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Financial stability in the last mile

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The economic sentiments from last week’s IMF and World Bank meetings were sanguine, at least compared to warnings of a ponderous recovery at the last meetings in October. Key to the mood is the surprising resilience of the global financial system. Central banks are near peak interest rates and geopolitical tensions are mounting, but the system seems to be weathering it.

Reports from the IMF and the Financial Stability Board, which monitors the global financial system, concur, however, that there are some notable remaining risks, and hidden ones may emerge on the bumpy road to disinflation. Policymakers must be vigilant.

First, stretched valuations across asset classes and high correlation could prove a toxic combination. Investors had seized on expectations of falling rates and increased earnings. Despite signs of fewer impending cuts, market valuations remain bullish, as continued buying drives up the price of assets, ranging from Magnificent Seven stocks to volatile cryptocurrencies, and widespread risk appetites continue to spike bonds, equities, credit and commodities, with the average correlation above the 90th historic percentile. A shift in investor sentiment could prove catastrophic, as price drops would spread through asset classes and cause global financial conditions to dry up.

Next, the shadow banking system — an assortment of financial institutions ranging from hedge funds to insurance companies — still lacks the liquidity to weather price adjustments, according to the FSB. Despite recent shocks that have alerted regulators to the sector, years of high interest rates and successive crises have made the situation worse by further depleting coffers. A spike in margin or collateral calls could give rise to fire sales by shadow banks, which could transmit stress to the global system.

There are also vulnerabilities in the banking system. Commercial real estate (CRE) prices have declined since the onset of COVID-19. Some countries’ banking systems are extremely overexposed, particularly Cyprus, Malaysia, and South Korea, and US regional banks have high exposure, though US supervisors appear to be more vigilant since Silicon Valley Bank collapsed. Further price declines could cause local bank failures, with the potential for global spillover. Losses from declining CRE prices and low-quality assets have also conspired to trim capital ratios. According to the IMF, 19 per cent of global banking assets are now held in banks that do not meet its capital ratio guidelines, many of them in China. 

Globally, government debt burdens are at concerning highs. In a record year for elections, it will be harder for governments to restrain spending and tax pledges — even if debt dynamics look troubling. US debt is a particular concern. High and volatile US treasury yields — which underpin pricing in financial markets — risk adding to global rate pressures. The recent strengthening of the dollar could also cause low-income nations to default, which, while not globally destabilising, would harm hundreds of millions of poor people.

These risks are material, but outstanding issues can be addressed. After a decade of flagging the issue, regulators must make progress on improving transparency in the shadow banking system. Stress testing and monitoring liquidity remain important, given the raised uncertainty. Central banks also need to be clear and cautious with their communications. Policymakers canfund debt relief, and can progress frameworks that would allow quick responses to failing banks.

There could be a benign end to this hiking cycle, with inflation tamed and the financial system intact. But that may imply that asset prices will remain high — raising the spectre that the inflation-focused agenda may still miss the mark.

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