The IMF s Systemic Financial Sector Surveillance

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1 The IMF s Systemic Financial Sector Surveillance Seminar for Senior Bank Supervisors from Emerging Economies October 21, 2010 Elie Canetti Advisor Monetary and Capital Markets Department International Monetary Fund

Article IV Consultations Financial Sector Assessment Programs

2 What Is Systemic Financial Sector Surveillance? The Fund s 3 Levels of Surveillance Bilateral Country Specific Article IV Consultations Financial Sector Assessment Programs (FSAP) Regional Regional Economic Outlook (REOs) Multilateral Economic (WEO) Financial (GFSR, EWE)

3 I. Why Is It Important to Do Systemic Financial Sector Surveillance at the Global Level? Global Financial Flows are Increasing Global Cross Border Portfolio Investment ($ trillions) Source: IMF's Coordinated Portfolio Investment Survey, Table 12

Finance Has Become More Complex and Opaque OTC Derivatives ($ trillions) 700 600 500 400 300 200 100 0 Jun.

4 Finance Has Become More Complex and Opaque OTC Derivatives ($ trillions) Jun.1998 Jun.1999 Jun.2000 Jun.2001 Jun.2002 Jun.2003 Jun.2004 Jun.2005 Jun.2006 Jun.2007 Jun.2008 Jun.2009 Source: BIS

5 Crises Have Become Global Global Impact of US Subprime Crisis August 2007 BNP Paribas Halts Redemptions on 3 Investment Funds September 2007 UK s Northern Rock Requires Rescue September 2008 Fed expands swap facilities with advanced country central banks October 2008 Fed establishes swap facilities with emerging market central banks September November 2008 Crisis Erupts in Iceland Late 2008 Early 2009, Synchronised G3 recession confirmed Sources: BIS, St. Louis Federal Reserve Bank

6 II. What Does Systemic Financial Sector Surveillance Achieve? Highlight Systemic Vulnerabilities Examine Possible Spillovers Across Markets: (e.g. US Subprime Mortgages to Global Interbank Markets) Countries: (Emerging Market Financing, European Sovereign Crisis Spillovers) Provide Policy Advice Financial Reform Assure Level Playing Fields

7 III. IMF s Major Publications Multilateral Financial Sector Surveillance GFSR GFSR Updates Staff Position Notes Addressing Information Gaps (March 2009) The Perimeter of Financial Regulation (March 2009) Policies to Address Financial Sector Weakness (October 2009) Capital Inflows: The Role of Controls (February 2010) The Making of Good Supervision (May 2010) The Contours of the Financial System (August 2010) Shaping the New Financial System (October 2010)

8 What is the Global Financial Stability Report Twice a year (timed to coincide with the Annual and Spring IMF/WB meetings) The IMF s flagship Financial Sector Publication Focus on Macrofinancial Linkages (e.g. impact on credit)

9 Chapter 1 The IMF s View on Financial Stability Risks Source: GFSR, October 2010

10 Source: GFSR, October 2010 Asset Class Heat Map

11 Recent Major Chapter 1 Topics Sovereign Risks (focus on Europe) and Financial Fragilities Sovereign and Banking System Spillovers Global Bank Loss/Writedown Estimates Managing Upside Risks to Emerging Markets (Capital Flows and Asset Bubble Risks)

12 GFSR Special Features Analytical chapters or essays on structural or systemic issues relevant to international financial stability Selected Recent Examples: Systemic Liquidity Risk: Improving the Resilience of Institutions and Markets (October 2010) The Uses and Abuses of Sovereign Credit Ratings (October 2010) Systemic Risk and the Redesign of Financial Regulation (April 2010) Making Over the Counter Derivatives Safer: The Role of Central Counterparties (April 2010) Restarting Securitization Markets: Policy Proposals and Pitfalls (October 2009)

13 Geographical Focus Global Financial Stability Systemic Focus Geographic Coverage is Primarily: Global Financial Centers Major Source Countries of Global Capital Major Recipients of Global Capital Flows Contagion Threats for Capital Markets Coverage Limited for Countries That Are: Non systemic; and Not Major Sources/Recipients of Private Capital; and Unlikely to Pose Contagion Threat

14 GFSR Market Update Off Cycle updates (July/January) Short (6 8 pages)

15 IV. imf Direct The IMF s New Blog imfdirect.imf.org/ IMF s financial bloggers (so far) include John Lipsky (First Deputy Managing Director Jose Vinals (Director of MCM) Laura Kodres (Division Chief Global Financial Stability) John Kiff (Senior Economist Global Financial Stability)

16 V. The Early Warning Exercise (EWE) the FSB should collaborate with the IMF to provide early warning of macroeconomic and financial risks and the actions needed to address them G20 London Communiqué, April 2, 2009 Focus on potential systemic crises, whether in advanced or emerging markets Combine IMF s macrofinancial strengths with FSB s expertise in regulation and supervision Provide actionable policy advice

17 What is the EWE? The EWE is a semi annual exercise launched during Annual Meetings in September 2009 Focuses on potential systemic crises, whether in advanced or emerging markets Identifies and prioritizes, macro financial vulnerabilities, key focus on potential spillovers Sets out tail risk scenarios Provides broad policy advice

18 Main output: EWE Presentation IMF Management and FSB Chair present EWE findings to IMFC* *The IMFC is the IMF s steering committee, responsible for advising, and reporting to, the Board of Governors. Its 24 members are central bank governors, ministers, or others of comparable rank drawn from the Fund s 187 member countries. 18

19 Outputs are confidential why? Provide unvarnished views to decision makers EWE should be able to be specific and name names EWE is about tail risk scenarios with focus on contagion and spillovers Warn of consequences of Policy Mistakes

EWE Methodology Although the output is confidential, the methodology is not Methodology paper just released See John Lipsky blog on imf Direct:

20 EWE Methodology Although the output is confidential, the methodology is not Methodology paper just released See John Lipsky blog on imf Direct: Forewarned is Forearmed: How the Early Warning Exercise Expands the IMF s Surveillance Toolkit

21 So How is the EWE Done? Integrates multilateral economic and financial surveillance Combine IMF s macrofinancial strengths (fiscal/economic/financial) with FSB s expertise in regulation and supervision Draws on IMF s model driven vulnerability exercises for emerging and for advanced countries Draws on wide ranging discussions with markets, academics and officials Ultimate Outputs are Based on Staff Judgments, but Underpinned by Extensive Internal Analyses

22 Vulnerabilities versus Triggers Crises require vulnerabilities and a trigger Vulnerabilities Excessive Leverage Balance Sheet Mismatches Liquidity Risks Complexity, Interconnectedness, Opacity Triggers, and hence crisis timing, unpredictable

23 The IMF s Vulnerability Exercises... for Advanced Economies (VEA) and Emerging Economies (VEE) Fundamentals Systemic risk and contagion Global macro environment Spillover analysis Model simulations 23

24 The VEA A Sampling of Sectoral Models External Overvalued Exchange Rates Empirical External Crisis Model Macro Growth Risks (GDP at Risk) Inflation/Deflation Risks Fiscal Rollover Risk Market Based Default Probabilities Fiscal Adjustment Need Fiscal Vulnerability to Adverse Growth Shocks Asset Prices Real Estate Equities Financial Sector Financial Crisis Model Asset Quality (NPLs) Contagion Models Trade Contagion Cross Border Financial Sector Exposure

25 VEA Ratings Country Flags Raised by the VEA 1 Country 1 Country 2 Country 3 Country 4 Country 5 Country 6 Country 7 Country 8 Country 9 Country 10 Country 11 Country 12 Country 13 Country 14 Country 15 Country 16 Country 17 Country 18 Country 19 Country 20 Country 21 Country 22 Country 23 Country 24 Country 25 Country 26 Country 27 Country 28 Overall VEA rating External External imbalances (empirical crisis model, thresholds for 3 external sector indicators) n.a. n.a Overvalued exchange rate (CGER) International Balance sheet analysis 0 0 n.a. n.a n.a. 0 n.a n.a. n.a. n.a n.a. n.a. n.a Macro Growth risks Growth risks (empirical crisis model) GDP at risk 2 0 n.a. n.a n.a n.a n.a. n.a. n.a n.a. n.a. n.a Growth above potential (general equilibrium macro model) 0 n.a. n.a. n.a. 0 n.a n.a. n.a. 0 n.a. n.a. n.a. 0 n.a. n.a. n.a. n.a. n.a. 0 0 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Inflation risks Loose monetary policy (Taylor rule) Loose monetary conditions (general equilibrium macro model) 0 n.a. n.a. n.a. 0 n.a n.a. n.a. 0 n.a. n.a. n.a. 0 n.a. n.a. n.a. n.a. n.a. 0 0 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Denflation risks Tight monetary policy (Taylor rule) Tight monetary conditions (general equilibrium macro model) 2 n.a. n.a. n.a. 0 n.a n.a. n.a. 0 n.a. n.a. n.a. 0 n.a. n.a. n.a. n.a. n.a. 1 0 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Fiscal Fiscal risks, overall indicator 2 0 n.a. n.a n.a n.a n.a. n.a. n.a Gross funding risk (sovereign financing risks analysis) 2 2 n.a. n.a n.a n.a n.a. n.a. n.a Market perception of sovereign default risk (CDS and RAS spreads, models for government 1 2 n.a. n.a n.a n.a n.a. n.a n.a. n.a. n.a bond yields and term risk premium) Medium-term fiscal adjustment need 2 0 n.a. n.a n.a n.a. 0 0 n.a. 0 n.a n.a. n.a. n.a Long-term fiscal adjustment need 1 2 n.a. n.a n.a n.a. 0 0 n.a n.a. n.a Fiscal vulnerability to an adverse growth shock 2 0 n.a. n.a n.a n.a n.a Contagion risk (distress dependence from other sovereigns) 0 n.a. n.a. n.a. n.a. n.a. 0 n.a. 1 1 n.a n.a. 0 0 n.a. n.a. n.a. n.a n.a. n.a. n.a. n.a. n.a. n.a. 0 Fiscal crisis risks (empirical crisis model) Asset prices 0 1 n.a. n.a n.a n.a n.a. n.a. n.a. 1 2 n.a. n.a. n.a. n.a. n.a Real estate overall vulnerability 0 1 n.a. n.a n.a. 0 n.a. 2 n.a. 0 n.a. 1 n.a. n.a. n.a. 0 2 n.a. n.a. n.a. n.a. n.a Residential real estate 0 0 n.a. n.a n.a. 0 n.a. 2 n.a. 0 n.a. 0 n.a. n.a. n.a. 0 2 n.a. n.a. n.a. n.a. n.a House price misalignment 0 0 n.a. n.a n.a n.a n.a. n.a. n.a n.a. n.a. n.a Household debt burden 0 0 n.a. n.a n.a. 0 n.a. 2 n.a. 0 n.a. 1 n.a. n.a. n.a. 0 0 n.a. n.a. n.a. n.a. n.a Potential impact on GDP 0 0 n.a. n.a n.a. 0 n.a. 0 n.a. 0 n.a. 0 n.a. n.a. n.a. 0 0 n.a. n.a. n.a. n.a. n.a Mortgage market characteristics 0 0 n.a. n.a n.a. 0 n.a. 1 n.a. 0 n.a. 0 n.a. n.a. n.a. 2 2 n.a. n.a. n.a. n.a. n.a Commercial real estate 0 1 n.a. n.a n.a. 0 n.a. 0 n.a. 0 n.a. 1 n.a. n.a. n.a. 0 2 n.a. n.a. n.a. n.a. n.a Equity prices 0 n.a. n.a. n.a. 1 n.a n.a n.a n.a. n.a. n.a. 0 1 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 0 Model based misalignments 0 n.a. n.a. n.a. 1 n.a n.a n.a n.a. n.a. n.a. 0 2 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 0 Valuation multiples misalignments 0 n.a. n.a. n.a. 1 n.a n.a n.a n.a. n.a. n.a. 0 0 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 0 Corporate sector vulnerability n.a n.a. n.a. n.a n.a. n.a. n.a Financial sector and systemic models Financial crisis (empirical crisis model) Financial stability at risk 1 2 n.a. n.a n.a n.a n.a. n.a. n.a n.a. n.a. n.a Expected deterioration of asset quality (NPL model) 2 0 n.a n.a. n.a n.a n.a. n.a n.a. n.a Interbank spreads n.a n.a n.a Distress from Large Complex Financial Institutions n.a n.a. 1 1 n.a. n.a n.a. n.a. n.a n.a. n.a. n.a. 1 n.a. 0 2 Duration of crisis (duration model) n.a n.a Contagion Cross-border financial sector exposure (contagion through bank channels) Financial sector exposure to vulnerable advanced economies Financial sector exposure to vulnerable emerging economies n.a Contagion through trade channels Country 29 Country 30 Country 31 Country 32 1 The table summarizes the main results of the VEA exercise. The colors indicate countries that were flagged as relatively vulnerable in each sector, with red, orange and green for high, medium and low vulnerabilities respectively. When "n.a.", the number of red and orange flags needed to rank a country with H or M drops accordingly. 25

26 Drawing Systemic Implications Spillovers and Contagion Analysis Models Based on Market Data Models Based on Exposures BIS Bank Data Bilateral Trade Shares LCFI Analysis Vulnerabilities on Individual LCFIs Risks of Systemic Distress/Spillovers Across LCFIs Global Macro Models

27 Looking for Risk in All the Wrong Places: The Limitations of Modeling Models Deepen, but Don t Widen, Understanding of Risks Financial Models Can Be Invalidated By Changing Human Behavior: I can calculate the motion of heavenly bodies but not the madness of people Isaac Newton Quantifying (e.g. VAR) Can Anchor Expectations in the Wrong Place

28 Going Beyond Models The Consultation Process Take stock of risk perceptions, especially contrarian views. Canvassing of IMF and FSB staff views Interactions with country authorities and FSB members Extensive discussions with market participants Conference call with leading academics 28

29 Goals of the EWE Presentation Connecting the dots Provide unvarnished views to decision makers Supplement public baseline messages Highlight consequences of inaction Focus on contagion and spillovers 29

30 The Art of Early Warning: Grabbing Their Attention (aka The Cassandra Problem)

31 Yes, We Have No Crystal Balls It s tough to make predictions, especially about the future Yogi Berra

32 The IMF s Systemic Financial Sector Surveillance Thank You

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