IMF Special Report: Fund Warns That Financial Risks Are Rising

The European debt crisis, the U.S debt ceiling debacle and a worldwide search by investors for yield at a time of record low interest rates have increased the risks of financial turmoil for the first time since the fall of 2008, the IMF said on Wednesday.

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Risks in the global financial system have risen substantially in recent months, and they aren’t coming only from Europe and the United States, the International Monetary Fund warned on Wednesday.

The European debt crisis, the U.S debt ceiling debacle and a worldwide search by investors for yield at a time of record low interest rates have increased the risks of financial turmoil for the first time since the fall of 2008, in the wake of the collapse of Lehman Brothers Holdings, the fund said in its semiannual Global Financial Stability Report. “This environment of financial and political weakness elevates concerns about default risk and demands a coherent strategy to address contagion and strengthen financial systems,” the report says.

For the first time, the IMF put a number on the cost of the European debt crisis. European banks have seen their holdings of European sovereign debt decline in value by about €200 billion since the debt crisis erupted at the end of 2009, the report states. That estimate values banks’ holdings of Greek, Irish, Portuguese, Belgian, Italian and Spanish debt at the levels implied by recent spreads on those countries’ credit default swaps. If banks’ holdings of the debt of banks in those countries are added to the mix, the decline in value mounts to €300 billion.

The report seems sure to trigger a tense debate between the IMF and European officials during the annual meetings of the IMF and World Bank, which begin in earnest in Washington on Thursday and continue through Sunday. In her first major policy speech last month, the IMF managing director Christine Lagarde called for European banks to increase their capital to cope with the sovereign debt crisis, prompting vigorous denials from European governments, which insist their banks are sound and that European governments won’t go bust. A stress test by the European Banking Authority in July found a capital shortfall of just €2.5 billion among Europe’s 91 leading banks, but that test excluded most of the banks’ sovereign debt holdings.

José Viñals, the IMF’s financial counselor, said the €200 billion loss estimate didn’t imply that European banks needed to raise that much capital, but he insisted that more capital was needed to convince financial markets that the banking system was sound. “The bar that the markets require has risen,” he said. Banking industry complaints that higher capital levels would increase bank costs and reduce the supply of credit to the economy were exaggerated, he said.

“The impact is likely to be very, very moderate,” Viñals said. “If you don’t raise these regulatory standards, you are going to have much worse consequences,” such as reduced wholesale funding for banks that would restrict their ability to provide credit to the economy.

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The report also put a spotlight on sovereign debt holdings among European insurers. Such holdings amount to some €1.3 trillion, or 21 percent of insurers’ assets. For at least one French and one Italian insurer, which the report doesn’t identify, potential losses on European sovereign debt, based on the values implied by CDS spreads, equals tangible common equity. Fund officials noted that insurers can pass off credit losses to policyholders, mitigating concerns about solvency, but they cautioned that the potential impact remains unclear because insurers provide much less disclosure about sovereign risks than banks.

Sovereign and bank CDS spreads are considerably higher in Europe now than they were following the September 2008 Lehman collapse, while U.S. spreads are lower, according to the IMF report. Still, the debt ceiling confrontation and the lack of political consensus on measures to reduce the U.S. deficit in the medium term pose a potential risk to financial stability. The report warned against a false sense of security from the lack of market to Standard & Poor’s one-notch downgrade of the U.S. debt rating last month, cautioning that “a larger or broader downgrade would have far more serious implications.” It also suggested that the U.S. consider removing the debt ceiling requirement because it “can raise near-term concerns over a technical default.”

Viñals encouraged banks and banking supervisors to consider setting aside capital for sovereign risks. The Basel III global accord on banking supervision puts a zero risk weighting on most sovereign debt, which means they don’t have to hold capital against it, but Viñals noted that Basel allows banks to use their own internal risk models and set higher capital requirements. “This is something supervisors may want to look at,” he said. “This is something that all banks should take into consideration, that there is no risk-free rate.”

The stability report also highlighted the risk posed by investors’ search for yield in a low policy-rate environment. Credit spreads on U.S. corporate debt have fallen further and faster than any previous business cycle extending back to the Great Depression even though the current economic recovery is the weakest in that time span. The search for yield has also driven investors into emerging market corporate debt, fueling a boom in offshore bond issuance by borrowers, especially in China. “The risk is that large capital flows may be moving too quickly into this asset class, potentially leading to mispricing and a sudden reversal,” the report says.

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