It seems like a paradox. The world’s financial system is getting stronger, thanks to healthy economic growth, buoyant markets, and low interest rates. Yet despite these favorable conditions, dangers in the form of rising financial vulnerabilities are starting to loom. That is why policymakers should act now to keep those vulnerabilities in check.
As we explain in the latest Global Financial Stability Report, the recovery from the global financial crisis isn’t yet complete. Central bankers rightly maintain easy policies to support growth. But this is breeding complacency and allowing a further build-up of financial excesses. Non-financial borrowers are taking advantage of cheap credit to load up on debt. Investors are buying riskier and less liquid assets. If left unattended, these growing vulnerabilities will continue to mount, threatening to derail the economic recovery when shocks occur.
To be sure, there are reasons for optimism. Low interest rates and rising asset prices are spurring growth. Big, globally systemic banks – so called because the failure of just one of them could shake the financial system – have added $1 trillion to their capital buffers since 2009. Overseas investment into emerging market and low income economies has increased. The global economic upswing is laying hopes for a sustained recovery and allowing central banks to eventually return their monetary policies to normal settings.
So why should policy makers be concerned?
Let’s start with risks in financial markets. Before the crisis, there were $16 trillion in relatively safe, investment-grade bonds yielding more than 4 percent. That has dwindled to just $2 trillion today. There is simply too much money chasing too few high yielding assets. The result is that investors are taking more risks and exposing themselves to bigger losses if markets tumble.
Then there are rising levels of debt in the world’s biggest economies. Borrowing by governments, households and companies (not including banks) in the so-called Group of 20 exceeds $135 trillion, equivalent to about 235 percent of their combined gross domestic product. Despite low interest rates, debt servicing burdens have risen in several economies. And while borrowing has helped the recovery, it has also created new financial risks. For example, chapter two of the Global Financial Stability Report showed growth in household debt relative to GDP is associated with a greater probability of a banking crisis.
In China, the size, complexity, and pace of credit growth points to elevated financial stability risks. Banking sector assets have risen to 310 percent of GDP, nearly three times the emerging-market average and up from 240 percent at the end of 2012. “Shadow” lending, including wealth management products, remains a big risk for smaller banks. The authorities have taken welcome steps to address these risks, but there is still work to do. Broader reform measures are necessary to reduce the economy’s reliance on rapid credit growth.
Low-income countries have also benefited from easy financial conditions by expanding their access to international bond markets. While borrowing has generally been used to fund infrastructure projects, refinance debt, and repay arrears, it has also been accompanied by an underlying deterioration of debt burdens as measured by the debt service ratio.
Overall, investors are growing complacent about potential shocks that could cause turmoil in markets. These include geopolitical risks, a surge in inflation, and a sudden jump in long-term interest rates. How should policymakers respond? There are several steps they can take:
- Major central banks can avoid creating market turbulence by thoroughly explaining their plans to gradually unwind crisis-era policies.
- To discourage riskier lending, financial regulators should deploy so-called “macroprudential” policies, such as limits on loan-to-value ratios for mortgages, for macro critical objectives.
- Emerging-market and low income countries should take advantage of benign external conditions to reduce vulnerabilities and enhance resilience by enhancing underwriting standards, building capital and liquidity buffers, and increasing reserves.
- Supervisors should focus more on the business models of banks to ensure sustainable profitability. We estimate that almost one-third of systemically important banks, with $17 trillion in assets, will struggle to achieve the profitability that’s needed to ensure their resilience to shocks.
- The global regulatory reform agenda should be completed and fully implemented. Global cooperation remains essential.
With the right measures, policy makers can take advantage of these benign times to keep a lid on mounting vulnerabilities and ensure that the global economic expansion remains on track. This is not the time for complacency. The time to act is now. Otherwise, future growth could be at risk.