Banking oversight was significantly strengthened after the global financial
crisis, in part by requirements for banks to hold more capital and liquid
assets and be stress tested to help ensure resilience to adverse shocks.
Yet the global financial system is showing considerable strains as rising
interest rates shake trust in some institutions. The failures of Silicon
Valley Bank and Signature Bank in the United States—caused by the fleeing
of uninsured depositors out of the realization that high interest rates
have led to large losses in these banks’ securities portfolios—and the
government supported acquisition of Switzerland’s Credit Suisse by rival
UBS have rocked market confidence and triggered significant emergency
responses by authorities.
Our latest
Global Financial Stability Report shows that risks to bank and nonbank financial intermediaries have
increased as interest rates have been rapidly raised to contain inflation.
Historically, such forceful rate increases by central banks are often
followed by stresses that expose fault lines in the financial system.
In its role of assessing global financial stability, the IMF has
flagged gaps in the supervision, regulation, and resolution of financial
institutions. Previous Global Financial Stability Reports
warned of strains in bank and nonbank financial intermediaries in the face of
higher interest rates.
It’s not 2008
While the banking turmoil has raised financial stability risks, its roots
are fundamentally different from those of the global financial crisis.
Before 2008, most banks were woefully undercapitalized by today’s
standards, held far fewer liquid assets, and had much more exposure to
credit risk. In addition, there was excessive maturity and credit risk
transformation of the broader financial system, high degrees of complexity
of financial instruments, and risky assets predominantly funded by
short-term loans. Troubles that began at some banks quickly spread to
nonbank financial firms and other entities through their interconnections.
The recent turmoil is different. The banking system has much more capital
and funding to weather adverse shocks, off balance sheet entities have been
unwound, and credit risks have been curbed by more stringent post-crisis
regulations. Instead, it was a meeting between the steep and rapid rise in
interest rates and fast-growing financial institutions that were unprepared
for the rise.
At the same time, we also learned that troubles at smaller institutions can
shake broader financial market confidence, particularly as persistently
high inflation continues to cause losses on banks’ assets. In this sense,
the current turmoil is more akin to the 1980s savings and loan crisis and
the events leading up to the 1984 failure of Continental Illinois National
Bank and Trust Co., which was then the
largest in US history. These institutions were less capitalized and had unstable
deposits.
Growing threats
Recently, bank stocks have declined on the industry’s travails, which have
raised the cost of funding of banks and may well lead to curtailed lending.
At the same time, perhaps surprisingly, overall financial conditions have
not tightened meaningfully and remain looser than in October. Equity
valuations remain stretched, notably in the United States. Modestly wider
corporate credit spreads are largely offset by lower interest rates.
Investors are therefore pricing a fairly optimistic scenario and expect
inflation to decline without much more increases in interest rates. While
market participants see recession probabilities as high, they also expect
the depth of the recession to be modest.
This sanguine view could be challenged by further acceleration of
inflation, resulting in a reassessment by investors of the path of interest
rates and possibly leading to an abrupt tightening in financial conditions.
Stresses could then re-emerge in the financial system. Trust—the foundation
of finance—could continue to erode. Funding could disappear rapidly for
banks and nonbanks, and fears could spread, amplified by social media and
private chat groups. Nonbank financial firms—a fast growing part of the
financial system—could also be exposed to credit risk deterioration
associated with a slowing economy. For example, some real estate funds have
seen large declines in their asset valuations.
Shares of banks in major emerging market economies have so far experienced
little contagion from the banking turmoil in the United States and Europe.
Many of these lenders are less exposed to the risk of rising interest
rates, but they generally hold assets with lower credit quality, and some
have less deposit insurance coverage. Furthermore, high sovereign debt
vulnerabilities are pressuring many lower-rated emerging market and
frontier economies, with potential spillovers effects to their banking
sectors.
Quantifying risks
Resolute policies
Faced with heightened risks to financial stability, policymakers must act
resolutely to maintain trust.
Gaps in surveillance, supervision, and regulation should be addressed at
once. Resolution regimes and deposit insurance programs should be
strengthened in many countries. In acute crisis management situations,
central banks may need to expand funding support to both bank and nonbank
institutions.
These tools would help central banks maintain financial stability, allowing
monetary policy to focus on achieving price stability.
If financial sector distress was to have severe repercussions affecting the
broader economy, policymakers may need to adjust the stance of monetary
policy to support financial stability. If so, they should clearly
communicate their continued resolve to bring inflation back to target as
soon as possible once financial stress lessens.
—This blog is based on Chapter 1 of the April 2023
Global Financial Stability Report, “A Financial System Tested by Higher Inflation and Interest Rates.”