Financial conditions remain strong, but risks on rise

• Author: Ina Kota
• Position: IMF External Relations Department
• Pages: 81-87

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Despite recent gyrations in world stock markets, financial market volatility across a broad range of assets has continued to be at remarkably low levels and risk spreads are narrow, both historically and relative to the same point in previous business cycles, according to the IMF's latest Global Financial Stability Report. However, the report, released on April 10, warns that investors may be giving insufficient weight to downside risks.

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Financial, credit market conditions strong, but risks are rising

Global economic conditions are underpinning a positive financial environment, but underlying risks and conditions have shifted somewhat since the September 2006 Global Financial Stability Report (GFSR) and have the potential to weaken financial stability (see Chart 1). Indeed, despite recent gyrations in world stock markets, financial market volatility across a broad range of assets remains at remarkably low levels and risk spreads remain tight, both historically and relatively to previous business cycles, according to the IMF's latest GFSR.

However, investors may be giving insufficient weight to downside risks, perhaps assuming that the current low risk premiums have become a semipermanent feature of the financial landscape. "A market correction, potentially triggered by a ‘volatility shock,' could be amplified by leveraged positions and uncertainties about concentrations of risk exposures stemming from the rapid growth in innovative, complex products, some of which have rather illiquid secondary markets.

For these reasons, we have raised our assessment of market risks." according to the first chapter of the report. None of the risks by themselves significantly threatens global financial stability. However, investors may not have adequately factored in the possibility that a volatility shock may be amplified, given the increased linkages across products and markets.

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The report identifies four key areas of heightened shortterm risk:

* The U.S. subprime mortgage market: The subprime segment of the U.S. housing market is showing signs of credit quality deterioration; although the fallout has so far been limited and diffused, it has the potential to deepen and spread to other markets-possibly to structured mortgage credit...