The greatest risks to financial stability at present are financial markets, trade tensions, and political instability in many countries. This is the IMF’s main conclusion following its Spring Meetings. Should these threats materialise, their negative impact could be amplified, even in a scenario of economic strength, given the existence of significant vulnerabilities such as credit supply, high external debt—especially in many developing economies—and the effects of exchange-rate instability. How can these vulnerabilities be addressed? For the supranational institution, it is a priority that monetary normalisation be prudent and transparent, and that it be combined with structural reforms that increase economies’ potential growth, as well as preventive measures against exchange-rate and financial instability in emerging economies. For the IMF, appropriate regulation and supervision of the financial sector are also essential.
Many of the vulnerabilities mentioned are largely a consequence of the prominent role assumed by monetary policy in overcoming the financial crisis. Extreme traditional measures were adopted, with negative real interest rates, combined with other exceptional measures such as expanding the monetary base through unlimited lending and central bank purchases of financial assets. This financial repression of savers and the improvement in borrowing conditions explain why official estimates of global debt are even higher than those that existed before the crisis. Financial asset prices have risen in an environment of yield-seeking by end investors and artificially low risk aversion. As a result of all this, wholesale funding has grown strongly in recent years and has complemented traditional bank funding. The recent volatility in financial markets in recent months is due to the shift in the stance of monetary policy towards a less expansionary one. However, it represents a real test of the sustainability of non-bank financing.
Excessively low interest rates foster vulnerabilities and are conducive to the build-up of imbalances. In fact, financial conditions that are too loose for too long become a threat to financial stability and, therefore, to preserving growth. It is reasonable to call, as the IMF does, for structural reforms to take over from monetary policy as the engine of growth. This shift in emphasis towards supply-side measures over demand-side measures is now a mantra repeated by both authorities and experts, without any real guarantees that it can be delivered. This is why preserving a stable flow of financing under the expected and almost unavoidable monetary normalisation is so relevant.
Banks are key to maintaining the flow of credit to the economy. And they have strengthened since the financial crisis. They have ceased to be vulnerable and to pose a threat to growth, and have become one of its main strengths. The IMF acknowledges this in its Financial Stability Report. However, the inertia of the past crisis leads it to recommend that authorities do not let their guard down. The institution recommends maintaining strict regulation and very close supervision of the sector, while also acknowledging that this implies a constraint on risk-taking on banks’ balance sheets. It is contradictory to ask banks to finance entrepreneurship and growth while limiting their ability to do so. It should be recalled that more than 70% of financing for European SMEs and households is provided by banks.
The Bank of Spain also warns in its latest Financial Stability Report of the risk of an abrupt correction in financial asset prices in response to changes in monetary policy expectations. It considers that the main challenge for Spanish banks is profitability in a low interest rate environment. The underlying message is not very different from the IMF’s: it highlights the vulnerability of the non-bank financial sector and the management of monetary policy as one of the risk factors for financial stability. Understanding the risks and vulnerabilities of the current situation is undoubtedly a necessary first step in addressing them.
