- International Monetary Fund. Monetary and Capital Markets Department
- Published Date:
- April 2008
© 2007 International Monetary Fund
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- Executive Summary
- Chapter I. Assessing Global Financial Risks
- Global Financial Stability Map
- Deterioration in the U.S. Subprime Mortgage Market—What Are the Spillover Risks?
- What Is Driving the Leveraged Buyout Boom and Does It Pose Stability Risks?
- Implications of Financing of Global Imbalances with Debt Flows
- Emerging Market Risks and Challenges in a Benign External Environment
- Are Global Financial Markets Too Complacent?
- Policies to Mitigate Stability Risks
- Annex 1.1. Implementing the Global Financial Stability Map
- Annex 1.2. Financial Systems in Mature and Emerging Markets
- Annex 1.3. Credit Derivatives and Structured Credit Market Update
- Annex 1.4. Trends and Oversight Developments in the Hedge Fund Industry
- Chapter II. Changes in the International Investor Base and Implications for Financial Stability
- Chapter III. The Globalization of Financial Institutions and Its Implication for Financial Stability
- Annex: Summing Up by the Chairman
- Statistical Appendix
- 1.1. The Alphabet Soup of Subprime Mortgage Securitization—ABS, ABX, and CDOs
- 1.2. Bond Flows: Demand Response to Interest Rate and Exchange Rate Shifts
- 1.3. Zambia: A Case Study
- 1.4. Have Hedge Fund Risks Also Risen?
- 1.5. Causes and Implications of the February–March 2007 Market Correction
- 1.6. Constant Proportion Debt Obligations
- 2.1. Foreign Direct Investment Flows
- 2.2. Shifting from Home Bias to “Intra-European” Bias?
- 2.3. Evolution of the Home Bias in U.S. Equity Portfolios
- 2.4. The Importance of Internationally Comparable Bilateral Statistics
- 2.5. Country, Regional, and Global Determinants of Capital Outflows
- 2.6. Liquidity of Brazilian Inflation-Linked Instruments
- 3.1. Some Evidence on Systemic Stability Aspects of Bank Globalization
- 3.2. Assessing Spillover Risks Among the World’s Largest Banking Groups
- 3.3. Operational Risk and Business Continuity
- 3.4. Examples of Bank Failures with Cross-Border Dimensions
- 1.1. Stress Test: Impact of Home Price Appreciation (HPA) on Asset-Backed Securities (ABS) Collateralized by Subprime Mortgage Loans
- 1.2. Foreign Currency Bond Issuance and Banking System Soundness: Europe, Middle East, and Asia (EMEA), and Kazakhstan and Russia
- 1.3. Changes in Risks and Conditions Since the September 2006 Global Financial Stability Report
- 1.4. U.S. Fixed-Income Trading Volume—Hedge Funds, 2005
- 2.1. Pension Fund Asset Allocation in Selected Countries
- 2.2. Accumulation of Official Foreign Exchange Reserves of Selected Countries
- 2.3. Top Sovereign Wealth Funds
- 2.4. Distribution of Foreign-Owned U.S. Long-Term Securities
- 2.5. Estimates of the Effect of Reserve Accumulation on U.S. Treasury Yields
- 2.6. Determinants of Returns on Emerging Market External Debt
- 2.7. Liberalization of Capital Outflows: Recent Experiences of Selected Countries
- 2.8. Performance of Selected Emerging Financial Markets, May 8–June 23, 2006
- 3.1. Financial Industry Mergers and Acquisitions (M&A), 1996–2006
- 3.2. Foreign Bank Ownership, by Region
- 3.3. Cross-Border Activities of the 90 Largest Banks, 2005
- 1.1. Global Financial Stability Map
- 1.2. Residential Mortgage-Related Securities Market
- 1.3. Mortgage Delinquency Rates
- 1.4. Subprime 60-Day Delinquencies by Mortgage Vintage Year
- 1.5. U.S. Mortgage Universe
- 1.6. Synthetic (ABX) and Cash (ABS) BBB- Subprime Spreads
- 1.7. Corporate Profits for Euro Area, Japan, and the United States
- 1.8. Weighted Average Cost of Capital versus Debt as a Share of Capitalization
- 1.9. Private Equity Buyouts and Leveraged Loan Issuance
- 1.10. U.S. Corporate and Buyout Leverage
- 1.11. U.S. Corporate Bond and Loan Issuance
- 1.12. Global Speculative Default Rates
- 1.13. Sources of Financing for the U.S. Current Account Deficit
- 1.14. Net Foreign Purchases of U.S. Fixed-Income Securities by Type
- 1.15. Response (of Bond Flows/GDP) to a 1 Percent Spread Increase: Period 2 (2002–05)
- 1.16. Indicators of External Vulnerability in Emerging Markets
- 1.17. Emerging Market External Issuance
- 1.18. Emerging Market Credit Quality Index
- 1.19. Cumulative Net Flows to Emerging Market Funds
- 1.20. Implied Volatility Indices
- 1.21. Volatility and the U.S. Business Cycle
- 1.22. Foreign Exchange Carry Trade Returns and Volatility
- 1.23. Institutional Currency Positioning
- 1.24. Japanese International Capital Flows
- 1.25. Bank Willingness to Lend and Corporate Default Rates
- 1.26. Relative Price of “Tail Risk” in Foreign Exchange Markets
- 1.27. Correlation of Asset Classes with S&P 500 and Broad Market Volatility
- 1.28. Volatility Shocks to Sovereign Spreads
- 1.29. G-3 Real Short-Term Interest Rates
- 1.30. G-3 Excess Household and Corporate Liquidity
- 1.31. Goldman Sachs Global Financial Conditions Index
- 1.32. Custodial Reserve Holdings at the Federal Reserve Bank of New York
- 1.33. Merrill Lynch Fund Manager Survey Question on Risk Appetite
- 1.34. State Street Investor Confidence Index
- 1.35. Total Inflows into Emerging Market Bond and Equity Funds
- 1.36. Goldman Sachs Risk Aversion Index
- 1.37. G-3 Average Economic Confidence Indicator
- 1.38. Dresdner Kleinwort Global Economic Activity Surprise Index
- 1.39. EMBIG Spreads: Actual and Fundamental Model Estimates
- 1.40. Emerging Market Credit Quality: Net Credit Ratings Changes
- 1.41. Median Volatility of Inflation Across Emerging Market Countries
- 1.42. JPMorgan Emerging Market Foreign Exchange Implied Volatility Index
- 1.43. Merrill Lynch Global High-Yield Index Spread
- 1.44. Share of CCC or Lower-Rated Corporate Securities in Merrill Lynch Global High-Yield Index
- 1.45. Moody’s Global Speculative Grade Default Rate
- 1.46. Probability of Multiple Defaults in Select Portfolios for Large Complex Financial Institutions
- 1.47. Hedge Fund Market Sensitivity Measure
- 1.48. Average Net Speculative Positions in U.S. Futures Markets
- 1.49. Composite Volatility Index
- 1.50. Probability of Multiple Defaults in Select Portfolios
- 1.51. Global Credit Derivatives Outstanding
- 1.52. Global ABS, MBS, and CDO Issuance
- 1.53. Global Hedge Funds
- 1.54. Global Hedge Funds by Geographic Source of Funds
- 1.55. Hedge Fund Sources of Capital by Investor Class, 2005
- 2.1. Total Global Cross-Border Inflows
- 2.2. Assets Under Management of Institutional Investors in Mature Markets
- 2.3. Portfolio Cross-Border Assets Held by Mature Markets
- 2.4. Globalization of the Asset Management Industry
- 2.5. Global Hedge Funds, Investor Base
- 2.6. Current Account, Capital Flows, and Reserve Accumulation
- 2.7. Foreign Exchange Reserves and the Short-Term Government Bond Market
- 2.8. Leading Oil Exporters: Major Asset Purchases, 2002–06
- 2.9. Volatility of Net Cross-Border Purchases of Long-Term U.S. Treasury Securities
- 2.10. Term Structure of Sovereign Credit Default Swap (CDS) Spreads, 2003–06
- 2.11. Volatility of Capital Inflows
- 2.12. Volatility of Capital Outflows
- 2.13. Changes in Net Capital Flow Volatility versus Reserve Ratios
- 2.14. Share of U.S. Dollars in Reserves
- 2.15. International Syndicated Loans to Emerging Market Corporates, by Credit Rating
- 2.16. International Emerging Market Corporate Bond Issuance by Credit Rating
- 3.1. Foreign Loans and Deposits of Bank for International Settlements Reporting Banks
- 3.2. Foreign Bank Participation in Emerging Countries
- 3.3. Foreign Bank Entry by Developing Countries, by Country Income Level, 2005
- 3.4. Worldwide Market Share of the Largest 40 Life Insurance Groups
- 3.5. Gross Reinsurance Premiums Assumed and Ceded by Region, 2005
- 3.6. Cross-Border Diversification and Individual Bank Soundness, 1994–2004
- 3.7. Stock Price Correlation for Major Banks, 1990–2006
- 3.8. Concentration of Cross-Border Risk, end-June 2006
- 3.9. Selected Regions: Net Foreign Assets
- 3.10. Net Foreign Bank Claims and External Position vis-à-vis Emerging Markets
- 3.11. Central and Eastern European (CEE) Countries’ Bank Asset Structure, by Key Bank Groups, end-2005
- 3.12. Structure of Foreign Claims to Central and Eastern European (CEE) Countries, by Key Creditor Countries, end-March 2006
- 3.13. Home-Host Asymmetry in Foreign Bank Exposure, March 2006
The following symbols have been used throughout this volume:
- … to indicate that data are not available;
- — to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist;
- – between years or months (for example, 1997–99 or January–June) to indicate the years or months covered, including the beginning and ending years or months;
- / between years (for example, 1998/99) to indicate a fiscal or financial year.
“Billion” means a thousand million; “trillion” means a thousand billion.
“Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to ¼ of 1 percentage point).
“n.a.” means not applicable.
Minor discrepancies between constituent figures and totals are due to rounding.
As used in this volume the term “country” does not in all cases refer 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 for which statistical data are maintained on a separate and independent basis.
The Global Financial Stability Report (GFSR) assesses global financial market developments with a view to identifying potential systemic weaknesses. By calling attention to potential fault lines in the global financial system, the report seeks to play a role in preventing crises, thereby contributing to global financial stability and to sustained economic growth of the IMF’s member countries.
The analysis in this report has been coordinated in the Monetary and Capital Markets Department (MCM) under the general direction of Jaime Caruana, Counsellor and Director. The project has been directed by Hung Q. Tran, Deputy Director of the MCM Department, and MCM Division Chiefs Peter Dattels, Daniel Hardy, Ceyla Pazarbasioglu, and Mark Swinburne. The report benefited from comments and suggestions from Laura Kodres, MCM Division Chief, and Christopher Towe, MCM Deputy Director.
Primary contributors to this report also include Brian Bell, Elie Canetti, Jorge A. Chan-Lau, Martin Čihák, Mangal Goswami, Andreas A. Jobst, Andrea M. Maechler, Rebecca McCaughrin, Paul Mills, Christopher Morris, Jack Ree, Mustafa Saiyid, Christopher Walker, and Mark Walsh. Martin Edmonds, Patricia Gillett, Ivan Guerra, Silvia Iorgova, Oksana Khadarina, Yoon Sook Kim, Ned Rumpeltin, Kiran Sastry, Kalin Tintchev, and Peter Tran provided analytical support. Caroline Bagworth, Norma Cayo, Elsa Portaro-Cracel, and Melissa Wills-Dudich were responsible for word processing. Other contributors include Jochen Andritzky, Nicolas Blancher, Charles R. Blitzer, Sean Craig, Kristian Flyvholm, Todd Groome, David Hoelscher, John Kiff, Lucie Laliberté, William Lee, Srobona Mitra, John Motala, Christian Mulder, Shinobu Nakagawa, Paul Ross, and André Santos, as well as Dilek Aykut and Neeltje van Horen (World Bank), and Joseph Battat and Thomas Davenport (International Finance Corporation). David Einhorn of the External Relations Department edited the manuscript and coordinated production of the publication.
This particular issue draws, in part, on a series of discussions with commercial and investment banks, securities firms, asset management companies, hedge funds, insurance companies, pension funds, stock and futures exchanges, credit rating agencies, and academic researchers, as well as regulatory and other public authorities in major financial centers and countries. Contributions from Craig Martin and Kevin Roth (Association for Financial Professionals) in the conducting of a survey are gratefully acknowledged. The report reflects information available up to February 6, 2007.
The report benefited from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussion of the Global Financial Stability Report on March 19, 2007. However, the analysis and policy considerations are those of the contributing staff and should not be attributed to the Executive Directors, their national authorities, or the IMF.
Favorable global economic prospects, particularly strong momentum in the euro area and in emerging markets led by China and India, continue to serve as a strong foundation for global financial stability. However, some market developments warrant attention, as underlying financial risks and conditions have shifted since the September 2006 Global Financial Stability Report (GFSR).
Through the use of a new global financial stability map, Chapter I charts principal near-term risks. Chapters II and III examine the financial stability implications of two longer-term trends: the changing investor base from which global capital flows are sourced, and the globalization of financial institutions, particularly banks.
The changing mix of assets, source countries, and types of cross-border investors identified in Chapter II should, for the most part, help to stabilize global markets. But the secular trend has been reinforced by low interest rates and by low volatility in many mature markets, with investors seeking higher-yielding assets in some emerging markets and other mature markets. Chapter I examines this investor strategy—the carry trade—noting that while countries’ fundamentals have improved and sovereign external debt has become less risky, international issuance of corporate debt and equities has risen rapidly to accommodate investor demand.
A theme of Chapter III—that the globalization of banks may help reduce individual bank risk but may not necessarily enhance the resilience of financial systems as a whole—is also echoed in Chapter I, which examines possible spillovers from a deterioration in credit quality in the U.S. subprime mortgage market.
Chapter I identifies several short-term risks. First, the subprime segment of the U.S. housing market is showing signs of credit quality deterioration. While the fallout to date has been limited, there is scope for it to deepen and spread to other markets, possibly to structured mortgage credit products held by a variety of global investors. Fortunately, the economic impact of the housing market slowdown has been limited and some market indicators have begun to stabilize, suggesting that the financial effects may also be contained.
Second, low interest rates and healthy corporate balance sheets have spurred an increase in private equity buyouts. This has led to a substantial rise in leverage in the acquired firms, potentially making such firms more vulnerable to economic shocks. The increased use of leveraged loans as part of financing also poses risks to some intermediaries that provide bridge financing to leveraged-buyout transactions. The situation bears careful attention, especially if a large high-profile deal runs into difficulty, as this could trigger a wider reappraisal of the risks involved.
Third, capital inflows to some emerging markets have risen rapidly, in part reflecting improved economic fundamentals, but also reflecting the search for yield given low interest rates in most mature markets. In general, strong private capital inflows are to be welcomed, as they reflect a reallocation of capital to more productive investments. However, the shift to private sector debt flows, especially bank-based flows into emerging Europe and portfolio flows into other regions, including sub-Saharan Africa, shows that foreign investors are taking more risk and an abrupt reversal cannot be ruled out.
Finally, while the downside risk from a possible disorderly unwinding of global imbalances has receded somewhat, it remains a concern. The larger role of fixed-income inflows in financing the U.S. current account deficit indicates that inflows into U.S. bond markets may have become more sensitive to changes in world interest rate differentials.
Against the backdrop of continued global growth, none of the individually identified risks by themselves threaten financial stability. However, with volatility across asset classes close to historic lows and spreads on a variety of credit instruments tight, investors may not have adequately factored in the possibility that a “volatility shock” may be amplified given the increased linkages across products and markets. Institutions may well be acting in accordance with their own incentives, but collectively their behavior may cause a buildup of investment positions in certain markets, possibly resulting in a disorderly correction when conditions change. For instance, the rapid growth of some innovative instruments, the rise in leverage in parts of the financial system, and the growth of carry trades suggest that market participants are expecting a continuation of the low volatility environment and that a sustained rise in volatility could perturb a wide range of markets.
Chapter II examines the recent acceleration in the accumulation of international assets as well as the investors behind rising cross-border flows. As noted above, flows and stocks of cross-border claims have increased both in absolute size and relative to the volume of domestic economic activity. The diversity of assets, source countries, and investor types now involved in cross-border asset accumulation suggests more stable flows. However, for some countries, the sharp increase in capital inflows has contributed to rapid credit growth and asset price inflation, at times complicating the conduct of policies. Furthermore, foreign investors have been venturing into markets previously regarded as excessively risky for outsiders, encouraged by the generally benign financial environment.
Policymakers can take advantage of these secular changes and at the same time minimize pockets of vulnerabilities that have become apparent. Recipient countries have to continue to establish a track record of credible macroeconomic policies. Vulnerabilities can be reduced by promoting efficiency, stability, and the effective regulation of domestic capital markets (including the development of local debt markets) so as to increase their attractiveness to a stable investor base. Liberalization of capital outflows from domestic investors, though not a panacea, may help balance the effects of capital inflows and allow domestic investors to better manage their risk.
Chapter III examines the implications of the accelerating globalization of financial institutions—particularly banks—for global financial stability. The institutional and regional pattern of globalization is remarkably varied. For large banks, greater geographical dispersion of assets and revenues tends to be associated with better share price performance and lower default risks. However, while cross-border diversification seems to be associated positively with the stability of the individual institution, the financial system as a whole may not be more stable, with the potential for linkages among markets and activities having increased. This is an especially important result for countries in regions with heavy foreign bank penetration across correlated economies.
The chapter highlights two clear priorities to help to contain the potential contagion risk arising from institutional globalization while maximizing its benefits. First, supervisors need to collaborate ever more closely in the oversight of cross-border institutions. Second, authorities need to continue improving crisis management procedures with the counterparts with whom they share the greatest overlapping responsibilities and interests. While the jurisdiction of supervisors and regulators remains predominantly domestic, at odds with the scope of activities of global institutions, these practical steps can go some way toward addressing the challenges to financial stability posed by institutional globalization.