Overview: Financial Stability and Systemic Risk
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1 Overview: Financial Stability and Systemic Risk Bank Indonesia International Workshop and Seminar Central Bank Policy Mix: Issues, Challenges, and Policies Jakarta, 9-13 April 2018 Rajan Govil The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management. Outline 1. Financial Stability 2. Systemic Risk 3. Systemic Risk and Balance Sheet Linkages 4. Conclusion 2 1
2 Financial Stability What is Financial Stability? Absence of system-wide episodes in which the financial system fails to function Important for conduct of monetary policy (transmission) Important for economic growth (provision of credit) 4 2
3 Financial Development vs. Financial Stability For EMs and LICs, desire to develop their financial sectors to finance much-needed investment Question is how fast to proceed with financial development Key issue: financial development is not just credit growth! 5 Financial Access and Depth Source: Sahay et. al., 2015, Rethinking Financial Deepening: Stability and Growth in Emerging Markets, IMF Staff Discussion Note, SDN/15/
4 Financial Development and Growth Indonesia Source: Sahay et. al., 2015, Rethinking Financial Deepening: Stability and Growth in Emerging Markets, IMF Staff Discussion Note, SDN/15/08. 7 Pace of Financial Deepening and Stability Source: Sahay et. al., 2015, Rethinking Financial Deepening: Stability and Growth in Emerging Markets, IMF Staff Discussion Note, SDN/15/
5 Bottom Line There is a tradeoff between financial development and growth There is a tradeoff between the pace of financial development and financial stability 9 Systemic Risk 5
6 Dimensions of Systemic Risk Time dimension (How aggregate risk evolves over time) Pro-cyclicality and macro-financial linkages Process of amplifying feedback between financial sector and real economy Policy question: how to dampen pro-cyclicality? Structural dimension (How risk is distributed in the system at a given point in time) Common exposures across institutions leading to externalities Direct exposures to similar asset classes Indirect exposures through counter-party relationships Policy question: how to limit joint failures of institutions that represent a significant portion of the system? 11 Time Dimensions of Systemic Risk Source: IMF, 2014, Staff Guidance Note on Macroprudential Policy. 12 6
7 A Feedback Loop between the Macroeconomy and Financial Markets The interactions between the financial system and the real sector can be mutually reinforcing Macroeconomy Financial Markets Ongoing efforts to understand, model, and quantify these linkages Important to improve policymaking and reduce the frequency/costs of crises 13 Link Between Finance and Macroeconomy The financial sector can be: An amplification mechanism for macroeconomic shocks (including policy shocks) A source of shocks (sometimes, crises ) A source of information about agent s expectations on macroeconomic variables 14 7
8 Amplification Channel: Bank Funding Decline in bank funding cost Increased risktaking Decline in measured risks Capital Inflows + Currency Appreciation Dampened volatility Source: Bruno and Shin, 2012, Capital Flows and the Risk-Taking Channel of Monetary Policy, BIS Working Papers, No Indonesia: Macro-Financial Linkages The growth rate of loans and deposits remain subdued, although the latter has recovered somewhat recently Source: IMF, Indonesia: Staff Report for the 2017 Article IV Consultation, February
9 Indonesia: Macro-Financial Linkages Property prices have remained stable in 2017 Source: IMF, Indonesia: Staff Report for the 2017 Article IV Consultation, February Indonesia: Macro-Financial Linkages Problem loans, including NPLs, special mention and restructured loans, remain elevated at over 10 percent of total loans due to legacy effects from the fall in commodity prices and the slight economic slack Source: IMF, Indonesia: Staff Report for the 2017 Article IV Consultation, February
10 Amplification Channel: Credit and the Current Account Source: IMF, Global Financial Stability Report, October Financial Risk Cycles and Business Cycles Source: BIS Annual Report (2014) and Borio (2012)
11 Credit Booms and Financial Crises 21 Empirical Evidence on Macro-Financial Linkages Source: Claessens et al., 2008, What Happens During Recessions, Crunches and Busts?, IMF Working Paper WP/08/
12 Managing the Financial Cycle Why do we want to manage the Financial Cycle? Busts of financial cycles go hand-in-hand with balance sheet recessions VERY COSTLY But setting policy without regard to the financial cycle can be costly Political economy considerations Can central banks meet two objectives (inflation control and financial stability) with one tool (interest rates)? Role for macroprudential policies Source: BIS Annual Report (2014). 23 Medium-Term Output per Capita after Financial Crises Korea Thailand Sweden Source: IMF, 2009, World Economic Outlook (Chapter 4, October 2009)
13 Structural Dimension of Systemic Risk Note: Large Domestic Bank (LDB), Small Domestic Bank (SDB), Mutual Fund (MF), Insurance Company (IC), Global Bank (GB), and Other Nonbanks (ONB). Source: IMF, 2014, Staff Guidance Note on Macroprudential Policy. 25 Assessing the Structural Dimension How to assess/quantify the systemic importance of financial institutions? How to gauge the likely impact of distress at a given institution, or group of institutions, on the stability of the overall system? 26 13
14 Capturing the Structural Dimension Balance sheet exposures at the level of financial institutions, jurisdictions, and sovereigns Risk-adjusted balance sheets Probabilities of distress for institutions Network analyses of bilateral and common exposures Other market-based indicators e.g. regime shifts in financial market volatility Identifying G-SIBs Indicator-Based Measurement Approach Category (and weighting) Individual Indicator Indicator Weighting Size (20%) Total exposures as defined for use in the Basel III 20% leverage ratio Interconnectedness (20%) Intra-financial system assets 6.67% Intra-financial system liabilities 6.67% Securities outstanding 6.67% Substitutability (20%) Assets under custody 6.67% Payment activity 6.67% Values of underwritten transactions in debt and equity markets 6.67% Complexity (20%) OTC derivatives notional value 6.67% Level 3 Assets 6.67% Trading and Available for Sale Securities 6.67% Cross-jurisdictional activity (20%) Cross-jurisdictional claims 10% Cross-jurisdictional liabilities 10% Source: Basel Committee on Banking Supervision, 2014, The G-SIB Assessment Methodology Score Calculation
15 The Smell Test Potential Questions to Ask About the Build-up of Vulnerabilities Are there signs of speculative behavior? Are particular asset classes heavily advertized or discussed in the media? Are banks taking large positions where profits continuously exceed measured risks? Are there relatively new products with large market shares, and have they been increasingly rapidly? Are lending standards weakening? Are profit margins decreasing? Is competition increasing from the shadow banking sector? Source: CGFS Papers No 48, 2012, Operationalising the Selection and Application of Macroprudential Instruments. 29 Systemic Risk and Balance Sheet Linkages 15
16 Key Role of the Banking Sector Provider /holder of assets and liabilities Bank balance sheets are intertwined with entire economy Implication: systemic banking crises can be VERY severe 31 Role of Leverage/Debt Leverage increases the vulnerability of debtors to environment changes (i.e. risk aversion, interest rate/exchange rate changes). Typically, crises involve debt repayment difficulties for one or more sectors (government, households, corporate sector). Debt servicing tends to become more difficult as the crisis develops (foreign credit dries up, banking system needs to deleverage, value of collateral falls, trade credit becomes more difficult, etc.) 32 16
17 US ( ): HH Debt United States: Ratio of Household Debt to Disposable Income (In percent) Q Q3 Q Q3 Q Q3 Q Q3 Q Q3 Q Q3 Q Q3 Q Q3 Q Q3 Source: CEIC 33 Greece ( ): Public Debt Greece Government Debt-to-GDP (In Percent of GDP) Source: CEIC 34 17
18 Sovereign and Nonfinancial Private Sector Debt-to-GDP Ratios (percent) Source: IMF: Global Financial Stability Report, October Sovereign and Nonfinancial Private Sector Debt-to-GDP Ratios (percent) Source: IMF: Global Financial Stability Report, October
19 Balance Sheet Linkages Government/Fiscal Banking System Financial assets Debt Loans to government Deposits Non-financial assets Firms Loans to firms Loans to households Other debt Bank deposits Debt (loans, bonds) Other assets Non-financial assets Bank deposits Households Stock market investments Equity (stock market issuance) Loans Foreign Creditors/ Debtors House 37 Balance Sheet Effects Key issue need detailed information on assets and liabilities for each sector. Currency composition currency risk/fx mismatch Maturity (short- vs. long-term) rollover/liquidity risk Fixed vs. flexible interest rates interest rate risk/rollover risk Counterparties counterparty/funding risk NOTE: Some balance sheet effects may be hidden/ masked need to look at the ultimate source of potential risk (e.g., foreign currency mortgages) and do stress tests/scenario analysis
20 Indonesia: Balance Sheet Linkages 39 Indonesia: Corporate Debt Corporate external debt stabilized in , after rising rapidly in previous years Source: IMF, Indonesia: Staff Report for the 2017 Article IV Consultation, February
21 Indonesia: Corporate Debt Overall corporate debt remains moderate Source: IMF, Indonesia: Financial System Stability Assessment, June Example: Capital Outflows Currency Depreciation No FX Mismatches FX mismatches Exchange rate plays self-correcting role: exports, imports, CA improves Fiscal: FX debt, FX debt service costs probability of default financing costs Firms/Households: FX debt, FX debt service costs bankruptcies job losses Banks: FX debt, FX debt service costs, NPLs credit crunch bankruptcies job losses CA still improves, but because of large compression of domestic demand + more difficult financing conditions 42 21
22 Why FX Mismatches? Foreign currency interest rates lower appears cheaper to take on FX debt This situation can be exacerbated during a credit boom: Credit boom domestic demand Domestic demand inflation Inflation central bank response (interest rates ) Differential between local currency and foreign currency interest rates incentive to borrow in FX for all!!! 43 Conclusions 22
23 Conclusions Financial stability is essential for the proper functioning of the economy There is a tradeoff between financial development and financial stability Important to manage systemic risk (time and structural dimension) to avoid crisis Balance sheet linkages critical financial sector is at the center of balance sheet linkages 45 Policies Policies to lean against the financial cycle and counteract the feedback mechanisms that amplify financial and business cycle risks are critical Addressing systemic risk through a macroprudential approach continues to evolve We will discuss macroprudential policies next 46 23
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