The turmoil in the global financial system will require a comprehensive effort by national authorities to restore confidence, get credit markets functioning properly again, and produce longer-term policies to rebuild the system, the IMF said in its Global Financial Stability Report.
Authorities must develop a consistent and coherent approach to stem the credit crisis that had its origins in the U.S. subprime mortgage market. The report lays out five principles to guide the effort to restore confidence:
• Employ measures that are comprehensive, timely, and clearly communicated.
• Aim for consistent and coherent policies.
• Ensure rapid response on the basis of early detection of strains.
• Ensure that emergency government interventions are temporary and taxpayer interests are protected.
• Pursue the medium-term objective of a more sound, competitive, and efficient financial system.
The IMF said in its report, published on October 7, that the preeminent near-term challenge for policymakers is to break—and reverse—the negative feedback loop between the financial system and the real economy, in which financial institutions’ distress leads to impaired credit intermediation and slower economic growth, which in turn leads to further credit deterioration.
The report noted that the U.S. authorities have abandoned their piecemeal approach to the credit crisis and are trying to develop a comprehensive and systematic strategy—to encourage private markets to function again and facilitate the rebuilding of capital. Among other steps, the current plan provides for further liquidity support to the credit markets, frozen because institutions fear making loans to one another; purchasing problem assets to free up bank balance sheets; and extending deposit insurance.
But the IMF questions whether the new measures will be enough to restore confidence in the credit system, because many of the details have yet to be determined. But the IMF said it is a step in the right direction. The asset-purchase program must also be managed soundly and clearly set out its objective to develop public support.
To break and reverse the spiral afflicting financial markets and to restore confidence, three interrelated areas need to be addressed simultaneously, according to the report: falling asset values, dysfunctional funding markets, and insufficient capital to support credit growth. Specifically:
•Capital: Some $675 billion of additional capital is needed by banks globally. With the ability to raise new private capital constrained, the authorities could consider injecting capital into viable institutions, coupled with the orderly resolution of non-viable banks.
•Funding: Because of the extreme difficulties in obtaining wholesale funding for many institutions, guarantees could be considered for senior and subordinated debt liabilities of banks for a temporary period. Deposit insurance of individual accounts could also be temporarily expanded.
•Assets: Public sector balance sheets can be used to absorb assets to prevent “fire sale” liquidations that threaten to reduce bank capital. Countries whose banks have large exposures to problem assets could consider government asset purchases or funding through an asset management company to provide legal clarity and accountability.
Even as national authorities deal with the immediate crisis, they must also begin to think of the longer run. Because the turmoil has caused such an upheaval, pressure to protect current business practices and regulatory structures has lessened, freeing authorities to rethink the global financial architecture. The private sector has a role to play as well, the IMF said.
“There is an opportunity and a need to move toward a macroprudential and regulatory architecture that is more integrated in its approach and uniform in standards, and that involves closer and more effective cross-border coordination and collaboration among supervisors, regulators, and central banks,” the report stated.
To improve the global financial structure, the IMF said:
• Authorities must ensure that firms’ risk measurement systems take a sufficiently long-term perspective and establish standards for risk disclosure that are consistent not only across firms but also across borders.
• Banks and securities firms must improve their liquidity management, while central banks must have in place backstops that can be “applied quickly and flexibly in the event of system-wide pressures.”
• Banks with significant activities in other countries must reassess their cross-border lending plans, and authorities have to work on cross-border cooperation and contingency planning to ensure that domestic laws do not interfere with international cooperation, when dealing with firms operating in more than one country.
Financial institutions’ losses continue to mount, and unless they receive sufficient capital infusions, the viability of some of them is uncertain. The GFSR estimates that losses on U.S.-based loans and securities may rise to some $1.4 trillion—a significant increase from the estimate of $945 billion in the April 2008 GFSR.
While roughly $560 billion of the losses had been realized through end-September 2008, bank share prices have continued to plummet and their revenue prospects have stalled. Raising capital has become harder, making it much more difficult for banks to repair their balance sheets.
The most serious risk going forward is an intensifying adverse feedback loop between the financial system and the real economy. The GFSR—using forecasts from the IMF’s World Economic Outlook—projects that credit growth in the United States, the euro area, and the United Kingdom, will slow to near zero over the next year before picking up again in 2010.
The deleveraging process is both necessary and inevitable—but it need not be disorderly. Current market conditions have meant that asset sales and the run-off of maturing assets have made the process difficult because prices of the many illiquid mortgage-backed securities are depressed and buyers are scarce. Private market solutions to put a floor under these securities haven’t worked.
Recently, the U.S. government approved a plan to have the U.S. Treasury use about $700 billion, under some restrictions, to purchase U.S.-based troubled assets with the hope of curtailing “fire sales” of these assets and establishing realistic prices. But a major issue for the plan is the difficulty for anyone to determine future cash flows from these assets under such uncertain conditions.
Supporting asset prices is necessary, but it is only one element in a three-part solution, the GFSR notes. Financial institutions need to raise more capital but cannot do so under current conditions. Some potential investors stepped forward earlier, but now are reluctant. Current business models and revenue streams are more uncertain because mortgage securitization has nearly halted, making private capital investments in banks more chancy.
Without the ability to obtain new capital from private markets, recapitalization using the public sector balance sheet should now be considered, as solvency concerns have led to a seizing-up of interbank funding markets. Finally, public action is being taken to provide much-needed liquidity to the financial sector and its clients.
Until recently, emerging markets had appeared resilient to spillovers from mature markets. But in recent weeks, that has changed. Capital outflows have intensified, leading to tighter external and, in some cases, domestic liquidity conditions. The problems were more serious in those economies with leveraged banking systems and corporate sectors that rely on international financing.
Although “decoupling”—the notion that emerging markets’ dependence on mature economies has declined—had faded from most economists’ vocabularies, some held out hope that this time, emerging markets would not succumb. It is true that emerging economies have made progress on a number of fronts.
Overall, they have higher fiscal balances, less sovereign debt, more foreign exchange reserves, better policymaking structures, and healthier economies. Many of these improvements are related to the recent commodity price boom. Nonetheless, the linkages to global markets and economies have continued to grow and these have begun to overwhelm the improved domestic fundamentals.
Moreover, although many emerging economies have made fiscal and financial improvements, others remain vulnerable. The report highlights the reasons some countries may be at particular risk—for instance, those dependent on terms-of-trade improvements or external credit.
Emerging European economies have relied on credit supplied by foreign banks or foreign investors through the issuance of local bank bonds abroad. This latter source has dried up, and even though foreign banks say they remain committed to their subsidiaries in these countries, if funding conditions in their home country become difficult, they may have little choice but to slow their credit extension abroad as well as at home.
Peter Dattels and Laura Kodres
IMF Monetary and Capital Markets Department
Fair Value Accounting Gathers Interest in Current Turmoil
The IMF has weighed in on a complicated and controversial question of how financial institutions should value assets and liabilities on their books.
It is rare that an arcane accounting principle becomes the subject of public debate. But the role of fair value accounting (FVA) in the financial turmoil that began last year has come under “close scrutiny,” the IMF noted. Some critics allege that it made matters worse, increasing volatility and amplifying the effects of the business cycle on the net worth of financial institutions and adding to the uncertainty about how accurately institutions could price some of their illiquid assets.
But the IMF concluded in the October Global Financial Stability Report that the FVA approach, which seeks to value assets and liabilities at prices reflecting current market settings, ensures the most accurate assessment under most conditions.
The IMF acknowledged that the application of F VA can exacerbate procyclicality in bank balance sheets and suggested some approaches to mitigate the impact. However, under some applications, F VA has the potential to reduce procyclicality. On balance, the IMF said, with some enhancements, FVA is “the preferred accounting framework for financial institutions.”
The Fund said that FVA is more transparent than alternative methods and that financial institutions and regulators could take steps to reduce the procyclical effects of FVA. Some of the problem lies not with the FVA framework itself, but with how financial institutions use it in their decisions and risk management, the IMF said.
The IMF suggested that financial institutions should take such steps as:
• Selectively adding information about how they value assets and liabilities;
• With regulators’ support, strengthening capital buffers and provisioning to cushion the impact of business cycle fluctuations on their balance sheets; and
• Issuing shorter, more focused accounting reports targeted to specific audiences at a higher frequency than they do now.