global financial stability report - april 2013
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W o r l d E c o n o m i c a n d F i n a n c i a l S u r v e y s
Global Financial Stability Report
Old Risks, New Challenges
April 2013
International Monetary Fund
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2013 International Monetary Fund
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Contents
International Monetary Fund | April 2013 iii
Prfac ix
excuiv summary xi
Chapr 1 Acu Rik Rducd: Aci ndd erch Fiacial sabiliy 1
Globe Financial Stability Assessment 1
Te Euro Area Crisis: Acute Risks Have Declined, Much Work Lies Ahead 6
Banking Challenges: Deleveraging, Business Models, and Soundness 16
Rising Stability Risks o Accommodative Monetary Policies 24
Emerging Markets: A Low-Rate Bonanza or Future Woes? 32
Policies or Securing Financial Stability and Recovery 42
Annex 1.1. Corporate Debt Sustainability in Europe 47
Annex 1.2. European Bank Deleveraging Plans: Progress So Far 52
Reerences 56
Chapr 2 A nw Lk a h Rl f svrig Crdi Dfaul swap
Summary
Overview o CDS Markets: Te Rise o SCDS
What Drives SCDS Spreads and How Do Tey Relate to Other Markets?
Eects o SCDS Regulations and Policy Initiatives on Financial Stability
Conclusions and Policy Implications
Annex 2.1. A Primer on Sovereign Credit Deault Swaps
Annex 2.2. echnical Background: Determinants o SCDS Spreads and Bond Spreads
Reerences
Chapr 3 D Cral Bak Plici sic h Crii Carry Rik Fiacial sabiliy?
Summary
MP-Plus: An Overview
Eects o MP-Plus on Markets
Eects o MP-Plus on Financial Institutions
Conclusions and Policy Implications
Annex 3.1. Key MP-Plus Announcements since 2007, by Central Bank
Annex 3.2. Estimation Method and Results or the Panel Regressions
Reerences 137
Glary 177
Ax: summig Up by h Acig Chair 185
saiical Appdix
[Available online at www.im.org/external/pubs/t/gsr/2013/01/pd/statapp.pd]
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CONTENTS
iv International Monetary Fund | April 2013
Bx
1.1. What Has Chinas Lending Boom Done to Corporate Leverage? 372.1. Interconnectedness between Sovereigns and Financial Institutions2.2. Te European Unions Ban on Buying Naked Sovereign Credit Deault Swap Protection
2.3. What Could be the Impact o the Demise o SCDS?2.4. Te Greece Debt Exchange and Its Implications or the SCDS Market3.1. Financial Stability Risks Associated with Exit rom MP-Plus Policies3.2. Te Macroeconomic Eectiveness o MP-Plus3.3. Balance Sheet Risks o Unconventional Policy in Major Central Banks
tabl
1.1 Selected Euro Area Countries: Vulnerability Indicators in the Corporate Sector 141.2. Deleveraging Progress, 2011:Q32012:Q3 221.3. U.S. Nonnancial Corporate Bonds: Yields, Spreads, and Valuations 281.4. Scenarios or U.S. reasury Bond Market Corrections 311.5. Distribution o Bank Lending and Nonperorming Loans 40
1.6. Credit and Asset Market Indicators or Selected Emerging Markets and Other Countries 411.7. Comparing Proposals or Structural Reorm 441.8. Nonnancial Corporate Debt and Leverage 471.9. Nonnancial Corporate Database Coverage 471.10. Corporate Sectoral Breakdown within the Sample 481.11. Progress on Deleveraging/Restructuring Plans o Selected Major European Banks,
as o January 2013 532.1. Rankings o CDS Amounts Outstanding2.2. Lead-Leg Relationship between Sovereign Credit Deault Swaps and Bond Residuals2.3. List o Countries Included in Empirical Studies2.4. List o Variables Used in Regression Analysis2.5. Summary o Estimation o Monthly Drivers or Sovereign Credit Deault Swap (SCDS) Spreads
and Bond Spreads, October 2008September 2012
2.6. Summary o Estimation Results on Drivers or Basis, October 2008September 20122.3.1. Relative Size o Sovereign and Bank Credit Deault Swaps Markets3.1. Asset Holdings o Major Central Banks Related to MP-Plus, 2008123.2. Results rom Event Study Regressions3.3. Marginal Eect o MP-Plus on Banks3.4. Calculated Losses on a 10-Year Bond as a Result o a Rise in Interest Rates3.5. Risks rom MP-Plus and Mitigating Policies3.6. Specication o aylor Rule3.7. Results o the Panel Regressions
Figur
1.1. Global Financial Stability Map 21.2. Global Financial Stability Map: Assessment o Risks and Conditions 31.3. Asset Perormance since the October GFSR 41.4. Global Equity Valuations 41.5. Global Equity Valuations, by Country 51.6. Property Price Valuations 51.7. Hard-Currency Debt Valuations in Emerging Market Economies 51.8. U.S. Sovereign Debt Valuations 5
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International Monetary Fund | April 2013 v
1.9. arget2 Balances and Sovereign Bond Yields 61.10. Periphery Euro Area Banks Bond Issuance and CDS Spreads 71.11. Italy and Spain: Nonnancial Firms Change in Bank Credit and Net Bond Issuance 71.12. Foreign Investor Share o General Government Debt 7
1.13. European Sovereign Bond Spreads, Current and Implied by Forward Curve 81.14. Asset Perormance, March 15April 2, 2013 81.15. Proportion o System Balance Sheets Encumbered 91.16. Periphery Banks Covered Bond Issuance and Spreads 91.17. Selected EU Banks Foreign Claims on Banking Sectors, June 2011September 2012 91.18. Changes in Interest Rates on New Bank Loans, December 2010January 2013 101.19. Corporate Real Interest Rates and GDP Growth, February 2013 101.20. Bank Lending to the Nonnancial Private Sector 101.21. Euro Area Periphery Bank Credit 101.22. Interaction between Credit Demand and Supply 111.23. Interest Rate on New Lending and Decomposition o New Bank Funding Rate 111.24. Euro Area Bank Lending Conditions or Firms 121.25. Met and Unmet Demand or Bank Credit or Small and Medium-Sized Enterprises 12
1.26. Spread o Interest Rates on New Loans to SMEs over ECB Policy Rate 121.27A. Corporate Debt 131.27B. Corporate Debt in Percent o GDP 131.28. Share o Firms with High Leverage and Low Interest Coverage Ratio, 2011 151.29. Share o Firms with High Leverage and Negative Net Free Cash Flow 151.30. Required Reduction in Leverage under Dierent Scenarios 151.31. Required Cuts in Capital Expenditures to Stabilize Debt o Euro Area Periphery Firms
with High Leverage and Negative Net Free Cash Flow 151.32. Bank Core ier 1 and Wholesale Funding Ratios, 2008:Q4 to 2012:Q3 161.33. Bank Leverage and Wholesale Funding Ratios, 2008:Q4 to 2012:Q3 161.34. Ranking o Banking Systems Based on Banks Balance Sheet Indicators, 2012:Q3 171.35. Average Net Interest Margins 181.36. Impaired Loans in Selected EU Countries 19
1.37. EU Banks Asset Quality and Protability 191.38. Buers at Individual EU Banks 201.39. Bank Risk-Weights and Impairments, Average or 200811 201.40. Deposit Funding Gaps o Foreign Subsidiaries o Large EU Banks 201.41. Average Return on Equity, and Cost o Equity 211.42. Ratio o Equity Price to angible Book Value, April 2013 211.43. GFSR EU Bank Deleveraging Scenarios 221.44. Large EU Banks: Contributions to Change in Balance Sheets 2011:Q32012:Q3 221.45. Banks Foreign Claims on All Regions 231.46. Net Foreign Assets Position 231.47. Global Mutual Fund and Exchange-raded Fund Flows 241.48. Net Issues o Fixed-Income Securities 251.49. U.S. Fixed Investment Spending versus Internal Cash Flow 251.50. U.S. Nonnancial Corporate Bond Issuance and Equity Buybacks 251.51. U.S. Nonnancial Firms Credit Fundamentals 261.52. U.S. Primary Dealer Repo Financing 281.53. Global Issuance o Leveraged Loans and Collateralized Debt Obligations 291.54. Risk olerance or Weakest 10 Percent o U.S. Public Pension Funds 291.55. Net Interest Margins and Investment in Risky Assets by U.S. Insurance Companies 301.56. U.S. reasury Sell-O Episodes 30
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vi International Monetary Fund | April 2013
1.57. U.S. High-Yield Corporate Spread and Liquidity and Volatility 311.58. Holdings o U.S. Corporate Bonds, by Investor ype 321.59. Net Capital Flows to Emerging Markets 341.60. Selected Emerging Market Bond, Equity, and Loan Issuance 34
1.61. Nonresident Holdings o Domestic Sovereign Debt 341.62. Emerging Market Nonnancial Corporate Issuance 341.63. Emerging Market Nonnancial Corporate Leverage, 2007 and 2012 351.64. Foreign-Exchange-Denominated Debt o Nonnancial Corporations in Emerging Markets 351.65. Emerging Market Corporate Issuance, by ype o Issuer 351.66. Corporate Leverage in Asia, excluding Japan 351.67. Interest Coverage Ratio or Emerging Market Firms 361.68. Hard Currency and Local Currency Sovereign Bond Issuance 361.69. EMBI Global Spread ightening (December 200812): Decomposition 381.70. Local Yield ightening in Emerging Market Economies (December 200812):
Decomposition 381.71. Impact o Shocks on EMBI Global Spreads 391.72. Impact o Shocks on Local Emerging Market Yields 39
1.73. Domestic Credit Growth, 200612 391.74. Consumer Price Index-Adjusted Residential Property Prices, 200612 401.75. Gross Nonperorming Loan Ratios, 201012 401.76. Banks Loss-Absorbing Buers by Region 411.77. China: Growth Rate o Credit, by ype 421.78. European Investment-Grade Corporate Fundamentals 481.79. Developments in Publicly Listed European Companies 491.80. Progress in Deleveraging Plans across Sample Banks, 2012 522.1. Credit Deault Swap (CDS) Contracts, Gross Notional Amounts Outstanding2.2. Nondealer Buyers and Sellers o Credit Deault Swap Protection: Net Positions by Counterparty2.3. Liquidity Indicators in the Sovereign Credit Deault (SCDS) Market2.4. Volatility o Sovereign Credit Deault Swap (SCDS) Spreads and Sovereign Bond Spreads2.5. Determinants o Sovereign Credit Deault Swap (SCDS) Spread and Bond Spreads, October
2008September 20122.6. Sovereign Credit Deault Swap (SCDS) Price Leadership and Liquidity, March 2009September
20122.7. ime-Varying Price Leadership Measures o Sovereign Credit Deault Swaps (SCDS)2.8. Sovereign Credit Deault Swaps (SCDS): Decomposition o Volatility Factors or Germany, Italy,
and Spain, February 2009October 20122.9. Markov-Switching ARCH Model o VIX, European ED Spread, and Sovereign Credit Deault
Swap (SCDS) Indices2.10. Overshooting and Undershooting o Sovereign Credit Deault Swaps (SCDS) and Sovereign
Bond Markets2.11. Sovereign Credit Deault Swaps: Net Notional Amounts Outstanding, Selected EU Countries2.12. Market Liquidity Measures beore and ater Ban on Short Sales o Sovereign Credit Deault
Swaps (SCDS)2.13. Constructing the Arbitrage rade between Credit Deault Swaps (CDS) and Bonds2.14. Dierence between Sovereign Credit Deault Swap Spreads and Sovereign Bond Spreads, Selected
Countries2.1.1. Measures o Sovereign Credit Risk or Euro Area Periphery Countries2.1.2. Interconnectivity Measures: Financial Institutions, to and rom Sovereigns2.3.1. Country Credit Ratings and Radio o Outstanding Sovereign Credit Deault Swaps (SCDS) to
Government Debt, 2011
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International Monetary Fund | April 2013 vii
3.1. Changes in Central Bank Balance Sheets, 2006123.2. OIS Counterparty Spread Decompositions3.3. Central Bank Intervention in Real Estate Securities Markets3.4. Central Bank Holdings o Domestic Government Securities and Market Liquidity, by Maturity
3.5. Correlations between Central Bank Holdings o Government Securities and Market Liquidity, byMaturity o Holdings3.6. Interest Rate Risk as Reported by U.S. Banks3.7. Bank Holdings o Government Debt in Selected Economies3.8. Various Measures o the aylor Gap in the United States
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Te Global Financial Stability Report(GFSR) assesses key risks acing the global nancial system. In normal
times, the report seeks to play a role in preventing crises by highlighting policies that may mitigate systemic
risks, thereby contributing to global nancial stability and the sustained economic growth o the IMFs mem-
ber countries. Risks to nancial stability have declined since the October 2012 GFSR, providing support to
the economy and prompting a rally in risk assets. Tese avorable conditions reect a combination o deeper
policy commitments, renewed monetary stimulus, and continued liquidity support. Te current report ana-
lyzes the key challenges acing nancial and nonnancial rms as they continue to repair their balance sheets
and unwind debt overhangs. Te report also takes a closer look at the sovereign credit deault swaps market
to determine its useulness and its susceptibility to speculative excesses. Lastly, the report examines the issue o
unconventional monetary policy (MP-plus) and its potential side eects, and suggests the use o macropru-
dential policies, as needed, to lessen vulnerabilities, allowing country authorities to continue using MP-plus to
support growth while protecting nancial stability.Te analysis in this report has been coordinated by the Monetary and Capital Markets (MCM) Department
under the general direction o Jos Vials, Financial Counsellor and Director. Te project has been directed by
Jan Brockmeijer and Robert Sheehy, both Deputy Directors; Peter Dattels and Laura Kodres, Assistant Direc-
tors; and Matthew Jones, Advisor. It has beneted rom comments and suggestions rom the senior sta in the
MCM department.
Individual contributors to the report are: Ali Al-Eyd, Sergei Antoshin, Serkan Arslanalp, Craig Botham,
Jorge A. Chan-Lau, Yingyuan Chen, Ken Chikada, Julian Chow, Nehad Chowdhury, Sean Craig, Reinout
De Bock, Jennier Elliott, Michaela Erbenova, Jeanne Gobat, Brenda Gonzlez-Hermosillo, Dale Gray, Sanjay
Hazarika, Heiko Hesse, Changchun Hua, Anna Ilyina, ommaso Mancini-Grioli, S. Erik Oppers, Bradley
Jones, Marcel Kasumovich, William Kerry, John Ki, Frederic Lambert, Rebecca McCaughrin, Peter Lindner,
Andr Meier, Paul Mills, Nada Oulidi, Hiroko Oura, Evan Papageorgiou, Vladimir Pillonca, Jaume Puig,
Jochen Schmittmann, Miguel Segoviano, Jongsoon Shin, Stephen Smith, Nobuyasu Sugimoto, Narayan
Suryakumar, akahiro suda, Kenichi Ueda, Nico Valckx, and Chris Walker. Martin Edmonds, Mustaa Jamal,
Oksana Khadarina, and Yoon Sook Kim provided analytical support. Gerald Gloria, Nirmaleen Jayawardane,
Juan Rigat, Adriana Rota, and Ramanjeet Singh were responsible or word processing. Eugenio Cerutti, Ali
Sharikhani, and Hui ong provided database and programming support. Joanne Johnson and Gregg Forte o
the External Relations Department edited the manuscript and the External Relations Department coordinated
production o the publication.
Tis particular issue draws, in part, on a series o discussions with banks, clearing organizations, securities
rms, asset management companies, hedge unds, standards setters, nancial consultants, pension unds, cen-
tral banks, national treasuries, and academic researchers. Te report reects inormation available up to April
2, 2013.
Te report beneted rom comments and suggestions rom sta in other IMF departments, as well as romExecutive Directors ollowing their discussion o the Global Financial Stability Reporton April 1, 2013. How-
ever, the analysis and policy considerations are those o the contributing sta and should not be attributed to
the Executive Directors, their national authorities, or the IMF.
PReFACe
International Monetary Fund | April 2013 ix
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Conventions
x International Monetary Fund | April 2013
The ollowing symbols have been used throughout this volume:
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to indicate that the fgure is zero or less than hal the fnal digit shown, or that the
item does not exist;
between years or months (or example, 200809 or JanuaryJune) to indicate the
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Basis points reer to hundredths o 1 percentage point (or example, 25 basis points is
equivalent to 1/4 o 1 percentage point).
n.a. means not applicable.
Minor discrepancies between constituent fgures and totals are due to rounding.
As used in this volume the term country does not in all cases reer to a territorial entity
that is a state as understood by international law and practice. As used here, the term
also covers some territorial entities that are not states but or which statistical data are
maintained on a separate and independent basis.
The boundaries, colors, denominations, and other inormation shown on the maps do
not imply, on the part o the International Monetary Fund, any judgment on the legal
status o any territory or any endorsement or acceptance o such boundaries.
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International Monetary Fund | April 2013 xi
eXeCUtIVe sUMMARY
Chapr 1: Acu Rik Rducd: Acindd erch Fiacial sabiliy
Global nancial and market conditions have
improved appreciably in the past six months,
providing additional support to the economy and
prompting a sharp rally in risk assets. Tese avor-
able conditions reect a combination o deeper
policy commitments, renewed monetary stimulus,
and continued liquidity support. ogether, these
actions have reduced tail risks, enhanced condence,
and bolstered the economic outlook. However, asglobal economic conditions remain subdued, the
improvement in nancial conditions can only be
sustained through urther policy actions that address
underlying stability risks and promote continued
economic recovery. Continued improvement will
require urther balance sheet repair in the nancial
sector and a smooth unwinding o public and pri-
vate debt overhangs. I progress in addressing these
medium-term challenges alters, risks could reap-
pear. Te global nancial crisis could morph into a
more chronic phase, marked by a deterioration o
nancial conditions and recurring bouts o nancialinstability.
th eur Ara Crii: Acu Rik Hav Dclid, Much Wrk
Li Ahad
In the euro area, acute near-term stability risks
have been reduced signicantly. Funding conditions
in the markets or sovereign, bank, and corporate
debt have improved. Despite this notable progress,
many banks in the euro area periphery remain
challenged by elevated unding costs, deteriorating
asset quality, and weak prots. Credit transmission
remains weak in several economies, as bank balance
sheet repair is uneven, while ragmentation between
the core and periphery o the euro area persists.
Corporations in the periphery are directly aected
by bank balance sheet weakness, cyclical headwinds,
and, in many cases, their own debt overhangs.
Te analysis presented in this report suggests that
the debt overhang at listed companies in the euro
area periphery is sizableup to one-th o debt
outstanding. o limit the extent o required dele-
veraging in the corporate sector, continued eorts
to reduce ragmentation and lower unding costs, as
well as ongoing restructuring plans to improve pro-
ductivity, are essential. In addition, a combination o
asset sales or cutbacks in dividends and investment
may be needed to reduce debt burdens.
Bakig Challg: Dlvragig, Bui Mdl, ad
sud Challg
Banks in advanced economies have taken signi-
cant steps to restructure their balance sheets, but
progress has been uneven, as systems are at dierent
stages o repair. Te process is largely completed
in the United States, but it requires urther eorts
or some European banks. Banks in the euro area
periphery, in particular, ace signicant challenges
that are impairing their ability to support economic
recovery. Balance sheet pressures are less acute or
other European banks, but the process o de-risking
and deleveraging is not complete. For banks in
emerging market economies, the main challenge
is to continue supporting growth while saeguard-
ing against rising domestic vulnerabilities. Te new
market and regulatory environments are also orcing
banks globally to reshape their business models to
become smaller, simpler, and more ocused on their
home markets.
Riig sabiliy Rik f Accmmdaiv Mary Plici
Te use o unconventional monetary policies in
advanced economies continues to provide essen-
tial support to aggregate demand. Tese policies
are generating a substantial rebalancing o private
investor portolios toward riskier assets, as intended.
However, a prolonged period o extraordinary
monetary accommodation could push portolio
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exeCutive summary
xii International Monetary Fund | April 2013
rebalancing and risk appetite to the point o creating
signicant adverse side eects. While the net benets
o unconventional policies remain highly avorable
today, these side eects must be closely monitored
and controlled. O particular concern is the pos-sible mispricing o credit risk, riskier positioning by
weaker pension unds and insurance companies, and
a rise in liquidity risk, particularly in countries where
recoveries are more advanced. Corporate leverage
is rising in the United States and is already around
one-third o the way through a typical cycle. Other
spillovers include excessive capital ows into emerg-
ing market economies, where corporationswhich
generally have sound nances at presentare taking
on more debt and oreign exchange exposure in
response to low borrowing costs. More broadly, the
avorable unding environment or emerging marketeconomies might breed complacency about growing
challenges to domestic nancial stability. Valuations
have not yet reached stretched levels (except in a ew
hot spots), but sensitivity to higher global interest
rates and market volatility has increased across asset
classes, including in emerging market economies. A
prolonged period o continued monetary accommo-
dation will increase vulnerabilities and sensitivity to
a rise in rates.
Rivigraig h Rgulary Rfrm Agda
While much has been done to improve global
and national nancial sector regulations, the reorm
process remains incomplete. Banking sectors are still
on the mend, and the pace o reorm has appropri-
ately been moderated to avoid making it harder or
banks to lend to the economy while they are regain-
ing strength. But the pace o the reorm process also
reects difculties in agreeing on the way orward
on key reorms due to concerns about banks acing
more structural challenges.
Delays in completing the reorm agenda are notonly a source o continued vulnerability, but also a
source o regulatory uncertainty that may impact
the willingness o banks to lend. Tey oster the
prolieration o uncoordinated initiatives to directly
constrain banking activity in dierent jurisdictions,
given the strong political imperatives to take action.
Such initiatives may be inconsistent with the eorts
to harmonize minimum global standards and may
hamper, rather than complement, the eectiveness o
the G20 reorm agenda.
Policymakers must thereore take decisive
action to restructure weak banks and encour-age the buildup o the new capital and liquidity
buers as part o the implementation o Basel
III rules on an internationally consistent basis.
Improved nancial reporting and disclosures by
banks remain essential to promote better transpar-
ency and prudent and consistent valuation o risk-
weighted assets. Enhanced disclosure will help
improve market discipline and restore condence
in banks. Eective resolution regimes also need
to be established to allow or the orderly exit o
unviable banks, including eective cross-border
agreements or winding down ailing cross-borderbanks. Finally, urther work is needed on the
too-big-to-ail problem, over-the-counter deriva-
tives reorm, accounting convergence, and shadow
banking regulation.
What is needed now is a renewed polit ical
commitment at the global and national levels to
complete the reorm agenda. Tis commitment
is critical to minimize regulatory uncertainty and
arbitrage, and to reduce nancial ragmentation.
Without greater urgency toward international
cooperation and comprehensive bank restructur-
ing, weak bank balance sheets will continue to
weigh on the recovery and pose ongoing risks to
global stability.
Plici fr scurig Fiacial sabiliy ad Rcvry
Further policy actions are needed to address
balance sheet weaknesses in the private and public
sectors, improve the ow o credit to support the
recovery, and strengthen the global nancial system.
Tese actions should continue to be supported by
accommodative monetary policies.In the euro area, the priorities are bank balance
sheet repair and steps toward a stronger nancial
oversight ramework within the European Union.
Bank balance sheets and business models need to
be strengthened to improve investor conidence,
reduce ragmentation, and improve the supply
o credit or solvent small and medium-sized
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exeCutive summary
International Monetary Fund | April 2013 xiii
enterprises. Enhanced disclosure or banks and
conducting selective asset quality reviews will help
restore conidence in bank balance sheets and
improve market discipline.
o anchor inancial stability in the euro areaand or ongoing crisis management, ast and
sustained progress toward an eective Single
Supervisory Mechanism (SSM) and the comple-
tion o the banking union are essential. A
Single Resolution Mechanism should become
operational at around the same time as the
SSM becomes eective. his should be accom-
panied by agreement on a time-bound roadmap
to set up a single resolution authority and
common deposit guarantee scheme, with com-
mon backstops. Proposals to harmonize capital
requirements, resolution, common depositguarantee schemes, and insurance supervision
rameworks at the EU level should be imple-
mented promptly. Modalities and governance
arrangements or direct recapitalization o
banks by the European Stability Mechanism
should also be established.
he developments in Cyprus underscore the
urgency or completing reorms across the euro
area in order to reverse inancial ragmentation
and urther strengthen market resilience.
On aglobal level, vigilance is needed to ensure
that accommodative monetary policies and an
extended period o low rates do not give rise to
resh credit excesses. Tis is particularly important
in the case o the United States. Financial supervi-
sion should be tightened to limit the extent o such
excesses; and regulation will need to play a more
proactive role in this cycle at both the macro- and
microprudential levels. Restraining a too rapid rise
in leverage and encouraging prudent underwriting
standards will remain key objectives.
In emerging market economies, policymakers mustremain alert to the risks stemming rom increased
cross-border capital ows and rising domestic nan-
cial vulnerabilities.
ogether, these policies will consolidate the recent
gains in nancial stability, strengthen the global
nancial system, and support continued improve-
ment in the economic outlook.
Chapr 2: svrig Crdi Dfaul swap
Te debate about the useulness o markets or
sovereign credit deault swaps (SCDS) intensi-
ed with the most recent bout o sovereign stress
in the euro area. Chapter 2 takes a closer look at
whether SCDS markets are good market indicators
o sovereign credit risk and whether they provide
valuable protection to hedgers; or whether they are
prone to speculative excesses and lead to higher
sovereign unding costs and nancial instability. Te
chapter nds that many o the negative perceptions
are unounded. Te markets or both SCDS and
sovereign bonds are similar in their ability to reect
economic undamentals and market actors. SCDS
markets tend to convey new inormation more
rapidly than do the markets or government bondsduring periods o stress, although not during other
times; but SCDS markets do not appear to be more
prone to high volatility than other nancial mar-
kets. While overshooting was detected in some euro
area SCDS markets during the latest bout o stress,
there is little evidence that excessive increases in a
countrys SCDS spreads generally lead to higher sov-
ereign unding costs. Te question o whether SCDS
markets are more likely to be contagious than other
markets is difcult to answer because sovereigns and
nancial institutions are now more interconnected,
and hence the risks embedded in SCDS cannot bereadily isolated rom the risk o the nancial system.
Te chapters results do not support the need or
a ban on naked SCDS protection buying, which
went into eect in the European Union in Novem-
ber 2012. Te policy initiatives underlying the over-
the-counter derivatives reormsmandating better
disclosure, encouraging central clearing, and requir-
ing the posting o appropriate collateralshould
help to allay concerns about spillovers and contagion
that may arise in these derivatives markets.
Chapr 3: D Cral Bak Plici sic hCrii Carry Rik Fiacial sabiliy?
Chapter 3 returns to the issue o unconventional
monetary policy and its potential side eects with
urther in-depth analysis. Te chapter investigates
the policies as pursued by our central banks (the
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exeCutive summary
xiv International Monetary Fund | April 2013
Federal Reserve, Bank o England, European Central
Bank, and Bank o Japan), which include a pro-
longed period o low real policy interest rates and
a host o unconventional measures including asset
purchases. Te policies, termed MP-plus in thechapter, appear to have lessened banking sector
vulnerabilities and contributed to nancial stability
in the short termin line with the intentions o
the central banks. So ar, central bank intervention
in specic asset markets has not adversely aected
market liquidity. MP-plus policies have improved
some indicators o bank soundness, although the evi-
dence suggests some reluctance by banks to clean up
their balance sheets. Although potential risks raised
by MP-plus in the banking system so ar appear
relatively benign, policymakers should be alert to the
possibility that risks may be shiting to other parts o
the nancial systemshadow banks, pension unds,
and insurance companiesdue in part to increasingregulatory pressures on banks. Policymakers should
use targeted micro- and macroprudential policies to
mitigate emerging pockets o vulnerability (identi-
ed in Chapter 1) that are likely to increase the
longer that MP-plus policies are in use. Implement-
ing macroprudential policies in a measured manner,
as needed, would allow central banks to continue to
use MP-plus to support price stability and growth
while protecting nancial stability.
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1chapter
International Monetary Fund | Apr 2013 1
Ga Fiaia Saii Assssm
Global financial stability has improved since the
October 2012 report. Policy actions have eased
monetary and financial conditions and reduced
tail risks, leading to a sharp increase in risk appe-
tite and a rally in asset prices. But if progress on
addressing medium-term challenges falters, the
rally in financial markets may prove unsustain-
able, risks could reappear, and the global financial
crisis could morph into a more chronic phase.
Sas Saii Iiars
Since the October 2012 Global Financial Stabil-
ity Report(GFSR) all risk dimensions o the global
nancial stability map have improved (Figures 1.1
and 1.2). Markets have rallied and near-term stabil-
ity risks have eased in response to accommodative
monetary policies and precautionary policy mea-
sures (Figure 1.3). In the euro area, the authorities
have clearly signaled their dedication to achieving
more and stronger Europe. Commitments by theEuropean Central Bank (ECB) have reduced sover-
eign liquidity risk, and together with the ongoing
advance toward a banking union and additional debt
relie or Greece, have greatly reduced redenomina-
tion risk. Tese broad improvements in risks and
conditions have helped boost the resilience o mar-
kets to political uncertainty in Italy and the events
in Cyprus. Te United States avoided a year-end all
rom the scal cli. However, the postponement
o decisions on the debt ceiling, automatic spending
cuts, and budget appropriations continue to weigh
on sentiment, as noted in the April 2013 Fiscal
Monitor. Te Federal Reserves move rom time-
specic to indicator-specic orward guidance has
provided assurance that the policy stance will remain
accommodative until meaningul increases in activity
and ination are realized. Te Bank o Japan has
also undertaken urther easing steps by adopting a 2
percent ination target and a commitment to open-
ended purchases o assets.
Improved nancial market conditions are beneting
the broader economy, but the transmission is slow and
incomplete, as noted in the April 2013 World Economic
Outlook. Overall macroeconomic riskshave declined. In
the United States, prospects have brightened; a recovery
in the housing market and progress in household
deleveraging are bolstering consumption, while banks
are poised to increase lending. Emerging market risks
have also declined, as growth has stabilized and external
unding conditions or emerging market economies are
very avorable. However, near-term economic prospects
in the euro area remain weak, as public and private bal-
ance sheet repair and bank deleveraging continue.Te reduction o acute nancial stress has led to a
substantial decline in market and liquidity risks. Mar-
ket positioning has become more optimistic, volatility
has declined, and access to unding has improved or
corporations and banks. In the euro area periphery,
bank issuance has recovered; even lower-tier banks
have gained some access to unding markets. External
investors have returned in orce to periphery sovereign
markets. Nevertheless, the situation remains ragile,
as illustrated by recent market volatility ollowing
the Italian parliamentary elections. Still-high unding
costs, amid persistent nancial ragmentation and lowgrowth in the euro area, compound the debt overhang
built up during the boom in periphery corporate
balance sheets. Te second section o this chapter
assesses tail risks, unding conditions in sovereign and
banking markets, and the sustainability o corporate
debt in the euro area, and concludes that persistent
ragmentation and continued impairment o credit
Acute RISkS Reduced: ActIonS needed to entRench FInAncIAlStAbIlIty
Note: Tis chapter was written by Peter Dattels and Matthew
Jones (team leaders), Ali Al-Eyd, Sergei Antoshin, Serkan Arsla-nalp, Craig Botham, Yingyuan Chen, Julian Chow, Nehad Chow-
dhury, Sean Craig, Reinout De Bock, Martin Edmonds, JennierElliott, Michaela Erbenova, Jeanne Gobat, Sanjay Hazarika,
Changchun Hua, Anna Ilyina, Bradley Jones, Marcel Kasumov-
ich, William Kerry, Peter Lindner, Rebecca McCaughrin, AndrMeier, Paul Mills, Nada Oulidi, Evan Papageorgiou, Vladimir
Pillonca, Jaume Puig, Jochen Schmittmann, Miguel Segoviano,
Jongsoon Shin, Stephen Smith, Nobuyasu Sugimoto, Narayan
Suryakumar, akahiro suda, and Chris Walker.
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GLOBAL FINANCIAL STABILITY REPORT
2 International Monetary Fund | Apr 2013
channels call or urther progress in restoring stability
and market unctioning.
Uneven progress in strengthening balance sheets
means that medium-term risks remain elevated.
Although credit riskshave improved somewhat, there
are still important downside risks and medium-term
challenges. In the euro area, the prospect or urther
reorm and balance sheet repair is clouded by political
uncertainties and rising reorm atigue, while eco-
nomic momentum remains weak and unemployment
high. In the United States and Japan, credible plans
or medium-term scal adjustment are needed to help
avoid a sudden deterioration in risk perceptions.
Te third section o this chapter, on Banking
Challenges assesses the state o recovery and healthin various banking systems and remaining structural
challenges, as the new market and regulatory envi-
ronment is orcing banks to reshape their business
models.
Monetary and fnancial conditionshave eased ur-
ther, as unconventional monetary policies in advanced
economies continue to provide essential support to
credit and aggregate demand. However, a prolonged
period o low interest rates and continued monetary
accommodation could generate signicant adverse
side eects. Risk appetitehas strengthened markedly
(three notches on the stability map) on expectations
o a prolonged period o low interest rates and lower
tail risks. A higher appetite or risk could lead to
exaggerated valuations and rising leverage, which may
become systemic and spill over to emerging market
economies.1 Most sectors exhibit ew clear signs o
asset price bubbles just yet, despite relatively rapid
price gains. For advanced economies, equity valua-
tions appear to be within historical norms, and or-
ward-looking valuations are below the peaks reached
beore the 200809 nancial crisis (Figures 1.4 and
1.5). However, signs o overheating in real estatemarkets are evident in some European countries, in
Canada, and in some emerging market economies
(Figure 1.6). Meanwhile, access by emerging market
and developing economies to international capital
markets has also picked up, with external actors
1See also Chapter 3, which discusses the impact o central bankinterventions on banks and asset markets.
October 2012 GFSR
April 2013 GFSR
Figure 1.1. Global Financial Stability Map
Creditrisks
Market andliquidity risks
Riskappetite
Monetary andnancial
Macroeconomicrisks
Emerging marketrisks
Conditions
Risks
Source: IMF staff estimates.Note: Away from center signifies higher risks, easier monetary and financial conditions, or higher risk appetite.
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c hA p t e R 1 Acute Risks Reduced: Actions needed to entRench FinAnciAl stAbility
International Monetary Fund | Apr 2013 3
Source: IMF staff estimates.Note: Changes in risks and conditions are based on a range of indicators, complemented with IMF staff judgment; see Annex 1.1 in the April 2010 GFSR and Dattels and others (2010)
for a description of the methodology underlying the construction of the global financial stability map. The notch changes in the overall indicator in each panel are the simple average ofnotch changes in individual indicators. The number next to the legend for each indicator is the number of components it contains. For lending conditions (monetary and financial
conditions panel), positive values represent slower tightening or faster easing of standards.
Figure 1.2. Global Financial Stability Map: Assessment of Risks and Conditions(In notch changes since the October 2012 GFSR)
Market and l iquid ity risks have decreased in response to looser policies
Emerging market risks have improved along with global macroeconomic and nancial
conditions.
Monetary a nd nancia l conditi onshave loosened further with central bank policy easing
and better nancing and lending conditions
but improved nancial conditions are only slowly translating into lower
macroeconomic risks.
The reduction insystemic risks along with continuing balance sheet repair have lowered
credit risks.
which, in combination with strong policy action and reduced near-term event risks, has
boostedrisk appeti te.
4
3
2
1
0
1
2
3
4
4
3
2
1
0
1
2
4
6
4
3
2
1
0
1
2
3
4
Overall (8) Banking sector(3)
Householdsector (2)
Corporate sector(3)
More risk
Less risk
4
3
2
1
0
1
2
3
4
Overall Economicactivity
Inationvariability
Sovereign creditOverall (7) Liquidit y &funding (1)
Volatility (2) Marketpositioning
(3)
Equityvaluations
(1)
Overall (5) Sovereign (2) Ination (1) Corporatesector (1)
Liquidity (1)
Overall (4) Institutionalallocations
(1)
Investorsurveys (1)
Relativeasset returns
(1)
Emergingmarkets (1)
4
3
2
1
0
1
2
3
4
More risk
Less risk
Less risk
More risk
More risk
Less risk
Lower risk appetite
Higher risk appetite
Overall (6) Monetaryconditions (3)
Financialconditions (1)
Lendingconditions (1)
QE & centralbank balance
sheetexpansion (1)
Tighter
Easier
4
3
2
1
0
1
2
3
4
3
5
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GLOBAL FINANCIAL STABILITY REPORT
4 International Monetary Fund | Apr 2013
being the primary driver behind the recent compres-
sion in spreads (Figure 1.7).
Asset price pressures are likely to grow urther
over time in the presence o abundant global
liquidity. Te ourth section o the chapter ocuses
on the United States and discusses the potential
consequences or the mispricing o credit risk,
riskier positioning by weaker pension and insurance
companies, and higher liquidity risk. It also exam-
ines the potential spillovers through an acceleration
o capital ows into emerging market economies.
Without measures to address medium-term vulner-
abilities and rein in credit excesses when they appear,
a prolonged period o low interest rates could lay the
ground or new nancial stability risks. Eventually,
an unexpected and rapid rise in risk-ree rates couldtrigger substantial market volatility and repricing.
Fair-value estimates or U.S. reasury yields have
already increased in the past six months on the back
o reduced tail risks (Figure 1.8).
In sum, i progress on addressing the above risks
and medium-term challenges were to stall, the recent
rally in global markets could prove unsustainable.
Pressures in the euro area periphery rom a sizable
debt overhangas much as one-th o the debt
o nonnancial listed rmstogether with bro-
ken credit transmission channels keep costs high.
Credit continues to contract (by 5 percent since the
outbreak o the crisis), starving the vital small and
medium-sized enterprise (SME) sector o nancing
and blocking economic recovery, while worsen-
ing bank balance sheets. Furthermore, progress in
returning banks to ull health to support recovery isuneven: a urther $1.5 trillion in EU bank delever-
aging may lie ahead as banks need to adjust busi-
ness models, reduce reliance on wholesale unding,
and rebuild buers.2 In the United States, accom-
modative monetary policies are bringing about an
intended shit toward risky assets. But could this go
too ar? Evidence suggests that corporate underwrit-
ing standards are weakening at an early stage, even
though leverage is still two-thirds below prior cycli-
cal peaks.
As discussed in the th section o the chapter,
in emerging market economies with capital inowsadvancing and external conditions avorable, rele-
veraging is occurring at a rapid pace in some areas,
along with riskier orms o borrowing. A prolonged
2Tis is based on the baseline scenario in the October 2012
GFSR, under which large EU banks were projected to reduceassets by $2.8 trillion during 2011:Q32013:Q4, adjusting or
the progress in bank deleveraging observed up to 2012:Q3 ($1.3
trillion). See the section on Banking Challenges.
Sources: Bank of America Merrill Lynch; Bloomberg L.P.; JPMorgan Chase; and IMFstaff estimates.
Note: CDS = credit default swaps; EM = emerging market; OECD = Organization forEconomic Cooperation and Development. Percent changes in CDS spreads are reversed.
Figure 1.3. Asset Performance since the October GFSR(Percent change)
50 5025025Greek bank equities
GoldOil
Italian bank equitiesU.S. Treasuries
Spanish bank equitiesGerman bundsCore bondsU.S. high gradeEM sovereignsEuropean high gradeEM corporatesU.S. CDS ()U.S. high yieldEM equitiesOECD leading indicatorsEuropean equitiesU.S. equitiesEuropean high yieldU.S. corporate CDS ()Japanese CDS ()French spreadsEuropean corporate CDS ()European bank CDS ()French bank equitiesVIX ()Italian spreadsU.K. bank equities
Spanish spreadsJapanese bank equitiesEuropean sovereign CDS ()Irish bank equities
2.5
2.0
1.5
1.0
0.5
0.0
0.5
1.0
1.5
2.0
10th90th percentileAdvanced economiesEmerging market economies Cheaper
Richer
Maximum
Minimum
Sources: Bloomberg L.P.; IBES; and IMF staff estimates.
Note: Based on GDP-weighted average of z-scores of price-to-book (P/B) and forwardprice-to-earnings (P/E) ratios. The z-scores represent the deviation from the period
average expressed in the number of standard deviations. Values above zero denote richervaluations relative to historical averages, while those below zero denote cheaper
valuations. P/B and P/E ratios are monthly series beginning in 1996 and 1987,respectively, or earliest available. Advanced economies include 22 countries, and
emerging market economies include 17 countries.
Figure 1.4. Global Equity Valuations(In z-scores)
2006 2007 2008 2009 2010 2011 2012
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International Monetary Fund | Apr 2013 5
10th90th percentile
JapanUnited States
United KingdomFrance
ChinaIndonesia
Mexico
2.5
2.0
1.5
1.0
0.5
0.0
0.5
1.0
1.5
2.0
Cheaper
RicherMaximum
Minimum
Sources: Bloomberg L.P.; IBES; and IMF staff estimates.Note: Based on unweighted average of z-scores of price-to-book (P/B) and forward
price-to-earnings (P/E) ratios. The z-scores represent the deviation from the periodaverage expressed in the number of standard deviations. Values above zero denote richer
valuations relative to historical averages, while those below zero denote cheapervaluations. P/B and P/E ratios are monthly series beginning in 1996 and 1987,
respectively, or earliest available.
Figure 1.5. Global Equity Valuations, by Country(In z-scores)
2006 2007 2008 2009 2010 2011 2012
gure . . roperty r ce a uat ons(In z-scores)
10th90th percentile
CanadaHong Kong SAR
SpainNorway
United StatesBrazil
SwedenFrance
Sources: Organization for Economic Cooperation and Development; and IMF staff
estimates.
Note: Based on unweighted average of price-to-rent ratio (PRR) and price-to-incomeratio (PIR). The z-scores represent the deviation from the period average expressed in thenumber of standard deviations. Values above zero denote richer valuations compared with
historical averages, while those below zero denote cheaper valuations. PRR and PIR arequarterly series beginning in 1970 , or earliest available.
3
2
1
0
1
2
3
Cheaper
Richer
Maximum
Minimum
2006 2007 2008 2009 2010 2011 2012
0
100
200
300
400
500
600
700
Model spreads (fundamental factors)
95% condence
interval for the
predicted model
Actual EMBIG spreads
Model spreads (fundamental + external factors)
Sources: Bloomberg L.P.; JPMorgan Chase; PRS Group; and IMF staff estimates.Note: The EMBIG index is the benchmark hard-currency government debt index for
emerging market economies. External factors for the model include the VIX, the federalfunds rate, and the volatility of federal fund s. Fundamental factors are political, economic,
and financial risk ratings published by the PRS Group. The estimation uses a panelregression with fixed effects for the period January 1998 to December 2012.
Figure 1.7. Hard-Currency Debt Valuations in Emerging
Market Economies(In basis points)
Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12
10-year Treasury yield
Fitted value
European Central Bank
president's speech
Federal Reserve's QE3
announcement
0
1
2
3
4
5 two standard deviations
Sources: Bloomberg L.P.; Haver Analytics; and IMF staff estimates.Note: The 10-year Treasury yield is estimated as a function of domestic
macroeconomic factors (business conditions, inflation, and the budget deficit);international factors (custody holdings by foreign central banks and GDP-weighted
average of European credit default swaps as a proxy for safe-haven flows); and bondvolatility to capture a risk premium. The equation is estimated for the period from August
2007 to December 2012
Figure 1.8. U.S. Sovereign Debt Valuations(In percent)
Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12
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6 International Monetary Fund | Apr 2013
period o low rates could result in increased vulner-
abilities, raising the risk o market instability when
rates do eventually rise.
Against this backdrop, the nal section o the
chapter on Policies or Securing Financial Stabilityand Recovery discusses urther policy actions needed
to prevent the crisis rom moving to a more chronic
phase, marked by a deterioration o nancial condi-
tions and recurring bouts o nancial instability as
reorms all short. Avoiding this ate will require
addressing weaknesses in private and public sector bal-
ance sheets, widening credit channels, and strengthen-
ing the nancial system. ogether, these policies will
reduce the reliance on supportive monetary policies
and acilitate a speedier normalization o central bank
policies. But in the interim, policymakers will need to
be vigilant to ensure that pockets o excesses linked tothe search or yield do not become systemic.
t er Ara crisis: A Riss havdi, M Wr lis Aa
Acute short-term stability risks have declined in the
euro area on the back of strong policy action. Prices
and liquidity conditions in sovereign, bank, and
corporate debt markets have improved dramatically,
and issuance has soared. However, medium-term
risks remain, reflecting a weak economic outlook,
persistent fragmentation, and structural challenges.
Some banks in the euro area periphery remain
challenged by deleveraging pressures, still-elevated
funding costs, deteriorating asset quality, and weak
profits.3 Corporations in the periphery are directly
affected by bank deleveraging, cyclical headwinds,
and their own debt overhangs. Against this backdrop,
more work needs to be done in the short term to
improve bank and capital market functioning, while
moving steadily toward a full-fledged banking union.
Policy actions have greatly reduced near-term perceptions of tail risk.
Te ECBs announcement o the Outright Mone-
tary ransactions (OM) programtogether with the
3In this GFSR, the euro area periphery consists o Cyprus,
Greece, Ireland, Italy, Portugal, and Spain, except as noted.
decision to support additional debt relie or Greece
and agreement on the Single Supervisory Mechanism
(SSM)has greatly reduced redenomination tail risks.
In response, external investors have moved rom short
to long positions on the periphery.4 Tough mar-
ket liquidity conditions are not yet back to normal,
they have improved. Correspondingly, the spread o
short-term (two-year) periphery sovereign bonds over
German bunds has allen back toward January 2011
levels (Figure 1.9). Te relie or short-term debt
markets provided by the OM pledge has been partly
transmitted urther along the curve. Still, marketscontinue to reect medium-term challenges: the long-
term (10-year) spread has reversed only about hal o
its previous widening, while arget2 imbalances are
declining at a slower pace, with about one-th o the
previous widening reversed so ar.
Private funding markets have reopened for
periphery borrowers.
Te reduction in perceived risks was elt in credit
markets more broadly, beneting even some lower-tier
4During 2012:Q3, the oreign investor share in total govern-
ment debt in Italy and Spain stabilized at about 35 percent and 30percent, respectively. Although oreign banks continued to reduce
exposures to Italian and Spanish government debt, the process
slowed down considerably in 2012:Q3. At the same time, oreignnonbanks started to increase their holdings o Italian and Spanish
bonds. Even so, the oreign share is still estimated to be ar below
the levels seen in mid-2011, beore market pressures emerged.
1200
1000
800
600
400
200
0 0
100
200
300400
500
600
700
800
Periphery Target2 balances (net, left scale)
Periphery 2year spreads over Germany (reverse scale, right scale)
Periphery 10year spreads over Germany (reverse scale, right scale)
Billionsofeuros
Basispoints
Sources: Bloomberg L.P.; Euro Crisis Monitor; and Haver Analytics.
Note: Spreads are weighted by nominal GDP, and Target2 balances are cumulative.Spreads for Ireland are constructed using the generic Irish government nineyear bonds.
Figure 1.9. Target2 Balances and Sovereign Bond Yields
Feb-11 Aug-11 Feb-12 Aug-12 Feb-13
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International Monetary Fund | Apr 2013 7
periphery companies. Te demand or bank debt has
strengthened, compressing spreads and prompting a
surge in issuance (Figure 1.10). More than 32.7 billion
(gross) was issued by banks and other rms in January
2013 alone.5 O this amount, lower-tier bank and corpo-
rate issuers accounted or about one-ourth.6 Some larger
Italian and Spanish companies have used the surge in
bond issuance to replace bank loans (Figure 1.11), while
some banks have started to repay LRO unds early.
5Excluding bank sel-unded issues, that was the strongestmonth since the run in February 2012 in the wake o the
ECBs longer-term renancing operations (LROs). Figure 1.10
distinguishes between sel-unded, where the issuer is the soleunderwriter, and regular debt issues.
6Tis includes all issuers rom Cyprus, Greece, Ireland, and
Portugal, and high-yield issuers rom Italy and Spain.
However, the virtuous dynamic prompted by
the OMT program has slowed, while adverse
events could still revive market stress.
Although investors and ofcials appear com-
ortable that the ECBs OM remains a virtual
program, this dynamic could change. In particular,
political developments could complicate imple-
mentation, as underscored by the uncertainty
surrounding the election outcome in Italy. And
while prospects or sovereign nancing in 2013 have
brightened, net nancing needs remain challenging
or some countries. Assuming that domestic inves-
tors keep exposures to their own sovereigns constant
(as some o them indicated), oreign investors will
need to continue to increase their allocations to
sovereign bonds to acilitate government nancing at
more moderate yields (Figure 1.12).
Furthermore, there are concerns that i growth and
scal outturns in the periphery do not improve, or i
progress on euro area architecture reorm stalls, recent
improvements in market conditions could be reversed.A lasting improvement in growth and scal trajec-
tories across the periphery hinges on the successul
implementation o structural reorms. Some market
participants are concerned that progress on this ront
could all short i political support or reorm wanes.
In part reecting medium-term risks, orward curves
suggest market concerns about the durability o the
10
20
30
40
50
00
100
200
300
400
500
600
700Selffunded issues (left scale)
Regular issues (left scale)
CDS spread (right scale)
Billionsofeuros
Basispoints
Sources: Bloomberg L .P.; Dealogic; and IMF staff estimates.Note: In selffunded deals, the issuer is the sole underwriter. CDS = credit default
swaps.
Figure 1.10. Periphery Euro Area Banks' Bond Issuance and
CDS Spreads
2008 09 10 11 12 13
40
30
20
10
0
10
20
30
40Italy, bank credit Spain, bank credit
Italy, corporate bonds Spain, corporate bonds
Sources: Bloomberg L.P.; Dealogic; Haver Analytics; and IMF staff estimates.
Figure 1.11. Italy and Spain: Nonnancial Firms Change inBank Credit and Net Bond Issuance(Billions of euros; threemonth moving average)
Jul11 Oct11 Jan12 Apr12 Jul12 Oct12 Jan13
20
25
30
35
40
45
50
5560
65
Scenario
projection
BelgiumFranceItalySpain
Sources: IMF, World Economic Outlook database; national sources; and IMF staff
estimates.Note: For all countries, government debt refers to general government debt on a
consolidated basis. The shaded area is a hypothetical scenario for 2013 that assumes that
domestic banks and nonbanks keep their sovereign exposure unchanged.
Figure 1.12. Foreign Investor Share of General
Government Debt(In percent)
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
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8 International Monetary Fund | Apr 2013
spread compression at the short end o the periphery
yield curve (Figure 1.13) and no urther declines in
10-year periphery sovereign spreads.7
Te potential or contagion rom developments in
Cyprus is an important reminder o the ragility o
market condence. Although the adverse reaction toincreased risk has not been intense in all markets, there
was a renewed ight to sae assets and a sello in some
euro area assets (Figure 1.14). Te clearest impact has
been on those markets with direct links to Cyprus
notably Greek government bonds and Greek and
Russian bank stocks. Slovenian government bonds were
also aected. Other eects have included higher und-
ing costs or euro area periphery banks and a sello in
euro area bank equities. Te impact o recent events
on periphery euro area sovereign spreads was limited,
likely reecting the existence o backstops (includ-
ing the ECBs OM). Although it is too early to tell
whether these developments have led to a persistent
increase in the cost o uninsured unding or banks
in countries with weak sovereigns, the experience o
Cyprus reafrms the need to make sustained progress
7Consensus orecasts do not suggest that the near-term ination
outlook or Italy or Spain is notably higher than or Germany.
with banking unionespecially Single Supervision, acommon resolution authority, and a common deposit
guarantee schemeas emphasized in the October 2012
GFSR, in the recent EU FSAP, and in the nal section
o this chapter.
More work needs to be done to address legacy
issues and medium-term vulnerabilities, lest the
crisis become mired in a more chronic phase.
Despite substantial improvements in unding
conditions, ragmentation between the core and the
periphery persists. Although the divergence between
wholesale unding costs or core and periphery bor-
rowers has partially reversed, the gap has not ully
closed. Tis partly reects investor concerns about
the quality o bank assets and increased asset encum-
brance (Figure 1.15): issuance o covered bonds
and other asset-backed securities declined in the
past year, while some banks in the periphery have
seen a marked rise in the cost o collateral-backed
debt issuance (Figure 1.16). While the previous
declines in oreign investors claims on periphery
sovereigns have begun to reverse (see Figure 1.12),the cross-border banking market in the euro area
remains deeply ragmented (Figure 1.17). Some o
the retrenchment in cross-border bank claims may
be encouraged by regulatory ring-encing (see the
section on Banking Challenges).
Fragmentation, in turn, impairs credit transmission
to the real economy. Recent market improvements
61.1
70.9
Sources: Bloomberg L.P.; and IMF staff estimates.Note: CDS = credit default swap. Yields are for 10year tenors unless otherwise
specified. Percent changes in CDS spreads and bond yields are reversed.
Figure 1.14. Asset Performance, March 15April 2, 2013(Percent change)
0 10 2040 30 20 10
Cypriot 7year government bond yields ()Cypriot CDS ()Slovenian 8year government bond yields ()Core bank CDS ()Periphery bank CDS ()Greek government bond yields ()Greek bank stocksRussian bank stock: VTBSpanish bank stocksItalian bank stocksFrench nancial stocksItalian government bond yields ()
Spanish government bond yields ()U.S. Treasury yields ()German government bond yields ()
0
100
200
300
400
500
600
France two-year yield spread
France two-year spread, forwards
Italy two-year yield spread
Italy two-year spread, forwards
Spain two-year yield spread
Spain two-year spread, forwards
Belgium two-year yield spread
Belgium two-year spread, forwards
Spreads as implied
by forward curves
Sources: Bloomber g L.P.; and IMF staff estimates.
Figure 1.13. European Sovereign Bond Spreads, Current
and Implied by Forward Curve(In basis points over German benchmark)
2009 2010 2011 2012 2013 2014 2015 2016
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are only just beginning to eed through to the cost
and availability o credit or productive sectors o
the periphery economies. Te dierences between
periphery and core in terms o bank lending rates and
corporate borrowing costs continue to persist, as bank
repair is still incomplete and unding costs are higher
or banks and sovereigns in the periphery. Credit tothe real economy remains restrained (especially in the
periphery and to SMEs), reinorcing divergence in
economic outcomes (Figures 1.18 and 1.19).
Private nonfnancial sector deleveragingcould
impede the recovery and raise nancial strains, as
corporations ace high debt burdens in an environ-
ment o lower growth and higher interest rates.
The transmission mechanism is still impaired and
credit conditions remain weak in the periphery.
Credit growth rates continue to diverge between
the core and periphery countries (Figure 1.20), with
periphery credit alling at a similar pace to the base-
line scenario outlined in the October 2012 GFSR
(Figure 1.21). Tis weakness in periphery lending is
arguably due to credit supply constraintsas banks
ace balance sheet pressurescombined with low
demand rom potential borrowers (given the anemiceconomic environment and, in many cases, with bal-
ance sheets burdened by high debt levels).
Disentangling the demand-side rom the supply-
side drivers o credit developments is not straight-
orward.8 Te relationship between credit demand
and supply is complex (Figure 1.22). For example,
cutbacks in credit supply raise the cost o borrow-
ing and lead to lower demand. Furthermore, both
supply constraints and alling demand can adversely
aect the real economy, which in turn can lower
demand and tighten supply urther. A weaker eco-
nomic outlook can also worsen the quality o bank
and borrower balance sheets, urther aecting the
supply and demand or credit.
8For example, an IMF (2012b) report on Italy and the Bank
o Italy (2012) report ound that while the slowdown in credit
growth refected both supply and demand, supply constraintswere dominant in 2011, and demand came to the ore in 2012.
Sources: European Central Bank; European Covered Bond database; and IMF staff
estimates.Note: LTROs = longer-term refinancing operations; MRO = main refinancing operations.1
Includes fine tuning, Multilateral Fund, and emergency liquidity assistance.
Figure 1.15. Proportion of System Balance Sheets
Encumbered(Percent of bank assets, end period)
20072012
Greece
07 12
Spain
07 12
Portugal
07 12
Italy
07 12
Ireland
07 12
Germany
07 12
France
Repo Covered bonds
MRO LTROs
Other ECB1
0
5
10
15
20
25
30
35
40
0
50
100
150
200
250
0
20
40
60
80
100
120
140
Volume (right scale)
Spread (left scale)
Basispoints
Billionso
feuros
Sources: Dealogic; and IMF staff estimates.
Note: Spreads are weighted by a banks share in the total volume of euro issuance.
Figure 1.16. Periphery Banks Covered Bond Issuance and
Spreads
2009 2010 2011 2012
French
Banks
German
Banks
Italian
Banks
Spanish
Banks
U.K.
Banks
Euro area periphery 28 39 34 20 34Core euro area 9 3 5 18 26United Kingdom 32 53Other Europeanadvanced economies 16 5 31 44 22
United States 61 2 4 5 30Japan 66 11 100 21 11Other advanced economies 58 48 26 30 18Emerging EMEA 21 11
11 27
Emerging Latin America 12 32 80 1826 24
16Emerging Asia 47 21 75 15 5Total 30 5 10 15 19
Sources: Bank for International Settlements, International Banking Statistics, Table 9E:Consolidated foreign claims and other p otential exposuresultimate risk basis; and IMF
staff estimates.Note: EMEA = Europe, the Middle East, and Africa.
Figure 1.17. Selected EU Banks' Foreign Claims on Banking
Sectors, June 2011September 2012(Percent change)
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Ireland
Portugal
ItalySpain
AustriaBelgium
France
Germany
Netherlands Finland
Cyprus
100
80
60
40
20
0
20
40
60
80
100
Corporate loans
Housing
loans
Core
Periphery
Sources: Haver Analytics; and IMF staff estimates.
Figure 1.18. Changes in Interest Rates on New Bank Loans,
December 2010January 2013(In basis points)
100 10080 60 40 20 0 20 40 60 80
Austria
Belgium Finland
France
GermanyLuxembourg
Netherlands
GreeceIreland
Italy
Portugal
Spain
1.5
0.5
0.5
1.5
2.5
3.5
4.5
2013 consensus growth forecasts
Corporate
rea
lrates
(Fe
bruary
2013)
Periphery
Core
Sources: Bank of America Merrill Lynch; Consensus Economics; and IMF staffestimates.
Note: Corporate rates are expost, inflationadjusted yields of all corporate bonds for
each country included in the Bank of America Merrill Lynch European corporate masterindex.
Figure 1.19. Corporate Real Interest Rates and GDP
Growth, February 2013(In percent)
4.5 3.5 2.5 1.5 1.50.5 0.5
6
4
2
0
2
4
6
8
France Germany Euro area Italy Spain Program countries
Sources: Haver Analytics; and IMF staff estimates.
Note: Chart adjusted for securitizations. Program countries are Greece, Ireland, andPortugal.
Figure 1.20. Bank Lending to the Nonnancial Private
Sector(In percent, yearoveryear)
Jan. Apr.
2010 2011 2012 2013
Jul. Oct. Jan. Apr. Jul. Oct. Jan.J an . Ap r. J ul. O ct .
16
14
12
10
8
6
42
0
2
October 2012 GFSR
scenario projections
Complete policies
Baseline
Weak policies
Actual
Sources: Haver Analytics; and IMF staff estimates.
Note: Ireland, Italy, Portugal, and Spain, adjusted for securitizations.
Figure 1.21. Euro Area Periphery Bank Credit(Percentage change, cumulative since September 2011)
S ep. D ec.
2011 2012 2013
Mar. Jun. Sep. Dec. Mar. Jun. Sep. Dec.
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But even i demand were seen as driving the
weakness in credit, barriers to supply would need
to be removed so that banks do not hold back the
economic recovery once it takes hold.9 In any case,
there is some evidence to suggest that credit supply
is tight in the periphery.
Interest rateson new bank lending are signiicantly
higher in the periphery than in core countries
(Figure 1.23). his divergence relects, in part, theincreased margin that banks require to compen-
sate them or the greater risk o lending in the
periphery. But it also relects the increased cost o
new unding as institutions have made less use o
oicial unding and have competed both among
themselves and with retail sovereign debt holders
or term deposits. he increase in term deposits
comes at a price, as interest rates on them are
higher than those on sight deposits.
9For example, the Financial Policy Committee o the Bank o
England has recently recommended that banks strengthen their
capital buers (which were ound by the March 2013 Asset Qual-ity Review to be overstated by about 50 billion) so that banks
could sustain credit and absorb losses in the event o urther
stress. Te nding that banks balance sheet weaknesses (e.g.,weak capital buers in absolute terms or relative to a target level)
have a signicant negative eect on their supply o loans has been
conrmed in a number o studies.
BANK
BALANCE SHEETCONSTRAINTS
BORROWER
BALANCE SHEETCONSTRAINTS
MACRO-
ECONOMICSLOWDOWN
Adversemacro
feedback
Tightenlending
conditions
Too costlyto borrow
Unableto lend
Too riskyto lend
Unwillingto borrow
Borrowersdeleverage
LESS
SUPPLY
LESS
DEMAND
Source: IMF staff.
Figure 1.22. Interaction between Credit Demand and Supply
Lower assetquality leads tolosses and bank
capital
constraints
Economic slow-down and falls inasset prices lead
to lower
collateral values
0.00.51.0
1.52.02.53.0
3.54.04.5
5.05.5
0.00.51.0
1.52.02.5
3.03.54.0
4.55.05.5
Core euro areaPeriphery euro area
Sources: Bloomberg L.P.; Haver Analytics; and IMF staff estimates.
Note: Interest rates on lending and funding are weighted by the amount of newbusiness (the contributions of funding components are shown in the chart). The sovereign
spread is the five-year sovereign yield over bunds. The interest rate on new lending is tothe nonfinancial private sector.
Figure 1.23. Interest Rate on New Lending and
Decomposition of New Bank Funding Rate(In percent, six-month moving average)
2009 10 11 12 13 2009 10 11 12 13
Sovereign spread Wholesale spread Deposit rateCentral bankliquidity
Margin Lending rate
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Lending surveysalso provide evidence: he recent
euro area bank lending survey shows a continued
tightening in bank lending conditions (Figure
1.24), as well as a urther weakening in demand or
loans. However, separate surveys o the SME sec-
tor suggest that supply constraints are binding or
some irms. Figure 1.25 shows that there has been
an increase through 201112 in the proportion
o Italian and Spanish SMEs that wanted a bank
loan but did not obtain most or all o the credit or
which they had applied.
For the euro area core, macro risk is the maindriver o recent credit conditions, as ECB policies
have substantially reduced banks balance sheet con-
straints and their cost o unding.
The high cost and restricted supply of credit
to SMEs impede recovery.
Te combination o high bank unding costs and
increased risk premiums on lending has impaired
the credit transmission mechanism. For example,
interest rates on new periphery SME loans are now
priced at spreads over the ECB policy rate that aresignicantly higher than in the past (Figure 1.26).
Loan originations or SMEs have also been alling
more sharply than or large rms, suggesting that
SMEs are bearing the brunt o the reduction in
bank credit. Tis is particularly worrisome given that
SMEs typically lack access to capital markets.10
The debt overhang poses challenges
for the corporate sector.
Firms in the euro area periphery have built a sizable
debt overhang during the credit boom, on the backo high prot expectations and easy credit conditions
(Figures 1.27A and 1.27B).11 While the construction
10Te latest SME survey by the ECB shows that only 2 percent
o SMEs in the euro area use bond markets.11Te debt overhangis dened in the literature as a debt burden
that generates such large interest payments that it prevents rms
rom undertaking protable investment projects that would
40
20
0
20
40
60
80
100
120
140
20
10
0
10
20
30
40
50
60
70CompetitionCyclical factors
Balance sheet constraintsOverall (right scale)
Tightening
Sources: European Central Bank; Haver Analytics; and IMF staff estimates.Note: Balance sheet constraints are capital, access to financing, and liquidity position.
Cyclical factors are general economic activity, industry outlook, and collateral needs.
Figure 1.24. Euro Area Bank Lending Conditions for Firms(Net percentage balance and factor contributions)
2007 2008 2009 2010 2011 2012
0
5
1015
20
25
30
35
40
45Met
Unmet
Spain Italy France Germany
Sources: European Central Bank (201 2); and IMF staff estimates.
Note: Unmet demand is the percentage of respondents that appplied for a loan and didnot get all or most of the requested amount.
Figure 1.25. Met and Unmet Demand for Bank Credit for
Small and Medium-Sized Enterprises(Percent of respondents)
1111 111120102010 201020101212 1212
0
100
200
300
400
500
600Program countries
SpainItalyFranceGermany
Median 200310
Range
Source: Haver Analytics; and IMF staff estimates.
Note: ECB = European Central Bank; SMEs = Small and medium-sized enterprises.Interest rate on new corporate loans with a value of 1 million or less. Program countries
are Greece, Ireland, and Portugal.
Figure 1.26. Spread of Interest Rates on New Loans to SMEs
over ECB Policy Rate(In basis points)
2003 2005 2007 2009 2011 2013
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sectors in Ireland and Spain were at the epicenter o the
crisis, the increase in leverage was broad-based across
the periphery. Firms in these countries now ace the
challenge o reducing the debt overhang in an environ-
ment o lower growth and higher interest rates, in part
related to nancial ragmentation in the euro area.
In this report, we assess the eects o high cor-
porate leverage on both debt servicing and debt
repayment capacity over the medium-term. (Te
methodology is described in Annex 1.1.) While
measures o debt servicing capacity, such as interestcoverage ratios, help detect immediate or short-term
risks, measures o debt sustainability, based on net
ree cash ows, help assess medium- and longer-term
risks.12 We conduct a cross-country analysis o the
corporate sector based on a sample o listed rms.13
Te rm-specic data allow us to identiy a weak
tail in the sample, highlighting vulnerabilities not
detected in aggregate data.
enable them to organically reduce debt over time. Te size o thedebt overhang is estimated as the required debt reduction such
that interest expense declines and net ree cash ows become
positive.12Net ree cash ows is dened as operating cash ows beore
interest minus interest expense net o taxes minus capital expendi-
tures and minus dividends.13Te sample includes about 1,500 publicly traded companies,
with average coverage o 30 percent o the corporate sector by
assets.
Te main conclusion o the analysis is that the weak
tail o rms with high and unsustainable leverage is siz-
able in the periphery, mainly in Portugal and Spain, call-
ing or continued vigilance by supervisors on bank asset
quality.14 Debt sustainability is dened as the capacity o
rms to generate sufcient cash ows over the medium
term to at least keep the debt level stable, while main-
taining current levels o capital expenditures and divi-
dend payments. I a rm is in the weak tail, this does not
mean that it will deault on its debt, rather it will need to
take measures (such as cutting operating costs, dividendsand capital expenditures) to bring its debt down to a
sustainable level. A comparison o vulnerability indica-
tors between the sample o listed rms and the entire
corporate sector suggests that the risks highlighted in the
exercise are likely to be greater in the broader corporate
sector, including in Italy, as SMEs are oten hampered
by high debt levels, low protability, and higher unding
costs (able 1.1).
Te ability o rms to service debtmeasured
by the interest coverage ratiois much weaker in
the periphery than in the core (Figure 1.28). Tese
stresses are already showing up in ast rising corpo-
rate NPLs at banks in the periphery.
14In Spain, construction companies are included in the sample
and are partly responsible or the sizable weak tail. Te risks orbank asset quality are mitigated by the act that most o the real
estate loans o the weakest (Group 1 and Group 2) banks have
been transerred to the SAREB.
90
110
130
150
170
190
210
230Ireland
Spain
United Kingdom
Portugal
FranceItaly
United States
Germany
Sources: Central bank flow of funds data; and IMF staff estimates.
Note: Debt for the entire corpor ate sector in each country. Gross debt figur es include securities other than shares, loans, and other accounts payable. Intercompany loans and tradecredit can differ significantly across countries. Consolidated debt levels are significantly lower for some countries, especially those with a strong presence of multinational companies with
large intercompany loans.
Figure 1.27A. Corporate Debt(Fourquarter moving average, 2002:Q1 = 100)
2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 007 2 00 8 2 009 2 01 0 2 011 2 01 2
70
120
170
220
270
Spain
France
PortugalUnited Kingdom
Italy Germany
United States
Ireland
Figure 1.27B. Corporate Debt in Percent of GDP(Four-quarter moving average)
2 00 2 2 00 3 2 004 2 00 5 2 00 6 20 07 2 00 8 2 00 9 2 01 0 2 01 1 2 01 2
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In our orward-looking exercise o debt sustain-ability, we project net ree cash ow over the medium-
term. Net ree cash ows are orecasted based on
assumptions on GDP growth and interest rates under
the World Economic Outlook (WEO) baseline, the
euro area upside, and the euro area downside sce-
narios (see the April 2013 World Economic Outlook).
Financial ragmentation measured by interest rates in
this exercise is substantially reduced in Portugal under
the WEO baseline and in other periphery countries
under the euro area upside scenario.
Te weak tail o highly leveraged rms with
projected negative net ree cash ows is substantiallylarger in some periphery countries than in the core,
particularly in Portugal and Spain (Figure 1.29).
Te size o the debt overhang is particularly
large in Italy, Portugal, and Spain. o achieve non-
negative net ree cash ows in the medium-term,
corporate leverage in these countries would have to
be reduced by 610 percent o assets under the base-
line and to converge to the levels in the core under
the downside scenario with continued ragmentation
and lower growth (Figure 1.30).
Te above analysis underscores the urgent need or
restructuring and consolidation in the periphery cor-
porate sector, where a range o measures will be needed
to smooth deleveraging (Figure 1.31). While large
diversied companies may sell assetsincluding oreign
unitsto reduce leverage, potential protable sales are
likely to negatively aect their revenues and earnings
going orward. Furthermore, additional cuts in operat-
ing costs, dividends, and capital expenditures may also
be required, posing additional risks to growth andmarket condence. Tus, a move to the upside scenario
with reduced ragmentation and productivity gains
rom restructuring will be critical to lower unding
costs and support orderly deleveraging. In special cases,
where the debt overhang issue is systemic, a mandatory
suspension o dividends can be considered as a policy
option, as well as principal reduction workouts.15
In addition, the strains in the corporate sector
may urther undermine bank asset quality. While the
recently conducted EU-wide and national bank stress
testing exercises have helped strengthen capital bu-
ers, continued bank supervisory vigilance is needed.Second-round eects rom lower capital expenditures
and higher unemployment may lead to an increase in
a wider range o NPLs, including mortgages.
More work lies ahead.
Sustaining condence in the euro area and urther