its debt, rather it will need to

take measures (such as cutting operating costs, dividendsand capital expenditures) to bring its debt down to a

sustainable level. A comparison o vulnerability indica-

tors between the sample o listed rms and the entire

corporate sector suggests that the risks highlighted in the

exercise are likely to be greater in the broader corporate

sector, including in Italy, as SMEs are oten hampered

by high debt levels, low protability, and higher unding

costs (able 1.1).

Te ability o rms to service debtmeasured

by the interest coverage ratiois much weaker in

the periphery than in the core (Figure 1.28). Tese

stresses are already showing up in ast rising corpo-

rate NPLs at banks in the periphery.

14In Spain, construction companies are included in the sample

and are partly responsible or the sizable weak tail. Te risks orbank asset quality are mitigated by the act that most o the real

estate loans o the weakest (Group 1 and Group 2) banks have

been transerred to the SAREB.

90

110

130

150

170

190

210

230Ireland

Spain

United Kingdom

Portugal

FranceItaly

United States

Germany

Sources: Central bank flow of funds data; and IMF staff estimates.

Note: Debt for the entire corpor ate sector in each country. Gross debt figur es include securities other than shares, loans, and other accounts payable. Intercompany loans and tradecredit can differ significantly across countries. Consolidated debt levels are significantly lower for some countries, especially those with a strong presence of multinational companies with

large intercompany loans.

Figure 1.27A. Corporate Debt(Fourquarter moving average, 2002:Q1 = 100)

2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 007 2 00 8 2 009 2 01 0 2 011 2 01 2

70

120

170

220

270

Spain

France

PortugalUnited Kingdom

Italy Germany

United States

Ireland

Figure 1.27B. Corporate Debt in Percent of GDP(Four-quarter moving average)

2 00 2 2 00 3 2 004 2 00 5 2 00 6 20 07 2 00 8 2 00 9 2 01 0 2 01 1 2 01 2


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In our orward-looking exercise o debt sustain-ability, we project net ree cash ow over the medium-

term. Net ree cash ows are orecasted based on

assumptions on GDP growth and interest rates under

the World Economic Outlook (WEO) baseline, the

euro area upside, and the euro area downside sce-

narios (see the April 2013 World Economic Outlook).

Financial ragmentation measured by interest rates in

this exercise is substantially reduced in Portugal under

the WEO baseline and in other periphery countries

under the euro area upside scenario.

Te weak tail o highly leveraged rms with

projected negative net ree cash ows is substantiallylarger in some periphery countries than in the core,

particularly in Portugal and Spain (Figure 1.29).

Te size o the debt overhang is particularly

large in Italy, Portugal, and Spain. o achieve non-

negative net ree cash ows in the medium-term,

corporate leverage in these countries would have to

be reduced by 610 percent o assets under the base-

line and to converge to the levels in the core under

the downside scenario with continued ragmentation

and lower growth (Figure 1.30).

Te above analysis underscores the urgent need or

restructuring and consolidation in the periphery cor-

porate sector, where a range o measures will be needed

to smooth deleveraging (Figure 1.31). While large

diversied companies may sell assetsincluding oreign

unitsto reduce leverage, potential protable sales are

likely to negatively aect their revenues and earnings

going orward. Furthermore, additional cuts in operat-

ing costs, dividends, and capital expenditures may also

be required, posing additional risks to growth andmarket condence. Tus, a move to the upside scenario

with reduced ragmentation and productivity gains

rom restructuring will be critical to lower unding

costs and support orderly deleveraging. In special cases,

where the debt overhang issue is systemic, a mandatory

suspension o dividends can be considered as a policy

option, as well as principal reduction workouts.15

In addition, the strains in the corporate sector

may urther undermine bank asset quality. While the

recently conducted EU-wide and national bank stress

testing exercises have helped strengthen capital bu-

ers, continued bank supervisory vigilance is needed.Second-round eects rom lower capital expenditures

and higher unemployment may lead to an increase in

a wider range o NPLs, including mortgages.

More work lies ahead.

Sustaining condence in the euro area and urther

Documents

Global Financial Stability Report - APRIL 2013