Global Financial Stability

Fabio NatalucciDeputy Director

Monetary and Capital Markets Department

International Monetary Fund

Risks:

• Global growth slowdown

• An unexpected monetary policy shift

• Trade tensions

• Disorderly Brexit

1

The Credit Cycle is Maturing

Vulnerabilities:

• Rising corporate debt

• Sovereign-financial sector nexus

• Maturity and liquidity mismatches

• House-price misalignments

• Vulnerabilities in emerging markets

Recent Market Developments

Most Markets More Than Retraced Their 2018 Losses

2

Returns by Asset Class

(Percent)

Markets sold off in 2018 on growth concerns, but

have retraced most of their losses …

Implied volatility across assets

(5 day moving average)

… along with a return to the low-volatility regime

-25

-15

-5

5

15

25

35

Oil (

Bre

nt)

Ch

ina e

qu

itie

s

Co

mm

od

itie

s

S&

P 5

00

Eu

rost

oxx

50

EM

eq

uit

ies

To

pix

US c

orp

HY

EM

so

v $

EM

co

rp $

Go

ld

Eu

ro c

orp

HY

US c

orp

IG

EM

go

vts

lo

cal

Eu

ro c

orp

IG

JGB

s

US T

-Bills

2019 YTD

Sep. 30, 2018 to end-2018

Global Financial Conditions Have Eased

3

Financial Conditions Indices

(z-score since 1996)

Financial conditions have eased this year…

Components of the US Financial

Condition Index

(z-score since 1996)

... driven by lower rates and higher corporate

valuations in the US

Central Banks Have Turned More Dovish in the US, Euro Area…

4

US: Market Implied Fed Funds Rate versus FOMC Median

Dots

(Percent)

AE central banks are expected to deliver less tightening or more easing

ECB: Market-Implied Policy Interest Rate

(Percent)

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

Current

Rate

1M 3M 6M 1Y 2Y 3Y

Sep. 28, 2018 (Last GFSR)

Mar. 3, 2019 (day before ECB meeting)

Latest (May 8, 2019)

…and Emerging Markets

5

EM central banks are expected to deliver less tightening or more easing

China: Interbank Interest Rate and Required Reserve

Ratio

(Percent)

EMs: Change in Market Implied Policy Rate, 1-year Ahead

(Basis points)

Hungary

BrazilPoland

Indonesia

Thailand

Malaysia

India

South Africa

RomaniaMexico

Russia

Philippine-50

-30

-10

10

30

50

70

90

-50 0 50 100 150 200

6 months ago

Cu

rren

t

Less tightening or more

easing

45 degrees

12

13

14

15

16

17

18

2.00

2.50

3.00

3.50

4.00

4.50

5.00

5.50

Mar.17 Aug.17 Jan.18 Jun.18 Nov.18 Apr.19

SHIBOR 3m

Required Deposit Reserve Ratio (right scale)

1.9

2.0

2.1

2.2

2.3

2.4

0

5

10

15

20

25

30

35

40

Oct.18 Nov.18 Dec.18 Jan.19 Feb.19 Mar.19

VIX

Standard deviation of global EPS forecasts (right scale)

Powell’s AEA remarks (Jan 4)

… To Counter Downside Risks to Economic Growth

6

MSCI World Index vs Global Forward EPS*

Forecast

(Index, y/y percent change)

VIX and Dispersion of Global Forward EPS*

Forecasts

(Index, y/y percent change)

Corporate earnings growth have revised down

sharply…

… while more dovish monetary policy outlook has

helped suppress market volatility and uncertainty

*EPS= Earnings per share

Medium-Term Financial Stability Risks Remain Elevated

7

Near-term downside risks are somewhat higher,…

Near-Term (1-year Ahead) Global Forecast Densities

(Probability density)

Near- and Medium-Term Risks

(GaR: Fifth percentile of forecast distribution)

… while medium-term risks remain elevated

compared to six months ago

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.8 1.8 2.8 3.8 4.8 5.8

2018:Q3 2018:Q4 2019:Q1

Note: Dots refer to 5th percentile of forecast distribution, GaR.

-1.4

-0.9

-0.4

0.1

0.6

1.1

1.6

2.1

2.6

3.1

Near term Medium term

2018:Q3 2018:Q4 2019:Q1

Growth-at-risk Estimates

8

Near-term GaR forecast signals deterioration from a

recent historically benign peak…

Near-Term (1-year Ahead) Global Forecast Densities

(Percentile Rank)

Medium-Term (3-year Ahead) Global Forecast Densities

(Percentile Rank)

… whereas the medium-term GaR forecast

remains close to historically high risk levels

Vulnerabilities Continue to Build Up in Parts of the Global Economy

9

Proportion of GDP of Systemically Important Countries* with Elevated Vulnerabilities, by Sector

(Share of countries with high and medium-high vulnerabilities by GDP; assets for banks)

Vulnerabilities in sovereign, corporate and nonbank financial sectors are elevated in systemically important economies

*The analysis includes 29 jurisdictions with systemically important financial sectors.

Banks

Sovereigns

Households

Nonfinancial

corporatesInsurers

Shadow

banking

Apr. 2019 GFSR

Oct. 2018 GFSR

Global financial crisis

80%

100%

60%

40%

20%

More

vulnerable

Indicator-Based Framework

10

Financial Vulnerabilities by Sector and Region

Vulnerabilities in the sovereign, corporate, and nonbank financial sectors are elevated by historical standards in

several systemically important countries and regions

Oct.

2018

Apr.

2019

Oct.

2018

Apr.

2019

Oct.

2018

Apr.

2019

Oct.

2018

Apr.

2019

Oct.

2018

Apr.

2019

Oct.

2018

Apr.

2019

Advanced Economies

United States

Euro area

Other advanced

Emerging Market Economies

China

Other emerging

Other

FinancialsSovereigns

Nonfinancial

FirmsHouseholds Banks Insurers

Highest Lowest

Vulnerabilities in a Maturing Credit Cycle

0

20

40

60

80

100

Dec.99 Feb.03 Apr.06 Jun.09 Aug.12 Oct.15 Dec.18

US Euro area

US recessionEuro area

recession

Corporate Debt Has Increased and Market-Based Finance Expanded

11

US and Euro Area Corporate Credit Cycles*

(Percentile rank)

Corporate credit cycle in the US is at its highest

point in recent history

Nonfinancial Business Financing: Loans and Debt

Securities

Nonfinancial business sector reliance on capital-

market financing has increased

*Based on a number of indicators. The late stage of the credit cycle is characterized by

deteriorating underwriting conditions, increased risk taking, easy credit conditions, strong

profit, and high leverage.

0

2

4

6

8

10

12

2005:Q1 11:Q1 17:Q1

$ t

rilli

ons

United States

0

2

4

6

8

10

12

14

2005:Q1 11:Q1 17:Q1

€ t

rilli

ons

Euro Area

Loans Capital market financing

Credit Quality Has Deteriorated

12

BBB-Rated Bonds in Investment Grade Indices

(Percent of total; billions of US dollars)

Stock of BBB corporate bonds has quadrupled

since the crisis…

Evolution of BBB Corporate Bond Universe from 2009

to 2018

…largely driven by new issuance, rating changes,

and new entrants

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

0

20

40

60

2000 2002 2005 2008 2010 2013 2016 2018

US face value ($ billions, right scale)

Euro area face value ($ billions, right scale)

US

Euro area

0% 20% 40% 60% 80% 100%

Europe

BBB outstanding New entrants Rating transitions

Net issuance Other

United

States

Indebted Firms Could Come Under Strain in a Downturn

13

Share of Corporate Debt Owed by Firms with High

(above 0.6) and Moderate (between 0.3 and 0.6)

Debt to Asset Ratios

(Percent)

As firms’ indebtedness remains high…

Share of Corporate Debt Owed by Firms with Low

(below 1) and Subpar (between 1 and 3) Interest

Coverage Ratio

(Percent)

…the debt service capacity could deteriorate quickly in a

significant economic downturn

0

5

10

15

20

25

30

35

2008 2018 2009 2018

United States Euro area

ICR<3 ICR<1

Note: ICR= Earnings before interest, tax, depreciation and amortization (EBITDA)/Interest

expense

0

20

40

60

80

100

2008 2018 2009 2018

United States Euro area

Debt to assets>0.3 Debt to assets>0.6

Shift in Sources of Credit Provision

14

High-Yield Bond versus Leveraged Loan Debt Outstanding

(Billions of US dollars; billions of euros)

The stock of leveraged loans is almost as large as that

of high-yield bonds…

US Leveraged Loan Investor Base: Banks versus Nonbanks

(Percent of primary market issuance)

…while nonbanks have taken a larger role in financing

highly indebted firms

0

50

100

150

200

250

300

350

0

250

500

750

1.000

1.250

1.500

2004 2006 2008 2010 2012 2014 2016 2018

US high-yield bonds (left scale)

US leveraged loans (left scale)

EU high-yield bonds (right scale)

EU leveraged loans (right scale)

0

10

20

30

40

50

60

70

80

90

100

1994 1997 2000 2003 2006 2009 2012 2015 2018

Nonbanks (institutional investorsand finance companies)

Banks and securities firms

Record Global Leveraged Loan Issuance

15

Global leveraged loan issuance reached record highs…(Billions of US dollars)

…with the share of proceeds used to fund acquisitions

and shareholder enhancements still large(Global Leveraged Loan Issuance by Use of Proceeds)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

05 06 07 08 09 10 11 12 13 14 15 16 17 18

M&A

Refinancing

Other

Dividends and

Buybacks

LBOs

0

100

200

300

400

500

600

700

800

900

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019

US Issuers

Non-US Issuers

Note: 2019 issuance is through Q1 and annualized to estimate full-year 2019 issuance.

Credit Quality Is Weakening

16

Covenant protections continue to deteriorate…(US Leveraged Loans)

… and new issue loan ratings continue to weaken(US Leveraged Loan Issuance by Ratings)

2,0

2,5

3,0

3,5

4,0

4,5

0

10

20

30

40

50

60

70

80

90

07 08 09 10 11 12 13 14 15 16 17 18

Covenant-lite percent of newissuance (left scale)

Moody's Loan CovenantQuality Index score (rightscale)

Higher

Score

Equals

Weaker

Covenants

0%

20%

40%

60%

80%

100%

2000 2003 2006 2009 2012 2015 2018

Split BBB/BB or higher BB+/BB/BB-Split BB/B B+/B/B- or CCCNot Rated

Nonbank Investor Base Is Growing

17

Nonbanks have increased their exposure in the leveraged

loan market…(US Leveraged Loan Investor Base, Percent of New Issuance)

…alongside robust CLO formation and loan fund growth(Billions of US Dollars)

59%

48%

21%

10%

6%

14%

5%

2%

1%

6%

8%

20%

0% 20% 40% 60% 80% 100%

2018

2006

CLOs

Loan mutual funds

Hedge, distressed and high-yield funds

Insurance companies

Finance companies

Banks and securities firms0

20

40

60

80

100

120

140

160

180

200

220

0

20

40

60

80

100

120

140

02 04 06 08 10 12 14 16 18

CLO issuance (left scale)

Bank loan mutual fund and ETFAUM (right scale)

Sovereign - Financial Sector Nexus

Concerns About Sovereign-Financial Sector Nexus Have Reemerged

18

…and bank market indicators have deteriorated

Sovereign Spreads

(Basis Points)

Italian sovereign spreads have widened since

last year…

Italian Sovereign Spread and Bank Market Indicators

(Basis points; ratio)

Channels of Contagion

19

Some Banks Have Strenghtened Their Links to Sovereigns

20

…and sovereign credit ratings have been

downgraded in some countries

Banking System’s Holdings of Domestic

Government Bonds

(Percent of assets)

Bank holdings of domestic government debt

have increased…

Bank Government Bond Holdings by Rating

(Percent of government bond portfolio)

0

2

4

6

8

10

12

2006 2008 2010 2012 2014 2016 2018

ITA

PRT

ESP

FRA

IRL

DEU

Stock Of NPLs Needs To Be Reduced Further

21

Efforts have been made to dispose off non-

performing loans

Stock of Nonperforming Loans in the Euro Area

(Billions of euros)

But banks need to continue reducing the stock of non

performing loans on their balance sheets

Nonperforming Loan Transactions

(Billions of euros)

Profitability Challenges

22

Bank provisioning is likely to curtail profitability…

Estimated Impact of Provisioning to Fully Cover New

Nonperforming Loans on Profitability, 2019-23

(Percent of 2013-17 pre-provision profits, annualized)

… as would a cleanup of bad loans

Estimated Losses from Reducing Gross Nonperforming

Loan Ratios to 5 Percent by 2023

(Percent of 2013-17 pre-provision profits, annualized)

Capital Ratios Could Come Under Pressure in Some Countries

23

Estimated Impact on Tier 1 Capital Ratios: Adverse Downside Scenario

(Percent)

* Scenario adjustment = impact of mark-to-market change in government

bond values + adjustment for potential loan losses on NPLs

0

2

4

6

8

10

12

14

16

18

20

2010

2018

:Q2

2010

2018

:Q2

2010

2018

:Q2

2010

2018

:Q2

2010

2018

:Q2

2010

2018

:Q2

DEU FRA ESP IRL PRT ITA

Reported

Tier 1 ratio:

2010

Scenario

adjustment *

Post shock

Tier 1 ratio

Current Tier 1 ratio

Insurers’ Exposures to Sovereigns, Banks and Corporates

24

Insurers are important investors in sovereign and

bank debt

Holdings of Euro Area Sovereign and Bank Debt by Issuer

(Percent of total debt stock, 2018: Q2)

Holdings of lower-rated bonds have increased

Sovereign and Corporate Bond Holdings by Ratings

(Percent of total bond holdings)

Asset Allocation Varies Across Countries

25

Asset allocation to lower-rated bonds vary

significantly across countries…

Asset Allocation to Low-Rated Credit

(Percent of corporate bond holdings, 2018: Q2)

… while some also have significant holdings of riskier

bank bonds

Asset Allocation to Bank Subordinated and Hybrid Debt

(Percent of bank bond holdings, 2018: Q2)

Vulnerabilities in Emerging Markets

EM Assets Have Rebounded in 2019

26

Equity benchmarks

(April 1, 2018 = 100)US and EM Credit Spreads

(Basis Points)

Emerging market assets came under pressure in late 2018; but have recovered recently

Flows to Emerging Markets Have Been Generally Resilient

27

Nonresident Portfolio Flows to EMs*

(Billions of US dollars, three-Month Moving Sum)

Portfolio flows have rebounded in recent

months…

* Last 3 months are estimates based on higher frequency data from the IIF

Estimated Cumulative Impact of External Factors on

Emerging Market Portfolio Flows

(Billions of US dollars)

… as the drag from external factors has partially

receded

Benchmark-driven Investors Are Increasingly Important

28

Assets Benchmarked to JP Morgan EM Indices and

Market Capitalization

(Billions of US dollars)

Benchmark-driven investors have a larger presence

in hard currency debt than in local currency

sovereign debt markets

Assets Benchmarked against JPMorgan Emerging Market

Indices

More fund managers are tracking emerging market-

dedicated fixed income benchmark indices

0

100

200

300

400

500

600

700

800

2007

08

09

10

11

12

13

14

15

16

17

18

Asia credit

Hard currency corporate debt

Hard currency sovereign debt

Local currency sovereign debt

Potential Increase in the Amplification of Shocks

29

Sensitivity of Debt Flows to External Shocks

(Percent of invested assets)

Benchmark-driven flows are highly sensitive to external

factors, such as global risk appetite and US interest

rates

Correlations between Flows to a Particular Emerging

Market Country and Overall Emerging Market Flows

Benchmark-driven flows are highly correlated

across countries

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

Risk shock: VIX Interest rate shock: US 10-

year

Benchmark driven (EPFR) Overall portfolio flows (BoP)

Risk shock: VIX

Interest rate shock: US

10-year

Treasury yield

China: Impact of Regulatory Tightening

30

Contribution to Bank Asset Growth

(Percent, year-over-year growth)

Regulatory tightening has succeeded in reducing links

between financial institutions

Net Increase in Bank Credit

(Trillions of renminbi)

…along with curbing shadow credit,

especially from smaller banks

China: Impact of Regulatory Tightening

31

Wealth Management Product Yield and Three-Year

Corporate Bond Yield

(Percent, basis points)

Yields on WMPs remain high, indicating continued

use of leverage and risky assets to boost returns

Investment Vehicle Borrowing in Interbank

Market and from Sponsor Banks

(Trillions of renminbi)

Investment vehicle short-term borrowing

continues to rise

Vulnerabilities Remain High, Especially Outside Big 5 Banks

32

Core Tier 1 Capital Ratio

(Percent)

Capital levels remain weak in the small and

medium-sized banks

Faster credit growth may delay bank balance sheet

repair

Share of Small and Mid-size Banks by Assets and Time

Needed to Repair Balance Sheets

Structural Issues

Market Liquidity Risks in Capital Markets

33

Proportion of Jumps versus Liquidity Strain

(Index and percent; September 2018-March2019)

The frequency of liquidity strained days has been

higher in emerging markets

Proportion of Intraday Price Variability Explained by

Jumps: EM and AE Average

(Percent; 10 day moving average)

EM Sovereign bond markets seem to be more

prone to liquidity strains than equity markets

0

10

20

30

40

50

Sep.18 Oct.18 Nov.18 Dec.18 Jan.19 Feb.19 Mar.19

AE equities EM equities AE sov. bonds EM sov. bonds

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

3.0

0 10 20 30 40 50 60

Higher proportion of all jumps

Hig

her

liq

uid

ity s

train

AE Treasuries

EM Treasuries

AE equities

EM equities

Downside Risks to House Prices Are Elevated in Some Economies

34

Economies with Three-Year-Ahead House Prices-at-Risk

Below -10% in 2017

(Percent)

Downside risks to house prices shift in time and

have recently increased in the US…

United States: Three-Year-Ahead House Prices-at-Risk

(Fifth percentile of forecast density)

…and remain elevated in several advanced and

emerging market economies

-10

-8

-6

-4

-2

0

2

1990 1993 1996 1999 2002 2005 2008 2011 2014 2017

Higher Risk

Qo

Q, an

nu

alize

d in

perc

en

t

0

10

20

30

Advanced economies Emerging markets

Note: The sample includes 22 advanced economies and 10 emerging markets.

Availability of Macroprudential Tools

There are few macroprudential tools for nonbanks

35

Availability/Use of Macroprudential Tools to Address Vulnerabilities

Based on the sample of 29 jurisdictions with systemically important financial sectors. Elevated vulnerabilities refer to countries/sectors with a percentile rank in the respective

vulnerability exceeding 60 percent according to our indicator based framework. Cells highlighted in blue have entries below 50 percent, which should be interpreted to mean

that 50 percent or more of systemically important countries do not have any prudential tools to address specific vulnerabilities.

Global Financial Stability

Fabio NatalucciDeputy Director

Monetary and Capital Markets Department

International Monetary Fund