Financial Stability Improves, but IMF Sees Fresh Challenges

Financial markets have rebounded since the lows following the 2008 collapse of the Wall Street investment firm Lehman Brothers, the result of improving economic conditions and wide-ranging policy actions by central banks and governments, according to the IMF’s update of its Global Financial Stability Report (GFSR).

"Notwithstanding the recent sell-off, risk appetite has returned, equity markets have improved, and capital markets have reopened," José Viñals, Director of the IMF’s Monetary and Capital Markets Department, said at a press conference January 26.

But policymakers still face extraordinary challenges as they seek to unwind the unprecedented fiscal, monetary, and financial support they provided to keep their economies, financial institutions, and markets from collapsing.

They must restore the health of banking systems still saddled with impaired assets and ensure that bank deleveraging does not undermine the nascent recovery by strengthening balance sheets and restructuring weak banks and dissolving insolvent ones to get credit flowing again. They also must make changes in supervision and regulation that lead to a safer and more resilient financial system.

Heavy debt burden

Moreover, the heavy load of debt that governments took on in fighting the economic downturn could elbow out private borrowers and present other complications to recovering global financial markets, the IMF said. Governments accumulated the debt as a result of heavy spending to compensate for sagging private demand and for financial system interventions, such as transferring risky assets to public balance sheets and investing in weakened institutions.

The IMF update outlined three potential issues for financial stability arising from higher fiscal deficits and transferred private risks:

- Public debt issuance "could crowd out private sector credit growth, gradually raising interest rates for private borrowers and putting a drag on the economic recovery." This would occur especially if private credit demand increased but banks were still constrained in their ability to lend as financial support measures were being withdrawn.

- A rapid increase in interest rates on public debt, which "could have negative effects on a wide variety of financial institutions and the recovery as sovereign debt is repriced."

- The remote possibility of "a substantial loss...