Analysis Of Global Financial Stability

By M. Isi Eromosele

The global economy suffered a major setback in late 2011 as concerns about financial stability in the euro area came to a head. Market stress spread throughout the currency zone, bond yields soared in peripheral economies, and liquidity evaporated as investors grew increasingly concerned about the risk of disorderly bank failures or sovereign defaults.

These developments dramatically highlighted the risk of adverse, self-fulfilling shifts in market sentiment that could rapidly push fragile sovereigns into a bad equilibrium of rising yields, a funding squeeze for their domestic banks and a worsening economy.

Today, sovereign spreads have eased, bank funding markets have partly reopened, and equity prices have rebounded. Market and liquidity risks have improved sharply, falling below the levels of the September 2011 level, as immediate concerns of an imminent collapse were averted and official funding relieved refinancing pressures in the banking system.

The additional liquidity has boosted risk appetite, and the price of risk assets has strengthened, reflecting both increased liquidity and declining perceptions of tail risk. Bank equities have recovered and default risk has declined sharply.

Sovereign financing markets have shown signs of easing from the extremes reached in late 2011, and recent auctions have been mostly well subscribed, supported in part by the ECB’s longer-term refinancing operations (LTROs) as banks in some countries appear to have increased holdings of government debt.

Nevertheless, bond markets remain fragile and volatile, reflecting the erosion of traditional investor bases and large fiscal financing needs.

As a result of the strong policy actions outlined above, credit risks have retreated from high levels. However, pressures on European banks remain elevated. Banks are coping with sovereign risks, weak economic growth, high rollover requirements, and the need to strengthen capital cushions to regain investor confidence.

Together, these pressures have induced a broad-based drive to reduce the size of bank balance sheets. Although some deleveraging is both inevitable and desirable, its precise impact depends on the nature, pace and scale of asset shedding. The EBA explicitly discouraged banks from shedding assets to meet the 9 percent capital target, by requiring that banks cover the shortfall mainly through capital measures.

Asset sales would be recognized toward achievement of the EBA target only if they do not lead to a reduced flow of lending to the economy. So far, deleveraging has occurred predominantly through buttressing capital positions and reducing non-core activities, leaving the impact on the rest of the world manageable. It is essential to continue to avoid a synchronized, large-scale, and aggressive trimming of balance sheets that could do serious damage to asset prices, credit supply and economic activity in Europe and beyond.

Although downside economic risks have been reduced, financial stability risks stemming from the macroeconomic situation remain unchanged. This is because the slowdown in growth in the euro area and the divergence between core and peripheral countries will make dealing with debt burdens more challenging. Deleveraging pressures in Europe’s banking system risk creating an adverse feedback loop that could have further effects on economic activity.

Emerging markets generally have substantial buffers and policy room to cope with fresh external shock, as reflected in the unchanged, moderate level of emerging market risk. So far, these economies have been well able to manage the deleveraging coming from European banks, but looking ahead, there is a potential for deleveraging to have a global impact on the supply of credit.

Although the pressures are likely to be most intense in emerging Europe, a sharp pullback in credit could expose existing external vulnerabilities throughout emerging markets, triggering additional portfolio outflows and upending domestic financial stability.

The risks to growth and financial stability during the deleveraging process are magnified by the fact that balance sheet repair often extends across several economic sectors (households, corporations, and the public sector).

Strained public finances are but one aspect of weak balance sheets in advanced economies. Many economies are weighed down by high debt burdens across multiple sectors. Indeed, historical experience suggests that balance sheet repair takes time and tends to dampen activity.

Countries with large external debts face a particular challenge, as the required rebalancing is hampered by entrenched competitiveness problems and subdued external demand. Policymakers need to coordinate a careful mix of financial, macroeconomic, and structural policies that ensure a smooth deleveraging process, support growth, and facilitate rebalancing.

In the Euro area, a clear path toward a more integrated and fuller monetary and economic union built on solidarity and strengthened risk-sharing arrangements are essential.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group